India – DVRs Are Dead, Long Live DVR!

Since December, 2000, Indian companies have been permitted to issue ‘dual class shares’. This was when the concept of ‘shares with differential voting rights’[1] was introduced in the Companies Act, 1956. The Securities and Exchange Board of India (SEBI) has, since July 21, 2009[2], disallowed listed companies to issue shares with superior rights to voting or dividend. However, listed companies were permitted to issue shares with inferior (or fractional) voting rights.

 

In an apparent reversal of its policy position, SEBI in its board meeting on June 27, 2019, approved a framework for the listing of companies that have shares with superior voting rights, while disallowing any further issuance of shares for those with inferior voting rights.

 

SEBI had previously invited public comments on a Consultation Paper titled ‘Issuance of shares with Differential Voting Rights (DVRs) issued by the Securities and Exchange Board of India’ (Consultation Paper). This had proposed a comprehensive regime for both shares with inferior rights (Fractional Rights Shares or FR Shares) and superior rights (Superior Rights Shares or SR Shares).

 

Against this background, the rationale for the complete prohibition on any further issue of FR Shares is not obvious. It is perhaps a reflection of the lack of popularity of the FR Shares in India, where only five out of more than 4,000 listed companies have issued such shares.[3]

 

The more immediate reason for which SEBI has chosen to allow the listing of companies with SR Shares, is the advent of start-ups in India that have now reached a stage in their life cycle when they may consider accessing public markets. Many such start-ups have high promoter involvement with relatively low shareholding. Such promoters may wish to retain controlling rights disproportionate to their economic interest.

 

In this context, we examine some key features of SEBI’s new framework for the issuance of shares with differential voting rights by listed companies (New DVR Framework).

 

New DVR Framework

 

SEBI does not have regulatory authority over unlisted companies. It has authority over listed companies and companies that propose to have their securities listed on stock exchanges. The New DVR Framework does not, therefore, regulate the issuance of SR Shares by unlisted companies, but regulates the listing of companies that have issued SR Shares. However, since the issuance of SR Shares (being equity shares) once completed will practically be irreversible, companies proposing an issue of SR Shares should ensure compliance with the New DVR Framework at the stage of issuance itself.

 

Who Can List with SR Shares?

 

SR Shares are shares that carry superior voting rights as compared to their economic interests. The New DVR Framework prescribes SR Shares to have voting rights in the ratio of a minimum of 2:1 and a maximum of 10:1 compared to ordinary equity shares (OR Shares). The Consultation Paper had proposed that all companies with SR Shares could list on the stock exchanges. The New DVR Framework restricts listing of SR Shares only to “tech companies”, i.e. companies that intensively use technology such as information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition, similar to the companies that are allowed access to the Innovators Growth Platform (the erstwhile Institutional Trading Platform)[4].

 

There is no bright line test prescribed for when a company’s use of technology can be considered “intensive” and the proposed definition is capable of subjective interpretation. It would be advisable for potential issuers to confirm eligibility for listing before issuance of SR Shares.

 

Who Can Hold SR Shares?

 

Under the New DVR Framework, only promoters who hold executive positions in the company can hold SR Shares. Corporate promoters and non-executive promoters cannot hold SR Shares. If a promoter holding SR Shares ceases to hold an executive position, the SR Shares will be converted into OR Shares. The collective net worth (excluding the OR Shares and SR Shares held by the SR shareholder in the issuer company) can be a maximum of ₹500 Crores. Thus, the New DVR Framework ensures that SR Shares are held only by promoters who actively participate in the business and who may not have access to enough funds to maintain their shareholding/control in the issuer company.

 

However, there may be certain practical challenges in this regard. The net worth, if it is to be tested at the time of filing the draft red herring prospectus (DRHP) with SEBI, may be different from the net worth at the time of the issuance of the SR Shares. Further, the lead managers who will be expected to conduct independent due diligence of the eligibility of such a company to list, will face considerable difficulty in determining the net worth of other persons/entities forming part of the promoter group.

 

How Long Should SR Shares be Held Before Listing? 

 

The Consultation Paper had proposed that SR Shares should be held by the promoter for at least one year prior to filing of the DRHP with SEBI. There are often scenarios where a significant change in the shareholding structure, including exits, consolidation or inter-se transfer by the promoters, takes place within one year before filing of the DRHP with SEBI. Therefore, the New DVR Framework has relaxed this restriction, and requires promoters to hold the SR Shares for a period of at least six months prior to filing of the red herring prospectus (and not the DRHP). However, practically, such SR Shares will have to be issued before the filing of the DRHP, since a disclosure to that effect will have to be included in the DRHP.

 

Since pre-IPO shareholders may not wish to issue SR Shares unless the IPO is a certainty, the issuance of SR Shares to promoters could have also been allowed in an IPO, simultaneously with the OR Shares.

 

How Long do the Superior Voting Rights Last? 

 

The Consultation Paper proposed a mandatory conversion of SR Shares into OR Shares five years after listing, which could be extended for a period of another five years through a resolution by the OR shareholders. The New DVR Framework provides that SR shareholders may not vote in such a resolution.

 

A fixed tenure for the sunset clause may not be the most suitable option in all cases. SEBI may consider making the sunset clause more flexible by granting the shareholders of the issuer company the right to structure the sunset clause, along with other conditions that they may wish to adopt, including a sunset period at their determination, with an upper limit of five years. Further, shareholders may be allowed to extend the sunset clause for a period less than five years.

SR Shares also automatically convert into OR Shares in certain specified events such as the demise/resignation of the SR shareholder, merger or acquisition where the control would no longer be with the SR Shareholder, etc.

 

“Minority” Protection

 

The New DVR Framework has made it mandatory for all companies with SR Shares to have independent directors making up at least half of their total directors and two-thirds of their board committees (other than the audit committee). The audit committee is required to comprise only independent directors.

 

The proposed framework also provides for additional safeguards for OR shareholders by way of ‘Coat-tail provisions’, which lay down a list of circumstances such as winding up of the company, appointment/ removal of independent, related party transactions etc. where the SR shareholders will vote on a ‘one share one vote’ basis. Thus, OR shareholders are entitled to exercise the same voting rights as SR shareholders on most material matters. Due to the coat-tail provisions, SR Shares become less attractive since the decision-making power with the SR shareholders is heavily diluted.

 

What Happens to Existing FR Shares?

 

The New DVR Framework does not address the issue of companies with existing FR Shares. As stated above, while the issue is relevant only for a small number of companies, it may be beneficial to provide an avenue for such companies to terminate their DVR programmes. Perhaps a specific period of time for such a measure could be considered.

 

This would require an amendment to Rule 4 of the Companies (Share Capital and Debentures) Rules, 2014. As no further issuance of FR Shares is permitted, unless these measures are implemented, such companies may not be able to make future bonus or rights issues.

 

Conclusion

 

The issuance of dual class shares, especially shares with superior voting rights, is a topic that has vexed regulators and investors in many jurisdictions. By permitting the listing of companies with dual class shares, SEBI has once again shown that it is proactive in anticipating changes that are bound to occur in the Indian capital market.

 

SEBI has taken a bold step which will be welcomed by many prominent Indian start-ups in the technology space. It will enhance the attractiveness of an Indian listing for many such companies.