Preferential Allotment of Securities- Uses And Abuses

INTRODUCTION

The functioning of a company today spans an array of mechanisms and procedures which legitimise its carrying out, and the way it performs. Be it incorporation or delegation of ownership in the form of distribution of shares, corporate law enables public or private companies to engage in various processes which help with its recognition and growth. This article deals with the issues faced by a company when it comes to securities and allotment of shares. Here, the term “securities” refers to any fungible, negotiable financial instrument with monetary value[1]. It reflects stock ownership in a publicly listed firm; a creditor connection with a public organisation or business indicated by holding that entity’s bond; or ownership rights represented by an option.

This paper primarily deals with the uses and abuses of these preferential allotment of securities, and shall highlight on how both these aspects directly or indirectly affect the functioning of the company.

SPECIFIC DISCUSSIONS

To understand preferential allotment, a stepwise approach is important to follow, where shall discuss how the process came about, what it refers to, its benefits and drawbacks, and the way it is used, and abused.

1. What is preferential allotment of securities?

A preferential issue is an issuance of shares or convertible securities to a chosen group of investors by a listed or unlisted company that is not an issue related to rights or the public. Based on people’s interest, preferential shares are allotted to people or companies at prices which are determined prior to allotment. Those securities or shares which are offered through an issuance to the public, employee stock option scheme, rights issue or bonus shares or sweat equity shares which are issued in a foreign country are not included in preferential allotment of securities. Any company can opt for preferential allotment of securities, be it private or public companies, listed or unlisted companies, under Section 8 of the Companies Act, 2013. Primarily three types of securities exist- those which provide ownership rights to holders(equity), those which provide loans paid with periodic payments(debt) and those which contain a mix of both providing ownership and loans, known as hybrids. Shareholders’ ownership stake in an entity (a business, partnership, or trust) is represented by equity securities, which are realised in the securities of the company of invested capital, which include both ordinary and preferred stock. Debt securities, include government and corporate bonds, certificates of deposit (CDs), and collateralised bonds (such as CDOs and CMOs). They generally entitle the holder to routine interest payment and principal repayment (regardless of the issuer’s performance), as well as any other contractual rights stipulated. Equity warrants, convertible bonds, and preference shares are examples of hybrid securities (company stocks whose payments of interest, dividends, or other returns of capital can be prioritised over those of other stockholders). The Securities and Exchange Commission is assigned the work of regulating the public sales of securities in India. This regulation acts as a check on the sale of securities in India.

Preferential share allotment is one of the most widely chosen approaches implemented by companies at present date. The purpose of doing so is that it has proven to be useful to companies as preferential allotment is one of the fastest ways to bring in capital into the company and increase overall share capital of the company. Since it is also free of a lot of documentation hassle, a lot of companies prefer preferential allotment of securities over the traditional methods. Additionally, this capital acquired by the company in the form of preferential allotment becomes an asset for the company instead of a liability. When a company raises capital in this way, it leads to increasing in the existing share capital amount of the company.

When investors and shareholders buy securities from the company as preferential shareholders, they automatically become stakeholders in the functioning of the company and that too at reasonable and moderate prices from that of other shareholders. This is because they can directly buy the preferential securities instead of wading into the stock market to buy larger shares. It can be considered as an incentive or a reward of sorts offered to them. These securities which are issued are fresh in nature and can be issued to employees, existing members, and additionally, outsiders as well. However, preferential allotment of securities can be made only in case of equity shares or for convertible securities, i.e. those shares which can be converted into equity shares. Also, one of its major limitation is that preferential allotment of securities can only be practised once a resolution in motion is passed by the existing shareholders of the company in majority. Hence, while it provides ease of access to new and existing shareholders in the company, it has certain procedural limitations which make preferential allotment a somewhat tedious process, even if it might be beneficial in the long run for the functioning of the company as a whole. It is also said that in case of preferential allotment of securities if the company is able to secure the equity participation of these preferential shareholders, it would bring immense capital into the company, since these preferential shareholders becomes assets of the company in the long run. The overall performance of the company in this case increases even more when veteran shareholders invest in the company as preferential shareholders.

2. What are the uses and benefits of preferential allotment of securities?

Preferential allotment of securities is related to allotting securities to shareholders of choice, which thereby creates an environment of trust between these buyers and the company offering them the shares. Since the treatment given to them itself is preferential and they have the benefit of buying securities at a moderate price over buying large shares at the stock market, the investment poured in by them in the company might be of a significant percentage. Preferential allotment can resolve issues of finance related to the company, as well as that of the economy, since one of the major problems in a lot of countries today is underinvestment[2].

