[The following is a guest post from Vinod Kothari of Vinod Kothari & Co. He can be contacted at firstname.lastname@example.org]
Closer to the gradual implementation of the 2013 Act, one gets an ever firmer feeling that the drafting of the law became highly superficial, and the twin Parliamentary committees merely went on the basis of innate assurances that MCA would do what is required to resolve all the problems in law-making. If the law has problems, rule-making can do nothing to resolve the same. And let us face it – the law has problems. In fact, it has big-time problems.
What is more important for companies than the liberty in capital-raising. There are plenty of restraints on capital raising in the new law, one, obviously being the intricate set of requirements in section 42 dealing with private placements. However, this article is about section 62, which apparently will have massive applicability, to all companies, and on all types of issuances, except in case of rights or bonus issuances. This article explains the dire consequences of sec 62.
1. What is the main purport of section 62?
The section corresponds to section 81 of the 1956 Act. Section 81 contained the right of pre-emption, which is a valuable right of shareholders of a company. They should be able to preserve the value of their shareholding, as well as their control over the company, by ensuring that any issue of shares is made to the existing equity shareholders, in proportion to their shareholding in the company. Otherwise, the shareholders will have to approve the proposal by a special resolution.
Even a special majority may try to bulldoze the minority, but for that, the Act has always had minority protection rights such as relief against oppression.
The section is not applicable to private companies. However, Supreme Court has, on several occasions (Kilpest is an example), held that the principles of sec. 81 are applicable to private companies as well.
2. Apart from sec 81, what other important provisions are applicable in case of capital raising by companies?
In case of private companies, the section did not apply at all. In case of public companies, if it is unlisted, the 2003 Rules called Unlisted Public Companies (Preferential Issue of Securities) Rules would apply. Read them with the substantial additions made in 2011.
In case of listed companies, SEBI’s ICDR Regulations contain separate set of provisions for preferential allotments and public offers.
3. Were there any notable examples of misuse/abuse of shareholding powers, where Sec. 81 failed to do justice?
Frankly, with some 30 years into the study of corporate laws, and about 25 years into its active practice, the author cannot find one flaw in the basic provisions of Sec 81. The additions about convertible loans, etc that were made over a period of time might have become redundant, but otherwise, the section was working perfectly fine.
4. What are the major differences between sec 62 and section 81 of the 1956 Act?
i. First, as usual with the rest of the provisions of the Act, the section applies to all companies. So it applies to private companies too. Now, one will keep waiting with all humility for the Central Government to “grant” exemption from what should never have applied in the first place to a private company. And who knows, like in case of sec 185, the enforcement may come like flashflood, and the exemption may come like rain in Sahara.
ii. Second, there was an initial capital raising exemption period of 2 years from incorporation or 1 year from first allotment, whichever is earlier. During this period, any capital raising did not require the section to be complied with. If the draftsmen of the new law chose to remove this initial capital raising exemption, they have only evidenced the gross failure to understand the essence. How could there be an anti-dilution provision even while the company is still ramping up the capital base? That is, when the company is populating its shareholders during the start-up period, there is no question of anti-dilution at that stage.
iii. Third, all one needed to do, to get away from the section, was a special resolution. There obviously was no regulation in the section about pricing. In SEBI’s preferential issue norms, in all fitness, there is elaborate pricing protection also. In Unlisted Public Companies Rules also, there was a requirement to state the manner of computing the price, but there was no absolute price protection. This section, in sub-section (1) (c), has legislated the fair-value pricing rule – that is, not only does one need to get a super majority vote, but also, ensure the issuance is at fair value.
Scope of applicability
5. Is the section applicable to a listed company?
There is no exemption in the section in case of a listed company. SEBI ICDR Regulations do not override the Companies Act, rather, the two are to be read in consonance.
6. Is the section applicable to public offers also?
Ridiculous as it may seem, the section has been made applicable to public offers as well. Sec 81 of the 1956 Act also applies to public offers, in as much as approval u/s 81 (1A) has to be taken. However, sec 62 has elaborate controls – pricing included. Draft Rules seem to be giving exception in case of public offers by creating a new definition of “Preferential Offer”. However, there is no scope for such a definition in the Act.
7. Is the section applicable to a private company?
As mentioned before, there is no exemption in the section for a private company.
8. Is the section applicable in case of issue of shares by a subsidiary company to its holding company?
In case of issue to wholly owning holding companies, there is no question of the section applying, as it is not other than rights offer.
In case of less than 100% holding companies, if the issuance is other than in proportion of existing holding, the section will be applicable.
9. The section is applicable in case of “increase of subscribed capital”. From the incorporation of the company, when does one start capturing “increase”? Is there an initial capital-raising period where the company is free to take capital contribution from just anyone?
