Restriction on transfer of shares

Will the Bom HC’s latest ruling end the debate?

-Sidharth Sharma*1

One of the longstanding questions of Indian corporate law awaiting a clear

answer is: whether there could be restriction on transfer of shares of a public
company? The debate mainly revolves around the language of Section 111A
of the Companies Act, 1956 which states – “the shares or debentures and
interest therein of a [public] company shall be “freely transferable”. This
provision suggests that there can be no restriction on transfer of shares of a
public company and any contractual arrangement imposing such restrictions
shall be void and unenforceable. Despite this provision, restriction on
transfer of shares is more a norm than exception in commercial transactions,
and their enforceability had not been an issue until a judgment of the
Bombay High Court held otherwise.

In February this year, a single judge bench of the Bombay High Court, in the
case of Western Maharashtra Development Corporation Ltd. vs. Bajaj Auto
Ltd., (“Western Maharashtra case”) had held that in view of Section 111A of
the Companies Act, any contractual arrangement which restricts the free
transferability of shares of public companies is void and unenforceable. In
2005, a Delhi High Court’s judgment in the case of Smt. Pushpa Katoch vs.
Manu Maharani Hotels Ltd. had taken a similar view.

Meanwhile, a two judge Division Bench of the Bombay High Court in another
case – Messer Holdings Limited vs. Shyam Madanmohan Ruia and Ors. – has
overruled the decision in Western Maharashtra case. Disagreeing with the
earlier decision, the division bench, in its judgment of September 1, 2010
(“the Division Bench Judgment”), has held that Section 111A of the
Companies Act does not prohibit or restrict rights of shareholders to enter
into consensual agreements/restrictive covenants in relation to their shares
either inter se among themselves or with a third party.

While this decision may not be the last word on the issue and an appeal to
the Supreme Court cannot be ruled out, the Division Bench Judgment has
surely come as a relief to the corporate sector after the cloud of uncertainty
the decision in Western Maharashtra case had left over several Joint Venture
Agreements, where restrictive covenants formed an integral part of
contractual relationship. But will the Division Bench Judgment meet the test

1
*In-house Counsel, Tata Group, Mumbai. Views are personal.
of ultimate legal analysis assuming the matter lands up – and most likely it
will – in the Supreme Court?

Prior to the two extreme decisions – Western Maharashtra prohibiting

restriction on transfers and the Division Bench Judgment allowing them – the
commonly held view was that contractual arrangement imposing restriction
on transfer of shares are valid so long as the same are incorporated into the
Articles of Association – the internal charter document – of the company
whose shares are in question. This view was based on the decision of the
Supreme Court in case of V.B.Rangaraj v/s V.B.Gopal Krishnan & ors.
(“Rangaraj Judgment”). The Apex Court had held that if shareholders’ right to
transfer their shares is to be restricted by way of a contractual arrangement
then such restrictions must be incorporated in the Articles of Association
without which the restrictions will neither bind the shareholders nor the
company. Although on facts the Rangaraj Judgment dealt with restriction on
transfer of shares of a private limited company, as a corollary, a view gained
acceptance that if restrictions are incorporated into the Articles, they could
be enforceable even in case of public limited companies. However, the legal
robustness of this approach remained doubtful and enforceability of the
agreements hinged largely on good faith commitment of the parties.

Rangaraj, which dealt with the case of a private company, was not – and
could not be – an authority on the point of free transferability of shares in
case of public companies. Section 111A itself excludes from its applicability
private companies, so in the Rangaraj case the Supreme Court never had an
occasion to interpret and decide the scope and mandate of Section 111A.
Private companies by their very definition are characterized by restriction on
transfer of shares. So, whether law permits restriction on transfer of shares
in case of private companies was never an issue in Rangaraj. Rangaraj
however did decide a nuanced issue of enforceability of those restrictions
against the shareholders and the company. The Supreme Court held that a
shareholder’s right to transfer shares cannot be restricted (even in case of
private companies) by an agreement which is contrary to the Articles of
Association of that company. For the restriction (which is otherwise valid in
law) to be enforceable and binding on the company and the shareholders, it
must be in conformity with the Articles. In other words, what Rangaraj
essentially held was that enforceability of an agreement imposing restriction
on transfer of shares is derived from the Articles of Association and not from
the agreement. A view, therefore, could be taken that according to Rangaraj,
while there is no prohibition in law on restrictions on transfer of shares, such
restrictions can only be operationalized or routed through Articles and only
then can they be binding on the shareholders or the company.

