Right of First Refusal

The Ruia’s had one with Hutch. Mukesh Ambani used this to scotch Anil Ambani’s deal with MTN. And more recently ONGC has claimed the same right in the Vedanta-Cairn deal. Yes, I am talking ROFR or the Right of First Refusal also known as preemption right or in other forms a tag-along drag-along right.

ROFR’s are commonly used across corporate India, especially in joint ventures. They were considered legally valid till a Delhi High court decision in 2005 and more importantly a Bombay High Court decision this year ruled that ROFRs are in fact not legally valid. Those decisions were based on the premise that Section 111A of the Companies Act 1956 provides “That shares or debentures and any interest therein of a company shall be freely transferable”.

A recent judgement by a divisional bench of the Bombay High Court in  Messer Holdings Limited v. Shyam Madanmohan Ruia upholding the validity of agreements like ‘right of first refusal’ between promoters of unlisted firms and strategic investors, has come as a big relief for both companies and private equity funds which invest in these firms. The court ruled that such arrangements do not violate Section 111A of the Companies Act, which holds that that shares and debentures of companies must be freely transferable.

This is a reversal of an earlier judgement in Western Maharashtra Development Corporation Ltd. v. Bajaj Auto Ltd by single bench of the same court in March that had deemed any restriction on free transfer of shares as illegal, and by extension ‘first right of refusal’, or ROFR, and other agreements that strategic stakeholders like private equity investors enter into with promoter groups.

Under ROFR, a private equity fund, planning to exit the company, is obliged to give the promoters an opportunity to buy the shares before the shares can be sold to a third party. Many corporates , unlisted as well as some listed ones, have such agreements with large shareholders.

In addition, there are other agreements such as tag along and drag along. Tag along right is a contractual obligation that protects a minority shareholder (usually in a venture capital deal) in case the promoter is selling out. In such an event, the minority shareholder has the right to join the transaction and sell his or her minority stake in the company. In a drag along, arrangement, the minority shareholder has the right to force the majority shareholder to join in the sale of a company.

The Division Bench of the Bombay High Court has analysed and interpreted the provisions of Section 111A of the Act. In brief, the Division Bench held that:

·         A company or all shareholder of the company need not have to be a party to a shareholder’s agreement and that such an agreement need not be embodied in the Articles for it to be enforceable on contracting parties.

·         If arrangement by a particular shareholder relating to his own shares by way of pledge or preemption was to be restricted by the Company, then there ought to be an express provision in that behalf in the Articles.

·         The sweep of Section 111A of the Act was intended mainly to restrict the right of Directors of the Company to refuse transfer of shares. It is not intended to and does not affect the right of shareholders to deal with their specific shares or to enter into any consensual arrangement or agreement regarding their shares (by way of pledge, pre-emption, sale or otherwise).

·         The shareholder has freedom to transfer his shares on terms defined by him, such as Right Of First Refusal (ROFR), provided the terms are consistent with other regulation

·         The fact that shares of a public company can be subscribed and there is no prohibition for invitation to the public to subscribe to shares, unlike in the case of a private company, does not curtail the right of the shareholder of a public company to arrive at consensual agreement which is otherwise in conformity with the extant regulations and the governing laws.

·         The legal provision of Section 111A of the Act does not expressly restrict or take away the right of shareholders to enter into consensual arrangement or agreement in respect of shares held by them. The expression “freely transferable” in Section 111A of the Act does not mean that the shareholder cannot enter into private arrangement with the third party (proposed transferee) in relation to specific shares. 

     

The decision will put to rest an uncertainty created by the decision of the Single judge of the Bombay High Court in case of Western Maharashtra Development Corporation Limited vs. Bajaj Auto Limited (2010), where it was held that in case of a “public company”, its shares are freely transferrable under the Act even if the Articles of Association (the Articles) contain restrictive provisions relating to transfer of shares.

In view of the Division Bench decision, existing arrangements in Articles of public companies which contains restrictions on transfer of shares and debentures such as ROFR, Tag-along rights, Drag-along rights and similar other arrangements can continue to be enforceable.