The Differential Dividend Story

[The
following guest post is contributed by Siddharth Raja, Founding Partner of Samvad Partners. Views are
personal.]
A
previous
post
on this Blog raises some
interesting questions – although this author believes that analysis is both
incomplete and, indeed, not purely academic. While the above blog post only
addressed one aspect of the issue, the larger question is this: whether a
dividend can be paid only to some shareholders and not to all; and, what role
does a contractual provision enabling a “waiver” play in relation to the issue
of a differential dividend? This post seeks to analyse these matters.
Financial
investors rely heavily on “liquidation preference” clauses.  Such clauses constitute a contractual measure
to order the priority upon which a portfolio company is expected to distribute
moneys to its shareholders different from a typical proportionate distribution
– upon the occurrence of a “liquidity” or distribution event that has resulted
in the company in question receiving cash proceeds, typically, as a result of
profits it has made upon a sale of its assets (or, some such valuable rights).  Within such a construct, the investors place
themselves – contractually – ahead (or, in most cases, first) in the order of
priority in respect of any such distribution from the company. This enables
them the right to receive before any others, especially the equity
shareholders, the proceeds of any distribution of moneys that the company might
make. 
One
of the methods companies utilize to effect such a distribution is the dividend
route.  However, the initial legal
presumption inherent in dividend distribution is that members of the same class
of shares are entitled to proportionately equal dividends, i.e., on a pari passu basis amongst themselves (in
the absence of an agreement to the contrary amongst, and binding upon, the members
of that class).  It is for this reason –
priority in distribution – amongst others, that investors in India choose to
hold preference shares as opposed to equity shares. 
In
other words, the holder of a preference share is able to both contractually, as
well as legally, avail himself of a superior and enforceable right to receive,
ahead of any payment to any other class of shareholders, moneys a company may
resolve to distribute.  The
characterization of such a right as one of a preference share and its holder,
in contrast to that of an ordinary equity share leaves no room for doubt or different
analysis.
The
issue, however, becomes more acute within the same class of preference
shareholders – that we will examine from the following paragraph onwards and
which forms the crux of this post. 
Obviously,
if there are several classes of preference shares themselves, then it is conceivable
that one class of preference shares may have superior rights to another class
of preference shares. That way of ordering does not militate against the
principle of equality of shareholders holding the same type or class of shares.
In fact, as noted in a leading commentary, where shares are expressly divided
into separate classes (thereby necessarily contradicting the presumed equality between
shares), it is a question of construction in each case as to what the rights of
each such class are.[1]
Viewed
thus, while analyzing the various legally available avenues open to a company
to distribute returns to its preference shareholders, two issues arise for
consideration, depending on which method is adopted:
EITHER:
1.
Can the terms of issue (or a company’s articles of association) prescribe that,
within the same class of preference shares, one preference shareholder (or a
separate group therein of such preference shareholders) will have a
differential right of dividend, such that it, in effect, gets a higher liquidation
or distribution preference?
OR
2.
Can a preference shareholder(s) waive – and, in some cases, waive permanently –
its right to a preferential dividend in favour of a particular preference shareholder
who is to get a higher liquidation or distribution preference, again of a
member within the same class.    
These are not
purely academic issues. In the case of a company which has raised several
rounds of financial investment (ecommerce or marketplace companies are good
examples), it is not uncommon to ask: can one investor give (by waiving his
dividend rights) the benefit of a differential treatment to another investor
who is contractually to secure a higher “liquidation preference”?   And whether this avenue of distributing
returns to just an institutional investor holding preference shares is legally
tenable as against other shareholders, including equity shareholders? 
I will deal with
the first issue.  Prima facie all shares rank equally, unless the terms of its issue (or
the company’s charter documents stipulating the rights of each share class) provides
for a priority of one or some shares over others in the same class.  Section 106 of the Companies Act, 1956,[2]
enables a minimum 3/4ths majority of the holders of a particular class of
shares (which majority can also be obtained via a special resolution passed at
a class holders meeting) to consent to a variation in “the rights attached to
the shares of [such] class”, provided the terms of issue does not prohibit such
a variation; or the company’s memorandum or articles of association has an
express provision enabling such variation – the yet-to-be-notified Section 48 of
the Companies Act, 2013 is in pari
materia
with this provision. 
Although the law
typically encounters differential rights between different classes of shares as
a matter of a class right (i.e., one
class’s rights are superior than another class, say, for instance, as regards
return of capital), it is not uncommon to find and, indeed, nothing which legally
prevents – I argue – such differential rights even within the same class, but
as between different holders of such shares as a matter of a shareholder’s right qua the particular shares of that class they hold. 
Implicit in
Section 106 is the right of a class of shares, through a prescribed majority,
to provide for variations in the share rights of its class, which must mean,
therefore, that some such shareholders could have a superior right (say, a
further preferential right to dividend), while other ‘non-entitled’
shareholders do not possess such rights – since the variation contemplated is
as regards the rights attached to a class of shares, such variation could
conceivably be more favourable to one or a group of shareholders therein and
not to the other shareholders of the same class, if the requisite consent in
accordance with law has been obtained. This position is underscored by the fact
that the consent mechanism in Section 106 of the 1956 Companies Act (and, by
extension, Section 48 of the 2013 Companies Act) is specifically predicated on
what is provided for as regards differential rights, in the terms of issue of
such shares or in the charter documents. 
In other words, such terms of issue or the charter documents could, at
the very first instance, validly provide for a differential rights basis even
between or amongst the holders of the same class of shares – and, hence, a
subsequent variation to the same or different effect is also permissible.  To the extent a shareholders’ agreement exists
among and binding upon the members of that class, the differential rights ought
best to be then incorporated into the terms of issue, or in the charter
documents, so as to keep expressly in line with these statutory provisions
relating to variation of class or shareholder rights.  In effect, I am arguing that a variation of a
class right extends even to a
variation in a shareholder’s right
within that class. That would seem obvious under Section 106, but stating it in
these terms, also recapitulative.
The
yet-to-be-notified Section 48 of the 2013 Companies Act, in fact, goes one step
further – the proviso to sub-section (1) stipulates that if the variation by
one class of shareholders of their rights affects the rights of any other class
of shareholders, a similar consent must be obtained from such other class –
meaning thereby, within the same class,
differential rights as between shareholders
are contemplated in the mechanism under the statute, if that provision is
adhered to either in its original terms or in its charter, or via a
modification in line with the proper and stipulated majorities.  Any transferee of such ‘entitled’
shareholders’ shares will succeed to such rights on the principle of assignment
of a contractually agreed to provision that is also in compliance with the
‘variation’ principle in Sections 106 / 48, as the case may be.
The second issue on
‘waiver’ raises questions that do not fit well with the above analysis. It is
one thing to mention ‘waiver’ effectively as a right of a person (namely, the
shareholder concerned), and then proceed to discuss how that is to be
legislated in various documents and analyze its consequences vis-à-vis the
company concerned along with the company’s rights – that is what the blog post above-mentioned
does.  But, that begs the question of a dividend
right (or a crystallized entitlement once declared) being a share or a class right, especially in the context of the nature of the
underlying share, whether equity or preference.  In the latter case, dividend is one of the
distinguishing characteristics of the type or class of share itself.  If so, it would sit better – I argue – with the
analysis of the issues under # 1 above of a share
or class right, that the differential
basis in the treatment of the receipt of the dividend as envisaged through such
a ‘waiver’ of any dividend entitlement, be actually captured through the terms
of issue itself or in the charter documents, or through a variation in due form
and proper majority according to the law specifically so providing for such
variations.
Undoubtedly, any
such ‘waiver’ contractually agreed to ought to be binding as a matter of mutual
agreement; and, so, if the effect of receiving a differential dividend is still
achieved whether through the ‘variation’ or original terms route under # 1
above, or through the ‘waiver’ mechanism, the legal consequence is the same as
to its intended effect.  So, the issue is
moot and are we not splitting hairs? 
Except that the
concept of ‘dividend’ itself under Indian law seems to militate against using
the ‘waiver’ route.  The point is driven
home if we were to consider this question: what happens if between interim and
final dividend (where the holder has waived its dividend rights), the share is
transferred and the shareholder who waived its right to a dividend is not the
same shareholder now holding the share which carries with it an inherent right
to dividend once declared?  Only if the transferee has accepted the
transfer of shares subject to the ‘waiver’ of dividend, will such ‘waiver’ bind
him – else not, on the basis of dividend being a share right; a position underscored in Section 123 of the 2013
Companies Act (Section 205 in the 1956 Companies Act) as it relates to the declaration
and payment of dividends.  In other
words, in order to have the ‘waiver’ operate subsequently especially so as to
confer a differential right in favour of one holder or some holders, as against
others, it would be prudent to incorporate such a differential basis into the
terms of issuance or charter document itself via a variation’ properly done, rather
than rely on a ‘waiver’ that may conceivably not bind all subsequent holders
since a waiver is a shareholder right
or benefit and not a share or class right. 
The question is
however moot whether a skillfully drafted ‘waiver’ binding a subsequent transferee
can be displaced by such a subsequent holder on the basis he did not take the
share subject to a right which he knew not, or ought not to be fixed with the
knowledge of – or if the ‘waiver’ is intended to operate only as a one-off. 
I would only end
by saying that if certainty in the law is the safest house for the corporate
lawyer as regards the rights and benefits of his client, then a differential
dividend is best incorporated in the terms of issue or the charter document
itself, rather than through the use of ‘waivers’.
– Siddharth Raja



