Transfer restrictions in shareholder agreements (“SHA(s)“) have come to play a critical role in shaping deal dynamics. With India reporting a steady growth in mergers and acquisitions (“M&A“), questions of control, transfer restrictions, ownership flexibility and exit options have become crucial for investors and companies alike. Restrictions on the transfer of securities such as rights of first refusal, tag along and drag along rights, and lock in provisions directly affect exit strategies. This article examines the judicial treatment and legal framework governing transfer restrictions, seeks to explore the mechanics of automatic and permitted transfers, and dives into the nuances and of drag along and tag along rights in India.
Legal Framework Governing Transfer Restrictions
Under the Companies Act 2013 (“Act“), Section 6 clearly states that if the memorandum of association (“MOA“),the articles of association (“AOA“) or any other agreement or document executed by a company are in violation of the Act, the same shall be, to the extent that the same is repugnant to the provisions of the Act, be void.
Under Section 58(2), the Act clearly states that the securities or interest of any member in a public company shall be freely transferrable. However, the proviso to this Section states that any contract or arrangement between two or more persons in respect of the transfer of securities shall be enforceable as a contract. This provision is in line with the ruling in case of Messer Holdings Limited v. Shyam Madanmohan Ruia[1], wherein the Bombay High Court held that: “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“. This ruling was upheld in the case of Bajaj Auto Limited v. Western Maharashtra Development Corporation Limited[2].
A private company, by its definition under Section 2(68) of the Act, is required to restrict the transfer of its shares through its AOA. Under Section 10, the Act provides that when the MOA and AOA are registered, the same shall bind the companies and the members thereof to the same extent as if they respectively had been signed by the company and by each member.
Strategic Value of the Transfer Restrictions
Transfer restrictions grant majority shareholders or promoters, as the case may be, contractual safeguards to allow them to exercise certain rights on the fulfilment of a set of conditions. Such rights, like in the case of the right of first offer or the right of first refusal, allow the majority shareholders or promoters the option to purchase shares prior to the same being offered to external parties. On the other hand, tag along rights allow for minority shareholders to participate in the transfer while drag along rights allow for majority shareholders and/or the promoter to require minority shareholders to participate in the transfer, often on similar or identical commercial terms. These rights seek to protect the interests of the minority and majority shareholders respectively.
Conversely, for the company, transfer restrictions can ensure stability and control in the ownership of the company, ensuring that control is retained in the hands of the known and vetted investors. From the company’s perspective, any sudden shifts in the ownership of the company could destabilize decision making or strategic direction. Such restrictions could further provide external investors predictability, and signal investor confidence in the company to any potential stakeholders.
Automatic and Permitted Share Transfers
Automatic transfers arise in the form of statutory obligations, regulatory changes or internal company mechanics or as a result of the death of the investor or its disqualification under the terms of the AOA. Such transfers are effectuated by the occurrence of an event, and the consent of the shareholders is not required. These forms of transfers can be seen in certain M&A transactions, as provided under the Act[3], any court mandated or voluntary winding up, or any mandated amalgamations. Permitted transfers, on the other hand, cover all voluntary transfers of shares undertaken by the shareholders, including sales to external parties, transfers to pre-approved entities and transfers following the rights and restrictions set out in the SHA and AOA.
Drag Along Rights
A drag along right is a right specifically afforded to a majority shareholder (typically owning over 50% of the shares of a company). This right empowers the majority shareholder to compel minority shareholders to sell their shares alongside the majority shareholder at the same price and on the same commercial terms as the sale of the majority shareholder’s shares. This right, while ensuring liquidity and flexibility for the majority shareholder, ensures that minority shareholders are unable to obstruct lucrative sales of the company to investors that demand or require full control of the same. While such rights seem to be more favorable towards the majority shareholder, the rights of the minority shareholder are guaranteed to the extent that the drag along provisions ensure that the sale of the shares of the minority shareholder is on the same commercial terms and rates as that of the majority shareholder.
It is important to note that the majority shareholders would not have an unfettered right to invoke their drag along rights. These rights are governed by the terms set out in the AOA and are often solely used in the context of M&As and the sale of a company.
Tag Along Rights
Tag along rights, in contrast to the drag along rights described hereinabove, are rights specifically designed to protect the interests of the minority investors. This right can be invoked by minority investors in the event that majority shareholders intend to sell a majority of their stake to a third party thereby allowing for the minority investors to require that their shares are sold on the same terms and price as the shares of the majority shareholder. This right ensures that minority shareholders are not left with less advantageous terms in selling their shares and give the minority shareholder the option to exit the shareholding of a company in tandem with the exiting majority investor.
Tag along rights provide investors with a minority stake an option to exit if the majority investor is selling majority of their stake. This may either prevent incoming majority shareholders from investing in a company as the price of the transaction would proportionately increase in accordance with the minority shareholders wishing to exercise these rights, or encourage a third-party investor who wishes to acquire entire control of the company.
Conclusion
Transfer restrictions are a cornerstone of modern shareholder agreements, facilitating balance between investor exit flexibility and protection against dilution and marginalisation of the investors. While the tag along and drag along rights are not specifically defined or provided for in the Act, these rights are essential to ensuring investor protection. They not only ensure smoother transactions during potential sales but also give investors clarity on their rights and any safeguards available to them. Ultimately, these rights help prevent disputes, align investor interests, and contribute to the long-term stability of the business. While the rights mentioned in this article are critical, they are only a few of the transfer restrictions present in SHAs. In the next part of this series, we will examine other restrictions on share transfers that play an equally important role in maintaining control, transparency and harmony among shareholders.
[1] (2010) 159 Comp Cas 29 (Bom).
[2] 2015 SCC OnLine Bom 2111.
[3] Under Section 235 of the Companies Act 2013, the transferee company is given the power to acquire shares of the shareholders dissenting in the transfer of the company, when the transfer of the company is approved by not less than 90% of the shareholding.
English
Chinese (Simplified)
Japanese