Right of first refusal is not a restriction on the freedom to transfer under section 111A

Introduction

1. the concept of free transferability of shares in a public company under section 111A of the Companies Act, 1956 is perhaps most significant unresolved controversy in Indian corporate law contemporaneously. Once the question was raised whether the right of first refusal (pre-emptive rights) at the meeting and the joint-venture agreement constitutes a restriction on the free transferability of the shares. Right of first refusal is a commonly used device in the corporate world. Under the right of first refusal, a party planning company second exit, is obliged to give the first party (Facilitator) the chance to buy the shares before shares can be sold to a third party who is a party. This is basically to prevent easy entry of third parties into the company by buying shares of the party wishing to exit the company. Many unlisted companies, as well as some of those listed, have such agreements with major shareholders.

Right of first refusal if they violate section 111A

2. in the recent ruling by a Division Bench of Bombay High Court in the case of Messer Holdings Ltd. v. Shyam Madanmohan Ruia decided 1 September 2010 and reported in [2010] 98325 CLA has established such a restriction on the transfer of share with the “right of first refusal ‘ clause of the agreement (pre-emtive) does not violate the provisions of section 111. In paragraph 55, Khanwilkar, j., stated as follows:

‘ [T] he expression ‘ freely transferable “in section 111A doesn’t mean that the shareholder can not enter the consensual agreement/contract with a third party (proposed assignee) in relation to its specific actions. If the company wants to prohibit even that right of shareholders, it may be necessary to provide for a condition expressed in the articles of association or in the Act and rules, possibly in that account. The statutory provision is obtained in the form of section 111A of the Companies Act does not specifically restrict or remove the right of shareholders to conclude the contract/agreement by mutual consent in respect of shares held by him.

This is a reversal of an earlier court judgment only in the case of Western Maharashtra Development Corporation v. 131 (Bom.) Bajaj Auto Ltd. [2010] CLA decided on February 15, 2010, holding that section 111A mandates that there can be no restriction on the transferability of shares in a public company. As a result, was held a concession agreement a right of first refusal in respect of such actions blatantly illegal. Justice D Y Colucci in the case said said the following:

‘ The principle of the free transferability must be given a wide size to meet the object of the law. Impose restrictions on the principle of free transferability, is a legislative function, simply because the premise of free transferability has been enunciated as a matter of legislative policy, when Parliament introduced section 111A. This is a precept of the Association that governs the discourse on the transferability of the shares. The word “transferable” is the widest possible import and Parliament by using the expression “freely transferable”, has strengthened the legislative intent to allow transfers of shares of public companies in a free domain. The effect of a pre-emption clause is to impose a restriction on the free transferability of shares by transfer rules laid down in section 111A a pre-emptive right created by agreement between the parties. This is unacceptable. ‘

This ruling in the case of Western Maharashtra (supra) had put India in a fix, with many companies facing the prospect of having to rework their sharing agreements with foreign investors. However, the recent decision of Messer Holdings Ltd. (supra) came as a great relief for companies and private equity funds that invest in these companies. The ruling also goes on to suggest that it is not mandatory for the company to be part of such an arrangement to share transfer restrictions and does not need to integrate the transfer quota restrictions in the articles of Association of the company.

111A section does not apply to a private company

3. restriction on the transferability of the shares of a private company must be contrasted with cases of public companies where the law provides for free transferability. Free transferability of shares is the norm in the case of shares in a public company. As regards private companies are concerned, the articles of Association restrict shareholders ‘ rights to transfer the shares and ban the invitation to the public to subscribe for shares or debentures of the company.