This article has been authored by Disha Lohiya, a third-year student at National Law University, Jodhpur.
Companies raise finance by various methods to meet different purposes depending upon certain factors like short/ long term requirement, dilution in ownership, cost of raising finance, etc. Various types of securities may be issued, depending on the issuer's requirements, such as equity shares, non-convertible debentures, non-convertible preference shares, etc., to hybrid securities such as convertible debentures, convertible preference shares, share warrants, etc. Under the Companies Act, 2013 ('Act'), the various financing options are available to companies for issuing different types of securities. In each case of an issuance of security, the issuer has to comply with various laws, including the ones prescribed under the Act.
If a company wants to raise capital by issuance of convertible debentures, provisions of section 71 of the Companies Act read with Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014 shall be complied with. However, the question to be considered is whether conformity with the provisions laid down in Section 62 and Section 42 of the Act and the corresponding guidelines for the further issuance of shares and the requirements for private placement also applies to the issuance of convertible debentures?
Section 42 of the Act governing the issuing of shares on a private placement basis was altogether subbed by the Companies (Amendment) Act, 2017. Notwithstanding the substitution, the underlying theme did not change, offer and issue of securities to certain investor(s) only i.e. ‘select group of persons’. The Hon’ble Securities Appellate Tribunal ("SAT") on 28 January 2020, has interpreted the rules pertaining to the private placement of securities in the case of Canning Industries Cochin Ltd. v. SEBI. In the light of the above, this article attempts to objectively examine the key legal problems present in the case in the context of the SAT decision.
Facts of the Case
Canning Industries Cochin Ltd., an unlisted public limited company offered to issue Unsecured Fully Convertible Debentures (‘FCDs’) of Rs.250/- each to its 1929 shareholders at the rate of 100 FCDs with no right to renounce the offer to any other person and that these debentures would be mandatorily converted into shares upon maturity i.e. after 5 years. However, out of the 1929 shareholders, only 335 shareholders subscribed.
One dissatisfied shareholder lodged complaint before SEBI and NCLT claiming the company's non-compliance with the rules of the Act with regard to public issue of shares.
The contention of SEBI was, that since the offer of FCDs was for more than 200 persons, the said offer is a deemedpublic offer under section 42 of the Act read with Rule 14(2)(b) of the Companies (Prospectus and Allotment of Securities) Rules, 2014. Accordingly, provisions of section 40 of the Act as well as SEBI ICDR Regulations was required to be complied.
The Company contended that Section 42 of the Companies Act is not applicable in the instant case and that the issue ofthe share capital is under Section 62(3) of the Companies Act, 2013 which has not been considered.
Observations of SEBI
SEBI in its Order dated 18 March 2019, noted that the offer made to all 335 persons is a ‘deemed public issue’ and therefore, is in violation of Section 42(1) of the Act. It also noted that the Company did not comply with the relevant IPO related provisions. Moreover, the company also failed to make an application to one or more of the stock exchanges for listing.
Observations of SAT
The company appealed to SAT which noted that section 42 will not be applicable to the offer of FCDs as it is not ‘private placement’ of securities. SAT noted that ‘private placement’ indicates a bid by a company to subscribe securities to a ‘select group of persons’. Even though the phrase ‘select group of persons’ isn’t defined in the Act, it applies to a specified number of persons limited to a total of 200 in the financial year.
As the offer was made to 1929 shareholders, it was noted that the offer of said FCDs should not be considered an offer to a ‘select group of persons’. SAT noted that “the expression ‘select group of persons’ is not a technical expression but has to be understood in its ordinary popular sense, namely, an offer made privately such as to friends and relatives or a selected set of customers distinguished from approaching the general public or to a section of the public by advertisement, circular or prospectus addressed to the public.” The SAT also noted that, in the present situation, the restriction of the subscription of shares to 200 or more persons is not valid since it is not a ‘private placement’. Thus,section 42 read with Rule 14(2)(b) of the Securities Rules are not applicable in the instant case. SAT also noted that since it is not a case of issuance of shares/securities ion preferential basis, section 62(1)(c) of the Act will also not apply.
