Any foreign investor intending to make an investment in the equity share capital of any company in India prefers to have an exit option (call & put option) under the transaction document(s). An exit option generally gives flexibility to the foreign investor(s) to sell the securities in the event of (i) the project for which money is infused in India is unsuccessful; or (ii) there is a dispute between the foreign investor and the Indian party in relation to the operation of the company or a project; or (iii) there is a change in the policies of the Government of India; or (iv) the foreign investor does not want to remain invested in the company due to any other reason.
In addition to the aforesaid exit option, the parties to the transaction documents also prefer to have some pre-emptive rights such as the right of first refusal, tag-along or drag-along rights due to some commercial reasons or in order to protect their interest. The legal enforceability of such pre-emptive rights in India including call & put option shall always be the concern of foreign investors. In this article, I have tried to analyze all the relevant legal issues in relation to the enforceability of the aforesaid options including the provisions of the Companies Act, 2013 ("C A 2013"), notifications issued by the Securities and Exchange Board of India ("SEBI") and the Reserve Bank of India ("RBI") in this regard.
It was well established under the provisions of the Companies Act, 1956 ("CA 1956") that any provision contained in any agreement executed between a company and a third party so far it is inconsistent with the provisions of the CA 1956 shall be void. However, in order to bind the company and all the shareholders inter-se, the foreign investor prefers to incorporate the relevant terms of their consensual arrangement (such as shareholders' agreement) in the Articles of Association of a company ("AoA").
As far as the new CA 2013 is concerned, there is no change under the aforesaid legal position under the said Act. Section 6 (Act to override memorandum, articles, etc.) and Section 10 (Effect of memorandum and articles) of CA 2013 continue to give effect to the aforesaid legal position.
In order to further analyze the enforceability of the aforesaid options, this Article is divided into three parts: Pre-emption Rights relating to transfer of shares; Pre-emption Rights relating to issue of shares by the company; and Call & Put Option.
Pre-emption Rights relating to transfer of shares
A pre-emptive right in respect of transfer of shares is essentially a right to impede the transfer/ sale of shares to a third party, and demand that such shares be transferred / sold to the agreed party(ies) / shareholder(s).
Relevant Provisions of CA 1956 & CA 2013
In terms of the provisions of CA 2013:
- A private company is required to restrict the transfer of its shares through its AoA [Section 2(68) of CA 2013].
- If a private company refuses to, whether in pursuance of any power of the company under its AoA or otherwise, register the transfer of any securities or interest of a member, it is required to intimate the transferor and transferee within the stipulated time period [Section 58 of CA 2013]. It is to be noted that as far as the provisions of CA 2013 and the erstwhile CA 1956 are concerned; there is no change in the aforesaid legal position of a private limited company providing restriction on transfer of its shares through its AoA. Such a restriction will continue to be valid and binding on such private company and its members under the new CA 2013.
- However, there were some debatable issues under the erstwhile CA 1956, in relation to the restriction on the transfer of shares by public companies, keeping in mind the provisions of Section 111A of erstwhile CA 1956, which made the shares of a public company 'freely transferable'.
- Section 58 (2) of CA 2013 provides that 'without prejudice to Sub-Section 58 (1)', the securities or other interest of any member in a public company shall be 'freely transferable' (emphasis supplied). Further, proviso to Section 58 (2) of CA 2013 provides that any contract or arrangement between two or more persons in respect of transfer of securities shall be enforceable as 'contract'. The provisions of Section 58 (2) of CA 2013 are similar to the provisions of Section 111A of the erstwhile CA 1956 except the proviso to Section 58 (2) of CA 2013 as mentioned above.
It must be noted that the proviso to Section 58(2) of the CA 2013 is in line with the judgment of the Bombay High Court in the matter of Messer Holdings Limited vs Shyam Madanmohan Ruia & Others [2010 159CompCas29(Bom)]. As per the Bombay High Court, any contract or arrangement between two or more persons with respect to transfer of securities can be enforced like any other contract and does not impede the free transferability of shares at all.
Hence, any consensual arrangement between the shareholders, in relation to the shares of a public company, shall be valid and binding as a 'contract' inter-se the shareholders. If any public company is also being made party to such a consensual arrangement/ contract, then such a contract will also be enforceable against the public company as a 'contract' in terms of the proviso to Section 58(2) of the CA 2013. In case of breach of such a contract by any party, the aggrieved party may avail legal remedies as available in case of 'breach of contract' including specific performance of the contract under the Specific Relief Act, 1963.
