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Restriction on transferability of shares – How far reasonable? - MMJC
Introduction.
Section 44 of the Companies Act 2013 (‘the Act’) states that, the shares of the company are movable property and are transferable in the manner provided in the Articles of Association (‘AOA’) of the company. These words ‘transferable in the manner provided in the articles of the company,’ are of very much importance especially in case of a private company as one of the basic features of a private company is the restriction on free transferability of shares. Pursuant to the definition provided under section 2(68) of the Act private company is allowed to restrict transferability of its shares by adding clauses in AOA. The law, however, places no limit on the power of a private company as to the nature and extent restrictions which a company’s articles may place on the right of transfer. Table F, which is the model AOA for a private company, is also silent in this regard. Hence there is no legal barrier with respect to nature of restriction that AOA can impose on transfer of shares. This restriction can be of any nature.
In this article, we shall deliberate upon this power of AOA to restrict the transfer of shares of a private company. Also we would see if company can by passing a resolution mandate a shareholder to sell shares at a particular time to a particular person?
Clause restricting transferability of shares.
If AOA of a private company has added a clause in AOA that on passing of special resolution by members, shares of one shareholder should be transferred to some other person as the mentioned in the resolution, then whether the said shareholder will have to transfer the shares mandatorily?
Memorandum of association and AOA when registered bind the company and the members thereof to the same extent as if they respectively had been signed by the company and by each member. So once a shareholder has subscribed to shares of company he has also agreed to the terms mentioned in the AOA of the company. So, if a company has added a clause in AOA of the company stating that shares of one shareholder should be transferred to some other person as the company specifies in the resolution passed in this regard then this clause is binding on the shareholder and he is bound to transfer shares of the company. The Act nowhere restricts having similar clauses. Now let us see if this would be valid in terms of merchantile law (viz. sale of goods act, 1930)
Restriction on transfer of shares in the context of sale of goods act, 1930.
Principle of ‘Nemo dat quad non habet’: Principle relating to transfer of goods
‘Nemo dat quad non habet’ commonly known as Nemo Dat Rule is a Latin phrase that means, “no one can transfer a thing which they do not possess.” This principle states that, person who does not have proper ownership of any goods, cannot transfer the said goods to anyone else. This principle is enshrined in section 27 to 30 of sale of goods act, 1930. Section 2(7) of Sale of Goods Act, 1930 states “goods” means every kind of movable property other than actionable claims and money; and includes stock and shares, growing crops, grass, and things attached to or forming part of the land which are agreed to be severed before sale or under the contract of sale. As ‘Shares’ are considered as goods as per sale of goods act the ‘Nemo Dat Rule’ applies to shares also. So in case of Shares only shareholder can transfer shares as he is in possession and ownership of goods. Therefore, looking at this rule one can argue that, since the company does not have proper title to shares of the shareholder, it seems company cannot by passing resolution, mandate the shareholder to sell the same. But there are exceptions to ‘Nemo Dat Rule’.
For this we will have to refer to section 27 of the Sale of Goods Act, 1930 again. Section 27 states that ‘Nemo dat rule’ does not apply if the original holder of goods has not denied through his conduct, the authority of the seller to sell the goods. As discussed above, the AOA of the company is a contract between the shareholder and the company. Therefore, by subscribing/purchasing the shares of the company, all the clauses of AOA are accepted by the shareholder and are also binding upon him. As this provision relating to sale of shares of one shareholder by passing special resolution by other shareholders is enshrined in the AOA, the single shareholder has consented to it and thereby has given authority to sell his shares in accordance with this clause of AOA. So under mercantile laws and companies act there seems to be no challenge in having similar clauses in articles of association
Reasonableness of clause relating to restriction on transfer of shares:
It needs to be understood that even if private companies are permitted to restrict transfer of shares through their AOA but the restrictions imposed thereon shall be reasonable. Restriction on transferability should not be oppressive to minority. Rights of majority and minority shareholders was discussed in famous case of FOSS V. HARBOTTLE. It states that the decision of the majority is binding upon the minority and even the courts do not interfere in majority’s decision. Therefore, as per this rule, the special resolution passed by the majority shareholders will be binding on the single shareholder whose shares are to be transferred.
Although the decision of the majority shareholders is binding on minority shareholders, there is an exception to Foss V. Harbottle rule. If the decision taken by majority is not in favour of minority or is ultra vires the AOA or memorandum of association, then in that case, FOSS V. HARBOTTLE rule does not apply. Therefore, care must be taken that such a special resolution must be passed only when there is a strong and valid reason to transfer the shares. Also, a proper opportunity of being heard must be given to the concern shareholder before passing such resolution. If this care is taken then, FOSS V. HARBOTTLE rule will apply, and the resolution might be considered as valid.
Procedural challenges pursuant to restrictions on transfer of shares.
Depositories Act, 1996 mandates depository to register the transfer only when he receives intimation from depository participant through a delivery instruction slip. In such situation a question arises is, “if the shareholder himself is not transferring the shares, then who shall sign the delivery instruction slip and how shall the transfer be registered”?
In the matter of Madhava Ramachandra Kamath v Canara Banking Corp. Ltd (1941) 11 Comp Cas 78 (Mad): AIR 1941 Mad 354. In this case it was held that, “Such provisions will constitute a contract between the company and its shareholder and be binding on both. The articles may provide in order to enforce such provisions that the shareholder when called upon to compulsorily transfer his shares, shall be deemed to have executed an instrument of transfer if it is executed by a person authorised by the company in this behalf in pursuance of the articles; otherwise, it would be ultra vires section 108 of the Act.”
On perusing this extract of the judgment, it is clear that if the delivery instruction slip is signed by the authorised person of the company, then in this particular situation, it will be deemed to have been signed by the shareholder in question and the transfer will be registered.
Conclusion.
Restrictions on transferability of shares by private company needs to be reasonable, should not be arbitrary and should not be used as a tool for oppression of minority. Also it seems that it would valid to have a clause in the AOA of the private company which would allow the majority shareholders to transfer shares of one shareholder by passing a special resolution or any other restriction on transferability of shares. The clause should provide for certain specific situations where in this clause may be invoked and most essentially, an opportunity of being heard must be given to shareholder whose shares are proposed to be sold through such resolution, before passing the resolution.
This article is published in Taxmann. The link to the same is as follows: –
This article is written by CS Vallabh M Joshi – Senior Manager – RND Team – vallabhjoshi@mmjc.in and Ms Rutuja Umadikar – Research Associate – RND Team – rutujaumadikar@mmjc.in