Issue and Redemption of Preference Shares - International Law Office

Introduction
Mechanics
Terms of Issue
Features
Voting Rights
Regulations
Issue of Further Shares
Comment

Introduction

The Companies Act 1956 provides that new issues of share capital should consist of only two types: (i) equity share capital with voting rights or differential voting rights regarding dividends or voting; and (ii) preference share capital (Section 86, introduced on December 13 2000 and applicable to public companies). Preference share capital is distincitve in relation to dividend pay-outs and the return of capital on a preferential basis. Regarding dividends, preference shares carry a preferential right to be paid a fixed amount as a dividend or an amount calculated at a fixed rate. Such payments may be free of or subject to income tax, as the terms of issue provide. Regarding capital, on a winding-up or repayment of capital preference capital carries a preferential right to be repaid the paid-up amount of preference capital. Preference shares are also entitled to participate either fully or to a limited extent with capital not entitled to preferential rights, both as regards dividends and return of capital (ie, a share in the surplus). This is the substantive provision of Section 85 of the act.

A company cannot be formed with only preference capital, as preference shares do not carry voting rights except in certain circumstances. Voting rights form the basis for corporate actions, particularly in respect of matters placed before general meetings. As the name suggests, preference shares carry preferential rights in relation to other classes of share. Therefore, a company can have only equity capital and cannot have only preference capital. Nothing prevents a company from having both equity and preference capital. Therefore, in the absence of equity capital, there cannot be preference share capital.(1)

Mechanics

There must be specific provisions in the articles of association empowering the board to issue preference shares, as well as setting out the terms and conditions subject to which such preference shares can be issued. The legal framework for this is set out in Section 80 of the act. The maximum period for which preference shares can be issued shall not exceed 20 years (according to Section 80A). This means that preference shares must be redeemed within a period of 20 years from the date of issue and companies are prohibited from issuing irredeemable preference shares. It is also necessary to ensure that the authorized capital of the company provides for issue of preference shares. If not, Clause V of the memorandum of association (ie, the capital clause) must be amended before issuing preference shares.

Terms of Issue

The articles may set down terms and conditions subject to which preference shares can be issued. Such conditions should include the following;

• Such preference shares shall be redeemed out of the profits of the company which are otherwise available for dividends or out of the proceeds of a fresh share issue made specifically for redemption.
• No such shares shall be redeemed unless they are fully paid.
• If payable on redemption, the premium shall be provided out of the company's profits or the company's security premium account before the shares are redeemed.
• Where shares are redeemed otherwise than from the proceeds of a fresh issue, the company is required to transfer, out of the profits of the company which would otherwise be available for dividends, to a capital redemption reserve account a sum equal to the nominal amount of shares redeemed. The reserve account is treated as if it were paid-up share capital. This is based on the fundamental principle that the capital of the company must be maintained intact. The subscription made to the capital of a company cannot be taken back, but can be converted into liquid cash by the sale of relative shares in the market. For the same reason, the redemption of preference shares must be done only out of the company's profits. Such redemption is an exception to the prohibition contained in Section 77 of the act as the company cannot buy its own shares.
• The articles may also provide for other terms and methods of redeeming preference shares. This may include:
  • whether the preference shares are convertible into equity shares of the company;
  • the timing of conversion or redemption, or whether this is at the option of the company;
  • whether the dividend payable is cumulative or non-cumulative; and
  • whether redemption will be made in installments by drawing lots or in full as the board may decide in accordance with the articles.

In the case of cumulative preference shares, the fixed dividend accumulates to the credit of the preference shareholder.

Section 80 provides for redemption of preference shares. However, such shares may be converted into equity shares provided that the terms of issue provide for this. The law does not prohibit such conversion provided that the equity share holders of the company have approved such conversion under Section 81(1A) of the act.

A preference shareholder is a shareholder of the company and not its creditor, and hence cannot exercise the rights of a creditor if the company fails to redeem the shares on the due date. However, the shareholder may approach the court for the winding-up of a company in default on just and equitable grounds.

