Several Open Issues In Sweat Equity Regulation

Updated: Oct 28 2002, 05:30am hrs
Recently, SEBI has notified Regulations for issuance of sweat equity shares by listed companies. These Regulations come after a delay of full 4 years since the Companies Act, 1956, was amended by insertion of the new Section 79A which enabled issue of such Sweat Equity Shares. Nevertheless, the Regulations so notified do not appear to have been the result of fruitful deliberations of four years, considering the poor drafting and open issues, it seems that not much time has been given to the whole matter. To its credit, SEBI has introduced several safeguards to prevent misuse of this instrument though, as will be seen later, the whole scheme and its restrictions and conditions are capable of being simply avoided and circumvented. But, before we go into the Regulations, let us refresh our memory on the basic concept of Sweat Equity Shares as generally understood and as promulgated under Section 79A of the Companies Act, 1956.

Sweat equity shares are often misunderstood as another form of ESOPs since there is a superficial similarity. For example, both are usually issued to employees and directors. Sweat Equity Shares are however issued for something done in the past or something being done and further, they are issued for consideration other than cash and normally intangible assets. If one goes by the classic understanding of this term, it is that ownership (equity) that is created through the efforts (sweat) of the employees and directors. Issuance of Sweat Equity Shares is recognisance and reward of this toil. While there is some further resemblance with ESOPs in the sense that Sweat Equity Shares also create a sense of ownership and loyalty for the Company, the basic structure is often different. Sweat Equity Shares are also very useful for financial structuring when some owners are unable to bring in cash but are able to bring in or create intangible assets.

Let us also further try to understand the term under Section 79A of the Companies Act, 1956. This Section defines Sweat Equity Shares as equity shares issued by the company to employees or directors at a discount or for consideration other than cash for providing know-how or making available rights in the nature of intellectual property rights or value additions by whatever name called. Thus, the essence is that the consideration for the issuance is providing value addition (whatever that means!) in various forms but usually in the form of intangible assets. The issue can be at a discount and hence it is an exception to the provisions of Section 79 that prohibits issue of shares at a discount.

Section 79A lays down certain preconditions for issuance of Sweat Equity Shares. The important ones are as follows- The issue can only be of equity shares. The issue should be authorised by a special resolution. Certain disclosures would have to be made in the notice seeking approval for issue of such shares. The issue, as the definition stated above highlights can only be to employees and directors. At least one year should have passed from the day when the Company was entitled to commence business. There is one glaring lacuna that should be removed if we go back to the concept and nature of such shares. These are issued against consideration that is intangible and even is perhaps suspect in the sense that it is as per the subjective judgement and discretion of the Board of Directors. It is a fundamental principle of the concept of a limited company that the share capital that is contributed should be valuable and full. For that very reason, reduction of share capital is allowed only after detailed scrutiny by court and after taking approval of the creditors. For that very reason, shares are not allowed to be issued at a discount. Even where the shares are issued against valuable consideration in kind, for the life of the company, this fact has to be disclosed with the quantity of shares and their amount. In this background, it is strange that there is no safeguard against misuse of the provision to inflate the share capital in the Act and minimal protection in the Regulations. As will be seen later, some indirect protection is provided in the Regulation by requiring proper accounting and valuation, but, there too, the focus is not on the creditors who are to be protected but on the shareholders. I submit that there should be detailed and lifetime disclosure in the accounts of the fact of issue of Sweat Equity Shares, the nature of consideration received, their amount, the persons to whom the Sweat Equity Shares are issued, etc. so that creditors and other persons are warned against possible scope of misuse of this instrument. Interestingly, unlike ESOPs, which cannot be issued to Promoters, Sweat Equity Shares can be issued to Promoters without any limit. Having said that, there are certain safeguards against misuse in the Regulations, as will be seen later. The Sweat Equity Shares can be issued only in accordance with the Guidelines prescribed by the Government in case of unlisted companies and Regulations issued by SEBI in case of listed companies. This was taken to mean that Sweat Equity Shares could not be issued till such Guidelines/ Regulations were notified. SEBI has recently issued the Regulations to which let us now turn. The Regulations start with 16 definitions, many of which are superfluous in the sense that they are not even applied anywhere in the Regulations. A good example is ESOS meaning the Employees Stock Option Scheme under the SEBI ESOPs Guidelines. Apart from superfluous definitions, certain Regulations themselves are also equally redundant. Regulation 4, for example, states that a listed company intending to issue Sweat Equity Shares should comply with Section 79A and can issue such Sweat Equity Shares only to employees and directors. Compliance with Section 79A is a statutory obligation of a limited company and hence there is no need for a Regulation to state this. Section 79A provides that Sweat Equity Shares can be issued to employees and directors only and thus the later part of the Regulation also is unnecessary. Then certain additional disclosures are required in the notice of the general meeting where approval for issue of Sweat Equity Shares is sought. Interestingly, the names of the employees/directors/Promoters who are to be issued Sweat Equity Shares have to be stated in the notice.