Corporate and Finance

Equity to Preference Share Conversion: Tenable reorganization or backdoor reduction of capital?

Regulatory framework: The Companies Act, 2013, section 66, section 230.

Introduction: Every company limited by shares may structure its share capital into equity and/or preference shares, representing the underlying value of the company.[1] They are issued as separate classes of shares, assuming distinct natures and fiscal weightage. Equity shares constitute the foundation capital of a company, entitling the shareholder to unqualified voting rights and represents the true value of the company. Preference shares carry priority in terms of dividend distribution and liquidation waterfall of a company while entitling the shareholder to only limited voting rights. Preference shares are compulsorily redeemable and carry with them the option of conversion into equity shares under the provisions of section 55 of the Companies Act, 2013 (the “Act”) r/w Rule 9 of the Companies (Share Capital and Debentures) Rules, 2014. However, there is no analogous provision in the Act for conversion of equity to preference shares as this can be tantamount to extinguishing capital.

Academically speaking, capital, being the cornerstone of corporate existence, cannot be eroded except by means of either reduction of share capital procedure stipulated under section 66 of the Act or winding up of the company. Be that as it may, practical application of the law allows for the conversion of equity class of shares into preference by way of a scheme of arrangement sanctioned by the National Company Law Tribunal (“NCLT”) or the National Company Law Appellate Tribunal (“NCLAT”) for restructuring purposes. As there is no clear legal provision addressing the aforesaid share conversion, this article seeks to examine judicial pronouncements on this subject and help understand the difference between such restructuring and share capital reduction mechanisms.

Section 66 and Scope of Reduction of Share Capital: As the share capital of a company is the primary security on which its creditors rely, the ambit of section 66 of the Act is highly limited and defined. Under the provisions of this section, a company may undertake a reduction of share capital, with or without payout against the shares so extinguished. Subject to confirmation by the NCLT/NCLAT, a company may under necessary circumstances such as paring-off its debt, making up for trading losses, managing inflated capital expenses and minimized financial position, etc. reduce its share capital, thereby, right-sizing its balance sheet. Additionally, in order to return surplus funds to its shareholders, a company may undertake share capital reduction, either by reducing the face value or by cancelling some shares as an alternative to paying dividends. As a key takeaway, all conceived scenarios under section 66 of the Act entail a financial outlay on part of the company thereby affecting the interest of the creditors.

Section 230 and Reorganization of Share Capital: Under the aegis of section 230 of the Act, the NCLT/NCLAT may sanction a scheme of compromise or arrangement between a company and its creditors and/or members subject to satisfaction of the rules laid thereunder. The explanation to this section states that an arrangement includes a ‘reorganisation of the companys share capital by the consolidation of shares of different classes or by the division of shares into shares of different classes, or by both of those methods’. Importantly, Section 230 (2) also factors in a reduction of share capital which may be supplementary to the proposed scheme of arrangement of a company. Questions that have arisen on whether any application entailing reduction of share capital should be exclusively tested under the provisions of section 66 or may be permitted as a means of capital reorganization under section 230 of the Act. Adopting a taut approach to reading the two sections, the Hon’ble NCLT, New Delhi Bench in Re: R Systems International Limited [2]disallowed a scheme or arrangement involving a reduction of the share capital of the applicant company, redirecting it to prefer an application under section 66 of the Act. However, against this order, the company preferred an appeal with the Hon’ble NCLAT, New Delhi Bench which sanctioned the scheme of arrangement taking cognisance of sub-clause 2 of section 230.

The Hon’ble NCLT, New Delhi Bench examined the purview of section 230 even more elaborately in Re: Integral Biosciences Private Limited[3]. By way of a scheme of arrangement the Scheme petitioner company sought to convert up to 50% of its equity share capital at par into redeemable preference shares at Rs. 10 each at a premium of up to Rs. 40 per share. Upon the scheme becoming effective, any of the existing shareholders of the petitioner company would have the right to approach the company and tender request to convert their existing paid-up equity shares into redeemable preference shares of the petitioner company in terms of the scheme. Consequently, equity shares to the extent offered by the existing shareholders in accordance with the scheme would stand cancelled and be extinguished. The petitioner company elucidated to the tribunal that it was desirous of attracting new investors to expand its financial base by converting part of its existing equity shares into redeemable preference shares. The Income Tax Department objected to the proposed scheme averring that the petitioner company was attempting to distribute its accumulated profit to the shareholders by circumventing the normal route i.e. by way of dividend, thereby, evading Dividend Distribution Tax under Section 115O/115QA of the Income Tax Act, 1961. The Hon’ble NCLT failed to see merit in this argument and placed reliance on Hon’ble High Court of Karnataka’s judgment in Smart Play Technologies (India) Pvt Ltd.[4] where the Hon’ble High Court had approved a scheme for the conversion of 70,260 equity shares into 70,260 redeemable preference shares of Rs. 10/- each carrying a dividend of 1% and the Hon’ble NCLT, New Delhi Bench order in Ratnagiri Gas and Power Private Limited & Anr. Vs. Purshottam Maneshwar Vartak & Anr.[5], permitting a similar restructuring exercise of the capital of a company by conversion of a portion of the equity into preference share capital under a scheme of arrangement.

Conclusion: In order to appreciate the difference between section 66 and section 230 of the Act, the legislative intent coupled with judicial interpretation of the two sections needs to be examined. Section 66 is built on exclusivity and shall be operable exclusively for a scrupulous scenario of share capital reduction. Section 230, in contrast, has a broader ambit in terms of corporate restructuring which may resultantly lead to a reduction of share capital without any financial outlay. In the present and future years of the ongoing COVID-19 pandemic, a large number of companies may require reorganization of share capital to remain afloat and attract new investors. In this regard, the NCLT and NCLAT have thus far managed to adopt a dynamic approach to interpreting company laws to afford greater flexibility and opportunity for preservation of corporate existence, a sign of mature and advanced economies. One can hope for further refinement in India’s corporate landscape.

[1] Section 43 of the Companies Act, 2013

[2] Company Appeal (AT) No. 416 of 2017, Order dated July 16, 2018

[3] (CAA)/424/ND/2017 in CA(CAA)/116/(ND)/2017, Order dated October 23, 2018

[4] Company Petition No.174 OF 2013, Order dated 29 November, 2013

[5] Company Appeal (AT) No. 294 of 2017 , Order dated 28 February, 2018


ABOUT THE AUTHOR

Shaleen Tiwari

Shaleen is a 2016 B.A., LL.B. (Hons.) graduate from Hidayatullah National Law University, Raipur currently working as an Associate with Cyril Amarchand Mangaldas Mumbai. He can be reached at shaleen.hnlu23@gmail.com.

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