Pre-emptive clauses in public companies void

By Vivek Vashi, Bharucha & Partners
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In Western Maharashtra Development Corporation Ltd v Bajaj Auto Ltd, Bombay High Court considered whether a pre-emptive clause incorporated in the articles of association of a public company would be valid and enforceable.

Vivek Vashi Bharucha & Partners
Vivek Vashi
Bharucha & Partners

On 2 October 1974, Western Maharashtra Development Corporation (WMDCL) and Bajaj Auto entered into a protocol agreement in order to incorporate Maharashtra Scooters (MSL) under the Companies Act, 1956. The agreement stated that WMDCL would gain experience from Bajaj on the manufacture of two-wheeled scooters in order to install a plant and machinery for a scooter project. MSL is a public company and its shares are listed on the Bombay Stock Exchange and the National Stock Exchange.

The agreement was structured to ensure that the parties would, between them, control at least 51% of the equity capital of MSL. The agreement also stated that neither party was allowed to alter the structure of MSL, whether in terms of the number of shares or the rights, privileges, restrictions or qualifications of any class of shares.

In addition, no further issue of capital could be made without prior consent of the other party. Finally, the agreement stipulated that neither party was entitled to increase or reduce, directly or indirectly, its proportion of the shareholding in the equity share capital of MSL, nor was either party allowed to deal with its shareholding so as to lose absolute control over their voting rights.

The dispute related to clause 7 of the agreement, which stipulated a right of pre-emption in the event of a transfer. The right of pre-emption was expressly incorporated in MSL’s articles of association. The clause further ensured that if the parties could not reach an agreement on the rate at which the shares were to be purchased, the rate would be decided through an arbitration process.

On 9 April 2003, WMDCL offered to sell its shares in MSL to Bajaj – an offer which Bajaj accepted on 3 May 2003. However, Bajaj disagreed with the price payable for that purchase so the issue was referred to arbitration to determine the value of the shares. WMDCL argued that the agreement was void since the right of pre-emption violated section 111A read with section 9 of the Companies Act.

After referring to the decision of the Supreme Court in MS Madhusoodhanan v Kerala Kamudi Pvt Ltd and VB Rangaraj v VB Gopalkrshnan, the arbitrator rejected the challenge and held that the agreement was valid.

Section 111A of the Companies Act which applies only to a public company states that subject to the provisions of the section, “the shares or debentures and any interest therein of a company shall be freely transferable”.

Section 9 of the act maintains that: “save as otherwise expressly provided in the Act, the provisions of the Act shall have effect notwithstanding anything to the contrary contained in the Memorandum or Articles of a Company or in any agreement executed by it, or in any resolution passed by the Company in general meeting or by its Board of Directors”.

Bajaj contended before Bombay High Court that MS Madhusoodhanan had explained to VB Rangaraj that there was nothing in law that prevented one shareholder from agreeing with another shareholder to certain restrictions in respect of the transfer of shares. It was also contended that section 111A did not impinge upon the right of a shareholder to agree with another to restrict transferability and that section 111A would apply only where there was a general restriction.

The high court rejected Bajaj’s contention and held that section 111A was mandatory and that the right of pre-emption, even if contained in the articles of association of a public company, was void.

The court observed that the purpose of the clause was to preclude a sale or purchase of the shares of a public company by members of the public in the event that the offer for those shares was accepted by the other party. The effect of the clause was thus to impose a restriction on the free transferability of the shares of a public company by subjecting section 111A to an agreement between the parties which was impermissible.

The court also observed that in view of the provisions of section 9 of the act, a provision contained in the memorandum, articles, agreement or resolution would be void if it contradicted the provisions of the act.

Consequently, a right of first refusal, tag, drag along, put or call options in shareholder agreements and joint venture agreements would have the same consequences as a right of pre-emption and would be unenforceable even if incorporated in the articles of association of a public company. There may be an exception in relation to private limited companies, but this would be the case only where the restrictions are embodied in the articles of association.

Vivek Vashi is the mainstay of the litigation department at Bharucha & Partners.

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