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CORPORATE LAW-RESTRICTIONS ON TRANSFERABILITY
LIST OF CASES
Bajaj Auto Limited vs. Company Law Board  INSC 348
Babulal Choukhani vs. Western India Theatres Ltd, AIR 1957 Cal 709
Shailesh Prabhudas Mehta vs. Calico Dying and Printing Mills Ltd.  67 CompCas 533 (Bom)
Bajaj Auto Limited vs. N.K. Firodia  41 CompCas 1 (SC)
Shanti Prasad Jain vs. Kalinga Tubes Ltd AIR1962 Ori 202
V.B. Rangaraj vs. V.B. Gopalakrishnan AIR 1992 SC 453
Gujarat Bottling Co. Ltd. vs. Coca Cola Company AIR 1995 SC 2372
Mafatlal Co. Ltd. vs. Gujarat Gas Co. Ltd. and Others  97 CompCas 301 (Guj).
Madhusoodhanan v Kerala Kaumudi Pvt. Ltd  117 CompCas 19 (SC)
Tett vs. Phoenix Property and Investment Co. Ltd 1984 BCLC 599
Hillcrest Realty Sdn. Bhd Vs. Hotel Queen Road Pvt. Ltd. and Ors.,  71 SCL 41 [CLB]
Satyanarayana Rathi vs. Annamalair Textiles Pvt. Ltd.  95 CompCas 368 CLB
Shorthridge vs. Bosanquet, (1852) 16 Beav 97
Coachcraft Ltd. vs. S.V.P. Fruit Co. Ltd. (1978) 3 ACLR 658
The expression ‘share’ can be defined as “A unit that measures the holder’s interest in and liability to a company"  . According to Section 82  of the Indian Companies Act, 1956 (hereinafter Act) a share constitutes a movable property and is transferable in nature. The manner of transfer is to be found in the articles of the company.
However, restrictions may be imposed on the free transferability of shares. Section 108B  of the Act provides for the restrictions on transfer of shares. It obliges every body corporate under the same management holding at least ten percent of the nominal value of the subscribed equity share capital to intimate to the Central Government its proposal to transfer a share in the specified particulars. Since this provision does not stipulate the kinds of restrictions on the transferability of shares a detailed discussion on it is not necessitated. Section 111(1)  of the Act confers upon the company the power to refuse registration. The decision of the company can also be appealed against. This section prescribes the procedure when a company refuses registration. Procedure of appeal against such refusal is also provided.
Such restrictions in case of a private company can broadly be classified into two categories. These are, firstly, the power of Directors to refuse the transfer and secondly, the pre-emptive rights of shareholders.
‘Board of Directors may refuse a transfer only on the grounds stipulated in articles of the company. And such refusal must lie in the interest of the company and its shareholders’  . Power to deny the transfer cannot be exercised whimsically.
A pre-emptive right refers to ‘The right conferred by the articles of association upon shareholders in some private companies to be offered on specified terms, first refusal of the shares of any shareholder wishing to transfer his holding’  . It restricts the transfer of shares to general members of public.
Major difficulties would arise however, when Articles of Association of a Company vest in the Board of Directors absolute discretion as regards the transfer of shares. Section 9  provides an immediate solution to such difficulties. It stipulates that any provision of the memorandum or articles of a Company repugnant to the Act shall be void to the extent of such repugnancy.
This paper aims to analyse the restrictions on the transferability of shares in a private company alone. It is broadly structured into two chapters. The first chapter lucidly discusses the first kind of restriction namely the power of Directors to refuse the transfer of shares through the relevant case law followed by the second chapter which seeks to trace the scope of the pre-emptive rights of shareholders of the company. The paper shall end with a reasoned conclusion.
RESTRICTIONS ON TRANSFER OF SHARES IN A PRIVATE COMPANY
This chapter aims to explore the power of Directors to refuse a transfer. This is done by analyzing the intricate aspects of the same. Some of the crucial areas in this regard are the exercise of discretion by Directors, legality of private agreements contrary to the articles of association and the legislative provisions restricting free transferability of the shares.
