THE FUTURE OF SHARES ISSUED WITH DIFFERENTIAL VOTING RIGHTS UNDER THE INDIAN CORPORATE REGIME (II)
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 first part can be accessed here.
In Part I of this post, there was a discussion on the background of DVRs in India, along with the changes made through the recent amendment. The general drawbacks of such shares were also discussed. This part analyses the DVR Framework in particular, and points out several issues with the same. Further, this post proposes certain safeguards and re-amendments which could be taken into consideration for successfully implementing the DVR Framework in India.
LIMITATIONS UNDER THE DVR FRAMEWORK
With respect to the eligibility requirements, it needs to be emphasized that permission to adopt such structures has to be expanded beyond tech-based companies. While tech companies are said to focus on growing revenue during the initial years for expanding their business and customer outreach, they give up on short term financial gains in order to achieve long term value for shareholders. However, non-tech companies cannot simply be discounted as being either unable or unwilling to achieve these objectives. Such businesses may also need financing through equity in their initial years, while retaining control at the same time. As per the data compiled in 2019 by Jay Ritter, around 15% of American non-tech companies going public have employed multi-class structures. On the other hand, India has restricted these companies from issuing such shares under the DVR framework. Moreover, there is no clarity on how the shares with the already issued inferior voting rights will be treated. A company that has issued DVRs to its promoters, may issue such shares through a bonus, split, or rights issue. Currently, the issuance of DVR shares is permitted only by unlisted companies, which was also laid down by SEBI in the consultation paper. While SEBI has not laid down the reason for not permitting an existing listed company to issue DVRs, it seems unfair that an existing listed company cannot issue such shares even if the same is approved by way of a special resolution of its shareholders. Thus, there is a need to reconsider the same by revising the eligibility requirements in line with other jurisdictions.
Further, the DVR Framework provides for a sunset clause of 5 years, after which the DVRs would automatically be converted into ordinary shares that can further be extended, subject to certain restrictions. The presence of a time-based sunset clause in the DVR Framework poses its own set of problems. Though inserted to dilute control after a certain period of time and avoid permanency, this clause might lead to opportunistic behavior just before the expiration of the DVR period, such as efforts from the controlling shareholders to act aggressively in the end period by using their powers over the company, due to fears of losing their outsized influence over the body corporate.[i] Moreover, the possibility of extension by another 5 years may propel the controlling shareholder to perform better in the first term and pursue private goals in the subsequent terms. This would essentially mean that a time-based sunset clause merely restrains the controllers from unilaterally getting their term extended, but does not put an end to such structures after the expiry of the stipulated period of time.[ii] Further, uniform arrangements for sunset clauses may be suitable for some companies and not for others. Thus, such clauses are arbitrary and presumptuous because they might not accurately depict as to when the promoters would be able to achieve their vision, and they do not take into account the short or long-term performance of the company.[iii] An argument in favor of time-based sunset clauses is that in situations where, due to their small shareholdings, controllers might be incentivized to retain control even when it would be economically more efficient to sell or unify the capital structure; such a clause would ensure that inefficient companies do not operate longer than they should. However, it should be emphasized that such a clause would not lead to the termination of only inefficient companies but also the efficient ones.[iv]
THE WAY FORWARD
The regulatory framework for DVRs in India should ensure protection to shareholders who could be in a disadvantaged economic position due to poor management decisions taken by the controllers and increase transparency and accountability in decision-making. This can be done by incorporating the following disclosure requirements in the offer document and the shareholders’ agreement while making the IPO: (a) the terms of the offer should clearly state the nature of the promoters’ vision, which would enhance the company’s profitability and performance in the market, the talent of the company’s management, the nature of the business, etc., (b) provisions mentioning methods or mechanisms through which the controllers could be held accountable by the public shareholders, and ways through which management decisions could be influenced, and (c) public shareholders to be protected against agency costs.[v] With respect to a breach of fiduciary duties by the promoters, directors, or controlling shareholders of the company towards public shareholders, provisions should be included in the Act, laying down the consequences of such a breach which could include impairment of control rights in the company.
With respect to the challenge of fundraising up until the IPO in sectors where the promoter’s involvement and vision are critical to the company, SEBI could consider permitting the issuance of SR shares to promoters, subject to a mandatory sunset clause of two- or three-years post-IPO, with no prospects of further extensions. After the expiration of two years, these shares would get converted into ordinary shares carrying one vote per share. In this manner, promoters will be able to retain control during this period of mutation, and at the same time, safeguard the public shareholders from any long-term governance risks, agency costs, and opportunistic behavior of the promoters which can be aggravated in the presence of a longer sunset period (i.e., 5 years as prescribed by the DVR Framework).
Furthermore, in line with Canadian law, the requirement of compulsory approval by a majority of the minority shareholders while issuing DVRs could be considered. This would ensure the inclusion of even the smallest of the shareholders in decisions pertaining to the issuance of DVRs. A provision can also be incorporated to disqualify persons who have already subscribed to shares above, say, 25 percent of the existing share capital from subscribing to SR shares. These safeguards would prevent centralized control and entrenchment, along with ensuring that the interests of the minority shareholders are protected, and accountability of the management is maintained. Moreover, as stated in the last section, the eligibility requirements need to be revised so as to enable non-tech companies and existing listed companies to issue DVRs since no rational justification has been provided by the SEBI for not permitting the same.
Lastly, the Government of India announced several measures during the lockdown imposed on account of COVID-19 breakout, for protecting Indian companies from hostile takeovers, especially from Chinese companies. The FDI policy was tightened for companies located in countries that share a border with India, wherein they will have to approach the Government of India for investing in the country, instead of taking the automatic route. While this is a temporary measure aimed to protect Indian companies from Chinese investors specifically, the threat of hostile takeovers can be avoided in the long run if the suggestions enumerated above are taken into consideration since the current DVR Framework would provide protection only to a limited set of companies. Even though India has rarely witnessed hostile takeovers in the past, the possibility of a hostile takeover of a non-tech and/or existing listed company in the future cannot be ruled out.
The core of the debate with respect to DVR structures, both at the national and the international level, lies in the constant conflict between promoters and investors. It has been observed that DVRs all over the world are traded much lesser than ordinary shares. This might be due to a multitude of reasons, which include, inter alia, the lack of knowledge about usage of such shares, and of confidence in such structures on the part of the investors. Amending the framework of these shares is the right step undertaken by SEBI, especially in the backdrop of Mindtree’s hostile takeover and the growing need to promote corporate autonomy. However, the framework has certain shortcomings. Imposing a blanket ban on these shares would end up projecting the Indian economy as being inflexible to changing situations. The advantages that these structures provide for young entrepreneurs cannot be neglected. It would be an exaggeration to say that an infallible framework for such structures could be developed which would serve the interest of both, the issuers and the investors, in all types of companies in all situations. However, if attempts are made to tweak the existing framework in line with the suggestions broadly enumerated in this article, the lacunae in the framework could be addressed to a substantial extent. If adequate efforts are made to analyze and rectify its shortcomings in practice, a progressive concept like the DVR Framework could prove to be immensely beneficial to the Indian economic structure.
[i] Lucian A. Bebchuk & Kobi Kastiel, The Untenable Case for Perpetual Dual-Class Stock, 103 Va. L. Rev., 626 (2017).
[ii] Id.,at 624.
[iii] Andrew William Winden, Sunrise, Sunset: An Empirical and Theoretical Assesment of Dual-Class Stock Structures, 2018 Colum. Bus. L. Rev., 917 (2018).
[iv] Id., at 920.
[v] Id., at 909-912.