Part I: Understanding the Legal Framework
- Definition and Explanation of Relevant Terms: Before delving into the legal framework, it’s crucial to understand the key terms involved. A loan refers to funds borrowed by a company from an individual, institution, or another entity, typically with an obligation to repay the borrowed amount with interest. Equity, on the other hand, represents ownership in a company, often in the form of shares or stock. Conversion refers to the process of converting a loan into equity, where the creditor becomes a shareholder in the company.
- Brief Introduction to the Companies Act and Section 62(3): The Companies Act, 2013 serves as the primary legislation governing the functioning and operations of companies. Section 62(3) of the Companies Act allows for the conversion of loans into equity. This section states that a company may, with the approval of a special resolution passed by its shareholders, convert any of its loans into shares of the company.
- Rules made under the Companies Act: The Companies (Share Capital and Debentures) Rules, 2014 (the “Rules”) play a significant role in providing further provisions and guidance regarding the conversion of loans into equity. These rules establish specific conditions that must be met for a loan to be converted into equity:
Part II: Pre-Conversion Considerations
- The terms and conditions on which the loan may be converted into equity, such as the date on which the conversion will take place, the number of shares that will be issued in exchange for the loan, and the price per share.
- The procedure for converting the loan into equity, such as the steps that the company and the lender must take in order to complete the conversion.
- The special resolution must be passed by a majority of the company’s shareholders at a general meeting. Once the special resolution has been passed, the company may convert the loan into equity at any time in the future, subject to the terms and conditions specified in the resolution.
Part III: Checklist for Converting a Loan into Equity
- Check if the loan agreement allows for conversion into equity. The loan agreement should specify whether the loan can be converted into equity and the terms and conditions of the conversion.
- Check if the company has passed a special resolution at the time of accepting the loan, which specifies that the loan may be converted into equity in the future. This is necessary to ensure that the lender is aware of the possibility of the loan being converted into equity, and that they have agreed to this possibility. The special resolution must be passed by a majority of the company’s shareholders at a general meeting. Once the special resolution has been passed, the company may convert the loan into equity at any time in the future, subject to the terms and conditions specified in the resolution.
- Check if the company has sufficient distributable profits to cover the amount of the loan that is being converted into equity. This is a requirement under the Companies Act. Important point with respect to the requirement of distributable profit is as under
- Distributable profits are the profits of a company that are legally available for distribution as dividends. In order to convert a loan into equity, the company must have sufficient distributable profits to cover the amount of the loan that is being converted into equity. This is a requirement under Section 62(3) of the Companies Act.
- For example, let’s say a company has a loan of INR 100,000. In order to convert this loan into equity, the company must have distributable profits of at least INR 100,000. If the company does not have sufficient distributable profits, it cannot convert the loan into equity.
- The company can calculate its distributable profits by taking its net profit for the year and subtracting any amounts that are not distributable, such as dividends paid, losses carried forward, and provisions for taxation.
- Once the company has calculated its distributable profits, it can then compare this amount to the amount of the loan that is being converted into equity. If the distributable profits are at least equal to the amount of the loan, then the company can proceed with the conversion.
- Check if the company has the necessary approvals from the shareholders and the lender to convert the loan into equity. The company must pass a special resolution at a general meeting of its shareholders, and the lender must agree to the conversion.
- Check if the company has the necessary documentation in place to complete the conversion. This includes the loan agreement, the special resolution, and the valuation report (if required). Whether a valuation report is required for the conversion of a loan into equity depends on the circumstances.
- If the loan was issued with the option to convert into equity at a predetermined price, then no valuation report is required. This is because the price of the shares to be issued in exchange for the loan is already known.
- However, if the loan was issued without the option to convert into equity, or if the terms of the conversion are not yet agreed upon, then a valuation report may be required. This is to ensure that the shares issued in exchange for the loan are fairly valued.
- The Companies (Share Capital and Debentures) Rules, 2014, require a valuation report if the conversion of the loan into equity results in the issue of shares for a consideration other than cash. This means that if the shares are issued for a consideration other than cash, such as for the transfer of assets or for the provision of services, then a valuation report is required.
- The valuation report should be prepared by a valuer registered with the Insolvency and Bankruptcy Board of India (IBBI). and should be based on the market value of the shares at the time of the conversion. The valuation report should also consider the terms of the conversion, such as the price per share and the number of shares to be issued.
Part IV: Step by Step Process for Conversion of Loan to Equity
Step 1: Check if the loan agreement allows for conversion into equity
Step 2: Special Resolution At time of Acceptance of Loan
Step 3: Check If Company has Sufficient Profits
Step 4: Obtain a valuation report (if required)
Step 5: Pass a board resolution approving the conversion of the loan into equity
- The terms and conditions on which the loan is being converted into equity.
- The number of shares that are being issued in exchange for the loan.
- The price per share.
Step 6: Pass Special Resolution
Step-7: File MGT-14
Step 8: Issue of New Shares
Part V: Post-Conversion Implications
- Balance Sheet Improvement: Once the loan is converted into equity, the liability section of the balance sheet decreases, which in turn decreases the company’s financial risk and improves the debt-to-equity ratio.
- Potential Dilution of Existing Shareholders: The conversion of loans into equity typically results in the issuance of new shares, which can dilute the shareholding percentage of existing shareholders. This could impact the distribution of dividends and voting rights.
- Increased Compliance: With a new class of shareholders, there may be an increase in reporting and disclosure obligations to comply with corporate governance norms.
- Tax Implications: Conversion of loans into equity can have several tax implications. For instance, the conversion may trigger a taxable event depending on the jurisdiction. It’s recommended to consult with a tax professional to understand these implications.
- Changes in Control and Decision Making: If the lender, who has now become a shareholder, holds a significant percentage of shares, it may influence the decision-making process and the overall direction of the company.
- Enhanced Investor Confidence: A healthier balance sheet and reduced financial risk can boost investor confidence and may make the company more appealing to future investors.