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In a Share Purchase Agreement we generally come across certain terms which do result in providing parties to the agreement with certain pre-emptive rights in respect of selling of shares. It is an accepted principle that such pre-emptive rights are valid as far as the private companies are concerned if incorporated in the Articles of Association. However, the validity of clauses which works out in providing the parties to agreement with pre-emptive rights in regards to shares of public companies is a topic of debate as it is one of the basic features of a public company that its shares have to be freely transferable. These clauses are very important if we look at them from a private equity investor’s perspective as they provide these strategic investors with an exit option and to liquidate their profits. This article is an attempt to understand the validity and enforceability of such clauses in the light of certain judgments of different High Courts and the Supreme Court.
These clauses are explained below as to their functionality in a Share Purchase Agreement  :
Right Of First Refusal (ROFR): It is a pre-emptive right given to the non-selling shareholder to receive an offer to purchase the shares at a certain price proposed to be sold by the selling shareholder to any third party. Upon refusal of the non-selling shareholder to purchase the shares, the selling shareholder is free to sell the shares to any third party but not at terms more favourable than those that were offered to the non-selling shareholder.
Right Of First Offer (ROFO): In this the selling shareholder is bound to enter into good faith negotiations with the non-selling shareholder when the former proposes to divest its stake in the company. In such a case, the latter has the right to make an offer to buy the shares. If the selling shareholder refuses the offer, it can sell the shares to any third party but not at terms less favourable than those offered by the non-selling shareholder.
Tag Along Rights: Here, instead of purchasing the shares offered by the selling shareholder, the non-selling shareholder has a right to sell its shares along with the shares of the selling shareholder and on the same terms as those of selling shareholder. It is typical for an investor having a minority stake in an entity to want to have such an exit option in the event the majority shareholder is divesting its entire or substantial holding in the company. Simply put as “if you sell, I will have the right to sell along with you”.
Drag Along Rights: In the event the selling shareholder is divesting a controlling stake in the investee company, it has the right to compel the non-selling shareholder to sell its shares on the same terms as its own shares. Simply put as “if I sell, you will be required to sell with me”.
Put Option: A put option means that the option holder has the right to require the other party, the party granting the option, to buy shares held by the option holder on the happening of certain events and on an agreed price or a pre determined formula.
Call Option: On the Contrary, a call option gives the person in whose favor such option has been granted a right to call on the person granting the option to sell the shares held by the option grantor to the option holder on the happening of certain events and on an agreed price or a pre determined formula.
The clauses like Right of First Refusal (ROFR) or a Right of First Offer (ROFO) are key terms in commercial contracts involving shareholders of corporate entities. ROFR/ROFO forms an integral part to investors’ protection in a Shareholders’ Contract. ROFR/ROFO (among other shareholders’ rights, such as Tag Along, Drag Along etc), has however often been viewed as a hurdle to the principle of ‘free transferability’ of shares of a Public Limited Company laid down in Section 111-A of the Companies Act, 1956. Such rights, though legally recognised in case of private limited companies, are highly debatable in case of public limited companies.
For convenience of comprehension, the Article is divided into five parts.
Scope of Section 111A of the Indian Companies Act, 1956.
History of the Section.
Scope of Section 111A
This section relates to transfer of shares or debentures in respect of a public company [Section 111A (1)] and provides for free transferability of its shares or debentures [Section 111A (2)]. As per the proviso to Sub Section 2, an aggrieved transferee may seek remedy by filing an appeal before CLB if the transfer is refused without sufficient cause within 2 months from the date of lodgment of request for transfer of shares with the company. The said proviso does not provide for any period of limitation for filing an appeal. Sub-section (3) of Section 111A relates to rectification of the Register of Members of Record of Depository in case any transfer is made in contravention of provisions of the Securities and Investment Boards of India Act, 1992 (“SEBI Act”) including the regulations made by the Board in exercise of the power conferred on it by the SEBI Act or the Sick Industrial Companies (Special Provisions) Act, 1985 or any law on an application made by the aggrieved, depository, company, participant or investor or SEBI within two months from the date of transfer. CLB is also empowered to pass interim orders regarding exercise of voting rights on impugned shares pending final hearing of the application.
History of the Section
Before enactment of this Section, two remedies were available to the aggrieved transferor/transferee in respect of transfer of shares in, or debentures of, a public or a private company either to file an appeal before the Central Government under Section 111 or to the High Court under Section 155 for rectification of the Register. A new Section 22A was inserted in the Securities Contracts (Regulation) Act to provide that shares of a listed company shall be freely transferable and restricting the arbitrary powers of the Board of Directors by allowing them to refuse transfer of the securities of the company on four provided grounds only.
