Rights Issue – Is the Board’s Discretion to Allot Unsubscribed Shares Absolute?


Rights issue, as the term denotes, is the recognition of an inherent right of an equity shareholder against dilution of his shareholding in the company. It is a pre-emptive right of the equity shareholder to subscribe to his proportionate share in all further issuance of equity shares.

Often, the companies are in urgent need of funds to expand their business operations. In such situations, where time is of the essence in raising capital, undertaking a rights issue of shares is a convenient, speedy, and relatively easier route. Section 62 of the Companies Act, 2013 (“the Act”) governs the framework for rights issue of shares. Section 62 of the Act substantially continues the earlier regime contained in Section 81 of the Companies Act, 1956 (“1956 Act”), but with some crucial changes. The law laid down by the Supreme Court (“SC”) in various judicial pronouncements on the earlier law remains unaffected to a large extent.

Undertaking a rights issue, as compared to raising capital by a preferential allotment or a private placement of securities, provides two other advantages to the company. First, unlike a private placement or a preferential allotment, a rights issue does not require shareholder approval by a special resolution. Second, the Board has an absolute discretion in determining the price of the securities, which need not be determined on the basis of a valuation undertaken by a registered valuer.

On the other hand, a private placement or a preferential allotment of securities must comply with the pricing guidelines specified in the Companies (Prospectus and Allotment of Securities) Rules, 2014 (“PAS Rules”) and the Companies (Share Capital and Debentures) Rules, 2014 (“Share Capital Rules”). Listed companies going for a private placement/ preferential allotment should additionally comply with the pricing guidelines specified in the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.

Legal framework under Section 62(1)(a) of the Act

According to Section 62(1)(a) of the Act, when a company proposes to increase its subscribed capital by the issue of further shares, then such shares shall be offered to equity shareholders of the company in proportion to the paid-up share capital by sending a letter of offer, subject to the following conditions:

  • the offer should specify the number of shares offered, and the acceptance period of the same should be 15 to 30 (fifteen to thirty) days. If the offer is not accepted within this period, it shall be deemed to have been declined.
  • Unless the company’s articles provide otherwise, the offer shall be deemed to include a right of renunciation.
  • After the expiry of the time specified in the notice, or on receipt of an earlier intimation from the person that he declines to accept the shares offered, the Board may dispose of the shares in a manner which is not dis-advantageous to the shareholders and the company.

The conditions specified in Section 62(1)(a) are exhaustive in nature, and a rights issue can be undertaken without obtaining prior approval of the shareholders. However, it is pertinent to note that in accordance with Section 179(3)(c) of the Act, a rights issue can be undertaken only after obtaining approval of the Board, by a resolution passed at a Board Meeting.

Landmark judicial pronouncements

The principles relating to the Board’s power to undertake a rights issue has been enshrined in landmark decisions of the SC, in the cases of Nanalal Zaver v. Bombay Life Assurance Company[1] (“Nanalal Zaver”) and Needle Industries (India) Ltd v. Needle Industries Newey (India) Holding Ltd[2] (“Needle Industries”). In the Nanalal Zaver case, the validity of the rights issue was challenged on the ground that it was not made for the benefit of the company; instead the objective was to retain control over the affairs of the company. The SC held that if the power to issue further shares is exercised by the directors not for the benefit of the company, but simply and solely for their personal aggrandisement, and to the detriment of the company, the court will prevent the directors from doing so. But, if the directors exercise their power for the benefit of the company, and at the same time have a subsidiary motive which does not affect the interests of the company or the existing shareholders – there shall be no basis for the Court to interfere.

This principle was reiterated in the Needle Industries case, which held that the test to be applied is whether the “issue of shares is simply or solely for the benefit of the directors.”  If the shares are issued in the larger interest of the company, the decision to issue shares cannot be invalidated on the ground that it has incidentally benefited the directors, in their capacity as shareholders. Further, if the directors incidentally succeed in maintaining their control over the company by virtue of the rights issue, this does not amount to an abuse of their fiduciary power.

Allotment of unsubscribed shares to a third party vis-à-vis private placement

Section 62(1)(a)(iii) of the Act provides that the Board of a company may dispose the unsubscribed shares in a manner that is ‘not dis-advantageous to the shareholders and the company’. Notably, under Section 81(1)(d) of the 1956 Act (which corresponds to Section 62(1)(a)(iii) of the Act), the directors were authorised to dispose unsubscribed rights issue shares “in such manner as they think most beneficial to the company.” While there has been no rationale provided under the ‘Notes on Clauses’ of the Companies Bills or the Parliamentary Standing Committee Reports on why the change has been made from ‘most beneficial’ to ‘not dis-advantageous’, in the view of the authors, the implication of this change is quite notable.

