In almost every private equity or joint venture or merger and acquisition (M&A) transaction, the client pops the question: Are the contractually agreed restrictions on transfer of shares enforceable under Indian laws?
Unfortunately, the judicial trend on this issue does not lend a simple answer to the question. Here, we try to give you a flavour of the issues involved and the judicial trend. While enforceability in the context of transfer restrictions in shareholders’ agreements clearly has two aspects—one of enforceability against the company under the Companies Act, 1956, (the Act) and the other of enforceability against the counterparty shareholder(s) based on the agreed contractual terms—the Indian courts have not had the opportunity to consider such a distinction.
It is important to first take note of some of the key provisions of the Companies Act. Section 3 (1) (iii) of the Act requires a private company to stipulate restrictions on the transfer of shares in its articles of association. Section 111A of the Act essentially states that shares of a public company (both listed and unlisted) are freely transferable. Section 9 of the Act makes void those provisions of the charter documents or any agreements of the company which are contrary to the provisions of the Act. Hence, the status of the company, that is, private or public, plays an important role when dealing with the issue on transfer restrictions.
As far as private companies are concerned, restrictions on transfer of shares are fully enforceable, given that the Act itself mandates such restrictions. The caution to be exercised is that all such restrictions, including those agreed under shareholder, investment or joint venture agreements, should be incorporated in the articles of association of the company.
In the very celebrated case of V.B. Rangaraj vs V.B. Gopalakrishnan, in 1991, the Supreme Court had refused to enforce restrictions on transfer of shares of a private company agreed inter se its shareholders, on the grounds that such private arrangements were not incorporated in the articles of association of the private company.
The controversies arise in relation to restrictions on transfer of shares of an Indian public company (whether listed or unlisted). Section 111A of the Act expressly states that the shares of a public company are freely transferable. Under subclause (3) of Section 111A of the Act, a transfer would be capable of being reversed if the transfer is in contravention of any laws.
In 2002, the Andhra Pradesh high court, while dealing with a matter that involved enforceability of privately- agreed restrictions on transfer of shares of a public company, gave a sweeping interpretation to this exception and went on to effectively hold that a violation of law also included violation of a contractual obligation. It held that if a public company is bound by certain pre-emptive contractual obligations on the basis of which it refuses to register the transfer, then such refusal would be treated as a valid ground for refusal under Section 111A. In other words, privately-agreed arrangements were given the same status as “law” and a breach by a party of such privately-agreed arrangements was treated as “a violation of law”.
The Bombay high court has, in the case of IL&FS Trust Co. Ltd & Anr vs Birla Perucchini Ltd (2004), held that the provisions in an agreement between the shareholders of a company cannot be enforceable against the company in question (even if the company is a party to such agreement) unless the same provisions have been reflected in the articles of association of the company.
These cases (among others) had essentially set the trend of incorporating private arrangements relating to transfer of shares of a public company in the articles of association of such public companies. But this is not where the story ends.
In 2005, the Delhi high court made a converse observation in the case of Pushpa Katoch vs Manu Maharani Hotels Ltd. The court observed that even if there is a restriction in the articles of association of a public company,?it would have been beyond the provisions of the Act, as a company cannot provide in the articles any matter which contravenes the provisions of the Act.
It even observed that if an aggrieved party wanted to have an arrangement (to restrict transfer), they should have been wise enough to incorporate a private company and further, to provide such a clause in the articles of association. What is pertinent to note here is that these observations were in the form of the obiter dictum of the case and not the ratio decidendi of the case. An obiter means remarks of a judge which are not necessary to reaching a decision, but are made as comments, illustrations or thoughts as opposed to a ratio of a judgement, which is the binding reasoning for the decision.
Given all the aforesaid considerations, the incorporation of all restrictions on transfer of shares in the articles of association, whether of a public or a private company, has become common practice. However, the issue in relation to a public company remains untested by the Supreme Court of India. The other pertinent issue which does not seem to have been dealt with is the issue of “contractual” enforceability of transfer restrictions agreed between parties pursuant to a valid contract. From a legal perspective, this distinction is important. Even if enforceability of transfer restrictions incorporated in the articles of association against a public company under the Act becomes doubtful on account of Section 111A read with Section 9 of the Act, in law, what prevents one shareholder from enforcing a mutually agreed transfer restriction under a valid contract against the other? This would effectively be a remedy pursued for a breach or potential breach of contract rather than a remedy under the Act. This distinction, though an important one, has not really been dealt with by the courts and, unfortunately, as the position stands today, in the wider context of M&A and private equity transactions, the enforceability of restrictions on transfer of shares in so far as public companies are concerned is untested, even where such restrictions have been contractually accepted by the concerned shareholder and have been incorporated into the articles of association of the company concerned.
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This column is contributed by AZB & Partners, Advocates & Solicitors.