November 29, 2021

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Transfer restrictions in shareholders rights in articles

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This article is written by Sanjana Rao, pursuing Diploma in Cyber Law, FinTech Regulations, and Technology Contracts from LawSikho.

Table of Contents

Section 44 of Companies Act, 2013(CA,2013) and 2(7) of Sale of Goods Act, shares are movable property and hence, freely transferable. Atlas, the world of corporate is not black and white. Concerning  2(68) of CA, 2013, shares transferred in a private company are mandated to be restricted by incorporating various clauses in its Articles of Association. This is based on the Partnership principle. However, these restrictions have to be exercised in the best interests of the company and its shareholders and complete prohibition on the transfer of shares is not allowed. Examples of sufficient cause can be due call money that has not been paid by the shareholder or is financially incapable of paying it if the transferee is a minor (unless through a natural guardian), improper documents or any other reason in the general interests of the company. The shareholder must study the articles of the company before registering himself as a member.

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Right of preemption

Concerning Bishan Singh v. Khazan Singh, preemption is a right to the offer of a thing being sold and not a right to the thing itself.

When a member decides to sell his or her shares, the shares must first be offered to other company members. The price will thereafter be established by the board of directors or the company’s auditor, or by applying the formula set out in the articles. However, if no existing member is prepared to purchase such shares, the transferor can transfer the shares to the proposed transferee.

The preemption rule is intended to limit transfers between members and non-members, but it does not apply to transfers among members. This means that, unless other members agree to buy all of the shares intended to be sold, a member is not obligated to sell his or her shares to other members under the pre-emption clause. Steps for implementation of these preemptive rights need to be stated in the articles.

A member cannot avoid a pre-emption clause in the articles by signing an instrument of transfer to such a person holding the shares as a bare trustee and not a registered member. The mandate and validity of preemption have been established in various case laws over time.

In Nanalal Zaver v. Bombay Life Assurance Co. Ltd, the Supreme court held that the existing shareholders must be given the first option by the company.

In Sahara India Real Estate Corporation v. SEBI, it was held that Section 81 of the Companies Act of 1956 presumes a preemptive right on existing shareholders to a new issue of shares.

Power of directors to reject a transfer

The directors in a private company can refuse registration of transfer of shares as per provisions in its articles of association. After exerting preemption rights, the transfer may be rejected only with sufficient cause or in the interests of the company. Provisions regarding rejection are incorporated in the articles and any contractual agreements between the shareholders regarding transfer are not admissible. In circumstances of refusal of transfer registration, a notice needs to be sent by the company to the transferor and transferee within thirty days of the date on which the instrument of transfer is received. The notice should state the reasons for refusal. Once the notice is received, the transferee may appeal to the tribunal within 30 days from the date of receipt of such notice.

The directors can refuse to register a transfer of shares only if they pass a resolution to that effect; just failing to approve a resolution owing to a deadlock is not a formal, active exercise of the right to decline, and the applicant will be allowed to be registered as a member of the company.

In M.J. Amirthalingam v. Gudiyatham Textiles Pvt. Ltd, the court held that the right to refuse transfer is a fiduciary and must be exercised in good faith. However, the Court will not interfere when the Board has rejected a transfer as per the interpretation of its articles but only step in where there is proof of bad faith.

Under the Companies Act, 1956 Section 111 of the Act aims to prohibit directors from abusing their power and to protect the interests of real and bona fide transferees and shareholders. Section 111 grants a right of appeal to the Company Law Board in the event of a refusal to register a transfer/transmission of shares, while Section 111A provides a right to petition the CLB for rectification of the members’ register.

Under Section 58 of the Companies Act, 2013- Refusal of registration and appeal against refusal.

Grounds of appeal in rejection of transfer of shares:

  1. When the board has acted with malafide intentions.
  2. Insufficient or irrelevant reasons are not specified in the articles.

In Master Silk Mills Private Limited v. Dharamdas H Mehta– the company rejected a transfer based on “not approving the purchaser”. The court held that such a blanket ban could not be imposed on the transfer of shares and it resulted in an improper exercise of power.

The individual bringing the accusation bears the burden of establishing that the directors have unlawfully accepted or opposed to sharing transactions. The courts will always assume that the

directors are acting in good faith. In Balwant Transport Company v. Deshpande, the Nagpur High Court decided that interfering with the director’s legitimate use of discretion would be unjustified. This is founded on the Court’s judgement that the directors are the ones who know what is best for the company and that it is, therefore, improper for the Court to substitute their opinion for the board’s.

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Shareholders provisions are usually updated with changes in the shareholding patterns or additional rights but these changes are not always incorporated in the articles of association. More often than not, this leads to inconsistencies and courts have passed mixed judgements in this regard.

B. Rangaraj vs. V.B. Gopalkrishnan and Ors: This is the Supreme Court’s first judicial pronouncement on the enforceability of clauses in the shareholder’s agreement(SHA) that are not referenced in the articles(AOA). The Supreme Court held that a restriction on the transfer of shares that has not been incorporated in an AOA but has been incorporated in an SHA is unenforceable and that such a condition is only enforceable when it has been incorporated in the company’s AOA. A similar judgement was passed by the Delhi High Court in HTA Employees Union vs. Hindustan Thompson Associates Ltd. and Ors, where it was held that, once the modified AOA takes effect, no rights or claims that violate it can be enforced or considered genuine.

In Vodafone International Holdings vs. Union of India and another, the Supreme Court concluded that shareholders can engage in agreements that are in the best interests of the company and that such terms of the SHA are not in conflict with the provisions contained in the AOA, such clauses of the agreements are legitimate and enforceable.

In conclusion, when the company is a party to the shareholders’ agreement, and the clause wherein does not clash with the articles of the company, shareholders agreement may prevail. However,  it must be noted that the articles of association are a charter document that serves as the company’s bible and will always take precedence over any agreement. As a result, it is recommended that the shareholders’ agreement clauses be inserted into the articles of the company.

  1. Bishan Singh v. Khazan Singh- https://indiankanoon.org/doc/47635/
  2. Sahara India Real Estate Corporation v. SEBI- https://indiankanoon.org/doc/158887669/
  3. Nanalal Zaver v. Bombay Life Assurance Co. Ltd- https://indiankanoon.org/doc/1679542/
  4. Master Silk Mills Private Limited v. Dharamdas H Mehta- https://indiankanoon.org/doc/65351/
  5. B. Rangaraj vs. V.B. Gopalkrishnan and Ors- AIR 1992 SC 453- https://indiankanoon.org/doc/140212/
  6. Vodafone International Holdings vs. Union of India and another- https://indiankanoon.org/doc/115852355/
  7. M.J. Amirthalingam v. Gudiyatham Textiles Pvt. Ltd- https://www.casemine.com/judgement/in/5608fe9ce4b0149711150acf
  8. https://taxguru.in/company-law/enforcement-contractual-restrictions-transfer-shares-i ncorporated-articles-association-company.html
  9. V.B. Rangaraj vs. V.B. Gopalkrishnan and Ors.- AIR 1992 SC 453
  10. Vodafone International Holdings vs. Union of India and another- 2012 6 SCC 613
  11. https://www.mondaq.com/india/shareholders/1089446/enforcing-shareholders39-agreeme nts-in-india-a-legal-laggard

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