This blog post is written by Ms. Ritu Sajnani, Senior Legal Counsel, Coinswitch, Ex-AZB & Partners and Cyril Amarchand Mangaldas.

Securities and their Issuance – Equity

Companies registered under the Companies Act, 2013 (“CA 2013”) have the choice to periodically meet their capital requirements by issuing a variety of instruments to their investors. “Securities” is the technical name for financial instruments that businesses offer to investors. Although the issuance of securities signifies an investor’s interest in the company, they are primarily a collection of rights and obligations that become due and payable to the investor either at the time of the issuance of the securities, upon the occurrence of certain events or the winding up of the company. 

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The capital table of the corporation may or may not change when the securities are offered to investors. The capital table is a structure that shows how much money has been invested in a company overall, broken down into the percentage of shares that each shareholder owns.

Investment into companies is generally in the form of an equity investment or debt investment. Equity instruments provide the investor with direct upside from the operations of the investee company, along with substantial control rights. On the other hand, debt investments provide investors downside protection, guaranteed returns and security against the sums advanced.

Let us give a brief background about Equity instruments.

I. Preference Shares:

The meaning of preference shares can be understood from the explanation in Section 43 of the CA 2013. A preference share is issued concerning the issued share capital of the issuer company limited by shares which carry or would carry a preferential right for payment of dividends and in the case of winding up of a company or repayment of capital.   

Prerequisites for issue 

The governing rules on the issuance of preference shares are the Companies (Share Capital and Debentures) Rules, 2014 (“Share Capital and Debenture Rules”).  A company may issue preference shares if it meets certain preconditions, as below:

1. Issuance of preference shares must be authorised by the Articles of Association (“AoA”) and Memorandum of Association (“MoA”) of the issuer company. If the AoA and MoA do not authorise the issue of preference shares, the issuer company must amend both constitutive documents.
2. Issuance of preference shares must be authorised by passing a special resolution in the general meeting of the issuer company. 

3. The issuer company at the time of such issue of preference shares shall not have subsisting default in:a) Redemption of preference shares; or
   b) Payment of any dividend due on any preference shares. 

4. A statement containing material facts concerning the special business to be transacted at the general meeting shall be annexed to the notice for such meeting.  According to the issuance of preferences shares, the statement that is annexed to the notice as mentioned above must set out the complete material facts concerned with the said issue as included below:a) size of the issue and number of preference shares to be issued and nominal value of each share;
   b) nature of such shares i.e. cumulative or non – cumulative, participating or non – participating, convertible or non – convertible;
   c) objectives of the issue;
   d) manner of issue of shares;
   e) price at which such shares are proposed to be issued;
   f) basis on which the price has been arrived at;
   g) terms of issue, including terms and rate of dividend on each share, etc.
   h) terms of redemption, including the tenure of redemption, redemption of shares at a premium and if the preference shares are convertible, the terms of conversion;
   i) manner and modes of redemption;
   j) current shareholding pattern of the issuer company; and
   k) expected dilution in equity share capital upon conversion of preference shares. 

(A) Issuance of preference shares for listed companies

This is guided by SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 and SEBI (Issue and Listing of Non-convertible Redeemable Preference Shares) Regulations, 2013. 

(B) Process of issuance of preference shares

Section 62(1)(c) of the Companies Act read with Rule 13 of the Share Capital and Debenture Rules provides for the issue of preference shares.

II. Equity Shares:

Section 43 of the CA 2013 lays down the scope and criteria governing the issuance of equity shares which is typical with voting rights or with differential rights as to dividend, voting or otherwise following such rules as may be prescribed. Equity share capital is issued in different ways as elucidated below:

a) Rights Issue

The issuance of equity shares through rights issues has been provided under Section 62(1)(a) of the CA 2013. This entails that people who are already equity shareholders in the issuer company are offered to purchase additional shares in proportion to their paid-up capital. 

b) Private Placement

The issuance of shares through private placement has been envisaged under section 42 of the CA 2013. The applicable rule for the private placement of shares is Rule 14 of Companies (Prospectus and Allotment of Securities) Rules, 2014 (“Prospectus and Allotment Rules”). Offer of shares can be made to a select group of persons by a company not exceeding 200 (two hundred) persons. 

c) Bonus Issue of Shares 

Bonus shares have been specified under Section 63 of the CA 2013. Bonus Shares are shares given to the existing shareholders in proportion to the number of shares they hold. They are additional shares given to the current shareholders. It is the further issue of shares by a company to its existing shareholders without any receipt of any consideration. Rule 14 of the Share Capital and Debenture Rules provides relevant information on the issuance of bonus shares. 

III. Mutual Funds:

A mutual fund is a type of financial vehicle made up of a pool of money collected from many investors to invest in securities such as stocks, bonds, money market instruments, and other assets. Mutual funds are operated by professional money managers, who allocate the fund’s assets and attempt to produce capital gains or income for the fund’s investors. A mutual fund’s portfolio is structured and maintained to match the investment objectives stated in its prospectus.

Mutual Funds in India are governed by the SEBI (Mutual Funds) Regulations, 1996.

IV. Exchange Traded Funds:

An exchange-traded fund (“ETF”) is a collection of securities-such as stocks-that tracks an underlying index. The best-known example is the SPDR S&P 500 ETF (SPY), which tracks the S&P 500 Index. ETFs can contain many types of investments, including stocks, commodities, bonds, or a mixture of investment types. An ETF is a marketable security, meaning, it has an associated price that allows it to be easily bought and sold.

ETFs are regulated under SEBI (Mutual Funds) Regulations, 1996. However, specific diversification norms for index funds and ETFs were circulated in January 2019.

V. Compulsory Convertible Debentures:

These are “deferred equity instruments” since after the maturity period has passed, they must be converted into equity shares. Due to their conversion from a debt (debenture) to an equity share, they are hybrid instruments and have features of both.

A corporation may issue Compulsory Convertible Debentures under Section 71(1) of the CA 2013. The Hon’ble Supreme Court stated that given the nature of these securities, “any instrument which is compulsorily convertible into shares is eventually recognised as equity and not as a loan or debt.”  On the other hand, under the RBI Guidelines, they are not treated as the Company’s share capital but rather as equity for all financial statements and records.

VI. Compulsory Convertible Preference Shares

They are the most popular option and most favoured by investors for two primary reasons.

• Preference shareholders receive the dividend first, and the set dividend amount provides them with more advantage

• In the event of a liquidation, the preferred shareholders have first claim to the venture’s assets under the waterfall process (Section 53 of the Insolvency and Bankruptcy Code, 2016).

Additionally, preference shares are converted to equity shares if the business is successful, enhancing the opportunity for capital development and profit retention for investors. The primary benefit of these shares is their conversion, which is based on the company’s success.