In this article, Ritika Sardar who is currently pursuing Diploma in Entrepreneurship Administration and Business Law from NUJS, Kolkata, discusses the restrictions on transferability of shares.

Abstract

The objective of this essay is to provide a thorough analysis of the restrictions and limitations imposed on the transfer of shares. The assignment begins with an introductory overview of the concept of restriction over free transfer of shares, delving into the rationale behind the same. The difference between the applicability of the concept in public and private companies is introduced in this section of the paper.

This is followed by a detailed analysis of the operation of the restrictions in private and public companies, along with relevant statutory provisions and case laws.  In the conclusion to the essay, I have provided my own views on the topic along with an overall evaluation of the same.

Restriction of share transfer and logic thereof

Restriction on transferability of shares is one of the flagship points of a private company; a company, in order to exist as a private company, has to provide for such restrictions as it deems fit by way of its Articles of Association (hereinafter referred to as “AoA”), which is one of the three constitutional documents of a company [the other two being the Memorandum of Association (hereinafter called “MoA”) and Certificate of Incorporation (hereinafter called “CoI”)]. The AoA is a document that specifies the regulations for a company’s operations, and they define the company’s purpose and lay out how tasks are to be accomplished within the organisation. This set of rules can be considered a user’s manual for the company because they outline the methodology for accomplishing the day-to-day tasks that must be completed.[1]

This has been statutorily codified in the definition of a private company as per Section 2(68)(i) of the Companies Act, 2013 (hereinafter referred to as the “2013 Act”) which provides that a private company is one which by way of its Articles, restricts the rights to transfer its shares.[2] The intention behind a private company is two-fold: Firstly, to facilitate the business and trade carried on by a small, close-knit group of members by allowing them to avail the benefits of corporate trading and corporate form of business. The structuring of a company affords many benefits as compared to a partnership and also reduces the liability of each member by providing for separation of business from the individual. Secondly, private companies are preferred to public companies because of the sheer volume of corporate filings to be made and requirements to be adhered to by a public company.[3]

The restrictions on transfer of shares in private companies flow from the Partnership Principle, which is the soul and basis of private companies. These restrictions, as stated above, are considered essential in a private company which is usually a group of trading persons bound together by close ties of kinship and/or friendship. These close associations cannot be established with anyone and everyone so easily and therefore, these members seek to keep the shares of such a company within the group. This motivates them to impose various restrictions to thwart the admission of members who may be unfavourable or hostile to the existing members and thereby to check the dilution of control over the company by the current members. These restrictions on transfer of shares help to keep the ‘soul and basis’ of the company intact. The rationale behind these restrictions in a private company has been endorsed by the Courts repeatedly and therefore they have acted as guardians of private companies, enabling them to retain a large degree of control over whom they admit as members.[4]

However, a completely different scenario plays out and prevails in public companies. One of the main reasons for investment in public companies is the free transferability of shares of such companies; there are no restrictions and anyone who follows the laws regulating share transfer can purchase shares of such a company. The shares of a public limited company are highly liquid and pose no impediments for a holder looking to sell them. This principle has been enshrined in Section 58(2) of the 2013 Act[5] which provides that shares and interests of a public company shall be freely transferable. This is one of the key identifying attributes of a public limited company in India.[6]

Thus, as can be seen from above, based on the motive behind the form of organisation and purpose to be fulfilled, the treatment of restrictions on share transferability differs; while it is sine qua non for a private company, the opposite (it is prohibited) is followed in a public company.

Restriction in transferability of shares vis-a-vis Private and Public Companies

Despite what is said above and at the risk of repetition, it is necessary to point out that the restrictions on transferability of shares of a company or lack thereof are almost entirely dependent on whether the company is a public or a private one. This having been said, various interpretations have been rendered by the Courts as to what is and isn’t permissible by way of a restriction and also whether in a public company, shareholders are absolutely prohibited from dealing with their own shares as they please. These facets of the concept have been elaborately dealt with below:

Share transferability restriction in Private Companies

As stated above, it is essential for a company seeking to be a private company to impose these restrictions; it is one of the defining features of a private company. Restriction on transfer of shares in private companies mainly takes two forms: right of pre-emption in favour of other members and powers of the Board of Directors (hereinafter referred to as “BoD”) to refuse to register the transfer of shares.[7]

1. Right of Pre-Emption

Pre-emption rights are usually such as ‘right of first offer’ and ‘right of first refusal’. The restriction basically embodies the principle that if a shareholder of a private company wishes to sell some shares, the existing shareholders have a right to be offered these shares first and on their refusal or failure to act within the given time, the shares can be sold to a third party. The motive behind this restriction is to prevent dilution of the promoter and other major shareholders’ stake in the company. This right of pre-emption is usually provided in shareholders’ agreements entered into between the various stakeholders in the company.

