Rights Issues In India: Law, Process And Practical Concerns

Rights issue is virtually one of the most common methods used by the companies to raise more cash. Instead of approaching new investors, companies issue new shares to existing shareholders in proportion to their holdings, usually at a discounted price. This is to protect the owners against dilution of their stakes and also provide the company with a boost to its finances.

In India, the entire thing is governed by the Companies Act, 2013 and in the case of listed companies there is a dosage of rules placed by SEBI. It is appears straightforward on paper, but once you actually go through the operation, several legal, governance, and investor-protection concerns arise in practice.

Legal structure of rights issues

The primary regulation is 62(1)(a) of Companies Act 2013, that provides a company with a green light to issue new equity shares. It states that the new shares shall be offered before the other already existing shareholders and proportionately to their fully paid-up capital. This is what pre-emptive rights are all about, to prevent what is commonly referred to as dilution of the ownership without the approval of the shareholders.

Shareholders must be given a minimum period of fifteen days and a maximum of thirty days to decide whether to accept the offer or not. You may also transfer your rights to another person unless the articles of the company indicate to the contrary. Assuming that no one takes up in that round, the board may dispose of the remaining unsubscribed shares, assuming that it is not impairing what the existing shareholders have to say.

In case of listed companies, SEBI's Issue of Capital and Disclosure Requirements Regulations impose additional disclosure and procedural safeguards. They introduce a number of disclosure requirements - a letter of offer, filings with the stock exchanges, and strict time constraints. The objective is to ensure that investors receive sufficient information to make informed decisions.

The practical working of rights issues

A rights issue really has a predefined course.

Initially, the proposal is signed by the board - all the points of pricing, rights ratio, record date and time frame are finalised. That is a significant decision, as it will determine the number of people who will participate in the issue.

Second, the company issues a letter of offer to the qualified shareholder. It does reason why they are raising money, gives financial information, discusses risk, and explains how to apply or choose not to participate. In the case of a listed company, the rights entitlements are usually credited in dematerialised form.

Third, the subscription window is open; you may subscribe, forfeit your rights or simply sit out. Meanwhile, it is possible to trade the rights on exchanges, in which case individuals who are not interested in committing more money to it can still get value.

Lastly, the shares are distributed. Any shares that nobody subscribed may be sold to other investors, underwriters or even promoters but this can only happen as long as it does not go against the rules.

Although everything seems to be orderly on paper, the outcome in practice often differs. This is highly dependent on the level of awareness people have, the feel of the market, and the level of disclosure transparency.

The reasons why rights issues are favored by companies

The reasons why companies normally choose rights issues are that it is cheaper and faster as compared to a complete public offering. Since the shares go to those that already had them, you still save marketing money and avoid extensive regulatory procedures.

Rights issues allow companies to raise equity without adding excess debt, which is a major advantage when the business is already facing financial stress or is about to undergo a balance-sheet remodeling. They are used to repay loans, acquire other businesses, or finance long-term expansion.

From a corporate governance perspective, rights issues are generally considered shareholder-friendly; they maintain ownership in the same proportion and provide an existing investor with another opportunity to raise his/her ownership.

Shareholder implications and risks

To shareholders, rights issues are characterized by both advantages and disadvantages.

On one hand, you get discounted shares as compared to those offered by the market. When you do purchase them, you retain your portion of the company, and when you do not, you may renounce their rights and receive payment thereon.

The negative side is that if shareholders fail to act within the prescribed time, their economic and voting rights will be diluted. The accountable fact is that, usually, it is retail investors who do not notice or are so confused in the process.

It is even worse when a large proportion of the population does not make the purchase. Then the promoters or the big players can take the remaining shares, and this implies that they have more control. Though it is not unlawful, this also brings up the questions of fairness and makes minority investors nervous.

Another angle is the perception of the market. Occasionally a rights issue is an indication of a business in distress, particularly when there is no clear purpose of the fund exercise. That will momentarily hit the stock price and rattle investor confidence.

Learnings of the current business practice

In my recent course, I have observed that, according to the legal letter of the law, there are no cases when the results will be just.

Before examining judicial decisions and real corporate disputes, it is useful to first illustrate, through a simplified example, how a rights issue can alter ownership outcomes in practice.

Practical illustration: ABC Ltd.

In order to explain the practical way a rights issue alters ownership, we will take the following simplified example with realistic figures.

ABC Ltd. is a board of five directors company. It has an ordinary share capital of 100,000 paid-up equity shares. The promoter, A, holds 60,000 shares (60%). Three non-promoter shareholders with 20,000 (20%), 12,000 (12%), and 8,000 (8%) shares are the owners of the remaining shares.

In the rights issue, board approves at the ratio of 1:2 i.e. 1 new share to 2 old shares. Consequently, the company is now suggesting to issue additional 50,000 shares of the company at the issue price of 50 per share. According to the date of the record, the promoter A will have the right to subscribe 30,000 shares and B, C and D will have right to subscribe 10,000 shares, 6,000 shares and 4,000 shares respectively.

In case all the shareholders take their respective entitlements, the overall shareholding will rise to 150,000 shares. The shareholding of every shareholder does not change. The promoter still retains 60% of the company with the remaining proportions held by the rest of the non-promoter shareholders. This is the optimal result which the rights-issue mechanism is aimed at attaining.