Private Placement is a common method of raising funds by offering securities to an individual or a small group of investors privately instead of general public. Since it’s not a pubic issue, it need not be registered with the Securities and Exchange Commission (SEC).
Private placements deliver a range of benefits over IPOs to small companies. It’s a cost effective way to raise capital. Because private placements do not require the help of brokers or underwriters, they are significantly less time-consuming. In addition, private funding can be the only source of capital open to risky projects or start-ups.
Section 42 of the Act read with Rule 14 of the Companies (Prospectus and Allotment of Securities) Rules, 2014 regulates private placements and Explanation I to the section 42(3) of the Act defines the term ‘private placement’ as –
"private placement" means any offer or invitation to subscribe or issue of securities to a select group of persons by a company (other than by way of public offer) through private placement offer-cum-application, which satisfies the conditions specified in this section.
The offer or invitation under private placement can be made to not more than 200 persons in aggregate in a financial year, except from the offer to Qualified Institutional Buyers and employees under employees stock option. This restriction applies to each kind of security i.e. equity share, preference share or debenture
Interpreting ‘select group of persons’ under Section 42 of the Act
The term private placement is not descried in the Companies Act, 1956. However, under section 67(1) the concept of ‘domestic concern’ is explained. Section 67 clarifies as to what will constitute an invitation to the public.
Further, the Hon’ble Punjab-Haryana High Court in Rattan Singh v. Moga Transport Co. 2; AIR 1959 P H 196,observed that in Nash v. Lynde, 1929 A. C. 158, Viscount Sumner at page 169, observed, “The ‘public’, in the definition Section 285, is of course a general word. No particular numbers are prescribed. Anything from two to infinity may serve: perhaps even one, if he is intended to be the first of a series of subscribers, but makes further proceedings needless by himself subscribing the whole. The point is that the offer is such as to be open to anyone who brings his money and applies in due form, whether the prospectus was addressed to him on behalf of the Company or not.”
Where directors make an offer to a handful of their associates, family or clients by sending them a copy of the prospectus labelled “not for publication” it will not considered an offer to the public. Unless the prospectus is issued to the public, the provisions of the act relating to prospectus will not be attracted. And whether the prospectus has been issued to the public or not is a matter of fact.
The term ‘public’, therefore, comprises any section of the public howsoever selected. Even an offer to a ‘limited class of people’ shall be an offer to public. In the case of Re South of England Natural Gas and Petroleum Co. Ltd. (1911) 1 Ch. 573, 3,000 copies of a prospectus were distributed among the members of certain gas companies was held to be an offer to the public because person other than those receiving the offer could also accept it.
However, offering securities to existing shareholder is an offer to issue securities to ‘select group of persons’ as opposed to public offering, where anyone can subscribe. In simple terms, if an offer is such where other than those invited cannot subscribe, it’s a case of private placement and on the other hand, when an offer is available to all without any restriction, the same is a case of public offer.
In the instant case, while the invitation was to a closed group, however, the number of offerees was in excess of the limits prescribed i.e. 1929 people, therefore, in our view SEBI was justified in holding it as a public offer.
As per Section 23 of the Companies Act, 2013, Public issue is a way of raising funds from the general public to finance its long-term objectives. It means the selling of share for subscription by the public via the issue of prospectus. By issuing the securities to public at large, a company can get listed to a recognized stock exchanges in India.
Securities are offered either by an Initial Public Offer (IPO) or Further Public Offer (FPO). IPO is the mechanism by which an unlisted issuer offers securities to the public and then shares are exchanged on an open market post its listing. Whereas when a listed issuer offers securities to the public to raise additional funds, it is an FPO.
