Prospectus, Share Capital and Debentures — Practice

Question 1

A company allots its entire issue of 50 lakh shares to an issue house on 1 April. The issue house offers them to the public on 20 July, by which date the company has received only 60% of the consideration. No prospectus has been issued by the company. Advise.

Accepted Answer

The offer document issued by the issue house is a deemed prospectus of the company. Section 25 provides that where a company allots or agrees to allot any securities with a view to all or any of them being offered for sale to the public, any document by which the offer for sale is made is deemed to be a prospectus issued by the company, and all enactments and rules as to the contents of prospectuses and liability in respect of statements in and omissions from them apply as if the securities had been offered to the public by the company itself. Two circumstances raise the presumption that the allotment was made with that view, and both are satisfied here. The offer for sale was made on 20 July, within six months of the allotment on 1 April. And at the date of the offer the whole of the consideration had not been received by the company, only sixty per cent having been paid. Either circumstance alone would suffice. The consequence is that the company must comply with the prospectus provisions, including registration with the Registrar, and the persons responsible are exposed to liability under sections 34, 35 and 36 for any untrue statement. The provision exists precisely to close this avoidance route: without it a company could reach the public through an intermediary and never issue a prospectus at all.

Question 2

A prospectus states that the company has been granted an environmental clearance, which is true, but omits that the clearance is under challenge in a writ petition that could result in its cancellation. The directors say every statement in the prospectus is literally accurate. Advise.

Accepted Answer

The directors' defence misunderstands the test. A statement included in a prospectus is deemed to be untrue where it is misleading in the form and context in which it is included, and the omission from a prospectus of any matter is deemed to be an untrue statement where the omission is calculated to mislead. So the question is not whether the words are literally accurate but what impression they create in the reader's mind. A statement that a clearance has been granted, standing alone, tells an investor that the company holds a permission it may rely on; the pending challenge, if successful, would remove it, and no investor reading the prospectus would take the same view of the company's prospects knowing of it. The statement is therefore misleading in its context, and the omission of the challenge is calculated to mislead, so both limbs are engaged. Civil liability under section 35 attaches to the directors, promoters, persons who authorised the issue and experts, subject to the statutory defences; criminal liability under section 34 attaches to every person who authorises the issue, with a defence of immateriality or reasonable belief. The general lesson is that a half-truth is treated as a lie for these purposes, and candidates who answer only on literal falsity miss the substance of the provision.

Question 3

Set out who is liable to pay compensation under section 35 and the defences available. A person consented to be named as a director, withdrew consent a week before issue, and the prospectus was nonetheless issued naming him. Advise.

Accepted Answer

Liability to pay compensation for loss or damage sustained by a person who subscribed for securities on the faith of a prospectus containing an untrue statement falls on five categories: every person who is a director of the company at the time of the issue of the prospectus; every person who has authorised himself to be named and is named in the prospectus as a director or as having agreed to become a director, either immediately or after an interval of time; every person who is a promoter of the company; every person who has authorised the issue of the prospectus; and every person who is an expert referred to in section 26. Three defences are available. That, having consented to become a director, he withdrew his consent before the issue of the prospectus and it was issued without his authority or consent. That the prospectus was issued without his knowledge or consent, and that on becoming aware of its issue he forthwith gave reasonable public notice that it was issued without his knowledge or consent. And that as regards every untrue statement purporting to be made by an expert, he had reasonable ground to believe, and did up to the time of the issue believe, that the expert was competent to make the statement, had given the consent required and had not withdrawn it. The person described falls squarely within the first defence: he withdrew his consent before issue and the prospectus was issued without his authority, so he is not liable, though he would be well advised to give public notice of the position.

Question 4

A company makes a private placement of equity shares to 150 persons and, in the same financial year, to a further 80 persons, of whom 30 are qualified institutional buyers. It also places debentures with 90 persons. Advise on compliance, and state the consequence of breach.

Accepted Answer

Count each kind of security separately, because the two-hundred person limit applies separately for each kind of security. For equity: the first offer reached 150 persons and the second reached 80, of whom 30 are qualified institutional buyers, who are excluded from the count along with employees receiving securities under an employees stock option scheme. The countable additions are therefore 50, giving 200 in the aggregate in the financial year, which is at the limit but not over it, so the equity placements comply on this point. For debentures, 90 persons is well within the separate limit for that kind of security, and the equity offerees are not aggregated with them. Two further conditions must be checked on these facts: no fresh offer may be made unless the allotments with respect to any earlier offer have been completed or that offer has been withdrawn or abandoned, so the second equity offer is valid only if the first was completed; and no advertisement of the offer may be made to the public nor any media, marketing or distribution channels used. The consequence of exceeding the limits is decisive: an offer to more than the prescribed number of persons is treated as a public offer, and the company must comply with all the provisions applicable to a public issue including the prospectus requirements, regardless of whether the securities are listed and regardless of the company's intention.

