With changing nature of economy, the nature of investments has changed. A company or a business which was once owned by an individual is now owned by a pool of individuals. These individuals buy shares of the company, and being the shareholders, they own the company to the extent of shares they purchase. The shareholders have right to decide constitution of the board of directors who manage the affairs of the company.
Transfer of shares refers to the transfer of title of the shares. Usually, one deems absolute right to transfer whatever one owns, however it is not the same in case of shares. There are certain constraints on such transfers which are examined in the post. The post also analyses the enforceability of “specific performance” as a remedy in two cases- the Transfer of Share clauses in shareholding and that in share purchase agreements.
RESTRICTIONS ON TRANSFER OF SHARES
Restricting the right to transfer shares is one of the pre-requisites for the company to be treated as a ‘private company’ under Companies Act, 2013. Companies impose certain restrictions on shareholder’s right to transfer shares. Transfer of shares has to take place in a manner prescribed in the Articles of Association (‘AOA’), lest the company should not register the transfer and unless the transfer is registered, the transferor remains the owner. Some of the restrictive clauses are examined as follows:
PRE-EMPTION RIGHTS– This is the Right of First Refusal whereby any shareholder who wants to sell the shares has to first notify other members of his intention to sell and if no member offers to buy shares at an acceptable (read fair) price, only then can the shares be transferred to an outsider. The validity of the pre-emption clause was upheld by Bombay High Court in Bajaj Auto Ltd. v Western Maharashtra Development Corporation Ltd.
This right of the company is concomitant with its duty to inform other members of the intended sale of shares in a time bound manner. After notifying the members, the “fair” price is decided by the Directors in consonance with the Auditors of the company according to terms specified in the AOA.
REFUSAL TO REGISTER THE TRANSFER– Under S.58 of Companies Act, 2013, company can refuse to register the transfer of shares in pursuance to its powers to restrict the transfer. However, any such refusal must have a “sufficient cause” and should not be arbitrary. Generally, acceptable causes are when; transferee is insolvent, those shares are kept as lien of debt advanced to transferor, transferee is a minor; or if the instrument is defective and incomplete.
RESTRAINT ON FREEDOM TO SELL/ TRANSFER– When any shareholder bypasses his duty and consequently diminishes/ abrogates company’s right to first refusal or any other right under the shareholder’s agreement, contractual principles of interpretation apply and the contract between shareholder and company is construed objectively. Freedom of Trade envisioned under S.27 of the Indian Contract Act doesn’t apply in such cases as courts have construed the such restrictions as a reasonable.
These restrictions though, prima facie unfair from shareholder’s viewpoint are nonetheless justified because they were entered into by the shareholder when he willfully agreed to such restrictions in the AOA. Thus, companies can pose only those restrictions which have been agreed upon by the shareholder and are mentioned in the AOA. The restrictions are therefore not absolute and are not to be considered as hindering growth of the company. Courts have, at various junctures, adjudged that the discretionary power to refuse the transfer of shares is not to be abused at the hands of the company.
If the transferee thinks that the transfer was rejected without a “sufficient cause”, he can appeal to the tribunal, and if not satisfied, to the court in order to get the decision reviewed. In Bajaj Auto Ltd. v N.K. Firodia, the Supreme Court held directors liable for acting in pursuance of their personal interests which were prejudicial to the interests of the company. Their use of power was categorized as arbitrary and unjustified. Court also said that directors must act in a bona fide manner keeping general interests of the company in mind. The court in Hemangiri Finance & Leasing (P.) Ltd v. Tamilnad Mercantile Bank Ltd restricted the ‘power to refuse’ to saying that without any specific provision in the AOA, directors don’t have the right to refuse the transfer and when they do have the right, it is not to be exercised arbitrarily.
EXCEPTIONS TO RESTRICTIONS
Some accepted exceptions to the rule are:
- Transfer of shares to the legal representatives or legal heirs.
- When allotment of shares is on basis of rights and existing shareholders renounce their shares.
