In this article, Arjun Radhakrishnan Nair pursuing M.A, in Business Law from NUJS, Kolkata discusses Restrictions on Transferability of Shares in private companies.

Everyone throughout the course of their day comes into contact with companies in one form or another. Be it through use of a mobile phone which is manufactured by a company, and where the network and services would be provided by another, or through the use of a vehicle which may be manufactured by yet another company. In general a company is a legal entity made up of an association of persons for the purpose of carrying on a commercial or industrial enterprise. In India, the laws relating to Companies are prescribed under the Companies Act, 2013 as well as certain provisions of the Companies Act, 1956.

The two most common types of companies one comes across are private companies and public companies. A major distinction that can elucidate the difference between a private limited company and a public limited company can be found in the manner they deal with the transferability of shares. While in a public limited company, a person is free to transfer shares in their possession subject to the procedure prescribed, a private company is bound to restrict the right to transfer shares within their Articles of Association itself. A Private Company is generally a closed group, wherein the shares are closely held amongst a limited number of persons. While providing the advantages of a corporate set-up to small businesses, a private company is also able to avoid the regulatory hassles that come with being a public company.

Shareholding in Private Companies

A ‘Private Company” has been defined under Section 2(68) the Companies Act, 2013 as a company which has the following characteristics:

1. a minimum paid capital of 1 lakh rupees,
2. Restriction on the right to transfer its shares imposed under its Articles of Association,
3. Limitation as to the maximum number of members which should be no more than two hundred (in cases where the company is not a one person company)
4. prohibits invitations to the public to subscribe for any of the companies securities.

Having a minimum paid up capital of 1 lakh rupees means that the individuals forming the company must invest at least an amount of Rs. 1 lakh by way of purchase of shares of the company. Section 2(84 of the Companies Act, 2013 defines a share to mean a share in the share capital of the company inclusive of stocks. The nature of a share was further provided under Section 44 of the Companies Act, 2013, which provides that shares are movable property transferable as provided under the Articles of Association. more specifically explained by the Hon’ble Supreme Court in CIT (Central), Calcutta Vs. Standard Vacuum Oil Co, as reported in AIR 1966 SC 1393 wherein it was held that a share is not just a sum of money but is an interest measured by a sum of money and made up of diverse rights contained in the contract evidenced by the articles of association of the Company. Shares are also transferable akin to other movable property and are included in the definition of ‘goods’ under Section 2(7) of the Sale of Goods Act, 1930. The value of shares ascertains the liability of the shareholder in a company and also determines the scope of his control over the affairs of the company and over other shareholders during general meetings.

The mandatory condition of imposing restrictions in the Articles of Association regarding the transfer of shares in Private Limited Company is distinct feature of such companies. Articles of Association prescribe the major regulations to be followed by the company, and are binding on the company as well as the shareholders of the company.The Supreme Court had opined in the V. B. Rangaraj vs. V.B. Gopalakrishnan and Ors, as reported in CDJ 1991 SC 464 that only restrictions imposed under the Articles of Association against transfer of shares may be enforced. Any other restrictions imposed in the absence of the mention of the same in the Articles of Association cannot be enforced to prevent a valid buyer of shares from taking possession of the same. In the said case, the parties had entered into agreements on the basis of which two branches of a family who held equivalent number of shares in the company had agreed that both branches would hold the same number of shares and where any member was desirous to sell his share, the branch to which he belonged would have first option of purchase. When one person from one branch directly sold his shares to the other branch, the members of the first branch approached the court to get the said sale nullified in view of the agreement. But as the said agreement was not made part of the Articles of Association and therefore no such restriction existed in the Articles of Association, the Hon’ble Apex Court opined that the said agreement could not be enforced. A similar decision was also rendered by the Supreme Court much earlier in S.P. Jain vs. Kalinga Tubes Ltd, 1965 AIR (SC) 1535.

While the Companies Act necessitates a restriction on the transfer of the shares in a private company, the Act is silent of the nature of such a restriction. There is no specific restriction provided and the severity of the restriction could greatly differ from company to company. But it has been consistently held by various courts that the said restriction cannot be in the nature of an absolute prohibition.

Restrictions on the transfer of shares

As a private limited company must mandatorily include restrictions on the transfer of shares in its Articles of Association, certain common types of restrictions are imposed by different companies so as to meet the requirements of the definition of a private limited company. The most common type of restriction that is imposed on the companies are by way of Right of Pre-Emption or Right of First Refusal.

