The document discusses controversies around Section 111A of the Indian Companies Act of 1956 regarding rights of first refusal, tag-along rights, and drag-along rights in shareholder agreements. It analyzes legislative history and various court judgments on the matter. Recent judgments have found that Section 111A does not prevent shareholders from entering agreements that can potentially restrict free transferability of shares, as long as such restrictions are not mentioned in the company's articles of association.

1. HEDGE-SQUARE CONSULTANCY SERVICES PRIVATE LIMITED
Address: Impress, 111A, Currimji Compound, M. G. Road, Fort, Opp. Mumbai University, Mumbai – 400 001.
Controversy on Section 111A of the Companies Act, 1956
I. ISSUES:
1.1 Whether Right of First Refusal (ROFR) agreements, Tag along and Drag along
rights are enforceable under law and in compliance with section 111A of the
Companies Act, 1956?
II. ANALYSIS:
2.1 ROFR are agreements entered between promoters and investors such as PE funds
etc. which mandates investor to offer its shares to the promoters for making exit
of shares. It can sell it to the third party, if promoters refuse to take those shares.
It’s also called preemption rights.
2.2 Tag along rights or Co-sale rights are contractual obligation used to protect a
minority shareholder (usually in a venture capital deal). If a majority shareholder
sells his or her stake, then the minority shareholder has the right to join the
transaction and sell his or her minority stake in the company.
2.3 Drags along rights are rights that enable a majority shareholder to force a minority
shareholder to join in the sale of a company. The majority owner doing the
dragging must give the minority shareholder the same price, terms, and conditions
as any other seller.
2.4 Legislative History:
(a) Section 111A of the Companies Act, 1956, is perhaps the most significant
unresolved controversy in contemporary Indian Corporate Law. Section
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2. HEDGE-SQUARE CONSULTANCY SERVICES PRIVATE LIMITED
Address: Impress, 111A, Currimji Compound, M. G. Road, Fort, Opp. Mumbai University, Mumbai – 400 001.
111A of the Companies writes that “…..Subject to the provisions of this
section, the shares or debentures and any interest therein of a company
shall be freely transferable….”. The section speaks about free transferability
of the shares and debentures of the Public Limited Company.
(b) Though ROFRs (Right of First Refusal) are commonly used across India Inc,
their legal validity has always been in question. Several High Court
Judgments have held ROFRs to be violative of the Companies Act, 1956,
(Act), on the basis of provisions of section 111A of the Act, which states that
all shares and debentures shall be freely transferable.
(c) This subject got controversial since the decision in Rangarajan. The
defendant in this case was a Private Limited Company. In this case Supreme
Court held that shares are “freely transferable” and that “a private
agreement that imposes … restrictions not stipulated in the articles of
association…” is “not binding either on the shareholders or on the
company”.
(d) The Year of 1996 is the enactment year of DIP guidelines and simultaneously
for section 111A in the Companies Act, 1956.
(e) In 1999 the Gujarat High Court heard Mafatlal, where the defendant was
a public limited company. In this case it was pointed out that the “ratio in
the case of V.B. Rangarajan will apply with much greater force to the case of
a public company”. After year 1999 there were some high court decisions
added to the controversies.
(f) One of the interesting judgments is of the Bombay High Court judgment
in Western Maharashtra Development Corporation Ltd. v. Bajaj Auto
Ltd. That judgment had ruled that any pre-emptive rights over shares in
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3. HEDGE-SQUARE CONSULTANCY SERVICES PRIVATE LIMITED
Address: Impress, 111A, Currimji Compound, M. G. Road, Fort, Opp. Mumbai University, Mumbai – 400 001.
public limited companies were illegal in view of the principle of “free
transferability” enshrined in Section 111A of the Companies Act, 1956. Still
after this judgment the debate on enforceability of terms of shareholder
agreements governing public limited companies was continued.
2.5 Recent position:
(a) The path of this controversies got new turn when in September, 2010,
judgment by a divisional bench of the Bombay High Court in case of
Messer Holdings reversed its earlier judgment in Bajaj Auto Ltd.
[referred above in Pt. 2.4(f)] and uphold that agreements like ROFR, tag
along and drag along between promoters and strategic investors, are not
contrary to the provisions of the section 111A of the Companies Act, 1956.
The judgment also goes on to suggest that it is not mandatory for the
Company to be a party to such an agreement relating to share transfer
restrictions and it is not necessary to incorporate share transfer restrictions in
the articles of association of the Company.
(b) The Dispute was on Section 111A of the Act, which held that shares of
public companies must be freely transferable but was interpreted to mean
that promoters can not enter in to any agreements with strategic investors
that could potentially restrict free transferability of shares.
(c) In paragraph 55, of above judgment it was stated that :
…“freely transferable” in Section 111A does not
mean that the shareholder cannot enter in to consensual arrangement/
agreement with the third party (proposed transferee) in relation to his
specific shares If the company wants to even prohibit that right of the
shareholders, may have to provide for an express condition in the Articles of
Association or in the Act and Rules, as the case may be, in that behalf …”
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4. HEDGE-SQUARE CONSULTANCY SERVICES PRIVATE LIMITED
Address: Impress, 111A, Currimji Compound, M. G. Road, Fort, Opp. Mumbai University, Mumbai – 400 001.
2.6 Comments:
(a) This division bench has gone into the intent of 111A. The division bench has
rightly held now that when shares are freely transferable doesn’t mean that the
shareholders lose the right to dispose off or deal with the shares in the manner
in which they like.
(b) The Bench has explained the intent that the section 111A was never
incorporated to take away the rights of the shareholders to dispose, which is
one of the bundle of rights enjoyed by any owner of any movable property.
ROFR and other such agreements are important exit provisions for any
financial or strategic investor.
(c) This may not be the last word because this controversy may knock the doors
of the higher authority but certainly it’s a division bench judgment and is the
only judgment in the case of a public companies of 111 (A) therefore in that
sense it certainly it sets aside the controversy which was raised right from the
beginning of Rangarajan from 1992.
Hemant Shah
Hedge-Square Consultancy Services Pvt. Ltd.
111A, Impress, Currimji Compound, Fort, Mumbai – 400 001.
Contact: +91 - 9870551611
Email: hemant@hedge-square.com
Website: www.hedge.square.com
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