Navigating the Twilight Zone Conundrum: A Cautionary Tale for Restructured Preference Shareholders

[Snigdha and Subhasish Pamegam are 3rd year B.A., LL.B. students at Gujarat National Law University, Gandhinagar]

The practice of companies issuing restructured preference shares (RPS) in exchange for operational debt during the ‘twilight zone’, a period wherein a company is susceptible to becoming insolvent, is now seen as a controversial strategy. The order of the National Company Law Tribunal (NCLT) in EPC v. Matix has unearthed certain critical issues faced by such RPS holders in the extant jurisprudence surrounding insolvency, which requires regulatory intervention on multiple levels, as this post elaborates.

Firstly, the post aims at highlighting unique challenges faced by RPS shareholders during insolvency in the absence of any regulatory acknowledgment of their position. Secondly, it argues that there exists a necessity for providing a separate and differential treatment to such RPS holders in cases of insolvency. Finally, the post provides certain recommendations to address this regulatory lacuna.

The Unique Nature of Restructured Preferential Shareholders

Preference shares by their very nature carry a preferential right with respect to the payment of dividend to the respective shareholders. More importantly, these preference shareholders enjoy a position much higher in the scale of priority as compared to other equity shareholders when it comes to an event of liquidation of the company. When it comes to a cumulative redeemable preference share (CRPS), upon a payment being missed, the dividend gets accumulated and added to future dividend payments. Unless the arrears on payment of dividend of CRPS are cleared out, any dividend on equity shares cannot be paid, therefore providing a preferential treatment to CRPS shareholders in the priority of dividend payments.

In EPC v. Matix, EPC initiated a corporate insolvency resolution process (CIRP) under section 7 of the Insolvency and Bankruptcy Code, 2016 (IBC) against Matix, primarily citing two grounds. Firstly, Matix failed to honor its obligation to redeem CRPS that were originally issued as part of a mutually agreed restructuring. Secondly, Matix also failed to pay the dividends on CRPS. By asserting its status as a ‘financial creditor’, EPC intended to argue that it had the right to initiate CIRP against Matix. However, the NCLT dismissed these contentions by holding that preference shares do not fall under the criteria of ‘debt’. The Tribunal in its analysis adopted a literal manner of interpretation. However, the issue warranted an approach that accounts for the unique situation of an RPS. The agreement to convert an operational debt into RPS during the twilight zone is not made with the singular purpose of providing a breathing room for the companies to improve their financial condition. The major incentive for an operational creditor to undertake this decision is based on the ‘apparent’ benefits that come together with holding a CRPS.

The absence of differentiation in the law between RPS holders and ordinary preference shareholders fails to acknowledge the unique circumstances of RPS holders. Although both categories of shareholders may appear to have similar rights, the purpose for which they were issued needs to be recognized, especially in the context of CIRP. The unique situation of an RPS holder is therefore created through a web of information asymmetry in a dichotomous manner, with the company itself being uncertain about its financial health in the future, fostering greater issuance of low risk-carrying preference stocks and the operational creditors threatened about the repayment mechanism in IBC choosing to go for a more lucrative approach through RPS conversion. The web of information asymmetry on the one hand and the lack of statutory or regulatory safeguards for preference shareholders in the case of insolvency on the other hand causes a greater detriment to the interests of these shareholders.

Subversion of RPS Holder’s Rights in the Absence of Regulatory Oversight

The primary advantage of converting operational debt into RPS is the potential for receiving a higher dividend rate and being prioritized during the repayment of share capital in the event of liquidation. However, section 55 of the Companies Act, 2013 provides that preference shares can only be redeemed out of the profits of the company or the proceeds from a fresh issue of shares. Moreover, any premium payable upon redemption must be sourced from the company’s profits or its securities premium account. Coupled with this is the absence of a mechanism through which a preference shareholder may enforce their right of redemption or payment of dividend. Further, owing to the preference holders not regarded as creditors, they lack the ability to file a CIRP under the IBC. As a result, they do not have any entitlement to reclaim their investment except in the event of winding-up. This inevitably leads to the interests of these shareholders left at the discretion of the company with limited recourse available to the former. This lack of accountability further emboldens the company to exercise its discretionary power without external constraints or oversight, leaving the RPS holders vulnerable to arbitrary decisions.

