[Rongeet Poddar is a final year B.A. LLB (Hons.) student at West Bengal National University of Juridical Sciences]
A hostile takeover is a rare occurrence in the Indian market because of the stringent control of promoter-families over companies and concentrated shareholding patterns in India. L&T’s hostile takeoever of IT services firm Mindtree however is an exception to this general trend. It is being considered as the first hostile takeover in the IT sector in India. L&T’s actions over the past few months to acquire Mindtree could change the rules of the game forever in the industry. It throws open a Pandora’s Box with regard to the introduction of dual class shares as envisaged by the Securities and Exchange Board of India (SEBI).
The Mindtree Takeover
Mindtree’s peculiar shareholding pattern is considered as a major factor which facilitated L&T’s hostile takeover. The four promoters of Mindtree collectively held only 13.32% of its shares. The acquisiton of coffee baron V.G. Siddhartha’s 20.32% stake in Mindtree was L&T’s first calculated move in the takeover process. This was followed by an order to purchase a further 15% stake before an open offer for buying 31% voting shares in consonance with the requirements under regulations 3(1) and 4 of the Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeover) Regulations, 2011.
According to latest reports, L&T has gained control of 60% share of voting rights in Mindtree after foreign portfolio investor Nalanda Capital sold its entire 10.61% stake in the company. Mindtree’s board also recently agreed to induct three senior executives of L&T as non-executive directors. Having already secured the approval of the Competition Commission of India for the takeover, L&T is well on course to make considerable headway in the IT sector by adding Mindtree to L&T Infotech Limited and L&T Technology Services Ltd.
Mindtree Ltd’s promoters explored many interesting defence tactics to prevent the hostile takeover. This included attempts to highlight dissimilar work cultures as well as the mooting of a share buyback proposal which was eventually dropped. A strategy of dividend announcements was also adopted including a recommendation for special dividends as a possible ‘poison pill’ defence to win over shareholders and make the acquisition of the IT firm unattractive for L&T. Question marks have been raised as to whether this action was contrary to regulation 26 of the SEBI Takeover Regulations. The concerned regulation imposes an obligation on the target company to ensure that its business is conducted in the ordinary course consistent with past practice following the public announcement of an open offer.
The promoters also made a last ditch effort to prevent the hostile takeover by facilitating an intervention by Mindtree’s largest institutional investor Nalanda Capital. However Nalanda Capital also retreated by selling its stake after SEBI issued a show-cause notice for acting in concert with the promoters of Mindtree and exhorting Mindtree’s public shareholders to refrain from selling their shares at L&T’s offered price. However, a defence mechanism that remains largely unexplored in India is the issue of shares with differential voting rights. (DVRs)
DVRs as a Safety Valve for Hostile Takeovers
DVRs are an alternative to the commonly prevalent rule of one share-one vote. These shares are disproportionate to their economic ownership. There can be two types of DVRs: shares with superior voting rights (SR shares) and shares with fractional voting rights (FR shares). DVRs offer an attractive proposition for promoters to ward off such hostile takeovers as a large proportion of voting rights remain firmly in the hands of the promoter group. This allows the promoters to raise capital without diluting control. As observed in SEBI’s Consultation Paper on Issuance of Shares with Differential Voting Rights, dual class shares were frequently used in the United Kingdom in 1960s to protect investors from hostile takeovers until they were discontinued due to opposition from institutional investors.
A few companies such as Tata Motors have explored this mode of shareholding in India. Such dual class shares are prevalent in the US, Canada, Hong Kong and Singapore. Facebook’s shareholding structure in the US for example, has two categories of shares. Class A shares carry one voting right per share and are listed through an initial public offer and held by public shareholders. Class B shares on the other hand are held by Mark Zuckerberg and his promoter group and they carry ten votes each. In Mindtree’s case, the promoters’ meagre collective shareholding meant that the company’s control effectively lay in the hands of investors who were not keen to retain their shares in the event of a hostile takeover. This could have been avoided had Mindtree’s shareholding pattern allowed the promoters ‘control’ by virtue of their voting power. Since promoters play an instrumental role in developing a start-up they have a strong case for retaining control over the affairs of a company atleast in the initial phase. This should however be subject to the observance of a requisite standard of corporate governance in the interest of minority shareholders.
The Law in India
Section 43(a)(ii) of the Companies Act, 2013 allows a company limited by shares to have equity share capital with differential rights as to voting or dividend in accordance to rule 4 of the Companies (Share Capital & Debenture) Rules, 2014. Rule 4 imposes certain conditions such as the requirement of authorization from the articles of association of a company and the necessity of havening a consistent track record of distributable profits for the preceding three years. Regulation 41(3) of the SEBI Listing Obligations and Disclosure Requirements) Regulations, 2015, however, bars a listed entity from issuing shares with superior rights as to voting or dividend. Therefore, the current law only allows the issuance of shares with fractional voting rights subject to the fulfilment of certain conditions only as mandated by rule 4 of the Companies (Share Capital & Debenture) Rules, 2014.
