The Companies Act, 2013, ('New Act') attempts to consolidate all the methods available to a company to raise capital. Chapter III and Chapter IV of the New Act sets out all the methods by which any company, whether private or public, could raise capital.
Chapter III is divided into 2 distinct parts. Part I deals with capital raise by a public company, whether listed or unlisted, and also expands the rights available to the Securities and Exchange Board of India ('SEBI'). Part II codifies the methodology of Private Placement dealt by Section 67 of the Companies Act, 1956 ('Old Act'). Section 67 came to be part of the public discourse owing to the pronouncements in the now infamous Sahara Judgement.1
A public company can raise capital by issuing securities to the public through issue of prospectus or by way of Private Placement to select individuals. As always, a public company can also issue securities by way of rights issue or bonus issue to the existing shareholders of the Company. Here, a public offer includes an initial public offer as well as further issue of shares or an offer for sale made to the public. A private company can raise capital by way of (a) Private Placement; (b) through rights issue; or, (c) preferential allotment.
The Fifty Seventh Report of the Standing Committee on Finance notes that the provisions of the Private Placement were introduced to prevent misuse of existing provisions on the matter, to protect the interest of the investors and to synchronize the provisions with SEBI regulations / norms. We see that Painstaking efforts have been made to address the issues that arose in the Sahara case. Unlike Section 67 of the Old Act which referred to 'shares and debentures', the New Act refers to securities which is wider in scope. This is intended to ensure that even issue of hybrid instruments, as in the case of Sahara, would be within the ambit of Private Placement.
A company can offer securities by way of a private invitation to not more than 200 persons in a financial year. The said limit does not include qualified institutional buyers and employees of the company who are offered securities under an ESOP scheme. Other conditions including the form and manner of Private Placement are governed by the rules. If an offer is made to more than the prescribed number of persons, regardless of the fact that the company has not received the consideration or that it does not intend to list the securities on a stock exchange, such issuance will be deemed to be a public issue.
Though this provides the companies with a viable alternate method of raising capital, the condition which requires the minimum offer to be at least INR 20,000 of the face value of the securities will prevent this from being a truly viable option for the small investors.
It has been contended that any issue of capital has to be by way of Section 62 and that provisions relating to Private Placement are not a code by themselves. Hence, any issuance by way of Private Placement has to be supported by necessary actions under Section 62. This argument is advanced on the basis that the entire requirements relating to preferential allotment of shares under Section 62 (1) (c) and under Rule 13 of the Companies (Share Capital and Debenture) Rules 2014 ("Rules") is rendered entirely redundant and would never need to be complied with under any scenario whatsoever if Private Placement is treated as a code in itself. It is argued that this would defeat the entire purpose of the specific requirements relating to preferential allotment of shares, and in fact would render the sub-section and rules thereunder redundant or otiose. Further the fact that Chapter IV, which is titled 'Share Capital and Debentures', deals with further issuance of shares by any company could be a valid argument to state that any issuance of shares by a company should be duly authorized under the provisions of Chapter IV.
On the other hand, given the fact that the process under Section 42 binds any issuance under Section 62 and there is no corresponding requirement for such compliance in case of issuance under Section 42, it is hard to dismiss Section 42 as being only ancillary to Section 62. Section 42 (9) of the Act authorises filing of return of allotment of shares issued through a Private Placement process, which by itself lends credence to the argument that Section 42 is a complete code in itself and need not turn to Section 62 for the purposes of issuance. Further provisions of Section 23 provide modes by which public and private companies may issue shares. It provides three modes for a public company for issue of shares; (i) to public through a prospectus, (ii) through a private placement and (iii) and by way of a rights issue or bonus issue. The same modes are also available to a private company except that the issue of shares to public through a prospectus is not permitted. This again seems to indicate that the Companies Act recognizes private placement as a separate and independent mode of issuance particularly since Section 23 states that private placement issue should be in compliance with Part II of the Companies Act (i.e. Section 42) and does not make any reference to Section 62.
The New Act extends the right of pre-emption to the shareholders of a private company as well which until now was available only to the shareholders of a public company. Under Section 62 of the New Act, a company limited by shares, if it intends to issue additional securities, is bound to offer such securities to the existing shareholders of the company. Equity shareholders will be entitled to participate pro rata their equity shareholding in the paid up capital of the company. Such company can also offer new shares to its employees by way of employee stock option if such offer is approved by way of a special resolution.
The New Act does away with the exemption available to private companies under Section 81 (3) of the Old Act. Henceforth any offer to a third party by a private company will have to be authorised by the shareholders by way of a special resolution as well as a valuation report. Under the Old Act, provisions pertaining to rights issue were applicable upon earlier of expiry of 2 years from the formation of a company or at any time after the expiry of 1 year from the allotment of shares in that company made for the first time after its formation. This exemption is no longer available and the companies are bound to offer additional shares to its existing equity shareholders no matter the time of issue.
