Legality of Pre-Emptive Rights

A pre-emptive right such as the right to first refusal of shares, a right to buy or to sell shares, and would be covered by the definition of the term “option in securities”, under s. 2(d) of the Securities Contracts (Regulation) Act. This was a relevant classification, when there was still a prohibition on options in securities. However, this was removed by the Securities Laws (Amendment) Act, 1995. 

The SCRA does allow for certain kinds of contracts to be prohibited by the Central Government through notification in the Official Gazette. SEBI / LE – 3650/2000 made under the SCRA does prevent any contract which does not involve spot delivery of securities, or contract for cash or hand delivery or special delivery of contract in derivatives. However, this notification should not apply to pre-emptive rights, for two reasons:

1. A reading of the definition clause shows that a pre-emptive right is an option in security, and more specifically merely the right to buy, and is not a contract to buy or to purchase the security. So, it should not come under the purview of the notification.
2. S.28(2) of the SCRA exempts share warrants and convertible bonds, and options and rights relating to them from coming under the purview of this Act, in the situations prescribed in that section. The section is wide enough to cover agreements between shareholders and the company, and between shareholders inter se. So, neither the SCRA nor notifications under the Act should apply to convertible bonds, or share warrants, of public companies, since s. 114 of the Companies Act restricts share warrants to public companies.

A further reading of recent case law on transferability of shares, leads to a conflicting position. While Western Maharashtra v. Bajaj Auto has held that there can be no restrictions on the transfer of shares, whether of a private or of a public company because it would result in a violation of the provisions of law, Messer Holdings v. Shyam Ruia  has held that the intention of the legislature is not to infringe on the rights of private shareholders to enter into consensual agreements with each other. Therefore, Messer Holdings has allowed consensual agreements between two shareholders on the ground that it is not a restriction imposed by the Company. Both these decisions have been delivered in light of an earlier decision of the Supreme Court, Madhusoodhanan v. Kerala Kammudi, which held that private agreements between shareholders should be honoured by the Company.

Messer Holdings and Western Maharashtra are in agreement to the extent that legislative intent should be looked at when agreements are honoured, however, they differ in the reading of this legislative intent. Jer Rutton Kavasmanek v. Gharda Chemicals did look at the question of transferability of shares, but did not go into the question of which position of law was correct.

However, given the above reading of the SCRA, it seems that there would be no violation of securities law when there are pre-emptive rights in a contract between two private parties, whether the shares are of a private, or a public company. When dealing with share warrants and convertible bonds, there is an exception under the SCRA, to the extent that the SCRA does not apply to those agreements. However, case law, such as Pushpa Katoch v. Manu Maharani prevents any restrictions on the transfer of shares of a public company. A right of pre-emption is considered to be a restriction which limits the free transfer of shares, and so would be prohibited.

The right of shareholders of private companies would be covered by the case law that has been referred to above, so there is no illegality relating to agreements regulating the transfer of shares, since there is a decision of the Supreme Court to that effect (Madhusoodhanan) which would have higher precedent value than the conflicting decisions of the Bombay HC. And it would seem that the notification under the SCRA would not apply, which ensures that there is no illegality under the SCRA either.  [By Malavika Chandu (3rd year)]