Later substantial changes were made to the Companies Act by the Depositories Act, 1996 and Section 111A was inserted to the Companies Act to provide for free transferability of shares and debentures and to deal with transfers through depositories, with the insertion of Section 111A into the Companies Act, and Section 22A of the SCRA was simultaneously deleted, which indicates that Section 111A takes into its sweep Section 22A of the SCRA.
Fact being, that Section 111A was introduced into the Companies Act not by way of an amendment to the Act itself but by the Depositories Act. The long title of the Depositories Act mentions that it is an Act to provide for the regulation of depositories in securities. Looking at the object and the long title we do get a hint that the rationale behind the enactment of Section 111A was not of emphasizing free transferability of shares but to facilitate transfer of shares in dematerialized forms and providing for a mechanism to check the misuse of power of the Board of Directors to refuse registration of transfer without sufficient cause.
The judicial interpretations of enforceability ROFR/ROFO and other clauses are discussed below through a few important case laws:
V.B. Rangaraj v. V.B. Gopalakrishnan  : In this case there was an oral agreement between the heads of two groups of a family to the effect that the two family branches would always hold equal stake in the private company and in the event of one family wishing to liquidate his holding, it would first offer it to the members of the other group.
The apex court held that only restrictions enforceable on the transferability of shares would be those contained in the Articles of Association of the Company and hence the above oral agreement was not enforceable. It is pertinent to note that the above case dealt with private companies.
M.S. Madhusoodhanan v Kerala Kamudi Ltd.  : there was an agreement between a few members of the family that provided that “there would be no change in the existing share structure” (among the family) of a private company. It also provided that the shares of two members would pass on to Madhusoodhanan in a certain percentage on their death.
The court distinguished this case from the Rangaraj’s case 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 and distinguished Rangaraj’s case on the grounds that there was a blanket restriction.
Western Maharashtra Development Corporation Ltd vs Bajaj Auto Limited  : A single bench of the Hon’ble Bombay High Court in this case, after examining Section 111A read with Section 9 of the Companies Act, held that the pre-emptive right contained in the shareholders agreement are fetters on ‘free transferability’ and was held to be unenforceable as use of the word “transferable” is of the widest possible import and the Parliament by using the expression “freely transferable”, has reinforced the legislative intent of allowing transfers of shares of public companies in a free and efficient domain.
However, it must be noted that Section 9 which contemplates an overriding effect to the provisions of the Companies Act over the MOA, AOA and other resolutions passed by the company or the Board of Directors applies only to cases where the company executes a document, and doesn’t deal with the case where the agreement is between the shareholders inter-se.
Recently a division bench of the Bombay High Court in the case of Messer’s Holding Limited vs R.M. Ruia & others  has upheld the validity of the clauses like the ROFR/ROFO which do affect the free transferability of the shares. However the judgment dealt with situation where the transfer is between the shareholders inter-se. The facts and the laws laid down by the abovementioned judgment are discussed in brief below.
Facts of the case:
The Plaintiffs in the Suit namely Mr. Ruia & Ors were the major shareholders, holding 75001 shares of a company, Bombay Oxygen Corporation Limited (BOCL), a public company listed with the Bombay Stock Exchange. They were also in control of the management of the company. Mr. Ruia & Ors had entered into a Share Purchase Agreement (SPA) with a German company agreeing to divest their major control in BOCL to the German company. By the SPA, the Ruias agreed to sell 45001 shares held by them in BOCL to the German company and in addition allowed them to purchase 30,000 shares from public making a total of 75001 shares equivalent to 50% + 1 share of BOCL. The dispute between the parties arose on account of the non-disclosure by the German company of a Share Purchase and Cooperation Agreement it had earlier entered into with another company which was a competitor of BOCL.
The Competitor Company first filed a suit before the Hon’ble Delhi High Court complaining about the breach committed by the German company. The matter eventually went up to the Supreme Court. The Supreme Court directed the parties to go for Arbitration. In the Arbitration, a Consent Award came to be passed.
Mr. Ruia & Ors on being acquainted with the litigation between the two parties filed the first suit in the hon’ble Bombay High Court against the German company and the Competitor Company.
In the Suit, ad- interim relief was granted in favour of the Ruias restraining the German company from transferring the shares in question in breach of clause 6.1  of the said SPA.
In the mean time the German company and the competitor company had formed another company, “Messrs Holding Limited”. This was essentially to transfer the shares of BOCL
purchased by the German company from the Ruias and from the public as per the regime provided by clause 6.1 of the SPA.
