Conversion of different kinds of preference shares into equity is a well-recognized practice for Indian companies, and is specifically permitted under the Companies Act, 2013 (CA 2013). The reverse scenario involving conversion of equity into preference shares has been a bit of a thorny issue as there is no specific section under CA 2013 that expressly permits it. There are divergent views on why equity cannot be converted into preference. The predominant stance has been that conversion will lead to capital extinguishment, and consequently, the same can only be done through reduction of capital and court approval. On the other hand, it can be contended that conversion is a form of capital restructuring that does not equate to reduction as only the nature of share capital changes. without any financial outlay.
In a breakthrough amalgamation order that is likely to aid corporates in providing structured exit and increased flexibility in reorganising capital, the Mumbai bench of National Company Law Tribunal (NCLT) in the Scheme of Arrangement and Amalgamation of Protrans Supply Chain Management Private Limited and Ors. (Protrans Order) has taken a pro-business stance to allow conversion of equity into preference shares.
This post provides a summary of the facts and arguments advanced in Protrans Order, and analyses the legality of NCLT findings.
1. Facts: Protrans Supply Chain Management Private Limited and Ag-Vet Genetics Private Limited (collectively Transferor Cos) were engaged in business of transportation and logistics; and buying, selling and dealing in poultry, seeds and agricultural products, respectively. They were desirous of amalgamating with another company, Baramati Agro Limited (Transferee Co) that is engaged in the business of farming, agriculture, horticulture dairy, poultry, sugar and farm produce and other allied activities. The restructuring was aimed at pooling of resources and synergies, sustainability of operations, enhanced financial strength, reduction of business costs, diversification of portfolio, and achieving economies of scale. Accordingly, the parties submitted a joint petition for the scheme for arrangement and amalgamation under Sections 230 to 232 of CA 2013. Before proceeding further with the facts, an overview of the above Sections is below:
- 230: It empowers NCLT to direct or dispense with meetings of members and creditors, require disclosure of information, pass orders approving compromise or arrangement, prescribes notice related requirements to regulators and timeline for making representations. In context of arrangement, it states that arrangement includes a reorganisation of company’s share capital by consolidation of shares of different classes, or division into different classes, or by both methods.
- 231: This section deals with powers of NCLT to supervise implementation of approved schemes and enforce other related orders.
- 232: It provides for mergers and amalgamation, and essentially states that an arrangement could be in the form of merger or amalgamation pursuant to certain requirements inter alia including preparation of a detailed scheme that is approved by board of directors and filed with Registrar of Companies (ROC), preparing report on impact of the scheme on different stakeholders, valuation, and other aspects.
Transferee Co had 21,675 Class A Equity shareholders, of which 21,000 held small proportions. These small shareholders were regularly requesting for dividends and had also insisted on redemption of their investments within a fixed timeframe. In light of this, the scheme proposed conversion of certain Class A Equity Shares of Transferee Co into 9% non-cumulative optionally convertible redeemable preference shares of INR 10 each.
The scheme was duly approved through corporate resolutions, filed along with necessary paperwork, and undertaking was furnished by the parties that they would comply with all NCLT directions, CA 2013 and applicable accounting standards. As such the scheme was not objected to by any stakeholder (such as Official Liquidator, Income-tax department), except Pune ROC.
2. ROC’s objections: Pune ROC was of the view that the scheme was not prejudicial to shareholders’ and public interest, except the proposal for conversion. ROC in its report presented 2 main grounds against conversion: (i) conversion is not permissible as value, terms, and rights of equity shares were different than preference shares, and (ii) as shares are different, an equivalent conversion ratio for preference shares is not possible. Alongside, it made observations on certain filing non-compliances and mismatches in financial statements of Transferee Co. urging NCLT to consider all facts while approving the scheme. Interestingly, ROC did not cite the argument of conversion resulting in reduction of share capital.
3. Company submissions: The amalgamating companies contended Pune ROC’s stance to be unfounded under CA 2013 and submitted the following:
- Section 43 of CA 2013 recognises both equity and preference as part of company’s share capital, and when equity is converted into preference or vice versa, the value of the subscribed and paid-up capital do not undergo any change. The only change is that of nomenclature. This contention is not correct as there is more than mere nomenclature change because preference shareholders do have different rights and obligations than their equity counterparts.
- There is no provision in CA 2013 that stops conversion of shares from one type to other, and the Supreme Court has decided that unless an action is expressly prohibited under law, the same should be understood as permitted until proved otherwise
- A conversion from one kind to another is reorganisation of share capital which is expressly allowed under Section 61 of CA 2013. Section 61 allows companies to pass necessary resolutions for increasing authorised share capital, consolidation and division of existing shares into larger value shares, conversion of fully paid share to stock and vice versa, sub-division of existing shares to smaller amounts, and cancellation of shares, subject to authorisation in articles.
- Section 230 of CA 2013 allows a scheme of compromise or arrangement to be in the form of reorganisation of share capital, and thus, a scheme could comprise of increase, consolidation, sub-division, reduction or conversion of shares. In any event, arrangement has to be given wide scope as well settled in several cases.