Exercise of Discretion
“The articles of a company regulate the transfer of its shares. Directors may accordingly be vested with the power to deny the registration of shares and withhold the reasons for the same. In other words, the Directors may enjoy an absolute and uncontrolled discretion in this regard. But if the exercise of such discretion is substituted by whim or caprice, then the Court may examine the exercise of this power under the articles of the company through a test known as the ‘test of discretion’. If it is shown that the Directors have exercised their discretion, Courts would be reluctant to examine it any further. But the legitimacy of reasons assigned by the Directors for taking a particular decision can always be inquired into. The Court further observed that the burden of proving fraud and mala fide lies on the alleging party"  .
Another landmark case in this regard was Bajaj Auto Limited vs. N.K. Firodia  where the Court interpreted the expression ‘discretion’ in these words- “Discretion does not mean a bare affirmation or negation of a proposal. Discretion implies just and proper consideration of the proposal in the facts and circumstances of the case. In the exercise of that discretion the Directors will act for the paramount interest of the company and for the general interest of the share-holders because the directors are in a fiduciary position both towards the company and towards every share-holder. The Directors are therefore required to act bona fide and not arbitrarily and not for any collateral motive". It then observed that the reasons adduced by a company for taking a decision and impact thereof can be scrutinized judicially.
This line of reasoning was carried further in Shailesh Prabhudas Mehta vs. Calico Dying and Printing Mills Ltd.  Exercise of discretion by directors was the subject matter of examination in this case. After a careful perusal of the facts it was observed that decision of directors in refusing the transfer of shares was bona fide as the allegations of petitioners were without any substance.
Bajaj Auto Limited vs. Company Law Board  best explains the position of law as regards the transferability of shares. The Court took the view that the real reason behind refusal to register is to be enquired into. It also restricted the scope of judicial review to scrutiny of the exercise of power by the Board of Directors. Heavy reliance was placed on Bajaj Auto Limited vs. N.K. Firodia  in observing that the action of Directors must lie in the interests of the company. The relevant excerpt from the judgment is as follows: “This Court while examining the action of the Board of Directors is not expected to exercise original appellate jurisdiction and sit in appeal on question of fact. The judicial review while hearing in appeal from the decision of the Company Law Board would be limited to see whether there was a bona fide exercise of power by the Board of Directors while refusing to register the transfer of shares".
Validity of Agreements Contrary to Articles of Association
In Shanti Prasad Jain vs. Kalinga Tubes Ltd  . Court was called upon to decide the legality of an agreement entered by two members of a company with a non member. It was held that agreement was no binding on the company and thus cannot be enforced in a Court of law.
The same question arose for consideration before the Court in V.B. Rangaraj vs. V.B. Gopalakrishnan  . The Court went into the definition of Articles of Association and found that “articles are those regulations which bind a company and its shareholders. The shares of a company can be transferred like every other movable property. A restriction if any, on the transfer of shares will be binding when specified in the articles alone"  .
In Gujarat Bottling Co. Ltd. vs. Coca Cola Company  , the Court extensively discussed the law on agreements in restraint of trade. ‘It opined that the effect of an agreement entered into between two persons is restricted to such persons and cannot in any way place any obstacle in the right of the shareholders who were not a party to this agreement’  .
Mafatlal Co. Ltd. vs. Gujarat Gas Co. Ltd. and Others  followed the same line of reasoning. In the former case, the Court maintained that the agreement of pre-emption having not been incorporated in the articles of the Company is incapable of being enforced.
Notable developments took place in Madhusoodhanan v Kerala Kaumudi Pvt. Ltd  where the Court while relying on Rangaraj case distinguished between an agreement imposing blanket restrictions on all shareholders and an agreement between particular shareholders relating to transfer of specified shares. It upheld the karar to be enforceable by distinguishing Rangaraj case from the facts before it.