Pre-Emption Clause or Right of First Refusal

The High Court of Judicature at Bombay in Bajaj Auto Ltd vs Western Maharashtra Development Corporation Limited, as reported in CDJ2015 BHC 1305, had remarked that a Pre-emption clause also known as a Right of First Refusal clause is a classic restriction on transferability which is one of the most common restriction clauses found in the Articles of Association of Private Companies. The right to pre-emption generally means that where a shareholder wishes to sell some of his shares or all his shares, then, at the first instance, the said shares shall be offered to the other members of the Company, who may purchase the shares at a fair price as decided in terms of the Articles of Association or calculated by the Directors in conjunction with the Auditors of the Company. The right to pre-emption ensures that the other shareholders in a company can acquire the shares if any other shareholder is selling. Such a clause is usually included to ensure that even in cases of conflict, where the shares are all held by a family, even if one member wishes to sell the shares to an outside he will be unable to without offering them to the persons in the family at the first instance. The right of pre-emption is not a specific right to shares of another shareholder is only the right to be offered the said shares in case they are for sale. It is therefore up to the shareholder to whom the said shares are offered to accept the offer and buy the shares. Where the none of the other shareholders are interested in purchase of the shares, the restriction on transfer is lifted and the shares may be transferred to any other person.

Enforcement of Pre-Emption Clause

For the enforcement of a pre-emption clause there must be a procedure to be followed by the Company. After receipt of the application for transfer of shares from the seller, the Company is bound to inform the other members in a time bound manner as to the availability of the said shares. Once the other members are notified, the Company has to ensure that the fair price of the shares are communicated to persons who are interested in purchasing the shares. If none of the other buyers show interest in the purchase of shares available for sale or are unable to purchase the same within the time stipulated then the Board may allow the seller to transfer the shares to any other person subject to any other restrictions as may be contained in the Articles of Association.

Power of a Private Company to Refuse Registration of Transfer

Another restriction on the transfer of shares is provided under Section 58 of the Companies Act, 2013. As per the first clause of the said section:

“If a private company limited by shares refuses, whether in pursuance of any power of the company under its articles or otherwise, to register the transfer of, or the transmission by operation of law of the right to, any securities or interest of a member in the company, it shall within a period of thirty days from the date on which the instrument of transfer, or the intimation of such transmission, as the case may be, was delivered to the company, send notice of the refusal to the transferor and the transferee or to the person giving intimation of such transmission, as the case may be, giving reasons for such refusal.”

The said provision implies that a Private Company can refuse the registration of shares both in pursuance of the powers granted to it for restriction of shares under the Articles of Association or otherwise. For this to Directors of the company on receiving an application for transfer of shares must actively send a notice whereby the refusal Is intimated to the person applying for the transfer and must also give reasons for the refusal of such transfer. Thereafter the person so aggrieved by the said notice may prefer an appeal to the Tribunal against the said notice.

Generally the power of the Companies to refuse to register shares may be due to some of the following specific reasons:

1. In the case of partly paid-up shares being transferred, the transferee is insolvent or a minor and therefore would be unable to pay the balance
2. When the transferor is a debtor of the company and the company has a lien on such shares.
3. If instrument is incomplete, irregular and defective and not properly stamped.

The said provision bestows upon the Directors of the Company a lot of power with regard to the transfer of shares. As the said provision seems to be unrestricted in its scope, the same has undergone rigorous judicial scrutiny. In the case of Bajaj Auto Ltd. Versus N.K. Firodia & Others, 1979 AIR 32, a three member bench of the Hon’ble Supreme Court looked into the scope of such powers bestowed on the Directors under the erstwhile Companies Act. In the said matter, it was held that powers bestowed on the Directors were discretionary and the Directors being in a fiduciary relationship with both the Company and each of the shareholders and must only be used for the ultimate benefit of the Company and the shareholders. The bonafide use of such powers, even when no such powers are provided in the Articles of Association are to be condoned as done in the best interests of the company.  It is pertinent to refer to the decision in Greenhalgh v. Arderne Cinemas Ltd., (1950) 2 All ER 1120 wherein it was held that in cases where such power is used the acts of the Directors would have to be scrutinized as to whether they were the honest opinion of the Directors acting for the company as a whole.

The provision under Section 58 takes into its ambit both cases where the said restriction is granted by the discretionary powers vested in the Directors as well as where there are specific provisions providing such powers to the Directors. In caseswhere such specific powers were granted in the Articles of Association, the decisions of various courts in both India and England has unambiguously held that unless clear and malafide intention on the parts of the Directors are proved, or the powers were used in derogation of the rights of the shareholders and the Articles of Association, the refusal to register shares cannot be set aside.In the case of Berry and Stewart v. Tottenham Hotspur Football and Athletic Co. Ltd., 1936-3 All ER 554 (E), where the articles of association of a company had given the Directors unrestricted power to refuse transfer of shares, the Directors refused to allow transfer of shares to a person on the basis that the person was objectionable to the Directors of the Company and therefore was not fit to be part of the Company. When the same was appealed against, the Courts in view of the specific powers granted under the Articles of Association refused to go into the matter unless gross misconduct or any other act done that was prejudicial to the interests of the company was shown. In such cases the Directors were not even required to provide the reasons for refusal to transfer the said shares. In fact a litany of case laws have held that it not be justified for the Court to interfere with the director’s bona fide exercise of their discretion. This is based on the Court’s belief that it is the directors who know what is in the best interest of the company and thus, it is inadvisable for the Court to substitute their opinion for the Directors without comprehending the workings of the Company and its shareholders.

