Cos Act, 2013: Capital issuance Regulatory Overkill?

By: Manvinder Singh, Partner, J. Sagar Associates

The Companies Act, 2013 (CA 13) affects the everyday life of more than 1.3 million corporate citizens registered in India. It is the principal business legislation and is, therefore, supposed to be simple, comprehensible and predictable.  But the zest for excessive regulation shown by the legislature and the Ministry of Corporate Affairs (MCA) seems to have defeated this purpose.  CA 13 has failed to distinguish between the big fish and a small fry.  While large public listed companies have the resources, means and a legitimate purpose in complying with complex laws due to higher public interest, it doesn’t seem to serve much purpose in subjecting the time and resources of small start-ups towards compliance of non-intuitive and complex laws.  Unless legislature is looking for a ‘gotcha moment’ at the cost of such small businesses, there’s really no need to seek heavy compliance from small companies.

For instance, further issuance of capital by private companies has become overly complex and cumbersome. CA 13 has imposed restrictions on the kind of instruments that may be issued by a private company for raising capital.  A company may issue equity shares with voting rights, equity shares with differential voting rights (DVR’s) or preference shares that do not carry any voting rights except under specific circumstances. For issuing DVR’s, a company is required to comply with stringent conditions including a consistent track record of dividend paying capacity for last 3 years. It may not be possible for small start-ups to comply with such conditions.  Under the Companies Act, 1956, none of these provisions relating to private placement were applicable to private companies. With the commencement of CA 13, if a promoter of a start-up proposes to raise capital for the private company from a private equity (PE) investor, the promoter may need to dilute his voting powers in the private company  except where the PE investor is content solely with the preferential right to repayment of capital in the event of liquidation with no voting rights in the company. The aforesaid limitations in structuring options for raising capital by companies does not seem to be a progressive step in the right direction.      

Further, CA 13 prescribes only two modes of raising capital viz. the rights issue to existing shareholders, and preferential allotment through private placement. So unless the existing shareholders have the means to put additional funds through a rights issue, the company will be required adhere to stringent norms for issuing further shares to a new shareholder. The same stringent conditions for issuing further shares will apply even if the new shareholder is the spouse, relative, friend or partner of the existing shareholder.  The rules provide that the price for issuance of shares is to be necessarily determined by a registered valuer. Also, if the convertible instruments are being issued, the price of resultant shares are also required to be determined beforehand based on the valuation report. Much against the literal interpretation of the aforesaid rules, the  popular or more reasonable view is that the aforesaid rules do not prescribe ‘the fixed price’ for issuance of shares but prescribe the ‘minimum price’ for issuance of shares based on the valuation report.    

Other important requirements for issuance of new shares under the rules prescribed by MCA include the minimum size of offer (viz. the face value of shares offered per investor cannot be lower than Rs. 20,000); requirement to issue shares within 60 days of receipt of share application money; and deposit of share application money in a separate bank account till issuance of further shares. 

The above requirements are markedly more stringent compared to those prescribed by Securities and Exchange Board of India (SEBI) for public issue of shares and those prescribed by Reserve Bank of India (RBI) for issuance of shares to non-residents.  SEBI does not prescribe a fixed price for the shares even for public offers.  The minimum application value prescribed by SEBI is between Rs. 10,000 to 15,000 and that includes not just the face value of the shares but also the premium payable on such shares. It is difficult to understand as to why MCA is being more restrictive and prescriptive than SEBI on such matters. 

RBI allows determination of minimum price for issuance of equity shares through discounted cash flow (DCF) method of valuation. Further, in case of convertible instruments, the formula for conversion into shares is required to pre-determined.  No-where does the RBI prescribe the determination of fixed price as required under the rules promulgated under CA 13. It would be a precarious situation, if the price determined by following DCF methodology is different from the price determined under CA 13 rules (which seem to recognise prevalent widely acceptable method of valuation), especially in case of industries with long gestation period. Also, RBI allows 180 days for issuance of new shares post the receipt of share application money as against 60 days permitted under CA 13 rules. While the objectives of SEBI and RBI for laying down the norms are predictable, the objective of MCA to come up with such stringent norms is hard to fathom.  

The stricter norms seem to be suffering from the bias of well-publicised cases of private placement of securities to large number of known and unknown investors by certain tainted promoters. However, it has made the life of a small entrepreneur proposing to issue new shares to his relative or a single PE investor, extremely difficult.  Interestingly, nothing stops the existing shareholders to transfer part of their shares to a third party, post which the company may come up with the rights issue.  None of the aforesaid restrictions relating to valuation etc. apply to a rights issue.  In view of the regulatory overkill, it may not be surprising to find private companies trying to structure the further issuance of shares as rights issue, and thereby defeating the spirit of law, while complying with the letter.