There is no initial period exemption at all. Now, it is anyone’s guess as to when does one start applying the section. Shares agreed to be taken up by the subscribers to memorandum are deemed allotted upon incorporation. Therefore, that capital becomes “subscribed capital”. Hence, technically, any issue of shares, from day 1, amounts to an increase in subscribed capital. If this view is too narrow, in fact, any other view will not be keeping in line with the language of the section.
Pricing of the issue
10. What is the anti-dilutive pricing mechanism provided by the law?
As mentioned above, the section stipulates pricing of any new issues to be at a fair value determined by a valuer. This ensures that there is no dilutive impact of the capital on the existing shareholders’ value of shares. Assuming that the valuer uses “earnings capitalisation method” as the basis for valuation, the EPS post-issue will hopefully be the same as the one before the issue. Hence, there will be no dilutive impact of capital issues on earnings per share.
11. Since the essential intent of right of pre-emption is to provide anti-dilution protection, how is that the section provide for both of (a) a special resolution and (b) anti-dilutive pricing?
The contention is correct. Anti-dilutive pricing itself is all there is right of pre-emption, except, of course, maintenance of shareholding control. However, maintenance of shareholding control is for the shareholders to fix up may be by articles and/or shareholders’ agreements. Having mandated anti-dilutive pricing, supermajority consent seems superfluous. Or, to put it differently, supermajority consent is needed if the company were to divert from an essential rule. If the company is deviating from the anti-dilutive pricing, insistence on special resolution seemed apt. But insisting on both the pricing rule and super-majority consent seem superfluous combination.
12. Is the anti dilutive pricing applicable in case of conversion of debentures or loans?
Section 62 (3) provides for an exception in case of conversion of debentures into shares. This is, however, only in case of “conversion”. It is said to be a conversion only where, to the extent of value of equity shares issues, debt gets converted into equity. There is a cessation of one, and birth of another. Typical “mezzanine debt” instruments which contain an option to subscribe to equity, and not conversion, are not exempted from the section.
13. Is the section applicable in case of conversion of warrants or other rights to subscribe to shares?
14. Is the section applicable in case of conversion of preference shares into equity?
No. The section does not apply in case of conversion of preference shares into equity, as there is no “increase” in subscribed capital. It is merely moving from one type of capital to another.
15. The section says “price determined by the valuation report”. Does the issue have to be made at the price determined by the valuation report? There is obviously no dilution if the price is higher than the valuation.
The section says “if the price for such shares is determined by valuation report of a registered valuer”. This clearly means at the price, neither less nor more.
Draft Rules seem to be trying to insert some sense by saying “price shall be determined on the basis of valuation report of a registered valuer”. It will remain arguable whether this tendency to pass the law with bunch of wrong expressions, missed exemptions, flawed concepts, and so on, and with the rules trying to do sawing, machining, polishing, fitting, filling, etc., would do a good to the democratic system that we pride ourselves in.
16. Does the section necessarily mandate uniform pricing in case of all capital offers?
There is no scope in the section for any preferential or differential pricing to anyone. The only exception is employee’s stock options. The draft Rules have laid bunch for rules for ESOPs.
17. Does the valuer have substantial discretion in valuing shares?
Valuer may use various valuation methods. Yes, the valuer has to exercise professional discretion, of course, in context of accepted valuation standards. Note that valuer is also subject to class action suits if his report causes a loss to the company or a class.
18. Are the Rules relaxing the requirements of the section?
Importantly, the Draft rules say that the valuation requirement shall not apply in case of listed companies.
19. Are the Rules adding any new requirements?
Importantly, Draft Rules provide that in case of any warrants, rights attached for subscription of any shares in future, the pricing shall have to be determined beforehand. This seems highly detached from reality – how is it possible to fix tomorrow’s value today? In several securities, that tomorrow may be deep into future. It will be fatal for both the shareholder and the company to fix the price today. What may be fixed is the methodology or formula for arriving at the price, but surely enough, the price cannot be fixed upfront.
Non compliance of the section
20. What is the impact of non-compliance of the section?
This is a very important question. The section is essentially not a breach of law but breach of shareholders’ right. The section is a mandatory provision, and not a compliance provision. Any issue of shares in breach of the section will be illegal, and therefore, may be quashed. Rectification of register of members, oppression, etc. may follow if the company issues any such securities violating the section.
21. Can members by unanimous resolution approve an issue at a price which is dilutive?
The author will strongly argue – yes. If the law requires super-majority, and still comply with the pricing norms, after all, who could be prejudiced if the company brings additional capital, albeit with dilutive pricing, if all shareholders consent to it? It is not a breach of public policy. It is not an offence of any regulatory requirement of the government. No one would claim to be prejudiced except the shareholders.
Clash with SEBI law
22. Are the provisions of the section clashing with SEBI’s ICDR regulations?
Since the provisions apply to listed companies as well, they are clearly clashing /overlapping with ICDR.