Failed Redemption of Preference Shares: Whether a Contractual Debt?

– Sikha Bansal, Partner and Megha Mittal, Associate (resolution@vinodkothari.com)

Preference shares, as the nomenclature suggests, represent that part of a Company’s capital which carries ‘preference´ vis-à-vis equity shares, with respect to payment of dividend and repayment of capital in case of winding up. However, the real position of preference shares may be quite baffling, given that the instrument, by its very nature, is sandwiched between equity capital and debt instruments.  Although envisaged as a superior class of shares, preference shareholders enjoy neither the voting powers vested with the equity shareholders (true shareholders) nor the advantages vested with debenture-holders (true creditors). As such, the preference shareholders find themselves suspended midway between true creditors and true shareholders – hence facing the worst of both worlds[1].

The ambivalence associated with preference shares is adequately reflected in the manner various laws deal with such shares – a preference share is a part of ‘share-capital’ by legal classification[2], but can be a ‘debt’ as per accounting classification[3]; similarly, while a compulsorily convertible preference share is classified as an ‘equity instrument’[4], any other preference share constitutes external commercial borrowing[5] under foreign exchange laws. Needless to say, the divergent treatment is owed to the objective which each legislation assumes.

Amidst that the status of preference shareholders changes with the law under  reference, a concrete determination of their rights as creditors or shareholders, as the case may be, becomes all the more significant in the event of insolvency/liquidation of the corporate entity, now being under the premises of the Insolvency and Bankruptcy Code, 2016 (‘IBC’). As is known, a party’s right in the insolvency of the corporate debtor (including right to initiate insolvency) as well as its priority in the liquidation waterfall will depend upon whether the party has been recognised as a creditor or as a shareholder – an insolvent’s estate will first be divided among secured creditors/workmen, then to unsecured financial creditors, then to residual creditors, and then whatever (if any) is left, to shareholders (first to preference shareholders and then to equity shareholders). While preference shareholders have been put under clause (g) of section 53 (1) of IBC, an interesting question of law which came to light in the matter of Indus Biotech Private Limited Vs Kotak India Venture (Offshore) Fund (earlier known as Kotak India Ventures Limited) & Ors[6]., the question on the sidelines, was  whether a preference share, becoming due for redemption, assumes the nature of a ‘financial debt’.

In the said matter, while dealing with the application filed by redeemable preference shareholders under section 7 of the Code, the Hon’ble Supreme Court upheld the adjudicating authority’s order and dismissed the application on grounds on an existing dispute vis-à-vis the terms of agreement between the company and the preference shareholders. However, SC categorically chose not to delve into the question whether ‘payment of investment in preference shares’ can be construed as ‘financial debt’[7].

The authors, in this article, critically examine whether preference shares due for redemption can be assumed as a debt. It may also be important to note that the consequences of an amount being regarded as ‘debt’ may be several – not only under IBC, but under other laws as well – e.g. under debt recovery laws like RDBA or SARFAESI, under winding up laws, etc.

Whether ‘shares’ can give rise to ‘debt’?

Before getting into the question if ‘preference shares’ can give rise to a ‘financial debt’, the fundamental question is – can ‘preference shares’ can result into a ‘debt’ at all? That is, whether (a) the principal payable on preference shares itself, including premium on redemption, if any and (b) unpaid but accumulated dividends – will amount to a debt.

‘Debt’ is a sum of money which is now payable or will become payable in the future by reason of a present obligation, depitum in praesenti, solvendum in future. See Web v. Stenton. However, the meaning of ‘debt’ may take colour from the provisions of the concerned Act. It may have different shades of meaning. In fact, in the context of recovery laws like RDBA Act/SARFAESI Act, Courts have chosen to give ‘widest amplitude’ to the expression debt. See United Bank of India v Debts Recovery Tribunal & Ors.

In so far as IBC is concerned, ‘debt’ has been defined as “a liability or obligation in respect of a claim which is due from any person and includes a financial debt and operational debt”, and ‘creditor’ has been defined as “any person to whom a debt is owed and includes a financial creditor, an operational creditor, a secured creditor, an unsecured creditor and a decree-holder”.

Now, it is a fundamental principle of company law that a company does not owe its members the share money paid by them (except, where there is a reduction of capital) and the members have no right to ask for the return of the money paid to them. Even in a winding up, what the members get if they get anything at all, is not a return of their share’ money, but their rateable share of any surplus left after satisfying the creditors, and this share may be less or more than the share money paid. See V.V. Krishna Iyer Sons v. New Era Manufacturing Co. Ltd. The distinction between a ‘debt’ and a share (specifically, preference share) was more clearly and elaborately brought out in Aditya Prakash Entertainment Pvt. Ltd. v. Magikwand Media Pvt. Ltd., wherein the Bombay High Court cited references to Hindustan Gas and Industries Ltd. v. Commissioner of Income-tax, West Bengal-II, as also “Company Law” by Robert R. Pennington, 2nd edn. and noted from the said judgment that:

“ . . .  we cannot persuade ourselves to accept the contentions of the assessee and hold that when a company issues redeemable preference shares it is in fact obtaining a loan as it could by issuing debentures. There is a fundamental difference between the capital made available to a company by issue of a share and money obtained by a company under a loan or a debenture. Respective incidences and consequences of issuing a share and borrowing money on loan or on a debenture are different and distinctive. A debenture-holder as a creditor has a right to sue the company, whereas a shareholder has no such right. Apart from that the scheme of the Companies Act and in particular the forms and contents of its balance-sheets are extremely rigid and, in our view, by reason of the specific compartments in such accounts it is not possible to convert an item of capital into an item of loan as has been suggested on behalf of the assesse.”

