For investment transactions particularly in private limited companies, in Bangladesh, we are historically more comfortable in dealing with ordinary shares. With a significant rise in foreign direct investment (FDI) in recent pre-Covid years, the government’s commitment to policy reforms to attract more FDI, rise in pre-seed and seed investments and the Bangladesh Securities and Exchange Commission’s move to ease the capital issue and requirements relating to conversion of companies from private to public and listing, we’ve seen more interest in and increased conversations around investment structuring through preference shares, over ordinary shares.
This begs the question – What are preference shares?
Preference shares make up a part of the issued or paid-up capital of a company. It is considered equity security and can be issued as another category of shares after or together with the ordinary share capital or ordinary shares of a company. There can be different types of preference shares: ‘Cumulative’ preference shares accumulate dividend arrears and carry them forward, whereas ‘non-cumulative’ shares receive dividends only if the company pays them. Convertible preference shares may be switched after a fixed term into ordinary shares, and redeemable shares pay the investor on a specified date.
What is clear therefore is that this class of shareholders get a preference over the class of ordinary shareholders. The Law Lexicon (3rd edition) describes the term “preference” inter alia as the act of preferring one thing above another, and a “preference share” as a guaranteed share and interest bearing share. As per the Black’s Law Dictionary, the term ‘preference share’ is a share giving its holder a preference, either as to receipt of dividends, or as to payment in case of winding up, or both.
In the US, ‘preferred stock’ holders are entitled to a fixed dividend to be paid regularly before dividends can be paid on common stock. They also exercise claims to assets, in the event of liquidation (that is, they get a liquidation preference), senior to holders of common stock but junior to bond holders. Holders of preferred stock normally do not have a voice in management.
In Bangladesh, although the features of a preferential issue of capital are dealt with in section 154, there is no comprehensive definition of ‘preference share’ under the Bangladesh Companies Act, 1994.
Why issue preference shares or different classes of shares at all? There can be a myriad of reasons: the founders and ordinary shareholders may be reluctant to issue further ordinary shares to outsiders when raising additional capital, because that would have the effect of diluting their control on the business. This is because ordinary shares generally carry the majority of voting rights at meetings and also entitle shareholders to the lion’s share of any declared dividend.
A solution, other than issuing debentures (which in Bangladesh would require the consent of the Bangladesh Securities and Exchange Commission), is to issue preference shares. The attractive feature of preference shares is that it affords a company means of raising additional capital without conferring voting rights equal to that of ordinary shareholders.
The common global standard for preference shares, therefore, is that preference shares generally carry preferential dividend rights and priority to a return of capital in a winding up. Preference shares generally have restricted voting rights such that they cannot vote in general meetings unless, for example, their dividends are in arrears.
In addressing preference shares, the Companies Act, 1994 provides for the issuance of “redeemable preference shares”, a provision which means that the shares can be redeemed after a certain pre-agreed period or at the option/upon notice of the company. It is noted that in the jurisdiction of neighbouring India, by the 2013 Act, no company limited by shares can issue shares which are irredeemable; and in fact redeemable shares there must be redeemed within 20 years (unless they relate to infrastructure projects). This, in fact, is advisable for our jurisdiction also, since the idea of preference shares is to meet the need for capital in return for secured pay-outs to investors without disturbing the operational element of the company.
Such a move can be beneficial for both the investors and investee companies as it identifies the furthest goal-post for an exit. The legislature may take note of this as the Bangladesh Companies Act embraces further reforms in addressing the ease of doing business.
In issuing equity in the form of preference shares, the first thing to note is that preference shares can be issued only if authorised by the articles of association of the company (the “Articles”). If the Articles do not cater for it, the Articles have to be first amended to insert necessary wording to issue preference shares in the company. A trend noticed at the Registrar of Joint Stock Companies and Firms (RJSC) is that preference shares are generally issued not at incorporation, but only at post-incorporation. However, this is only due to the fact that the forms to be submitted at the time of incorporation do not allow for creating a separate class of shares as preference shares. This is an unnecessarily cost-incurring exercise which is not prescribed by the law and should be looked into by the Registrar.
Next, the rights attaching to the preferential class of shares (or for any other class for the matter) should be clearly stated in the agreement for subscription, in the special resolution authorising the share issue and the company’s charter/articles of association and in the return of allotment. The matter of voting rights, information rights and representation must be particularly addressed, other than the obvious matters of dividend, exit and convertibility.
When time comes for redemption, section 154 of the Bangladesh Companies Act, 1994 provides that no redeemable preference shares can be redeemed except, (a) out of profits of the company which would be otherwise available for dividends or (b) out of the proceeds of a fresh issue of shares made for the purposes of the redemption or (c) out of sale proceeds of any of the assets of the company.
Compliance requires inclusion in every balance sheet of a company which has issued redeemable preference shares, a statement specifying what part of the issued capital of the company consists of such shares and the date when the shares are liable to be redeemed. Once redeemed, the redemption of preference shares by a company is considered a transfer into the hands of the shareholders, and they will be liable to capital gains. And in fact, the restriction in our laws of a company purchasing its own shares does not apply in the case of preference shares.
Overall, as private investment transactions in our jurisdiction shifts with the times and draws level with international approaches, the thing to be kept in mind is that as we utilise the laws, tools and processes in our jurisdiction and learn from structures off-shore, we must, however, be careful not to capitalise on bargaining power and impose conditions, rights and obligations which vary the basic nature of the security on which the law is silent. Such move is unlikely to bode well for the investors or the company (which must be a promising one to invest in the first place) in the long run and may result in a stalemate in terms of returns. Fair play and conscientiousness are after all proven to be the best approach even when the ultimate goal is profit and shareholder returns.
Anita Ghazi Rahman is an Advocate of the Supreme Court of Bangladesh and managing partner at The Legal Circle.