[Rituraj Singh Parmar and Priyam Indurkhya are 4th year B.A., LL.B. (Hons.) students at National Law Institute University, Bhopal]
Think & Learn Private Limited, popularly known as Byju’s, has been facing several legal battles nationwide. In February 2024, the investors of Byju’s filed a petition for oppression and mismanagement with the National Company Law Tribunal, Bengaluru (“NCLT”). The grounds raised by the investors included serious allegations of siphoning off the funds by the promoters, pending investigation by the Enforcement Directorate (“ED”) and the Ministry of Corporate Affairs (“MCA”), and other financial irregularities. Amongst the various concerns raised, an important one was the oppressive nature of rights issue conducted by the ed-tech giant at a $225 million pre-money valuation which was a 99% drop from its previous round. This would substantially dilute the shareholding of the non-participating investors. The NCLT, on February 27, 2024, allowed the first rights issue with a direction that Byju’s must retain the proceeds of the issue in a separate bank account until the petition is resolved. However, on June 12, 2024, the NCLT halted Byju’s second rights issue until the main petition is decided. Thus, the decision on the oppressive nature of the rights issue is pending.
In this backdrop, this post aims to analyse when a rights issue is considered as oppressive in nature. The authors examine the common law jurisprudence and Indian position on the subject matter to pre-empt the analysis the NCLT may undertake in adjudicating the Byju’s dispute. It is to be noted that while the NCLT may factor in several factual allegations to decide upon the oppression and mismanagement claims, the scope of this post is limited to examining the issue of oppression in context of rights issue.
Common Law Position: Twin Tests for a Valid Rights Issue
Section 171(a) of the Companies Act, 2006 (“UK Act”) incorporates the bona fide test. It mandates the directors to act in good faith and in the best interests of the company. Directors, as fiduciaries of the company, must demonstrate that any exercise of powers was in the paramount interest of the company at the time of making the decisions. In context of a rights issue, as long as its purpose is to benefit the company, it would generally pass the bona fide test. This mainly covers circumstances when the company needs capital to fund a business project or discharge pressing liabilities.
Another test applied by the court along with the bona fide test is the proper purpose test. It is incorporated under section 171(b) of the UK Act. Courts have observed that the duty of the directors does not stop at the requirement to act bona fide. They must also adhere to the “proper purpose doctrine”, which was propounded in Hogg v. Cramphorn Ltd and later affirmed in Howard Smith v. Ampol Petroleum Limited. In the former case, it was ruled that although the directors acted in the interest of the company, the primary purpose of the issue was to ensure control of the company by them. Therefore, the issue was set aside by the Court since it was carried out with an improper purpose. In the latter case, although the company was in pressing need of capital, the Court found that that the primary purpose of the allotment was to reduce the proportionate shareholding of majority shareholders. This was regarded as an improper purpose irrespective of the need for capital and therefore the further issue was set aside. The proper purpose doctrine has been further relied on in subsequent cases (see, here & here).
Lord Sumption in Eclairs Group Ltd and Glengary Overseas Ltd v. JKX Oil & Gas Plc opined that the proper purpose rule “is not concerned with excess of power by doing an act which is beyond the scope of the instrument creating it” but rather, it is concerned with an “abuse of power, by doing acts which are within its scope but done for an improper reason”.
To determine if there has been a breach of the duty to act for proper purposes, the following steps may be followed by the court:
- evaluate, as a matter of law, the intended purpose of the power in question; and
- ascertain, as a matter of fact, whether the directors have exercised the power for purposes other than those for which it was granted.
The first prong is objective—the purpose of a rights issue, as discussed earlier, is primarily to meet the pressing need for funds. The second requires a closer scrutiny of the facts and circumstances to determine if the issue was for extraneous purposes, such as maintaining or acquiring control over the company’s affairs or converting the existing majority into a minority. If found so, the rights issue becomes oppressive.
Indian Position: Towards Twin Test?
The provision pertaining to prevention of oppression and mismanagement under Indian law are contained in Chapter XVI (sections 241 to 246) of the Companies Act, 2013 (“2013 Act”). For a conduct to be called oppressive, it must be burdensome, harsh and wrongful, involving lack of probity or fair dealing to a member in the matter of his proprietary rights as a shareholder. The Supreme Court has observed that an illegal act will not be ipso facto oppressive, unless it is accompanied by a mala fide intention or if otherwise such an act was harsh, burdensome and wrongful. A logical corollary that follows is that if the directors can prove that they have discharged their fiduciary duties towards the company without any mala fide intention, they can circumvent the allegation of oppression and mismanagement.
Section 166(2) of the 2013 Act casts a fiduciary duty upon directors to act in good faith in the best interest of the company, the shareholders, and other stakeholders. Although the scope of a director’s fiduciary duties under section 166 is not settled by courts yet, a catena of precedents reveal that Indian courts have endorsed the subjective standard to judge the ‘good faith’ duty. It would suffice if the directors subjectively believe that they are acting in the interests of the company and various stakeholders.
In context of a rights issue, Indian courts have implicitly adopted the bona fide test. In Needle Industries (India) v. Needle Industries Newey (India) Holding Ltd., the Supreme Court rejected the allegations of oppression and mismanagement and upheld the decision of the board of directors to make a rights issue of equity shares, observing that the company needed funds and the decision was taken for the larger corporate purpose. The court noted that the directors had acted in the best interests of the company and, therefore, the issue was valid. Needle Industries also recognised the principle that if the directors incidentally benefit from an issue of further shares which can be shown to be otherwise for the benefit of the company, such incidental benefit would be overlooked.