Question 5

A company receives private placement application money of ₹4 crore on 1 June and has not allotted by 15 September. State the company's obligations, the interest position, and the rules on how the money may be held and received.

Accepted Answer

Allotment must be made within sixty days of receipt of the application money, which from 1 June expired on 30 July. Where the company is unable to allot within that period, it must repay the application money to the subscribers within fifteen days from the expiry of the sixty days, that is by 14 August. If the money is not repaid within that further fifteen-day window, the company becomes liable to repay it with interest at the rate of twelve per cent per annum from the expiry of the sixtieth day, that is from 30 July, and not merely from the date the fifteen days ran out. Here nothing has been done by 15 September, so the company must repay the four crore together with interest at twelve per cent from 30 July until repayment. Two related conditions govern the money itself. It must be received by cheque, demand draft or other banking channel and not by cash, so that the source of the funds is traceable. And it must be kept in a separate bank account in a scheduled bank and must not be utilised for any purpose other than for adjustment against allotment of securities or for repayment of monies where the company is unable to allot; using it for the company's ordinary purposes in the interim is a breach even if allotment later occurs on time.

Question 6

A company proposes a resolution to alter its main objects. Its preference shareholders demand a vote. The dividend on the preference shares was last paid three years ago. Advise, and state the general position on preference voting rights.

Accepted Answer

The preference shareholders are entitled to vote on this resolution, and on every other resolution placed before the company. The general position is that preference shareholders have restricted voting rights: they vote only on resolutions placed before the company which directly affect the rights attached to their preference shares, on any resolution for the winding up of the company, and on any resolution for the repayment or reduction of its equity or preference share capital. A resolution altering the main objects would not ordinarily fall within any of those, since it does not directly affect the rights attached to the preference shares, however much it may affect the business in which their money is invested. But the restriction is conditional on the company honouring the preferential right that justifies it. Where the dividend in respect of a class of preference shares has not been paid for a period of two years or more, the holders of that class acquire the right to vote on all resolutions placed before the company. Here the dividend has been unpaid for three years, so that right has accrued and the demand is well founded. The logic is straightforward: preference shareholders accept limited voice in exchange for a prior claim to income, and when the income stops the justification for the limited voice stops with it.

Question 7

A company wishes to reduce the dividend rate on its preference shares from 10% to 8%. State the procedure, and the remedy of a shareholder who did not consent.

Accepted Answer

This is a variation of the rights attached to a class of shares and cannot be effected by an ordinary alteration of the articles. The rights attached to the shares of any class may be varied with the consent in writing of the holders of not less than three-fourths of the issued shares of that class, or by means of a special resolution passed at a separate meeting of the holders of the issued shares of that class. Two further requirements apply. Where the provision with respect to variation is contained in the memorandum or articles, or in the absence of such provision, the variation must not be prohibited by the terms of issue of the shares of that class. And where the variation by one class of shareholders affects the rights of any other class, the consent of three-fourths of that other class must also be obtained, and the provisions apply to that variation as well. The remedy of a dissentient is a statutory right of challenge. Where holders of not less than ten per cent of the issued shares of a class did not consent to or vote in favour of the resolution for the variation, they may apply to the Tribunal to have the variation cancelled. The application must be made within twenty-one days after the date on which the consent was given or the resolution was passed, and where an application is made the variation does not take effect unless and until it is confirmed by the Tribunal.

Question 8

A company proposes to issue further shares to a strategic investor for cash without offering them to existing shareholders. State the routes available under section 62, the notice requirements for a rights issue, and the exception where section 62 does not apply at all.

Accepted Answer

Section 62 provides that where a company having a share capital proposes to increase its subscribed capital by the issue of further shares, they must be offered in one of three ways. First, to persons who at the date of the offer are holders of the equity shares of the company in proportion, as nearly as circumstances admit, to the paid-up share capital on those shares, which is a rights issue. Second, to employees under a scheme of employees stock option, subject to a special resolution and the prescribed conditions. Third, to any persons, if authorised by a special resolution, whether or not those persons include the existing holders, either for cash or for a consideration other than cash, provided the price is determined by the valuation report of a registered valuer, subject to prescribed conditions. The proposed issue to a strategic investor is available under the third route, requiring a special resolution and a registered valuer's report on price. For a rights issue, the offer must be made by notice specifying the number of shares offered and limiting a time not being less than fifteen days and not exceeding thirty days from the date of the offer within which the offer, if not accepted, shall be deemed to have been declined; and unless the articles otherwise provide, the offer is deemed to include a right to renounce the shares in favour of any other person. Section 62 does not apply at all to an increase of subscribed capital caused by the exercise of an option attached to debentures issued or loans raised by the company to convert them into shares, provided the terms of issue were approved before the issue by a special resolution.