Determination of what is most beneficial to the company accords a wider power on the Board, whereas determination of what is not dis-advantageous to the company and the shareholders is more practical – as it significantly dilutes the burden on the Board to justify their decision in such situations. In the case of In Re: Mafatlal Industries Ltd[3], the Gujarat High Court held that the power of the Board to dispose of such surplus shares arising out of failure to subscribe by shareholders or through renunciation is very wide under the 1956 Act, and the Board can dispose of such surplus shares to non-members as well. It was further held that the law imposes no time limit for receipt by the Board of subscription for disposal of surplus shares.

Therefore, in the event the eligible shareholders of a company to whom the offer for rights issue is made either declines to accept the offer or does not respond within the offer period as specified in the rights issue notice, the Board of a company is empowered under Section 62(1)(a)(iii) of the Act to dispose of the unsubscribed shares in a manner which is not disadvantageous to the company or its shareholders. One of the preferred manners for disposal of unsubscribed shares is the allotment of the unsubscribed shares to third party investors who are currently not the shareholders of the company.

Consequently, the question that follows is whether the Board is required to follow Section 42 of the Act, which deals with private placement of securities, while allotting the unsubscribed equity shares of the rights issue to a third party? However, the Act is silent regarding the procedure for such allotment of unsubscribed shares to a third party.

Section 62(1)(a) of the Act, which governs the framework for rights issue, does not require a company to comply with the provisions of Section 42 of the Act, for the purposes of disposing of the unsubscribed portion of the equity shares offered to the eligible shareholders by a company through a rights issue. The language of Section 62(1)(a)(iii) empowers the Board to dispose the shares in its wisdom, which is not disadvantageous for the company and the shareholders.

Unlike the language of Section 62(1)(c) of the Act, which states that “subject to the compliance with the applicable provisions of Chapter III and any other conditions as may be prescribed,” no such qualifying language is present in Section 62(1)(a) of the Act. Further, the Explanation to Rule 13 of the Share Capital Rules provides that the expression ‘Preferential Offer’ means an issue of shares or other securities, by a company to any select person or group of persons on a preferential basis and “does not include shares or other securities offered through rights issue”. Therefore, it can be argued that allotment of unsubscribed shares to a third party under Section 62(1)(a) of the Act operates independently from private placement and preferential allotment under the Act.

However, given that the definition of ‘public issue’ is wide, companies should be circumspect in undertaking a rights issue to ensure that for the purposes of the unsubscribed portion of the equity shares of such a company, its Board of Directors do not dispose of such unsubscribed shares by offering or inviting to subscribe to, and consequently allotting to more than 200 persons in aggregate.

Allotment of unsubscribed shares to a non-resident third party

Rule 7A of the Foreign Exchange Management (Non-debt Instrument Rules), 2019 (“NDI Rules”) was inserted vide the Foreign Exchange Management (Non-debt Instruments) (Second Amendment) Rules, 2020. It provides that a person resident outside India, who has acquired a right to the unsubscribed portion of a rights issue from a person resident in India who has renounced it, may acquire equity instruments (other than share warrants) against the said rights as per the pricing guidelines specified under Rule 21 of the NDI Rules. This has changed the earlier position as the Explanation to Rule 7 of the NDI Rules, which provided that a non-resident, who is eligible in case of renunciation by a resident shareholder could subscribe to a rights issue at the same price offered to a resident shareholder of a company, has been omitted.

Concluding Thoughts

Section 62 of the Act has not imposed any restrictions on the Board’s discretion in allotting unsubscribed rights issue shares to a non-shareholder, so long as it can demonstrate that such allotment is not disadvantageous to the company and its shareholders. If a view is taken that such allotment of unsubscribed shares to non-shareholders would tantamount to ‘private placement’ under Section 42 of the Act, then it would render the said provision almost unworkable as the company cannot change its course mid-way to comply with several other requirements of Section 42 and the PAS Rules. Nothing in the scheme of Section 62 suggests taking such a view. However, companies would have to comply with the NDI Rules for any subscription by a non-resident shareholder beyond his rights entitlement. It also needs to be ensured that the number of non-shareholder subscribers in such category does not exceed 200. The Board’s discretion in this regard otherwise remains unfettered.

[1] AIR 1950 SC 172.

[2] AIR 1981 SC 1298.

[3] (1996) 87 CompCas 705 (Guj).