- A view taken by a regulator is only reflecting the regulator’s interpretation of the law, and as such Pune ROC’s views are not binding on NCLT.
For other issues raised and specifically on mismatches on financial statements, the petitioner companies provided detailed clarifications on accounting treatment and underlying transactions, which were then acknowledged by the Regional Director in a subsequent document that was placed before NCLT.
4. NCLT ruling: NCLT ruled that taking into account the materials on record, amalgamating companies’ submissions and undertakings provided, the scheme was fair and reasonable and allowed the proposed conversion as part of the scheme. While NCLT did not provide a detailed analysis on merits of each argument, it had ease in giving a favourable order in light of the fact that no adverse observations or objections were raised by Official Liquidator or Income-Tax department plus all procedural compliances under CA 2013 were fulfilled. This approach of NCLT is in line with the limits of judicial review of restructuring schemes that has been settled through a series of judgments – a court shall not while deciding on a restructuring scheme sit in review of the business prudence of applicant companies and shareholders’ democracy, as long as the process is followed, and there is no prejudice to the interest of the company or its stakeholders. However, NCLT never opined on whether petitioner companies’ arguments on Section 43 and 61 were valid.
5. Analysis: It is important to note here that conversion from equity to preference does not involve a payment to shareholders as happens in the case of reduction or buy-back. Overall, the authorised, paid-up and subscribed capital remains same, but with necessary changes to the constituent number of equity and preference shares. In essence, from a particular data as decided by consensus, equity shareholders will have rights and obligations of preference shareholders. In scenarios where there are small shareholders who do not actively participate in company’s operations, their main interest lies in receiving dividends. They are often reluctant in exercising equity shareholder voting rights, or bearing the liability that comes with it. To this extent, perhaps, they would be better positioned, if they are provided with preference shares that comes with first rights on dividends and must be compulsorily redeemed within a certain timeframe. Bearing these practical situations in mind, it would not be incorrect to state that Pune ROC’s objections were based on a narrow interpretation of what Section 230 allows as an arrangement. It side lines settled jurisprudence that what is not directly or indirectly prohibited calls for a higher burden of proof to be ruled as impermissible, and this burden was not discharged in Protrans Order.
The scope of arrangement includes share capital reorganisation and Section 230 only provides an indicative list as it uses the term “includes” while illustrating some instances. This cannot be used to rule out all other possibilities of share capital reorganisation. In fact, in a 2013 Karnataka High Court decision, the court allowed conversion of equity shares into redeemable preference shares under a company application for reduction of share capital. Although this case was filed as reduction application (maybe because a key objection raised by ROCs is that conversion leads to reduction of equity capital), the court observed that there was no financial outlay, no impact on creditors’ interests and hence, permissible under law. Not just Section 230, but one could also rely on Section 61 to contend that conversion from equity to preference is a form of reorganisation that involves consolidation and division versus reduction of share capital (but this has to be based on facts of each case). Mere absence of an express permission for equity to preference conversion should not form the only basis for dismissing arrangement schemes that are otherwise fair, reasonable and not prejudicial to company or its stakeholder’s interests.
While the arguments of amalgamating companies draw strength from CA 2013 provisions and jurisprudence, it is important to note that the order may have taken a different course, if the process for preparing and approving schemes were not followed, or where the financial mismatches were not adequately explained, or if there were objections from creditors or regulators. Protrans Order is a positive step and should pave way for a shift in the approach towards conversion of equity into preference shares as a viable route for exit and a streamlined capital structure. But corporates must be mindful of the impact of schemes on members and creditors, take the overall scheme into consideration, and pay greater attention to follow the process for arrangements under CA 2013.
 In the matter of the Scheme of arrangement and Amalgamation of Protrans Supply Chain Management Private Limited and Ag-Vet Genetics Private Limited with Baramati Agro Limited and their respective shareholders, NCLT Mumbai Bench order dated September 20, 2021 in C.P. (CAA) 996/MB-II/2020 in C.A. (CAA) 1067/MB-II/2019 available at https://nclt.gov.in/gen_pdf.php?filepath=/Efile_Document/ncltdoc/casedoc/2709138039272020/04/Order-Challenge/04_order-Challange_004_16321378471266557070614872774cb8b.pdf (last accessed on Oct 28, 2021)
 Decision of the Supreme Court in Rajendra Prasad Gupta v. Prakash Chandra Mishra and Ors. in Civil Appeal No(s). 984 of 2006 decided on January 12, 2011available at https://main.sci.gov.in/jonew/judis/37364.pdf (last accessed on Oct 28, 2021)
 Decision of the Karnataka High Court in Company Petition No. 174 of 2013 filed by Smartplay Technologies (India) Private Limited dated November 29, 2013 available at http://judgmenthck.kar.nic.in/judgments/bitstream/123456789/913546/1/COP174-13-29-11-2013.pdf (last accessed on Oct 28, 2021)