[1] Paul L.
Davies, et al, Gower and Davies’ Principles of Modern Company Law, 8th
Edn., London: Sweet & Maxwell, 2008, pg. 823.
[2] This
provision of the 1956 Companies Act is
still in
force as the corresponding provision, Section 48 of the Companies Act, 2013, is
yet to be notified as the National Company Law Tribunal is yet to be
established.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

4 comments

  • I am a little unclear as to your conclusion. Very simply put, are you saying that a shareholder cannot waive dividend on ordinary equity shares? If dividend is a right that inheres in a shareholder, and by waiving dividend on a one-time basis, the shareholder isn't looking to permanently alter his rights or even bind a transferee, is the shareholder or the company violating company law?

  • I should clarify — waiver is an inherent contractual right. Unless something in the law prevents it, it will exist. I find nothing in the law that prevents a waiver of a dividend as a matter of right. So as a one-off waiver is fine. That's no violation of the law. However, if a waiver is meant to operate for the future (i.e., more than just as a one-off), my argument is that may not work legally. To achieve such an objective, it would be best to amend the terms providing for such differential right. Trust this clarifies, Siddharth Raja.

  • Wont the creation of two different classes be two different classes of shares, not within the same class? Anyways, I think the question is moot. If one creates differential rights, those are different classes of rights and thereby, best done at the level of different classes of shares. Sec. 106 ought to be complied with.

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