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Restriction on transfer of shares

Restriction On Transfer Of Shares In A Private Company

Introduction:

Philosophical Foundations Of Transfer Of Shares In A Private Company

The intention behind a modern private company is dual:Firstly, to facilitate small traders or private personscarrying on a family business to avail of the advantagesof corporate trading. Secondly, to act as a subsidiary in

a group of companies so as to avoid having to establisha public company, given the plethora of exactingrequirements they are required to follow.

Now, section 3 of the Companies Act, 1956(hereinafter, the Act') defines a Private Company. Themain characteristics of private companies that emergefrom a perusal of this definition relevant to thediscussion at hand are:

Restrictions on the rights of members to transfer theirshares

Limitation of the number of members to 50.

A prohibition on the public subscription of its shares ordebentures as also acceptance of deposits from thepublic.

In view of the definition, a private company is requiredby law to incorporate certain specified restrictions,

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prohibitions and limitations with regard to transfer ofshares in its Articles of Association. Section 27(3)further endorses and states that a private company

limited by shares must have articles containing theregulations required by Section 3(1)(iii) clauses (a), (b)and (c); while other forms of private companies musthave in its articles the regulations contained in clauses(b) and (c) of Section 3.

It is to be noted the transferability of shares is one ofthe most vital features of a company. This is iterated inSection 82 of the Act, echoing the philosophy relatingto transfer of shares given in Palmer's Company Lawwhere it is stated:

It is well settled that unless the articles provideotherwise the shareholder has a free right to transfer towhom he will. It is not necessary to seek in the articles

for a power to transfer, for the Act itself gives such apower. It is only necessary to look to the articles toascertain the restrictions, if any, upon it. Thus, amember has a right to transfer his shares to anotherperson unless this right is clearly taken away by thearticles.

In order to truly comprehend the transfer of shares inprivate companies' the focus has to be on therestrictions on transfer of shares' in these companies.This project seeks to explore the rationale for suchrestrictions, the types of restrictions and the ambiguities

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that stem from such restrictions. Finally, the researcherconcludes by examining the statutory and institutionalmechanisms available to check such vagrancies. The

scope of this project is limited to an analysis of thetransfer of shares in private companies. The lawrelating to transfer of shares in public companies hasnot been explored in detail. Moreover, the Americanposition with respect to transfer of shares in closecorporations' has not been looked at.

Issues

What is the concept of private companies?

What exactly does a transfer of a share entail?

Why does a private company need to incorporaterestrictions on transfer of shares in its articles?

What are the various types of restrictions on transfer ofshares in private companies?

What are the implications and important issues relatedto these restrictions?

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What are the various remedies available to theaggrieved persons when the company refuses toregister transfer of shares?

Research Methodology

The researcher has followed the doctrinaire method ofresearch. The project is analytical as well as descriptivein nature. Primary resources such as the IndianCompanies Act 1956 have been used. Besides this,secondary resources have been referred to. A host of

leading textbooks on Corporate Law as well as relevantarticles from leading Law Journals have been referredto. Case reporters like Supreme Court Cases, AllEngland Law Reports, Company Cases and All IndiaReporter have been used.

Need For Restriction On Transfer Of Shares: The Soul And Basis' Of A

Private Company

Section 3(1)(iii)(a) of the Act provides that the Articlesof a private company shall restrict the right to transferthe company's shares. Typically, a family or otherprivate group may own 100% shareholding of a privatecompany. Hence, in the United States privatecompanies are referred to as Close Corporations'.

Bonds of kinship, friendship or similar close ties usuallyunite the members of a private company. In thisscenario, the transfer of shares to a stranger would beundesirable, unless the existing members accept hisadmission. Observance of such regulations allows

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private companies to meet the goals and purposes forwhich they are set up.

