DVRs: Why SEBI Wants To Give India Inc.’s Promoters Superior Rights

Like their global counterparts at Facebook, Nike, Google, Alibaba, Xiaomi, Indian promoters too may soon be armed with a corporate brahmastra - shares with superior voting rights. Interestingly, market regulator Securities and Exchange Board of India has sought to balance the control skew with a unique two-pronged approach towards differential voting right shares, and with governance safeguards.

Differential voting right shares or dual class shares are shares with higher or lower rights, in respect of dividend or voting. They allow founders to raise money while retaining control. DVRs also serve as defense in hostile takeover situations. Many jurisdictions, such as the United States and Canada and more recently Hong Kong and Singapore, allow differential voting rights or dual class structures.

To be clear, DVRs have been long permitted in India. Company law allows issuance of shares with differential rights, both, higher and lower voting and dividend rights, for all companies - private and public. Except it mandates a three-year profitability track record for the issuing company. SEBI permitted such DVRs until 2009 when it changed its mind and prohibited listed entities from issuing shares with superior dividend or voting rights. As a result of these many limitations, DVRs have not taken off in India, in unlisted or listed companies.

A situation that SEBI now hopes to rectify.

Such structures help in fund raising without dilution of control and serve as defense mechanism against any hostile bid for change in control. Such shares have rights disproportionate to their economic ownership. In promoter/founder led companies where promoters/founders are instrumental in the success of the company, such structures enable them to retain decision-making powers and rights vis-à-vis other shareholders either through retaining shares with superior voting rights or issuance of shares with lower or fractional voting rights to public investors.

SEBI Committee Consultation Paper - March 2019

Superior And Fractional Rights Shares

The consultation paper issued by a SEBI committee in March suggests two classes of differential shares -

Shares with superior voting rights (SR Shares)
Shares with fractional rights (FR Shares)

SR Shares
SR Shares, where each share will have a greater voting right when compared to ordinary shares, may be issued only to promoters/founders of the company. Here are the key proposed conditions of issuance of SR Shares:

Can be issued before the equity listing of a company but not after an IPO. They remain unlisted even after company lists.
No third party interest, such as pledge or non-disposal undertaking, can be created over SR shares.
Subject to a perpetual lock-in after the IPO.
Voting ratio: Only distinction between SR and ordinary shares will be in respect of voting (not dividend etc). Voting ratio can be maximum 10:1 for SR Shares vis-a-vis ordinary shares. Such ratio, once adopted, will apply to any subsequent issuance. Only one class of SR shares may be issued.
Corporate governance: On a list of matters, SR Shares will carry only one vote per share, including for appointment or removal of independent director or auditor, change in control, material change to articles of the company etc.
Sunset period: SR Shares must be converted to ordinary shares on the 5th anniversary of listing of ordinary shares of the company. This would be extendable by 5 more years via a special shareholder resolution.
In case of a merger/acquisition/death of promoter etc. the SR Shares automatically convert to ordinary shares.

FR Shares
FR Shares, which carry lower voting or dividend rights when compared to ordinary shares, were already permitted to be issued and listed. SEBI has now proposed some additional conditions:

Can be issued by companies whose equity shares have been listed for at least 1 year.
Voting and other rights on FR shares shall not exceed a 1:10 ratio vis-a-vis ordinary shares.
At a time only one class of FR shares allowed.
Additional dividend compared to ordinary shares is allowed.
FR Shares can convert to ordinary shares only pursuant to a scheme of arrangement and can be extinguished pursuant to a buyback.
Delisting is permissible; if ordinary shares are delisted, FR Shares must also mandatorily be delisted.
ESOPs of FR Shares will also be permissible.

Companies intending to issue dual class shares must be authorised to do so in their articles of association, SEBI has proposed. Such an issuance and its terms would require shareholder approval via special resolution (75 percent majority). The size of the issuance is also limited by company law provision - DVRs shall not exceed 26 percent of the total post-issue capital.

Use Cases Of DVRs

Each class of DVR shares address different concerns, said Prashant Gupta, national head - capital markets at law firm Shardul Amarchand Mangaldas.

For FR Shares, I think companies would probably use them more as a capital raising instrument (such as Tata Motors did several years ago), without diluting existing voting rights, but SR Shares are trying to protect founders’ ability to control the company post listing.

Prashant Gupta, Partner, Shardul Amarchand Mangaldas

The usual way to retain control of companies is to own significant, if not majority, shares of the company. But for tech companies, like Paytm and Ola, where investors have been pumping significant cash into the companies from inception, the promoters are already very diluted and retain control only through contractual rights, Manan Lahoty, partner at law firm L&L explained.

