JUDGMENT
S. Rangarajan, J.
(1) M/S. Globe United Engineering & Foundry Co. Ltd., after being registered under the provisions of the Companies Act, 1956 (hereinafter called the Act) could not succeed in obtaining technical aid it expected to get and hence could not carry on business as per Articles of Association and Memorandum. At a general meeting, on 23-12-1968, the members unanimously decided to wind up the company; Shri V. Rajaraman was appointed as its Liquidator. A petition was subsequently presented to this Court by one of the promoters challenging the voluntary winding up, but it ended in a compromise that the voluntary winding up may continue subject to supervision of the Court.
(2) This application has been filed by the Liquidator, Shri V. Rajaraman, on a request made to him, at a general meeting held on 18-9-1971, to apply to this Court under section 518 of the Act, referring the controversy between the company and some of the preference shareholders as to whether the latter are entitled to payment of dividend as per the Articles of Association and Memorandum of the company (i.e.) on a basis of priority over ordinary shareholders.
(3) The issued and called up capital, according to the Liquidator, are as follows: 35,000 Preference Shares of Rs. 100.00each 17,50,000.00 50% Called up as per list 'F. 1,45,000 Equity shares of Rs. 100.00each. 100% Called up as per list 'G' 30,400.00 50% Called up as per list 'G' 72,34,800.00 (4) The rights of the preference shareholders have been provided for in clause 7 of the Articles of Association as follows: "THEpreference shares shall confer on the holders thereof the right to a fixed cumulative preferential divident @9.5% per annum free of company tax but subject to deduction of taxes at source at the prescribed rates on the capital paid up thereon, and in the event of winding up, the right of repayment of capital and arrears of dividend whether earned, declared or not, up to the commencement of winding up in priority to the equity shareholders."
(5) The question for consideration is whether in spite of the company not commencing business, not making any profits and there having been nothing to declare by way of dividend the preference shareholders of the company are entitled to arrears of cumulative dividend at the prescribed rates as per the said Articles of Association in priority to the ordinary shareholders. The contention on behalf of the company is that as per section 205 of the Act no dividend shall be paid or declared by the company for any financial year except out of the profits of the company for that year arrived at after providing for depreciation in accordance with the provisions of sub-section (2) or out of the profits of the company for any previous financial year or years arrived at after providing for depreciatoin in accordance with those provisions and remaining undistributed or out of both or out of moneys provided by the Central Government or a State Government for the payment of dividend in pursuance of a guarantee given by that Government. The further contention is that since as per section 9 of the Act the above Articles provision is contrary to section 205 of the Act it is invalid.
(6) Before discussing this question it is necessary to dispose of a subsidiary contention put forward on behalf of the company and against the preference shareholders based upon the following entry in the Prospectus: “PREFERENCEShares will confer upon the holders thereof a right to fixed cumulative preferential dividend @9.5 per cent per annum, calculated prorata from date of allotment of shares, on the capital paid thereon (free of Company’s tax, but subject to deduction of taxes at source at the prescribed rates), and prior right on winding up to the repayment of capital and any arrears of dividend earned, whether declared or not, up to the commencement of the winding up but shall not confer any right to participate in the profits of assets of the Company. Subject to the provisions of Section 80 of the Companies Act, 1956, the Company shall have the right to redeem, the whole or any part of the preference shares at part, at any time after twelve years from the date of issue, giving not less than six months’ prior notice in writing, but in any event not later than the 15th year of the date of issue. A preference Shareholder shall have the right to vote only on resolutions directly affecting the rights attached to his Preference Shares, unless the dividend due on preference shares has remained unpaid for not less than two years, in which case the preference shareholder shall have the same right to vote as an equity shareholder. In the event of the Company intending to create and/or issue further preference shares, ranking pari passu with the preference shares now being issued, the same shall be done only with the consent of the holders of not less than three-fourth of preference shares then outstanding. Preference Shares, if subscribed for by the Haryana Government in terms of their underwriting commitment, shall be redeemable in a lot at the expiry of Twelve years”.