The intent behind the conversion of operational debt into RPS should be a critical consideration when determining the treatment of RPS holders under the IBC, particularly during CIRP. Unlike ordinary preference shareholders who typically invest for financial returns, RPS holders undertake this conversion with the expectation of preferential treatment during insolvency. By recognizing the intent behind the conversion and the distinct expectations of RPS holders, the law can better address their rights and ensure fair treatment during insolvency proceedings. Therefore, a clear delineation between RPS holders and ordinary preference shareholders is imperative to acknowledge the distinction and safeguard the justified expectations of RPS holders for preferential treatment during insolvency proceedings.

Moving Beyond the Watertight Compartmentalization of RPS Shares
The characterization of RPS as either ‘debt’ or ‘liability’ is contingent on the circumstances of their issuance. Moreover, the variability in the treatment of preference shareholders under the law requires a clear determination of their status as creditors or shareholders more specifically in the event of a company’s insolvency to ensure adequate protection for stakeholders affected by the restructuring.

Under the SEBI (Issue and Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013, redeemable preference shares are deemed as Tier II Capital on par with subordinated and hybrid debt capital instruments under regulation 7. Further, According to the Reserve Bank of India’s Master Direction on External Commercial Borrowings (ECB) policy, subscription to preference shares is considered as ECB, a form of debt borrowing if not mandatorily convertible into equity. However, the scope of this treatment is limited to foreign investors. Therefore, based on the specific circumstances, redeemable preference shares could potentially be categorized as debt, and their holders (foreign investors) can be classified as ‘creditor’.

Furthermore, the Indian Accounting Standard (IAS) 32  allows for the classification of certain preference shares as liabilities if they entail an obligation to transfer economic benefits, aligning with the principle of substance over form, which assesses the commercial purpose of the financial instrument rather than its legal structure. According to paragraph 18(a) of IAS 32, preference shares mandatorily redeemable by the issuer for a fixed or determinable amount at a fixed or determinable future date are classified as financial liabilities. Therefore, RPS issued with a mandatory redemption date which is admitted in the balance sheet of the company as a financial liability may be classified as ‘debt’.

In Mahesh Sharma v. Onspon Services Pvt Ltd., the NCLT necessitated the thorough examination of a ‘shareholders agreement’ to ascertain the nature of the investment made by creditors. The NCLT in this case held OCPS to be considered as ‘debt’. Similarly, in HDFC Ventures Trustee Company Limited v. Kakade Estate Developers Private Limited, the NCLT determined that the funds disbursed by the operational creditor in exchange for compulsorily convertible preference shares through the ‘exit route’ constituted a ‘debt’ owing to the ‘effect of commercial borrowing’. 

Therefore, the substance of the agreement between the two companies must be examined to determine the nature of such preference shares. If these preference shares were issued as a form of financing for the company, with a promise of redemption along with dividends, they should reflect the true financial position of the company and be classified as a ‘liability’ on its balance sheet.

Way Forward

The unique predicament of the holders of RPS who exchanged their operational debts for such shares during the ‘twilight zone’ of a company insolvency necessitates legislative remedies and policy reforms to better protect their interests.

Firstly, the legislative remedies may necessitate the examination of the balance sheet and agreements, prioritizing the substance over form principle to classify such preference shares as either ‘debt’ or ‘equity’. Such scrutiny should assess the purpose of issuance and the manner in which funds were raised through the issuance of preference shares.

Secondly, the issuance procedure for RPS during the twilight zone should involve a rigorous scrutiny by the concerned regulatory authority. This step would ensure transparency and accountability, requiring companies to disclose detailed information about the terms and conditions of RPS issuance, including conversion ratio, dividend rates, redemption terms, and any associated risks.

Thirdly, the  holders of RPS should be accorded a higher priority in the waterfall mechanism, at least on par with operational creditors. This adjustment would align with the expectations of RPS holders when they exchanged their operational debt for restructured preference shares. By implementing these measures and fostering accountability, the interests of RPS holders can be better protected, thereby fostering a conducive environment for attracting foreign investment and ensuring robust corporate governance practices.

Snigdha & Subhasish Pamegam

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