THE FUTURE OF SHARES ISSUED WITH DIFFERENTIAL VOTING RIGHTS UNDER THE INDIAN CORPORATE REGIME (I)
This two-part post is authored by Pranshu Gupta and R. Kavipriyan, 4th-year students of B.A. LL.B. (Hons.) at NALSAR University of Law, Hyderabad. The second part can be accessed here.
Contrary to the corporate law principle of ‘one share one vote’, shares with differential voting rights (“DVRs”) enable the company to issue shares with either superior voting rights (“SR Shares”), or fractional voting rights (“FR Shares”). Recently, the Securities and Exchange Board of India (“SEBI”) issued the DVR framework by amending various regulations to permit the issuance of SR shares by tech-based start-up companies. The underlying objective behind this move was to promote corporate autonomy. New companies may not be able to raise capital through external sources. Since they obtain investment from external sources through institutional investors, there are fears of dilution of the promoters’ control over such companies. Therefore, DVR shares act as safeguards for promoters, with respect to their control over the decisions of the company. However, existing listed companies are not permitted to issue such shares. This amendment was in the backdrop of the recent hostile takeover of Mindtree Ltd. by Larsen Toubro Ltd., eventually leading up to their resignation.
While there are multiple advantages of issuing DVR shares to promoters as well as investors, its drawbacks cannot be neglected. Part I of this post shall discuss the background of DVR Shares and the general drawbacks associated therewith. Part II shall discuss the limitations under the amended regulations, and the possible rectifications through a re-amendment of the DVR Framework, in pursuance of minimum standards of norms of corporate governance.
Prior to the DVR Framework, Section 43(a)(ii) of the Companies Act, 2013 read with Rule 4 of the Companies (Share Capital & Debentures) Rules, 2014 provided that only companies with a consistent record of three-year profitability were permitted to issue DVRs. Moreover, DVRs could not constitute more than 26% of the post-issue share capital of the company. However, SEBI amended its equity listing agreement in 2009 to prohibit listed companies from issuing SR shares.
Recently, SEBI proposed the DVR Framework for issuance of DVRs, based upon the ‘Consultation Paper’, that was circulated for public comments in March 2019. The paper recommended issuing SR shares to promoters in tech startups, and existing listed companies to allow promoters to retain control over the decision-making of the company. Therefore, SEBI, in order to incorporate these changes, amended a number of its regulations, including the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”), SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”), SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Regulations”), and the SEBI (Buy-back of Securities) Regulations, 2018, to be collectively referred to as “the Regulations” with effect from July 29, 2019. However, the DVR Framework has not permitted the issuance of such shares by the existing listed companies. The recent SEBI circular dated November 3, 2020, repealed several provisions of the guidelines released on March 10, 2017. It is in line with this restriction, that it no longer permits the listing of DVRs without making an initial public offer (“IPO”).
With the introduction of the new framework, the erstwhile conditions have been done away with, so as to enable start-ups to issue DVRs. Furthermore, the condition with respect to the quota of DVRs in the share capital has now been changed to 74% of the total voting rights post-listing. Under this framework, SR shares shall be treated equally in all respects, as ordinary shares, including dividends except voting rights. However, the issuance of FR shares shall not be permitted henceforth.
A company with SR shares while making an IPO has to abide by the eligibility requirements under Regulation 6 of the ICDR Regulations. For the issuance of such shares, the issuer company should be a tech-company, i.e., it should intensively use technology, intellectual property, data analytics, IT, nanotechnology, or biotechnology for providing goods, services, or business platforms.[i]
The ratio of such shares, as compared to ordinary shares, shall be at least 2:1, with a maximum of 10:1, and the face value of DVRs shall be the same as that of ordinary shares, and the class of such shares shall not be more than one. As per the listing and lock-in provisions under the framework, SR shares will be locked-in post-IPO until they get converted into ordinary shares. Moreover, the sunset clause mandates the compulsory conversion of SR shares into ordinary shares. This sunset clause is of two types: (a) time-based mandatory conversion after five years of such listing, which can further be extended by five years, subject to certain conditions; and (b) event-based compulsory conversion in the circumstances, such as resignation or demise of the SR shareholder, or if he loses rights over those shares due to a merger or acquisition. The framework also contains several coat-tail provisions where SR shares shall be treated as ordinary shares. Some of them include related party transactions involving SR shares, appointment or removal of independent directors, winding up of the company, etc.
3. DRAWBACKS OF DVRs
There are certain advantages of issuing DVRs to the investors as well as promoters. For issuers, in addition to preventing hostile takeovers, DVRs provide a way to raise capital without losing control. For founder-led companies, an effective interest in such companies is beneficial for its growth and thereby, for the subscribers. DVRs also ensure higher dividends for investors. Notwithstanding the upsides, there are certain drawbacks of DVRs.