Expression 'Free Transferability'
The expression 'freely transferable' is not defined under the CA 2013 . However , Section 58(4) of CA 2013, provides that if a company without 'sufficient cause' refuses to register the transfer of shares, the transferee may appeal to the National Company Law Tribunal ("NCLT") and the NCLT shall direct such a company to register the transfer of shares in terms of the provisions of Section 58(5) of CA 2013.
The board of directors, upon 'sufficient cause' being seen, may refuse to register the transfer of shares. The words 'sufficient cause' in Section 58(4) takes within its ambit not only those contingencies contemplated under sub-section (3) but also circumstances and reasons other than which might require the company to refuse to register the transfer of shares. Thus, there can be various reasons, though it is not possible to enumerate all of them and dependant on the facts of each case, which would constitute 'sufficient cause' for a company to refuse the registration of transfer of shares.
Messer Holdings Judgement
The Hon'ble High Court of Bombay in Messer Holdings Limited vs Shyam Madanmohan Ruia & Others [2010 159CompCas29 (Born)], while dealing with the question of validity of an agreement having a first right of refusal (pre-emption right), inter-alia observed that:
"... For that, we may have to consider the objects and reasons for which Section 111 A has been introduced in the Companies Act. Prior to the introduction of Section 111 A, Section 111 of the Companies Act, 1956 provided for the remedy of appeal to a transferor or transferee seeking relief in respect of a transfer/ transmission of shares in a public or private company.
They could apply for rectification of register of members under Section 155.
With effect from January 17, 1986, Section 22 A was inserted in the Securities Contracts (Regulations) Act, 1956. It provided that the shares of the registered company be made freely transferable. However, the company could refuse transfer only on four specified grounds. The said provision was introduced in the backdrop of a series of complaints regarding arbitrary powers exercised by the Board of Directors in refusing or non consideration of request for transfer/transmission of shares in favour of the transferee. It thus follows that the provisions of Section 22A of the Securities Contracts (Regulation) Act 1956 was intended to regulate the right of the Board of Directors of the company to refuse transfer of shares. That was not a provision to restrict the right of shareholders to deal with their shares or to enter into consensual arrangement I arrangement regarding their shares (by way of pledge, pre-emption, sale or otherwise). Suffice it to observe that the intention behind introducing Section 22 A in 1986 was to regulate the right of the Board of Directors to refuse transfer of member's share and it was not to impose restriction on the right of the shareholder to deal with his shares by entering into a consensual arrangement with the third party to which the company need not be a party."
"51 (7)........ In other words, the setting in which Section 111A is placed in part IV of the Act under the heading "transfer of shares and debentures", it is not a provision to curtail the rights of the shareholders to enter into a consensual arrangement with the purchaser of their specific shares. The right to enter into a consensual arrangement must prevail as long as it is in conformity with the terms of Articles of Association and other provisions of the Act and the Rules. Whereas, 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 a consensual arrangement/contract with the purchaser of their specific shares. If the legislature intended to take away that right of the shareholder, it would have made an express provision in that regard. Reliance has been rightly placed on the decision of the Apex Court in the case of Byram Pestonji Gariwala (supra) which takes the view that the freedom of contract generally, the legislature does not interfere except when warranted by public policy, and the "legislative intent is expressly made manifest...... .. .. ..."
In view of the aforesaid judgement:
- The expression 'freely transferable' should be given wider interpretation and any consensual arrangement/ contract providing pre-emptive rights pertaining to transfer of shares should not be construed as violation of the expression 'freelytransferable'. Had that not been the intention of the legislature, the proviso to Section 58(2) of the CA 2013 would not have been specifically inserted and appropriate restriction would have been placed in the CA 2013 in relation to transfer of shares in terms of consensual arrangement; and
- The expression 'freely transferable' is a mandate against the board of directors to register the transfer of the specified shares. However, such expression does not in any way way restrict the power of the board of directors of a public company to refuse the registration of transfer of such shares on 'sufficient cause'.
As far as a private company is concerned, such a private company is permitted to insert restrictions on transfer of shares in its AoA in terms of provisions of Section 2(68) and Section 58(1) of CA 2013. Hence, any restriction on transfer of shares as agreed under the consensual arrangement shall be valid and binding on such a private company and it may be duly incorporated in the AoA and may be enforced against the shareholders of a private company.
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