Redeemable preference shares not debt under IBC

– SC reinforces the distinction between ‘debt’ and ‘share capital’ for the purpose of IBC

– Sourish Kundu | resolution@vinodkothari.com

Introduction

The Supreme Court in a recent judgement in the matter of EPC Constructions India Limited v. M/s Matix Fertilizers and Chemicals Limited, has categorically clarified that holders of Cumulative Redeemable Preference Shares (“CRPS”) are classified as investors rather than creditors (more specifically, financial creditors) and are therefore not entitled to file for insolvency under Section 7 of the IBC, since non-redemption of these shares do not qualify as a “default” under the Code.

In an article titled “Failed Redemption of Preference Shares: Whether a Contractual Debt?”, written way back in May, 2021, in the context of SC judgment in Indus Biotech Private Limited v. Kotak India Venture (Offshore) Fund (earlier known as Kotak India Ventures Limited) & Ors, we  concluded, on the basis of the provisions of section 55 of the Companies Act, 2013 (“Act”) and related judicial precedents around the meaning of “debt”, that 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’.

The findings of the SC in EPC Constructions judgement resonate with our views as explained in the article. However, we delve deeper into the aspect with analysis of the ruling as below, as to on what basis it was concluded that preference shares cannot be considered as ‘debt.

Brief facts of the case

The appellant entered into a contract for construction of a fertilizer complex with  the respondent, pursuant to which certain amounts  became due and payable by the respondent to the appellant, The receivables under the contract was converted into NCRPS, and such conversion was duly approved by the respective boards. Eventually, in course of certain events, the appellant filed a Section 7 petition against the respondent, on account of failure to pay the redemption amount on account of maturity of CRPS. The application was dismissed by NCLT, and then NCLAT on grounds that the CRPS cannot be termed as debt. The application then came for appeal before SC.

Below is a discussion highlighting the rationale for which dues pertaining to preference shares were not held to be financial debt.

Actions speak about “intent”: Conversion of receivables into CRPS conclusive of intent

It was contended by the Appellant that the true nature of the transaction should be unveiled in order to determine whether such preference shares should be treated as debt or not. The fact that there were outstanding receivables, which had become due and payable, the Appellant argued that conversion of the same into preference shares was in a way ‘subordination of debt’, i.e. debt which is having lower priority than other debt in terms of payment, and was with the objective of maintaining the debt-equity ratio. As clear from the communication between the parties, the CRPS merely acted as a temporary tool for borrowing, providing Matix “a pause point” under the arrangement entered by way of exchange of emails. Therefore, the substance of the transaction should be given weightage, and an expansive interpretation of the term “commercial effect of borrowing” should be applied, as was interpreted by the Apex Court while classifying home buyers as FCs.^[1] In fact, the SC, in another matter^[2] delved into the real nature of a transaction while determining whether a debt is a financial debt or an operation debt.

On this, the Court noted that the preference shares were issued upon conversion of outstanding receivables. The board of the preference shareholder exercised its commercial wisdom in accepting the shares, given the low recovery prospects. Therefore, what was actually a financial debt, extinguished owing to such conversion, and hence the appellant cannot pose as a financial creditor.There is no question of there being any underlying contrary intent as the only intent was to convert the debt into preferential shareholding^[3]. The SC, therefore, remarked:

“There is no question of there being any underlying contrary intent as the only intent was to convert the debt into preferential shareholding. The egg having been scrambled, . . .  attempt to unscramble it, must necessarily fail.”

Debt vs. preference shares: Redeemable preference shareholder not a creditor

The SC placed reliance on the relevant provisions of the Companies Act, particularly Sections 43, 47, and 55, and held that preference shares form part of the company’s share capital and not its debt capital. Consequently, preference shareholders cannot be treated as creditors, nor can they initiate insolvency proceedings under Section 7 of the IBC, which is reserved for financial creditors.

The Court noted that –

“It is well settled in Company Law that preference shares are part of the company’s share capital and the amounts paid up on them are not loans. Dividends are paid on the preference shares when company earns a profit. This is for the reason that if the dividends were paid without profits or in excess of profits made, it would amount to an illegal return of the capital. Amount paid up on preference shares not being loans, they do not qualify as a debt.” (Emphasis added)

Dividends on preference shares are payable only out of profits or proceeds from a fresh issue of shares for redemption. Thus, only a profit-making company can redeem its preference shares, as profits accrue after all expenses, including interest on borrowings. To suggest that preference shareholders become creditors upon default, even when the company has no profits, would distort this basic principle. ^[4] As aptly stated in “Principles of Modern Company Law”^[5]:

“The main difference between the two in such a case may then be that the dividend on a preference share is not payable unless profits are available for distribution, whereas the debt holder’s interest entitlement is not subject to this constraint; and that the debt holder will rank before the preference holder in a winding-up.”