The dual class shares option will give promoters - on the brink of undertaking an IPO - the ability to acquire decision making powers they wouldn’t otherwise be able to get.

Manan Lahoty, Partner, L&L Partners

Interestingly, the SEBI paper allows a company with SR Shares to issue FR Shares after listing. Could this result in a further concentration of control?
Promoters can’t retain their voting ratio in case of subsequent issuances, said Lahoty. They may be able to reduce the extent of dilution however, by issuing FR shares to other shareholders, he added.

Control Vs Governance

Dual class shares were introduced in the U.S. back in 1980s in the midst of multiple takeover battles like the infamous hostile acquisition of RJR Nabisco by private equity firm KKR or Standard Oil’s acquisition of Gulf Oil.

But soon thereafter DVR structures attracted criticism from various stakeholders. Superior voting rights have often led to entrenchment of promoters/management, and the compromise of public shareholders’ rights. Those concerns are accentuated in India - a country rife with family-owned companies.

The key issues revolve around investor awareness and corporate governance. The former because there is lack of understanding regarding these products in the market today, which in turn impact their liquidity and the latter, because corporate governance standards in India are still evolving, Shruti Rajan, partner at law firm Cyril Amarchand Mangaldas said.

But SEBI’s proposal to include coattail provisions - matters in which SR Shares will have same voting rights as ordinary shares - will largely take care of the governance concerns, she added.

SEBI has proposed a list of matters - a coattail list - which are of fundamental interest to the company, appointment or removal of independent directors, voluntary winding up of the company, material change to charter documents etc. In such circumstances, it is proposed, SR shareholders and ordinary shareholders will be on equal footing. This will ensure that corporate governance is not jeopardised. But at present, this list is only indicative.

Shruti Rajan, Partner, Cyril Amarchand Mangaldas

Lahoty agreed that these coat tail matters will certainly balance out the power equation which is more unique to India than other economies. Checks on related party transactions and appointment of directors and auditors are crucial and SEBI has walked the tight rope rather well here, he said.

But Gupta said the proposed coat tail list is too long. Especially as SEBI has mandated a one share-one vote policy in the event of a change in control.

I understand that SEBI’s intent is to protect the rights of public shareholders but according to me the coat tail list is too exhaustive, especially the provision on losing the special status once there has been a change of control - because that is the one place where founders would want to have the DVR status in case a “hostile” party acquires control by purchases from non-founders and then an open offer. If the acquisition of control is with the consent of the founders/promoters, they would in any case probably have to give up the DVR voting rights.

Prashant Gupta, Partner, Shardul Amarchand Mangaldas

It is also not clear what the definition of ‘control’ from this perspective is - will it include voting ratio taking into account the SR shares or not, Gupta posed.

The other point of disagreement among experts is over the sunset clause of 5 years for SR Shares. This has been a common demand of stakeholders in other jurisdictions. SEBI has proposed that on the fifth anniversary of the company’s listing, the SR Shares should convert to ordinary shares. An extension of five years may be permitted if approved by 75 percent shareholders, on a one-share-one vote basis.

Such sunset provisions are a recognition that DVRs are required only at the initial stages in the lifecycle of a company where they perform the role of enabling the promoters to assume business risks without ceding control. Once that purpose runs its life, there is no longer a continued rationale for DVRs, and hence they must come to an end.

Umakant Varottil, Associate Professor of Law, National University of Singapore (in his blog IndiaCorpLaw)

But Gupta argued that the five year period is a relatively short period for promoters to retain this control.

The extension of five years may not be workable since institutional investor bodies that are shareholders in most listed entities typically are not on board with these kind of rights, so in all likelihood SR Shares status will fall away after the five-year period. If SEBI is serious about introducing DVRs in India, then either they should not have a sunset clause or extend it to up to 10 years, at least.

Prashant Gupta, National Head - Capital Markets, Shardul Amarchand Mangaldas

The Final Stretch

The SEBI paper has also recommended concurrent changes to company and other laws so as to facilitate this new DVR regime. Most importantly, company law requires companies issuing such shares to have a consistent track record of distributable profits for the three years prior to listing.

The market regulator has sought comments on its proposals by Apr. 20. How institutional and retail investors respond will be interesting. Varottil writes in his blog that SEBI missed a safeguard - higher governance provisions for companies issuing DVRs. “This is a precondition in some of the other leading jurisdictions that have permitted such structures, given the greater concerns regarding the ability of promoters holding higher voting rights to adversely affect the interests of minority shareholders.”

On the other hand, Lahoty believes that if and when DVR structures become a reality, investors will look at a company’s business model and founder’s capabilities - if they are compelling, investors may consider investing even without control and equal simply because of the promising financial returns.