Features

Preference shares are an integral part of the share capital. The redemption of preference shares does not reduce the authorized and issued capital of a company. Where preference shares are redeemed, the company has the power to reissue preference shares up to the nominal amount of the shares redeemed. Accordingly, the share capital of the company shall not be deemed to be increased for the purpose of calculating the fees payable under Section 611 of the act.

However, if new preference shares are issued before redemption of the old shares, the new shares will not be deemed to have been issued unless the old shares are redeemed within one month after the issue of the new preference shares.

Another distinctive feature of preference shares is that the capital redemption reserve account may be applied in paying for unissued shares of the company to be issued to members as fully paid bonus shares. The law provides for this facility as preference shares are part of the authorized and paid-up capital of a company and the redemption reserve created out of genuine profits can be utilized for the issue of bonus shares.

Voting Rights

Preference shares do not carry voting rights as equity shares do. However, in order to protect the interests of preference shareholders, Section 87 of the act confers voting rights on preference shareholders in certain circumstances. They have a right to vote only on resolutions that directly affect the rights attached to preference shares. Any resolutions regarding the winding-up of the company or the repayment or reduction of share capital are deemed directly to affect the rights attached to preference shares.

In the case of cumulative preference shares in respect of an aggregate period of not less than two years before the meeting, preference shareholders also have a right to vote on every resolution placed before the company at any meeting if dividends due on preference capital or any part of such dividends has remained unpaid. In the case of non-cumulative preference shares, the right to vote arises if the dividend is in arrears in respect of a period of not less than two years ending with the expiry of the financial year immediately preceding the meeting or in respect of an aggregate period of not less than three years in the six years ending with the expiry of the financial year. The voting right on a poll is in the same proportion as the capital paid up in respect of preference shares is to the total paid-up equity capital of the company.

Regulations

A person resident outside India may purchase shares, including preference shares, under the Foreign Direct Investment Scheme, subject to sectoral caps. The rate of dividends on preference shares or convertible preference shares should not exceed 300 base points over the prime lending rate of the State Bank of India on the date of the board meeting at which the issue of such shares is recommended.

A company issuing shares should receive the amount of consideration by inward remittance through normal banking channels or by debit to the account of the person concerned with an authorized dealer or bank.

Foreign institutional investors can invest up to an individual limit of 10% with an aggregate limit of 24% by all foreign institutional investors; this can be increased to 49% with the approval of the board or general meeting of the investee company. Similarly, non-resident Indians can invest in a Indian company with an individual limit of 5%. The non-resident Indian portfolio investment can be up to 10%, and can be increased to 24% with the approval of the board or general meeting of the investee company. These percentages refer to the paid-up capital of the Indian company.

Issue of Further Shares

Section 81(1) of the act protects the preemptive rights of existing shareholders by requiring the company to offer further shares to them in proportion to their existing holding. In principle, this applies to the issue of further shares of the same kind as previously issued. Such further shares or preference shares may be offered on a rights basis to existing shareholders or on a preferential basis to an outside strategic partner. The terms and conditions of such offer are approved by the shareholders of the company by a special resolution under Section 81(1A) of the act.

Comment

Preference shares are a special risk-free type of security as both the principal and dividend pay-outs are guaranteed by the issuer company. Such security is subscribed by those who are not interested in the management control of the company, but who enjoy a secured income on their investment. As the security is risk free it is a useful type of investment for banks, financial institutions, investment companies, mutual funds and others. However, the quality of the management of the investee company and its ability to generate profits should be such that it inspires the investors' confidence in the company's ability to honour the commitment.

For further information on this topic please contact DK Prahlada Rao at FoxMandal Little by telephone (+91 080 2559 5911) or by fax (+91 080 2559 5844) or by email (prahlada.rao@foxmandallittle.com).

Endnotes

(1) Bihar State Financial Corporation v CIT, Bihar (1976) 46 Com Cases 155 (pat –DB).