Takeover code unclear on preference shares

WITHOUT CONTEMPT

Voting rights on preference shares are creating serious complications under the Sebi (Substantial Acquisition of Shares and Takeovers) Regulations, 1997 (takeover regulations).

The takeover regulations are primarily concerned with acquisition of equity shares since they carry voting rights. In 2002, the "Reconvened Bhagwati Committee" wanted to expressly exclude preference shares from the definition of the term "shares" for purposes of the takeover regulations, explaining that "preference shares normally do not carry voting rights."

The Companies Act, 1956, which provides for two broad types of share capital"�equity and preference"�sets out circumstances in which preference shares too carry voting rights. Under the Act, preference shares are shares that entitle the holder to a "preference right" to dividend and to liquidation proceeds. All other shares are equity shares.

In other words, when the company makes profits, it is the preference shareholder who first gets paid the contracted rate of dividend. The equity shareholder is paid later. Similarly, when a company is wound up, the preference shareholder has a preference over the equity shareholder in the queue for distribution of residual assets after the discharge of all liabilities.

However, normally, only equity shares have voting power. Yet, should the dividend due on preference shares remain unpaid for the time periods specified in Section 87(2)(b) of the Act, preference shareholders too get a right to vote on every resolution of the company.

Such voting power on preference shares would be proportionate to the paid-up face value of the preference share capital as compared with the paid-up face value of the equity share capital. In other words, the voting power of the equity shareholders would automatically erode to make room for the preference shareholders.

Despite the Bhagwati Committee recommendation to expressly exclude preference shares from the definition of "shares" having been accepted, (the committee report even notes that in special circumstances, voting rights do arise), acquirers are now being forced to include voting power on preference shares within the scope of equity shares for purposes of takeover regulations.

To begin with, the voting power on preference shares springs up involuntarily, once the arrears on dividend payment cross the stipulated timelines. Of course, a secondary purchase of preference shares on which voting power has already accrued would be a positive voluntary act, but the takeover regulations are not structured to dealing with even that situation.

If the regulator were to force preference shareholders who involuntarily get voting rights to make an open offer, it would be unfair "� the imposition of a pecuniary obligation on a person whose dividend is not paid, to fork out even more funds to buy additional shares in that very defaulter company.

Moreover, it ought to be remembered that no sooner than the company pays dividend, the voting power would automatically vanish. This is no parallel with forcing an open offer on purchase of equity shares, since there is no scope for voting power on equity shares to vanish involuntarily.

The takeover regulations mandate the open offer to be for "twenty per cent of the voting capital of the company". However, even if one were to make an open offer upon accrual of voting rights on preference shares, there is no clarity on what the offer should be for "�proportionate number of voting preference shares, or even more equity shares.

Worse, when the voting power on preference shares gets extinguished upon payment of dividend, the voting power of the equity shareholders would involuntarily increase again. If an involuntary accrual of voting power on preference shares were to trigger an open offer, so would an involuntary increase in the equity shareholders' voting power. All of this would lead to an unhealthy disorder with frequent open offers being announced for shares of the company.

The conspiracy theorists would of course argue that companies could deliberately default on dividend to confer voting power on preference shareholders.

That would amount to cutting the nose to spite the face. Companies would have to consistently post losses to ensure that there is no dividend, or default on dividend despite profits, leaving even the equity shareholders high and dry. In either case, no one would touch such companies. Besides, the takeover regulations adequately empower Sebi to act against any such contrivance.

The Act now provides for differential voting rights even on equity shares. However, the rules for such issuance are quite unworkable. But if cleaned up, a further range of issues would arise.

The Indian market has indeed moved away from an era of cynicism to an era of compliance. The consequences of a default under securities laws are getting increasingly dreadful. There is an urgent need for clarity.

(The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own)