The Act compulsorily requires private companies toimpose restrictions on the transfer of shares byincorporating such restrictions in their articles.However, the Act does not specify any particular modeof restriction or prescribe the extent of the restrictionrequired. Thus the restrictions may be as slight or assevere as the framers of the articles desire. Suchrestrictions should be general and apply unvaryingly toall shareholders and types of shares.

In V.B Rangaraj v. V.B Gopalakrishnan and Others theSupreme Court held that shares are movable propertyand the articles regulate their transfer. The articles arethe regulations of the company, binding on both thecompany and its shareholders. Therefore, the only

permissible restrictions on the transfer of shares arethose, which are contained in the Articles. An additionalrestriction not contained in the articles but in a privateagreement between two shareholders, which placesfurther obstacles in the way of transferability, is notbinding either on the company or the shareholders. Thetransferee cannot be denied the registration of the

shares purchased by him on a ground other than statedin the Articles.

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Contrasting Transfer Of Shares In A Public Company With That In APrivate Company

The above-discussed feature is what differentiatesprivate companies from public companies, which haveno restrictions on the right of their members to transfer

their shares. Section 111A(2) provides that the sharesor debentures of a public company shall be freelytransferable. In a public company there is no controlover whom the shares are transferred to on the stockexchange. This is unlike the controls on a privatecompany's transfer of shares through preemptory rightsand approval of the board of directors (hereinafter

directors'). Infact, it is provided that if a companyrefuses to register transfer of shares without sufficientcause, within two months from the date on which theinstrument of transfer or the intimation of transfer isdelivered to the company, the transferee can appeal tothe Company Law Board. The Act states that the Boardshall direct such offending company to register the

transfer of shares.

These restrictions on transfer of shares in privatecompanies flow from the Partnership Principle, which isthe soul and basis of private companies. In economic

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terms, a private company can be so construed so as toamount to nothing more than incorporated partnershipswith particularly close ties between the members.

These restrictions on transfer of shares helps keep thesoul and basis of the company' intact.

Restriction Not Prohibition

These restrictions are not to be construed as a ban or aprohibition on the transfer of shares. The Courts haveconsistently held that the restriction upon transfer

means any restriction that will give some control to thecompany over transferability of shares. It was held inChiranji Lal Jasrasaria v. Mahabir Dhelia that arestriction which amounts to a prohibition on transfer ofshares or which precludes a shareholder altogetherfrom transferring is invalid. Moreover, a prohibition onthe transfer of shares will amount to violation of Section

82 of the Act and Section 6 of the Transfer of PropertyAct, 1872.

It is relevant to note that restrictions upon transfer ofshares in private company are inapplicable in thefollowing cases:

(i) On a member's right to transfer his shares to his

representatives.

(ii) In the event of death of a shareholder, legalrepresentatives may require the registration of share intheir name. Transferability is the general nature of

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property and even when there is a restriction ontransfer, when the person dies the restriction will notapply.

Types Of Restrictions On The Transfer Of Shares In A Private Company

Restrictions on the shareholder's right to transfer theirshares has two common forms:

1. Right of Pre-emption in favor of the other members

Powers of the Board of Directors to refuse to register

transfer of shares

Let us now explore these two forms of restriction insome more detail.

Pre-Emption Clause

In Bishan Singh v. Khazan Singh the Court stated that

the right of pre-emption is not a right to the thing soldbut a right to the offer of a thing to be sold. The mostfrequent type of transfer restriction is the right of pre-emption. The pre-emption clause in the articlesgenerally provides that when a member wishes to sellsome or all of his shares, he shall first offer them to theother members for purchase at a price ascertained in

accordance with a formula set out in the articles, or at afair price at which the shares are valued by thedirectors or by the company's auditors and he shalltransfer the shares to his proposed transferee only if

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the other members do not exercise their right of pre-emption.

The pre-emption clause goes a long way in ensuringthat the control of the shares does not fall into thehands of undesirable persons by allowing the existingshareholders the first opportunity to buy the shares.

