[Sarthak Sharma and Aabha Dixit are 3rd year and 4th year students respectively at Hidayatullah National Law University, Raipur]
The Securities and Exchange Board of India (SEBI) on 27 June 2019, after much deliberation, approved the issuance of shares with differential voting rights (DVRs) and issued a framework governing issuance and listing of shares with DVRs. Prior to this, whilst issuance of shares with lower voting rights was permitted in certain limited circumstances, the issuance of fractional rights shares (FR shares) was limited to 1/10th of ordinary voting power and issuance of superior rights shares (SR shares) was prohibited. The Companies Act, 2013 also required a 3-year profitability record for companies to be eligible to issue DVRs and, thus, excluded start-ups.
The new framework brings about a fresh scope for DVRs structure in India and is likely to act as an incentive to increase market breadth and promote corporate autonomy. It allows listed companies to issue super voting stock or SR shares to its founders. It will benefit home-grown tech companies and finally allow them to match global competition without lowering voting powers to single-digits.
Skepticism about super voting stocks in India and globally
Generally speaking, DVRs have been the exception rather than the norm in the corporate equity structure. Conceptually, they go against the basic principle of ‘one share, one vote’ which has been the cornerstone of corporate governance in most jurisdictions around the world and, therefore, shareholder resistance towards DVRs is not uncommon. Another reason for this resistance is that the concentrated voting power enabled through DVRs might also lead to managerial entrenchment and expropriation and the executives might act in personal interests rather than those of all shareholders. However, many corporate giants like Facebook, Viacom and Snapchat continue to have structures whereby way of super voting shares, majority voting power is concentrated in the founders or promoters who have a comparatively low equity shareholding. In fact, superior rights shares were the backbone of Mark Zuckerberg’s free reign over Facebook’s policy regarding user privacy and related violations. The Council of Institutional Investors (viz. a non- profit association of pension funds and other employee benefit funds in the USA) has made representations to stock exchanges to implement compulsory sunset clauses to prevent abuse of superior rights shares.
Thus, speculations that DVRs are not suited to the Indian scenario are not entirely misplaced, as similar structures have a history of causing an erosion of corporate governance. However, SEBI has prioritized shareholder interests over competition by galvanizing the framework with layers of enhanced compliance requirements and enhanced corporate governance.
Analysis of the framework
In order to limit issuance of SR shares only to companies that truly need them, SEBI, based on the Hong Kong stock exchange’s recently introduced DVRs model, has set up eligibility criteria that permits only tech companies to issue SR shares. Most of these companies are based on an asset-light model which is an impediment to debt capital funding. Equity capital funding, on the other hand, carries the risk of hostile takeovers and short termism due to dilution of control. DVRs allow them to raise equity without dilution and insulate them from short termism of institutional investors. The primary purpose served by DVRs will, thus, be protection of tech companies during the incubation period. The framework allows companies with SR shares to carry out an initial public offering of only ordinary shares to be listed at stock exchanges. Further, SR shares can only be issued to promoters or founders who hold an executive position in the company and the SR shareholders should be a part of the promoter group whose collective net worth does not exceed INR 500 crores.
Perhaps the biggest concerns regarding DVRs in India are mainly those revolving around corporate governance. Accordingly, SEBI has implemented a compulsory sunset clause on SR Shares by requiring mandatory conversion of the SR Shares to ordinary shares upon the occurrence of certain events. The sunset clause will be triggered at the fifth anniversary of the listing and is extendable by another five years with the approval of the shareholders, thus ensuring that an inefficient structure is not prolonged at the hands of the controlling promoters and only efficient DVR structures are retained. The sunset clause is also set off on the occurrence of events that result in a change in control of the company. The sunset clause, prima facie, will be effective to prevent a Facebook-like investor suppression in India and is the most appreciable bit of the framework. As an additional measure, the net voting power of all SR shares issued has been capped at 74 per cent post-listing.
SR Shares are also subject to a perpetual lock-in, to ensure that they are not traded by the promoter or founder to avoid a fiduciary duty to the shareholders with inferior voting rights. It facilitates the promoters’ focus on long term policies of the company that enhance long-term value, free from short-term market pressures and the constant risk of being ousted. Transfer, pledging or lien of SR shares amongst promoters is also not permitted. Further, a maximum ratio of SR Shares to ordinary share voting rights of 10:1 has been prescribed to prevent excess gap between the extreme ends of the voting power in a company and to avoid the concentration of voting rights with bare equity share in the enterprise. In addition, given that promoters raise funds through, inter alia, structured alternatives such as mutual funds, non-banking finance companies and pledging shares, changes by way of amendments have been made to the Takeover Code to the definition of ‘encumbrance’ to include any restriction on free and marketable title to shares, directly or indirectly, so as to put restrictions on the free marketability of SR Shares.
The earlier SEBI consultation paper on DVRs suggested a framework that permitted issue of both SR as well as FR shares. However, the approved framework only permits issuance of SR Shares and excludes issue of new fractional rights shares by listed companies. SEBI has indicated that it might review the prohibition of FR shares after assessing market response to SR Shares. The specific reason underlying the prohibition, however, is unclear, especially considering that fractional rights shares carry significantly less risks than SR Shares.
The framework also provides for coat-tail provisions which create an additional layer of protection of shareholder interests. To ensure inclusion of all shareholders in certain key management decisions, such as appointment or removal of independent directors, voluntary winding up of the company and changes in the articles of association, the voting rights of DVR shares would be akin to those of ordinary shareholders. The exhaustive list of coat-tail provisions, however, does not extend to existing FR shares issued before the framework. Though only a handful of companies have engaged in issuing FR shares prior to the SEBI decision, this may create an absence of a level playing field between superior, ordinary and fractional rights shareholders of these companies. Additionally, if the regulator allows issue of FR shares in accordance to the consultation paper in the future, the resultant situation may create a 1/100th difference between voting rights of shareholders at the extreme ends of the DVR structure. These factors, in the long run, will contribute to damaging shareholder equity relation to decisions crucial to the company. It is necessary that the SEBI keeps an eye on the market reaction to the framework and if necessary, extends the coat-tail provisions to fractional rights shareholders in the future.
SEBI has also imposed enhanced corporate governance compliance requirements on companies engaging in issuance of SR shares by requiring a higher participation of independent directors on the board as well as committees of the company. Overall, SEBI seems to have done a good job of incorporating adequate measures against foreseeable risks that SR shares carry. However, the reaction of the Indian market will be the true test of the viability of the framework.
The introduction of SR shares will broaden the spectrum of the investor’s choice in the Indian market. Higher dividend returns for reduced voting rights is an appealing compromise for minority investors. SR shares also provide a functional framework for relatively smaller private companies that are otherwise hesitant to be listed owing to fear of hostile takeovers. A recent example could be that of Mindtree Ltd. which was subject to a hostile takeover by L&T. Hostile takeovers like this one can be avoided in the future through super voting structures. SR shares-based structures would ensure raising equity effectively without dilution of control.
DVRs provide plenty for debate between competition and interests of the shareholders and challenges to SEBI in its pursuit to make India an appealing avenue for emerging technologies. Though the framework cannot necessarily be said to be an airtight solution to the risks of DVRs, it attempts to address and avoid problems that other jurisdictions have faced.
– Sarthak Sharma and Aabha Dixit