Preferential allotment of securities is mostly in the interest of the shareholders, since they are the ones given preference. In case they wish to purchase shares at a moderate rate, they could approach the companies as preferential shareholders instead of approaching the stock markets and buying larger shares at higher prices. They usually are in benefit in this case inevitably compared to the market value of these common shares. Additionally, it is a benefit for the companies as well, since they can directly raise immense amounts of capital just from their preferred shareholders without risking any of its assets by approaching banks or other monetary agencies in the quest of taking loans.

The principal amount and dividend of preferential shareholders is always reserved. Even when in one fiscal year the company doesn’t pay the dividend to preferential shareholders, the dividend amount can be claimed by these shareholders in the approaching year. This acts as a financial shield for the preferential shareholders, wherein they can always ask for their dividend as per convenience of their own, as well as the company without any loss being claimed on their part due to the company’s inability to pay them in one particular financial year due to financial constraints or any other such reasons because of which the company would not be able to pay them their respective dividends. Additionally, preference shareholders are always at a priority for the company, and their principal amount is always safe. For example, even if the company goes bankrupt, it is always the preference shareholders who would be getting the first priority when it comes to claiming renumeration over any other ordinary shareholder. Preference shareholders are paid directly by the company with no brokerage cost involved in the process of transactions, which is not the same in case of ordinary shareholders. Such benefits put preference shareholders at a more advantageous position over others.

3. What are the disadvantages of preferential allotment of securities?

The primary concern of preferential shareholders is that even if they enjoy preferential treatment in a lot of aspects related to buying of shares and finances, they lack one of the major aspects of formation and functioning of a company, which is that they lack voting rights, which other shareholders ordinarily have. This makes the company not be liable to the preferential shareholders as much as to other common equity shareholders. Though the fixed returns on capital compensates for this weakness, if interest rates increase, the once-enticing fixed dividend may be reduced. Therefore, voting rights are of a lot of importance in the decisions taken by a company, which is not one of those rights enjoyed by preferential shareholders.

One of the advantages we have read about is that the company can abstain from paying dividends in one financial year and pay it cumulatively to the preferential shareholders in the next year, which might cause the company some financial relaxation. Although it might be beneficial to the company in monetary terms, etc. but it brings bad name and image of the company in the eyes of its investors, even if they are paid their cumulative dividend in the following year. Thus, it affects the image of the company indirectly, although it can reduce the financial constraint incurred by the company. Since this tarnishes the image of the company to a certain extent, when the company might apply ahead in the future for loan, it might affect the lender’s perception regarding the company’s history, which might lead to the lender not sanctioning the required amounts by the company.

There is a major concern over the credit worthiness of the company getting affected with the company distributing preferential allotment of securities. This is the case since in case of preferential allotment of shares, the company in a way hands over a lot of rights to these shareholders, which also includes rights over personal assets of the company. For example, when the company might go bankrupt, the preferential shareholders would not suffer losses, since the company had to hold them at priority over other shareholders and provide reimbursement.

Additionally, before the setting up of guidelines regarding preferential shares, companies used to set up price limits for allotment of preferential shares which were at an extraordinarily high price. These prices were financially very lucrative, following which minimum pricing limits and other guidelines had to be set up.

Preferential allotment of shares also allows elements to reap benefits which might otherwise not be welcome. For instance, promoters are known to have reaped benefits of these preferential shareholders to their personal benefit on multiple occasions. This denies the same rights to other otherwise interested shareholders who are genuine and deprives them of shareholding rights and keeps them somewhat at an inferior position than preferential shareholders.

4. What are the ways in which preferential allotment can be abused?

As per Section 81(A) of the Companies Act, 1956, there is a window for companies to initiate preferential allotment of shares by passing a single special resolution of shareholders. This can be done in compliance with the rules set down by the Securities and Exchange Board of India(SEBI) such as minimum pricing, disclosure and lock-in of shares allotted on preferential basis at the option of the shareholders desiring to seek listing on the Stock Exchange[3]. As per reports from the Press Information Bureau of India and SEBI, such preferential securities had been granted in exorbitant amounts to people living abroad, i.e. overseas citizens.