But in reality shareholders who are not promoters are not always fully involved. There are cases where B, C and D do not subscribe to their entitlements whether out of ignorance or aversion to putting extra money. Assuming that the promoter has subscribed to the promoter's portion as well as to the unsubscribed portion of the non-promoter, the promoter will have a holding of 110,000 shares (out of 150,000 in total). Therefore, the promoter will increase his/her stake to a minimum of 73 percent whereas the non-promoter will dilute.

This case illustrates that despite the fact that the rights issues are formulated with the primary aim to safeguard the existing shareholders, their actual functioning is very much dependent on the rate of participation and the manner in which the unsubscribed shares will be distributed eventually. Bright disclosure about treatment of unsubscribed shares and effective communication with the retail shareholders are hence very essential to avoid concentration of control unintentionally.

In the case of Needle Industries (India) Ltd. v. Needle Industries Newey (India) Holding Ltd., the Supreme Court ruled that when issuing further shares, directors have to act in good faith and in the interest of the company as a whole. The Court also made it clear that technical adherence to the provisions of the company law cannot cause aggressive actions that are unfair to already existing shareholders.

In Nanalal Zaver v. Bombay Life Assurance Company, the Supreme Court has highlighted the significance of shareholder approval in decisions of capital restructuring and has stressed the fact that the process of dilution of shareholders' right should be justified by a lawful corporate objective.

Corporate practice in the recent past depicts these principles. The controversy of the rights issue of the Byju illustrates the effect of low participation in a rights issue by the populace and how this situation may result in increased control by the promoter and contention between shareholders and disclosure and equity accountability. On the same note, recurrent rights issues by Vodafone Idea Ltd. are also reflective of how during the face of financial strains, such issues even though legal, can dilute minority shareholding by far a lot.

To illustrate, big rights issues made when the company is financially strained have recorded a low turn-up by the retail investors and a high turn-up by the promoters to the unsubscribed shares. In other instances, the rights issues have been subject to court and tribunal proceedings through the shareholders who asserted that disclosure was not good and dilution was not fair.

Overall, these developments suggest that the efficiency of the rights issues is determined not only by the statutory adherence but also by the quality of the disclosures, availability of information, and the general fairness of the procedure.

Regulatory gaps and the need for reform

Although the rights-issue framework in India is generally sound, there still exist some loopholes.

The judicial review has pointed out that the compliance of the procedures is not enough. In Raj Kumar Bhatia v. AV Light Automotives Ltd., the court under consideration, AV Light Automotives Ltd. was focused on the issue of whether the rights issue mechanism was applied in a prejudicial way to the interests of shareholders. Equally, in Vikramjit Singh Oberoi v. Registrar of Companies, the court, with its reconsideration of Registrar of Companies (RoC), claimed that regulatory approval does not sanction transactions that cause lack of transparency or shareholder participation.

These determinations show that better transparency and more clarity over the disclosure would be required over the issue of allotment of unsubscribed shares, especially where there can be an increment in promoter control due to a rights issue.

Starting with, disclosure reports tend to be highly technical or use information by referencing, thus not being easily comprehendible by retail clients. Summaries made easy to understand, and with the investor-friendly approach, may go a long way in encouraging participation.

Second, at the end of rights issue, the distribution of the unsubscribed shares is not very transparent. The agreement on a clearer disclosure of who buys these shares and at what terms would help in increasing the confidence level among the minority shareholders.

Third, rights issues are occasionally designed in such a way that promoters or majority shareholders indirectly control the results of the ownership. Promoters can attempt to fix the price or terms of issues that do not appeal to the non-promoter shareholders in order to guarantee low participation and then repurchase unsubscribed shares. Although these practices can be in accordance with the letter of the law, they can be unfair in substance, deceiving the current investors and facilitating the consolidation of power under the pretext of raising capital. There is a need, therefore, to have increased regulatory oversight of the pricing justification and involvement of promoters.

Fourth, with the growing involvement of Indian companies in cross-border fund raising efforts, it will be necessary to harmonise the disclosure standards. No uniform regulation requirements may discourage a foreign presence and make it difficult to comply with.

The measures to these problems would enhance investor protection without sacrificing the effectiveness of rights issues as a means of raising capital.

Practical considerations for investors

Shareholders are expected to scrutinize the letter of offer, as well as to analyze the intention of the fund raise stated before they engage in a rights issue. This is important in knowing whether funds are being raised to develop growth or survival on a long-term basis.

The timelines must also consider the procedures and requirements of the shareholders. The consequence of not acting during the given time interval is possible for unintended dilution.

The aspect of rights issues still plays a significant role as a corporate fundraising mechanism in India. They can have positive effects on the companies and shareholders when they are undertaken in a transparent manner and for a good commercial cause. Laws in the Companies Act, 2013, and justification to legislation by the SEBI aim to strike a balance between corporate flexibility and investor protection.

Nonetheless, the relatively recent experience shows that disclosure that matters and equality in application are imperative. Although rights issues are commonly discussed as shareholder-protective measures, their form and prices can, practically, be utilized to change the ownership and control results without any official managerial shift. Enhancement of transparency, bettering the communication to retail investors, and the enhancement of regulatory protection means that rights issues will remain valid and legitimate in the changing Indian corporate environment.

Author is an LLM Student. Views are personal