Various types of pre-emption clauses are found in thearticles of private companies. Such as a provision thatthe proposing transferor shall first offer the shares to all

other shareholders; or that he is entitled to select theshareholder to whom he wants to sell; or the first offerhas to be made to certain enumerated shareholderse.g., those holding founder's shares; or the articlesprovide that in certain circumstances e.g. in the case ofdeath of a member, the surviving members or directorsare obligated to acquire the deceased member's

shares.

In addition, these pre-emption clauses aresupplemented with a general restriction clause, forinstance, after the failure of those entitled to pre-emptive rights to acquire the shares and theirsubsequent offer to another person, the directors may

decline the transfer. There is no doubt as to the validityof these pre-emption clauses and courts haveconsistently upheld the validity of the pre-emptionclause in the article of a private company.

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Implementation Of Pre-Emptive Rights: Procedure For Transfer OfShares In A Private Company

As stated above, the transfer of shares in a private

company, are governed by the articles of the company.Where the articles provide a procedure forimplementation of pre-emptive rights the procedure laiddown has to be followed. The steps followed by aprivate company to give effect to the transfer of sharesif the articles contain a pre-emption clause are genrallyas follows:

(i) Transferor should give a notice in writing to thecompany stating his intention to transfer his shares.

(ii) The company should in turn notify the othermembers of the availability of such shares and theprice at which they will be available; along with the timelimit within which they should communicate their

decision to purchase such shares.

(iii) The price is determined by the company's directorsor auditors. Normally, articles of a private companycontain provisions in this regard and provide that theshares are to be sold at a fair price as determined bydirectors or the company's auditors.

A member cannot elude a provision for pre-emption inthe articles by executing an instrument of transfer tosuch a person, with the intent that the purchaser shallnot apply for registration as a member, but be satisfiedwith the transferor holding the legal title to the shares

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as a bare trustee for him. It has been held that a pre-emption provision was adhered with where onemember sold to another member even though an

outsider paid the purchase price and it was thetransferee who was to vote at the outsider's discretion.

It is humbly submitted that the decision of the Court torecognize this as a valid transfer and to hold it incompliance with the pre-emptive clause is erroneous.The decision goes against the purpose of the pre-emptive clause i.e., to prevent outsiders andundesirable persons from gaining control of thecompany. In this case, although the pre-emptiveprovision was complied with in form it was violated insubstance. The court should have looked at thesubstance of the matter and not the form.

Now moving to the second way in which a restriction

can be exercised on the transfer of shares in a privatecompany.

Power Of The Board Of Directors To Refuse To Register Transfer OfShares

The articles of a private company commonly vest theBoard of Directors with discretion regarding the

acceptance of a transfer of shares. This power vestedin the Board is fiduciary in nature i.e., it must beemployed in good faith and for the benefit of thecompany and not for some inappropriate purpose. Theconsequences of the directors abusing this power and

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the remedies available to the aggrieved persons havebeen dealt with below.

Exercise Of Power Of Refusal

The directors exercise their right to decline to register atransfer of shares only by passing a resolution to thateffect; mere failure, due to a deadlock to pass aresolution is not a formal, active exercise of the right todecline and thus the applicant will be entitled to beregistered as a member of the company.

Burden Of Proof

The burden of proving that the directors havewrongfully accepted or objected to transfers of sharesrests on the person making the allegation. The Courtswill always presume bona fide on the part of thedirectors.

According to Section 111(1) of the Act, the Board ofDirectors must exercise their power of refusal withintwo months from the date of receiving the application.The question that now arises is that if the directors donot exercise their power of refusal then on the expiry ofthe two months does the company lose the right ofrejection and the transferees get a vested right? Canthey go ahead and register themselves?

Section 111 is silent regarding this question. Whenfaced with this issue the Bombay High Court neitheragreed to the argument that the company would lose

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the right of rejection nor that the transferee wouldacquire a vested right to the shares. It is thought that insuch cases a court order would be necessary and a

decision should be made on merits.