Similarly, the proper purpose rule was referred to in the case of Dale and Carrington Invt. P. Ltd. v. P.K. Prathapan, although the scope of the rule remains unexplored. The case dealt with further issue of share capital by the managing director of a company. The Supreme Court noted that Commonwealth countries, including England and Australia, have gone a step ahead to recognise the proper purpose doctrine in addition to the bona fide test. Referring to the common law jurisprudence of Howard Smith, the Court in this case held that the motive for the allotment of shares was mala fide, and the sole intention of directors was to gain control of the company and hence, the issue was set aside. Similarly, in Sangramsinh P. Gaekwad v. Shantadevi P. Gaekwad, the Supreme Court held that “directors are not entitled to use their powers of issuing shares merely for the purpose of maintaining their control…over the affairs of the company, or merely for the purpose of defeating the wishes of the existing majority of shareholders”. Thus, both these cases substantially align the Indian position with the twin tests of the common law jurisprudence.
Although the courts have not yet directly invoked the provisions of section 166 of the 2013 Act to test the validity of rights issue, the authors believe that the courts can also rely on section 166 in addition to the twin tests for this purpose. This is because the ambit of “good faith” duty under section 166 is broad enough to include the bona fide and proper purpose tests within its ambit. Section 166(2) mandates the directors to act in good faith in the “best interest of the company”. Moreover, this duty is owed by the directors to the company. The requirement to act in the best interest of the company is akin to the bona fide test under common law in as much as both require the directors to act in a way that promotes the benefit of the company. Similarly, the proper purpose doctrine requires the directors to avoid any extraneous consideration other than the interest of the company, which is again an extension of the good faith duty owed to the company because any act of the directors that is extraneous to the purpose of rights issue will violate the duty owed to the company under section 166.
Rights Issue by Byju’s
While an investigation against Byju’s for financial irregularities is pending before the MCA, the investors have separately filed an oppression and mismanagement suit before the NCLT. One of the pleas of the investors is to declare the rights issue as void. The investors have argued that the rights issue is prejudicial against them as their shareholding could decrease from 24.5% to 2.5% if they do not subscribe to the rights issue. There is also an apprehension that subscribing to the rights issue might result in financial losses given the valuation of the issue is 99% lower than the previous round. Byju’s, on the other hand, argues that the rights issue is essential for meeting its operational needs. These needs include covering working capital requirements, discharging its obligations, paying the employees, and meeting general corporate expenses.
Therefore, the primary issue for consideration before NCLT is whether the allotment of shares under the rights issue was in the best interests of the company and for a proper purpose, or whether it was a deliberate attempt to sideline the petitioners by significantly reducing their shareholding from 24.5% to 2.5%.
Applying the bona-fide test, the right issue must benefit the company. According to the company’s the claims, the further issue of shares is necessary for its operation as it is in dire need of funds. It is a question of fact best left to the determination of the NCLT to decide whether Byju’s is in pressing need of funds. If the NCLT deems it appropriate based on the evidence that the company urgently needs capital, then simply reducing the shareholding of non-participating shareholders significantly does not justify labelling the issue as oppressive to the minority shareholders. This is provided that equal opportunity was afforded to them to participate in the issue, proper procedures were followed, and the directors did not act with ulterior motives.
It could be argued that the capital requirement could alternatively be met through a loan or debt instruments. However, this argument can be discounted on two grounds. Firstly, availing loan facility is difficult considering the precarious financial affairs of Byju’s. Secondly, the courts have recognized the benefit of raising capital through equity over debt. In any case, the decision to raise equity capital over debt is a commercial decision in which the courts generally do not interfere.
For the application of the proper purpose principle, the following observations in Hanuman Prasad Bagri v. Bagrees Cereals Pvt. Ltd. become relevant:
“If the issue of further shares could be shown to have brought a group of shareholders controlling 25 per cent of the paid-up capital or more to below such level which would have allowed them to block a special resolution; or such issue resulted in a group’s shareholding being reduced from above 10 per cent to a single- digit control; or, in the best case scenario, of a majority being reduced to a minority – the principle would apply if the decision were that of the board of directors of a company.”
The above observations are applicable in the current factual matrix as the shareholding of the investors is being reduced to 2.5%. However, this does not necessarily mean that the rights issue is for an improper purpose. It is again a question of fact whether the further issue was motivated by a desire to reduce the shareholding of non-participating shareholders or whether the reduction was incidental to augmenting the paid-up capital of the company. If it is the latter, the further issue will not be liable to be set aside because the dominant purpose of the issue was proper and any incidental benefit to the directors is immaterial.
In the absence of any apparent illegality, the validity of the rights issue hinges on the collective wisdom of the board as to whether the company is in pressing need of capital. If this question is answered in the negative, the purpose of the rights issue would become extraneous, and it would fail to meet both the tests.
Conclusion
The NCLT’s order to halt Byju’s rights issue until the time the petition for oppression and mismanagement is decided has led to several questions concerning the validity of the issue. Under English law, the validity of the rights issue is determined by the statutory compliance of the bona fide test and the proper purpose doctrine which flows from section 171 of the UK Act. The Indian courts have also referred to these tests to address the allegations of oppression in rights issue. The combined requirement of both the tests is that a rights issue must benefit the company and not serve any unfair purpose. If the shares are issued in the larger interest of the company, the decision to issue shares cannot be struck down on the ground that it has incidentally benefited the directors in their capacity as shareholders. However, this benefit must be incidental and should not be the primary purpose of the issue.
It is clear that the purpose of the rights issue, along with the compliance of a director’s fiduciary duties towards the company, are the determining factors to decide upon the allegations of oppression and mismanagement. While the twin tests will be key in the adjudication of the dispute, it remains to be seen whether the NCLT will also invoke the “good faith” duty under section 166 of the 2013 Act in the Byju’s case.
– Rituraj Singh Parmar & Priyam Indurkhya