Why prefer the preferred – subtleties of the preferred capital
November 2013 | PROFESSIONAL INSIGHT | FINANCE & INVESTMENT
Financier Worldwide Magazine
This year, the month of April alone saw the total foreign direct investment (FDI) in India reach approximately Rs. 12,623 crores (US$2.32bn), according to the Department of Industrial Policy and Promotion. This represents a 31 percent increase from April 2012, at a time when the country’s GDP has nose-dived. Now, in light of the recent steps taken by the government to raise the FDI limits in various sectors, it is hoped that India’s FDI will rise further, pulling the country out of the rupee slide. In view of the government’s resolve to make the capital market more attractive, this article seeks to highlight the reasons why a foreign investor may prefer to invest in preference shares in India, by explaining not only the statutory differences in the equity and preference shares of a company but also the practical issues associated with the subscription of equity and preference shares in India.
The million dollar question – equity or preference?
A foreign investor typically seeks to invest millions of dollars for investment purposes in a sector of its choice. The instrument, or instruments, through which the investor will exercise its rights in the company are of vital importance to the overall structure – specifically in relation to voting rights, anti-dilution, dividend and liquidation preference. The balance between control and preferential treatment has to be right for the transaction to be lucrative. This article explores the range of rights that can be bundled together with respect to each of these aspects, to ensure that the investor gets a powerful package.
What is permitted – foreign direct investment policy
As per the extant foreign direct investment policy, an eligible foreign investor can invest in equity shares and in certain specified types of preference shares and debentures of an Indian company. The FDI policy treats non-convertible, optionally convertible or partially convertible preference shares as debt; but a fully, compulsorily and mandatorily convertible preference share is a valid instrument for investment. Therefore, equity shares and compulsorily convertible preference shares and compulsorily convertible debentures are the three options facing an investor for the purposes of investment in India. The question that arises, then, is what to choose, and why?
The big fight – equity v. preference
American business magnate Warren Buffet once said “It is optimism that is the enemy of a rational buyer”. Keeping an eye out for when the ship might sink is an important aspect of investment for any investor. If the target has to wind-up, then to ensure protection of the investor’s money, an investor would typically prefer to have preferential rights at the time capital is repaid. Here, too, preference shareholders have an edge over equity shareholders. The (Indian) Companies Act, 1956 (the ‘Act’) provides that, with regard to capital, preference shares carry or will carry on winding up or repayment of capital a preferential right to be repaid the amount of the capital paid up or deemed to have been paid up, whether or not there is a preferential right to the payment of either or both of the following amount: (i) any dividend remaining unpaid up to the date of winding up or repayment of capital; and (ii) any fixed premium or premium on any fixed scale, specified in the company’s charter documents.
Apart from the above, a preference shareholder can also be provided with a right to participate in that part of the company’s capital which is not entitled to the preferential right, which may remain after the entire capital has been repaid. However, it is pertinent to note that the right to participate in the surplus capital, after it has been subject to all preferential carve outs, is not automatically provided to a preference shareholder. Such rights must be contractually preserved on behalf of the investor under the investment agreement. On winding up there is no presumption that the preference shareholders are entitled to a share in the surplus assets. The onus will be on the preference shareholder to ensure that its right to this effect is preserved under the investment agreement and the articles of the company. Accordingly, the winner of this round is clearly preference share capital.
Another practical advantage of preference shares over equity is that they provide ‘down round’ protection to the investor. A preference shareholder has the option to require the company to protect its interest in the event the company issues shares in the subsequent rounds at a price lower than the price of the investor’s share. This is achieved by conversion of the existing preference shares of the investor into such number of equity shares, or by issuing a further number of preference shares to the company at lower value, such that the shareholding percentage of the investor does not take a hit. It is arguable here that anti-dilution protection can also be afforded to an equity shareholder. However, such protection is limited by the fact, in the event of a down round investment at a price lower than, let’s say the Class A equity shares issued to the investor, the absence of an option to convert the Class A equity shares into a greater number of equity shares, coupled with the fact that for a foreign investor the shares will have to be subscribed to at minimum DCF value, means the foreign investor will be forced to invest further amounts to protect its percentage shareholding in the target company. This round clearly goes to preference as anti-dilution protection is extremely hard to achieve without further investment if the investment is in equity.
The control of a company resides in the voting power of its shareholders. Whilst a foreign investor typically does not look to control the day to day functions and operation of the company, it is, of course, pertinent for its protection that the investor reserves the right to block any resolution relating to such key business decisions which it feels would adversely impact its investment. This fine detailing of voting right is to be etched from the nature of the shares owned by the investor.