(7) The difference between the Prospectus and the Articles, shortly stated, is whereas the Prospectus refers to “the repayment of capital and any arrears of dividend earned, whether declared or not”, Article 7 reads: “repayment of capital and arrears of dividend whether earned, declared or not”. The bargain has to be ascertained not from what is stated in the Prospectus but in the Articles of Association. There appears to be no doubt that the expressions employed in the Articles are correct; this will become clearer if one understands the need for making such a provision in the Articles. Palmer’s Company Precedents (Seventeenth Ed., Part I, p.779), while dealing with the question whether arrears of dividend on preference shares are payable in a winding up, has stated as follows: “Cases sometimes arise in which it is desired to give to the preference shareholders priority in a winding up not only as to capital, but also ‘as to arrears of dividend whether earned or declared or not down to the commencement of the winding up’ and in order to preclude controversy a formula including these words ‘whether earned or declared or not’ should be used”. This formula, and the need to employ it, has been explained in almost all leading text-books on the subject (vide for example, Cower : Company Law, 3rd Edn. page 365).
(8) Pennington (Company Law, 3rd Edn., pages 185, 186) explains when arrears of preference dividend can be paid during winding up: “UNPAIDpreference dividends for years preceding the winding up of a company are not payable out of its assets in a winding up even though the company has earned sufficient profits to pay them, unless :- (a) the dividends have been declared, in which case they will be debts owing from the company and will be payable in the winding up immediately after all other debts of the company ; or (b) the articles or terms of issue provide that the profits of the company shall be applied in making specified payments which include the payment of preference dividends, but in this case the arrears can be paid only if sufficient profits have been earned ; or (c) the articles or terms of issue provide that arrears of preference dividend shall be paid in a winding up.
(9) It is provisions under head (c) which are of particular interest at this point. A typical clause in the terms of issue of preference shares which clearly expresses the rights intended to be conferred, is the following:- THEholders of preference shares shall be entitled to a fixed cumulative preferential dividend at the rate of x per cent per annum upon the amount paid up thereon, and in the event of the winding up of the company, to repayment of the amount paid up thereon together with any arrears of dividend calculated to the date of such repayment in priority to the claims of the holders of ordinary shares, but shall have no other right to participate in the assets or profits of the company.’
Under such a clause unpaid preference dividends for earlier years are payable when the company is wound up, even though they have not been declared (a), and even though the company did not earn sufficient profits to pay them while it was a going concern. It is important that the arrears of dividend payable should be expressed to be calculated to the date when the preference capital is repaid; if the preference shareholders are merely entitled to ‘arrears of dividend’, the dividends are calculated only down to the commencement of the winding up.” Among the decisions referred to are In re Crichton’s Oil Company, (1902) 2 Ch. 86; Re W. Foster & Son, Ltd., (1942) I A.E.R. 314(2), In re New Chinese Antimony Company. Limited, (1916) 2 Ch- 115; In re Springbok Agricultural Estates, Limited, (1920) I Ch. 563; In re Wharfedale Brewery Co. Ltd., (1952) Ch. 913; and Re E. W. Savery, Ltd., (1951) 2 A.E.R. 1036;
(10) Re Walter Symons, Ltd., (1934) Ch. 308; C) has been quoted by Palmer as authority for the position that where the Memorandum provided that the preference shares should confer a right to a fixed cumulative preferential dividend and that the preference shares should rank both as regards dividends and capital in priority to the ordinary shares, the preference shareholders are entitled to arrears of dividend in a winding up. In the above case, the clause on preference shares conferred on the preference shareholders the right to a fixed cumulative preference dividend at the rate of 12 per cent per annum on the capital for the time. being paid up on the ordinary shares, but did not confer the right to any further participation in profits and assets. Maugham, J. held that the preference shareholders were entitled to unpaid dividend on shares during winding up; he construed the whole of the said clause, including the latter part of it, as applicable to winding up because the former part of it was applicable only in case of a winding up. The above case may be usefully compared with Re Wood, Skinner & Co., (1944) Ch. 323 where Cohen, J. held, again as a matter of construction, that the preference shareholders in that case were entitled to the dividends declared while the company was a going concern but not as conferring on them a right to arrears of dividend in a winding up.
(11) The Court of Appeal held in Re F. de Jong & Co., Ltd., (1946) Ch. 2211, following Walter Symons but distinguishing Wood Skinner & Co., that the preference shareholders were entitled to the unpaid preference dividend in a winding up. The effect of some of the above and other cases has been stated by H. R. Hahlo (A Casebook on Company Law, 1970) in his note. at page 126 as follows : “EVERYTHING,of course, turns on the construction of the relevant provisions in the company’s articles. It would appear that with the slightest encouragement the courts will conclude that arrears of cumulative dividends of preference shareholders have to be paid out of surplus assets, with priority over the claims of ordinary shareholders, even if no declaration of dividend has been made prior to the winding up”, etc.
