Right of first refusal (ROFR)

1. What is Right of First Refusal (ROFR):

1.1 As per this right, the promoters before making their exit from the company shall have to make first offer for sale of their shares to the existing investors of the company i.e., venture capital/ private equity funds etc., on the same terms as those shall be offered to the third party and, if the investors denied accepting the offer, the promoters are free to sale their shares to the third party.

2. Importance of ROFR:

2.1 ROFR is a clause incorporated in the share purchase agreement entered between promoters of the company and the probable investor(s). This clause gives confidence to the investors that their interest is secured in the company and shall not be affected, if promoter(s) exit from the company at any point of time. It’s nothing but a contractual right protects the investors’ interest in the company, if promoter(s) exist.

2.2 Along with ROFR, there are other three important clauses, which are generally part of every shareholders agreement i.e., Tag Along Rights, Drag Along Rights and Pre-emption Rights.

Tag Along Rights: This right protect the 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.

Drag Along Rights: This rights 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.

Pre-Emptions Rights: This right is also called First Option to Buy. Under this right, the ceasing investor, before selling his shares to the third party shall have to make first offer to buy his shares to the existing promoters of the company. In this way the promoters can avoid the conflict of interest by restricting the third party’s entry in the company.

Apart from having various similar clauses in the shareholders agreement, the validity of ROFR has always been subject of discussion and arguments, because of its viral role in protecting the commercial interest of the investors.

3. What is ROFR Conflict:

As per section 58(2) of the Companies Act, 2013 (the Act) the securities of any member in a public company are freely transferable, while section 58(4) of the Act, state that it is open to the public company to refuse registration of the transfer of securities for a ‘sufficient cause’. To that extent, section 58(4) of the Act, can be read as a limited restriction on the free transfer permitted under section 58(2) of the Act. However, the statute does not provide any guidance on what would constitute ‘sufficient cause’ and leaves it open to the company itself to ascertain the same. Further, it may be noted that the provision contained in section 58(4) of the Act, are similar to the proviso contained in section 111A(2) of the Companies Act, 1956 (the Act, 1956).

Section 111A(2) of the Act, 1956 used the term ‘sufficient cause’ as a reason for refusal for registration, whereas section 111A(3) set out an exhaustive list of matters where rectification of register could be undertaken. Looking at the judgments of Indian courts towards section 111A of the Act, 1956, there appears to be a differences in the views taken by various courts while evaluating the meaning of ‘sufficient cause’ as used in section 111A(2) and 111A(3) of the Act, 1956.

3.1 Legislative History:

3.1.1 In Bajaj Auto Ltd. v. NK Firodia, AIR 1971 SC 321 where company has refused to register the transfer of shares, Supreme Court held that, the discretion of the Directors is to be tested as the opinion of fair and sensible men in the interest of the company. The Directors did not act bonafide nor did they act in the general interest of the company. On the contrary, they acted upon a wrong principle and for the oblique motive of squeezing…..

3.1.2 In V. B. Rangaraj vs. V.B. Gopalakrishnan and Ors, as reported in CDJ 1991 SC 464.
It was held that, in case of private limited company, transfer restrictions, if any, agreed, between the shareholders shall not be valid and binding, if not formed part of the Article of Association of the company.

3.1.3 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”……. “Alleged agreement for pre-emption is not binding on any of the defendants”. After year 1999 there were some high court decisions added to the controversies.

3.1.4 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 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.

3.1.5 However, the judgment in case of Messer Holdings reversed its earlier judgment in Bajaj Auto Ltd. gave new bends in the controversies by suggesting 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. In paragraph 55, of this 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 …”.

3.1.6 The High Court of Andhra Pradesh in the case of Karamsad Investments Limited v. Nile Limited, took the view that the expression ‘sufficient cause’ covers within its ambit not just the contravention of law, but would also include other circumstances and reasons that might require the company to refuse the registration of transfer of shares.

3.2 Current scenario:

In Mackintosh Burn Limited v. Sarkar and Chowdhury Enterprises Private Limited (Mackintosh Case), it was held that the registration of a share transfer may not only be refused on the ground of it resulting in a violation of any law but also for any other sufficient cause.

The Mackintosh Case involved an unlisted public company, which had refused to register a transfer of shares to its competitor. Here the Supreme Court noted “…The Company Law Board, it appears, was of the view that the refusal to register the transfer of shares can be permitted only if the transfer is otherwise illegal or impermissible under any law. Going by the expression “without sufficient cause” used in section 58(4), it is difficult to appreciate that view. Refusal can be on the ground of violation of law or any other sufficient case. Conflict of interest in a given situation can also be a cause…”

The Supreme Court has remitted the said matter to the National Company Law Tribunal for a it’s fresh consideration and final verdict.

According to above mentioned case law, we can state sufficient cause’ would include matters that are not in the best interests of the company. Therefore, if, ROFR is not permitted then acquisition of shares by the competitors could be considered ‘sufficient cause’ as they may give rise to a conflict of interest.

4. Conclusion / Comments:

4.1 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.

4.2 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

4.3 New hopes has been given by the Mackintosh Case, which may consider to be one of the landmark judgment on the controversy of ROFR running over the decade.

Disclaimer:

The content of this article is only to provide knowledge and reference on the subject matter and should not be relied upon as it is without seeking advisory from professionals on the specific case and matter.