Unsecured loans advanced could be adjusted against allotment of shares in the rights issue

In a recent order dated 6 June, 2011 (SRM Energy Limited v. SEBI, Appeal No. 34 of 2011) (SRM Case), the  Securities Appellate Tribunal (SAT) set aside the Securities and Exchange Board of India (SEBI) order and allowed an appeal with a verdict that the unsecured loans can be adjusted against the allotment of shares in the rights issue.

In the SRM case’s scheme of things:

·         SEPL (a promoter of SRM Energy Limited) as on 31 December, 2010 had lent Rs. 4160.89 lacs of unsecured loan to SRM Energy Limited. 

·         On 13 August, 2010, shareholders of SRM Energy Limited passed a unanimous resolution through postal ballot approving the rights issue.  SEPL, was holding 71.19 % shares of SRM Energy Limited on the date of the right sissue, its entitlement in that issue worked out to 4,19,25,000 shares amounting to Rs. 4192.50 lacs.

·         SEPL by its letter dated 13 August, 2010 authorised SRM Energy Limited to adjust the unsecured loans provided to it towards its entitlement in the proposed rights issue (this was done based on the oral understanding between the parties).

·         SEBI objected to this arrangement and ordered that condition so section 81(3) of the Companies Act, 1956 (the Companies Act) should be strictly met.

Interpretation of section 81 of the Companies Act

SAT ordered that:  A bare reading of section 81 (1) makes it clear that when it is proposed to increase the subscribed capital of a company by allotment of further shares, the normal rule referred to therein needs to be followed.  The normal rule is that further shares must be offered to the existing body of shareholders of the company in the same proportion in which they already hold shares of the company.  The underlying object of this normal rule is to maintain the balance of voting rights and control in the company.  It is for this reason that section 81(1) mandatorily requires that further shares shall be offered to the existing shareholders in the same proportion to the capital paid up on these on the date of offer.  Section 81(1A), carves out an exception to the aforesaid normal rule and enables the company to offer further shares to a chosen few who may or may not be its shareholders.  When offer is made to this select group of persons, the section requires, as a condition precedent, that the general body of the shareholders must pass a special resolution in a general meeting authorizing and permitting the said allotment.  A special resolution is one which is passed by a majority of three fourth shareholders.  The underlying objective of this requirement is that the shareholders who are going to waive their right and entitlement to such further shares must agree to do so and if three fourth of them agree, that decision would bind the entire body of the shareholders.  It is pertinent to note that when the normal rule as aforesaid is resorted to, there is no requirement for the shareholders to pass any resolution, special or otherwise, because none of them is going to be deprived of the further allotment.  It is only when the company decides to deprive them of the further allotment that a resolution from them is required.

The opening words of section 81(3) makes it clear that cases which fall under this provision shall not be governed by section 81(1) and section 81(1A).  A reading of this provision makes it clear that it carves out yet another category/ exception for a preferential allotment to which section 81(1) and section 81(1A) shall not apply.  Section 81(3) would apply where a company has raised loans or issued debentures and these loans/ debentures have a stipulation attached thereto that the lender will be entitled to exercise an option to convert these loans/debentures into shares or subscribe to the shares of the company.  The proviso then imposes further restriction requiring the terms of the loan to be approved by the Central Government before the raising of the loan or such terms have to be in conformity with the rules made by the Central Government in that behalf and if the loan has been obtained from a person other than the government or a specified institution a special resolution approving the same has to be passed by the company in a general meeting before the loan is raised.

SAT’s decision

“The unsecured loans were payable on demand and SEPL could have demanded from the appellant the immediate return of those loans and then paid the money back to it towards the price of the shares allotted to SEPL in the rights issue.  It did not go through this ritual and instead, requested the appellant to adjust the amount of unsecured loans towards the price of shares allotted to it.  In other words, SEPL requested and made payment to the appellant by adjustment in the books of accounts.  Payment by adjustment in the books of account is a well-recognized mode by all accounting standards and we find no fault with this mode being adopted…In the strict sense of terms, it is not a conversion of a loan into equity.”

Takeaways for Capital Markets lawyers

·         There is no requirement to pass a special resolution for further issue of shares under section 81(1) of the Companies Act.

·         While drafting a rights issue offer document, in ‘objects of the issue’ section, following may be inserted-

Our Company intends to utilize the proceeds of the Issue towards repayment/adjustment of the unsecured loan forwarded to us by [name of the lender].

·         If a company has taken any loan, following may be inserted in the rights issue letter of offer:

Out of the total Rights entitlement of [●] Equity Shares amounting to Rs. [●], our promoter company/lender’s name [●], has, till [●], extended [●]as interest free unsecured loan (depends on the terms of issuance of loan) which has been utilized for [●]and meeting a part of the issue expenses. This amount will be fully adjusted against their entitlement/ additional subscription in the proposed Right issue.

I would like to put a caveat here; this order of SAT is appealed by SEBI in the Supreme Court and the above holds good only, if not reversed by the Supreme Court.