Thus, the transferee has to silently wait out thereasonable period of two months, which is given to thedirectors to make their decision and can resort to legalproceedings only after this period has expired. Abelated exercise of the power of refusal by the Boardwill be looked upon with suspicion by the Court and willstrengthen the position of the aggrieved transferee.

Use Of Judicial Sword Against Shield- Abuse Of Power Of Board OfDirectors To Refuse To Register Transfer Of Shares And Remedies

As discussed above, private companies are required bylaw to incorporate into their articles restrictions on thetransfer of shares. A common form of these restrictions

is the power conferred on the directors to refuse toregister a transfer. Very often the articles of a privatecompany may vest absolute discretion in the directorsto refuse to register transfer of shares.

In Balwant Transport Company v. Deshpande, theNagpur High Court felt it would not be justified for the

Court to interfere with the director's bona fide exerciseof their discretion. This is based on the Court's beliefthat it is the directors who know what is in the bestinterest of the company and thus, it is inadvisable forthe Court to substitute their opinion for the board's.

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However, the Board of Directors does not alwaysexercise its powers of refusal in good faith or bona fide.In the name of acting in the interests of the company

the Board may abuse its power and refuse to registertransfer of shares. The fact that close ties of kinshipand friendship generally bind the directors in a privatecompany would make such abuse easier. They mayconspire to refuse to register a transfer based in saypersonal hostility towards the transferee andsubsequently use the defense of acting in the interests

of the company as a shield. Such acts may prejudiciallyaffect the interests of genuine transferees andshareholders as well as those of the company.

Section 111 of the Act seeks to prevent this abuse bythe directors and ensure that the interests of genuineand bona fide transferees and shareholders are notadversely affected. Section 111 provides a right ofappeal to the Company Law Board (hereinafter, CLB')in respect of refusal to register transfer/transmission ofshares and Section 111A gives the right to petition theCLB for rectification of register of members. This righthas been iterated even in clause 52 of the recentCompanies Bill, 2009.

There are several grounds on which such an appeal tothe CLB can lie. Firstly, when it is found that the boardof directors has acted with mala fide. In HarinagarSugar Mills v. Shyam Sunder the Supreme Court statedthat while exercising its appellate jurisdiction under

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Section 111 the CLB has to decide whether inexercising their power the directors are acting,oppressively, capriciously, or corruptly or in some way

mala fide. Secondly, the CLB can exercise itsjurisdiction if it is found that the board has not disclosedsufficient reasons to justify its refusal to accept thetransfer of shares. By virtue of the 1988 Amendment tothe Act, the board is bound by law to disclose itsreasons for refusing to register a transfer of shares.This gives an opportunity to the CLB to examine the

relevancy of the reasons given by the board andensure basic adherence with the principles of natural

justice.

The third ground based on which the CLB can exerciseits jurisdiction is when it finds that the board hasexercised its power of refusal based on irrelevantconsiderations, grounds which are not specified in thearticles. Lord Greene MR in Smith and Fawcett Ltd., Restated, The directors (in refusing a transfer) must haveregard to those considerations and thoseconsiderations only which the articles on their trueconstruction permit them to take into consideration.The Calcutta High Court in Master Silk Mills PrivateLimited v. D.H Mehta has followed the same line ofreasoning. Here the board refused to accept a transferin favor of another company whereas the articlesempowered them to exclude only undesirable persons.The Court held that such blanket ban on admissionother companies was beyond the authority vested in

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the board by the articles. The Court stated Approval ofthe transferee means approval of the transfereepersonally as distinguished from laying down a general

rule that no corporate body would be allowed to join thecompany as a shareholder. This decision is extremelywell analyzed and clearly lays down the principle that ifthe directors exceed the power of refusal granted tothem by the articles the court will strike down theirorder refusing to register transfer of shares.

