This article provides an insight on differential voting rights (DVR) and India’s regulatory framework for the issuance of shares carrying DVRs (DVR Shares). As the name suggests, DVR Shares, also referred to as dual class shares in various jurisdictions, are different classes of shares issued by a company which carry unequal or dissimilar voting rights. This is a deviation from the general rule of one-vote-per-share. DVR Shares may either be shares carrying superior voting rights (SR Shares) or shares carrying lower/fractional voting rights (FR Shares).
Historically, DVR Shares were issued by family-run businesses (e.g., Ford and Volkswagen AG) or media companies (e.g., New York Times and Wall Street Journal), wherein there was a need to retain control in the hands of a few for various reasons. In the recent times, technology companies such as Facebook, Alibaba and Snapchat have adopted ownership structures with DVR Shares. DVR Shares are relevant for founders/promoters driven businesses in order for them to retain or regain control, and implement their vision without getting distracted by short-termism or without ceding control over their businesses. Very few companies in India have issued DVR Shares. To name a few – Tata Motors, Pantaloons Retail and Jain Irrigation Systems Limited.
2. Rationale for Issuance of DVR Shares
The rationale for issuing DVR Shares primarily stems from a need to prevent dilution of management and control in a company while meeting the capital requirements of the company. Technology companies typically operate on an asset-light model of business, and rely on (or have more access to) equity funding as opposed to debt funding. The ownership of founders/promoters in these companies gets diluted pursuant to multiple rounds of equity financing, which, in certain instances, results in them losing control over their companies. In the Indian context, a promoter is a person who typically has control over the affairs of the company or someone on whose advice, directions or instructions the board directors is accustomed to act. Additionally, if anyone is named as a ‘promoter’ in the prospectus (i.e., the offer document for raising capital from public) or the annual returns of the company, such person is also deemed to be a promoter whether or not such person actually has control over the affairs of the company. Founders/initial promoters generally continue to be named as promoters in these documents even after getting diluted significantly. (See section 2 (69) of the Companies Act 2013 (Act) for the definition of ‘promoter’).
DVR Shares serve as a tool to demarcate interests of various shareholders in a company. While some shareholders may wish to be involved more in the decision-making process, others may be financial investors seeking to reap only economic returns on their investment. Further, if structured appropriately, DVR Shares can act as deterrent to hostile takeovers.
3. Disadvantages of Issuance of DVR Shares
On the flip side, if appropriate checks and balances are not put in place, DVR Shares may lead to corporate governance lapses and oppression of minority shareholders. If the controlling shareholders are also in the management of the company, issues may arise around conflict of interest and transparency in the company’s affairs. Role and independence of compliance officials, auditors and independent directors will be key to avoid or mitigate these issues in companies with DVR Shares.
4. International Precedents
Globally, DVR Shares are more popularly referred to as dual class shares (DCS). While several jurisdictions including United States, Canada, Hong Kong and Singapore, to name a few, permit the issuance of DCS and listing of companies having DCS, jurisdictions such as Australia, Spain and Germany do not permit the listing of companies having DCS on stock exchanges. The jurisdictions allowing the listing of shares on stock exchanges have in place their own system of heightened checks and balances to regulate the listing of such companies.
5. Regulatory Landscape in India
Issuance of DVR Shares in India is primarily governed by: (a) the Act read with the Companies (Share Capital and Debentures) Rules, 2014 (Rules); and (b) regulations framed by India’s securities market regulator, Securities and Exchange Board of India (SEBI) in case of companies that are listed or to be listed. The extant regulatory framework in India is discussed below.
5.1 History of the Law
In India, DVR Shares were referred to as ‘deferred shares’ in the early 1900s. The Companies Act 1913 (now repealed), was silent on issuance of DVR Shares. However, the structures adopted by companies like Tata Iron and Steel Company Limited show that ‘deferred shares’ were issued during the 1920s. Subsequently, the Companies Act 1956 (now repealed) specifically disallowed public companies and private companies that are subsidiaries of public companies from issuing any shares with disproportionate rights (cf. section 3 of the Companies Act 1956 and section 2 of the Act for meanings of ‘public company’ and ‘private company’). It was only on 13 December 2000, when Companies Act 1956 was amended to include DVR Shares as a sub-class of equity shares and the provision prohibiting issuance of DVR Shares was repealed. This enabled public companies and private companies that are subsidiaries of public companies in India to issue equity shares with differential voting rights again.
