Shares with Differential Voting Rights: A New Life?

[By Deeksha Gabra and Shivam Gupta]

Deeksha is a Chartered Accountant and Shivam is a fifth year student of RGNUL, Punjab

1. Background

Shares with Differential Voting Rights (hereinafter “DVR Shares”), also known as Dual Class Shares internationally, are shares with rights disproportionate to their economic ownership. The concept of DVR is not new to India. It can be traced back to 2000 when the then Companies Act, 1956 was amended by Companies (Amendment) Act, 2000 to inculcate Section 86, which allowed the Indian companies to issue DVR Shares.

The Consultation Paper on DVR Shares released by SEBI categorized DVR into two types:

Shares with Superior Voting Rights (hereinafter “SR Shares”) which carry superior voting or dividend rights in comparison to ordinary shares. The minimum votes to share ratio in SR Shares should be 2:1 which can reach up to maximum of 10:1, implying a shareholder holding one share will have 10 votes.
Shares with Fractional Voting Rights (hereinafter “FR Shares”) which carry inferior voting rights in comparison to ordinary shares. The minimum votes to share ratio in FR should be 1:2 which can reach up to maximum of 1:10, implying a shareholder holding 10 shares will have one vote.

Till 2009, there were only few listed companies that issued shares with differential rights. For instance, in 2008, Tata Motors issued DVR Shares carrying 1/10th voting right and 5% higher dividend on these shares as compared to ordinary shares; and in 2009 Pantaloons Retails (now, Future Enterprises Ltd.) issued DVRs with 1/10th voting rights to the existing ordinary shares and offered 5% additional dividend.

Later in 2009, SEBI amended the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 to bar listed companies from issuing DVR Shares with superior voting or dividend rights, meaning that only FR Shares could be issued by listed entities. Since then, the use of DVR Shares in the Indian corporate sector is almost negligible, which can be attributed to various reasons including low awareness about the concept of DVR shares, inadequate corporate governance measures which may lead to minority oppression and lack of legal framework for regulating the DVR Share market.

The release of Consultation Paper on DVR Shares by SEBI followed by the hostile takeover of Mindtree by the L&T, being the first hostile takeover in the Indian IT sector ignited a debate in the corporate arena regarding the importance of DVR Shares to avoid such hostile takeovers. Thereafter, SEBI in its Board Meeting on 27^th June, 2019 approved the Framework for issue of DVR Shares. This article briefly discusses how DVR Shares would have helped to prevent the hostile takeover of Mindtree and makes an attempt to analyze the new approved framework for DVR Shares and the provisions inculcated therein.

2. Mindtree’s Hostile Takeover

The whole mishap can be attributed to the bizarre shareholding pattern of Mindtree. The four promoters of the company held only 13.32% of the shares collectively. The first step taken by L&T was to acquire 20.32% stake held by coffee tycoon, V.G. Siddhartha, in Mindtree. Then L&T further purchased 15% from open market before making an open offer of 31% under the Takeover Code. In the end, L&T gained a control of 60% after it further purchased 10.61% stake from Nalanda Capital.

Mindtree tried to prevent the hostile takeover by using various defense mechanisms. The main tactics included proposal to announce increased dividends, raising of a contention that both the companies have dissimilar work culture, proposal for buyback of shares. The last effort made by Mindtree was to facilitate an intervention by its largest institutional investor, Nalanda Capital. However, Nalanda Capital also recoiled by selling its stake after SEBI issued a show-cause notice for acting in concert with the promoters of Mindtree and spurring Mindtree’s public shareholders to abstain from selling their shares at L&T’s offered price.

Had there been DVR Shares in place, it could have helped the promoters to defend against the hostile takeover as a large percentage of voting rights would vest in the hands of promoter group.

3. Need for a New Framework

The Indian start-up market is witnessing a boom. These start-up companies depend majorly on the promoters/founders for their growth, vision and sustenance. Also, these companies are in requirement of funds/capital frequently which is fulfilled by equity capital. This results in erosion of promoter’s stake, thereby weakening their control. This is particularly significant for new technology firms with asset light models. DVR Shares as a paradigm for procuring capital can tackle this concern meritoriously, consequently operating as a defence mechanism to fight hostile takeovers.

4. New Framework

The SEBI Consultation Paper proposed a detailed framework for issue of both SR shares and FR shares. According to the framework, a company with SR shares is permitted to list its ordinary shares by an initial public offer subject to certain conditions prescribed under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009:

The company should necessarily be a tech company, i.e. companies that intensively use technology such as information technology, intellectual property, data analytics, bio-technology or nano-technology.
The Promoter Group (excluding corporate & non-executive promoters) is only eligible to hold SR shares. The collective net worth of the promoter group should not exceed Rs 500 Cr. (notwithstanding the investment of SR shareholders in the shares of issuer company).
A Special Resolution is passed for issuance of SR shares.
The SR shares are held by the promoter group for at least last 6 months prior to filing of Red Herring Prospectus (“RHP“).

After the listing of the ordinary shares, the SR shares shall also be listed on the stock exchanges. However, SR shares shall subject to sunset clause according to which the SR shares will be converted to ordinary shares. Furthermore, provision relating to lock-in will prohibit the trading/ transfer and creation of encumbrances on the SR shares.

The coat tail provision is one of the main highlights of the new framework along with the sunset clause. The coat tail provision provides for the circumstances where the SR shares are treated with parity vis-à-vis ordinary shares that is to say one share one vote. The coat tail circumstances include winding up of the company, related party transactions, appointment/ removal of director, etc.

In addition to this, company shall also be subject to heightened corporate governance for enhancing the functioning of the framework and safeguarding the interest of the stakeholders.

5. Conclusion

India being a late entrant in formulating a framework for DVR shares, has closely observed the national and international market and has drafted the clauses accordingly. The DVR structure in USA and Singapore is more or less similar to the approved framework in India.

The framework approved by SEBI is a calculative framework on all fronts indeed. It lays down balanced effort to defend the companies against the hostility simultaneously protecting the stakeholders by enhancing the corporate governance requirements. Above all, the new framework allows the new technology start-ups to raise the initial growth capital to nurture their nascent companies without erosion of promoter’s stake thereby sustaining the control over the company.

But this may not be a cakewalk owing to the sentiments of strategic investors who are more enticed in having a role in the management. On the contrary, retail investor would be fascinated by capital appreciation rather than the management of the company. Furthermore, the successful implementation and the benefit of the new framework can only be reaped if companies are cognizant of the benefits of SR shares and the legal framework in place to regulate such shares.

Last but not the least, gaining the confidence of public at large is another concern as the public might get cautious about the new class of shares attributing to the growing corporate governance concern in spite of the amendments primed by SEBI on these grounds. If these amendments fail to induce the stakeholders, it shall be a setback for our aspirations concerning the new framework, as well as the IT sector of India predominantly the start-ups. Thus, it is a long walk from here to envisage the reception as well as the implementation of the new framework in Indian corporate arena.