It is thus seen that the Act has vested the CLB with theappropriate judicial sword in order to mete out justiceand remedy wrongful refusals by the directors. TheCourts too have implemented the law zealously andinterpreted the legislative provisions to ensure justice ismeted out and the rights of the Company, shareholderand the injured transferee are not affected adversely.

Conclusion

The core issue with respect to transfer of shares inprivate companies is the restrictions on this transfer ofshares, which a private company must mandatorilyincorporate into its articles as per Section 3(1)(iii)(a) ofthe Act. It must be noted that the Act does not specifythe exact form of these restrictions. Consequently, it isopen to the framers of the articles to design theserestrictions and clarify their scope and extent.

Such restrictions on the rights of the members totransfer their shares is one of the main characteristics

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of a private company and is considered somethingintrinsic to a private company given that it is based onthe partnership principle. In fact, it is said that the

partnership principle is the soul of a private company. Aprivate company is usually an association of personsbound together by close ties of kinship, friendship andsharing a camaraderie and trust, which cannot beeasily shared with another person. This restriction ontransfer of shares allows the members of a privatecompany to thwart admission of members who may be

unfavorable or hostile to the existing members andthus, checks the dilution of control over the company bythe current members. The Courts have proved to bethe guardians of these restrictions and have preservedthe soul of the private company and consequentlyenabling the private company to achieve its aims andobjectives.

However, there are certain problems that threaten thiscontinued preservation of the soul of a privatecompany. These restrictions create some areas ofuncertainty, which in turn create problems in companylaw and affairs. For example there is ambiguity withrespect to valuation of shares in the case of exercise ofpre-emption rights. Moreover care must be taken to seethat these restrictions do not exceed the scopeprescribed by the articles, as this could hamper therights of the shareholders, transferees and thus, thecompany may be adversely affected. The power vestedin the directors to refuse to register a transfer is a

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common restriction found in the articles of a privatecompany. The Board often abuses this power. The1988 amendment, which requires the Board to give

reasons for its refusal, has helped to check the abuseof this power. However, we must not becomecomplacent and should constantly search for innovativemeans of checking such abuse. Section 111 of the Actadequately provides for the remedies available in caseof abuse of this power. The Courts too have done theirbest to check abuse of this power and ensure that no

injustice or prejudice is caused to the aggrievedperson.

Besides the statutory mechanism available to controlvagrancies, it is important that companies themselvestake the initiative and draft these restrictions withutmost care and foresight. Illustratively, the abuse ofthe power to refuse to register a transfer by the boardwould be considerably reduced if proper guidelineswere incorporated into the articles with respect to theexercise of this discretion.

Concrete steps must be taken to rectify abuse and toclear the ambiguous areas created by these restrictionson the transfer of shares in private companies. It is

indispensable for the smooth working and success ofprivate companies and consequently is in the largerinterest of the Indian economy!

Bibliography

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Articles

1.Avtar Singh, Company Law Annual Survey of IndianLaw, Vol. XV (1979) at 43.

N.Vijia Kumar, Transfer of Shares SEBI andCorporate Laws, Vol. 35 (2002) at 122.

Books

1. A. Ramaiya, Guide to the Companies Act Part I 14thed. (New Delhi: Wadhwa and Company Law

Publishers, 1998).

A.K Majumdar and Dr. G.K Kapoor, Company Law andPractice (New Delhi: Taxmann Publications Limited,2000).

2. A.L Saha, Lectures on Company Law (Bombay: N.MTripathi Private Limited, 1990).

Avtar Singh, Company Law (Lucknow: Eastern BookCompany, 1999).

3. Clive M. Schmitthoff, Palmer's Company Law Vol. 1(London: Steven and Sons Limited, 1976).

Paul L. Davies, Gower's Principles of Modern Company

Law (London: Sweet and Maxwell Limited, 1997).

4. Robert R. Pennington, Company Law (London:Butterworths, 1995).

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