Reduction Of Capital Creditors' Interests Paramount

REDUCTION OF CAPITAL – CREDITORS' INTERESTS PARAMOUNT

Requisite checks have been prescribed to be followed before reduction of capital can be sanctioned under law, by the National Company Law Tribunal ("Tribunal") under the 2013 Act, and earlier by the High Court under the 1956 Act to ensure that creditors' interests are paramount

Reduction of capital, as the name suggests, is extinguishing or reduction in liability of a corporate entity towards its shareholders. The provisions relating to reduction of capital have been encapsulated by the legislature in section 66 of the Companies Act 2013 ("2013 Act"), and under section 100 to 105 of the erstwhile Companies Act, 1956 ("1956 Act"). A perusal of the said provisions highlights that while carrying out reduction of capital, the interest of creditors is paramount. Accordingly, requisite checks have been prescribed to be followed before reduction of capital can be sanctioned under law, by the National Company Law Tribunal ("Tribunal") under the 2013 Act, and earlier by the High Court under the 1956 Act.

Other than under section 66 of the 2013 Act, reduction of capital can also be carried out by way of scheme of arrangement under sections 230 to 232 of the 2103 Act. In such a scenario, provisions of section 66 do not apply¹. However, this route of reduction of capital also requires the consent of creditors in the form of consent affidavits or by way of their approval in Tribunal convened meetings.

Reduction of capital acquires the utmost importance primarily in view of the corporate structure wherein the shareholders have limited liability. This is in contrast with the unlimited liability of the sole proprietor or a partner in the case of a partnership firm where the creditors can continue to legally proceed against the sole proprietor/ partner for recovery of their dues despite the entity not having sufficient funds to pay off the creditors. Having safeguards in place also brings the reduction proposal in consonance with the liquidation provisions wherein creditors' interests hold priority over shareholders' claims.

Courts and the legislature have been conscious that under the corporate structure, the shareholders may try to claim their investment to the detriment of creditors. Creditors grant credit to the company believing that their interest shall not be prejudiced. To protect such faith of creditors, the legislature has enacted the provisions for reduction of capital. The above provisions which safeguard against unscrupulous payment of shareholders' funds by foregoing the creditors' interests came into existence under various decisions of Courts, and thereafter by legislative enactment.

Courts have held that any arrangement concerning the company's capital which has the effect of reducing it, is within the purview of the aforesaid statutory provision². The provisions enable a company to reduce its capital in any manner it deems proper.

Time and again it has been upheld that before carrying out reduction of capital, creditors' interests have to be protected. Recently, the National Company Law Tribunal ("NCLAT") reiterated the said principle in Precious Energy Services Limited v. The Regional Director in Company Appeal (AT) No. 17 of 2021 decided on 28th July, 2022

BRIEF FACTS OF THE CASE

The Appellant Company(Precious Energy Services Limited), as on 31 March 2019 had an authorised capital of Rs.7.51,00,000/-, with Rs.6,98,50,050/- being itsissued, subscribed, and paid-up share capital. The Board of the Appellant Company vide Resolution dated 30th September 2019, and subsequently, the members in an annual general meeting convened on 24th September 2019,unanimously, by way of a Special Resolution, approved the reduction of share capital by cancelling Rs.69,75,000/- equity shares of Rs.10 each, by paying to the holders of such equity shares an agreed amount of Rs.77.49 per equity share totalling to Rs.54,04,92,750/-.

Upon the Appellant Company filing a petition before the National Company Law Tribunal, Ahmedabad Bench, Ahmedabad, ("NCLT") and notices having been issued, the Regional Director objected to the proposed reduction of capital inter alia on the grounds that the Company did not have sufficient liquidity for making payment towards reduction of share capital and that certain persons claiming to be creditors had objected to the proposed reduction of capital.

Considering the submissions of the parties, the NCLT rejected the reduction of capital proposed by the Appellant Company noting that the net worth of the Company, as per its books, was negative, the Company is having high borrowings and that the proposed capital reduction by way of return of capital to its shareholders is not in the overall interest of the Company and its stakeholders.

Aggrieved by the aforesaid Order of the NCLT, the Appellant Company approached the NCLAT by way of Company Appeal (AT) No. 17 of 2021.

Before the NCLAT, citing various case laws, the Appellant Company submitted that:

• The proposed reduction of capital had been unanimously approved by its shareholders with the objective of reducing the overall weighted average cost of capital and improving the earning per share. The said approval was issued by the shareholders in their commercial wisdom, keeping in view the financial health of the Appellant Company.

• NCLT has failed to look into the complete records of the Financial and Valuation Report of the Appellant Company.

• The Appellant Company had satisfied all the requirements prescribed under section 66 of the Act and the rules framed the reunder and it was not in violation of any provision of law or contrary to any public policy.

• The Appellant Company had sufficient funds and regular sources of Cash Flow arising out of the Power Purchase Agreement. It was contended that the net worth of the Appellant Company appeared to be negative in its books of account only due to depreciation being charged on the assets of the capital-intensive industry i.e., the Solar Power Plant.

• The statement for projected Cash Flows depicts sufficient liquidity which the Tribunal should have taken into consideration.

DECISION BY NCLAT

Referring to the following inter alia judicial pronouncements, the NCLAT allowed the appeal and set aside the order of the NCLT on the premise that the interests of creditors were not hampered and that the shareholders had approved the proposed reduction of capital.

i. The House of Lords of England in 'British and American Trustee and Finance Corporate' v. 'Couper'³, , observed as hereunder:

"I do not see any danger in the conclusion that the Court has power to confirm such a scheme as that now in question, or any reason to doubt that this was the intention of the Legislature. The interests of the creditors are not involved, and I think it was the policy of the Legislature to entrust the prescribed majority of the shareholders with the decision whether there should be reduction of capital, and if so, how it should be carried into effect ...."

