Cross-Characterization of Share Capital

[Naren BS is an independent legal consultant and was previously a Senior Associate with a leading law firm]

This post represents a brief discussion on the characteristics of equity and preference capital under the Companies Act, 2013 and the flexibility of cross-characterization between the two kinds of capital, i.e. imputing the characteristics of one kind of capital to the other.

Background and Statutory Framework

The Companies Act, 2013 (the “Act”) in section 43 contemplates and enables a company to broadly create two kinds of share capital – equity share capital and preference share capital. Within the first category (i.e. equity shares), the Act also contemplates equity shares with either voting rights or with differential rights as to dividend, voting or otherwise, created in accordance with the rules issued pursuant to the provisions of the Act.

As for preference share capital, the Act defines ‘preference share capital’ as that part of a company’s issued share capital which carries (or would carry) a preferential right in respect of the following two characteristics –

(a) Dividend – preference shares would enjoy precedence over equity share capital in payment of dividend (“Preferential rights in Dividend”).

(b) Repayment – preference shares would also enjoy precedence over equity share capital in repayment of share capital in case of winding up of the company or repayment of capital (“Preferential rights in Repayment”).

The Act defines ‘equity share capital’ in an exclusionary manner as share capital which is not ‘preference capital’.

Further, the Act, through an explanation under section 43, also creates a deeming provision whereby share capital shall be deemed to preference capital if such share capital has either or both the following characteristics:

(a) In addition to the Preferential Rights in Dividend mentioned above, the share capital is entitled to participate with other capital that is not entitled to participate in the Preferential Rights in Dividend. In other words, if shares are first entitled to Preferential Rights in Dividend and thereafter also entitled to further dividend (over and above the Preferential Rights in Dividend) along with other shares which are lower in precedence, then the first referenced shares shall be deemed to be preference shares.

(b) In addition to the Preferential Rights in Repayment mentioned above, the share capital is entitled to participate with other capital that is not entitled to participate in the Preferential Right in Repayment. In other words, if shares are first entitled to Preferential Rights in Repayment and thereafter also entitled to a further repayment (over and above the Preferential Rights in Repayment) along with other shares which are lower in precedence, then the first referenced shares shall be deemed to be preference shares.

The above-mentioned explanation under section 43 likely covers a situation where, while a class (or classes) of equity shares with superior economic rights (such as differential rights in dividend and/or repayment akin to those associated with preference shares) is created, it is also expected that this class (or classes) would in addition to such superior economic rights also receive additional economic rights on par with regular equity shares. Given that the Act clearly distinguishes equity and preference shares (in terms of rights available vis-à-vis the company), this explanation under section 43 appears to restore any deviation which a company may attempt to make in imputing characteristics of preference shares to equity shares and yet expecting to enjoy all rights otherwise enjoyed by equity shares. Therefore, any attempt at disguising preference shares as equity shares would likely be in conflict with this explanation under section 43 and such equity shares will be deemed to be preference shares.

Cross-Characterization

Companies seeking financial investments frequently issue preference shares to investors (who prefer to remain in precedence over equity capital as far as distribution of profits and repayment of capital is concerned). Yet, these investors, in order to be able to oversee the affairs of the company better, also seek to enjoy the rights which equity capital enjoys.

While accommodating such an expectation is not entirely prohibited by the Act, any changes in the fundamental characteristics of equity or preference shares would be subject to the requirements under the Act. That said, any change in the characterization of shares that would result in equity shares behaving like preference or vice versa may be examined from the following perspectives:

(a) altering rights associated with equity shares such that they enjoy rights typically attributable to preference shares (and yet not lose the fundamental characteristics of equity shares); or

(b) altering rights associated with preference shares such that they begin to enjoy rights associated with equity shares (over and above the preferential rights that preference shares typically enjoy).

This discussion on cross characterization would however also be different for private companies and companies other than private companies.

Private companies: While section 43, which was brought into effect from April 1, 2014, was initially applicable to both private and public companies, the Ministry of Corporate Affairs, by way of a notification dated June 5, 2015 (“Notification”) exempted private companies from the application of inter alia section 43, provided that the memorandum or articles of the company contain a provision for such exemption. This Notification essentially restored the applicability of section 43 to exactly the way it was under the erstwhile legislation, the Companies Act, 1956. Therefore, given that private companies will not be affected by the limitations under section 43 (subject of course to an enabling provision in the memorandum or articles), private companies can alter the rights associated with equity and preference shares including the cross characterization referred to above.

Companies other than private companies: As regards companies other than private companies, section 43 will continue to apply and the limitations therein would affect such companies. It would therefore be useful to analyze cross characterization in this scenario. In terms of judicial precedents, the Company Law Board in the case of Anand Pershad Jaiswal v Jagatjit Industries Limited (MANU/CL/0002/2009) had the opportunity to examine the validity of equity shares with differential voting rights issued by a public company. While this case did not directly deal with cross-characterization, i.e. imputing characteristics of preference shares to equity shares or vice versa, it however recognized equity shares with altered or differential rights.

Analysis

As mentioned earlier, the distinctions drawn in section 43 are essentially two-fold – first between equity shares and preference shares and second between equity shares with voting rights and equity shares with differential rights as to voting, dividend, etc. The framework in the Act however does not create any distinctions within the category of preference shares. Even the explanation in section 43 which sets out a deeming provision for the purpose of characterizing shares as preference shares in a situation where a company attempts to impute economic rights over and above those normally associated with preference shares does not contemplate a reverse situation where preference shares are imputed with characteristics of equity shares. Therefore, it appears that while the framework under section 43 contemplates situations where equity shares can behave like preference shares (through creation of differential rights), the framework is silent in the reverse situation. However, the only situation where preference shares get to enjoy certain rights associated with equity shares is contemplated in the second proviso to section 47 (2) of the Act – where if dividend in respect of preference shares has not been paid for two years or more, then such preference shares shall enjoy voting rights on all resolutions placed before the company (including those on which equity shareholders vote).

Drawing a generic understanding from the above, it appears that while it would be possible to create a class of equity shares with characteristics of preference shares imputed to such equity shares, the position in respect of a reverse scenario is however not clear.

Naren BS

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