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Shri Prem Seth And Others v. National Industrial Corporation Ltd. And Others..
Factual and Procedural Background
The petitioners (four shareholders of respondent No. 1 company) filed a petition under Section 397/398 read with Section 151 of the Companies Act seeking certain reliefs and, in the alternative, a winding up order under Sections 434 read with 439 of the Companies Act. The present application seeks an order restraining the respondents from issuing 20,05,000 shares.
By an earlier judgment dated 2 February 1993, it was held that the petition under Sections 397 and 398 was not maintainable; the question of winding up was directed to be dealt with separately. The winding up petition has not yet been admitted and remained at the show cause stage at the time of this opinion.
Legal Issues Presented
- Whether the respondents should be restrained from issuing 20,05,000 shares.
- Whether the proposed issue of shares violates Section 81 of the Companies Act.
- Whether the proposed issue is a bona fide exercise of the directors' discretion or is mala fide/for the purpose of diluting the petitioners' shareholding.
- Whether the issuance of shares is justified by a genuine need to raise capital (i.e., whether the power to issue shares is conditioned on such need).
Arguments of the Parties
Petitioners' Arguments
- The respondent company proposes to issue 20,05,000 fresh right shares in violation of the provisions of Section 81 of the Companies Act.
- There is no genuine need for raising capital; the proposed issuance would only raise about Rs. 50,00,000 and is unnecessary given the company's financial position (annual accounts and reserves were relied upon).
- The issuance is sought to dilute the petitioners' shareholding and is therefore mala fide.
- Material demonstrating the quantum of expenditure required for raw material purchases and annual raw material requirements was not placed before the Court, according to petitioners' counsel.
Respondent's Arguments (Respondent No. 1 Company)
- The shares are being offered as a rights issue at par to existing ordinary shareholders in the ratio of one new share for each ordinary share held; if accepted, existing shareholders' percentage holdings will not be diluted.
- Of the proposed 20,05,000 shares, 19,95,000 would be allotted to existing shareholders on a 1:1 basis; the remaining 10,000 would be allotted in proportion to additional applications by existing shareholders.
- The company needs additional funds for working capital because the price of molasses (a raw material) has risen drastically following decontrol: from Rs. 14 per quintal (control) to Rs. 250 per quintal (market), with excise duty and sales tax increases (each cited as 20%).
- Only one quarter of required quantity would now be available at the control rate (which has increased to Rs. 70 per quintal for that portion). Decontrol became effective 1 April 1994 (though announced earlier), and the company received large orders (claimed to be approximately Rs. 2 crores) from State and other services, creating immediate working capital needs.
- The company prefers raising equity (no interest burden) to further bank borrowing which would attract high interest (cited around 21% p.a.) and increase interest burden already borne by the company.
- The company had initially contemplated a smaller rights issue (about Rs. 8 lakhs) but the subsequent large order and change in raw-material pricing prompted the present proposal.
Table of Precedents Cited
| Precedent | Rule or Principle Cited For | Application by the Court |
|---|---|---|
| Nanalal Zaver and another v. Bombay Life Assurance Co. Ltd., 1950 (1) S.C.R. 391 | Directors occupy a fiduciary position and must exercise powers for the benefit of the company; the Court can intervene to prevent abuse of power, but will not ordinarily interfere where directors bona fide exercise discretion. Interpretation of earlier Section 105-C (para materia with Section 81 of the present Act) indicates directors have discretion to decide whether to increase capital and on what terms; Section 105-C (or Section 81) operates after that decision is taken. | The court relied on this precedent to recognise directors' fiduciary duty and their discretion in deciding to increase capital; once directors decide to increase capital, statutory provisions governing offers to existing shareholders operate. This supported evaluating whether the present issue was bona fide rather than assuming illegality. |
| Needle Industries (India) Ltd. & others v. Needle Industries Newey (India) Holding Ltd. & others, 1981 (51) Co. Cases 743 | The power to issue shares is not conditioned upon a demonstrable need to raise additional capital. While primary purpose is to enable capital raising when required, the power is not strictly limited to instances where need exists. | The court invoked this principle to reject the proposition that shares can be issued only if there is a strict, demonstrated need to raise capital; it treated the directors' decision to raise funds by issuing shares as a matter of discretion to be assessed for bona fides and interest of the company. |
Court's Reasoning and Analysis
The court proceeded in several analytical steps:
- Legal framework and discretion: The court recounted authority (Nanalal Zaver and Needle Industries) establishing that directors act in a fiduciary capacity, have discretion to decide whether to increase capital, and that the power to issue shares is not strictly conditioned on a demonstrable need to raise capital. The essential enquiry is whether the directors' exercise of that discretion is bona fide and in the interest of the company.
- Issue of dilution: The court observed that the proposed issue is a rights offer at par to existing ordinary shareholders on a 1:1 basis; therefore, if petitioners (and other existing shareholders) exercise their rights, their percentage holding would not be diluted. The proposed allotment of 19,95,000 out of 20,05,000 shares to existing shareholders on that basis was noted; the remaining 10,000 were to be allotted pro rata among applicants.