"...If the parties to the transaction come to the conclusion that the bargain is a fair one; why should the Court say that there is a preference on the one side or on the other. If there is nothing unfair or inequitable in the transaction, I cannot see that there is any objection to allowing a company limited by shares to extinguish some of its shares without dealing in the same manner with all other shares of the same class. There may be no real inequality in the treatment of a class of shareholders although they are not all paid in the same coin or in coin of the same denomination..."

(Emphasis Supplied)

ii. The Madras High Court in 'Re. Panruti Industrial Company (Private) Ltd.'⁴, , held as follows:

"...the question of reduction of capital has been treated as a matter of domestic concern, one for the decision of the majority of the shareholders of the company."

(Emphasis Supplied)

iii. In 'Reckitt Benckiser (India) Ltd. (CP 206 of 2004) (Delhi High Court)' it was held that:

"(i) The question of reduction of share capital is treated as a matter of domestic concern, i.e. it is the decision of the majority which prevails. (ii)If the majority by special reduction decides to reduce the share capital of the Company, it has also the right to decide how this reduction should be carried into effect...."

(Emphasis Supplied)

iv. In 'IL&FS Engineer and Construction Company Limited' v. 'Wardha Power Company Limited' ⁵, , held as follows:

"Either in the case of a reduction of capital or a scheme of arrangement or both, the Court cannot interfere with the discretion and commercial wisdom of the stakeholders and theBoard of Directors. (Re Ratners Group Plc; In Re Hindalco Industries Ltd). If the reduction is one which is properly passed by the shareholders who are treated equitably, have had the facts explained, and provided the creditors are safeguarded, the court will habitually sanction reductions and exercise its discretion in favour of them unless the act is a pointless and hollow act. Provided those requirements are satisfied, the company may reduce its capital in any way that it thinks fit. (Re Rafter Group plc; Re Ratners Group plc; In Re Hindalco Industries Ltd2). The court does not exercise any appellate power over the decision of the Company or its management. The Court is required to satisfy itself and see that the procedure, by which the resolution is carried through, is legally correct and the shareholders and creditors are not prejudiced. It is also the duty of the Court to see that the scheme is fair and equitable between the different classes of shareholders, (In Re Hindalco Industries Ltd; Hyderabad Industries Ltd., In re), the arrangement is such as a man of business would reasonably approve, (Hindustan Lever Employees' Union v. Hindustan Lever Ltd.; Custina Re Haare and Butfe Press LIC ), and the proposed reduction is within the powers of the company, and for the purposes allowed by the statute. The courts have a 'discretion' to confirm or not to confirm, which it is their duty to apply in 'every proper case,' and this discretion is to be exercised by reference to - whether the scheme would be 'fair and equitable,' 'just and equitable,' 'fair and reasonable' or 'not unjust or inequitable'. (Gower's Principles of Modern Company Law (Fourth Edition) Chapter 1 O; Scottish Insurance Corpn. v. Wilson & Clyde Coal Co.). Petitions, for approval of such schemes, are usually matters where the court can sanction the scheme without more than a careful check that all the correct steps have been taken. Although the court must be satisfied that "the proposal is such that an intelligent and honest man, a member of the class ... might reasonably approve" - yet the underlying commercial purposes need not be investigated. The court will not be concerned with their commercial reasons for approval. (Re MB Group plc ; In re Dorman, Long and Company Limited v. In re South Durham Steel and Iron Company).

(Emphasis Supplied)

v. The High Court of Andhra Pradesh in 'Hyderabad Industries Ltd.'⁶, has observed as hereunder:

"…6. It is very well settled and needs no restatement that this Court does not exercise any appellate power over the decision of the Company or its management. The Company Court in its equity jurisdiction is required itself to satisfy and see that the procedure by which resolution is carried through is legally correct and the shareholders and creditors are not prejudiced. It is also the duty of the Court that it had to see that the scheme is fair and equitable between the different classes of shareholders. It is no doubt true that it is the duty of the Court to protect the interests of the creditors and it must be safeguarded. Public interest is also a paramount consideration…".

(Emphasis Supplied)

The NCLAT observed that the Appellant Company had complied with all the statutory requirements as per the directions of the Tribunal and has also filed necessary affidavits to that effect. The NCLAT further noted the contents of the clarificatory affidavit filed by the Company regarding its financial position which was not in the negative and also that the reduction of the Share Capital was approved by its shareholders and that the creditors of the Company had not objected to the same. It was also noted that the said reduction did not cause any prejudice to any class of creditors. Accordingly, having satisfied the aforesaid parameters, the reduction of the share capital, as approved by the majority of Shareholders by way of a Special Resolution, was confirmed and approved by the NCLAT.

Thus, both the NCLT and NCLAT again confirmed that, apart from following other parameters, the interest of creditors is paramount and is required to be safeguarded for approving reduction of capital proposed by a company. The decisions by the NCLT and NCLAT both were centred around the liquidity of the Company and its ability to meet the obligations towards its stakeholders. The NCLT rejected the petition of the Company on the grounds that the net worth of the Company was negative and that the proposed capital reduction by way of return of capital to its shareholders was not in the overall interest of the Company and its stakeholders. Later, (i) basis the clarification cited by the Company that its financial position was not in the negative and further that (ii) the reduction of the share capital was approved by its shareholders (iii) the creditors of the Company had not objected to the same and (iv) the said reduction did not cause any prejudice to any class of creditors, the NCLAT allowed the petition.

The principle of prioritizing the interests of creditors while approving reduction of capital of a Company, was thus re-affirmed.

Disclaimer – The views expressed in this article are the personal views of the authors and are purely informative in nature.