Murray A Pickering, in a scholarly analysis [vide The Problem of the Preference Share, Vol. 26 (1963) Modem Law Review pages 499-519] deals with certain problems of the preference shareholder, arising out of a process of long legal evolution, where his rights have not been set out comprehensiely in the provisions which create this class of shareholding; such holding has not always had the same character. The legal rights, which may be and normally are attached to all shares, he points out, are broadly classifiable into three groups: (1) rights in relation to the payment of dividend (income rights); (2) rights of voting at company meetings (voting-rights); (3) rights to the return of capital on an authorised reduction of capital or on a winding up (capital rights). The most important class is usually that where preferential rights are conferred; the shares concerned may be termed preference shares. As pointed out in Alliance Perpetual Building Society v. Clifton. (1962) 1 W.L.R. 1270 (10) whether shares are ordinary or preference shares may be a question of construction (p. 469). He concludes :”. . .the preference share which combines both equity and fixed interest characteristics is a somewhat unique anomally in business finance which must continue to give rise to problems and apparent injustices for investors, and as such is a security which can hardly reflect credit on the law under which it has been evolved and which continues to sanction existence” (p. 519).
(12) The problem of preference shareholders can arise in a variety of contexts. One such is the reduction of capital which gives rise to the question, in particular, whether the consent of preference shareholders is necessary for reduction of capital. It may also relate to the right to participate in surplus capital as in winding up. It has been held (vide Dimbula Valley (Ceylon) Tea Co. Ltd. v. Laurie, (1961) Ch. 353 and Re Sallean Estate Co. Ltd., (1968) 1 W. L. R. 1844) (12) that where preference shareholders do have such a right it extends to all the available assets including those representing profits which before the winding up of the company could have been distributed as ordinary dividend, unless as held in re Bridgewater Navigation Company, (1891) 2 Ch. 317 (13) a provision in the Memorandum or Articles makes it clear that profits belong to ordinary shareholders or in some other way reserves them for such shareholders. The position in this regard has been summarised, with reference to decided cases, in Gore-Browne on Companies (42nd Edn.) at pages 335-36 as follows : “WHERE,however, different shareholders or classes of shareholders have different rights as to return of capital on a winding up, there is a prima facie rule that a reduction of capital should be framed so as to conform with these rights, unless consent is obtained from the particular shareholders or classes of shareholders whose rights are prejudiced. The most important instance of this rule is that where there are preference shares having priority as to return of capital (but no rights of further participation in surplus assets) and there are ordinary shares as well, then in a reduction involving a return of capital in excess of the company’s wants, the preference shares should be paid off first, whereas in a reduction involving partial or total cancellation of shares on account of losses, it is the ordinary shares that should first be cancelled. Sometimes, the preference shareholders in a prosperous company may feel aggrieved at losing a favoraable investment through being thus paid off at par in. advance of the ordinary shareholders but this of itself gives them no legal grounds of objection, not even if under the articles they had a right of participation in disiributions of surplus profits by way of dividend. It is only when they have clearly defined rights of participation in surplus assets on a winding up (whether under the memorandum or articles or terms of issue, or under some special statutory provision), or (perhaps) where there is an independent agreement between them and the company that capital will not be reduced without their consent, that they can raise the objection that their rights are not being strictly observed. This vulnerability of preference shareholders who have no such rights of participation is sometimes overcome in quoted companies by the use of the so-called “Spens formula”‘, viz., a provision in the memorandum or articles or terms of issue that where preference shares are paid off, the prize should be tied to the quoted market value at the time and the preference shareholders should have voting rights on the resolution for reduction. Where preference shares rank pari passu with ordinary shares in the return of capital on a winding up, any cancellation of shares should bear upon both classes rateably. Even though the actual amount (though not the percentage rate) of a fixed dividend on the preference shares will be thereby reduced, the preference shareholders have no grounds of objection, because their class rights are not being infringed.”
(13) Pickering regards three principles as basically established and quotes from three decisions : (1) The rights inter se of preference and ordinary shareholders must depend on the terms of the instrument which contains the bargain that they have made with the company and each other (a question of construction, vide Lord Simonds in Scottish Insurance Corporation, Limited v. Wilsons & Clyde Coal Company Limited, 1949 A.C. 462); (2) (14), where the articles set out the rights attached to a class of shares to participate in profits while the company is a going concern or to share in the property of the company in liquidation; prima facie, the rights so set out are in each case exhaustive (vide Wynn Parry, J. in re The Isle of Thenet Electricity Supply Co. Ltd., (1950) Ch. 161) and (3) (15). In the absence of specific provisions the rights of all shareholders are deemed to be the same (vide Lord Macnaghten in Birch v. Cooper and others, (1889) 14 A.C. 525)-case not referred (page 500 of Pickcring’s Article).