The decision in Western Maharashtra case, on the other hand, dealt with the
very permissibility in law of restriction on transfer of shares of a public
limited company. The decision of Justice Chandrachud was entirely based on
the provision under Section 111A. In his opinion, restrictions on the
transferability of shares which are contemplated by the definition of a private
company under Section 3(1)(iii) of the Act, are expressly made impermissible
in the case of a public company by the provisions of Section 111A. And if this
is the case, a private agreement between the shareholders imposing
restrictions on free transferability shall be against the mandate of Section
111A and hence, shall be void and unenforceable. The fact that company is
also a party to the agreement and the restrictive provisions of the
agreement are incorporated into the Articles will be immaterial and cannot
change the legal position. In any event, as per Section 9 of the Act, the
provisions of the Act will override anything to the contrary contained in the
charter documents or any agreement executed by the company.

The Division Bench Judgment, overruling Western Maharashtra, is based on a

two pronged reasoning – (i) the scope of Section 111A; and (ii) right to
property of a shareholder in his shares (a moveable property) and his
freedom of contract.

As regards the first limb of the argument, the Division Bench has held that
“Section 111A is a provision mandating the Board of Directors of the
company to transfer shares in the name of the transferee, subject to the
stipulations in Section 111A of the Act. The expression “freely transferable”
therein is in the context of the mandate against the Board of Directors to
register the transfer of specified shares of the members in the name of the
transferee, unless there is sufficient cause for not doing so. The said
provision cannot be construed to mean that it also intends to take away the
right of the shareholder to enter into consensual arrangement/agreement
with the purchaser of their specific shares.”

The Division Bench Judgment has corroborated its conclusion with a second
line of reasoning – “the legislature does not generally interfere with freedom
of contract except when warranted by public policy, and the legislative
intent is expressly made manifest…..while enacting a Statute, Parliament
cannot be presumed to have taken away a right in property and deprivation
of legal right existing in favour of a person,” which is not the case with the
provision under Section 111A.

So far so good. The Division Bench Judgment however falters – and even
contradicts itself – in its fine print and certain other conclusions that it lays
down. These are some of the questions the Judgment raises:

1. According to the Judgment, Section 111A is a mandate to the Board of

Directors of the company to transfer shares in the name of the
transferee; it is not a prohibition against the shareholders to enter into
consensual agreement and the same will be valid and enforceable.
This conclusion appears contradictory. Enforceability of agreements
providing for restriction on transfer of shares will have no meaning if
the same is not recognized by the company. Consider for instance a
situation where a party to a joint venture agreement transfers his
shares to a third party in breach of the transfer restrictions in that
agreement. The third party transferee then seeks registration of the
shares in his name. The question arises: should the company refuse
registration to that third party? If the answer is that the company
should register such transfer, then enforceability of transfer restriction
will have no meaning. If, however, the company refuses transfer on the
ground that it is in breach of a contractual arrangement then wouldn’t
that be against Section 111A which, as per the Division Bench
Judgment’s own finding, is a mandate to the Board of Directors of the
company to transfer shares in the name of the transferee except on
very limited grounds specified therein. Can the non-defaulting party in
a joint venture contract seek against the company, an injunction on
registration of transfer of shares which is in breach of transfer
restrictions under the joint venture contract? Should such injunction be
granted on the basis of a private agreement to which company is not a
party? Can it be said that the legislative mandate to the Board under
Section 111A is subject to private contract of the shareholders?

