[By Rudra Shandilya and Disha Chaturvedi] The authors are students at Damodaram Sanjivayya National Law University, Visakhapatnam
Perceived by the common law from the nineteenth century, pre-emptive rights are allowed to the current shareholders in an entity, in proportion to their existing holdings, so that they could take part in the fresh proposal of new shares by the entity. This right is codified/arranged by the Companies Act, 2013, and the term used for issuance of such shares is ordinarily named as the ‘rights issue’. It is a popular method commonly used by a listed company to increase additional investment. In a rights issue, the companies, instead of going to the public, provide the existing shareholders/investors of the company with the right to subscribe to freshly-issued shares. While the Companies Act doesn’t explicitly refer to this, “the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations (ICDR Regulations) characterize rights issue as an issue of fresh shares to the current shareholders by a listed company”.
For instance, in May 2020, existing shareholders of Reliance Industries Limited (RIL) were invited to subscribe to the rights issue by paying only 25% of the amount. Further, the leftover balance has to be paid in May 2021 and then in November 2021 (two instalments). RIL offered the shares at the ratio of 1:15 i.e. one new share was offered for every fifteen shares owned at an amount of Rs 1,257/share, almost thirteen percent less than the closing price for 18 May 2020.
Right of renunciation
The right to a subsequent share of capital in a rights issue is guided by the right of renunciation under the Companies Act. The aforementioned right permits shareholders to renounce part or all of their entitled share capital in favour of any other person. The shareholders commonly trade such entitlements of rights after the circulation of the rights issue and before its completion. It can be broadly divided into four points:
- The right holder can subscribe to all the new shares which he is entitled to.
- The right holder can transfer some of the new shares to another person while keeping the left ones.
- The right holder can transfer all the new shares which he has entitled to a third person by renouncing his rights.
- The right holder at his/her discretion can avoid subscribing to any new share or even avoid transferring shares.
Furthermore, the existing shareholders can also subscribe to more number of shares than he/she is entitled to. The extra shares would be provided in case if there are any leftover shares with the offering company after the completion of the rights issue (per point number 4).
Past and recent events affecting the rights issue process
The Indian Government recently announced The Foreign Exchange Management (Non-debt Instruments) (2nd Amendment) Rules, 2020 (hereinafter referred to as FEMA NDI Rules) vide a notification dated 27 April 2020. The aforementioned amended rules endeavor to transform the pricing of the rights issue and its position. The pricing guidelines would be applicable in case of renunciation of rights in favour of a non-resident by a resident.
The aforesaid rules including the “Foreign Exchange Management (Transfer or Issue of security by a person resident outside India) Regulations, 2017 and the erstwhile Foreign Exchange Management (Transfer or Issue of security by a person resident outside India) Regulations, 2000 have explicitly recognised free pricing of rights issue”. The FEMA NDI Rules prescribe that (i) securities have to be offered to non-residents at a cost not less than the cost offered to residents under a rights issue, in case of unlisted entities; and (ii) in case of listed entities, the cost would be as decided by the entity itself. The FEMA NDI Rules are silent on the board of directors’ decision to sanction the unsubscribed portion of the rights issue in favour of a non-resident. It only considers renunciations in favour of non-residents by residents which leads to varying views on the treatment of renunciations.
Furthermore, according to a recent announcement made by the Ministry of Corporate Affairs, it is now not required for the listed companies to notify their shareholders about rights issues through courier or postal services because of the hindrances on transport and travel amidst the catastrophic pandemic. Therefore, the listed companies are now allowed to serve the application form, letter of offer, and other such offer materials electronically following the guidelines of capital market regulator Securities and Exchange Board of India (SEBI). Moreover, the issuers have been recommended by the SEBI to employ necessary steps to reach out to investors through advertisements on television, digital advertisements, or SMS in addition to posting an advertisement in a newspaper that is commonly required. The issuers are also recommended to post the offer materials, inter alia, letter of offer on their web pages, the stock exchange, and with the Registrar of Companies to avoid ambiguity. The investors whose email addresses are not registered with the company could face problems after the implementation of the aforesaid guidelines as they might not be notified about the rights issue, therefore missing out on the chance to invest. This possibly led to a surge in the unsubscribed portion of a rights issue, sanctioning promoters of the company to invest in the unsubscribed section of the issue to expand its stake in the company.
Rights issue permits entities to raise capital when alternative sources of investment end up being unviable and expensive. This course of lifting investment is favoured because it defers the requirement for obligatory underwriting, accommodation of prospectus, and investor endorsement. The rights issue is similarly invaluable for the existing shareholders who have been provided with an opportunity to acquire extra share capital at a discounted cost while forestalling any equity dilution. This gives the corporates much-needed flexibility to structure a hike in investment from current shareholders, especially during urgency. A rights issue also has some inherent dangers associated with it like ‘price risk’. The cost of a corporation’s share is affected by price risk as due to the declaration of fresh issue of shares, a negative signal is sent to both prospective and current investor which causes a drop in the share price. If an investor doesn’t buy into the rights issue then the entity may fail to accomplish its objective. Furthermore, on the off chance that a more grounded balance sheet company proceeds for the rights issue, a negative market assumption is automatically made for that specific company. It’s presumed by the market that the company is struggling to carry on its market ventures. Also, there is a delay between the issuance of rights share and moving it to the holder’s account. Therefore, the same percentage of discount might not be availed while selling the rights shares.
Be that as it may, rights issue for a company is one of the most efficient ways to raise additional capital without inviting further loans from the banks on high-interest rates thus cutting on the finance cost for a company.