Course correction on free transferability of shares

Two recent judgments – Messer Holdings Limited v Shyam Madanmohan Ruia and Western Maharashtra Development Corporation Limited v Bajaj Auto Limited – have sought to bring clarity, albeit in their own respective ways, on transferability of shares. They focus on the right of the shareholder to deal with shares in a public company and their ability to enter into right of first offer and first refusal agreements.

While the Western Maharashtra judgment delivered in February by Bombay High Court sort of pulverized the world of M&A deals, the judgment delivered in Messer Holdings on 1 September by the same court has, to a great extent, provided the necessary course correction.

Unexpected move

The Western Maharashtra judgment threw up more questions than answers and caused confusion among stakeholders. In it the judge held that the right of pre-emption, i.e. the right of first offer and first refusal, for shareholders of a public company creates a restriction on free transferability of shares of a public company. This violates section 111A of the Companies Act, 1956, which mandates that the shares of a public company are to be freely transferable. Accordingly the judgment held “the effect of a clause of pre-emption is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in section 111A to a pre-emptive right created by the agreement between the parties. This is impermissible.”

Western Maharashtra struck at the very core of joint venture arrangements and M&A transactions involving public companies, as pre-emptive agreements struck between the shareholders are integral to them. Such deals are designed to give an opportunity to the non-exiting shareholders to buy out the exiting shareholders’ stake or accept a new shareholder. Without it, shareholders could be tied to a new and undesired partner with whom they would have never initiated a commercial venture.

The Western Maharashtra judgment created anxieties for investors and shareholders in public companies and there was a rush to put in place alternate structures that would recognize the validity and effectiveness of pre-emptive provisions. Wherever possible, attempts were made to convert public companies into private companies, as pre-emptive rights in the case of shareholders of a private company are statutorily recognized. However, here too there were problems as the definition of a public company under section 3(1)(iv) of the Companies Act suggests a private company that is a subsidiary of a public company is deemed to be a public company. However, some comfort was drawn from the January 2006 decision of the company law board in Hillcrest Realty v Hotel Queen that held the basic characteristics (which includes transfer restrictions) of a private company do not get altered just because it is subsidiary of a public company.

Putting matters in perspective

The uncertainty created by the Western Maharashtra judgment has recently been addressed in the Messer Holdings judgment. In it Bombay High Court held: “The concept of free transferability of shares of a public company is not affected in any manner if the shareholder expresses his willingness to sell the shares held by him to another party with right of first purchase (pre-emption) … The shareholder has freedom to transfer his shares on terms defined by him, such as right of first refusal, provided the terms are consistent with other regulations.” The court also held that: “The fact that shares of a public company can be subscribed and there is no prohibition for invitation to the public to subscribe to shares, unlike in the case of private company, does not whittle down the right of the shareholder of a public company to arrive at consensual agreement which is otherwise in conformity with the extant regulations and the governing laws.”

The Messer Holdings judgment upholds the legal enforceability of pre-emptive provisions in the context of a public company and also clarifies the scope of section 111A of the act. It held that the section is not meant to curtail the rights of the shareholder to enter into a consensual arrangement with the purchaser of their shares. It also clarified that the term “free transferability” is used in the context of the board of directors being mandated to register the transfer of specified shares in the name of the transferee, unless there is sufficient cause for not doing so. As such this section cannot be used to remove the right of the shareholder to enter into consensual arrangements and agreements with the purchaser of their specific shares.

Messer Holdings relied also on the judgment in MS Madhusoodhanan v Kerala Kaumudi, where the Supreme Court held that an agreement on transfer of shares between shareholders can be enforced like any other agreement. However, although the Messer Holdings judgment is applicable in Maharashtra, in the absence of a final and concluding judgment by the Supreme Court, its applicability in any other state is subject to orders passed by the high court of that state.

Amit Kumar is a partner, Arvind Sharma is principal associate and Ambarish Mohanty is an associate at Amarchand Mangaldas & Suresh A Shroff Co. The views expressed are those of the authors and do not reflect the official policy or position of Amarchand Mangaldas.