It has been argued that arrangements of this nature violate basic corporate governance norms, such as accountability and shareholders’ democracy, since it goes against the norm of ‘one share one vote’. The minority shareholders, by virtue of their limited voting powers, would find it extremely difficult to hold the majority shareholders accountable for their decisions. Advocates of corporate governance have argued that in the absence of sufficient investor protection mechanisms, dual-class shares might damage the medium-to-long term market development, causing investors to abandon the company. The performance standard of the companies that adopt such structures is lower than that of companies with one class of shares.[ii] Furthermore, it is difficult for the controlling group of shareholders to be monitored or policed by the public shareholders.[iii] Some of the leading pension funds, mutual funds, and shareholder advisory groups have expressed reservations against these structures due to some of the aforementioned drawbacks.[iv] Even in jurisdictions where these structures are permitted, institutional investors have urged the authorities to impose limits upon their issuance.[v]
Two important yet related arguments against the issuance of such shares are risks related to corporate governance and agency costs. As the controlling group of shareholders is insulated from the market disciplinary forces, they are under no obligation to pursue the interests of the general shareholders, and might rather serve personal gains, misappropriating corporate value.[vi] Generally, two kinds of agency costs are posed when promoters are left in control of the company post-IPO: management agency costs, and control agency costs.[vii] The former refers to the costs arising from mismanagement, which include reducing commitment, neglecting, or pursuing acquisitions in order to increase the size, or diversify the product line with no generation of value. The latter costs arisingout of transferring benefits to the controlling shareholders through related party transactions, excessive remuneration, etc. DVR structures could lead to an increase in management agency costs because controlling shareholders hold a lesser economic stake with greater control over the company, as compared to other shareholders.[viii] Higher governance risks and higher agency costs would inevitably lower the value of the body corporate.[ix]
In the Indian context, these agency costs and governance risks pose a greater threat since India’s economic structure is majorly constituted by family-owned listed companies, accounting for 43% of India’s market cap. Family-owned businesses would mean centralized control and ownership, which then becomes a norm in the context of India, rather than the exception. The direct risks posed by such companies are wealth expropriation, and entrenchment of concentrated ownership, thereby resulting in poor accountability, and inevitably poor economic results (proved through studies conducted).
Although hostile takeovers are often taken positively only by the target company’s shareholders, they can sometimes be a blessing in disguise. When the autonomy and power granted to the management starts increasing, it may start getting inefficient or complacent, leading to poor utilization of the company’s resources. In such a situation, the threat of a hostile takeover may bring the management back on track to perform their duties with due diligence, efficiency, and good faith. If much harm has been done, and the management is either unwilling or incapable of mitigating the damage, a hostile takeover could turn the fortunes of the company through better administration and efficient management of the company’s resources. This would ultimately benefit the shareholders and the company as a whole.[x] However, it has been suggested that hostile takeovers should not be the solution to inefficient management, and other alternatives should be explored, which could range from strengthening the role of institutional investors and independent directors in keeping a check on the functioning of the management, to voluntary liquidation initiated by the shareholders. In India, voluntary liquidation can be initiated under the Insolvency and Bankruptcy Code, 2016 only after approval from the majority of directors. In such a case, the shareholders do not pose a threat to the management since they cannot effectuate such liquidation by themselves. It is, therefore, necessary to grant such power to the shareholders in order to indirectly discipline healthy corporations by serving as a background threat against managerial inefficiency and save the corporate value.
In the next part, the authors discuss the limitation under the DVR Framework and the possible rectifications therewith.
Endnotes: [i] As defined under Ch. X “Innovators Growth Platform” of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.
[ii] Donald H. Chew & Stuart L. Gillan, U.S. Corporate Governance XVII (Columbia University Press) (2009).
[iii] Lucian A. Bebchuk & Kobi Kastiel, The Untenable Case for Perpetual Dual-Class Stock, 103 Va. L. Rev., 585, 613 (2017).
[iv] Id., at 598.
[v] Id., at 601.
[vi] Id., at 603.
[vii] Andrew William Winden, Sunrise, Sunset: An Empirical and Theoretical Assesment of Dual-Class Stock Structures, 2018 Colum. Bus. L. Rev., 892-893 (2018).
[viii] Id., at 897.
[ix] Bebchuk & Kastiel, supra note iii, at 603.
[x] Harry DeAngelo & Linda DeAngelo, Managerial Ownership Of Voting Rights: A Study Of Public Corporations With Dual Classes Of Common Stock, 14 J. Financ. Econ., 36-54 (1985).