Legal Issues In Formation of Capital In Public Company

INTRODUCTION

A company is a corporate body which is operated by its members. These members are shareholders and directors who actively take part in the daily affairs of the company. There are different types of companies one of which is a public company which is described under section 2(71) of Companies Act, 2013. There are different ways for how a company is going to be incorporated as well as different instruments that have to be issued in order to ensure compliance working of the company.

Capital can be formed by way of increasing assets and equipment which is known as physical capital formation and the one raised by way of deposits and securities is financial capital formation. However, in doing so a company is naturally going to face rules, regulations, and requirements which may at times lead to non-fulfillment of capital formation plans. Some of the legal issues with respect to financial capital formation will be discussed further in this project by looking into provisions of the Companies Act, 2013 and some landmark case laws.  

RESEARCH QUESTIONS 

1. What legal issues does a public company face while forming capital?
2. Whether these issues make it reluctant for people to incorporate a public company?

RESEARCH OBJECTIVES

1. To analyze legal issues that a company faces while forming capital through public issues and preferential allotment.
2. To study the regulatory framework of a public company and how it hinders the functioning of a company in the long run.

LITERATURE REVIEW

1. The author in this paper talks about public and private companies and how shares are issues in them. The major focus of the paper is on statutory and regulatory requirements that are mandatory for public companies. The instruments that can be used for raising capital are defined showing the restricted environment of a public company.[1]
2. The article deals with the material information that a prospectus should contain and with the question to find whether the company or the SEBI has the discretionary powers to decide what is material information for a prospectus. The article concluded by having the company’s financial information and risk factors to be mandatorily included in a prospectus of a public company. [2]
3. The paper deals with the issue of a prospectus and the types of risk factors that can arise while issuing a prospectus such as operational, financial, litigation, manpower, and regulatory risks. These risks have the capacity to hinder the daily functioning of a company in a smooth manner as there is low secrecy and every step of a company is under continuous monitoring.[3]
4. The paper deals with the preferential allotment of shares and securities to raise additional capital in any company. With respect to a company’s capital formation, preferential allotment means the issue of shares and securities on a preferential basis and these are the ones who are prioritized when dividends are distributed out of profits. The preferential allotment first goes to existing majority shareholders and then to employees as the basic purpose is to dilute the minority shareholders’ powers leading towards activism. No hassle in passing the special resolution as the majority of shareholders who would benefit from this allotment would eventually pass the resolution.[4]

ANALYSIS

1. PUBLIC COMPANY AND CAPITAL FORMATION

A public company as given under Section 2(71)[5] of the Companies Act, 2013, is defined as a company that is not a private company. However, the definition is not exhaustive as it means a company:

• where there are no restrictions on the transferability of shares,
• where investments can be raised from the general public through public issues,
• where there is no restriction on the number of members in a public company and a minimum of 7 members and 3 directors are required to start a public company and to constitute a board of directors.

     However, since the money belongs to the public, greater rules and regulations have been imposed on such companies so as to keep a check on their functioning and to protect the interests of shareholders and investors.

Capital formation is usually done by increasing stock and assets or by increasing the capital structure of the company. For the purpose of financial capital formation, a company has to issue shares and securities at a certain price, which will be subscribed to by the potential investors, money will be paid by them to the company, and the company will use the money for carrying out its activities and when there are profits, they either distribute dividends to investors/ shareholders or retain them again in the business for growth and expansion.  

When a public limited company wants to form its capital they have various options to do the same one of them is through public offer or public issue of shares and securities. This public offer consists of an Initial Public Offer (IPO) and a Further Public offer (FPO). When a private company gets converted into a public company, the very first issue of shares to the public is known as an IPO and when this public company gets itself listed on any of the recognized stock exchanges as a listed company, any further issue/ subsequent issue of shares will be known as FPO. Now there is a second option of preferential allotment which is also a way capital is formed and its second purpose is to dilute the dominance of the minority shareholders in the company- here a public company. This is different from public offering but is equally beneficial.

2. LEGAL ISSUES IN THE FORMATION OF CAPITAL AND CASE LAWS

No way of raising capital can be perfect and suited to both the investor and the company. There are rules and regulations which they have to follow for successful capital formation. Since the monies are generated from the public and there lies a public interest in the same, there is bound to be utter transparency and stricter regulations so that the dividend distribution process can accommodate every investor. When it comes to preferential allotment, minority shareholders are not the only ones, a company needs to cater to, other shareholders and directors also have an equal interest in the functioning of the company and when there is activism of shareholders, the power needs to be curbed upon.

Some of the legal issues with their respective provisions from the Companies Act, 2013 are given below along with important cases:

• IPO and Prospectus: The public issue of shares demands greater transparency and accountability. Section 26 [6]states for a company to issue a prospectus when it wants to go for public issue/IPO. This prospectus is a document that will contain all the important information of the company. The Securities Exchange Board of India Act, 1992, is the regulating act that will look after the material information that a prospectus should contain, which is, the financial information of the company and the risk factors associated when an investor invests in the company by purchasing the shares. This transparency as given in Section 134[7] to be one of the important responsibilities of a company, may at times lead to loss of control and lack of secrecy of any future prospects that a company may want to keep confidential and hence cannot do so because of the prospectus.

