In this article, Aditya Rajagopal analyses the aspect of Further Issue of Share capital under the Companies Act.
Introduction
In some situations, a company would consider it economically viable to increase its subscribed capital after its incorporation. This is because such a further issue would substantially increase its financial reserve and incentivize the shareholders of the company, thereby ensuring the healthy functioning of the company. Such a company which is desirous of increasing its subscribed capital by the further issue of shares is required to comply with the procedure laid down in section 62 of the Companies Act, 2013. This section encapsulates a scenario wherein the authorized capital of the company is not exhausted and the further allotment of shares is made out of the unsubscribed portion of the capital.[1] In this paper, I shall discuss the various dimensions of this section by analyzing the judicial pronouncements of the court over the years.
Scope
The scope of this project is to analyze the aspect of further issue of shares in relation to the provisions of the Companies Act, 1956 and Companies Act, 2013. I would specifically focus on the aspects relating to the pre-emptive rights of the existing shareholders, the duty of the directors in such further issue and the ambit of the right of renunciation available to the shareholders. While engaging in these aspects, I would analyze the effect or the impact of the amendments and changes introduced in the Companies Act, 2013. In addition, I would also point out various contentious situations which might arise when the company is engaging in a further issue of shares for which the Companies Act does not provide a solution or recourse and is silent regarding the same.
Research Questions
In accordance with the scope of this project, I would like to address the following questions
- Whether the new stock of shares can be given to an outsider without offering the existing shareholders?
- What is the extent of the shareholder’s interference when the Board of Directors have engaged in the further issue of shares?
- What are the duties of the director while engaging in the further issue of shares?
Chapters
In this section of the paper, I would strive to answer the research question as provided earlier and deal with additional aspects as well. While engaging in the same, I would trace the legislative history and analyze the judicial trend on the specific aspects of rights issue of shares.
Rights of the existing shareholders at the time of further issue of shares
The inherent right of the existing shareholders to the new shares of the company has extensive judicial backing in India and other jurisdictions as well. The earliest well recognized judicial pronouncement which laid down the same was the New York Court of Appeals decision of Stokes v. Continental Trust Co.[2] In this case, the court held that the firm which is a mere trustee for all the shareholders has no right to dispose of the new stock without offering it to the existing shareholders. The same principle has been recognized in other jurisdictions as well, such as the United Kingdom which explicitly mentions about the pre-emptive right of the existing shareholders in its Companies Act.[3]
In India, the companies act has always found mention regarding the presumptive right of the existing shareholders to the new shares of the company. Section 105C of the Companies Act, 1936 had explicit mention relating to the presumptive right of the existing shareholders. The Supreme Court while dealing with this provision in the landmark case of Nanalal Zaver v. Bombay Life Assurance Co. Ltd[4] laid down that the company must give the first option to the existing shareholders before favouring anyone else. The Companies Act, 1956 and the Companies Act, 2013 also explicitly provides for a preemptive right of the shareholders to the new shares of the company. The Supreme Court also recently in the landmark case of Sahara India Real Estate Corporation v. SEBI[5] held that Section 81 postulates a preemptive right on the part of the existing shareholders to the new issue of shares. Thus, it is evident that a company which engages in the further issue of shares should offer it to its existing shareholders before favouring anyone else. This is a recognized principle in India and other jurisdictions as well.
This principle is in existence to ensure that the shareholder is not unfairly treated. If new shares are issued without offering them to the existing shareholders in proportion to their existing holding, then their share of control over the company would substantially reduce.[6] Further, the existence of pre-emptive rights acts as a serious check on the directors’ discretion to issue further shares.[7] In addition, not granting a pre-emptive right would result in an inequitable treatment of the existing shareholders. This is because the additional shares which are issued at a lower price would facilitate outsiders into the company in an extremely flexible manner but on the other hand, existing shareholders who paid a higher price to acquire shares would stand to lose unfairly.[8] Thus, the existence of pre-emptive rights ensures the well-being of the existing shareholders as there is no financial dilution.[9] However, this pre-emptive right is available only for a maximum of 30 days within which the existing shareholder must express his interest.[10]
The legislature has made some changes in relation to the aspect of the further issue of shares in the Companies Act, 2013. Under Companies Act, 1956 a company is obligated to follow the procedure prescribed in Section 81 (including preemptive rights of the existing shareholders) only if the company has been in existence for two years (or) at “any time after the expiry of one year of the allotment of shares”. Thus, a company could flout the well-laid out procedure prescribed in Section 81 of the Companies Act, 1956 if it allotted shares within two years of its formation. This would include a situation wherein a company could disregard the preemptive rights of the shareholders if it allotted shares within two years of its formation. The Legislature realizing the loophole has modified the section and it now obligates any company who issues further shares at “any time” to be within the ambit of Section 62 of the Companies Act, 2013. This, according to me is a great step to ensure complete compliance with the procedure prescribed in the act.
