New norms of Differential Voting Rights

Introduction

1. The Ministry of Corporate Affairs (MCA) recently amended the Companies (Share Capital and Debentures) Rules, 2014 (SCAD Rules) which are relaxed norms for shares with Differential Voting Rights ('DVR') that will help such companies to retain control while raising equity capital. The MCA move was long-awaited and follows closely on the heels of the Securities and Exchange Board of India (SEBI) amending the DVR regulations applicable to listed entities. DVRs allowing founders/promoters to have a greater say over decision making with a minority shareholding and help the promoter led companies to raise funds without diluting their holding and enabling them to retain their decision making powers. Such shares have rights disproportionate to their economic ownership and serve as defense mechanism against any hostile bid for change in control.

Lack of demand for DVRs

2. Though the DVR instrument is popular in global markets like US, Canada, Hong Kong and Singapore, yet it has not picked the popularity among Indian investors in the Indian securities market. Only 5 listed companies like Tata Motors, Pantaloons Retails, Gujarat NRE Coke, Jain Irrigation Systems and Stampede Capital have issued DVRs with lower or fractional voting rights. These DVR's are continuously trading at a steep discount which is around 35% to 45% whereas the average discount on which DVR/duel class stocks are traded globally is around 10% to 15%. They are barely liquid even at that discounted price. It denotes that Indian investors continue to value their voting rights/powers rather than economic benefits. Also, for a county like India, where PE or strategic investor would not like to have inferior voting rights, they would like to have voting rights so that they can have active role in the management of the company. Considering this Indian market situation, sore perks are required to be given for stimulating its demand in Indian security market.

Non-convertibility conditions

3. SCAD Rules currently prohibit a company to convert its existing share capital into DVRs or vice versa. Since the conversion is restricted, promoters or founders may not have the necessary funds at their disposal to subscribe to fresh DVRs required by the SCAD Rules. The inability to convert existing shares would make issuing DVRs virtually impossible for most of the startups.

The Government's rationale for not allowing conversion is that it may raise governance issue and give undue control to promoters or founders. If this rational hold is valid then government could have prescribed governance riders before exercising conversion. There is no rational in restricting conversion as it would not attain its intended purpose of easing startups to raise funds without ceding control.

Conversion of existing shares to DVRs is a common practice around the world and has been successful in the United States, Singapore, Canada and Hong Kong. For instance, some listed companies in the US like Google which retain control of the listed entity Alphabet by resorting to duel class shares. For meeting fund requirement, Google converted part of their holding in the superior class shares into ordinary shares. Similarly, Snapchat has also issued duel class shares under which superior right shares can be converted into ordinary shares and ordinary shares can be converted into non-voting shares. Viacom issued duel class shares in which ordinary shares which are owned by majority shareholders can be converted into non-voting shares whereas non-voting shares can't be converted into ordinary shares.

Minority rights won't get affected

4. In the earlier SCAD Rules, the threshold was 26% of total post-issue paid-up equity capital of the company at any point of time so as to align the Companies Act, 2013 provision with the SEBI regulations of DVR; this limit has been increased to 74% of the total voting power at any point of time. This would provide more liquidity to startups without ceding their control. There was a debate that for increasing this threshold may oppress minority rights. The SCAD Rules already prescribed sufficient measures by providing eligibility criteria for issuance of DVR; also the minority shareholders can still restrict special resolutions, as it requires the nod of 75% member's approval for passing special resolution. Therefore, the increased threshold would not cause any threat to minority.

Removing profitability criteria would widen the benefits to startups

5. In the earlier SCAD Rules, the companies which were not having consistent track record of distributed profits for the last 3 years, could issue DVRs. However, SEBI already permits IPOs of companies without a consistent track record of distributable profits for the last 3 years under Regulation 6(2) of the SEBI ICDR Regulations. The profitability condition is a big hindrance, since none of the leading startups today are making any profits. To remove this anomaly between the Companies Act, 2013 and the SEBI regulation and the hardship caused to new startup by mandating to have consistent track record of profits, the criteria of consistent track record of distributable profits for the last three years has been removed in the amended SCAD Rules.

Amended rules are not in line with SEBI regulations

6. Though the thresholds are aligned in the SCAD Rules with the SEBI regulation, yet they are not in line with the SEBI regulation. For instance, after 5 years the SR shall be converted to ordinary shares. This may be further be extended to 5 years. Restrictions on voting rights which may range between 2:1 to 10:1. These restrictions are not there for unlisted companies under SCAD Rules.

No governance riders under for issuing superior right for unlisted companies

7. DVR can be issued via two ways-one is issuing superior voting rights (SR) under which holder shall have excess voting power above its economic value. Fractional ownership under which holder would get inferior voting rights which are less than its economic ownership. Unlisted companies can issue DVRs via both ways where as listed companies earlier allowed to issue only fractional voting shares. Now SEBI has allowed issuance of SRs by complying with certain additional corporate governance conditions. The rationale behind not allowing SR was that it may harm the governance and may oppress the minority. Since in the unlisted public companies, there is no general public interest involved there are no restrictions prescribed under the Companies Act, 2013 and SCAD Rules for issuing SR shares but there are certain unlisted public companies which have availed public deposits or having borrowings above certain limit should have some additional governance riders for issuing SR so as to ensure better Governance and prevent the misuse of SR.