Section 111A of the Companies Act, 1956, is perhaps the most significant unresolved controversy in contemporary Indian corporate law. The blog noted today that a Division Bench of the Bombay High Court (Messer Holdings) has held that a private arrangement between shareholders conferring a right of first refusal is not contrary to s. 111A of the Companies Act. In this post, I offer some thoughts on ascertaining the existing position of law on the scope of s. 111A(2). A close analysis of five decisions is crucial for this exercise – the oft-quoted judgment of the Supreme Court in VB Rangaraj v. VB Gopalakrishnan [“Rangaraj”], the 1997 judgment of the Gujarat High Court in Mafatlal Industries [“Mafatlal”], the 2002 judgment of the Supreme Court in M.S. Madhusoodhanan [“Madhusoodhanan”], and the twin Bombay High Court 2010 judgments in Bajaj Auto and Messer Holdings. It is important to identify exactly what these decisions hold. In addition, it is necessary to consider the legislative history of s. 111A, and the position on transferability of shares in common law. Interested readers may also refer to Puspha Katoch, Bhadresh Kantilal Shah (CLB) and re Morgard Shammar (CLB).
Like most accounts, we must begin with the decision in Rangaraj. The defendant in that case was a private limited company, and in time, its sole shareholder came to be a family that consisted of two branches. The principals of each branch orally agreed in 1951 that the proportion of shareholding of their respective branches would not change, and provided, for this purpose, that any member of a branch who wished to sell his shares must first offer the shares to his own branch. After referring to the decision of the Supreme Court in Kalinga Tubes, common law decisions and scholarly opinion, Sawant J. held that shares are “freely transferable” and that “a private agreement that imposes … restrictions not stipulated in the articles of association…” is “not binding either on the shareholders or on the company”. The latter part of his decision – that it does not bind the company – is not new, and is an accepted rule of English law. However, that it does not bind the shareholders is a requirement peculiar to Indian law, and the only possible statutory provision that supports it is s. 82, which Sawant J. cites. However, s. 82, which provides that shares in a company constitute movable property “transferable in the manner provided by the articles of association”, is widely thought to in fact refer to the procedure of transfer.
In 1996, the Depositories Act was enacted, which omitted s. 22-A of the Securities Contract Regulation Act, and added s. 111A to the Companies Act.
In 1999, an eminent judge of (then) the Gujarat High Court heard Mafatlal, where the defendant was a public limited company. The plaintiff had sold 3.87 % of the equity in that company to an FII with a pre-emption right, who later disposed of a part of those shares in the open market. The plaintiff relied on the right of pre-emption to invalidate the subsequent sale by the FII, and argued, interestingly, that “free transferability of shares refers to absence of restrictions which may be imposed by third parties, but it cannot exclude the right of a shareholder to impose restrictions on himself in the matter of transfer of shares to another person.” This argument was rejected by M.B. Shah J., who pointed out that the “ratio in the case of V.B. Rangaraj will apply with much greater force to the case of a public company”. As we shall see, the contention Justice Shah rejected is remarkably similar to the contention the Bombay High Court accepted in Messer Holdings.
In 2002, the Supreme Court decided Madhusoodhanan. The case arose out of a complex family dispute in Kerala, and specifically out of a karar (agreement) that provided in Clause 2 that “there would be no change in the existing share structure” (among the family) of a private company. Clause 2 also provided that the shares of two members would pass to Madhusoodhanan in a certain percentage on their death. Ruma Pal J. distinguished Rangaraj and Kalinga Tubes on the basis that this restriction was not on a share as a class, but on specific, identified shares between specific, identified members, to which the company need not be a party. Whether the decision is consistent in its entirety with Rangaraj is a matter of disagreement, especially as to the clause that there would be no change in the existing share structure – a provision similar to the requirement in Rangaraj that the shareholding pattern of the two branches would remain constant. However, it is clear that it is not authority for the general proposition that a private arrangement is legal under existing Indian law, but at best for the proposition that a transaction between identified members imposing a restriction on identified shares is legal.
