India: Selective Bonus Issue: Is It Possible?

Last Updated: 31 July 2017
Article by Vishal Achanta

This article will debate a point of company law: whether a company can do a 'selective' issue of bonus shares to just a few shareholders?

By way of a brief background: a company can issue fully paid up shares for "free" to its extant shareholders by capitalizing its profits or amounts lying in its share premium/redemption reserve account – this is called a bonus issue. Bonus issue is understood in the market as a way for a financially healthy company to distribute its profits to its shareholders, not in cash (like a buyback or a dividend) but in kind (i.e., shares). To illustrate, if A holds 100 shares in a company, B holds 50 shares in a company, and the company does a bonus issue in the ratio of 2:1, then A will receive 200 shares (taking her total to 300), and B will receive 100 (taking her total to 150).

Thus, the legal construct 'bonus issue' will have two economic effects: (1) shareholders will get a greater number of shares than their initial investment would have purchased at no additional cost, and (2) the total number of issued shares of the company will go up. Since each shareholder receives bonus shares pro rata to their shareholding, (a) none of the shareholders will get diluted, and (b) while the value of each share would go down, given that there is no dilution and no actual change in the value of the company, the aggregate value of each shareholders' stake in the company would also not change.

The question which arises is, can the company issue bonus shares in a 'selective' manner i.e., to A only, and not B? In the example of a pro rata bonus issue given above, neither A nor B is diluted. However, in a selective bonus issue, bonus shares would be issued to A only, thereby diluting B and effectively increasing the value of A's investment in the company. If possible, selective bonus issue could find application in situations where the ownership pattern has to be reset, where a valuation gap needs to be addressed, or where certain shareholders have to be compensated for a drop in the company's value (anti-dilution rights seen in PE/VC deals come to mind).

Company law practitioners seem to be divided on whether a selective bonus issue is possible. Before getting into this debate, it should be noted that the previous company law, the Companies Act, 1956 (the '1956 Act') did not have any provision that expressly dealt with bonus issue, whereas the Companies Act, 2013 (the '2013 Act') does have such a provision – but arguably, still does not adequately address the question of whether a selective bonus issue is possible or not.

Due to the vacuum in the 1956 Act, the following arguments could be made against selective bonus issue, relying on first principles of company law: (1) unless shares are of different classes, they are equal in all respects, and equal economic benefits should flow to each shareholder in line with her shareholding percentage – since a bonus issue is in essence a distribution of profits, these profits should go to all shareholders ratably, (2) the intent behind bonus issue is to capitalize profits and "bring nominal share capital into line with the true excess of assets over liabilities" (Ramaiya, 17th Ed., Part 1, p.1255), not to permit disproportionate value extraction by a few controlling shareholders, and (3) allowing unregulated selective bonus issues would quickly result in abuse of minority shareholders, which is undesirable.

My two cents worth: a selective bonus issuance is indeed possible, and this is largely due to the language now found in Section 63 of the 2013 Act, which begins: "A company may issue fully paid-up bonus shares to its members, in any manner whatsoever...". Applying the literal rule of interpretation, we can see that the provision does not prohibit selective bonus issue, but rather, contains wide permissive language which suggests it is possible. While the words "in any manner whatsoever" are a little ambiguous, I don't think there is enough ambiguity to call for the application purposive rules of interpretation which require consideration of the intent behind bonus issue or first principles of company law.

There are two other factors which support the proposition that a selective bonus issue is possible from a company law point of view: (1) the high-profile precedent of a selective bonus issue which was set when Reliance Power did a selective bonus issue in 2008 (which excluded its promoter) to protect the value of its public shareholders' investment, and (2) the fact that selective bonus issues are a permitted mechanism for listed companies to bring their shareholding pattern in line with minimum public shareholding norms.

However, the above examples of permitted selective bonus issue should be taken with a pinch of salt since both were/are geared to benefit minority/retail shareholders and hence had/have the blessings of regulators. They do not give comfort when considering whether a controlling shareholder/financial investor can get away with a selective bonus issue that dilutes the minority or other shareholders. Such selective bonus issuances will come with significant legal risk since the diluted shareholders may question the validity of the bonus issue later on as being oppressive, mala fide, or simply not possible in law.

A few further points should be noted in conclusion: (1) a selective bonus issue to foreign investors to the exclusion of Indian shareholders may be viewed negatively by the RBI for being contrary to the intent of the Foreign Exchange Management Act, 1999, and (2) companies doing a selective bonus issue must be very careful by maintaining a paper trail of consents so that there is no exposure to claims from diluted shareholders at a later point in time, and must also be scrupulous about compliance, so that there is no opportunity for the validity of the bonus issue to be questioned.

The views expressed in this article are of the author and not the firm.

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