The Right to First Refusal in Public Companies: Conflicting decisions and the debate over enforceability

The Right of First Refusal created by a clause of pre-emption provides a company’s shareholders an option of purchasing the shares before being offered to the third parties, in effect providing them protection from wealth transfer and erosion of control. 

Western Maharashtra Development Corporation Ltd. v. Bajaj Auto Limited is a February 2010 decision of the Bombay High Court. It is notable for observations of the Court upon the legality of the right of first refusal in case of public companies under Indian Law.

The matter came up before the court in relation to a pre-emption clause set out in the protocol agreement entered into between the two parties to set up Maharashtra Scooters Ltd. which was a public limited company. The Clause permitted neither party to the agreement to alter the structure, the number of shares or the rights, privileges, restrictions or qualifications of any class of shares or make any further issue of capital without the specific prior consent of the other party.

In examining the arbitral award concerning the legality of the same among other issues, the Court analysed the legislative intent behind the inclusion of Section 111A of the Companies Act, 1956. It observed that the said provision providing free transferability of shares in a public company is founded on the principle that members of the public must have the freedom to purchase and, every shareholder, the freedom of transfer and must be given a broad interpretation in order to fulfil the objective of the law.

The effect of a pre-emption clause, the Court noted, is to impose a restriction on the free transferability of the shares by subjecting the norms of transferability laid down in Section 111A to a pre-emptive right created by an agreement between the parties. This, the Court held to be unenforceable under the Indian law in light of Section 9 of the Act that gives overriding effect to the provisions of the Act to any agreement entered into by the parties. 

The decision in Bajaj therefore has made all agreements entered into by shareholders that confer the right of pre-emption, void and unenforceable. This is in line with a previous judgement of the Delhi High Court in Smt. Pushpa Katoch v. Manu Maharani Hotels Ltd. in 2005 which the Court decided upon the validity of such agreements, holding them to go against the very purpose of Section 111A and therefore unenforceable.

The decision can have far reaching consequences for joint venture partners, banks, financial institutions and even for regulators and stock exchanges. For instance, a pledge of shares by a shareholder would fall within the ambit of a ‘fetter on transfer’, illegalized by the said decision. Also, a non-disposal undertaking given by shareholders of a public company to raise funds from banks for the company would amount to a fetter or restriction on transfer and therefore unenforceable.

Perhaps in consideration of similar concerns over transferability of shares of a public company, a division bench of the Bombay High Court ruled in Messers Holdings Limited v. Shyam Madanmohan Ruia that a private arrangement between shareholders of a public limited company on voluntary basis relating to a right of first refusal is not violative of Section 111A. The judgement has revived the debate on the issue, bringing to the fore the intrinsic right or the freedom to contract between two shareholders, to which the Company may or may not be a party.

The Court has attempted, by way of its judgement, to do away with the undesirable consequences of Bajaj Auto judgement. It also further explained the position with respect to Section 9, stating that it has effect on agreements executed by the company and not by the shareholders and a distinction is ought to be made in this regard. 

It is submitted that the purpose of Section 111A is to regulate the powers of the Board of Directors regarding the transfer of shares, providing that the board cannot refuse a transfer in the absence of a sufficient cause. The legislative intent of the section is not to curtail the rights of the shareholders to enter into any consensual agreement for transfer of particular shares as has been wrongfully interpreted in the Bajaj Auto case. Shares are to be treated as any other movable property carrying with it certain rights and obligations that can be transacted upon in any way that the holder wishes to. Thereinafter, a consensual agreement for the transfer of specific shares is merely a contract between two or more parties and cannot be said to be violative of the provisions of Section 111A.  

The current position of law, however, continues to remain unclear with the corporate sector eagerly awaiting the Supreme Court’s deliberation on the same through the appeal filed against the Bombay High Court’s ruling in the Messers Holdings case. [By Aanchal Basur  (3rd year, NUJS)]