Question 9

A company proposes to issue bonus shares by capitalising ₹5 crore of revaluation reserve and ₹3 crore of securities premium. It has some partly paid shares outstanding and has defaulted on payment of employees' provident fund contributions. Advise fully.

Accepted Answer

The proposal fails on three grounds. First, the revaluation reserve cannot be capitalised. Section 63 permits a company to issue fully paid-up bonus shares out of its free reserves, the securities premium account or the capital redemption reserve account, and provides expressly that no issue of bonus shares shall be made by capitalising reserves created by the revaluation of assets. The reason is that a revaluation reserve represents an unrealised gain arising from a valuer's opinion rather than from a transaction, and converting it into share capital would present to the reader as capital contributed something that has never been received and may never be realised. The securities premium of 3 crore is a permitted source and may be used. Second, the partly paid shares are an obstacle: a condition of a bonus issue is that partly paid-up shares, if any outstanding on the date of allotment, are made fully paid-up, so those shares must be called up and paid before the bonus allotment. Third, the provident fund default is fatal until cured: the company must not have defaulted in respect of the payment of statutory dues of the employees such as contribution to provident fund, gratuity and bonus. The company must also not have defaulted in payment of interest or principal in respect of fixed deposits or debt securities issued by it, the issue must be authorised by the articles, and it must be recommended by the board and authorised in general meeting. A bonus issue once announced cannot subsequently be withdrawn.

Question 10

State the rule on issuing shares at a discount and its exceptions. What are sweat equity shares and what approval does their issue require?

Accepted Answer

A company may not issue shares at a discount, and any share issued at a discount is void. The prohibition protects the capital fund on which creditors rely, since shares issued below par bring in less than the nominal capital the balance sheet records. Two exceptions exist. Sweat equity shares may be issued at a discount, and a company may issue shares at a discount to its creditors when its debt is converted into shares in pursuance of any statutory resolution plan or debt restructuring scheme, which is a narrow provision serving the rescue of distressed companies. Sweat equity shares are shares issued by a company to its directors or employees at a discount or for consideration other than cash, for providing know-how or making available rights in the nature of intellectual property rights or value additions, by whatever name called. The concept exists because a person may contribute to a company something of real value that is not money and cannot easily be valued in money, and the ordinary rule against issuing shares below par would prevent the company rewarding it with equity. Issue requires a special resolution passed by the company, specifying the number of shares, the current market price, the consideration if any, and the class or classes of directors or employees to whom they are to be issued, together with compliance with the prescribed conditions and, for a listed company, the applicable SEBI regulations.

Question 11

State the three modes of reduction of share capital under section 66, the approvals required, and the one circumstance in which reduction is prohibited outright.

Accepted Answer

A company limited by shares, or limited by guarantee and having a share capital, may reduce its share capital in any manner, and in particular in three ways that the section names. By extinguishing or reducing the liability on any of its shares in respect of share capital not paid up, which releases shareholders from a future call. By cancelling any paid-up share capital which is lost or is unrepresented by available assets, with or without extinguishing or reducing liability on shares, which is the mode used in most reconstruction schemes because it aligns the capital figure with what the company actually has. And by paying off any paid-up share capital which is in excess of the wants of the company, which returns surplus capital to shareholders. The approvals are a special resolution of the members and confirmation by the National Company Law Tribunal, the Tribunal's involvement reflecting that a reduction diminishes the fund on which creditors relied and that their objections must be heard. The outright prohibition is that no reduction of share capital shall be made if the company is in arrears in the repayment of any deposits accepted by it, either before or after the commencement of the Act, or the interest payable thereon. The logic is direct: a company that has not repaid its depositors cannot be permitted to return capital to its shareholders, who rank behind them.

Question 12

Distinguish a debenture holder from a shareholder on four points, and state whether a company may issue debentures carrying voting rights.