Legislative provisions restricting free transferability of shares
"As far as private companies are concerned, the articles of association restrict the shareholder's right to transfer shares and prohibit any invitations to the public to subscribe for any shares in, or debentures of, the company." This is how a "private company" is now defined in section 3(1)(iii) of the Companies Act, 1956 and how it was defined in section 2(13) of the 1913 Act viewed the Court in Kaumudi case. This excerpt clearly shows that the restrictions on the transferability of shares can be found in the Act which also existed in the 1913 Act signifying that these restrictions existed since time immemorial. Private companies are characterised by the restrictions on the free transferability of their shares which continue even when such companies are subsidiary to a public company  .
PRE-EMPTIVE RIGHTS OF SHAREHOLDERS
“A pre-emptive right can place a restriction in the way of transferability of shares only when it is stipulated in the articles of association of the Company and not otherwise. In other words, if any restriction in the nature of a pre-emptive right is found in the articles of a company it shall be binding upon the shareholders. It operates by creating an additional restriction in the way of transferability of shares in that the share sought to be floated should be offered to the shareholders of the Company"  . Under section 111 of the Act the power to refuse registration is confined to the grounds stipulated in the articles.
‘While transferability of shares may be restricted to some extent there can be no absolute restrictions on the same. A pre-emptive right does not amount to a prohibition on the right to transfer’  .
Transfer in contravention of pre-emptive clauses
Company has a right to invalidate a transfer which contravenes the provisions of its articles. But when once it accepts a contravening transfer, it can no longer question the validity of such transfer  . It follows that such a transfer is neither a nullity  nor void ab initio  .
Such a transfer can be validated by subsequent assent of shareholders or even by acquiescence  . The purchaser in such transfers is not left without remedies. The seller remains accountable to him for all accretions such as dividend and bonus  .
The law is unclear on this aspect in that there are two diverging opinions as regards the legality of a transfer in contravention of pre-emptive clauses. One of these views was expressed by J. Vinelott in Tett vs. Phoenix Property and Investment Co. Ltd  . He observed that-“Despite the disregard of pre-emptive provisions there occurred a complete and effective transfer between transferor and transferee in terms of which the equitable title passes to the latter". The Court of Appeal however, maintained that the company was not bound by such transfer.
“The privacy of a close corporation is more important than the price offered by an outsider. A different intention would have defeated the intention of the incorporators when they formed the company  " was the contrary view which is close to the basic rationale in restricting the transferability of shares.
Position of Law
The transfer in contravention of pre-emptive clauses is neither void nor illegal. It is a valid transfer in that the title of the share passes to the purchaser and the seller is liable for all accretions to such share. However, neither a company nor its shareholders are bound by any such transfer when prohibited by the articles. In other words, company has a right to refuse a transfer in contravention of pre-emptive clauses but if it waives this right for once the transfer is deemed valid. Such transfers can be subsequently validated by the assent of shareholders. It is also to be noted that there is no general right to pre-emption. It is only when included in articles of the company that it operates in the nature of an exclusionary right and not otherwise.
Articles of a company are of paramount significance in determining the transferability of shares. Transferability of shares in a company is regulated by its articles and something not stipulated in the same cannot place any obstacle in the transmission of shares. However, contravention of the articles invites rejection. This follows that an agreement to transfer shares in contravention of the articles is incapable of enforcement.
Board of Directors may be vested with an unfettered discretion in this regard but this discretion has to be discharged honestly and not whimsically. Once the Court satisfies itself as to the exercise of discretion the correctness of the decision arrived at by the Directors would no longer be relevant. The reasons if any given by the Directors to deicide in a particular manner can always be looked into by the Court.
An agreement in contravention of a pre-emptive clause is not invalid. But it has no binding effect on either the company or its shareholders.