The procedure to be followed in such situations is as follows: the transferor gives a notice in writing to the company of his intention to sell his shares, which is forwarded to other members of the company along with the time limit for them to respond. The price of these shares is determined by the company’s directors or auditors. Normally, provisions for this are contained in the company’s AoA. On the failure of the other shareholders to respond within the stipulated time, the transferor is free to sell the shares to a third party.[8]

2. Powers of BoD to refuse to register transfer

The Articles of a private company commonly vest the BoD with discretion regarding the acceptance of a transfer of shares. This power vested in the Board is fiduciary in nature i.e., it must be employed in good faith and for the benefit of the company and not for some inappropriate purpose.[9] As per Section 58 of the 2013 Act, the BoD shall communicate the refusal within 30 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 and shall assign reasons for such refusal. This refusal can be appealed against to the National Company Law Tribunal (hereinafter referred to as “NCLT”) which shall pass such orders as it deems fit. [10] Several judgements have been pronounced regarding the scope of the Company Law Board (the predecessor of the NCLT and hereinafter referred to as “CLB”) to hear appeals against refusal to register transfer under Section 111 of the Companies Act, 1956 (this Section corresponds to Section 58 under the 2013 Act).

For example, In Harinagar Sugar Mills v. Shyam Sunder Jhunjhunwala and Ors.[11] the Supreme Court stated that while exercising its appellate jurisdiction under Section 111, the CLB has to decide whether in exercising their power the directors are acting, oppressively, capriciously, or corruptly or in some way mala fide.[12] Another ground on which the NCLT can exercise its jurisdiction is when it finds that the BoD has exercised its power of refusal based on irrelevant considerations, grounds which are not specified in the Articles. Following the reasoning of Lord Greene MR in Re Smith and Fawcett Ltd.[13], the High Court of Calcutta in Master Silk Mills (P) Ltd v. D.H. Mehta[14], held that the BoD’s refusal to accept a transfer in favour of another company whereas the Articles empowered them to exclude only undesirable persons, was beyond their authority. The Court held that such a blanket ban on admission of other companies as a shareholder was beyond the authority vested in the board by the Articles.[15]

Case Laws Relating to Restriction in Private Companies

Because the 2013 Act (like the 1956 Act) is silent on the issue, several judgements have been rendered over the years in order to lay down the law regarding the type and extent of restrictions that can be placed in the AoA. The pivotal position of law is laid down in the case of V B Rangaraj v. V B Gopalakrishnan and Others.[16]. On the question of whether shareholders can, amongst themselves, enter into an agreement which is contrary to or inconsistent with the Articles of association of the company, the Supreme Court of India held, that only restrictions laid down in the Articles of the company are permissible. A restriction which is not specified in the Articles is therefore not binding either on the company or on the shareholders.[17]

It is interesting to note that the Principal Bench of theCLB has pronounced that even though a private company, being a subsidiary of a public company is defined as a public company in the 1956 Act, all the provisions in the Articles of association to maintain the basic characteristics of a private company in terms of Section 3(1)(iii) will continue to govern the affairs of such a company. One of the basic characteristics of a private company in terms of that section is the restriction on the right to transfer the shares and the same will apply even if a private company is a subsidiary of a public company.[18]

The restrictions on transferability, so essential to the character of a public company, are however not to be construed as a ban or a prohibition on the transfer of shares. The Courts have consistently held that the restriction upon transfer means any restriction that will give some control to the company over transferability of shares. It was held in Chiranji Lal Jasrasaria and Anr. v. Mahabir Dhelia and Ors.[19] that a restriction which amounts to a prohibition on transfer of shares or which precludes a shareholder altogether from transferring is invalid. Moreover, a prohibition on the transfer of shares will amount to violation of Section 82[20] (which corresponds to Section 44 of the 2013 Act) of the 1956 Act and Section 6[21] of the Transfer of Property Act, 1882.[22]

