CLB upholds free transferability of shares in a public company

In an order dated May 14, 2010 (“CLB Order”), the Company Law Board (“CLB”) has upheld the concept of free transferability of shares in a public company. The order came while dismissing an application filed by Mr. Kavasmaneck and the Rebello Group against Mr. Keki Gharda, the chairman of Gharda Chemicals Limited (“Gharda Chemicals”).

An application was filed for restraining Mr. Keki Gharda from transferring his 65% shareholding in Gharda Chemicals to a third party. The applicant based its claim on the exercise of the ‘right of first refusal’ (“ROFR”) incorporated in the articles of association of Gharda Chemicals that mandated the exiting promoter to offer his stake to the other shareholders, at a fair value, before transferring it to any third party. CLB while dismissing the petition made the following observation[1]:

“Gharda Chemicals was a public company and its shares were freely transferable.... The petition (filed by Mr Kavasmaneck and the Rebello Group) had miserably failed and is liable to be dismissed.”

Earlier this year, in the matter of Western Maharashtra Development Corporation Ltd. v. Bajaj Auto Ltd[2], the Bombay High Court had also held that any restriction on the ability of a shareholder to transfer his shares is in clear violation of the law laid down under section 111A of the Companies Act, 1956 (“Act”).

Background

Restrictive covenants, such as ROFR, call options and put options, are routinely negotiated by parties in shareholders agreement. Such restrictions are then incorporated in articles of association of the company. Several judicial pronouncements, in past, have held various forms of restrictive covenants as violative of the mandate set out in Section 111A.

Transferability of shares of a public company is regulated under Section 111A of the Companies Act. Section 111A (2) provides that “the shares or debentures and any interest therein of a (public) company shall be freely transferable.”

In the case of Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd[3], Delhi High Court had held that in view of Section 111A of the Act, even if transfer restriction like ROFR have been included in the articles of association of a public company, a shareholder cannot be restricted from transferring his shares. Further, section 9 of the Act, renders those provisions of the articles of association void, which are contrary to any provision of the Act.

The verdict in Western Maharashtra Case

Under a shareholders agreement entered into between the Western Maharashtra Development Corporation Limited and Bajaj Auto Limited, if either party intended to part with its shareholding in the Maharashtra Scooters Limited, then such party was required to give the other party the first option to purchase such shares at a price mutually agreed or decided by an arbitrator. These rights were adequately captured in the articles of association of the Company.

The question before the court was whether the pre-emptive rights granted under the said agreement and also incorporated in the articles of association of the company were valid in light of Section 111A read along with Section 9 of the Act.

While allowing the appeal, the Bombay High Court, made the following observations:

1. The incorporation of a company in the public, as distinguished from the private realm, leads to specific consequences and the imposition of obligations envisaged in law. The word “transferable” is of the widest possible import and by using the expression “freely transferable” under section 111A of the Act, the legislature intends to allow transfers of shares of public companies in a free and efficient domain.

2. The effect of the clause of pre-emption under the Agreement is to impose a restriction on the free transferability of the shares, which is in clear violation of the norms laid down under Section 111A of the Act. This is impermissible by virtue of Section 9 of the Act that gives overriding force and effect to the provisions of the Act. Court held that anything contrary to the provisions of the Act even if contained in the memorandum or articles of association of a company, or agreed in any agreement executed by it, or any matter resolved in general meeting or the meeting of its board of directors, would be invalid and hence unenforceable.

Conclusion

The judicial pronouncements are increasingly making it clear that public companies ought to keep their shares freely transferable. It may still be possible to argue that put options are still valid as they do not affect the free transferability of the shares, however, given the judicial trend the position is far from clear. Other forms of restrictions on transferability of the shares in public companies seem unenforceable.

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[1] Maherally Almas, CLB dismisses plea against promoter’s stake-sale plan in Gharda Chemicals, The Economic Times, May 15, 2010.

[2] [2010] 154 Comp Cas 593 (Bom)

[3] [2006] 131 Comp Cas 42 (Delhi)