Know about preference shares, their types, and the redemption process outlined step-by-step in this concise blog. Learn about the implications during bankruptcy and the significance of Vakilsearch for legal assistance in financial matters.

Introduction 

Redeemable preference shares serve as a strategic financial instrument for companies, offering investors fixed dividends and a potential buy-back option at a predetermined date. Issued when capital is needed with a desire for future share repurchase flexibility, these shares benefit companies by enabling effective capital structure management.

Investors, in turn, enjoy regular income through higher fixed dividends compared to common stock. Additionally, the predetermined exit strategy provides a clear path for disinvestment. However, it’s essential to note that the terms, including price and redemption details, are established at the share issuance, influencing the potential future value of the investment.

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What are Preference Shares?

The repayment of the capital of preference share capital to shareholders is referred to as redemption of preference shares. Only the terms under which they were issued or those that have been changed with the proper permission of preference shareholders are acceptable for a corporation to redeem its preference shares.

Types of Preference Shares

There are basically four main types of preference shares. They are:

1. Cumulative preferred share
2. Non-cumulative preferred share
3. Participating preferred share
4. Convertible share.

In contrast to non-cumulative preferred shares, holders of cumulative preferred shares are entitled to dividends retrospectively for any dividends that were not paid in earlier periods. Because of this, cumulative preferred shares will often cost more than non-cumulative preferred shares.

Participating in preferred shares provides the benefit of increased dividends if specific performance goals are met, such as when corporate profits surpass a predetermined level. Similar to convertible bonds, convertible preferred shares permit the holder to exchange their preferred shares for common shares at a predetermined exercise price.

Purpose of Issuing Redeemable Preference Shares

• Raising finance in a slow primary market can be challenging
• When a company’s shares aren’t actively traded on the stock exchange, potential investors may hesitate to invest
• Offering redeemable preference shares can encourage investment, as investors have the option to redeem their shares directly with the company
• This option becomes attractive when the company has surplus capital that cannot be profitably utilised in the business
• Unlike debentures or loans, preference shareholders aren’t entitled to dividends in case of losses or lack of profits, offering financial flexibility.

Redeemable Preference Shares Formula

The fundamental formula is as follows:

Redemption Value = Nominal Value of Shares + Any Accumulated Dividends

• Nominal Value of Shares (₹): This signifies the initial value at which the shares are issued, commonly known as the face value or par value
• Accumulated Dividends (₹): These are dividends that have been declared but remain unpaid to shareholders during the time they hold the shares.

For instance, considering XYZ Corporation, if an investor possesses redeemable preference shares with a nominal value of ₹100,000 and accumulated dividends of ₹15,000 over the investment period, the redemption value at the end would be ₹115,000 (₹100,000 nominal value + ₹15,000 accumulated dividends).

This overall payout encompasses both the invested capital (nominal value) and the earned dividends, offering investors a comprehensive return upon the redemption of these shares.

What Happens When the Company Goes Bankrupt?

The various security holders in a firm that declares bankruptcy will be entitled to the company’s assets. The specific rights granted to those security holders in their security agreements will determine the order in which they receive their respective shares of the assets. Preference shares, for example, will typically be paid before common shareholders since they have priority over the common shares. However, compared to corporate bonds, debentures, or other fixed-income assets, preference shares will typically have a lesser priority.

Provisions of the Companies Act (Section 55)

Section 55. Issue and Redemption of Preference Shares:

(1) Following the commencement of this Act, no company limited by shares may issue irredeemable preference shares

(2) Subject to prescribed conditions, a company limited by shares, if authorised by its articles, may issue preference shares redeemable within twenty years from their issuance. 

However, for infrastructure projects, shares may be issued for a period exceeding twenty years, with a prescribed percentage redemption annually at the option of preferential shareholders. Conditions include:

• Redemption from company profits available for dividend or from proceeds of a fresh share issue
• Full payment before redemption
• Transfer of the nominal amount to a Capital Redemption Reserve Account when redeeming from company profits, treated akin to paid-up share capital
• Premium payment on redemption provided for from company profits or securities premium accounts. 

(3) If unable to redeem preference shares or pay dividends, the company may issue further redeemable preference shares, with consent from holders of three-fourths in value of such shares and Tribunal approval. The issuance will be deemed as redemption of unredeemed preference shares, subject to redemption of shares held by dissenting shareholders

(4) The Capital Redemption Reserve Account may be used by the company to pay up unissued shares as fully paid bonus shares

Explanation: ‘Infrastructure projects’ refers to those specified in Schedule VI.

Methods of Redemption of Fully Paid-Up shares

Redemption of preference shares entails the company repaying its obligation for the shares issued. As per the Companies Act, 2013, such shares must be redeemed within a specified period, typically 20 years. Therefore, companies cannot issue perpetual preference shares. Section 55 of the Companies Act, 2013, addresses the redemption of preference shares, ensuring no reduction in shareholders’ funds and safeguarding outsiders’ interests. This is achieved through either issuing new shares or retaining distributable profits in the Capital Redemption Reserve Account. 

