552 Oct 9, 2024 at 11:53

Preferential Offers: A Comprehensive Guide to Preference Shares

Introduction

“Preferential Offer” refers to the issuance of securities by a company to a specific individual (investor) or a select group of individuals (investors) on a preferential basis to raise its capital. This approach allows companies to attract investment without going through a public offer process. These securities may include equity shares or fully or partly convertible securities to a selected group of investors, such as existing shareholders or institutional investors. Fully or partly convertible securities can be later converted into or exchanged for equity shares. A preferential offer is distinct from other forms of share issuance such as public issues, rights issues, employee stock option schemes, employee stock purchase schemes, or the issuance of sweat equity shares or bonus shares. It also excludes depository receipts issued outside India or foreign securities, underscoring that such offer are made directly to select parties, not through open market mechanisms or broader employee incentive programs.

Preference Share Capital

Preferential share capital refers to the portion of a company’s capital raised through the issuance of preference shares. As per Section 42 of the Companies Act, 2013, “preference shares” refers to that portion of a company’s share capital which grants the holders a preferential right. This preferential right applies both to the receipt of dividends and the repayment of share capital in the event of the company’s liquidation.

Types of Preference Shares

1. Based on Right to Dividend

  • Cumulative
    • Cumulative preference shares refer to shares that entitle their holders to receive dividends even in years when the company does not generate profits.
    • If the company does not declare dividends in a particular year, the unpaid dividends are considered arrears and are carried forward to subsequent years.
    • These arrears accumulate over time, and the company must clear them before distributing any dividends to equity shareholders.
  • This arrangement characterizes cumulative preference shares, as it guarantees that the shareholders’ entitlement to dividends is fulfilled, regardless of the company’s profitability in a given year.
  • Non-Cumulative
    • Non-cumulative preference shares do not accumulate unpaid dividends. If the company does not declare dividends in a particular year, the shareholders are only entitled to receive dividends from the profits earned during that specific year.
    • Dividends are paid solely from the net profit of each year, and if no profit is generated in a given year, the shareholders cannot claim arrears of dividends in future years.
    • Thus, non-cumulative preference shareholders forfeit their dividend rights for any year in which the company fails to declare or pay dividends due to insufficient profits.

2. Based on Convertibility

  • Convertible
    • Those shares refer to convertible preference shares, which can be converted into equity shares at a predetermined rate upon the expiration of a specified period.
    • Shareholders holding such shares have the right to convert them into equity shares within the designated time frame, offering flexibility to transition from preference to equity ownership as per the terms set by the company.
  • Non-Convertible
    • Non-convertible preference shares are those that cannot be converted into equity shares. Unlike convertible shares, these remain as preference shares throughout their tenure.
    • However, they may still be redeemed by the company, typically after a specified period, according to the terms of issuance.

3. Based on Maturity Period

  • Redeemable
    • Redeemable preference shares are those that can be redeemed or repaid by the company after a specified period, or in some cases, even before the fixed period, as outlined at the time of issuance.
    • This allows the company to buy back the shares from shareholders at a predetermined time.
    • In the case of K.K. Jindal v. Rajaram Com Products (Pb) Pvt. Ltd.[1] the court held that holders of redeemable preference shares do not automatically attain creditor status if their shares are not redeemed on time, as their rights remain subject to the provisions of the Companies Act.
  • Irredeemable Preference Shares
    • Non-redeemable preference shares, on the other hand, are shares that cannot be redeemed during the lifetime of the company.
    • These shares remain outstanding until the company is liquidated, at which point they are settled as part of the company’s final distribution of assets.

4. Based on Participation in Surplus Profits

  • Participating
    • Participating preference shares grant their holders the right to share in the company’s surplus profits and any remaining assets upon liquidation, in addition to receiving their fixed dividend.
    • These shareholders benefit from a stipulated rate of dividend and can also participate in the company’s extra earnings, alongside equity shareholders, once other shareholder obligations are met.
  • Non-Participating
    • Non-participating preference shares do not entitle their holders to any share in surplus profits or additional assets beyond the fixed dividend.
    • In the event of liquidation, these shareholders receive only the stated dividend and do not benefit from any further distribution of surplus or residual assets.

Issue and Redemption of Preference Shares

The issue and redemption of preference shares refer to the process by which a company issues preference shares to raise capital and subsequently repays the shareholders according to predetermined terms.

  • As per Section 55(1), After the commencement of the Companies Act, no company limited by shares may issue irredeemable preference shares.
  • As per Section 55(2), A company, if authorized by its articles, may issue preference shares that are redeemable within a maximum of twenty years from the date of issue, subject to certain conditions. Companies involved in infrastructure projects may issue preference shares exceeding twenty years, but not beyond thirty years, provided at least ten percent of such shares are redeemed annually from the twenty-first year onward, based on the shareholders’ option.