5.2 Act and the Rules
Issuance of DVR Shares is permitted under the Act subject to the conditions prescribed in the Rules. Section 47 of the Act provides that every holder of equity share capital in a company has the right to vote on every resolution placed before the company, and his voting right will be in proportion to his share in the paid-up equity share capital of the company. As an exception to this general rule, section 43 of the Act provides that the equity share capital of a company may carry differential rights as to dividend, voting or otherwise, in accordance with the Rules. The Rules prescribe the following key requirements for issuance of DVR Shares:
(a) Issuance of DVR Shares must be authorized (i) in the articles of association of the company and (ii) by the shareholders through an ordinary resolution;
(b) Voting power in respect of DVR Shares must not exceed 74% of the total voting power;
(c) The issuer company must not have: (i) failed to file financial statements and annual returns in the last three financial years immediately preceding the financial year in which issuance of DVR Shares was decided, (ii) subsisting default in the payment of declared dividends to its shareholders, repayment of matured deposits or redemption of preference shares or debentures that are due, or (iii) failed to make certain prescribed payments (such as dividend on preference shares, repayment of loans from certain categories of lenders and statutory dues in relation to its employees); however, an issuer company may issue DVR Shares after the prescribed cooling-off period of five years has elapsed from the end of the financial year in which the default in (iii) was remedied; and
(d) Conversion of any existing equity share capital with voting rights into equity share capital having DVR is prohibited, and vice versa.
Until recently: (a) the DVR Shares could not be issued if the issuing company did not have a consistent track record of distributable profits for the last three years, or (b) the DVR Shares could not carry total voting power in excess of 26%. The Rules were amended on 16 August 2019 to modify/remove these conditions.
Once DVR Shares are issued, the holders thereof enjoy the rights which other equity shareholders enjoy, such as rights to participate in rights issue and bonus issue, subject to the differential rights with which such shares have been issued.
Notably, regarding private companies, the position under the Act is similar to the position under the defunct Companies Act 1956. Applicability of sections 43 and 47 of the Act is excluded in the case of private companies so long as the charter/constitutional documents of such private companies provide for it. Accordingly, private companies are allowed to issue DVR Shares without having to comply with the requirements set out in the Rules, if their charter/constitutional documents provide for issuance of such shares.
5.3 SEBI Regulations
In its board meeting held on 27 June 2019, the SEBI approved the framework for issuance of DVR Shares (SEBI Framework) by issuers that are intensive in the use of technology, information technology, data analytics, bio-technology, nano-technology, etc. To give effect to the SEBI Framework, on 29 July 2019, SEBI notified relevant amendments to the SEBI (Listing Obligations and Disclosures Requirements) Regulations 2015 (LODR), SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018 (ICDR), SEBI (Substantial Acquisition of Shares and Takeovers) Regulations 2011, SEBI (Buy-Back of Securities) Regulations 2018, and SEBI (Delisting of Equity Shares) Regulations 2009 (collectively the SEBI Regulations).
Pursuant to these amendments, Indian companies having SR Shares are permitted to undertake an initial public offering of their ordinary shares (Issuer Company) upon fulfilment of the eligibility requirements laid down under the ICDR. The eligibility requirements include the following:
(a) The Issuer Company must be a tech company, which is defined as companies “intensive in the use of technology, information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition”.
(b) The holders of SR Shares must not be part of the founder/promoter group whose collective net worth (excluding the investment of the shareholders holding SR Shares) is more than five billion Indian Rupees.
(c) SR Shares must have been issued only to the founders/promoters who hold an executive position in the Issuer Company.
(d) SR Shares must have been held by the founders/promoters, for a period of at least six months prior to filing a red herring prospectus for listing of the issuer company (i.e., prior to filing of the offer document for an initial public offer).
(e) Voting rights of SR Shares compared to ordinary shares must be in the ratio of minimum of 2:1 and maximum of 10:1.
(f) There must be only one class of SR Shares, and other than having superior voting rights, the SR Shares must be equivalent to ordinary equity shares in all respects.