- Examination of financial evidence: The court examined the company's annual return and accounts for the year ending 31 March 1993 (annexed as Annexure-C). The accounts showed substantial sales (quoted figures), reserve funds (quoted), and historically large expenditure on molasses and other raw material (Rs. 2,46,77,888 on previous prices). The balance sheet also showed significant interest payments (Rs. 77,30,982) and various outstanding borrowings (specific loan figures were noted).
- Recent factual developments: The court took into account evidence of recent purchases at the new market price (invoice dated 27 April 1994 showing purchases at Rs. 250 per quintal and total value quoted), the announced decontrol of molasses, the effective date of decontrol (1 April 1994), and the company's claimed large order (approx. Rs. 2 crores) which would increase working capital requirements.
- Weighing alternatives and bona fides: The court considered the petitioners' argument that the company could raise funds by bank borrowing, but noted the company was already incurring heavy interest and that equity would not carry interest obligations. It rejected the petitioners' contention that raising funds by issuing shares for working capital was impermissible as a matter of law.
- Conclusion on mala fides: On the totality of the financial picture and the contemporaneous commercial developments, the court found no evidence of mala fide conduct or ulterior motive by the company in proposing the rights issue. The earlier proposal to raise a smaller amount did not, by itself, demonstrate an ulterior motive for the present decision.
Holding and Implications
Holding: The court DISMISSED the application seeking restraint of the issuance of 20,05,000 shares.
Direct implications:
- The application for injunctive relief restraining the issuance of the proposed 20,05,000 shares was refused (i.e., no restraint granted).
- By this order the court found the company's decision to issue the rights shares to be a bona fide exercise of discretion and not tainted by mala fide or an intent to dilute existing shareholders who accept their rights.
- The earlier procedural posture in relation to the petition under Sections 397/398 remains that the petition was held not maintainable by the February 2, 1993 judgment; the winding up petition remained at show cause stage (not admitted) as noted in the opinion.
The opinion applied existing case law to resolve the instant dispute but did not announce or claim to establish any new principle of law beyond applying those authorities to the facts before the Court.
P.K Bahri, J.— I have heard arguments for disposing of this application.
2. The prayer made in this application is that the respondents be restrained from issuing 20,05,000 shares.
3. The petitioners, who are four in number and are share holders of the respondent No. 1 company, have brought a petition under Section 397/398 read with Section 151 of the Companies Act seeking certain reliefs and in the alternative have sought winding up order under Section 434 read with Section 439 of the Companies Act.
4. Vide elaborate judgment dated February 2, 1993, it was held that the petition under Sections 397 and 398 of the Companies Act is not maintainable and the matter regarding prayer of winding up was directed to be dealt with separately. The petition for winding up has yet not been admitted and the same is at the show cause stage.
5. Learned counsel for the petitioner/applicant has contended that the respondent no. 1 company has sought to issue fresh right shares in violation of the provisons of Section 81 of the Companies Act and secondly, in fact there is no genuine need for raising any capital for which necessity could arise for issuing of the fresh right shares which would only fetch about Rs. 50,00,000/- to the company. It is argued that the holding of the petitioners is sought to be diluted by resorting to issuance of aforesaid right shares.
6. Learned counsel for the respondent, on the other hand, has argued that there is no question of any dilution of the share holding of the petitioners inasmuch the shares are being offered for subscription at par by way of rights to the existing ordinary shareholders in the ratio of 1 ordinary share against each ordinary share held by them. Admittedly, there are about 19,95,000 shareholders and out of the proposed 20,05,000 shares 19,95,000 shares would be given to the existing shareholders in the ratio of 1 share to ordinary share against each ordinary share held by the shareholder. The remaining 10,000 ordinary shares are to be issued again to the existing shareholders in proportion of additonal shares applied by them. So, it is contended on behalf of the company that there is no proposal to dilute the shareholding of any person inasmuch as if the existing shareholders exercise their option to accept the right share then their ratio of their existing shareholding would not get diluted in any manner. It is also contended on behalf of the respondent No. 1 company that the necessity for issuing the fresh shares had arisen on account of the fact that the company is in dire need of additional funds for working capital inasmuch as the cost of raw material has substantially increased because of decontrol policy introduced by the Government in respect of molasses. The price of the said raw material has shot up from Rs. 14/- per quintal to Rs. 250/- per quintal with consequential increase in excise duty and sales tax, which is again 20% each. It is emphasised that now only 1/4th of the quantity required by the respondent company would be available at control rate which is also gone up from Rs. 14/- per quintal to Rs. 70/- per quintal. It is emphasised that this decontrol has become effective with effect from 1st April, 1994 although policy of the decontrol was announced in November, 1993 but the Government was liberal enough to allow the control prices to remain in force for three months to enable the companies to execute their existing orders. It is emphasised that the company has the requirement of raw material in order to meet the huge order received from the State Government, para military, civil and defence services. That order is to the tune of Rs. 2/- crores. It is then contended by learned counsel for the respondent that earlier the company had proposed to increase the shareholding by issuing right shares of the value of only Rs. 8/- lakhs or so but at that time neither the Government policy had changed with regard to the supply of molasses nor the company had received any such huge order and negtiations for obtaining the aforesaid order took place in early. March, 1994 and thereafter, the company thought it fit to issue shares in question in order to make available funds for which no interest is liable to be paid, whereas the company had already secured loans and huge amount of interest every year is being paid, which amount is increasing every year.