Further, unlike the erstwhile companies act of 1956, Section 62 of the Companies Act, 2013 applies to private companies as well. This change of scope in the Companies Act in relation to this aspect is a welcome move since the existence of pre-emptive rights of the existing shareholders would ensure that the membership is limited and that control remains within the framework of the existing shareholders. The scope of interference of the shareholders in the director’s discretion of further issue of shares will be dealt with in the subsequent section of the paper.
Scope of Interference of the shareholders in the Director’s decision of further issue of shares
Even though the existing shareholders possess a pre-emptive right to the new shares, the extent of their interference in the further issue of shares will be analyzed in this section of the paper. A shareholder can interfere in the director’s exercise of discretion only in special or exceptional situations. This aspect was considered by the court in the case of Sri Hari Rao v. Gopal Automotive Ltd.[11] In this case, the court held that there was sufficient evidence available for the director to engage in the further issue of shares.[12] Therefore, they held that they could not restrain the company from issuing further shares for the mere reason that the minority shareholder is unwilling to subscribe to the additional capital.[13]
This similar aspect was considered by the court in the case of Chandrakant Mulraj v. Tata Engineering and Locomotive Co Ltd.[14] In this case, the court laid down that the reduction in the market value of the shares is not a sufficient reason for restraining the company from the further issue of shares.[15] This is because such a measure was undertaken keeping in view the interests of the company. Thus, it is clear that the scope of interference of the shareholders in the director’s decision is extremely narrow and only in special or exceptional situations. The exceptional situations which warrant such interference will be dealt with in the next section of the paper which is in relation to the director’s duties while engaging in the further issue.
Fiduciary duty of the directors while issuing further shares
The Companies Act, 1936 had explicit mention regarding the power of the director to issue further shares of a company.[16] In the later statutes which followed the Companies Act, 1936 there was no explicit mention regarding the power of the directors to issue further shares. Nevertheless, it is the board of directors of a company who are vested with the intrinsic right to issue further shares.[17] The manner of exercise of such right has been a bone of contention in various situations. In India, such a situation was dealt with by the Supreme Court in the landmark case of Nanalal Zaver v. Bombay Life Assurance Co.Ltd.[18] In this case, the appellants contended that the director’s exercise of discretion in issuing further shares was male fide in nature as it was done to gain control of the company.[19] The Court, while dealing with this contention held that since the directors exercised their discretion in a bona fide manner for the best interests of the company, mere incidental benefits to the directors would not warrant interference in the further issue of shares.[20]
The same aspect relating to the manner of exercise of the director’s discretion was dealt by the Supreme Court in the case of Needle Industries (India Ltd) v. Needle Industries Newey (India) Holding Ltd.[21] In this case, the Court did not restrain the acts of the director since he not only acted in a bona fide manner for the benefit of the company but also acted without any motive to promote his own cause.[22] The Court also held that the exercise of director’s discretion would be for an improper motive if it is solely done for their own benefit.[23] Thus, it is apparent that the court added another standard (Proper Purpose) apart from the requirement of the director to act in a bona fide manner. The requirement of a proper purpose before the further issue of shares was first postulated in the landmark case of Hogg v. Cramphorn Ltd.[24] In this case, the court interfered in the further issue of shares even though they felt that he acted for the interests of the company, since he acted with the improper motive to control a greater share of the company.[25] The same principle was reiterated with greater force in the case of Clemens v. Clemens Bros Ltd.[26] In this case, the court held that the director was acting in breach of its fiduciary duty since the further issue was done for the sole motive to squeeze out the majority shareholders. The additional principle of proper purpose along with the bona fide requirement was thereafter applied extensively in India as well.