Based on the above observations made and decisions rendered by judicial authorities, the following principles may be discerned regarding restrictions on transfer of shares in private companies:

1. The right to transfer is subject to restriction contained in the Articles; in case of two possible interpretations of the restrictions, the one that is less restrictive should be adopted.
2. The power to refuse the transfer of shares cannot be exercised arbitrarily or for any other collateral purpose and can only be exercised for a bonafide reason in the interest of the company and the general interest of the shareholders.
3. While there may be restrictions on the transferability of the shares, there cannot be an absolute prohibition on the right to transfer of shares.[23]

Scenario prevalent in Public Companies

Though shares of a public company are widely accepted to be freely transferable, the question of whether this means that shareholders of such a company are absolutely prohibited from dealing with their movable property (as per Section 44 of the 2013 Act) as per their wishes, is frequently posed. The question of whether transfer restrictions imposed by agreement on shares of a listed company are enforceable has been a vexed one. Numerous decisions of the Supreme Court as well as High Courts had expressed somewhat different views on the nuances of the issue. However, some stability was brought about in 2010 by a decision of a division bench of the Bombay High Court in Messer Holdings v. Shyam Madanmohan Ruia and Ors[24]., which effectively ruled that restrictions expressed in an agreement between shareholders do not violate of the 1956 Act and that they can be enforced inter se among shareholders. In doing so, the Court diverged from the ruling of a single judge in Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Limited,[25] wherein a pre-emption clause in a shareholders’ agreement was held to be in violation of Section 111A[26] of the 1956 Act.[27]

The division bench held,

“The concept of free transferability of shares of a public company is not affected in any manner if the shareholder expresses his willingness to sell the shares held by him to another party with right of first purchase (preemption) at the prevailing market price at the relevant time. 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. The fact that shares of public company can be subscribed and there is no prohibition for invitation to the public to subscribe to shares, unlike in the case of private company, does not whittle down the right of the shareholder of a public company to arrive at consensual agreement which is otherwise in conformity with the extant regulations and the governing laws. That means that it is open to the shareholders to enter into consensual agreements which are not in conflict with the Articles of Association, the Act and the Rules, in relation to the specific shares held by them; and such agreement can be enforced like any other agreement. That does not impede the free transferability of shares at all.”[28]

This has now been codified and statutorily provided in the proviso to sub-Section (2) of Section 58 of the 2013 Act which provides that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as a contract.

Conclusion

Given the rationale behind the establishment of a private company, the restrictions imposed on the transfer of shares seem reasonable, especially considering that the proposed transferee has an option to move the Tribunal in case the BoD appears to have exercised its powers of refusal capriciously or in a mala fide manner. These restrictions help maintain the sanctity of the private company and help the founders/promoters retain majority control and thereby steer the company in the desired direction.

With respect to a public company, keeping in mind that the shares belonging to a person are his movable property and can be transferred in accordance with Section 6 of Transfer of Property Act, 1882, the Court has tried to strike a balance between the conflicting principles of this aforementioned ownership and the free transferability of shares that characterises a public company and provides liquidity to its stock. As a result of the effort, the Court correctly ruled that as long as the agreement to transfer complies with the AoA of the Company and relevant statutory provisions governing the transfer, shareholders of a public company are free to deal with their shares as they please and can enforce an agreement for such transfer.

In my humble opinion, the kinds of restrictions imposed and liberties granted for each kind of company are befitting to them and will enable them to achieve their respective goals.

 

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REFERENCES

Table of Cases:

• Harinagar Sugar Mills v. Shyam Sunder Jhunjhunwala and Ors, 1962 SCR (2) 339
• Re Smith and Fawcett Ltd, [1942] Ch 304
• Master Silk Mills (P) Ltd v. D.H. Mehta, (1980) 50 Comp Cas 365 Guj
• V B Rangaraj v. V B Gopalakrishnan and Others, AIR 1992 SC 453
• Hillcrest Realty Sdn. Bhd. v. Hotel Queen Road Pvt. Ltd. and Ors, 2006 71 SCL 41 CLB
• Chiranji Lal Jasrasaria and Anr. v. Mahabir Dhelia and Ors, AIR 1966 Gau 48
• Messer Holdings v. Shyam Madanmohan Ruia and Ors., [2010 ]159CompCas 29 (Bom)
• Western Maharashtra Development Corpn. Ltd. v. Bajaj Auto Limited, [2010] 154 CompCas 593 (Bom).

