[By Manvi Sahni]
The author is a student of National Law School of India University, Bangalore.
Introduction
On 23 February 2024, MIH Edtech Investments B.V (“MIH”) and other investors filed a petition under Section 241 and Section 242 of the Companies Act, 2013 (“the Act”) against Think and Learn Private Limited (“T&L”) and its directors, alleging oppression and mismanagement. This was claimed on the ground of several corporate governance violations such as unreasonable delay in completion of R1’s statutory audit, regulatory probes by the Ministry of Corporate Affairs and Enforcement Directorate, and serious allegations of siphoning of funds (para 5).
The petition also sought an interim stay on the operation of a Letter of Offer for rights issue of shares, which refers to issue of further shares by a company to its existing equity shareholders in order to increase its subscribed capital. This was done because the petitioners claimed that allotment of shares under rights issue should not occur until an Extraordinary General Meeting is conducted where all the modalities regarding the rights issue, such as purpose behind it and subsequently utilisation of funds raised, are decided. The National Company Law Tribunal (“NCLT”) issued an order preventing any allotment of shares without increasing the authorised share capital (para 11). Despite this, the respondents proceeded with allotment of shares under the first rights issue and proposed a second rights issue. This led to an appeal before the Karnataka High Court, which remanded the matter to the NCLT while temporarily restraining the respondents from further allotting shares (para 6.4).
As the NCLT’s adjudication on the rights issue is pending, this paper argues that the NCLT was justified in staying the second rights issue and maintaining the status quo of shareholding until the case is resolved. To this end, it first, analyses how the first rights issue has violated Section 62 of the Act. This has been illustrated by contesting T&L’s submission stating that preference shares are included within the scope of Section 62(1)(a) and in turn highlighting the non-passing of a special resolution in the present case for issuing of further shares on a preferential basis. Second, it examines how the respondents’ conduct is oppressive to the petitioners as per the standard proposed in Needle Industries (India) Ltd. v. Needle Industries Newey (India) Holding Ltd., thereby substantiating their claim of oppression and mismanagement under Section 241.
Violation of Scheme of Section 62 due to Preferential Allotment of Shares
This section aims to highlight how the respondents have violated the conditions specified in Section 62 of the Act and thus, the allotment of shares under the first rights issue must be set aside. To this end, this article first, establishes how the respondents are legally incorrect in claiming that preference shareholders are included within the ambit of Section 62(1)(a). Second, it argues that the non-passing of a special resolution in the present case is violative of the scheme outlined in Section 62(1)(c).
Non-inclusion of Preferential Shareholders within Section 62(1)(a)
Section 62 of the Act provides for stipulations that are to be followed when a company proposes to increase its subscribed capital through issue of further shares. In this context, the respondents argued that Section 62(1)(a) has not been violated by issuing further shares to preference shareholders as this section does not expressly bar preference shareholders from participating in rights issue (para 11). They relied on Article 43 of the Articles of Association (“AoA”), along with a Shareholders Agreement, to argue that T&L had also permitted its preference shareholders to participate in the rights issue under Section 62(1)(a) (para 11). According to the NCLT Order dated 27.02.2024, no extension was granted with respect to closure date of first rights issue (para 11). The implication of this argument then would be that if the shareholders decline to subscribe to additional shares, directors could use their discretion under Section 62(1)(a)(iii) to allocate unsubscribed shares on a preferential basis, even to preference shareholders.
This argument is not legally sound because, firstly, the language of Section 62(1)(a) expressly provides that further issues of shares shall be offered to all ‘equity shareholders’. This is relevant as Section 43 of the Act creates a distinction between ‘equity capital’ and ‘preference capital’ as preference shareholders are entitled to preferential rights in context of payment of dividend and repayment in cases of winding up. Additionally, Section 62(1)(c) permits the issue of further shares to anyone, whether an equity shareholder or not, only if authorised by a special resolution. Upon comparing this with the language of Section 62(1)(a), the explicit mention of ‘holders of equity shares’, and not ‘shareholders’, in the latter indicates towards the legislative intention to exclude preference shareholders from the scope of Section 62(1)(c) and to provide for issue of shares to preferential shareholders under Section 62(1)(c). Hence, the respondents cannot be permitted to circumvent the requirement of a special resolution in Section 62(1)(c) by including preference shareholders under Section 62(1)(a).
Secondly, Section 6 of the Act states that the provisions of the Act will override the AoA, in case of a conflict. In the present case, Article 43 of the AoA, by including preference shareholders under Section 62(1)(a), contradicts the scheme of Section 62. Hence, since Section 62 will override Article 43 of the AoA, hence in the present case, preference shareholders are not included within Section 62(1)(a).
Therefore, the rights issue in question by T&L is liable to be set aside as preference shareholders are not included in the scope of Section 62(1)(a) of the Act.
Non-passing of Special Resolution
Section 62(1)(c) provides that further shares shall be offered to any person, if authorised by a special resolution. This qualifies as a preferential offer, which refers to issue of shares by a company to select persons or group of persons on a preferential basis, as defined in Rule 13 of the Companies (Share Capital and Debentures) Rules 2014. It specifically excludes scenarios where shares are offered through public issue, rights issue, or employee stock option scheme.