The landmark case which applied the said modified principle (proper purpose + bone fide requirement) was the Supreme Court decision of Dale and Carrington Invt. (P) Ltd and Anr v. P.K Prathappan and Ors.[27] In this case, the Court invalidated the director’s further issue since he was neither able to prove that such issue was for the benefit of the company nor was he able to prove that he was acting in a bona fide manner since his motive was to gain control of the company.[28] The same principle was enunciated by the Supreme Court in the subsequent case of Shri V.S Krishnan and Ors v. Westford Hi-Tech Hospital Ltd and Ors.[29] Thus, it is clear from the judicial pronouncements of the court that the standard for analyzing the manner of exercise of the director’s discretion has shifted from a mere bona fide requirement to a modified principle of bona fide + proper purpose. This, according to me is the right standard for scrutinizing the discretion of the director in the further issue of shares. This is because the Companies Act does not provide any guidance on the aspect of the director’s discretion in issuing further shares. Thus, by adopting the modified principle, the possibility of a director exercising his discretion in an irregular manner is minimized to the maximum extent possible.
Conclusion
In this paper, I have first analyzed on the aspect relating to the preemptive rights of the existing shareholders in the further issue of shares. In the next part of my paper, I have analyzed the extent of the shareholder’s interference in the further issue of the shares. After analyzing both these aspects, I have come to a conclusion that even though the existing shareholders have a preemptive right to the new stock of shares, the scope of such interference in the director’s discretion is limited. It is only in exceptional situations where the further issue of shares is restrained. On the aspect of the fiduciary duties of the director, even though there is no mention of the same in the companies act, judicial pronouncements of the court indicate that the director is required to act in a bona fide manner with a proper purpose. These are some of the aspects of the Companies Act regarding the aspect of further issue of shares under the Companies Act.
[1] A. Ramaiya, Guide to the Companies Act, 1164 (18th ed., 2014). Also, the change in authorized share capital shall take place as per Section 61 of the Companies Act, 2013.
[2] Stokes v. Continental Trust Co., 186 NY 285, 299 (1908, Court of Appeals, New York).
[3] S. 561, Companies Act 2006 (United Kingdom).
[4] Nanalal Zaver v. Bombay Life Assurance Co. Ltd, AIR 1950 SC 172.
[5] Sahara India Real Estate Corporation v. SEBI, (2013) 1 SCC 1.
[6] Gower and Davies, Principles of Modern Company Law, 632 (7th ed., 2003)
[7] Ibid.
[8] Ibid.
[9] Ibid.
[10] Sec. 62(a)(i), Companies Act, 2013.
[11] Sri Hari Rao v. Gopal Automotive Ltd, (1999) 96 Com Cases 493.
[12] Ibid at ¶29.
[13] Ibid.
[14] Chandrakant Mulraj v. Tata Engineering and Locomotive Co. Ltd, (1985) 58 Com Cases 320 (Bom).
[15] Ibid at ¶6,7,8.
[16] S.105(C), Companies Act, 1936.
[17] Supra 1 at 1167; Avtar Singh, Company Law, 231 (16th ed., 2015).
[18] Supra 4.
[19] Ibid at ¶2.
[20] Ibid at ¶25.
[21] Needle Industries (India) Ltd v. Needle Industries Newey (India) Holding Ltd, AIR 1981 SC 1298.
[22] Ibid at ¶116.
[23] Ibid at ¶111.
[24] Hogg v. Cramphorn Ltd, 3 All ER 420 (1966, Chancery Division).
[25] Ibid.
[26] Clemens v. Clemens Bros Ltd, 2 All ER 268 (1976, Chancery Division).
[27] Dale and Carrington Invt. (P) Ltd and Anr v. P.K Prathappan and Ors, AIR 2005 SC 1624.
[28] Ibid at ¶29.
[29] Shri V.S Krishnan and Ors v. Westford Hi-Tech Hospital Ltd and Ors, (2008) 3 SCC 363.