Accepted Answer

A debenture holder is a creditor of the company, whereas a shareholder is a member and part-owner, and four practical differences follow. On return, debenture interest is a charge against profits and is payable whether or not the company earns a profit, whereas dividend is an appropriation of profits and can be paid only out of profits after providing for depreciation. On governance, a debenture holder has no voting rights and no say in the management of the company, whereas a shareholder votes on resolutions placed before the company. On priority in winding up, debenture holders rank ahead of shareholders and are paid before any return of capital, and secured debenture holders rank ahead of unsecured creditors in respect of the charged assets. On security, a debenture may be secured by a charge on the company's assets, which a share never is. The Act is express that no company shall issue any debentures carrying any voting rights, and the prohibition follows from the nature of the instrument: voting is an incident of membership and of bearing the residual risk, and a person entitled to a fixed return whether or not the company prospers has neither the exposure nor the interest that justifies a voice in how it is run. A debenture may, however, be convertible into shares, in which case voting rights arise on conversion because the holder has by then become a member.

Question 13

When must a debenture trustee be appointed, what is the trustee's function, and who is disqualified from acting as one?

Accepted Answer

A company must appoint a debenture trustee before issuing a prospectus or making an offer or invitation to the public or to its members exceeding five hundred for the subscription of its debentures. The trustee's function is to protect the interests of the debenture holders and to redress their grievances, and its powers are substantive rather than formal: the trustee may approach the Tribunal where the company defaults in payment of interest or in redemption of the debentures, and may also do so where it is of the opinion that the assets of the company are insufficient or are likely to become insufficient to discharge the principal amount as and when it becomes due, in which case the Tribunal may restrict the company from incurring further liabilities. The disqualifications are designed to secure independence and cover anyone whose interests might conflict with those of the debenture holders. A person cannot be appointed if he beneficially holds shares in the company; is a promoter, director, key managerial personnel or any other officer or an employee of the company or its holding, subsidiary or associate company; is beneficially entitled to moneys which are to be paid by the company otherwise than as remuneration payable to the debenture trustee; is indebted to the company or its holding, subsidiary or associate company or a subsidiary of such holding company; has furnished any guarantee in respect of the principal debts secured by the debentures or interest thereon; has any pecuniary relationship with the company amounting to the prescribed percentage of its total turnover or gross receipts; or is a relative of any promoter or of any person in the employment of the company as a director or key managerial personnel.

Question 14

State the maximum tenure of secured debentures and the exception, the purpose of the Debenture Redemption Reserve, and the remedy where a company fails to redeem on maturity.

Accepted Answer

Secured debentures may be issued subject to prescribed terms and conditions, of which the first is that the date of their redemption shall not exceed ten years from the date of issue. An exception applies to specified classes of companies, namely infrastructure companies, infrastructure finance companies, infrastructure debt fund non-banking financial companies, and companies permitted by a Ministry or Department of the Central Government or by the Reserve Bank of India or by the National Housing Bank or by any other statutory authority, which may issue secured debentures for a period exceeding ten years but not exceeding thirty years. The issue must be secured by a charge on the properties or assets of the company or its subsidiaries, holding company or associate companies, of a value sufficient for the due repayment of the amount and interest, and a debenture trust deed must be executed within the prescribed period. The Debenture Redemption Reserve must be created out of the profits of the company available for payment of dividend, and the amount credited to it may not be utilised by the company except for the redemption of debentures; its purpose is to ensure that the company sets aside distributable profit progressively rather than facing the whole redemption from cash flow at maturity. Where a company fails to redeem the debentures on the date of maturity or to pay interest when it is due, the Tribunal may, on the application of any or all of the debenture holders or the debenture trustee, direct the company to redeem the debentures forthwith on payment of principal and interest due.

Question 15

Distinguish a shelf prospectus from a red herring prospectus, stating the validity or filing period of each and the additional document each requires.

Accepted Answer

The two solve different problems. A shelf prospectus addresses repeated issues by the same company: classes of companies prescribed by the Securities and Exchange Board of India may file a shelf prospectus with the Registrar at the stage of the first offer of securities, and no further prospectus is required in respect of a second or subsequent offer of securities included in that shelf prospectus issued during the period of its validity. Its validity is not more than one year commencing from the date of opening of the first offer of securities under it. The additional document it requires is an information memorandum, filed with the Registrar within the prescribed time before a second or subsequent offer, containing all material facts relating to new charges created, changes in the financial position of the company as have occurred between the first offer and the succeeding offer, and such other changes as may be prescribed; the shelf prospectus and the information memorandum together constitute the prospectus. A red herring prospectus addresses a different problem, that of pricing: it is a prospectus which does not include complete particulars of the quantum or price of the securities included in it, and it is used where the price is to be discovered through the book building process. It must be filed with the Registrar at least three days prior to the opening of the subscription list and the offer, and upon the closing of the offer a prospectus stating the total capital raised, the closing price of the securities and any other details not included in it must be filed with the Registrar and SEBI.

Practice — Prospectus, Share Capital and Debentures

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