The Diminishing Allure of Preference Shares: A Modern Financial Paradox

Introduction

Companies form the backbone of an economy who acts as a perfect catalyst for economic activities. To achieve their goals companies require a large number of funding. This has been the most challenging part for the company’s management as the promoters of the company may not have sufficient funds to finance the Company’s ventures. But with the advent of securities and establishment of Stock Exchanges, companies now have a mechanism to issue shares and raise adequate capital. Shares are broadly categorized into equity and preference shares. While preference shares as a concept looks very lucrative, they have largely fallen out of favor, particularly among Indian companies.

Concept of Preference Shares

As per section 431 of the Companies Act, 2013 Preferential shares mean those shares that carry preferential rights over -

1. Payment of Dividend either at fixed amount or fixed rate

2. Repayment of capital in case of winding up

Except for infrastructure Companies, preference shares should be redeemed within 20 years of their issuance2 . If a company wants to reduce its preference share capital it can do so with the approval of the NCLT by either canceling unpaid preference shares or paying off preference shareholders.3

Image taken under Creative Commons license

Declining Trend of issuance of preference shares

Perspective of Company

The issuance of preference shares has witnessed a significant decline, particularly since the introduction of the Companies Act, 1956. Several factors contribute to this trend:

• Market Image: Issuing preference shares creates a negative image in the market by indicating that the company’s future prospects are uncertain and, in extreme cases, it may face corporate insolvency. Companies with strong financial health prefer cheaper instruments like debentures, which do not dilute their ownership.

• Tax Disadvantage: Dividends on preference shares are not tax-deductible increasing burden on company and shareholders making company bound to cut TDS from the dividend4. In contrast, interest on debentures classified as business expense is tax deductible making debt financing far more tax efficient than preference shares.5

• Regulatory Compliance Burden: The compliance burden of preference shares is heavier than other instruments under SEBI and Companies Act regulations. 

• Redemption Obligation: There is an obligation on Companies for redemption of preference shares within 20 years of its issuance leading them to opt for equity shares, which have no mandate for repayment of capital until winding up.

  
  

Shareholder’s perspective

• Less Lucrative: Looking at the current scenario there are hardly any investors who purchase securities for the purpose of dividend as dividends are provided on the face value of the shares which is of meagre value. Instead, they prefer to gain profits through stock appreciation in the secondary market, making equity shares more suitable.

• No voting rights: Every investor would want to become a part of company’s decision-making process through his right of voting in Annual General Meetings but preference shareholders do not carry voting rights with them.

Other side of preference shares 

While it is true that preference shares are not the first choice of the company and investors, it does not necessarily mean that they have become redundant and there are situations when they are the only saving light for the company. There is a limit of 200 members on private companies but if its article of association permits private companies can issue preference shares to any number of investors for the purpose of raising capital as they do not come within the ambit of the 200 mark.6 

Further, to maintain a healthy debt-to-equity ratio companies sometimes prefer to issue preference shares in place of bonds in fact payment of interest on debentures is a more stringent obligation on companies than payment of dividends.7 From the perspective of large shareholders of the company they may raise objections if company decides to issue equity shares which dilutes and reduces their existing voting rights. Lastly, in anticipation of financial distress or insolvency, redeemable preference shares provide a safe and quick exit for shareholders. Additionally, shareholders can safeguard their dividend rights by purchasing cumulative preference shares.

Conclusion

It is true that preference shares have lost their appeal which at first seemed like a perfect medium to invest in companies but have lost their appeal due to their technical complexities, creating a deterrent for companies. They have a limited scope yet they still manage to hold some relevance as demonstrated by recent events such as Vodafone raising 222 million dollars and Nazara tech raising 855 crore rupees through allotment of preference shares. This substantiates that they remain a pertinent financing instrument in specific circumstances, serving a niche function in corporate financing.8

References

1 The Companies Act, 2013, No. 18, Acts of Parliament, 2013, § 43 

2  The Companies Act, 2013, No. 18, Acts of Parliament, 2013, § 55 

3  The Companies Act, 2013, No. 18, Acts of Parliament, 2013, § 66

4  The Income Tax Act, 1961, No. 43, Acts of Parliament, 1961, § 194

5  The Income Tax Act, 1961, No. 43, Acts of Parliament, 1961, § 36(1)(iii)

6  Ministry of Corporate Affairs, General Circular No. 13/2014 (July 25, 2014)

7 James Chen, Why Would a Company Issue Preference Shares Instead of Common Shares?, INVESTOPEDIA (last visited Oct. 26, 2023), https://www.investopedia.com/ask/answers/042015/why-would-company-issue-preference-shares-instead-common-shares.asp.

8  Business Standard, Preferential Allotment, BUSINESS STANDARD (last visited Oct. 26, 2023), https://www.business-standard.com/topic/preferential-allotment.

This article is authored by Daksh Singhal. He was among the Top 40 performers in the Corporate Law Quiz Competition organized by Lets Learn Law.