When does a rights issue by an unlisted company become a public issue? What are the implications if such a rights issue is deemed to be a public issue? Whether it will become liable to comply with extensive requirements relating to public issue? More specifically, does a right to renounce shares so offered to non-shareholders make it an offer to the public?
The issue is important since it is becoming common that unlisted companies issue shares on rights basis. It is also a fact that renouncing rights shares is a statutory right unless taken away by articles, that one can renounce only in favour of another shareholder.
The Kerala High Court has held recently in SEBI vs. Kunnamkulam Paper Mills Ltd. (dated 20th December 2012, WA No. 2203 of 2009, In WPC 19192/2003, Unreported) that a rights issue to more than 50 shareholders would become a public issue if such a right could be renounced in favour of non-shareholders. Accordingly, SEBI required that the whole of the proceeds raised through such rights issue be refunded, with interest, or else the company would face penalty and prosecution.
At the outset, it may be emphasised that this decision would effectively apply only to those unlisted public companies who have more than 50 shareholders and who make a rights issue carrying such right of renunciation. By definition, private companies do not have more than 50 shareholders (the marginal cases of private companies having exactly 50 shareholders or having employee shareholders are not discussed here). Thus, any public company that has more than 50 shareholders would be affected by this decision.
The background of introducing safeguards in case of issue of shares can be easily appreciated. There is a concern that unlisted companies try to raise monies from public without following procedures that are in investors’ interest and are provided in detail under SEBI Regulations/Guidelines and the Companies Act, 1956. To prevent this, certain issues of shares made are deemed to be public issues under Section 67 of the Companies Act, 1956 (“the Act”).
Section 67 (reading its sub-sections and provisos together) provides that any offer/invitation to the public, whether selected as members of the Company or otherwise, would amount to a public offering. However, if the offer is limited to existing shareholders, then it will not amount to a public offer, unless such offer to begin with is to 50 or more persons.
In the present case, the petitioner Company had made a rights issue to its 296 shareholders. The offer document relating to the rights issue permitted renunciation of such rights to non-members. Pursuant to such rights issue, 1,73,995 equity shares were allotted to 163 persons including non-members. The question was whether issue to shareholders – whose number was admittedly more than 50 – carrying the right of renunciation amounted to a public issue. SEBI held that it was indeed a public issue and ordered the company to refund the monies raised with interest. On appeal before the High Court, a Single Judge held that SEBI had no jurisdiction since the company was an unlisted company. SEBI appealed and a two-member bench reversed the decision of the Single Judge.
The Court examined the relevant provisions of the Act, the SEBI DIP Guidelines (as they then were before the SEBI (ICDR) Regulations were notified in 2009), analysed several precedents including decisions of the Supreme Court and held that the issue was indeed a public issue.
The Court observed:-
“No doubt that section 67(3) clearly indicates that such offer or invitation shall not be applicable under certain circumstances as provided u/s/s. 3(a) and (b). But the first proviso to sub-section (3) clearly indicates that the deeming provision u/s. 67(1) and (2) applies in respect of subscription of shares or debentures made to 50 or more persons. That being the situation when a company exercises its power u/s. 81(1)(c) which gives right to a shareholder to renounce right shares in favour of persons who are not shareholders and when such right is given to 50 or more persons that also will be deemed to be an offer made to any section of the public as provided u/s. 67(1) and (2).”. It may be added that the Court also held that such a rights issue would also amount to a public issue for the purposes of the SEBI Guidelines/SEBI Act and thereby SEBI has jurisdiction. This aspect, however, has not been discussed here in detail in view of space constraint. Further, another point of note is that the Court held that SEBI Act, being a special Act, overrides the provisions of the Companies Act, 1956.
The dilemma for public companies having more than 50 shareholders or more can be imagined. On one hand, Section 81(1)(c) provides for a right, unless the articles provide to the contrary to renounce in case of a rights issue. On other hand, such an issue would become a public issue with serious adverse consequences. It needs to be noted that the Court did not hold a final view on the merits of the case but set aside the decision of the Single Judge setting aside SEBI’s order. This was because the remedy for the petition are company against SEBI’s order was appeal to the Securities Appellate Tribunal (“SAT”). Accordingly, the Court asked the petitioner company to appeal to SAT, if it still felt aggrieved.
A few incidental observations:
Letter No. 8/81/56-PR dated 4th November, 1957 issued by the Department of Company Law Administration prescribes that issue of further shares by a company to its members with the right to renounce in favour of third parties does not require registration of prospectus. It would be a matter of consideration whether this clarification would apply to a case particularly where the issue is to more than 50 persons. In any case, the Court’s decision, is quite clear on the issue.
Readers may recollect that in the Sahara companies matter too, an issue had arisen as to where an offer of shares is to more than 50 persons whether it becomes a public offer and the Supreme Court had extensively analysed the provisions of the Companies Act, 1956, and SEBI Act/Regulations. The Supreme Court dwelt on matters such as the power and jurisdiction of SEBI, when an issue of securities becomes a public issue. The facts in that case were of course, very glaring where a very large number of persons were issued securities. A reference can be made to earlier articles in this column though this decision of the Kerala High Court stands on its own. Particularly since it deals with a peculiar situation of rights issue by a public company with right of renunciation.
It is worth considering also what the Companies Bill, 2012, as passed by Lok Sabha provides. The provisions proposed in the Bill seem ambiguous and contradictory in this context. The scheme of the Bill for issue of shares seems to broadly categorize issue of shares into three, namely,
1. a public issue, or
2. as a rights issue or
3. “private placement”.
The provisions clearly state that rights issue need to allow for, as the existing Section 81 also provides, right of renunciation, unless the articles provide to the contrary. Rigorous restrictions have been placed in case of a private placement of shares including prohibition of offer to more than 50 persons in a year. However, in the changed scheme, wordings similar to the existing Section 67 in the Companies Act, 1956, are not there. The way the term private placement is defined and placed alongside a public issue and a rights issue seems to suggest that a rights issue may not be deemed to be a private placement. At the same time, it has been stated that any offer to allot shares to more than 50 persons shall be deemed to be a public offer. Thus, it is not wholly clear whether the intention is to permit issue of rights shares carrying right of renunciation to more than 50 members without deeming such issue to be a public issue. One will have to wait till the law is passed and examine the exact wordings, to understand whether the new law will apply or not to such rights issue.
In conclusion, it may be said that SEBI and the law makers are generally grappling with the issue of companies raising funds from the public without following the statutory safeguards of disclosures, promoters’ contribution, etc. Members of the public may unsuspectingly fall prey to fly by night operators or otherwise do not have the various benefits of listing. if they acquire shares which do not follow the required provisions of law relating to public issue. One has also to concede that in case of a rights issue with a right to renounce in favour of non-members — persons who are not familiar with the company — may end up buying shares of companies promoted by unscrupulous persons. Hence, while companies may find the provision restrictive, it makes sense to restrict the right of renunciation only in favour of existing shareholders or as an alternative, follow SEBI regulations.
In either case, public unlisted companies seeking to issue ‘rights shares’ will have to keep in mind the decision of the Kerala High Court. It would also be interesting to watch what the Companies Bill 2012 finally provides.
Stop Press: – Just as this article was going for print, this author received a copy of unreported decision of Supreme Court in appeal to the Kerala High Court decision discussed above. The Supreme Court has, vide its decision dated 21st February 2013, stayed this judgment of the Kerala High Court. An update will be provided in this column on the final decision of the Supreme Court.