(14) A few suggestions for reform were put forward before the Jenkins Committee (Cmnd. 1749 of 62) to alter the law concerning the rights of preference shareholders consequential upon the decision of the House of Lords in Scottish Insurance Corporation Ltd. v. Wilsons & Clyde Coal Co. Ltd. (1949) A.C. 462(16) and Prudential Assurance Co., Ltd. v. Chatterley-Whitfield Collieries Ltd., (1949 A.C. 512(17), which decided that their consent was not legally necessary for reduction of share capital; this would have the effect of paying oil even preference shareholders who might have acquired them on the assumption that they were irredeemable but thus lose the benefit of the preferential rate of dividend when it was impossible to reimburse that money except at substantially lower rates of interest. The Jenkins Committee felt that it would be wrong to alter the existing laws by making a new provision that preference shares, rights of which are not always set out in the Articles or in the terms of issue, carrying a specified rate of dividend should have certain defined rights unless the Articles or terms of issue specifically provide otherwise. The Committee doubted the wisdom of attempting to define by statute the basic rights attaching to preference shares of which there are so many varieties (para 196 of the Report). The Committee also observed that these investors who acquired preference shares on the assumption that they were irredeemable only to discover that they could be paid off at any time (when the capital itself was reduced) without their consent, which was held to be unnecessary by the House of Lords in the Scottish Insurance Corporation Ltd. v. Wilsons and Clyde Coal co. Ltd., (1949 A.C. 462) (14) and Prudential Assurance Co. v. Chatterley-Whitfield Collieries Ltd., (1949 A.C. 512) (17). The Committee was not in favor of any alteration of the law, which may have the effect of retrospectively altering contractual rights of some shareholders; they did not see sufficient justification for that. course (para 195 of the Report). There was no question raised about the position which is different, where the rights of preference shareholders are set out in the Memorandum or Articles of Association; the said bargain alone would govern, subject, however, to one question, namely, whatever it is opposed to statue and hence invalid.
(15) The outside investor may be induced to subscribe for preference rather than ordinary shares by reason of the bargain offered; such investor has usually little knowledge of the company’s business, has no wish to participate in the company’s management and is keen only on his promised return. It may also happen that if the companies want to raise new capital when their existing shares are worth less than the nominal value the only direct way of raising new capital. apart from borrowings and debentures, will be to issue new class of shares with preferential rights over the existing ones. The preference shares are really part of the company share capital: they arc not loans.
(16) Section 205 of the Act places a limit on the payment of dividends; they can be paid only out of profits. If Section 205 were to apply to the instant case the company not even having commenced business and not having made any profit no dividends could be paid to the preference shareholders and any provision in the Articles cannot permit such dividends being paid, otherwise than out of profits, when the company is a going concern-that would be contrary to Section 9.
(17) In a going concern, it is settled law, the declaration of dividends has to be made in annual general meetings; when accounts of a particular year are closed dividends for that period cannot be declared in a subsequent year (vide the decision of A. N. Ray, J. (as his Lordship then was) in Raghu Nandan Neotia v. Swadeshi Cloth Dealers Ltd., 1964 Air Calcutta 247) (18).
(18) The contention of Shri F. S. Nariman, the learned Additional Solicitor General, is that Section 205 of the Act does not apply to the present case because Section 205 appears in Part Vi of the Act (commencing from Section 146 up to and inclusive of Section 424) relating to management and administration and not in Part Vii, relating to winding up. Section 510, which appears in Part Vii, specifically provides for Sections 511 to 521, both inclusive, applying to every case of voluntary winding up. Section 511 reads as follows : “511.Subject to the provisions of this Act as to preferential payments, the assets of a company shall, on its winding up, be applied in satisfaction of its liabilities pan passu and, subject to such application, shall, unless the articles otherwise provide, be distributed among the members according to their rights and interests in the company”.
(19) The section is expressly subject to the provisions in the Act relating to preferential payments; they are dealt with by Section 530. The preference shareholders do not fall within Section 530. It will be useful to set out once again, the words of Section 511 excluding those that do not apply to the present case : “….the assets of the company shall on its winding up, … unless the articles otherwise provide, be distributed among the members according to their rights and interests in the company.”
