INTRODUCTION
Shareholder Agreement (“SHA”) is a contract between shareholders of the company; it delineates the rights, duties and obligations of all the shareholders. Indian law does not mandate shareholders’ agreements but SHA can be considered as one of the most important agreements between the shareholders.
Section 2(68)(i)1 of the Companies Act, 2013 (“Act”) explicitly states that a private company is a company which restricts transferability of its shares by adding clauses in its Article of Association. While the shares of a public listed company are known to be freely transferable, such rights do not exist with regard to the shares of a private limited company. However, the law is ambiguous regarding transfer restrictions in public company. The proviso to Section 58(2)2 is unclearly worded and fails to clarify whether any contractual restrictions on the transferability of shares in public companies are legally valid.
Section 58(2) of the Act states:
“Section 58 – Refusal of registration and appeal against refusal
(2) Without prejudice to sub-section (1), the securities or other interest of any member in a public company shall be freely transferable:
Provided that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract.”
The proviso to Section 58(2) creates confusion as to whether any contractual transfer restrictions can exist between two or more shareholders of a public company. Therefore, reference is often made to Messer Holdings Limited v. Shyam Madanmohan Ruia3, wherein the Bombay High Court held that, “So long as the member agrees to pay such prevailing market price and abides by other stipulations in the Act, Rules and articles of association, there can be no violation. For the sake of free transferability, both the seller and purchaser must agree to the terms of sale“. This ruling was upheld in the case of Bajaj Auto Limited v. Western Maharashtra Development Corporation Limited4.
Moreover, the Securities and Exchange Board of India (“SEBI”) has also issued a notification5, prohibiting any person from entering into any contract with respect to sale or purchase of securities except “contracts for pre-emption including right of first refusal, or tag-along rights or drag-along rights contained in shareholders agreements or articles of association of companies or other body corporate;”
Two main conclusions can be drawn from above the provisions. First, there is no explicit prohibition in the Act; however, due to the ambiguous wording of the proviso to Section 58(2), there is arguably no clear affirmation regarding the enforceability of restrictions on transfer of shares. Consequently, it has been left on the courts to determine the validity. Secondly, judicial pronouncements have now made it fairly clear that these rights, when forming part of contractual agreement between shareholders are generally enforceable.
PURPOSE
Transfer restrictions are imposed on the share transfer in a shareholders agreement as each shareholder wants to ensure that the other shareholders continue to be invested in the company and are willing to contribute value in the company. Transfer restrictions are also evidence of each shareholders’ commitment to the partnership. The shareholders want control over the company and ultimately the profit so at any given time they would want to know with whom they are sharing control and profit. Moreover, shareholders in a comparatively smaller company need each other’s assistance and expertise to manage the company so it can be said that a shareholder is not interchangeable with any other person which makes transfer restrictions necessary.
There are various types of transfer restriction provisions:
Pre-emptive rights
Pre-emption rights ensure that no outsider can join the company without first giving existing owners the option to replace departing stockholders. In other words, shares cannot be transferred to a prospective buyer unless they are first offered to existing owners (or a specific set of shareholders) at the same price. The capacity to accept a preemptive offer will largely depend on whether the shareholders can pay the suggested or agreed-upon price for those shares.
Lock-in restrictions/Non disposal undertaking
Lock-in restrictions include a complete contractual embargo on the transfer of securities for a specific period of time or transfer is restricted to a certain specific set of individuals or groups. Lock-in clauses have been referred to as the “commitment principle”, which states that promoters must make credible promises in order for long-term investors to stay engaged. It is common in private equity; venture capital or M&A transactions to provide for lock-in restrictions on the shares held by the promoters of the company from transferring their shareholding in the company to protect the interests of other shareholders/ investors.
ROFO (Right of First Offer)
This is an agreement between the existing shareholders whereby the shareholder wishing to sell, shall first offer the shares to other shareholders (the holder of the right of first offer). If the holder of the right does not exercise its right to purchase the shares, then the selling shareholder is free to sell it to a third party on the same or better terms. This is a type of pre-emptive right.
ROFR (Right of First Refusal)
This is an agreement between existing shareholders in which the shareholder who wishes to sell his shares to a third party on the basis of an offer received must first offer the shares to other shareholders. A ROFR gives existing shareholders (the holder of the right of first refusal) the right to match any third party offer that the other shareholder has received. The shareholder may sell to a third party based on the offer made by that third party if the right of first refusal holder does not purchase the shares.
Drag-Along Right
A drag along right is an exclusive advantage granted to a majority shareholder where the majority shareholder can use drag along right to force minority shareholders to sell their shares alongside the majority shareholder at the same price and on the same commercial terms. This right guarantees the majority shareholder flexibility and liquidity while preventing minority shareholders from blocking profitable sales of the company to investors who want complete control. The minority shareholder’s rights are protected to the extent that the drag along provisions guarantee that the minority shareholder’s shares are sold on the same commercial terms and rates as those of the majority shareholder.
It is crucial to take into account that the majority shareholders would not be able to use their drag-along rights without restriction. These rights are subject to the conditions outlined in the AOA and are frequently only utilised in relation to mergers and acquisitions or complete sale of business.
Tag-Along Right
When a shareholder wants to sell their shares to a third party, the other shareholders have the option to sell their shares alongside the selling shareholders. This is known as a tag-along right.6 In common parlance we can say that, tag along rights allow minority shareholders to join a sale initiated by a majority shareholder, on the same terms.
Assignability of Rights
The rights available are heavily dependent on the shareholders’ shareholding percentage in the company, so along with flexibility to transfer their stake, shareholders also want full flexibility to assign their rights along with the transfer of the shares rights available to the
Call and Put Options
A call option entitles its holder to purchase specific shares from other shareholders at a predetermined price or pricing mechanism at a later time or upon the occurrence of an event; whereas a put option gives its holder the right to sell certain shares to other shareholders. In order to prevent uncontrolled transfers to third parties that would upset the company’s ownership structure, these clauses function as internal transfer limitations, controlling who may purchase or sell shares, under what circumstances and at what price.
CONCLUSION
Transfer restrictions play a crucial role in modern shareholder agreements as they help to prevent disputes, align investor interests and contribute to the long-term stability of the business. They not only facilitate transactions during possible sales, but they also inform investors about their rights and any precautions accessible to them. Courts have increasingly acknowledged the legitimacy of such contractual provisions and has emphasised that shareholders’ autonomy should be respected so long as transfer restrictions are also embedded in the Article of Association of the company and remain consistent with statutory and regulatory frameworks.
Notes:
1 The Companies Act, 2013 (Act No. 18 of 2013) s. 2(68).
2 The Companies Act, 2013 (Act No. 18 of 2013) s. 58.
3 (2010) 159 Comp Cas 29 (Bom).
4 2015 SCC OnLine Bom 2111.
5 SEBI Notification bearing reference number No. LAD-NRO/GN/2013-14/26/6667, dated October 3, 2013
6 IBA Guide on Shareholders’ Agreements
Author Bio