2. The Judgment holds that “consensual agreements between particular

shareholders relating to their shares can be enforced like any other
agreements. It is not required to be embodied in the Articles of
Association.” The Judgment also holds that “the company does not
have to be a party to the agreement” either. The correctness of this
conclusion of the Division Bench Judgment appears doubtful. If
according to the Supreme Court’s ruling in the Rangaraj case, transfer
restrictions in case of private companies are required to be
 incorporated into the Articles, can it be said that the same is not
necessary in case of public companies? The point is that when we say
“enforceability” of transfer restrictions, it cannot operate in isolation,
independent of the company and its Articles. Enforceability of transfer
restrictions – a right of first refusal, for instance – can only have real
meaning if the same is also recognized by the company and its
Articles. If that is not so, the transfer restrictions will be against the
Articles which is, as per the Division Bench Judgment, is not
permissible. (The Judgment in paragraph 51 holds that the right to
enter into consensual arrangement must prevail so long as it is in
conformity with the terms of Articles of Association and other
provisions of the Act and the Rules).

3. Another question that could be raised is whether in law the Division

Bench could validly disagree with the Supreme Court’s ruling in
Rangaraj – that for transfer restrictions to be binding and enforceable,
they must be incorporated into the Articles – and hold otherwise. But
this is merely a technical issue. The real issue is whether the
conclusion is right. In support of its conclusion, which is at variance
with Rangaraj judgment, the Division Bench has heavily relied upon
another Supreme Court’s judgment in the case of M.S.
Madhusoodhanan and Anr. vs. Kerala Kaumudi Pvt. Ltd. The Division
Bench Judgment relies on this decision (although it was in the context
of a private company and because of which it was not relied upon by
Justice Chandrachud in the Western Maharashtra case) because
Supreme Court in this case had considered the general question
regarding the right of shareholders – not limited to shareholders of a
private company – to enter into such consensual arrangement which is
not in violation of Articles of Association or the provisions of Act or
Rule. However, what is notable is that the decision of the Supreme
Court in M.S. Madhusoodhanan case never disagreed with the earlier
decision in Rangaraj. The Supreme Court in M.S. Madhusoodhanan
case did not apply Rangaraj not because it disagreed with its reasoning
but because the Court found Rangaraj inapplicable to the facts of M.S.
Madhusoodhanan case which was dealing with no such restriction (as
in Rangaraj) on the transferability of shares. This indicates that the
principle laid down in Rangaraj – that for transfer restrictions to be
binding and enforceable, they must be incorporated into the Articles –
stands. Could then the Division Bench Judgment hold otherwise?
4. The Division Bench Judgment holds that for transfer restrictions to be
valid and enforceable the company does not need to be a party and it
is also not required to be embodied in the Articles of Association. It
means then that the company can be a party, although it is not
necessary. Similarly, the restrictions can be incorporated into the
Articles, although that is not necessary. If this is indeed the conclusion
one can draw of the Division Bench Judgment, then it appears
contradictory on two grounds:–

Firstly, as stated earlier, if company is not a party to the

agreement and the transfer restrictions therein are not incorporated
into the Articles, then enforceability of those restrictions will face
practical difficulty and also the restrictions could be challenged on the
ground that they are inconsistent with the Articles.

Secondly, if the company does become a party to the agreement

and transfer restrictions are embodied in the Articles, the same will be
against the provision under Section 9 of the Act. The judgment in
Western Maharashtra had held that transfer restrictions on shares of
public companies are illegal in view of Section 111A. And the fact of
company being a party to such agreement or such restrictions being
incorporated in the Articles will be immaterial because as per Section 9
of the Act, the provisions of the Act will override anything to the
contrary contained in the charter documents or any agreement
executed by the company. On this point, the Division Bench Judgment,
in paragraph 55, holds that “Section 111A is not a law dealing with the
right of the shareholders to enter into consensual
arrangement/agreement by way of pledge, preemption/sale or
otherwise…. Consensual arrangement/agreement between
shareholder and third party or shareholders inter se to which
company is not a party, Section 9 of the Act will not come into play
at all.” This means that according to the Division Bench Judgment if a
company does become a party to an agreement imposing transfer
restrictions, it will offend the provision of Section 9.

One can find little fault with the decision of the Division Bench on the
“permissibility” of transfer restrictions on shares of a public company. Prima
facie, the Judgment lays down a proposition which is convincing, sound and
grounded in the reality of modern trade and commerce. The line of legal
argument that the Judgment follows is logical too. It is however in its fine
print that the Division Bench Judgment falters and throws up certain
contradictions which may make the Judgment vulnerable to challenge in the
ultimate legal analysis.

Dtd: September 10, 2010