(20) The rights and interests of preference shareholders, who rank below the debenture holders, are governed by the Articles and there can be no impediment in the Article being applied unless the same is contrary to any provision of the Act. Section 9 of the Act provides that save as expressly provided in the Act the provisions in the Act shall have effect notwithstanding anything to the contrary contained in the Memorandum of Association of the company. If Section 205 of the Act does not apply to the instant case then there is no question of there being any provision in the Act contrary to the Articles. If Section 511 applies, it will specifically govern the case of preference shareholders being paid dividend also in terms of the contract as evidenced by Article 7 read above. Section 511 is the specific provision-applicable to voluntary winding up and in relation to this specific aspect Section 511 would appear to authorise a provision like Article 7; the bar against Article 7 operating could possibly apply only as long as the company is a going concern; this would be only stating in another form that Section 205 applies only up to the stage prior to winding up, namely, to the stage of management and administration of the company (as a going concern).
(21) The preference shareholder can, according to the above Article 7, rank only after the debenture holders and before the ordinary shareholder; he would get priority over the equity shareholders and nothing higher. The present application does not give any clue as to whether any occasion has arisen or may arise, in the instant case, for any payment to the preference shareholders, in priority to the equity shareholders. In the absence of such information I have only to deal with the question raised in the present application in the abstract and answer it accordingly, so that in the eventuality of their being any occasion for practically applying Article 7 the position may be clarified legally and the matter merely allowed to rest there, if there is going to be no occasion to apply the principle.
(22) The net result is there seems nothing illegal in Article 7 permitting arrears of dividend, whether earned declared or not, up to the commencement of the winding up being paid in priority to the equity shareholders. Section 205 of the Act applies obviously only to a company as a going concern but not to one in liquidation; I have not been able to find any other provision of the Companies Act which might invalidate such an Article provision. It is worth recalling, on the other hand, according to the tenor and plain language of Section 511, unless the Articles otherwise provide, the assets of a company shall on its winding up, be distributed among the members according to the rights and interests in the company. The said Article 7 falls within the scope and ambit of Section 511 and being the section specifically applicable to the instant situation, of a voluntary winding up, there is nothing in Section 9 of the Act which can invalidate the said. Article.
(23) The view taken by me seems to accord with the observations of K. K. Desai, J. in re The Bombay Chlorine Products Ltd: Chandulal Manekji Sharma v. The Bombay Chlorine Products Ltd., (35 (1965), Company Cases 282) (19), where the question arose whether ordinary shareholders were entitled to set off call against repayment of capital contributed and payment of arrears of dividends to preference shareholders for money due to them as preference shareholders. Referring to the English authorities, which were cited before him, K. K. Desai. J. formed the impression from those authorities that the question was “not of law, but of facts” to be determined on a true construction and effect of the provisions in the Memorandum of Association and the Articles of Association as regards the rights of shareholders of each class. Referring to similar words, as in the present case, payment of capital and arrears of dividends (whether declared or undeclared) up to the commencement of the winding up, in priority over the holders of the ordinary shares, it was observed that the prohibition against payment of dividends out of assets other than profits did not arise in a winding up.
(24) Oil behalf of the seventh respondent it was urged with reference to Section 2(22) of the Income Tax Act, 1961 that distribution, on liquidation, of accumulated profits of any past year or even the current profits of the company immediately before its liquidation, is taxable as dividend. No assistance can be derived here from what the position is according to a fiscal statute like the Income Tax Act. The question here is one of pure construction and the legality of Article 7.
(25) The view of Eve, J. was that the preference shareholders are “constantly victimised”. Reference has been made to his evidence, to the above-said effect, before the Greene Committee in the article “Preference Shareholders in the Reconstruction of English Companies” be Joseph Gold (Vol. V, 1943-44, University to toronto Law Journal, p. 282 at p. 320). Joseph Gold has, in the above-said informative article, explained the “strategically inferior position” of preference shareholders, in the matter of reconstruction of companies.
(26) When that is seen to be the position of preference shareholders, generally speaking, and they had taken preference shares on definite terms, as a matter of bargain, in a company registered under the Companies Act, the protection so given to them by the Article, cannot be either ignored or curtailed in any manner adverse to them, unless there is any provision in the Companies Act necessitating such a course.
(27) There being nothing in the Companies Act to invalidate Article 7 as it has been framed the preference shareholders have right of repayment of capital (which is not disputed) and arrears of dividend (whether the same has been earned declared or not) up to the commencement of the winding up in priority to the equity shareholders. The reference by the Liquidator is answered against the Company and in favor of the preference shareholders, in the above said manner.
(28) The costs of this reference alone would come out of the Company’s funds. The other parties will, in the circumstances, bear their own costs of this proceeding.