In the case of SEBI v. Shriram Mutual Fund (2006)[8], misleading statements in the prospectus were held to be violative and fraud/ misrepresentation on the part of the company. However, it discloses information about a company, it is compulsory and a process of law, which if not followed can lead to litigations against the company.

In another case of SEBI v. Bhagyanagar India Ltd. (2005)[9], it was held that when some information would have the capability of reversing the investor’s decision, it was considered to be material information and failure to provide it would be unlawful activity capable of attracting liability. Even if it means that the investment rate will lower and it will take greater time to subscribe to the shares, information has to be disclosed.

• Preferential allotment and dilution of interests of existing shareholders: preferential allotment is a process of capital formation through equity source of financing again, where after IPO and FPO have been issued and subscribed for, internal issue of shares can be made in order to increase the internal ownership of the investors/ shareholders. Section 62 [10]of the Act provides for the process of issuing additional capital through equity shareholders. The company will have to offer the shares first to existing equity shareholders, if refused then to the employees and then to any other person who would have been passed in the special resolution. This special resolution is generally difficult to pass as no one would want more dilution of ownership. It may be a legal issue because of the dividend distribution as then it comes to the reputation of the company for paying the dividend definitely.

In the case of Mrs. Proddaturi Malathi v. SRP Logistics Pvt Ltd & Ors. (2017)[11], it was held that directly going to the existing shareholders is the norm of preferential allotment and it can even be done to family members, relatives, and friends. There is no bar to whom this can’t be offered.

• Reduction Of Share Capital: when a company wants to have its share capital reduced because it needs to reduce the liability on shares, cancel or pay off any paid-up capital which may increase the company’s liabilities, they need to visit section 66 of the Companies Act, 2013. Section 66[12] has a lot of legal requirements namely: approval from Tribunal that is National Company Law Tribunal (NCLT), approval and passing of resolution in board meetings, notice to creditors and shareholders, resolving objections raised by the Tribunal, and registration with Registrar. All these requirements have their own time, economic, and flexibility issues but being a mandatory procedure cannot be ignored.

In the case of Innoventive Industries Ltd. v. ICICI Bank & Anr. (2017)[13], it was held that when a company wants to undergo debt restructuring, the insolvency proceeding won’t be stopped or vice-versa. The different spheres of both the company and insolvency law were discussed in this case and held that the corporate insolvency resolution process does not bar the reduction of share capital process. It may be due to financial distress or because of paying off liabilities but companies are not prohibited from taking actions after going through a very long procedure of following the legal requirements. 

These legal issues make up most of the regulatory process and framework of a public company and it may take a lot of time, cost, and effort to fulfill each and every legal requirement, but since the procedure cannot be ignored, these are followed by special persons appointed such as Company Secretary, Board of Directors or Auditors.

CONCLUSION

A company is incorporated to carry out business activities for the production of goods and services. The companies work for the interest of the public, it is naturally the case that they will need to follow rules and regulations in order to be in the eyes of law and society a valid and ethical company.

When a company follows rules and regulations it may be the case that the legal requirements are so much that they eat up most of the finances and time of the company, however, looking at the greater side these regulations are the only way, companies are not resorting to fraudulent and malpractices. The Securities Exchange Board of India and the legislation protect the majority of the company’s affairs relating to raising capital and debts in the securities market. The regulations are a must for a company to fulfill its social and legal responsibilities.   

Reference(s):

[1] Royan Jain & Harshit Jain, ‘Issue of Shares in Public and Private companies’ (2022) 4 Indian JL & Legal Rsch 1.

[2] Divya Shah, ‘Material Information in a Prospectus’ (2020) 3 Int’l JL Mgmt & Human 549.

[3] Krishnan Pal & Dr. Pritpal Singh Bhullar, ‘Identification Of Risk Factor Categories For An Initial Public Offering Prospectus- An Indian Perspective’ (2021-22) Journal Of Education, Rabindra Bharati University 160-169.

[4] Sakshat Bansal & Ananya Vajpeyi, ‘The warning of an ambush: disarming and appeasing activist shareholders’ (2021)  ILI Law Review 157-185.  

[5] Companies Act 2013, s 2(71).

[6] Companies Act 2013, s 26.

[7] Companies Act 2013, s 134.

[8] SEBI v. Shriram Mutual Fund (2006) 5 SCC 361.

[9] SEBI v. Bhagyanagar India Ltd. 2013 SCC OnLine ITAT 7847.  

[10] Companies Act 2013, s 62.

[11] Mrs. Proddaturi Malathi v. SRP Logistics Pvt. Ltd. & Ors. 2018 SCC OnLine NCLAT 930.   

[12] Companies Act 2013, s 66.

[13] Innoventive Industries Ltd. v. ICICI Bank & Anr. (2018) 1 SCC 407.