In an important development, in M.S. Madhusoodhanan & Anr v Kerala Kaumudi Pvt. Ltd. & Ors, the court held that private agreement between the shareholders of the company regarding transfer of shares would be enforceable and the company need not necessarily be a part of that agreement. This gave shareholders additional right to transfer the shares to the member of the company voluntarily without attracting restrictions from the directors.
SPECIFIC PERFORMANCE IN EVENT OF BREACH
Shareholding agreements bind all the existing shareholders of the company while AOA binds both existing and future shareholders. In all agreements, there is always a possibility of breach by either party which is remedied by contractual law. One of the remedies, and which is discussed hereinafter, is “specific performance.” Specific performance is an equitable relief, granted against the defendant according to which, the defendant is asked to perform the duties and obligations he initially contracted for. This is in contrast to the remedy by way of damages, which gives pecuniary compensation for failure to carry out the terms of the contract.
Specific performance is a desirable remedy and whatever is desirable is always hard to attain. In share transfer cases too, it has been difficult for plaintiffs to compel courts to grant specific performance in cases of breach of shareholding agreements. One such instance was Kidambi Vatapatra Sayi vs V. Venkata Punnayya And Ors. in which case, specific performance with the respect to transfer of shares was demanded; but in due course it was discovered that the transfer was not registered by the company which was one of the pre-requisites under the AOA. Since the board of directors didn’t consent to the transfer, the transferor could not legally transfer those shares and specific performance was rendered impossible.
BREACH OF RIGHT OF FIRST REFUSAL
As already mentioned, the transferor is obliged to inform other members of the company of his intention to sell first before offering the shares to outsiders. When this obligation is breached and shares are directly transferred to an outsider, the holder of Right to First Refusal can enforce the agreement and ask for specific performance. However, it would be legally impossible and economically inefficient if specific performance is invoked in such a case because shares would have already been transferred. For specific performance, the transferee will have to give up his right on shares which he had purchased legally and is now the owner of. Elizabeth Conseza, in her article, talks about the impracticality of specific performance as a remedy in case of breach of right of first refusal.
SPECIFIC PERFORMANCE IN SHARE PURCHASE AGREEMENTS
In share purchase agreements, “specific performance” can be and is invoked as a suitable remedy. Specific performance has been mentioned as a remedy for the purchaser of a share in Specific Relief Act, 1963. Section 14(3)(b)(ii) reads as follows: “The Court may enforce specific performance in cases: where the suit is for- the purchase of a share of a partner in a firm.”
Section 10 of the Specific Relief Act lay down cases where specific performance of the contract has to be enforced. Generally, in cases of moveable property, remedy of specific performance is not granted. However, Explanation (ii)(a) of Section 10 provides for exception to this generality in case the property in issue is not “an ordinary article of commerce.” In Jainarain Ram Lundia v Surajmull Sagarmull, the court held that shares of a private company are not easily obtainable and would thus come under the exception. Therefore, specific performance can be invoked in cases of transfer of shares wherever possible. This was also upheld in Bank of India v J.A.H. Chinoy.
Therefore, courts are not averse in recognizing specific performance as a suitable remedy in cases of share purchase agreement but due to impracticality, specific performance cannot be enforced in cases of breach of terms of shareholding agreements.
Shareholders agreements are therefore an inevitable part of investment transactions and transfer of shares is a crucial part of such agreements. The post analyzed restrictions imposed on the Transfer of Shares by the company and justified them on the grounds of Freedom of Contract theory whereby shareholders had agreed to be bound by such restrictions when they entered into the shareholding agreement. The safeguards against the abuse of such power of restriction have been provided by the Supreme Court judgments.
The post examined the remedy of “specific performance” in light of share purchase and shareholding agreements. Generally, the remedy is granted in former cases while damages are awarded in latter ones.
ABOUT THE AUTHOR
Kartik is a second-year law student at National Law School of India University, Bangalore. This cricket aficionado is an avid reader of current legal advancements with a keen interest in Constitutional Law.