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Cos Act, 2013: Differential Rights

Published on Mon, May 19,2014 | 17:12, Updated at Mon, May 19 at 17:13Source : 

By: Raj Ramachandran, Partner, J. Sagar Associates

The differential rights regime has undergone a significant change with the coming into effect of the provisions of the 2013 Act. Under the 1956 Act, the provisions governing issue of shares with differential rights did not apply to purely private companies. There was therefore sufficient freedom to structure the contractual terms agreed between parties to a joint venture should they choose a purely private company as the JV vehicle.

Without going into the issue as to whether the exemption available for purely private companies should have continued, what requires to be clarified immediately is that the actions taken by purely private companies under the provisions of the 1956 Act will continue to remain valid. This would help avoid confusion as to whether beginning 1 April 2014, the provisions of the 2013 Act will be applicable notwithstanding actions duly taken under the 1956 Act, although the legal basis for such an interpretation is not very sound.  

Under the 2013 Act and rules governing issue of shares with differential rights, it is specified that shares with differential rights shall not exceed 26% of the total post issue paid up equity share capital. This 26% includes equity shares issued with differential rights issued at any point in time.  

There are various purely private companies whose capital comprises of shares with differential rights in excess of 26%. An explanation in the rules clarifies that differential rights attached to the shares issued by any company under the provisions of the 1956 Act shall continue. However, the grandfathering effect seems to have a condition attached to it. The condition states that such rights shall continue till they are converted with differential rights in accordance with the 2013 Act.  It therefore appears that while the existing differential shares can continue, the differential terms cannot be converted/ modified.

One other condition imposed is that a company shall not convert its existing equity share capital with voting rights into equity capital carrying differential voting rights and vice versa. This is possibly to address a situation where parties would have attempted to convert existing shares into differential shares by adopting a strict interpretation that such conversion does not amount to ‘issue’ and therefore will not be subject to the limit prescribed.

There are numerous instances where a purely private company has issued convertible instruments that convert into equity shares having differential rights. Although a very strict reading of the rules may convey that ‘issue’ of differential shares post 1 April 2014 pursuant to conversion of convertible securities issued under the 1956 Act cannot be given effect should the 26% limit stand breached, this clearly would not have been the intention of the legislature. Therefore, akin to grandfathering of prior issues of differential shares (provided they are not converted/ modified), a grandfathering of prior issues of convertible securities should also be implied.

The rules clearly stipulate that where there are bonus issues or rights issues, the holders of shares with differential rights will be entitled to participate in the same manner as holders of equity shares. The condition however is that such shares issued pursuant to the bonus or rights issues will be subject to the differential rights with which they have been issued.

While a bonus issue in itself would not ordinarily result in a change in the percentage of the shares with differential rights, the position as regards rights issue demands a finer examination. Since the parties will be required to contribute additional monies pursuant to a rights issue, a scenario could arise where the holder of differential shares exercises his right to participate in the rights issue with the holder of a common equity share not participating. If in such a case, the differential shares are to exceed 26%, would the holder of differential shares be permitted to participate and subscribe to the rights shares resulting in breaching the 26% limit or would the right be subject to the key rule that the differential shares cannot exceed 26%?

It may be unfair to suggest that the holder of differential shares cannot at all participate in such rights issue for the reason that one of the holders of common equity shares chooses not to participate. Participation in a rights issue could be critical for the holder of differential shares to continue to maintain his percentage holding, and therefore it would be imperative to allow participation atleast to the extent necessary to continue to maintain its holding. Even such limited participation could alter the economic interest/ ratios as between the shareholders.  

Additionally, rights issues are considered favourably by non-resident parties since that is one of the few instances where the pricing norms prescribed under the foreign exchange regulations are not applicable. In such rights issues, a non resident party is permitted to subscribe to shares at a price which is not less than the price at which the offer on rights basis is made to a resident shareholder/ party.

While the industry continues to grapple with the new law and related compliances, key clarifications would provide the necessary positives in adapting to the reformed legal environment.

The author is a Partner at J. Sagar Associates. Views expressed are personal.


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