Payable “only” out of profits

Section 55 of the Companies Act, 2013 clearly answers the first question. Clause (a) of the second proviso to Section 55 states that –

“no such shares (read: preference shares) shall be redeemed except out of the profits of the company which would otherwise be available for dividend or out of the proceeds of a fresh issue of shares made for the purposes of such redemption” (emphasis supplied)

Again, the third proviso to section 55 also requires that “premium, if any, payable on redemption of any preference shares issued on or before the commencement of this Act by any such company shall be provided for out of the profits of the company or out of the company’s securities premium account, before such shares are redeemed.” (Emphasis Supplied)

This aspect was also considered in Aditya Prakash (supra), where the Court specifically noted,

“ . . . shows that where redeemable preference shares are issued but not honoured when they are ripe for redemption, the holder of those shares does not automatically assume the character of a “creditor”. The reason is that his shares can be redeemed only out of the profits of the company which would otherwise be available for dividend, or by a fresh issue of shares. This is a limitation which is not applicable to any other creditor of the company. The shareholders of redeemable preference shares of the company do not become creditors of the company in case their shares are not redeemed by the company at the appropriate time. They continue to be shareholders, no doubt subject to certain preferential rights.”

Note also, that interest payable to a creditor is quite a different thing from dividends paid to a shareholder. Dividends are paid out of the profits of a company, whereas interest on money lent has to be paid even though the borrower does not make any profit from the money borrowed by him. See, A.H. Wadia v. Commissioner of Income-Tax.

Similar stance has been taken by foreign Courts too – for example, see Heesh v. Baker [2008] NSWSC 711 wherein the Court emphasised that the contract for redemption of preference shares requires performance as is consistent with the statutory constraints and that there are no absolute obligations. That is, the parties ‘contracted on the basis of law’ and thus, the contract does not impose an obligation to make the payment which in turn effects the redemption due on a specified date if the payment and redemption will entail contravention of those parts of the law.

In Vinod Kothari’s Securitisation, Asset Reconstruction and Enforcement of Security Interests,[8] the author, while critically examining the judgment rendered by DRT Chennai in ICICI Bank Ltd v. Premier Housing and Industrial Enterprises Ltd.[9], had expressed his view resonating with the judgments as above. He says, “In an apparent and understandable effort to give a wide meaning to the term “debt”, the Tribunals have sometimes travelled an extraordinary distance. . . . In fact, preference shares are only a modified form of capital of a company, and it can, by no stretch of argument, be contended that ownership capital supplied by the bank to a corporate is a debt due to the bank. In fact, it is even difficult to understand whether subscription to preference shares is at all a part of the “business of banking”. Sadly enough, banks in India have en masse invested in preference capital, and have even signed agreements requiring companies to pay a penal interest for failure to pay preference dividend, without realising that preference dividend cannot be declared unless the company makes a profit, and there can be no penalty for not making a profit. Likewise, a company cannot redeem preference shares except out of profits, or out of a fresh issue of capital—inability to do either cannot constitute default of a “debt”.”

Shareholder vs. Creditor

On the very basis that the payment obligation to preference shareholders cannot be taken as ‘debt’, Courts have emphasised on the legal position of ‘preference shareholders’ as only ‘shareholders’ and not ‘creditors’. This is evidently clear from the observations of the Bombay High Court in Aditya Prakash (supra).

Again, in Anarkali Sarabhai v. CIT Gujarat, the Gujarat High Court held –

“14. As observed by the learned author in Pennington’s Company Law, 4th Edn. at p. 195, if redemption would make the company insolvent, the company may not be allowed to redeem preference shares because repayment of preference capital would be a fraud upon its creditors. This would clearly indicate that the holder of preference shares is not in the same position as that of a creditor. The learned author has further observed:

If a company defaults in redeeming redeemable preference shares by the date or the last date fixed for redemption, the holder of the shares cannot compel it do so by suing in debt for the return of his capital or by seeking a mandatory injunction….” (emphasis supplied)

Closing Remarks

Thus, there can be no debt associated with a preference share – and, where there is no ‘debt’, there is no question of it being a ‘financial debt’. Therefore, a preference shareholder cannot have a priority over a creditor u/s 53 of IBC. Logically too, it must be noted that in the event of winding up / liquidation of a company under the Companies Act/ IBC, distribution to preference shareholders are made only in priority to equity shareholders, that is, after payment to all third-party liabilities. To state that the redeemable preference shareholders could stand at par with the other creditors and initiate action against the company to which they were contributories, and have a cake with the superior ranking external creditors from the insolvent’s estate, would frustrate the implied safety net offered to the secured/unsecured creditors and jeopardize the commercial sanctity of priority in distribution.

[1] In the paper titled ‘The Problem of Preference Shares’ M.A. Pickering discusses that “The problems of the preference share can only be finally resolved when the law has clearly determined its essential nature. Is it merely a form of fixed interest loan security, is it a share conferring real rights of participation in corporate management and profits, or is it to remain a hybrid legal device with a unique, and varying, character of its own?”

[2] Section 43 of the Companies Act, 2013

[3] Para 18 of Ind AS 32

[4] See definition of ‘equity instrument’ under rule 2 (k) Foreign Exchange Management (Non-debt Instruments) Rules, 2019

[5] See Para 2.1 and 8.2 of Master Direction – External Commercial Borrowings, Trade Credits and Structured Obligations

[6] (Civil Appeal No.1070 /2021 @ SLP (C) NO. 8120 OF 2020)

[7] See Para 33

[8] LexisNexis, 6th Edition, 2020. See comments under definition of “debt” as defined under section 2(1)(ha) of the SARFAESI Act.

[9] II (2004) BC 37 (DRAT/DRT)