Issue and Redemption of Preference Shares
Chapter Twenty-Seven
Syllabus topic 1.4, label: "Issue and Redemption of Preference Shares"
Pages 157 to 162 of 830
In one line
Preference shares must be redeemable within twenty years, can be redeemed only out of profits or a fresh issue, and only if they are fully paid.
In exam wording: section 55(1) prohibits a company limited by shares from issuing irredeemable preference shares. Section 55(2) permits redeemable preference shares, if authorised by the articles, redeemable within a period not exceeding twenty years, with an exception for infrastructure projects, and subject to four conditions in the second proviso, of which the most important are that redemption must be out of profits available for dividend or out of the proceeds of a fresh issue, that the shares must be fully paid, and that a Capital Redemption Reserve Account must be created where profits are used.
Why the law has this at all
A preference share is a hybrid. It looks like a share, because the holder is a member and the money is capital. It behaves like a loan, because the return is fixed and the capital comes back.
That hybrid quality is useful and it is also dangerous. Useful, because a company can raise money without giving away control and without the fixed obligations of a debt. Dangerous, because if the capital can be handed back at will, the creditors' cushion evaporates. Creditors lend against the capital, and capital that walks out of the door is not a cushion.
So the Act allows redemption but polices the source of the money. Redemption may come only out of profits that could otherwise have been paid out as dividend, or out of the proceeds of a fresh issue. In the first case the shareholders give up a dividend to buy the capital back; in the second, new capital replaces old. Either way the total capital available to creditors does not fall. And where profits are used, an equal sum is locked into a Capital Redemption Reserve Account which is treated as if it were paid-up capital, so it cannot be distributed.
That is the whole design, and an answer that explains it reads far better than one that lists the conditions.
Some words this chapter uses
Redeemable means repayable by the company. Irredeemable means never repayable, so the capital stays out forever. Profits available for dividend are the distributable profits. A fresh issue is a new issue of shares made for the purpose of the redemption. Fully paid means nothing remains unpaid on the share. Premium on redemption is an amount paid over and above the face value when the share is repaid. Pari passu means ranking equally.
The prohibition: section 55(1)
No company limited by shares shall, after the commencement of this Act, issue any preference shares which are irredeemable.
Issue and Redemption of Preference Shares
Three points. It binds a company limited by shares. It applies to shares issued after the commencement of this Act, so irredeemable preference shares issued long ago under earlier law are untouched, and the proviso to section 43 protects the winding-up rights of such holders. And it is absolute: no resolution, no article and no approval can authorise an irredeemable preference share.
The permission and the twenty year rule: section 55(2)
A company limited by shares may, if so authorised by its articles, issue preference shares which are liable to be redeemed within a period not exceeding twenty years from the date of their issue subject to such conditions as may be prescribed.
Two threshold requirements. The articles must authorise it, so a company whose articles are silent must first alter them under section 14. And redemption must be within twenty years from the date of issue.
The first proviso, infrastructure. A company may issue preference shares for a period exceeding twenty years for infrastructure projects, subject to the redemption of such percentage of shares as may be prescribed on an annual basis at the option of such preferential shareholders.
Read that carefully, because it is often misstated. The exception does not create a perpetual share. It allows a longer term for infrastructure, and it gives the shareholder an annual option to have a prescribed percentage redeemed. The choice is his, not the company's.
The four conditions: the second proviso to section 55(2)
(a) The source of the money. No such shares shall be redeemed except out of the profits of the company which would otherwise be available for dividend, or out of the proceeds of a fresh issue of shares made for the purposes of such redemption.
Two permitted sources, and no third. In particular, redemption may not be made out of borrowed money or out of ordinary capital.
(b) Fully paid. No such shares shall be redeemed unless they are fully paid. A company cannot return capital on a share while part of it is still owed to the company.
(c) The Capital Redemption Reserve Account. Where the shares are redeemed out of profits, there shall out of such profits be transferred a sum equal to the nominal amount of the shares to be redeemed to a reserve called the Capital Redemption Reserve Account, and the provisions of this Act relating to reduction of share capital shall, except as provided in this section, apply as if that Account were paid-up share capital of the company.
This is the sub-clause that makes the whole scheme work. Profits that could have been paid out as dividend are converted into something that is treated as capital, and can be touched only by going through section 66. The creditors' cushion is preserved in substance even though preference shares have gone.
Issue and Redemption of Preference Shares
Note that (c) applies only where profits are used. Where the redemption is funded by a fresh issue, no transfer is needed, because new capital has already replaced the old.
(d) The premium on redemption. Where a premium is payable on redemption:
- (i) in the case of such class of companies as may be prescribed, whose financial statements comply with the accounting standards prescribed under section 133, the premium shall be provided for out of the profits of the company, before the shares are redeemed. A further proviso allows the premium on preference shares issued on or before the commencement of this Act by such a company to be provided out of profits or out of the securities premium account.
- (ii) in any other case, the premium shall be provided for out of the profits of the company or out of the company's securities premium account, before the shares are redeemed.
So the general rule permits the securities premium account to be used, and the prescribed class of companies is confined to profits for shares issued after the Act. Section 52(2)(d) is the matching provision on the securities premium side, permitting that account to be applied in providing for the premium payable on redemption of redeemable preference shares.
A worked example
Sangli Sugars Limited has articles authorising redeemable preference shares.
The issue. On 1 April 2027 it issues two lakh, ten per cent redeemable preference shares of one hundred rupees each, redeemable at par at the end of eight years. That is within twenty years, so section 55(2) is satisfied, and because they are redeemable, section 55(1) is not offended.
Could it have issued them irredeemable? No. Section 55(1) is absolute for a company limited by shares.