SEBI’s Proposed Framework on Issuance of Shares with Differential Voting Rights
SEBI’s recent Consultation Paper on Issuance of Shares with Differential Voting Rights recognized the need to allow greater control for promoters who initiate start-ups. There were certain key recommendations that were made for the introduction of both FR shares and SR shares. The Consultation Paper had further recommended the introduction of coat-tail provisions and a sunset clause for the SR shares in addition to suitable amendments to the existing laws and regulations. An analysis of the same can be found here.
In its board meeting on June 27, SEBI has also approved a new framework for issuance of shares with differential voting rights. This framework seeks to allow a company with superior voting rights shares to do an initial public offering of only ordinary shares subject to the fulfilment of specific conditions in addition to the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.
The first condition proposed by SEBI is that the issuer company must be a tech company. The illustrative list of qualifications provided to a tech company includes the intensive use of information technology. Secondly, the SR shareholder must be a part of the promoter group whose collective net worth does not exceed 500 crore rupees. The calculation of collective net worth will not involve the investment of SR shareholders in the shares of the issuer company. Thirdly, the SR shares can only be issued to the promoters or founders who hold an executive position in the company. Fourthly, the issue of these shares must be authorized by a special resolution passed at a general meeting of shareholders. Fifthly, the SR shares must have been held for a period of atleast 6 months prior to the filing of the Red Herring Prospectus. Finally, the SR shares can have voting rights in the ratio of minimum 2:1 to maximum 10:1 as compared to ordinary shares.
Additionally, the SR shares will also be listed on Stock Exchanges after the public issue by the issuer company. However, the SR shares shall be under lock-in after the initial public offer until they are converted to ordinary shares. Significantly, a transfer of SR shares is not permitted among promoters. Any encumbrance on the shares in the form of pledge or lien is also prohibited. The SR shares will be treated at par with ordinary equity shares in all circumstances including the payment of dividends. The ownership of SRs will only offer an advantage at the time of voting of resolutions. The total voting rights of SR shareholders post listing will not exceed 74%. This threshold will include the ordinary shares owned by the SR shareholders.
SEBI has endorsed an enhanced standard for corporate governance for companies having SR shareholders. The securities market regulator considers this as a necessary to protect the interests of minority shareholders. Half of the board of directors and two-third of the board committees must mandatorily consist of independent directors while audit committees will comprise of only independent directors. Much like the Consultation Paper on DVR shares, SEBI’s proposed framework also includes ‘coat-tail’ provisions wherein the SR shares will be treated as ordinary equity shares for certain purposes. For example, the ‘coat tail’ provisions will only come into play when the promoters are willing to transfer control to another entity.
SEBI provides for two types of sunset clauses for SR shares: time-based and event-based. The former category provides for an automatic conversion of SR shares into ordinary shares at the end of five years from the date of listing. The life-span of the SR shares can only be extended once by another five years by virtue of a resolution. A SR shareholder is barred from voting on such resolutions. The latter category SR shares will get converted into ordinary shares on the occurrence of certain specific events such as demise, resignation of SR shareholders or in the event of merger or acquisition only when the control would no longer be with the SR shareholder.
Surprisingly, SEBI in its board meeting has decided to bar the issue of FR shares by the existing listed companies. However, it has stated that the issue of FR shares may be allowed in due course ‘after gaining enough experience with the use of SR shares’.
SEBI’s proposed legal framework is clearly meant to protect the promoters of companies in a specific sector, i.e, the information and technology sector. SEBI’s framework for SR shares, much in the mould of Facebook, has enough leverage to preserve the position of a promoter in a fledging tech company in the event of a hostile takeover. The SR shares will allow promoters to channelize their attention towards nurturing their nascent companies while their superior voting power creates an in-built defence mechanism against unsolicited takeover bids in the initial life-cycle of the business. This additional layer of protection will only last for a maximum period of ten years till it has helped promoters tide over the difficulty of raising a certain amount of foundational capital without divesting control.
SEBI’s Consultation Paper had raised a valid apprehension that public investors may be wary about investing in a company that has a large proportion of DVR shares due to corporate governance concerns. In its board meeting, SEBI has made an attempt to address such reservations by incorporating separate ‘corporate governance’ provisions that involve independent directors. It remains to be seen whether these are sufficient to convince the public investors about their utility. India’s aspirations as an emerging IT hub may take a hit if the growth potential of promising start-ups is overshadowed by the challenge to safeguard the interests of non-promoter shareholders.
– Rongeet Poddar