Non-redemption does not result in preference shareholders becoming creditors or debt of the company – Supreme Court
In a recent judgment, Hon’ble Supreme Court has held that non-redemption does not result in preference shareholders becoming creditors or debt of the company. Preference shares can be redeemed only out of the profits of the company.
Investor companies should take due note of the foregoing position of law before investing in redeemable preference shares. They must remain vigilant and not fall prey to schemes designed to entice investments into shell companies that are unlikely ever to generate profits, where the invested funds may ultimately be misappropriated or diverted.
ABCAUS Case Law Citation:
4812 (2025) (10) abcaus.in SC
In the instant case the appellant company had challenged the order passed by the National Company Law Appellate Tribunal (NCLAT) holding that the Cumulative Redeemable Preference Shares (‘CRPS’) held by the appellant was in the nature of an investment and not a debt. It further held that since payment against the CRPS was not due, no liability can be said to arise.
The appellant had entered into an engineering and construction contract with the respondent company for establishment of a fertilizer complex. An Off-shore Supply Contract was entered for supply of non-Indian origin plant and equipment. Under the said contract a sum became due and payable by respondent to the appellant.
The respondent requested the appellant to convert the part of outstanding amount into CRPS to which the appellant agreed.
Subsequently Corporate Insolvency Resolution Process (CIRP) under the IBC was initiated against the appellant. The respondent informed the appellant that it had unilaterally adjusted the total liability of CRPS against its purported claim against appellant.
The appellant through its Resolution Professional (RP) issued a demand notice to the respondent calling upon payment on account of outstanding receivables which was denied by the respondent.
The appellant filed a Section 7 petition against the respondent on account of failure to pay the redemption amount payable on account of maturity of CRPS. However, the NCLT dismissed the appeal observing that the respondent had incurred losses and if the issuing company is not making profits which are available for dividend or has not raised any equity investments specifically for the purpose of redemption of preference shares, then the preference shares cannot be redeemed. It also held that non-redemption of preference shares does not result in preference shareholders becoming creditors or the carrying value of preference shares and dividends becoming a debt.
The appellant filed an appeal before the NCLAT. However, NCLAT also dismissed the appeal observing that the respondent never declared dividend or earned profit to redeem the preferential shares. The preference shares shall be redeemed only out of the profits of the company which would otherwise be available for dividend or out of the proceeds of a fresh issue of shares made for the purposes of such redemption.
The Hon’ble Supreme Court observed that it is well settled in Company Law that preference shares are part of the company’s share capital and the amounts paid up on them are not loans. Dividends are paid on the preference shares when company earns a profit. This is for the reason that if the dividends were paid without profits or in excess of profits made, it would amount to an illegal return of the capital. Amount paid up on preference shares not being loans, they do not qualify as a debt.
The Hon’ble Supreme Court further observed that Section 55 of the Companies Act stipulates that preference shares shall be redeemed only out of the profits of the company which would be otherwise available for dividends or out the proceeds of the fresh issue of shares made for the purpose of such redemption.
The Hon’ble Supreme Court noted that it had distinguished between creditors and the preference shareholders and held that where redeemable preference shares are issued but not honoured when they are ripe for redemption, the holder of those shares does not automatically assume the character of a “creditor”. The reason is that his shares can be redeemed only out of the profits of the company which would otherwise be available for dividend, or by a fresh issue of shares. This is a limitation which is not applicable to the case of an ordinary creditor. In the face of this position in law, and in the absence of any authority on the subject, the holders of redeemable preference shares do not and cannot become creditors of the company in case their shares are not redeemed by the company at the appropriate time. They continue to be shareholders, no doubt subject to certain preferential rights mentioned in section 85. If they do not become the creditors of the company, they cannot apply for winding up of the company under section 433(e).
The Hon’ble Supreme Court further noted that as per “Principles of Modern Company Law” there is distinction between “debt” and “share”. The main difference between the two in such a case may then be that the dividend on a preference share is not payable unless profits are available for distribution, whereas the debt holder’s interest entitlement is not subject to this constraint; and that the debt holder will rank before the preference holder in a winding-up.
The Hon’ble Supreme Court further held that it is clear from a plain reading of IBC Provisions that to maintain a proceeding under Section 7, an application has to be filed by a financial creditor and the application has to be filed when a default has occurred.
The Hon’ble Supreme Court pointed out that admittedly, the CRPS had not become due and payable since the respondent had not made profits and did not have any reserve out of the profits made in the past nor did it possess any proceeds from a fresh issue of shares made for the purpose of redemption. In this admitted scenario, the question of there being any default under Section 3(12) of the IBC does not arise.
The Hon’ble Supreme Court further held that the CRPS were at a stage when the redemption period had expired would not lend greater weight to the case of the appellant. They continue to be preference shareholders and by being preference shareholders they do not enjoy the status of the creditors of the company. Hence, they do not fulfil the definition of a financial creditor for the purpose of Section 7 of the IBC.
The appellant further contended that financial debt was an admitted liability in the books of accounts of respondent. The Hon’ble Supreme Court held that the treatment in the accounts due to the prescription of accounting standards will not be determinative of the nature of relationship between the parties as reflected in the documents executed by them. Further the IBC has its own prerequisites which a party needs to fulfil and unless those parameters are met, an application under Section 7 will not pass the initial threshold.
Accordingly, the Hon’ble Supreme Court dismissed the appeal being without any merit.
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