Proceed with Caution: Evaluating Rights and Risks under Indian Law before Swapping Operational Debt for Preference Shares

Much remains unexplored regarding the position and rights of preference shareholders in companies during the 'twilight zone'. The twilight zone is when a company is considered highly likely to be insolvent but has yet to initiate the insolvency procedure. In the twilight period, Indian companies may issue restructured preference shares (RPS) in exchange for operational debt, raising questions regarding the status of RPS.

Recently, the National Company Law Tribunal (NCLT), in EPC v. Matix, deliberated whether preference shareholders are ‘financial creditors’ under the Insolvency and Bankruptcy Code 2016 (IBC). In this case, EPC asserted a default claim against Matix, regarding, first, the non-redemption of cumulative redeemable preference shares (CRPS) initially issued as part of an agreed restructuring and subscribed through the conversion of operational debt, and, second, the non-payment of dividends. Matix cited its vulnerable economic condition and accumulated losses to justify the absence of dividend payments and redemption of the CRPS.

EPC claimed that it qualified as ‘financial creditor’, and had the right to initiate insolvency proceedings against Matix and participate in the committee of creditors and vote on a resolution plan. The NCLT rejected these arguments and ruled that preference shareholders should not be considered financial creditors under the IBC.

In my opinion, the NCLT's decision is accurate as a matter of Indian law. The NCLT referred to the definition provided under the (Indian) Companies Act, 2013 (CA), as there is no definition of preference shares in the IBC. The CA establishes that preference shareholders take precedence in dividend payment and capital redemption over ordinary shareholders. The NCLT concluded that RPS does not result from lending transactions and hence does not qualify as financial debt. While relying on established precedents, the order states that redeemable preference shares, including CRPS, do not qualify as financial debt since redemption is only permissible where the company has enough profits or issues new redeemable shares. Further, CRPS allows investors to receive accumulated dividends. CRPS is an investment in shares rather than debt.

Even though the NCLT's decision is not surprising and reiterates the established norm that preference shareholders are shareholders and not creditors, such finding is a bitter pill to ingest for RPS holders, especially operational creditors contemplating the conversion of operational debt into redeemable preference shares during the twilight period. Hence, it is important analyse the position of preference shareholders under the Indian Law.

The CA allows companies to issue preference shares that carry preferential income and capital rights. As a matter of commercial practice, preference shares provide the holder with a higher rate of preferential dividends and capital returns, with no participation rights in business decisions except on matters that affect them. In this context, the flexibility for customization and the higher rate of dividends are notable aspects of holding preference shares, making it look slightly similar to creditors. The IBC, in its text, mentions preference shareholders only once in the waterfall mechanism, one step above equity shareholders where the committee of creditors opts for liquidation. This is rightly so, since the preference shareholders have no rights except to receive payments from the liquidation of assets decided by the committee of creditors under the IBC. Insolvency law does not grant any more rights to preference shareholders.

It is a prevalent practice in India to restructure operational debt into redeemable preference shares during the twilight period, with the consent of operational creditors. The most noteworthy advantage of being a preferred shareholder compared to other restructuring outcomes is the potential for a high dividend rate. Dividend declaration is a discretionary power of the board of directors of issuing company. In practice, distressed corporate debtors may opt not to pay dividends or redeem preference shares since there is no right or remedy available against the issuing company for non declaration of dividend under the CA. Hence, deliberate non declaration of dividends undermines the primary purpose of issuing preference shares in exchange of operational debt. .

Consequently, even the most significant benefit of holding preference shares may remain unrealized in situations of distress. The corporate debtor could mindfully exploit the discretion for declaring dividends and the perceived limited recourse available to preference shareholders, as the laws do not differentiate between RPS holders and ordinary preference shareholders. Under Indian Law, preference shareholders have the right to vote on all resolutions if the dividends are declared and not paid for a period of two years. But this right is of no use if the issuing company does not declare dividends in the first place.

Preference shareholders have no right in insolvency procedure under the IBC except in liquidation.    Under the IBC, creditors have a better say than shareholders. Therefore, operational creditors find themselves in a worse situation than in the absence of the preceding restructuring. In addition, the CA provides that more preference shares may be issued to preference shareholders in exchange for non-redemption of already issued preference shares. It is unrealistic to expect that the preference shares issued to the benefit of RPS opting for non-redemption would be paid. 

In light of the above weak company law and insolvency rights available to preference shareholders, the conversion of debt into preference shares during the twilight period often becomes a promise for a promise without genuine intent to pay, necessitating a more cautious approach to be taken by operational creditors before restructuring operational debt into preferential share capital.

Anand Shrivas is Assistant Professor of Law at Vinayaka Mission’s Law School Chennai