Could it have issued them for thirty years? Only for an infrastructure project, under the first proviso, and then the shareholders would have an annual option to have a prescribed percentage redeemed.
Redemption, case one, out of profits. In 2035 the company redeems the whole two crore rupees out of distributable profits. Conditions: the shares must be fully paid, by proviso (b); the money must come from profits which would otherwise be available for dividend, by proviso (a); and a sum equal to the nominal amount redeemed, two crore rupees, must be transferred out of those profits to the Capital Redemption Reserve Account, by proviso (c). That Account is then treated as paid-up share capital, so it can be reduced only under section 66.
Issue and Redemption of Preference Shares
Redemption, case two, out of a fresh issue. Instead the company issues two crore rupees of new equity for the purposes of the redemption and uses the proceeds. Proviso (a) is satisfied by the second limb. No transfer to the Capital Redemption Reserve Account is required, because the capital has been replaced rather than paid away.
Redemption, case three, out of a bank loan. Not permitted. Proviso (a) allows only profits available for dividend or the proceeds of a fresh issue.
A premium. Suppose the shares are redeemable at a premium of ten rupees each, twenty lakh rupees in all. Under proviso (d)(ii) that premium must be provided for out of profits or out of the securities premium account, before redemption, and section 52(2)(d) expressly allows the securities premium account to be applied for exactly that. If the company falls in the prescribed class under (d)(i), it must use profits for shares issued after the commencement of the Act.
Partly paid shares. Ten thousand of the preference shares have twenty rupees unpaid. Those shares cannot be redeemed until they are fully paid, by proviso (b).
And note the voting consequence. If the company fails to pay the preference dividend for two years or more, the second proviso to section 47(2) gives that class a right to vote on all resolutions, which is a real lever when redemption is being negotiated.
Distinctions that carry marks
| Redemption out of profits | Redemption out of a fresh issue | |
|---|---|---|
| Source | Profits otherwise available for dividend | Proceeds of a fresh issue made for the purpose |
| Capital Redemption Reserve Account | Required, equal to the nominal amount redeemed | Not required |
| Effect on capital | Distributable profit is converted into something treated as capital | New capital replaces the old |
| Effect on shareholders | They forgo a dividend | They are diluted by the new issue |
| Preference share | Debenture | |
|---|---|---|
| Holder | A member | A creditor |
| Return | Preferential dividend, only if there are profits | Interest, payable whether or not there are profits |
| Repayment | On redemption, from profits or a fresh issue only | On the due date, from any source |
| Maximum term | Twenty years, longer for infrastructure | No statutory limit |
| Voting | Limited, section 47(2), full after two years of unpaid dividend | None |
| Priority on winding up | After creditors, before equity | Before all members |
What this does NOT mean
It does not mean preference shares must be redeemed within twenty years. They must be liable to be redeemed within that period. The company and the terms decide when within it.
It does not mean infrastructure preference shares are irredeemable. The first proviso allows a longer period, with an annual redemption option for the shareholder of a prescribed percentage.
Issue and Redemption of Preference Shares
It does not mean a Capital Redemption Reserve is always needed. Only where the redemption is out of profits.
It does not mean the premium can always come from the securities premium account. For a prescribed class of companies whose statements comply with section 133 standards, the premium on shares issued after the commencement of this Act must come out of profits.
Quick revision
- 55(1): no company limited by shares may issue irredeemable preference shares after the commencement of this Act. Absolute.
- 55(2): redeemable preference shares, if authorised by the articles, redeemable within twenty years of issue, on prescribed conditions.
- First proviso: longer than twenty years for infrastructure projects, with annual redemption of a prescribed percentage at the shareholder's option.
- Second proviso, four conditions:
- (a) redeem only out of profits otherwise available for dividend or the proceeds of a fresh issue made for the purpose;
- (b) only if the shares are fully paid;
- (c) where profits are used, transfer a sum equal to the nominal amount to the Capital Redemption Reserve Account, which is treated as paid-up share capital;
- (d) the premium on redemption is provided before redemption, out of profits for a prescribed class under section 133, and otherwise out of profits or the securities premium account.
- Section 52(2)(d) permits the securities premium account to be applied to that premium.
- Section 47(2) second proviso: dividend unpaid for two years gives the class a vote on all resolutions.
Test yourself
1. May a company issue irredeemable preference shares? No. Section 55(1) prohibits a company limited by shares from issuing any irredeemable preference shares after the commencement of this Act.
2. What is the maximum period for redemption, and what is the exception? Twenty years from the date of issue: section 55(2). The exception, in the first proviso, is for infrastructure projects, where a longer period is permitted subject to redemption of such percentage as may be prescribed on an annual basis at the option of the preference shareholders.
3. Out of what may preference shares be redeemed? Only out of the profits of the company which would otherwise be available for dividend, or out of the proceeds of a fresh issue of shares made for the purposes of the redemption: proviso (a) to section 55(2).
4. When must a Capital Redemption Reserve Account be created, and what is its effect? Where the shares are redeemed out of profits. A sum equal to the nominal amount of the shares redeemed is transferred out of those profits to the Account, and the provisions relating to reduction of share capital apply as if the Account were paid-up share capital: proviso (c).
Issue and Redemption of Preference Shares
5. Can partly paid preference shares be redeemed? No. Proviso (b) to section 55(2) requires that no such shares shall be redeemed unless they are fully paid.
6. Out of what may the premium on redemption be provided? Generally out of the profits of the company or the securities premium account, before redemption: proviso (d)(ii), and section 52(2)(d) permits the latter. For a prescribed class of companies whose financial statements comply with the section 133 standards, it must come out of profits for shares issued after the commencement of this Act.
The rest of this subject
These notes are cut from the University's printed syllabus. Open the syllabus itself, or the past papers, for the same subject.