By Priyanshi Singhal
In Indian law, manner of distribution of funds in case of liquidation or winding up is prescribed under the Companies Act, 2013 (Act) [See End Note 1] and the Insolvency and Bankruptcy Code, 2016 (Code),[See End Note 2] application of which is subject to the nature of the event. The waterfall, as recognized at Indian law, puts shareholders right at the end, with preference shareholders above equity shareholders at all times. The Code specifically prohibits any contractual agreements that might disrupt the order of priority of payment upon liquidation of assets.
Liquidation preference (LP) is essentially a tool for downside protection of an investor. It protects the investor, at the time of a ‘liquidity event’, from exiting the company at a price lower than what was initially expected out of its investment. Thus, LP can be understood as the preferential right of the investor to get paid in case of a ‘liquidity event’. A ‘liquidity event’ includes any recapitalization, reorganization, liquidation, winding up, dissolution or any other similar transaction which might modify or reclassify the rights of the investor.
LP can be built into an investment either though a non-participating LP agreement or through a participating LP agreement. Under a non-participating LP agreement, the investor is entitled to receive either the amount equal to its investment, or in certain cases a multiple of the amount of the investment made by it, depending upon the commercial arrangement between the parties. Under a participating LP agreement, the investor after receiving the pre-determined returns in accordance with the agreement, is further entitled to participate along with the other shareholders in distribution of the surplus proceeds.
LP can be given by creating a special class of shareholders of the company and providing them special rights with respect to preference in liquidation.[See End Note 3] Any such variation of rights must be authorized by the charter documents of the company as well.
Section 43 of the Act characterizes the share capital of a company limited by shares into – (i) equity share capital (either with voting rights or with differential rights to dividend, voting or otherwise) and (ii) preference share capital. Preference shareholders enjoy preferential treatment in payment of dividend as well as repayment in the event of liquidation, winding up or repayment of capital of the company. Companies can issue equity shares with differential rights only in compliance of conditions related thereto specified under the Companies (Share Capital and Debentures) Rules, 2014.
Section 47 of the Act distinguishes between equity shareholders and preference shareholders with respect to voting rights. Equity shareholders are entitled to vote on all resolutions, whereas preference shareholders have a right to vote on limited matters which include inter alia such resolutions which affect the rights attached to those preference shares; or are in relation to winding up or repayment or reduction of capital of the company as prescribed under the Act.
Thus, the limitation on voting matters may appear to make investment in preference shares unappealing for investors despite the right of preferential payment in case of a ‘liquidity event’. However, the Ministry of Corporate Affairs has provided certain exemptions to private companies[See End Note 4] under Sections 43 and 47 of the Act, where the memorandum or articles of association of the company so provide. Illustratively, ensuing exemption, a private company may provide for priority capital and voting rights for equity and preference shares, as long as these rights have been built into the charter documents of the company.
Therefore, in case of private companies, the purpose of LP for investors, not looking to forgo their voting rights, can be achieved by issuing preference shares with voting rights rather than by way of equity shares with differential rights.
Subject to the company’s charter documents, preference shareholders may also be permitted to receive, upon winding up or repayment of capital, a preferential right to payment of either a fixed premium or premium on any fixed scale.[See End Note 5] In addition to the preferential right to repayment, on occurrence of a ‘liquidity event’, preference shareholders may be accorded the right to participate, whether fully or to a limited extent, in any surplus proceeds that remain after repayment of the entire capital (equity and preference), along with the other shareholders of the company.[See End Note 6] This feature of preference shares, essentially fulfils the purpose of a participating LP agreement.
Nevertheless, while the issuance of preference shares with rights as discussed above may appear to give full benefits of an LP clause to investors, there are certain features of an LP clause that make it more attractive than preference shares.
One such downside to the abovementioned arrangement is the concept of distributable compensation to preference shareholders in case of a ‘liquidity event’ being net of repayment of capital, on a pro rata basis.
Further, the uncertainty of adequate funds distributable as premium to the preference shareholders upon repayment of capital, makes the existence of an LP clause, subject to the provisions of the company’s charter documents, prudent in a shareholders’ agreement.
The enforceability of an LP clause, however, is a looming question. While the Act does not restrict contractual agreements that call for assured returns, as is the case with an LP clause in case of ‘liquidity events’, the enforcement has not yet been tested in Indian courts. It is important to understand that effective enforcement of an LP clause would be strictly dependent on the nature of the ‘liquidity event’ itself. Application of laws in case of sale or transfer of securities is different from that of liquidation ordered by courts.
The effects of an LP clause must also be reviewed from a taxation perspective. Further, in light of the pricing guidelines issued by the Reserve Bank of India, accommodating LP clauses in case of foreign investors is a tricky proposition. With such uncertainties in the Indian context, it would be interesting to watch out for the rise or fall of LP clauses going forward.