New Indian company law – eroding the concept of a private company?
February 2014 | LEGAL & REGULATORY | CORPORATE LAW
Financier Worldwide Magazine
Private limited companies in India have been an entity of choice for both Indian and foreign investors for organising their business ventures in India, except in cases of business plans involving fundraising from public sources. This was facilitated largely by the differential compliance regime provided by the (Indian) Companies Act, 1956 (Companies Act) for private companies vis-à-vis public companies. While public companies were made subject to numerous restrictions and corporate compliances, private companies (except when they were subsidiaries of public companies) were generally exempt from such restrictions and corporate compliances. This was perhaps attributable to the concept of private companies under the Companies Act, which considered them as closely held, and therefore there was no need for greater regulation of their affairs (unlike in the case of public companies). Accordingly, private companies were allowed the flexibility to regulate their affairs in accordance with the terms contained in their constituent documents, namely their articles of association (AOA).
Recently, the Indian Parliament enacted a new company law, the (Indian) Companies Act, 2013 (New Companies Act) which in due course will completely replace the current company law, the Companies Act. The New Companies Act was many years in the making and is expected to usher in far reaching changes, particularly in the area of corporate governance standards in India. The New Companies Act provides for greater management accountability, better enforcement provisions, better protection for minority shareholders and sound corporate governance practices. However, the devil, as they say, is in the details, and the New Companies Act is no exception. Yet another significant but less publicised change under the New Companies Act is the removal or dilution of the distinction between private companies and public companies, making both subject to somewhat similar restrictions and corporate compliances.
This article discusses some of the key changes in the New Companies Act which have brought private companies closer to the identity of public companies. While certain provisions of the New Companies Act have already been notified and are in force, other provisions are yet to be notified. For the purposes of this article, we have discussed both notified and other provisions of the New Companies Act on the assumption that these will be notified in the near future.
Preferential issue and rights issue
As per the Companies Act, any issue of share capital of a public company after expiry of two years from the date of its incorporation or one year after the date of first allotment of its shares, is required to be done on a rights basis (i.e., to the existing shareholders in proportion to their existing shareholding) (Rights Issue). Any preferential issue (i.e., to any person in any manner other than through a Rights Issue) (Preferential Issue) requires a special resolution to be passed by the company in a general meeting or permission of the central government in certain cases. This requirement is not applicable to private companies and their shareholders are free to regulate in the AOA the manner of further issue of shares.
The provision in the New Companies Act dealing with further issue of shares does not distinguish between public companies and private companies and, accordingly, any further issue of shares by both public companies and private companies is required to be a Rights Issue. Further, a Preferential Issue is permitted only if it is authorised by a special resolution passed by the general meeting, i.e., shareholders’ meeting, with a further requirement that the issue of shares should be made at a price determined by the valuation report of a registered valuer.
Kinds of share capital
The Companies Act permits only two kinds of share capital for public companies: equity share capital (with voting rights or with differential rights as to voting, dividends or otherwise) and preference share capital (with preferential rights to dividend and repayment of capital in case of winding up, but no voting rights except in limited circumstances). This restriction on the kinds of share capital does not apply to private companies and accordingly private companies are free to issue different kinds of share capital with any rights attached to them. This practically manifests itself in different series of preference shares being issued to investors investing at different points in time, such as series A preference shares, series B preference shares with holders of an earlier series of shares usually enjoying a priority unless contractually agreed otherwise. This flexibility is especially helpful and frequently used in equity financing (private equity and venture capital) transactions wherein different classes of shares are generally issued to the investors and the promoters and investors investing in different points in time. Subject to the discussion below on voting rights, this flexibility for private companies has been withdrawn under the New Companies Act. Accordingly, private companies have been put on par with public companies and can issue only equity share capital and preference share capital.
Private companies are permitted by the Companies Act to freely regulate the voting rights of their shareholders via their AOAs. This allows a private company to provide for differential voting rights to its shareholders or even restrict the voting rights for certain shareholders. This is particularly relevant for joint ventures and equity financing (private equity and venture capital) transactions wherein different categories of shareholders or shareholders investing at different times are often provided different voting rights. This flexibility has been significantly diluted by the New Companies Act, thereby bringing private companies closer in their characterisation to public companies. Under the New Companies Act, private companies’ flexibility to issue shares with different voting rights has been confined to equity share capital.Accordingly, a private company can now issue only equity share capital with differential voting rights as to dividends, voting or otherwise. This flexibility has been further proposed to be subject to other conditions, including: (i) shares carrying differential rights cannot exceed 25 percent of the post-issue paid up equity share capital; and (ii) past track record for payment of dividends.
Procedure for the conduct of general/shareholders’ meetings
The Companies Act provides detailed procedures for conducting general meetings. These procedures include requirements such as a minimum notice period for calling general meetings, the contents and manner of serving such notice, providing an explanatory statement with the notice calling general meetings, the presence of a minimum quorum for convening general meetings, specific procedure for appointing proxies and the procedure for voting at general meetings. While these procedures are mandatory for public companies, private companies are given the freedom to not submit to these provisions and prescribe different requirements in their AOAs. The New Companies Act has taken away this flexibility from private companies and the procedures prescribed in the New Companies Act are mandatorily applicable to private companies as well.
The above is merely an illustrative list of various changes whereby restrictions and compliance requirements which were not applicable to private companies under the Companies Act have been made applicable to them under the New Companies Act. Other similar changes include, inter alia, restrictions on voting rights of interested directors, requirements for the appointment of managerial personnel, restrictions and requirements for appointing directors, restrictions and requirements for granting loans, security and guarantees and making investments, restrictions on the powers of directors for certain actions, and restrictions on the method of calculating company profits.
In search of greater control and better corporate governance, Indian lawmakers seem to have erred in taking away the ‘unique selling point’ of private companies, which has long been minimal compliance and maximum flexibility. The implementation of the New Companies Act (along with the rules thereunder, which are still in draft form) and practical challenges it will present will only be known over time. One thing is clear, however: it reduces the benefits of using a private company as a business entity and could trigger a move towards alternative business vehicles such as limited liability partnerships under the relatively new (Indian) Limited Liability Partnership Act, 2008.
Abhishek Saxena is a partner, and Pranav Srivastava and Niyati Bhatt are associates, at Phoenix Legal. Mr Saxena can be contacted on +91 11 4983 0000 or by email: firstname.lastname@example.org. Mr Srivastava can be contacted on +91 11 4983 0000 or by email: email@example.com. Ms Bhatt can be contacted on +91 11 4983 0000 or by email: firstname.lastname@example.org.
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Abhishek Saxena, Pranav Srivastava and Niyati Bhatt