Aastha Agarwalla, Law Student, Campus Law Centre, Faculty of Law, University of Delhi
The Ministry of Finance, through a notification dated 19th March 2020, (hereinafter, “Amendment”) introduced a significant development in the legal framework of Differential Voting Rights (DVR), especially in shares having Superior Voting Rights (SR), by amending the Securities Contracts (Regulation) Rules, 1957 (hereinafter, “SCRA Rules”).The Amendment provides that in case a company seeks to list its ordinary equity shares for offering to the public, then it shall be mandatorily required to list its shares having SR on the same recognized stock exchange.
Differential Voting Rights (hereinafter, “DVR”) refers to equity shares holding differential rights as to dividend and/or voting, and are broadly classified into Superior Voting Rights (hereinafter, “SR”) and fractional voting rights. The Companies Act, 2013 under section 43 (a) (ii) allows a company limited by shares to issue DVRs for raising investments and concomitantly, retain control over the company.
In the article, the author seeks to discuss the Amendment, and critically analyse the potential impact of the Amendment on the transactions pertaining to the issuance of SR shares by the companies/start-ups.
Key Takeaways of the Amendment
The Amendment has inserted a novel proviso after the second proviso of Rule 19, sub-rule (2), clause (b) of SCRA Rules, which postulates the requirements with respect to for the listing of securities on a recognized stock exchange. The proviso reads as follows:
“Provided also that the applicant company, who has issued equity shares having superior voting rights to its promoters or founders and is seeking listing of its ordinary shares for offering to the public under this rule and the regulations made by the Securities and Exchange Board of India in this regard, shall mandatorily list its equity shares having superior voting rights at the same recognized stock exchange along with the ordinary shares being offered to the public.”
Simply put, by way of this Amendment, a mandatory requirement of listing of SR shares along with the ordinary equity shares is set forth on the companies that willingly seeking to list its ordinary shares for offering to the public in the primary market. Henceforth, SR shares issued by the companies would be freely tradable in the secondary market by the SR shareholders. The notification also stipulates that these SR shares will not be covered under the minimum public shareholding rules as prescribed by the Securities and Exchange Board of India (hereinafter, “SEBI”) under clause (b) of sub-rule (2) of the said rules.
Mandatory listing: Analysis
To understand the impact of the Amendment, it becomes imperative to briefly understand the extant legal framework surrounding the issuance of DVRs in India. In order to regulate issuance/listing of DVRs by a company, SEBI has laid down a comprehensive framework. SEBI allows a company having SR shares to enter into the primary market, if and only, the issuer company is a tech company i.e. employing intensive use of technology, information technology or/and data analytics and thus, facilities technology-driven start-ups more room to raise equity funds without losing management control. Pertinently, SEBI entitles issuance of SR shares solely to the promoters/ founders who hold an executive position in the company.
Hence, we can safely assume that the said Amendment will substantially impact the promoters/ founders of the technology-driven start-ups and companies.
Prior to the Amendment, SR shareholders were not permitted trading of SR shares on the stock exchange and hence, hindered the shareholders to generate liquidity and fungibility of their shares. A simple understanding of the above Amendment exhibits that the investors, promoters, venture capitalists, and private equity funds who have SR shares can now generate liquidity with their shares by being able to sell these shares at the stock exchange. Consequently, the Amendment holds the potential to act as a panacea for the promoters/founders by providing an opportunity to exit that particular company, without being baffled by the fear of losing massive value on their investment. Therefore, mandating listing of SR shares will generate liquidity of the capital of the promoters/founders through the stock market in case of extreme business risks. More importantly, this cashing-out behavior by promoter will foster corporate restructuring mechanisms and greater corporate risk taking will increase economic welfare.
Throwing a flipside of the Amendment, the promoters get a leeway to exit the company in distressed business conditions, and can severely impair the interest of the investors by shifting the burden to bear the potential risks/losses of the entity on the investors. Thus, the investors may have to bear the brunt of the consequences of the mismanagement by the promoters. Additionally, as the promoters can dilute their shareholdings up to certain extent, they in order to maintain the position may resort to infusing funds in the core operations of the entity mandatorily, whilst diversifying through secondary market.
Moreover, this Amendment inherent an underlying risk of shifting the corporate control through unsolicited and hostile takeover. SEBI in the framework clearly stated that “…there is a need for a structure to enable them to retain decision-making powers and rights vis-à-vis other shareholders. One such possible structure could be the issuance of shares with superior voting rights to founders/promoters of the company.” However, dispelling the intent of SEBI, this Amendment perils the effective corporate management of the company, as the issuance of SR shares was premised on the objective to avoid the attempts of an unwarranted and unsolicited takeover of the company by retaining the majority control in the affairs of the company through SR shares. However, after the Amendment, the prospective acquires will be able to pursue any unsolicited takeover by acquiring SR shares from the secondary market without the consent of the management and hence, successfully have corporate control on the company. The change introduced will indeed extend the trading of SR shares for the promoters/founders; however, it will also significantly give rise to the risk of hostile takeovers through the secondary market.
The Amendment also encompasses an unwanted anomaly for the efficient corporate governance of the entity. The listed SR shares will essentially be an attractive investment avenue on the secondary market because these shares would be traded at a substantial premium and may render greater returns. Thereby, it will encourage institutional investors to invest in SR shares. However, as institutional investors are inherently focused on the high earnings, they will not prudently and efficiently exercise their voting shares attached with SR shares to control the company. Thereupon, the passive attitude of the institutional investor (as a majority voting rights shareholder) will invariably act as a dampener to the corporate governance. Thus, it must be understood that it’s pertinent to balance between these conflicting paradigms through the acceptance of the principle of good faith and corporate governance by the SR shareholders.
The framework of shares having SR is adopted by various conglomerates, both domestically and internationally, for structuring their shareholding in dual categories to raise funds and retain control. Thus, this Amendment will further encourage companies to come forward and issue SR shares as promoters/founders will now always have a window to exit the company at the time of high business risks. Hence, the pertinent question raised on the efficacy and impact of the Amendment to successfully gear up the interest of the company/start-ups will be unfolded in the times to come.