Preference Shares and Their Transfer: Sections 55 and 56 Explained for Founders

An investor wants a dividend ahead of equity and a defined exit. A founder wants to move some shares into a holding entity. Both moves sit under two neighbouring sections of the Companies Act 2013: section 55 for how preference shares are issued and redeemed, and section 56 for how any security, including a preference share, is transferred. This guide takes preference shares first, then their transfer. Our companion guide on share transfers and certificates covers section 56 and section 46 in more depth; here the focus is how the two sections meet when the shares are preference shares.

Legal basis: Sections 55 and 56, Companies Act 2013; rules 9, 10 and 11, Companies (Share Capital and Debentures) Rules 2014 as amended.

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Preference shares cannot be irredeemable

Section 55(1) is blunt: "No company limited by shares shall, after the commencement of this Act, issue any preference shares which are irredeemable" (s.55(1), Companies Act 2013). Every preference issue therefore carries a redemption mechanism. That is different from equity, which stays with the company until it is bought back or the company winds up.

A company limited by shares may issue preference shares "if so authorised by its articles" and they must be "liable to be redeemed within a period not exceeding twenty years from the date of their issue subject to such conditions as may be prescribed" (s.55(2)). Two things follow for a startup term sheet:

• The articles must authorise preference shares. If they do not, amend them before the issue, not after.
• The redemption term must be fixed within twenty years of issue. A term sheet promising a longer, non-infrastructure preference does not fit the text of s.55(2); fix the term at drafting stage.

The infrastructure exception: up to thirty years

The first proviso to s.55(2) lets a company "issue preference shares for a period exceeding twenty years for infrastructure projects, subject to the redemption of such percentage of shares as may be prescribed on an annual basis at the option of such preferential shareholders." For this purpose, "infrastructure projects" means the projects specified in Schedule VI (Explanation to s.55).

The rules fill in the numbers. A company "engaged in the setting up and dealing with of infrastructural projects may issue preference shares for a period exceeding twenty years but not exceeding thirty years, subject to the redemption of a minimum ten per cent of such preference shares per year from the twenty first year onwards or earlier, on proportionate basis, at the option of the preference shareholders" (rule 10, Share Capital and Debentures Rules 2014). The holders, not the company, decide whether to take that annual redemption. Unless the business is in Schedule VI, this route is not available.

Issuing preference shares: the rule 9 conditions

Rule 9 adds the procedure. A company having a share capital may, if its articles authorise, issue preference shares only if:

• the issue is authorised by a special resolution in general meeting (rule 9(1)(a)); and
• the company, at the time of issue, "has no subsisting default in the redemption of preference shares issued either before or after the commencement of this Act or in payment of dividend due on any preference shares" (rule 9(1)(b)).

The resolution must set out the particulars of the priority for dividend and capital repayment against equity, participation in surplus funds, participation in surplus assets and profits on winding up, cumulative or non-cumulative dividend, conversion into equity, voting rights and redemption (rule 9(2)). The explanatory statement to the general meeting notice must give the complete material facts, including the size of the issue, the nature of the shares (cumulative or not, participating or not, convertible or not), the objects, the price and the basis for it, the terms of dividend and redemption, the current shareholding pattern and the expected dilution on conversion (rule 9(3)). The Register of Members must carry the preference shareholder particulars (rule 9(4)). A company planning to list its preference shares must follow SEBI's regulations (rule 9(5)).

How preference shares are redeemed

Redemption is limited by the second proviso to s.55(2), in four steps:

• Source of funds. No such shares "shall be redeemed except 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" (s.55(2), second proviso, clause (a)).
• Fully paid only. "No such shares shall be redeemed unless they are fully paid" (clause (b)).
• Capital Redemption Reserve. Where the redemption is out of profits, a sum equal to the nominal amount of the shares redeemed must be transferred, out of those profits, "to a reserve, to be called the Capital Redemption Reserve Account". The Act's reduction-of-capital provisions then apply as if that account were paid-up share capital (clause (c)). The reserve keeps redeemed capital inside the company as a cushion for creditors.
• Premium on redemption. For companies of a prescribed class whose financial statements follow the accounting standards under section 133, the premium payable on redemption "shall be provided for out of the profits of the company, before the shares are redeemed". In other cases the premium may come "out of the profits of the company or out of the company's securities premium account, before such shares are redeemed" (clause (d)(i) and (ii)).

Rule 9(6) adds that a company may redeem its preference shares "only on the terms on which they were issued or as varied after due approval of preference shareholders under section 48", and the terms may allow redemption at a fixed time or on a particular event, at the company's option, or at the shareholder's option.

The Capital Redemption Reserve may also be used to pay up unissued shares issued to members as fully paid bonus shares (s.55(4)).

If the company cannot redeem

Section 55(3) gives a relief valve. Where a company "is not in a position to redeem any preference shares or to pay dividend, if any, on such shares in accordance with the terms of issue", it may, with the consent of "the holders of three-fourths in value of such preference shares" and with the Tribunal's approval on a petition, issue further redeemable preference shares equal to the amount due, including dividend. The unredeemed shares are then deemed redeemed. The Tribunal must order forthwith redemption of the shares held by those who did not consent. Issuing the further shares, or redeeming under this section, is not treated as an increase or reduction of share capital (Explanation to s.55(3)).