To make a public issue, various rules and regulations have to be followed, like SEBI (Issuance of capital and disclosure requirement) regulation, 2009 and SEBI (Listing obligations and Disclosure Requirements), Regulations 2015 as under section 24 of the act, 2013, SEBI also has the authority to govern the issue and transfer of securities by listed and unlisted companies. Publicly traded securities are subject to more rules and scrutiny than those for private placements.
Deemed Public Offer
While the distinction between private placement and public offer is explicitly clear, however securities offered to more than the prescribed limit of 200 persons in a financial year shall deemed to be a public offer and shall be subject to the provisions applicable to public issues. Section 42 (3) clearly specified this deeming provision under explanation III, which is produced as follows-
“Explanation III.—If a company, listed or unlisted, makes an offer to allot or invites subscription, or allots, or enters into an agreement to allot, securities to more than the prescribed number of persons, whether the payment for the securities has been received or not or whether the company intends to list its securities or not on any recognised stock exchange in or outside India, the same shall be deemed to be an offer to the public and shall accordingly be governed by the provisions of Part I of this Chapter.”
Looking at the above-mentioned language, it is completely clear that the legislature did not have any reservations as to whether or not to regard the intended private placement as an offer made to the public if the limit on the number of individuals offered exceeded the specified limit of 200.
Analysis of SAT Order: A Perplexing dilemma?
Not considering the issue as a deemed public issue: As addressed before, SAT noted that such issue is neither rights issue nor public issue nor a private placement. The SAT has disregarded various significant legal provisions and relevant decisions of the Supreme Court of India while deciding whether the issuance of FCDs to current shareholders would be considered a deemed public issue in accordance with section 42 of the Act.
Section 42 of the Act read with rule 14(2)(b) of the Rules specifically states that, if the allotment of securities offered to more than the prescribed limit of 200 persons in a financial year shall deemed to be a ‘public offer’ and shall be subject to the provisions applicable to public issues. Furthermore, the Supreme Court in Sahara India Real Estate Corporation v. SEBI pointed out, that in case of an invitation to 50 or more persons, the invitation is deemed to have been issued “to the public” (under the mandate of section 67 of the Companies Act). It observed that when an offer to subscribe is issued to more than a prescribed number of persons., it ceases to be a private placement.
The SAT has, thus, explicitly violated the current legal provisions on ‘deemed public issue’ by excluding the issued FCDs by the company to 335 shareholders from the scope of section 42 of the Act.
Interpreting section 62(3) as an exception: When a company wants to increase its existing subscribed capital by the issue of further shares, the provisions of section 62 have to followed. Section 62(1)(a), (b) and (c) provides 3 ways to raise the funds for the company by way of rights issue, preferential allotment and employee stock option. However, in the present case, SAT has taken a total distinctive view, wherein, in addition to the aforementioned modes of raising fund, it treats section 62(3) of the Act, dealing with conversion of debenture/loans into equity, as an independent method of raising fund.
In any case, its relevant to take note that 62(3) merely envisages a method of excluding companies from the criteria prescribed in section 62(1) at the stage of conversion and does not extend autonomy to companies from regulatory compliances at the time of original issuance of securities.
The said offer of FCDs has the features of public issue, yet the Tribunal made it falls under the provisions of Section i62(3) of the Act read with debenture-related provisions, which is not part of the basic provision relating to issue of securities under section 23 of the Act.
After discussing the different principles of fund raising in the light of the SAT decision, it is clear that the position taken by SAT is totally at odds with the basic understanding of the provisions of sections 62 and 42 of the Act. The restricted interpretation adopted by the Tribunal would certainly leave the stakeholders baffled. While SAT has hit hard on the topic by holding the offer independent under section 62(3), it strongly seems to have missed the deeming provision under section 42 which gives the offer in the instant case, the colour of a public issue. Henceforth, it will be intriguing to see whether this issue is referred again to SAT or a High Court to find the lost boundary.