Mostly, the misuse of such provisions have been undertaken by promoters of companies in the past which is why the Vice President of ICICI Securities, Ravi Sardana in 2004 had talked about the evolving issue with examples[4]. He talks about how promoters have been prohibited in a lot of countries from voting in issues related to preferential allotment, since then they become the unsaid, but the biggest stakeholders in the company which makes an entire mockery of the process. It is an important decisions as per him, since the promoter is an interested party in this entire process, and keeping him at a position which is at his advantage is unfair to the other shareholders. There could be a number of ways to prevent this misuse of position by promoters or other such agents of the company. One of them could be that while issuing warrants rather than shares being rationalised in favour of providing the promoter more time to raise cash, the conversion might be made mandatory. This would illustrate the promoter’s dedication to his firm regardless of market fluctuations. Alternatively, the future conversion price might be tied to the existing market rate at the time of option execution. This would restrict the promoter’s earnings by matching the conversion price with the market price. Increasing the upfront payment and raising to a higher limit from the 10% that exists today could also yield positive results.

Thereby, the abuse of preferential allotment of securities can be manifold, but limitations to it can also be made, which have worked in the past. Companies adhering to SEBI guidelines can limit the ways in which the allotment of securities function, thereby reducing any sort of unfairness in preferential share allotment.

5. What are the key considerations during appointment of shares on a preferential basis?

The procedure to allotment of preferential shares is a lengthy one which involves a number of considerations before allotment by the company for willing shareholders, members and other outsiders who wish to invest in the company. For this purpose, the company has to ensure that:

a. At the time of allotment, all the equity shares which are to be accounted for should be ensured to have been fully paid up right at the time of allotment of the security concerned.

b. The company should hold an extraordinary general meeting, where the issue of rolling out preferential shares is discussed and all the shareholders consent their approval to passing the same, post which rolling out of preferential allotment of shares would be considered acceptable.

c. The issue of allotting Preferential shares has to be authorized under the Article of Association of the company.

d. The special resolution without which a call for preferential shares cannot be passed should have been approved by all the existing shareholders of the said company willing to roll out preferential shares.

e. All the proposed allottees have dematerialised their existing equity shares so as to avail the benefit of becoming preferential shareholders of the company.

f. The issuer has received the Permanent Account Numbers (PAN) of the intended allottees, with the exception of those allottees who may be exempted by the Board from declaring their PAN while trading in the securities market.

g. It also has to be noted that a person who has sold his equity shares 6 months prior to the issuance of the Preference shares cannot be included as a member in the preference shares list.

Considering all these notions, a company can move ahead with allotting preference shares to those willing to be preference shareholders of the company.

6. What is the impact of preferential allotment of securities on a company and its shareholders?

As mentioned above, there are various pros and cons to issuing preference shares by a company. While monetarily it can cause an umpteen amount of relaxation to the company by for example, delaying dividends which are to be paid to shareholders for a later date, to raising capital rapidly and without hassle, it can also harm the reputation of the company if these delays and other easing provisions are taken by the company for granted. A harm in reputation of the company might lead to issues later, wherein the company might face difficulties in getting loans sanctioned, and might have a loss in shareholder numbers.

While preference shares do not necessarily affect the ordinary shareholders of the company who already exist, it puts them at a somewhat disadvantageous position monetarily, since most of the monetary security benefit is reaped by those holding preference shares. For instance, if the company goes bankrupt, the first people it would cater to would be those holding preference shares, and not the ordinary shareholders of the company. Simultaneously, they also hold an upper hand over the preferential shareholders, since it is only the ordinary shareholders and not the preferential shareholders who hold the voting rights, which is a major discretionary power in deciding the fate and functioning of the company at large.

CONCLUSION

While there are both pros and cons of preferential allotment of securities, they can be extremely beneficial when it comes to financial ease for a company, since they can help the company garner capital at a rapid rate.

The abuses in case of preferential allotment of shares have mostly been practised by promoters, and one of the only ways to prevent the same is by checking the access promoters have in the company and like foreign countries, banning them from being a part of the voting process of preferential securities. Additionally, adhering to the new SEBI guidelines as stated above can be of much help, since SEBI has recognised this issue of abuse of preference securities since the early 2000s.

[1] Kenton W, “Security” (Investopedia February 8, 2022) <https://www.investopedia.com/terms/s/security.asp> accessed April 10, 2022

[2] “What Is Preferential Allotment?: Definition, Pros and Cons” (Ask Any Difference February 2, 2022) <https://askanydifference.com/what-is-preferential-allotment/> accessed April 10, 2022

[3]“Preferential Securities” (Latest releases) < https://archive.pib.gov.in/archive/releases98/lyr2002/rapr2002/04042002/r040420021.html> accessed April 10, 2022

[4] “Misusing Preferential Issues” (The Economic Times) <https://economictimes.indiatimes.com/misusing-preferential-issues/articleshow/1257541.cms>