Raising Capital under the Companies Act, 2013 (Contd.) – Treatment of Share Application Money: An analysis

In our previous post (available here), we had dealt with raising capital under the Companies Act, 2013 (“2013 Act”) on a private placement basis. This issue would deal with share application money which was once a mode of short term finance for Companies but has now been stringently regulated by the 2013 Act.

Prior to the enactment of the 2013 Act, companies had a wider range of options when it came to raising short term finance for its working capital requirements. Share application money, being the money raised from potential shareholders for the allotment of shares was one such method adopted largely by private companies that did not have access to public funds.

The treatment of share application money has had a chequered history under the Companies Act, 1956 (“1956 Act”), mostly because the 1956 Act did not prescribe a maximum time limit upto which share application money could be retained by a company. This provided companies with an option of retaining such share application money for as long as its working capital requirement lasted, without having to compulsorily capitalize the same within a specific period of time.

The aforementioned option proved to be favourable for all parties involved when share application money was received from existing members, directors or their relatives, making it a means for promoters and their relatives to infuse easy short term finances into the company. However, this option also placed external investors in a sticky situation when the company did not allot shares against their share application money within a reasonable period. In fact, certain Companies have share application money exceeding their Authorised Capital and the Registrar of Companies in the absence of specific regulations was not able to take requisite action. This led to gross misuse of the money obtained under the guise of share application.

In many such cases, the Courts have had to come to the rescue of investors and have held that an application to take shares lapses if allotment is unreasonably delayed (INC Trading Company Limited v. Padamsey Premji ((1934) 4 Comp Cas 110 (Bom)).

A classic case affirming the above argument can be found in the decision of the Company Law Board, Principal Bench New-Delhi in the matter Shri Hari Narayan Sharma and others vs. Baghpat Engineering Company Limited. (C.P. No. 49/96 dated 09/02/2001). In this matter, the Company Law Board came to the rescue of investors who had contributed funds to the company as share application money and were not allotted shares for over eight years. The case is also a prime example for emphasising the need for investors to have a thorough knowledge of corporate regulations and protections offered by the law before investing in a company. In the instant case, fortunately the Company Law Board stepped in and directed the Respondent company i.e. Baghpat Engineering Company Limited to allot shares and provide rightful shareholding to the Petitioners in the company.

Investor pitfalls:

An investor who contributes towards the share application money is neither a shareholder nor a secured creditor, but will rank as an unsecured creditor featuring in the bottom of the hierarchy in terms of repayment. Therefore, even if the courts direct repayment of the share application money, the investor’s would not be entitled to interest on the same until the institution of a winding up petition, thus putting investors whose advance has been outstanding for several years at a great loss.

Companies Act, 2013:

Share application money under the 2013 Act is stringently regulated by Rule 2 (vii) of Companies (Acceptance of Deposit) Rules 2014, the explanation to which provides that a company must allot shares against share application money within 60 days from the date of its receipt failing which they shall refund the same within 15 days after expiry of the said 60 day period to avoid being classified as a deposit under Section 73 of the 2013 Act.

Dual Investor Protection:

In addition to the above, the explanation states that the aforesaid provisions shall apply “without prejudice to any other liability”. This has a number of implications which are detailed below:

1. Section 42 of the 2013 Act prescribes a penalty of Rs. 2 crores if securities issued on a private placement basis are not allotted within 60 days. Therefore, non allotment in case of a private placement, in addition to be being treated as a deposit, also attracts a fine of Rs. 2 crores.
2. It is also pertinent to note that the extant Consolidated Foreign Direct Investment Policy (being Circular 1 of 2014) issued by the Reserve Bank of India, provides that a company in India issuing shares or convertible debentures, must allot such shares against share application money received within 180 days from the date of inward remittance or debit to NRE/FCNR (B)/Escrow Account failing which such amount must be refunded to the investor by outward remittance through normal banking channels or by credit to his NRE/FCNR (B) Account as the case may be.

There is a direct conflict as to the number of days for retaining the share application money, as provided under the 2013 Act and the extant foreign exchange regulations, an issue that the Ministry of Corporate Affairs (“MCA”) is yet to clarify.

Conclusion:

As evidenced above, the 2013 Act has ensured that share application money retained for a period exceeding 60 days would be classified as a deposit thus making it compulsory for the Company to follow cumbersome deposit procedures such as deposit repayment reserve, deposit insurance, providing security for due repayment etc.

It is also pertinent to note that the government has gone that extra mile in the interest of investor protection and provided additional penalty under Section 42 for non allotment in the case of raising equity through private placement, a move that accords added protection, especially to private equity investors.

The MCA is yet to resolve the issue of direct conflict between the provisions of FDI and Companies Act with regards to the time period of retention of Share Application Money. This provision also gives rise to two conflicting principles of interpretation, i.e. the principle of special law over general law (Lex specialis derogat legi generali) versus the principle of a newer law over the older law (lex posterior derogat legi priori).

However, in light of the stringent penalties prescribed by the 2013 Act, it appears that until a clarification is issued, it would be in the interests of the Company not to retain share application money, from domestic as well as foreign investors, for a period of over 60 days.

  (The Author was a Senior Associate in the Corporate team, Jayanth Pattanshetti Associates, Bangalore)