The abovementioned case of Bajaj Auto Ltd. Versus N.K. Firodia & Others is one such case wherein it was shown that the Directors were acting in a manner that was prejudicial to the interests of the company and was in personal interest of the Directors thereby an abuse of the fiduciary powers of the Directors.

Further it has been held by the Company Law Board in Hemanigiri Finance & Leasing (P.) Ltd v. Tamilnad Mercantile Bank Ltd. 1996 86 CompCas 875 CLB that there is no absolute power vested in the Directors of the Company to refuse to register any share especially when no such provision is provided for in the Articles of Association. Similarly in the case of Harinagar Sugar Mills v. Shyam Sunder reported in 1961 AIR 1969, it was held that in the Company Law Board must decide during the course of the appeal whether the Directors of a Company had acted capriciously, oppressively or in a corrupt manner or without specifying any proper cause for the same.

In view of the same, it must be appreciated that the power to refuse to register shares is a discretionary power that is limited based on the extent of power imparted by the Articles of Association. Various Courts have rightly adjudged that even Company Boards may err in their judgment due to personal or trivial reasons which do not find merit in the Articles of Association, and therefore, the Company Law Board is empowered to look into the circumstances of each case and judging whether the discretionary power has been rightly used. Where the Articles give an absolute right to the Company to refuse, then the Directors may use this power if they feel their actions would best benefit the Company, but where no such power is granted, then the scope of the said power is very limited and the company cannot stop a rightful transfer of shares.

Case Study of Restrictions on Transfer of Shares

A general understanding of the pre-emption clause and the power of the Board to refuse registration of transfer could be gained from the decision of the Company Law Board in Satyanarayana Rathi vs. Annamalayar Textiles (P) Ltd, as reported in 1999 32 CLA 56.

In the said matter the Private Company in its Articles of Association had inserted a clause wherein no member of the company could transfer his shares to any other person who is not a member of the company without offering the same to the other members at a price decided by the Directors of the Company from time to time. If the said shares were not purchased within a specified time as decided by the Board then the person desiring to sell his shares may transfer the same to any other party as he likes. Matters being so, the appellant in the said matter who was supplier of cotton was given shares as security for payment (to the extent of 52%, being the controlling interest) by 3 members of the Company. The members also gave the appellant the share certificates and transfer deeds. Unfortunately due to several factors, the payments for the cotton supplied by the appellant was not made and therefore the appellant made an application to the Board of the Company to have the shares transferred to him. But as there were members within the company who were desirous of purchasing the shares themselves the Board rejected the application as the same was in violation of the pre-emption clause included in the Articles of Association. This stand of the Board was upheld by the Company Law Board, which held that in view of the restriction as provided in the Articles of Association of the Company the Board is bound to deny the request of the appellant to transfer the shares to him.

Firstly this clearly espouses the concept that even where there exists contracts between the members of the company and the appellant to the extent that the appellant may transfer the shares to his name in case where there is a default in payment on the part of the members of the company the same cannot be upheld in view of the Pre-emption clause as contained in the Articles of Association. The Company will be bound by the restriction as imposed under the Articles which are binding on them over and above any other agreements that may be entered into by the members of the company. Therefore where certain other members of the Company has shown willingness in purchasing the shares, unless they decide not to purchase the shares or are unable to do so within a time specified by the Board of the Company, the shares cannot be transferred to the appellant in the matter.

Secondly, where there is a violation of the Articles of Association, the Directors of the Company may refuse to register the shares. In the present case, though the transfer deeds were with the appellant and there was an agreement between him and the members of the Company, the Board of the Company used its discretionary power to hold that the transfer violated the Articles of Association and therefore had to be set aside.

Similar decisions were rendered in Cruickshank Co. Ltd vs. Stridewell Leather Pvt. Ltd, (1996) 86 CompCas  439  CLB, Tarlok Chand Khanna v. Raj Kumar Kapoor, (1983) 54 Com. Cas. 12 (Delhi) among others.

Conclusion

Shares play an important part in the identity of a Company, be it Private or Public. The transferability of shares is what sets Companies apart from other forms of businesses, as it enables the company to cultivate its legal identity. The concept of perpetual succession is based on the transferability of shares which ensures that the legal entity that is the Company survives the change in its shareholders. Therefore, the transferability of shares is an important aspect in any Company.

A private limited company is distinct in that it has to restrict the transfer of shares in its Articles of Association. This goes with the principle behind the creation of private limited companies, which is generally started by families or friends or persons who share similar goals and vision. Therefore in a partnership firm, restrictions in the transferability of shares ensures that control of the company stays within a small group and unwanted influences can be kept out. This is distinct from a public limited company where anyone can buy into the company. While the concept of restriction of transferability of shares ensures that a private company can maintain its identity and its shareholders, it can also result in untenable situations where due to the said restrictions there may be conflict. For the said reasons, it is ensured that said restrictions are not absolute and persons who are not willing to remain in the company may sell their shares and opt out subject to restrictions imposed. The said restrictions can also ensure that sales are not made to any persons who are detrimental to the growth of the company. In view of the above, the restriction of transfer of shares it what gives the private company its character and allows it to maintain the values of its shareholders.