Among other conditions, the SEBI Regulations also requires;
(a) minimum promoter contribution;
(b) listing and lock-in of SR Shares until their conversion into ordinary shares;
(c) treatment of SR Shares at par with ordinary shares except voting rights;
(d) enhanced corporate governance mechanisms by increasing the role of independent directors on the boards and the committees of the board;
(e) circumstances in which voting rights of SR Shares will be the same as ordinary shares (‘coat tail provisions’), such as for the appointment or removal of independent directors or auditors, a voluntary winding up, a voluntary transfer of control by promoter to another entity, or changes to the charter documents other than changes affecting SR Shares; and
(f) time-and-event-based conditions governing mandatory conversion of SR Shares into ordinary shares. For example, SR Shares are required to be mandatorily converted into ordinary equity shares inter alia on (a) the fifth anniversary of listing of ordinary shares of the listed company (or a further period of five years, subject to a resolution of the holders of ordinary shares), (b) demise of the promoter or founder holding SR Shares, (c) resignation of the holder of SR Shares from the executive position in the listed company, or (d) merger or acquisition of the listed company having holders of SR Shares, where the control would no longer remain with the holder of SR Shares. The SEBI Regulations however permit conversion of SR Shares into ordinary shares even prior to the occurrence of such time and event based conditions.
As for the FR Shares, while the SEBI Framework stipulated that issue of FR Shares by existing listed companies will not be allowed, this prohibition has not found place in the SEBI Regulations yet. A specific reference to such prohibition in the SEBI Regulations would be helpful in removing any ambiguities in relation to such prohibition.
5.4 Issues in the Current Regulatory Framework
Even though the Indian regulatory framework now provides for a more conducive environment for issuing DVR Shares, it is not free from shortcomings. For instance, the applicability of the SEBI Regulations for listing of ordinary shares of companies having DVR Shares is restricted to ‘tech companies’. This leaves outside its ambit several companies that may not be intensive in the use of technology but whose growth could benefit from the ability to issue DVR Shares. Further, the framework does not set any objective test to determine what ‘intensive’ means.
Another issue is that the Rules prohibit the conversion of the existing ordinary equity shares into DVR shares, and vice versa. This would mean that founders/promoters will have to subscribe to new DVR Shares to limit dilution and hold control of the company. Further, under the LODR, SR Shares must be converted into ordinary equity shares on the occurrence of certain events (as discussed above). However, such mandatory conversion under the LODR will conflict with the Rules’ prohibition on converting DVR Shares into ordinary equity shares.
DVR Shares are double-edged swords. As stated above, control pursuant to such instrument may lead to corporate governance lapses. However, on the other hand, these instruments can be utilised positively to implement a founder’s or a promoter’s long-term vision and strategies without being distracted with pressure for short-term results.
In a country like India, this regulatory evolution supports the growth of companies with non-traditional business model and capital requirements. This will likely incentivise these companies to list on the domestic stock exchanges instead of exchanges overseas. However, given that the developments in the Indian regulatory framework are fairly recent, it remains to be seen how founders/promoters and companies will utilise this, and how investors and the market will react to this.
- Framework for Issuance of Differential Voting Rights Shares, Khaitan & Co, 5 July 2019, https://www.khaitanco.com/thought-leadership/framework-for-issuance-of-differential-voting-rights-shares
- The Companies (Share Capital and Debentures) Amendment Rules 2019 – Welcome relaxations for Promoters and Start-Ups!, Khaitan & Co, https://www.khaitanco.com/thought-leadership/the-companies-share-capital-and-debentures-amendment-rules-2019%E2%80%93welcome-relaxations-for-promoters-and-start-ups
- SEBI Amends Certain Regulations to Implement Framework for Issuance of Superior Voting Rights Shares, Khaitan & Co, https://www.khaitanco.com/thought-leadership/SEBI-amends-certain-regulations-to-implement-framework-for-issuance-of-superior-voting-rights-shares
- Consultation Paper on Issuance of Shares with Differential Voting Rights, Securities and Exchange Board of India, 20 March 2019, https://www.sebi.gov.in/reports/reports/mar-2019/consultation-paper-on-issuance-of-shares-with-differential-voting-rights_42432.html