Summary: The Board’s discretion to dispose of unsubscribed portion of rights issue to non-shareholders was made a bit easier by the Companies Act, 2013, by giving more flexibility to the Board as compared to the language used in the 1956 Act. However, whether such disposal is tantamount to a preferential allotment or a public offer (when offered to more than 200 persons) has always been a subject of legal debate. This blog demystifies the legal position and clarifies the applicability of the RBI’s pricing guidelines under FEMA, when such allotment is made to a non-resident investor.
Legislative History
A rights issue allows a company to raise additional/ further capital from its existing equity shareholders in proportion to their current shareholding. It provides existing equity shareholders the first opportunity to subscribe to additional shares before they are offered to outsiders. The rights issue process balances a company’s need for funds while not diluting the shareholding of its existing shareholders.
Section 62(1)(a) of the Companies Act, 2013 (“2013 Act”), deals with rights issue of shares to existing equity shareholders. Section 62(1)(a)(iii) of the 2013 Act reads:
“(iii) after the expiry of the time specified in the notice aforesaid, or on receipt of earlier intimation from the person to whom such notice is given that he declines to accept the shares offered, the Board of Directors may dispose of them in such manner which is not dis-advantageous to the shareholders and the company.”
The corresponding provision under the Companies Act, 1956 (“1956 Act”), to Section 62 of the 2013 Act, was Section 81 of the 1956 Act. Section 81(d) of the 1956 Act reads:
“(d)after the expiry of the time specified in the notice aforesaid, or on receipt of earlier intimation from the person to whom such notice is given that he declines to accept the shares offered, the Board of Directors may dispose of them in such manner as they think most beneficial to the company.”
Under the erstwhile provision, if the existing shareholders did not subscribe to such additional issue, the unsubscribed portion had to be disposed of by the Board in a ‘manner which would be beneficial to the company’. However, under the current provision, the Board must dispose of such unsubscribed portion in a ‘manner not disadvantageous to the shareholders and the company’. While Section 62(1)(a)(iii) of the 2013 Act uses the term “disadvantageous”, the Act itself does not provide a statutory definition for it.
Under the 1956 Act, the Supreme Court has held that as long as the shares are issued in the larger interest of the company, an incidental benefit to the directors cannot invalidate a company’s rights issue. Further, it was held that maintaining control over the company through a rights issue is not a breach of the fiduciary power of the directors.[1] This standard was relevant to the 1956 Act wherein the disposal had to be done in a manner which is “most beneficial to the company”. According to a literal interpretation of the 1956 Act, the phrase “most beneficial to the company” sets a higher threshold as it obliges the Board to differentiate between multiple approaches and ensure that the approach employed is superlative to all other approaches. On the other hand, “not disadvantageous to the shareholders and the company” simply stipulates that the chosen approach does not harm shareholders or the company, even if it is not more beneficial than other options.
FEMA implications of renunciation or disposal of unsubscribed capital in favour of non-residents
Section 62(1)(a)(ii) of the 2013 Act empowers an existing shareholder of the company to renounce his right to participate in a rights issue in favour of another person. If a shareholder renounces such right in favour of a non-resident, it will have implications under the Foreign Exchange Management Act, 1999 (“FEMA”). Such renunciation entails the transfer or assignment of a vested right from a shareholder to either another existing shareholder or a third party. Rule 7 of the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”), specifically exempts rights issue from the applicability of the pricing guidelines stipulated under Rule 21 of the NDI Rules. Post insertion of Rule 7A of the NDI Rules, done through the 2020 amendments, acquisition of shares through rights issue by way of renunciation is excluded from this exemption. Such transactions are subject to pricing guidelines stipulated under Rule 21 of the NDI Rules. The pricing guidelines under Rule 21 of the NDI Rules contemplate three scenarios: (a) the company issuing shares to a person resident outside India (“non-resident”); (b) a person resident in India (“resident”) transferring the shares to a non-resident; and (c) a non-resident transferring shares to a resident.