A preference shareholder of a public limited company or a private company subsidiary of public company has very limited voting rights bestowed upon it under Indian law. The Act is very clear that a preference shareholder in a public company limited by shares or in a private limited company which is a subsidiary of a public company is entitled to vote only on a resolution placed before the company which directly affects the rights attached to that holders’ preference shares. It is further clarified that any resolution for winding up the company or for repaying or reducing its share capital will also be deemed to directly affect the rights attached to the holders’ preference shares. Subject to the aforesaid, the preference shareholder is also entitled to vote on every resolution placed before the meeting if the dividend due on such capital or any part of such dividend has remained unpaid. This entitlement is subject to certain specified conditions in relation to cumulative preference shares and non-cumulative preference shares.
An equity shareholder, on the other hand, will have a right to have a say in all the governance matters of a company which are tabled at a shareholders’ meeting, irrespective of whether the company is a public company or a private company, and of the nature of the issue raised. Therefore, in a public company or a private company which is a subsidiary of a public company, a preference shareholder will be entitled to receive notice only in relation to such meetings which bear relation of the preference shares held by that member. This creates a hurdle for the investor, since keeping a tab on the business progress is a vital checkpoint in a transaction for the investor. A possible solution to this problem could be that the investor retains a minimum number of equity shares, thus providing the investor with the benefits bestowed on an equity shareholder by the Act, including the right to receive notices in relation to all business matters of the company. Round Three therefore goes to equity – especially if there is a significant possibility of the company becoming a public company.
“The first rule in investing: don’t lose any money. The second rule: don’t forget the first rule!” exclaimed Warren Buffet on another occasion. Since the be all and end all of all investments is returns, it is only prudent to investigate the nature of an instrument in respect of returns. While most investments are done looking at the returns being received via enhanced value of the shares at the time of exit, it is still prudent – especially in mature, profit making companies – to also look at dividends.
A preference share gives a preferential right in regard to dividends under the Act. Here, an interesting fact to note is that the provision relating to preference shares under the Act only contemplates the payment of a fixed amount or an amount calculated at a fixed rate, in preference to the equity shareholders of a company. The provision is silent on the time period within which a dividend has to be paid. Therefore, the investor is free to contractually require the company to pay not only a dividend in preference to other shareholders but also to require the company to pay a dividend on a year-on-year basis, rather than as and when declared.
The courts have held that the right of preferential payment of cumulative dividends to preference shares becomes enforceable at the time of winding up. The division bench further held that even in the event that a company has not made any profit during its term or has suffered only losses, if it has issued cumulative preference shares, then such shareholder shall be entitled to a dividend from the capital at the time of winding up.
In case of preference share issued to non-residents, the FDI policy stipulates that the maximum dividend payable shall not be more than 300 basis points over the Prime Lending Rate of SBI. There are no such restrictions on the dividend payable on investment into equity shares under the FDI policy. Therefore, whilst greater protection of dividends is afforded to preference shares, greater participation is provided to dividends for equity – accordingly, there is no clear winner in this instance.
The differences outlined above do not, however, apply to a private company. Although equity may score over preference in voting rights – especially in a public company – anti-dilution and liquidation preference are far more important for an investor; on that score, preference clearly wins. Even on dividends, since an investor is more interested in protecting cash flow through dividends and rarely on returns through dividends, preference shares do not really lose. So, on balance, it is better for an investor to invest in preference capital.
In private companies, in any event, the law permits attachment of voting rights to preference shares as it deems fit, provided this is recorded in the charter documents of the company. Therefore, in the case of a private company, a preference share can be customised to the needs of the investor, making preference shares a more attractive solution for investments than equity or debt. However, it is advisable to retain a minimum number of equity shares of the company in the investor’s kitty at the time of investment itself or prior to conversion to a public company. The reason for this is that the investor will have to retain adequate voting rights to protect its interests in the company, especially relating to affirmative or reserved matters, without actually being in control of the company. Since under the Act the share capital of a company limited by shares can only be of two kinds, and the equity share capital can consist of shares with different rights on voting, if the investor owns a few equity shares it can vote as if on a converted basis, thereby ensuring that the entire percentage of its shareholding is taken into account for the purpose of its votes.
Suneeth Katarki is a partner and Ashi Bhat is an associate at IndusLaw. Mr Katarki can be contacted on +91 80 4072 6600 or by email: email@example.com. Ms Bhat can be contacted on +91 80 4072 6622 or by email: firstname.lastname@example.org.
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Suneeth Katarki and Ashi Bhat