Conditions for Redemption of Preference Shares

  • Redemption Sources- Redemption can be effected either from the company’s profits otherwise available for dividend distribution or from the proceeds of a fresh share issue specifically for redemption purposes.
  • Full Payment Requirement- Shares must be fully paid up before redemption.
  • Capital Redemption Reserve- If shares are redeemed from profits, an amount equivalent to the nominal value of the redeemed shares must be transferred to the Capital Redemption Reserve Account. This reserve is treated as paid-up share capital and may be used by the company for issuing fully paid bonus shares to its members.
  • Accounting Compliance- Compliance with accounting standards under Section 133 is mandatory for prescribed classes of companies.
  • Premium Coverage- Any premium payable on redemption must be covered by the company’s profits before the shares are redeemed.
  • Duration for Infrastructure Companies- Companies engaged in infrastructure projects may issue preference shares for a duration exceeding twenty years, but not beyond thirty years.
  • Annual Redemption Requirement- Such companies must redeem at least ten percent of the preference shares annually from the twenty-first year onward or earlier, at the shareholders’ option, ensuring a steady redemption process.

Rights of a preferential shareholder

1. Voting Rights

  • Every preference shareholder is entitled to vote only on resolutions that directly affect their rights associated with preference shares, as well as on any resolution regarding the company’s winding up or the repayment or reduction of its equity or preference share capital.
  • On a poll, the voting rights of preference shareholders are proportional to their share in the company’s paid-up preference share capital.
  • The ratio of voting rights between equity and preference shareholders corresponds to the proportion of paid-up equity share capital to paid-up preference share capital held by each group.
  • If dividends on a particular class of preference shares remain unpaid for two years or more, shareholders of that class gain the right to vote on all company resolutions.
  • Additionally, preference shareholders who have paid for unpaid share capital that has not yet been called up by the company are not entitled to voting rights in respect of such share capital.

2. Dividend

  • Each preference shareholder is entitled to receive a preferred dividend according to the terms outlined at the time of issuing the preference shares.
  • Additionally, participating preference shareholders have the right to receive supplementary dividends from surplus profits.
  • A company may distribute dividends in proportion to the amount paid-up on each share if its articles of association permit this practice.

3. Right to uniform calls on shares

  • When a company makes calls on the uncalled capital for a specific class of shares, such calls must be made uniformly across all shares within that class.

4. Conversion Rights

  • Preference shares are convertible either fully or partly.
  • Shareholders can convert their preference shares into ordinary shares under specified conditions.
  • This right can be beneficial if the company’s performance improves significantly.

5. Right to Redemption

  • Preference shareholders are entitled to receive payment for their shares at the redemption price as per agreement.
  • Preference shares are redeemed at their nominal value (at par), or at a price higher than their face value of the shares, or can be funded through the company’s profits ensuring it doesn’t adversely affect the company’s financial stability. 

6. Right to be paid at winding up of the company

  • Each preference shareholder holds a preferential right to payment upon the winding up of the company or the repayment of capital.
  • If they hold participating preference shares, they may also have the right to share in the surplus capital.
  • In the case of Globe Motors Ltd. v. Globe United Engineering & Foundry Co. Ltd.[2]The Delhi High Court held that preference shareholders are entitled to the preferential payment of cumulative dividends during the winding-up process, even if the company has not generated profits.

7. Right of participation in Annual General Meeting (AGM)

  • Shareholders are entitled to receive notice to attend the company’s Annual General Meeting (AGM).
  • Each shareholder also has the right to receive financial statements, including the auditor’s report and other documents annexed to the financial statements, as well as the directors’ report presented by the Board of Directors at the AGM.

Conclusion

Preferential shareholders enjoy a blend of financial security and limited participation in a company. Preference shares offer advantages like preferential dividends and priority claims on capital repayment during liquidation. The different types of preference shares—cumulative vs. non-cumulative, convertible vs. non-convertible, redeemable vs. irredeemable, and participating vs. non-participating—cater to various investor needs with distinct benefits and limitations.

While preferential shareholders generally lack extensive voting rights, they can vote on issues affecting their shares and participate in surplus profits when applicable. They have rights to specified dividends and repayment upon winding up, with participating preference shareholders potentially receiving additional surplus distributions. The structure of preference shares reflects a balanced approach to capital raising and shareholder interests, defining a clear, though somewhat restricted, role for these investors in the company’s financial and governance framework.

[1] 2013 SCC ONLINE CLB 143.

[2] 974 SCC ONLINE DEL 211.

Sahil Kumar