A differentiation is drawn in Rule 21 of the NDI Rules between issuance of an equity instrument by the company and transfer of an equity instrument by a shareholder. Equity instruments are defined as “equity shares, convertible debentures, preference shares and share warrants issued by an Indian company”. It is noteworthy that a renunciation of a right to subscribe to shares in a rights issue does not constitute a transfer of shares by a shareholder to a third party/ existing shareholder; rather, it constitutes a transfer of the right to participate in the rights issue. Since shares offered through a rights issue are not directly transferred by the current shareholder, renouncing a right essentially results in the company issuing those shares directly to a third party. Therefore, the pricing guidelines set out in Rule 21(2)(a) of the NDI Rules shall be applicable.
Further, the 2025 Amendment to the RBI Master Directions on Foreign Investment (“FDI Master Directions”) provided that the unsubscribed portion of a rights issue can be issued to non-resident third parties as long as they follow applicable NDI Rules, entry routes, sectoral caps and pricing guidelines. This amendment clarified that in case the Board decides to dispose the unsubscribed capital, fully or partially, in favour of non-residents, the pricing guidelines, as set out above in line with Rule 21(2)(a) of the NDI Rules, shall apply.
Renunciation of unsubscribed portion of rights issue to more than 200 persons: Does it amount to public offer?
Section 62(1)(a)(ii) grants a company’s shareholders the option to renounce their right to subscribe to additional shares in favor of any other person. Hence, when such a right is exercised, resulting in the renunciation of shares in favor of more than 200 persons, such a renunciation should not lead to the rights issue being classified as a public offer, as per the provisions of Section 42 of the 2013 Act.
The right to renounce is an essential part of a rights issue process and cannot be regarded as violative of Section 42 of the 2013 Act, even if the renunciation is made in favor of more than 200 persons. Section 62(1)(a)(ii) imposes an obligation on companies to provide shareholders with right to renounce and hence it would be contradictory to treat an obligation imposed by a provision to be violative of another provision. Section 23 of the 2013 Act deals with public offer and permits rights issue, explicitly excluding it from the definition of ‘public offer’. A similar stance was taken by the Madras High Court in Vikramjit Singh Oberoi v. ROC[2]. It relied on a letter dated November 4, 1957, issued by the Ministry of Corporate Affairs (“MCA”), which stated that there was no need to issue a prospectus in case of renunciation. Hence, the court held that a rights issue would not lead to a public offer.
Rights issue to preference shareholders
As discussed above, it is a cardinal principle of company law under Section 62 of the 2013 Act that when a company increases its subscribed capital through rights issue, such shares must only be offered to equity shareholders in proportion to their existing shareholding. Consequently, where a company has preference share capital, further equity shares cannot be offered to preference shareholders on a rights basis.
However, many companies are exploring methods to issue equity shares on a rights basis to preference shareholders without undergoing the private placement process under Section 42 of the Companies Act, 2013. In such circumstances, the best course of action would be for the preference shareholders (to whom equity shares are proposed to be issued) to acquire a nominal number of equity shares before the record date. Such shareholders can then apply for additional shares (subject to appropriate provisions in the articles of association), and the offer of additional shares will not be regarded as private placement but will be treated as a rights issue.
Alternatively, the unsubscribed portion of equity shares can be offered to such preference shareholders, provided they have residence in India. If they are non-resident preference shareholders, then such issuance would be subject to pricing guidelines under FEMA.
Renunciation of rights entitlement by equity shareholders to preference shareholders is the third option. However, this would have tax implications for the selling shareholders.
Concluding Thoughts
Hence, if the shares are not fully subscribed by the existing equity shareholders under the rights issue process, the Board may dispose of such unsubscribed shares in a manner not disadvantageous to the company. Consequently, if the Board determines that offering unsubscribed shares to outsiders is not disadvantageous, the shares may be offered externally. Basis the above discussion, it is evident that such issuance of unsubscribed portion to outsiders would not amount to preferential allotment under Section 42 of the 2013 Act since the offer originates as a rights issue and not a private placement. Also, renunciation in favor of more than 200 persons will not result in the rights issue being treated as a public offer given the provisions of Section 23 of the 2013 Act and MCA’s clarification.
[1] Needle Industries (India) Ltd. v. Needle Industries Newey (India) Holding Ltd., AIR 1981 SC 1298.
[2] 2020 (223) Comp Cas. 199