In the present case, no special resolution was passed to authorise issue of further shares on a preferential basis. This implies that allotment of shares to specific individuals occurred without the consensus of the general body. Additionally, as held in Rachakonda Kumar v. Zetatek Engineering Systems Pvt. Ltd., preferential allotment of shares, in the absence of a special resolution, is oppressive to shareholders under Section 241 (para 34-35). Therefore, in this scenario, further issue of shares under Section 62(1)(c) is not viable, and allotment of shares is liable to be set aside.
Thus, the scheme of Section 62 suggests that NCLT was justified in staying the second rights issue, thereby maintaining status quo with respect to the shareholding pattern of T&L.
Finding of Oppression and Mismanagement under Section 241
Section 241 permits members to file complaints for oppression and mismanagement. In Needle Industries, the SC interpreted ‘oppression’ and propounded that a conduct is oppressive if it: “lacks in probity, is unfair to the member, and causes prejudice to the member in the exercise of their legal and proprietary right as a shareholder” (para 52). This inquiry depends upon the facts of every case. In this section, this paper argues that the respondents’ conduct, in the present case, would qualify as oppressive under Section 241 based on the test propounded in Needle Industries.
Lack of Probity
The standard for ‘lack of probity’ involves unfair abuse of power and loss of trust in management of the company, as distinguished from mere resentment by the minority shareholders (para 49). In the present case, the respondents’ conduct lacked probity on two grounds. Firstly, the respondents tried to circumvent the procedural requirement of a special resolution under Section 62(1)(c) by trying to include ‘preference shareholders’ within the scope of Section 62(1)(a). Secondly, no clarity was provided to petitioners regarding the purpose behind further issue of shares (para 8). It is the fiduciary duty of the directors to the shareholders to issue further shares for a proper purpose and in the interest of the company. Amid allegations and investigations of fund siphoning, the concerns regarding lawful utilisation of proceeds from the rights issue are justified.
Thus, this lack of transparency, coupled with the failure to pass a special resolution, could reflect a mala fide intention on part of the respondents.
Unfairness in the Respondents’ Conduct
The respondents’ conduct has been unfair to the petitioners as the decision of a few directors regarding preferential issue of further shares, without passing a special resolution, would impose external transaction costs on other equity shareholders. External costs have been defined as transaction costs that are imposed on individuals due to actions of others, without taking the individual’s consent.1 In the present case, external costs are being imposed on other existing equity shareholders as they have not consented to a reduction of their shareholding. Thus, they may unwillingly face dilution of their ownership and voting power, thereby decreasing the value of their shares.
Additionally, even if the respondents argue that they have complied with the procedural requirements specified under Section 62(1)(a) by sending letter of offer to all shareholders, this would not qualify as sufficient fulfilment of their obligation.2 This is because the board of directors has not been forthcoming with the shareholders about the purpose behind increasing the subscribed capital (para 8). This coerces the petitioners to either participate in the rights issue in a non-transparent manner, or face potential dilution of their shareholding, thereby not qualifying as a real choice. This can be substantiated by the petitioners’ submissions in the NCLT Order dated 27 February 2024, stating that if the NCLT permits the respondents to go ahead with the first rights issue, then the petitioners stand to face a drastic reduction in shareholding from 24.5% to 2.5%, in case they do not subscribe (para 5).
Thus, the present allotment of shares will benefit only select individuals (such as the promoters and directors), while the expense of the same would be borne by other equity shareholders.
Prejudicial to Shareholders’ Exercise of Proprietary Right
Property entitlements are defined by Prof. Guido Calabresi and A. Douglas Melamed as rights that can be removed from their holder only when someone buys them through a voluntary transaction, where the value of the entitlement is agreed upon by the holder (pg.1092). These holders are entitled to all rights associated with such entitlements.
Rights of shareholders under Section 62 constitute ‘property entitlements’. Under Section 62(1)(a), all equity shareholders have a right to be offered further shares, proportional to their shareholding. This is a property entitlement as shareholders are entitled to it on account of being owners of equity shares in the company. Thus, shareholders have the right to decide whether they wish to maintain their proportional ownership.
Preferential issue of further shares under Section 62(1)(c), without passing a special resolution, violates this property entitlement. The special resolution requirement safeguards the shareholders against deviations from the norm of ‘proportional issue of shares’. By bypassing it, the respondents have unilaterally altered the petitioners’ proprietary rights, risking dilution of their ownership and control in T&L.
Therefore, this paper argues that the respondents’ conduct in the present case is oppressive to the petitioners under Section 241.
Conclusion
This paper argues that the NCLT must stay the second rights issue and ensure status quo with respect to current shareholding. This is because the rights issue initiated by T&L is violative of the scheme of Section 62 as firstly, preference shareholders are not included within the scope rights issue under Section 62(1)(a), and secondly, further shares cannot be allotted to preference shareholders due to non-passing of a special resolution. Further, the conduct of the respondents is oppressive to the petitioners under Section 241 as it lacks probity, unfairly imposes external costs on the shareholders, and prejudicially affects their proprietary rights under Section 62. Thus, the present case illustrates that violation of the scheme for rights issue under Section 62 can constitute grounds for oppression and mismanagement under Section 241. Additionally, the rationale illustrated in this article should constitute as guidance for courts in the future when adjudicating similar petitions.