Transferring preference shares: the section 56 rules

A preference share is a security like any other for transfer purposes. The company must not register a transfer "unless a proper instrument of transfer, in such form as may be prescribed, duly stamped, dated and executed by or on behalf of the transferor and the transferee and specifying the name, address and occupation, if any, of the transferee has been delivered to the company by the transferor or the transferee within a period of sixty days from the date of execution, along with the certificate relating to the securities, or if no such certificate is in existence, along with the letter of allotment of securities" (s.56(1)). Transfers between persons whose names are both entered as holders of beneficial interest in a depository's records are carved out.

For physical shares, rule 11 prescribes Form SH.4 and delivery to the company "within sixty days from the date of such execution" (rule 11(1), Share Capital and Debentures Rules 2014).

If the instrument "has been lost or the instrument of transfer has not been delivered within the prescribed period, the company may register the transfer on such terms as to indemnity as the Board may think fit" (proviso to s.56(1)). That is board discretion, not a right.

Three related rules apply:

• Transmission. A transmission by operation of law (for example on death) is registered "on receipt of an intimation of transmission" without the s.56(1) instrument (s.56(2)). A transfer by a deceased holder's legal representative is valid as if he had been the holder when the instrument was executed (s.56(5)).
• Partly paid shares. If the transferor alone applies and the shares are partly paid, the transfer is not registered unless the company gives notice to the transferee and the transferee gives no objection "within two weeks from the receipt of notice" (s.56(3)); rule 11(3) prescribes Form SH.5 for the notice.
• Certificates. The company must deliver certificates of securities allotted, transferred or transmitted within two months from incorporation for subscribers to the memorandum, two months from allotment for allotted shares, "one month from the date of receipt by the company of the instrument of transfer under sub-section (1) or, as the case may be, of the intimation of transmission under subsection (2)" for transfers and transmissions, and six months from allotment for debentures (s.56(4)(a) to (d)).

For a transferee of preference shares, the clock that matters is therefore one month from the company's receipt of the instrument (s.56(4)(c)), not two months from execution.

A worked scenario

A company issues preference shares to an investor with redemption in year twelve. Before the issue, its articles authorise preference shares, a special resolution is passed with the rule 9(2) particulars, and the explanatory statement carries the rule 9(3) facts. The company confirms it has no default on earlier preference redemptions or dividends. In year twelve the shares are fully paid, the company redeems out of profits, transfers the nominal amount to the Capital Redemption Reserve, and provides for any premium before redeeming.

In year five the investor sells half of its holding to a fund. The instrument is stamped, dated and signed by both sides, delivered with the certificate within sixty days of execution (Form SH.4). The company registers the transfer and delivers the new certificate within one month of receiving the instrument. The two files, redemption and transfer, sit on different clocks and do not affect each other.

Penalty for default

For default in complying with s.56(1) to (5), "the company and every officer of the company who is in default shall be liable to a penalty of fifty thousand rupees" (s.56(6)). That figure is ₹50,000.

What to do now

• Before issue: check the articles authorise preference shares; fix the redemption term at not more than twenty years (s.55(2)), unless Schedule VI infrastructure rules apply (rule 10). Next step: pass the special resolution with the particulars required by rule 9(1) and (2) and prepare the rule 9(3) explanatory statement.
• At redemption: confirm the shares are fully paid, identify the source (profits or fresh issue), and book the Capital Redemption Reserve transfer (s.55(2) second proviso). Consequence of getting this wrong: the redemption does not meet the conditions of s.55(2).
• On transfer: deliver the stamped, executed instrument and certificate within sixty days of execution (s.56(1)); the company must then deliver the new certificate within one month of receipt (s.56(4)(c)). Consequence of default: a penalty of ₹50,000 on the company and each officer in default (s.56(6)).

Have a CA review your facts before you act or file.

Frequently asked questions

Can preference shares be irredeemable?
No. Section 55(1) bars a company limited by shares from issuing irredeemable preference shares.

What is the longest redemption period?
Twenty years from issue (s.55(2)). For Schedule VI infrastructure projects it can be longer, up to thirty years under rule 10, with at least ten per cent redeemable per year from the twenty-first year at the holders' option.

What can fund redemption?
Profits otherwise available for dividend, or the proceeds of a fresh issue of shares made for the redemption, and only if the shares are fully paid (s.55(2) second proviso, clauses (a) and (b)).

What is the Capital Redemption Reserve?
A reserve to which the nominal amount of shares redeemed out of profits is transferred; it is treated like paid-up share capital for reduction-of-capital purposes (s.55(2) second proviso, clause (c)).

What if the company cannot redeem?
It may seek the consent of three-fourths in value of the holders and Tribunal approval to issue further redeemable preference shares in place (s.55(3)).

How long does the company have to deliver a certificate after a transfer?
One month from receiving the instrument of transfer or intimation of transmission (s.56(4)(c)).

Do heirs need a transfer instrument?
No. Transmission by operation of law is registered on intimation (s.56(2)).

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See Also

• Moving Shares Between Founders? Transfer Deeds, Certificates and Timelines Under Sections 46 and 56
• Allotting Shares After a Public Offer? Minimum Subscription, Listing Permission and Refunds Under Sections 39–40
• Debentures Under Section 71: Conversion, DRR, Trustees and Holder Remedies