7. Learned counsel for the petitioner has made reference to Nanalal Zaver and another v. Bombay Life Assurance Co. Ltd. 1950 (1) S.C.R 391, wherein it has been held that it is well settled that in exercising their powers whether general or special, the directors must always bear in mind that they hold a fiduciary position and must exercise their powers for the benefit of the company and for that alone and that the Court can intervene to prevent the abuse of a power whenever such abuse is held proved, but it is equally settled that where directors have a discretion and are bona fide acting in the exercise of it, it is not the habit of the Court to interfere with them. It may be noticed that when the company is in no need of further capital, directors are not entitled to use their power of issuing shares merely for the purpose of maintaining themselves and their friends in management over the affairs of the company, or merely for the purpose of defeating the wishes of the existing majority of shareholders.
8. In this very judgment it was also laid down by the Supreme Court while giving interpretation to section 105c of the previous companies act, which is para materia with Section 81 of the present Companies Act and it was held that the directors have a discretion in the matter of the increase of the capital when it says “when the directors decide to increase capital of the company” it means that it is within their absolute discretion to take the decision whether to increase the capital or not. It is also within their discretion to say to what limit and to what extent they will increase the capital and it also for them to decide how many shares and of what value they will issue and once that decision has been taken only then Section 105-C comes into operation.
9. It is quite evident that while issuing the right shares, in case the petitioners exercised their right to obtain the aforesaid right share, the percentage of their shareholding would not be diluted in any manner.
10. In Needle Industries (India) Ltd. and others v. Needle Industries Newey (India) Holding Ltd, and others, 1981 (51) Co. Cases 743, the Supreme Court has again emphasisd at page 816 of the judgment that it is necessary to clear a misunderstanding in regard to the power of directors to issue shares. It is not the law that the power to issue shares can be used only if there is need to raise additonal capital. It is true that the power to issue shares is given primarily to enable capital to be raised when it is required for the purposes of the company but that power is not conditioned by such need.
11. As far as the law is concerned, it is quite evident that the directors of the company act in fiduciary capacity and if they in their discretion decide to issue shares for purposes of raising the funds, the only question for decision is whether the issuance of the shares for the purposes of raising funds is in the interest of the company.
12. The learned counsel for the petitioners has drawn my attention to the annual return and accounts of the company for the year ending 31st March, 1993, copy of which is annexed as Annexure-C filed along with the application, which shows that the company had sales of about 22,28,42,956 in the current years i.e up by 14 crores or so from the previous year and the company had about 1,52,70,603 as reserve funds. By merely raising of Rs. 50,00,000/- by issuing right shares the company would not be having any material effect for carrying on its business. Learned counsel for the petitioners has argued that no material has been placed by the respondent company before this Court to show as to how much financial expenditure would be for purchasing the raw material molasses keeping in view the increase in the price of the said raw material. He has also argued that it is not shown by the company as to how much raw material in a year is required by the company and what would be its investment for purchasing the said raw material in a particular year.
13. The aforesaid balance sheet of the company also shows that on molasses and other raw material the company incurred expenditure of Rs. 2,46,77,888/-, on previous prices, which was up by about 41 lakhs from the previous year. The company has also placed on record an invoice dated 27th April, 1994, showing that the company had made purchases of molasses at the rate of Rs. 250/- per quintal and a total value in respect of such purchases is Rs. 1,75,1014/-. So it is quite evident that the company had to now incur huge expenses for purchasing the said raw material of molasses in this financial year. The said balance sheet of the company also shows that the company is already paying Rs. 77,30,982/- as interest which is up by about Rs. 3,00,000/- from the previous year. The company has about 2,37,00,000/- cash credit loan and about Rs. 23,76,000/- medium term loan and Rs. 24,96,000/- as term loan on molasses and then rs. 5,00,000/- on another term loan loan of Rs. 7,08,000/- and about Rs. 2,33,000/- as cash loan and about Rs. 45,00,000/- as loan from other sources than bank.
14. Could it be said that in view of this picture of the company when the company had in its discretion thought it proper to raise Rs. 50,00,000/- by issuing right shares, the company had acted in any mala fide manner. It is not possible to accept the bald contention of the learned counsel for the petitioners that for raising the funds for the working capital no company had any legal right to raise such funds by issuance of shares and funds for working capital must be raised only by raising loans from the banks. It is not disputed before me that raising of funds by issuance of the shares would not involve any payment of interest while by raising bank loans, the company had to pay interest at quite a high rate of 21% p.a or so.
15. In view of the above discussion, I find that there is no mala fide act on the part of the company in trying to raise the funds by issuance of right shares in question. The mere fact that the company had earlier tried to raise funds by issuance of right shares in 1993, does not mean that the present decision of the company in issuing the right shares is actuated by any ulterior motives and is not bona fide exercise of the discretion in the interest of the company. I find no merit in this application, which I, hereby, dismissed.
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