In the context of a CIRP, initiation under Section 7 requires a “default”, a debt that has become due and payable. The Supreme Court observed that since preference shares are redeemable only out of profits or fresh issue proceeds, no “debt” arises unless such conditions exist; consequently, there can be no default under Section 7.

Difference between preference shareholder and a creditor was concisely captured in “A Ramaiya’s Guide to the Companies Act”^[6]:

“It must be remembered that a preference shareholder is only a shareholder and cannot as a matter of course claim to exercise the rights of a creditor. Preference shareholders are only shareholders and not in the position of creditors. They cannot sue for the money due on the shares undertaken to be redeemed, and cannot, as of right, claim a return of their share money except in a winding-up. In Lalchand Surana v. Hyderabad Vanaspathy Ltd., (1990) 68 Com Cases 415 at 419 (AP), where a preference shareholder was denied redemption in spite of maturity, he was not allowed to file a creditor’s petition for a winding-up order under s. 433(e) of the 1956 Act. An unredeemed preference shareholder does not become a creditor.”

A financial debt necessarily involves disbursal against the consideration for time value of money, typically represented through interest.^[7] While interest may not be a sine qua non in every case^[8], there must at least be an element of consideration for the time value of money. In the present case, no such disbursal or consideration existed and hence, the claim failed to meet the threshold of a financial debt.

As such, preference shares do not fall within the ambit of “financial debt” under Section 5(8)(f) of the Code, and equating them with financial creditors would distort the fundamental distinction between shareholders and creditors^[9].

Whether accounting entries/recognition as “liability” would make a difference

It was contended that financial debt is an admitted liability in the books of accounts of Matix.

However, the SC^[10], held the treatment in the accounts due to the prescription of accounting standards will not be determinative of the nature of relationship between the parties as reflected in the documents executed by them. Further the IBC has its own prerequisites which a party needs to fulfil and unless those parameters are met, an application under Section 7 will not pass the initial threshold. Hence, by resort to the treatment in the accounts this case cannot be decided.

Our Analysis

While the judgment firmly settles that preference shareholders cannot be treated as creditors, since shares represent ownership and not loans, the question often arises why such instruments, though debt-like in spirit and accounting treatment, are not “debt” under law. The rationale goes beyond mere nomenclature.

Ind AS 32 [Para AG25 to AG28] clarifies that in determining whether a preference share is a financial liability, or in other words, a debt, or simply an equity instrument, the shares has to be assessed against the rights attached to it, and whether it signifies a character of financial liability. In other words, if a preference share is redeemable at a specific date in the future at the option of the shareholder, such instrument carries a financial liability and is treated as such. However, it should be noted that every law has to be read in a given context. Treatment under accounting standards is more from the perspective of the financial position of the issuer. However, in case of IBC, the question is of rights – as a creditor will have right to file an application under section 7, but a shareholder will not have such right; similarly, a creditor will have a higher priority under section 53, while a shareholder stands in the lowest step of the priority ladder.

Therefore, the context in which accounting standards operate cannot be superimposed while interpreting the rights and liabilities under laws like the Code. Therefore, preference shares, depending on their terms of issuance may be classified as a liability for the purpose of complying with accounting principles, however, that cannot be said to be confer such preference shareholders the status of a creditor, and consequently, entitling them to file CIRP application under the Code.

Hence, there is a fundamental difference between “debt” and “shares” – a “debt” once converted into “shares”, moves from one end of the spectrum to another, and cannot retain its original nature and rights under the Code.

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^[1] Pioneer Urban Land and Infrastructure Ltd. and Another v. Union of India and Others ((2019) 8 SCC 416)

^[2]  Global Credit Capital Ltd and Anr. v. Sach Marketing Pvt Ltd and Anr. (2024 SCC OnLine SC 649)

^[3] Commissioner of Income Tax v. Rathi Graphics Technologies Limited (2015 SCC OnLine Del 14470), where it was held that, where the interest or a part thereof is converted into equity shares, the said Interest amount for which the conversion is taking place is no longer a liability.

^[4] Lalchand Surana v. M/s Hyderabad Vanaspathy Ltd. (1988 SCC OnLine AP 290)

^[5] (Tenth Edition) at page 1071

^[6] (18th Edition, Volume 1 Page 879)

^[7]  Anuj Jain, Interim Resolution Professional for Jaypee Infratech Limited v. Axis Bank Limited and Others ((2020) 8 SCC 401)

^[8]  Orator Marketing v. Samtex Desinz (Civil Appeal No. 2231 of 2021)

^[9] Radha Exports (India) Private Limited v. K.P. Jayaram and Another ((2020) 10 SCC 538)

^[10] Relied on State Bank of India v. Commissioner of Income Tax, Ernakulam ((1985) 4 SCC 585)

Read more:

Failed Redemption of Preference Shares: Whether a Contractual Debt?

Kabhi Naa, Kabhi Haan: Key Takeaways from the SC’s verdict in Bhushan Steel

Presentation on Interest under IBC: Balancing Creditor Recovery and Resolution Viability