These provisions aim to protect outsiders’ interests by maintaining the same level of shareholders’ funds before and after redemption. The transfer of profits to the Capital Redemption Reserve ensures that profits retained in the business ultimately convert into share capital. The security cover for outside stakeholders depends on both called-up and uncalled capital, ensuring that only fully paid-up shares are redeemed to maintain outsiders’ interests. 

Therefore, the gap created by the redemption of redeemable preference shares can be filled by proceeds from new share issues, capitalising undistributed profits, or a combination of both.

Procedure to Redeem Preference Shares

When it is proposed to redeem preference shares using company profits, a sum equal to the nominal value of the shares to be redeemed will be transferred from those profits to a reserve that will be called the Capital Redemption Reserve Account, and the provisions of this Act relating to reducing a company’s share capital will apply as if the Capital Redemption Reserve Account were paid-up share capital increase of the company.

With regard to the procedure for redemption of shares, the first and foremost point to be noted is only redeemable preference shares can be redeemed. Equity shares cannot be redeemed at any cost.

The procedure for redemption of shares is:

1. It must be authorised by the articles of association. Verify whether the issuance of preference shares is covered by the Articles of Association. If that is not the cast then first it must be edited in the AOA.
2. The shares will be redeemable only if they are fully paid up
3. The shares may be redeemed out of profits of the company which otherwise would be available for dividends or out of proceeds of the new issue of shares made for the purpose of redeeming shares.
4. If there is a premium payable on redemption it must have been provided out of profits or out of shares premium account before the shares are redeemed.
5. When shares are redeemed out of profits a sum equal to the nominal amount of shares redeemed is to be transferred out of profits to the capital redemption reserve account.
6. Within 30 days of the shareholders’ approval, submit form MGT-14 to the Registrar of Companies together with a copy of the special resolution and an explanatory statement.

This amount should then be utilised for the purpose of redemption of redeemable preference shares. This reserve can be used to issue fully paid bonus shares to the members of the company.

Redemption From the Profit of the Company

When it is proposed to redeem Preference shares using company profits, a sum equal to the nominal value of the shares to be redeemed will be transferred from those profits to a reserve that will be called the Capital Redemption Reserve Account. 

The provisions of this Act relating to reducing a company’s share capital will apply as if the Capital Redemption Reserve Account were paid-up share capital of the company. The corporation may use the capital redemption reserve account to settle outstanding shares that will be issued to members of the company as fully paid bonus shares.

Redemption of Partly Called-Up Preference Shares

Redemption of partly called-up preference shares occurs when a company opts to repurchase a segment of its preference shares that have been issued but not fully paid up by shareholders:

• Repurchase Process: The company buys back these shares at a predetermined price, often outlined in the company’s articles of association or the original issuance agreement
• Financial Improvement: Through this redemption process, the company minimises outstanding liabilities, contributing to an enhancement of its overall financial position
• Return to Shareholders: Shareholders who have partially paid for their shares receive a return of the amount they have already paid, while still maintaining ownership of the unpaid portion
• Motivation Behind Action: This action may be driven by various reasons, including restructuring capital, reducing debt, or aligning the company’s capital structure with its current financial needs and objectives
• Flexibility: Redemption of partly called-up preference shares offers flexibility to the company, enabling adjustments to its capital base without diluting existing shareholders’ ownership interests or resorting to more expensive financing options.

Redemption of Fully Called but Partly Paid-Up Preference shares

Redemption of fully called but partly paid-up preference shares refers to the process by which a company repurchases preference shares that have been called by the company but not fully paid for by the shareholders.

• Notification: Shareholders are informed by the company about its intention to redeem their shares, even though only partial payments have been made on those shares
• Repurchase Price: The company typically repurchases these shares at a pre-agreed price, as outlined in the original issuance agreement or the company’s articles of association
• Financial Improvement: By redeeming these shares, the company eradicates outstanding liabilities linked to them, contributing to an enhancement of its financial position
• Return to Shareholders: Shareholders who have partially paid for their shares receive a return of the amount they have already paid but relinquish their ownership interest in the company
• Capital Structure Cleanup: The action of redeeming these shares allows the company to optimise its capital structure, reduce debt, and streamline financial obligations
• Clarity in Financial Statements: Additionally, the redemption brings clarity and certainty to the company’s balance sheet by eliminating the contingent liability associated with partly paid-up shares.

Conclusion

Preference shares are the ideal financial tool for a business seeking capital without compromising its control or voting rights. Additionally, vakilsearch it provides a fixed income and dividend and repayment priority to the preference owners. As businesses navigate financial strategies, preference shares stand out as a well-rounded choice, combining financial flexibility with legal clarity. Furthermore, Vakilsearch proves invaluable, providing not only legal support but also emphasising the fixed income, dividend, and repayment priority that preference shares afford to their owners.

Frequently Asked Questions

Also.Read:

• How Authorized Share Capital Works?
• What Makes up a Company’s Capital Structure?