JUDICIAL PRECEDENTS

a) V.B. Rangaraj v. V.B. Gopalakrishnan1

In this Case shareholders of a private limited company were two branch of family and it was
agreed orally in 1951, it means in backdrop of Independence and partition, that the proportion of
the shareholding of respective branches would not change, and further agreed that for this
purpose, any member of a branch want to sell his shares must first offer the share to his own
branch. The crux in this case is the oral agreement about restriction was not incorporate in
Articles. Referring its own earlier relevant decision in Kalinga Tubes, the Supreme Court held
that the shares are “freely transferable” and that a private agreement imposing restriction on
transfer of shares which is not stipulated in Articles of association is neither binding to the
Company nor to shareholders. It means such kind of agreement is void in toto. One thing very
clearly established in this case is any restriction on share transfer must be incorporated in the
Articles of the Company otherwise it will not have any effect and aggrieved shareholder can not
have any legal remedy against violation of such restrictive provisions of agreement or
understanding.

The Supreme Court held that a restriction on the transfer of shares contrary to the articles of
association of a private company was not binding on the private company or its shareholders.
Although this judgment was in relation to a private company, its reasoning has also been applied
to public companies. Therefore, if restrictions on transfer of shares are to be enforceable,
provisions in the articles of association of a company are needed. The Court had taken the view
that provisions of the SHA imposing restrictions even when consistent with company law are to
be authorized only when they are incorporated in the articles of association.

b) Vodafone International Holdings B.V. v. Union Of India and another2

1
AIR 1992 SC 453
2
2012 (1) UJ 334
The Court has taken a view that freedom of contract can be restricted by law only in cases where
it is for some good of the community. The Companies Act, 1956, or the other legislations do not
explicitly or impliedly forbid shareholders of a company to enter into agreements as to how they
should exercise voting rights attached to their shares.

In this case the Supreme Court did not subscribe with the view taken in the Rangaraj case (as
stated above) and stated that SHA is a private contract between the shareholders compared to the
articles of association of the company, which is a public document. SHA is essentially a contract
between some or all other shareholders in a company, the purpose of which is to confer rights
and impose obligations over and above those provided by the company law.

Further, the Court stated that the provisions of the SHA incorporating ROFRs need not
necessarily be authorized by the articles of association of the concerned company. Accordingly,
the Court has implied that in the event the articles of association of a company are silent with
regards the provision of ROFR’s, they can be legally enforceable, subject to the same being
incorporated in the SHA.

CURRENT POSITION IN INDIA

Recently on the October 3, 2013 a Notification 3 was issued by SEBI (Securities Exchange Board
of India), which said that Right of First Refusal was legally allowed and valid in the
Shareholders Agreement. It also allowed tag along and drag along rights. Through this, SEBI has
rescinded its previous notification of March 1, 2000 that prohibited contracts other than spot
delivery contracts or those entered into through the stock exchange mechanism. Accordingly,
SEBI now permits various types of pre-emption rights and put and call options, but subject to
certain conditions. The new position is as follows:

1. Spot delivery contracts are permitted, consistent with the previous position;

3
The Gazette of India Extraordinary, Part III, SEBI Notification (Mumbai), 3rd October, 2013
2. Sale and purchase contracts on securities are permitted so long as they are in accordance with
securities regulations and stock exchange regulations and by-laws. These would include
transactions, including in derivatives, which are carried out through the stock exchange.

3. Contracts for pre-emption including right of first refusal (ROFR) or tag-along or drag-along
rights contained in shareholders agreements or articles of association are allowed. Note that this
is only an inclusive provision and is not exhaustive of all the types of provisions in the
agreements or articles that can be enforced. This enables investors to exercise their exit rights in
companies through the above mechanisms that are generally recognized. No conditions are
attached for the exercise of these rights.

4. Put and call options contained in shareholders agreements or articles of association are treated
somewhat differently from pre-emption rights discussed in item 3 above. The reason is that the
exercise of options is subject to certain conditions:

a) The underlying securities that are the subject matter of the options must have been held
by the relevant party for a minimum period of 1 year from the date of entering into the
option contract. This seems to be to ensure that options are not short-term in nature and
are permitted only when the holding of the securities is for a considerable period of time.
The genesis for the erstwhile prohibition on options was to prevent speculation in
securities, and this approach is imposing a minimum 1-year term on the options is
consistent with that philosophy.
b) The pricing of the options and the exercise is to comply with applicable laws. More
specifically, the notification states that all contracts permitted through it must comply
with the provisions of the Foreign Exchange Management Act, 1999. This applies when
options and pre-emption rights are granted by or in favour of a non-resident investor.
Where the exercise of the option or pre-emption results in a transfer of securities between
a resident and a non-resident investor, then the idea is that the relevant pricing norms
imposed by the Reserve Bank of India (RBI) must be complied with. This is significant
for foreign investors to take into account. Merely because SEBI has now conditionally
permitted options, it does not mean that parties have complete freedom in exercising the
options. The pricing is still regulated by the relevant RBI norms, and hence the
 commercial understanding between the parties regarding the exercise price will be
subject to these regulatory constraints.
c) The new permissible regime applies only to physically-settled options where there is an
actual delivery of the underlying securities. It does not cover cash-settled options, which
are essentially contracts for differences. This is understandable given the philosophy of
the legal regime to curb speculation. Moreover, investment agreements (where investors
seek exit rights) usually relate to an actual sale or purchase of securities rather than a
contract for differences, and hence this should not pose difficulties for customary
investment transactions.
5. This new permissible legal regime applies only prospectively, and does not “affect or
validate any contract which has been entered into” prior to the date of the notification.
Hence, past contracts with pre-emption rights or put and call options will not be
“grandfathered”. One possibility to overcome this restriction would be for parties to
existing contracts to re-execute them as of a future date.
6. Finally, an explanation to the notification states that the contracts specified in the
notification would be valid without regard to anything contained in section 18A 4 of the
Securities Contracts (Regulation) Act, 1956, which refers to exchange traded contracts. In
other words, such pre-emption rights and option contracts would be permissible even
though they are entered into on an over-the-counter (OTC) basis and not traded on the stock
exchange.

4
Section 18A: Notwithstanding anything contained in any other law for the time being in force, contracts in
derivative shall be legal and valid if such contracts are- (a) traded on a recognised stock exchange; (b) settled on the
clearing house of the recognised stock exchange, in accordance with the rules and bye-laws of such stock exchange.