[Job Michael Mathew is a 4th year BA.LL.B (Hons) student at NALSAR University of Law. He may be reached at firstname.lastname@example.org]
This post examines whether the instrument of rights issue can be used by unlisted companies in enforcing anti-dilution provisions which may be one of terms in a shareholders’ agreement with a foreign investor. Put simply, anti-dilution means compensating the investor by issuance of further shares for the loss of its share value due to a downward issue (issuance of shares at a lower price than the price at which the investor subscribed) by the investee company. For example, if the value of the shares of a company is 1 rupee and the promoters issued 40 shares to the foreign investor and kept 60 shares for themselves. A few years down the line, the company is in dire need of funds and therefore issues 60 shares at 0.5 rupee each to a domestic investor. As a result of the same, the shareholding of the foreign investor falls from 40% to 25%. In order to protect themselves from such situations, investors demand anti-dilution rights. The operation of an anti-dilution right can result in the promoters issuing 40 more shares to the foreign investor at a very low price, so that the shareholding of the foreign investor in the company is back to 40%. Note that an anti-dilution provision may take different forms, but the central idea is to ensure that a future downward issue does not reduce the shareholding of the initial investor.
The enforcement of anti-dilution clauses in India by foreign investors can be extremely cumbersome, if not impossible, on account of pricing guidelines issued by the Reserve Bank of India (RBI). The RBI pricing guidelines require that, in case of unlisted companies, shares issued to foreign residents should be priced as per any internationally accepted pricing methodology for valuation on an arm’s length basis duly certified by a Chartered Accountant or a Securities and Exchange Board of India registered Merchant Banker or a practicing Cost Accountant. Since the purpose of anti-dilution is to compensate the investor by issue of shares for the loss of its share value, it is not difficult to imagine that shares will mostly be issued at prices which are low and not determined according to any valuation or pricing methodology. Requiring the investor to buy shares at fair market price would defeat the idea of compensating it.
The Companies Act, 2013 however provides an avenue where shares can be issued to foreign investors without reference to pricing guidelines. Section 62 of the Act deals with rights issue, under which companies may increase their capital at any time by offering shares to existing equity shareholders in proportion to the shares they are presently holding. The RBI guidelines do not require rights issue to be done in accordance with pricing guidelines. The only condition imposed by RBI as regards issue of shares by rights issue to foreign investors is that such shares be issued at a price not lower than the price at which the shares are offered to resident investors. An unlisted company has absolute discretion in determining prices under a rights issue. Thus, the price fixed can very well be below the value as determined under the pricing guidelines. However, under a rights issue shares are offered to all existing shareholders in proportion to the shares that they already hold. Going back to the example, this means that shares will be offered to the promoters along with the foreign investors. Let us assume that 0.4 of a share is offered for every single share held by existing shareholders. This will mean that promoters are offered 24 shares whereas the foreign investor will be offered 16 shares. However, such an issue will not help the foreign investors maintain their shareholding of 40%. For the shareholding to be maintained at 40% after the issue of shares to new investors, all the 40 shares will have to be issued to the foreign investors. Since the rights issue is only an offer to issue securities on part of the company, it will always be open to the existing shareholders to not accept the offer.
The question the author wishes to pose is on the validity of a contractual agreement the foreign investor may enter into with the promoters (resident investors) at the time of initial investment to the effect that anti-dilution will be effected through a rights issue and resident investors are required to not subscribe to the rights issue. Strictly speaking, a rights issue in pursuance of such a contract would not violate the language of Section 62 or RBI’s pricing guidelines. An offer was made to all existing shareholders at the same price and one set of shareholders did not take up the offer and shares were issued to foreign investors at a price not less than the price at which shares were offered to the resident investors. However, the ultimate impact and intention of such a contract is to sidestep the pricing guidelines and violate the law. Thus, even though such a contract does not violate the letter of the law, it may be argued that it does violate the spirit of law, thereby raising doubts as to the enforceability of a contract under which such an arrangement may be stipulated. In the opinion of the author it would be ideal if a clarification can be issued by the RBI on the validity of such an agreement which is arguably permissible under the letter of the law. Until then, any investor who embarks upon such an arrangement to enforce anti-dilution provisions would be exposed to significant regulatory risks.
– Job Michael Mathew