The New Act also specifies the minimum and the maximum duration for which the offer should be kept open thus providing much needed clarity in this regard. The New Act also clarifies that the board will be entitled to dispose of the shares at its will if the offer is declined by the equity shareholders within the offer period without waiting out the expiry of the offer period. However, such disposal should not be disadvantageous to the interests of the shareholders and the Company. This should be construed in light of the duty that was imposed under the Old Act which asked of boards to dispose of shares "in such manner as they think most beneficial to the company." The New Act imposes a higher duty of care on the board in exercise of its discretionary powers when compared to the duty imposed under the Old Act.
As the exemption available to private companies stands repealed, any company which wishes to make a rights issue of shares will be bound to offer it to the equity shareholders of the company. Hence preference shareholders will not be entitled to participate in such issuance in exercise of their rights of pre-emption which are routinely included in shareholders agreements. It needs to be seen how the contractual rights of preference shareholders under suchshareholders agreements will be reconciled with the provisions of the New Act.
As noted earlier, the conditions relating to preferential allotment are now applicable to private companies as well. Any issuance by way of preferential allotment needs to be supported by a valuation report issued by a 'registered valuer'. However, it fails to specify the valuation method to be adopted for arriving at the said valuation. Rule 13 (1) states that any issuance of preferential basis should also comply with conditions laid down in Section 42 of the Act.
However, it fails to clarify if a preferential allotment will be bound by all the conditions laid down in Section 42 and whether such preferential allotment is bound to comply with the rules prescribed under Section 42 as well. This clarification will be key to ensure that a preferential allotment can be made without going down the Private Placement route given the inherent limitations. Further, Rule 2(h) prescribed for Preferential Allotment states that if convertible securities are offered on preferential basis then the 'the price of the resultant shares shall be determined beforehand on the basis of the valuation report.' However, what it fails to clarify is whether setting out the conversion ratio of the convertible securities which is subject to future adjustments will amount to compliance with this requirement since the extant FDI policy provides an option of setting out a conversion formula at the time of issuance of convertible instruments. It has been also been argued that if the conversion price is within the price band determined by the Registered Valuer for the proposed allotment then the allotment could be deemed as compliant with the requirements of Clause (h) set out above. Hence necessary clarification will be crucial in light of the fact that many deem that Section 42 is not a code in itself and hence all issuances need to have roots in Section 62.
It is noteworthy that Rule 13 (1)(ii) defines "securities and shares" to include any security which is convertible or exchangeable with equity shares. Given this definition, one could argue that redeemable/ non-convertible securities cannot be issued through the preferential allotment process and would have to be issued by way of Private Placement. If this is not the intention of the legislature then necessary clarification should be provided in this regard.
The New Act includes a separate provision with regard to bonus issue which was earlier subsumed under Section 205 of the Old Act. A company is entitled to issue bonus shares (a) out of its free reserves; (b) securities premium account; or, (c) capital redemption reserve account. The bonus issue cannot be made by capitalizing reserves created by the revaluation of assets. A company can issue bonus shares if (a) it is authorised by its articles; (b) it has on the recommendation of the board, been authorised in the general meeting; (c) it has not defaulted in payment of interest or principal in respect of fixed deposits or debt securities issued by it; (d) it has not defaulted in respect of the payment of statutory dues of the employees, such as, contribution to provident fund, gratuity and bonus; (e) the partly paidup shares, if any outstanding on the date of allotment, are made fully paid-up; (f) it complies with such conditions as may be prescribed.
Similar to the conditions set out in the Issue of Capital and Disclosure Requirements ('ICDR Regulations'), a company is prohibited from issuing bonus shares in lieu of dividend.
Fifty Seventh Report of the Standing Committee on Finance notes that the number of companies has expanded from about 30,000 in 1956 to nearly 8 lakh companies. Given the ubiquitous nature of the private companies, the New Act tries to provide protection to shareholders of the private company on par with a public company. Introduction of the valuation report as a pre-requisite to issuance to third parties shows an attempt at protecting shareholders from unjust dilution and is expected to empower the shareholders to make informed decisions. Legislators have also made efforts to bring clarity to private placement to ensure that the Sahara episode is not repeated in the future.
However, in an attempt to protect the shareholders and to codify the issuance processes, the legislature has inadvertently introduced greater confusion. The overlapping nature of Private Placement and Preferential Allotment has made the process more cumbersome. By extending all the provisions of Private Placement to a Preferential Allotment, the legislature has ensured that almost all the issuance processes are riddled with unnecessary procedure and compliance requirements which appear to serve no discernible purposes. We hope that the legislators will, in keeping with the past practice, introduce necessary clarifications which will help all the stakeholders reap the benefit of this sleek new legislation without being bogged down by unwarranted complexities.
1. Sahara India Real Estate Corporation Limited & Ors. v. Securities and Exchange Board of India & Anr.
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