When this came to the notice of the Ruias, they filed another suit. The two suits and several notices of motions were disposed off by the common impugned Judgment passed by Single Judge of the Bombay High Court.
The German company and the competitor company filed Appeals challenging the injunction granted in favour of the Mr. Ruia & Ors and also for rejection of their prayer for allowing executing the Consent Award between them.
Laws laid down
The court, while deciding the question whether the ROFR clause in the SPA was valid in law, relied a lot on the object and reasons of the amendment by which Section 111A of the Companies Act was enacted.
The important observations made by the division bench are enumerated below:
Given the historical background of the deletion of Section 22A of the Securities Contracts (Regulations) Act, 1956 by the Depositories Act, 1996 and the introduction of Section 111A in the Act, it can be inferred from the object of the Depositories Act that the provisions of Section 111A was meant to regulate the powers of the Board of Directors of a company in relation to the transfer of shares or debentures of a company and any interest therein. The Board of Directors cannot refuse to register a transfer of shares unless there is sufficient cause to do so.
Section 111A of the Act is not a law dealing with the right of the shareholders and does not expressly restrict or take away the right of shareholders to enter into consensual arrangement/agreement by way of pledge, pre-emption/sale or otherwise. The expression freely transferable in Section 111A of the Act does not mean that the shareholder cannot enter into consensual arrangements/agreement with the third party or with other shareholders in relation to his specific shares.
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 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. For the sake of free transferability both the seller and purchaser must agree to the terms of sale.
The decision in Madhusoodhanan’s case is an authority on the proposition that consensual agreements between particular shareholders relating to their specific shares do not impose restriction on the transferability of shares. Further, such 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 as the arrangement is only between the shareholders inter se to which the company is not a party, Section 9 will not have any application on the transaction. The Court relied on the hon’ble Supreme Court judgment in the case of S.P. Jain vs. Kalinga Tubes  and stated that “…two different situations. In the first case, it is the company which issues and allots the new shares and the second situation is of recognition of private arrangement between the existing shareholders by way of sale of share in favour of new shareholder. In the latter case, the company comes into the picture only for the purpose of recognition of transferee as the new shareholder. It is also noted that it is not necessary for the company to be a party in any agreement relating to the transfers of issued shares for such arrangement to be specifically enforced between the parties to the transfer. Notably, in S.P. Jain’s case, the company was a public company at the relevant time during which alleged oppression was caused in violation of the agreement by the two shareholders qua S.P. Jain. In Paragraph 142 of the reported decision, the Apex Court has noted that the Judgment in the case of S.P. Jain (supra) does not in any way hold that transfer of shares agreed between shareholders inter se does not bind them or cannot be enforced like any other agreement. 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.”
The Division Bench also relied on the distinction drawn by the Supreme Court in Madhuoodhanan from the proposition laid down in V.B Rangaraj in that the judgment arrived at by the hon’ble Supreme Court in V.B Rangaraj was on account of the restriction being a blanket restriction on all the shareholders present and future and could not be imported to a private agreement between particular shareholders.
As a result of the Judgment of the Bombay High Court in the case of Messer’s Holding Limited vs S.M. Ruia, now it can be said that certain clause like the ROFR/ROFO are valid and can be enforced, if it is between a shareholder with another shareholder or any third party even though the said agreement is not included in the Articles of Association of the Company and it will not be hit by Sections 9 and 111A of Companies Act as it is essentially a contract between two parties and the company is in no way involved and as far as Section 111A is concerned, the object of the enactment of Section 111A was to limit the arbitrary powers of the Board of directors and to enable transfer in dematerialized form.
Reading all the judgments together following bullets can be termed as the law in regards to the validity of the above explained pre-emptive rights:
Shares of a company are “freely transferable” both as matter of common law and under the Indian Companies Act and a restriction is “unenforceable unless contained” in the Articles
“Freely transferable” refers not to the act of sale, but to the subject of the sale
The above rules do not apply when – 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 when 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.
Madhusoodhanan stands for the general proposition that private arrangements are legal, and “freely transferable” refers to the freedom of the buyer and the seller.
A private arrangement imposing a restriction is enforceable unless barred by the Articles.
These agreements are not required to be incorporated in the Articles of the Company as it can be enforced like a contract between two parties if the company is not a party to such a contract.
The position as to call and put option is still not very clear as it contemplates selling or buying at a pre determined price. However, in the Messers Holding case the Bombay High Court had expressed that it is valid to sell and buy at the prevalent price.
Certainly, a relief to all the private equity investors.
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