Websites Referred:

• Articles of Association’; Available at http://www.investopedia.com/terms/a/articles-of-association.asp, Retrieved at 12:17 on 31^st March, 2017.
• Restriction on Transfer Of Shares’, Available at https://www.lawteacher.net/free-law-essays/finance-law/restriction-on-transfer-of-shares.php; Retrieved at 20:12 on 30^th March, 2017.
• Subashini, ‘India: Restrictions on Transferability of Shares’; Available at http://www.mondaq.com/india/x/102852/Directors+Officers/Restrictions+on+Transferability+of+Shares, Retrieved at 18:48 on 30^th March, 2017.
• Balram, ‘Share Transfer Restrictions in Shareholders’ Agreements-Whether to be incorporated in the Articles of Association of a Public Company?’; Available at http://corporatelawcorpus.blogspot.in/2014/06/share-transfer-restrictions-in.html, Retrieved at 21:35 on 31^st March, 2017.

List of Statutes

• Transfer of Property Act, 1882
• Companies Act, 1956
• Companies Act, 2013

Legal Databases

• Manupatra
• SCC Online

[1] ‘Articles of Association’; Available at http://www.investopedia.com/terms/a/articles-of-association.asp, Retrieved at 12:17 on 31^st March, 2017.

[2]Section 2 of the Companies Act, 2013- Definitions; Available at http://www.mca.gov.in/SearchableActs/Section2.htm, Retrieved at 12:22 on 31^st March, 2017.

[3]‘Restriction on Transfer Of Shares’, Available at https://www.lawteacher.net/free-law-essays/finance-law/restriction-on-transfer-of-shares.php; Retrieved at 20:12 on 30^th March, 2017.

[4] Ibid.

[5] Section 58 of the Companies Act, 2013- Refusal of registration and appeal against refusal; Available at http://www.mca.gov.in/SearchableActs/Section58.htm, Retrieved at 20:16 on 30^th March, 2017..

[6]R.Subashini, ‘India: Restrictions on Transferability of Shares’; Available at http://www.mondaq.com/india/x/102852/Directors+Officers/Restrictions+on+Transferability+of+Shares, Retrieved at 18:48 on 30^th March, 2017.

[7] Supra note 3.

[8] Ibid.

[9] Ibid.

[10] Supra note 5.

[11] 1962 SCR (2) 339.

[12] Ibid, para 10.

[13]  [1942] Ch 304.

[14] (1980) 50 Comp Cas 365 Guj.

[15] Supra note 3.

[16] AIR 1992 SC 453.

[17] Ibid, para 6.

[18] Hillcrest Realty Sdn. Bhd. v. Hotel Queen Road Pvt. Ltd. and Ors., 2006 71 SCL 41 CLB, para 36.

[19] AIR 1966 Gau 48.

[20]Section 82, Companies Act, 1956- Nature of shares; Available at

http://www.manupatrafast.in.elibrary.symlaw.ac.in:2048/ba/fulldisp.aspx?iactid=785&snos=150, Retrieved at 20:28 on 31^st March, 2017.

[21]Section 6, Transfer of Property Act, 1882- What may be transferred; Available at http://www.manupatrafast.in.elibrary.symlaw.ac.in:2048/ba/fulldisp.aspx?iactid=794, Retrieved at 20:28 on 31^st March, 2017.

[22] Supra note 19, para 4.

[23] Supra note 6.

[24] [2010 ]159CompCas 29 (Bom).

[25] [2010] 154 CompCas 593 ( Bom ).

[26] Section 111A of the Companies Act, 1956-Rectification of register of transfer; Available at http://www.manupatrafast.in.elibrary.symlaw.ac.in:2048/ba/fulldisp.aspx?iactid=785&snos=200, Retrieved at 21:27 on 31^st March, 2017.

[27] G. Balram, ‘Share Transfer Restrictions in Shareholders’ Agreements-Whether to be incorporated in the Articles of Association of a Public Company?’; Available at http://corporatelawcorpus.blogspot.in/2014/06/share-transfer-restrictions-in.html, Retrieved at 21:35 on 31^st March, 2017.

[28] Supra note 24, paras 51-52.