This brings us to the two High Court decisions. In Bajaj Auto, which we discussed here, Chandrachud J. noted that the karar in Madhusoodhanan had dealt with specific, identified shares between identified members, followed Rangaraj, and declared that a right of pre-emption is contrary to s. 111A. That has now been overruled in Messer Holdings. In Messer, Khanwilkar J. makes three points – first, that the legislative history of s. 111A shows that the intention of the legislature was to fetter the actions of the Board of Directors, not individual shareholders; secondly, that Madhusoodhanan is authority for the general proposition that “consensual arrangements between particular shareholders relating to their specific shares do not impose restriction on the transferability of shares”; and thirdly, that “freely transferable” in s. 111A only means that “both seller and purchaser must agree to the terms of the sale”. It was further held that this need not be embodied in the articles of association. It is submitted that the first point may well be correct, but cannot in itself displace the plain language of the provision. The second and the third points are considered below in the summary.
One last point remains on Messer Holdings. In paragraph 55, Khanwilkar J. held as follows:
…“freely transferable” in Section 111A does not mean that the shareholder cannot enter into consensual arrangement/agreement with the third party (proposed transferee) in relation to his specific shares If the company wants to even prohibit that right of the shareholders, may have to provide for an express condition in the Articles of Association or in the Act and Rules, as the case may be, in that behalf [emphasis mine].
The rule in Rangaraj was that a restriction on the transfer of shares is “unenforceable unless contained” in the Articles of Association. If Messer Holdings is good law, the rule is that a restriction on the transfer of shares is “enforceable unless barred” by the Articles.
The present position of law
The present position of law may be summarised in the following propositions – the case that stands for the proposition is in bold:
- Shares of a company are “freely transferable” both as matter of common law and under the Indian Companies Act (s. 82) and a restriction is “unenforceable unless contained” in the Articles – VB Rangaraj
- “Freely transferable” refers not to the act of sale, but to the subject of the sale (the shares themselves) – VB Rangaraj
- The above principle applies with even greater force to a public company, and is reflected in s. 111A(2), inserted after Rangaraj – Mafatlal Industries
- Rules (1) and (2) do not apply when – Madhusoodhanan
- The “restriction” is on identified shares – meaning that further shares acquired by the same person in the same class may not be subject to the restriction; and
- Those shares are held by identified members;
- A general right of pre-emption in relation to the shares of a public company is contrary to s. 111A – Bajaj Auto
- Madhusoodhanan stands for the general proposition that private arrangements are legal, and “freely transferable” refers to the freedom of the buyer and the seller – Messer Holdings
- A private arrangement imposing a restriction is enforceable unless barred by the Articles – Messer Holdings
The correct position of law
It is easy to appreciate the adverse commercial consequences of the rule in Rangaraj. It means that a pre-emption right, ubiquitous in the world of joint ventures, is illegal and unenforceable. Messer Holdings, by reformulating the Rangaraj rule, averts this consequence.
From my reading of Madusoodhanan, it seems as if the necessity of identified shares was in the context of specific performance of the agreement. Rangarajan was distinguished on the basis that it was only authority for the proposition that there can be no restriction on transfer of shares except as in the Articles. So, Madusoodhanan held that it cannot be extended to say that an agreement to sell shares outside of the Articles cannot be enforced.Wouldn't you agree?
The context undoubtedly was specific performance, but I don't think that had a bearing on the view the Court took of Rangaraj. The respondents resisted specific performance (counsel's argument is noted in para 129 of the SCC Report) on the basis that the karar was itself unenforceable in view of art 29 of the Articles of Kerala Kaumudi. The Court held that Rangaraj cannot be extended to prevent the enforcement of an agreement to sell shares only because the karar dealt wth identified shares (paras 144, 145), which the agreement in Rangaraj (according to the Court) had not. Of course, the scope of the "identified" shares reasoning is unclear, in both English and Indian law.
"However, the better answer lies perhaps in the Supreme Court adopting the rule of English law that while a restriction does not bind the company, it binds the shareholders. This, for example, permits a shareholder to obtain an injunction against his fellow shareholders preventing transfer."
Would you agree that this is exactly what is sought to be done by the Proviso to s.98(2) of the Companies Act, 2013 (in respect of a public limited company)?
Apologies, I meant the Proviso to s.58(2) of the Companies Act, 2013.