Introduction

Differential voting rights (“DVR”) refer to equity shares holding differential rights as to dividend and/or voting. In India, section 43 (a) (ii) of the Companies Act, 2013 (“Companies Act”) allows a company limited by shares to issue DVRs as part of its share capital. Introduced for the first time in 2000, DVRs are seen as a viable option for raising investments and retaining control over the company at the same time. Recently, there has been renewed interest in DVRs with the Securities and Exchange Board of India (“SEBI”) releasing a consultation paper on the ‘issuance of shares with differential voting rights (DVRs)’ and subsequently approving the framework for the same in line with the present government’s 100 (hundred) day agenda to revive the economy.

DVRs Prior to the Companies Act, 2013

DVRs were first introduced in India by way of an amendment[i] to section 86 of the Companies Act, 1956 (“Old Act”), which provided that the share capital of a company limited by shares shall only be of 2 (two) kinds, namely equity share capital and preference share capital. The aforesaid section 86 permitted equity share capital to have differential rights as to dividend, voting or otherwise, in accordance with such rules and subject to such conditions as would be prescribed by the government. Pursuant to this amendment, two Indian companies, namely, Tata Motors and Pantaloons Retails (now renamed as Future Enterprises Limited) issued DVRs with 1/10th (one by ten) voting rights as compared to ordinary shares in exchange for 5% (five per cent) higher dividend as compared to ordinary shares.

In a similar vein, 2,500,000 (two million five hundred thousand) preference shares (with DVRs) of Jagatjit Industries Limited were issued to a company controlled by Mr. Karamjit. This issuance of DVRs effectively raised Mr. Karamjit’s voting rights and gave him substantial control over Jagatjit Industries Limited even though his economic contribution did not reflect such a leap. While this move was challenged by minority shareholders of the company, the Company Law Board approved the allotment of preferential shares with DVRs, the same being legally permissible in light of section 86 of the Old Act[1].

However, shortly thereafter SEBI issued a circular dated July 21, 2009[2] which stated that “the company agrees that it shall not issue shares in any manner which may confer on any person, superior rights as to voting or dividends vis-à-vis the rights on equity shares that are already listed.”

The net effect of this circular resulted in companies being prohibited from issuing superior voting rights or lower voting rights with higher dividends as compared to ordinary equity shares that were already listed. Thus, as a result of the abovementioned circular, Indian companies who opted for issuance of shares with DVRs did so by issuing bonus shares with lower voting rights but carrying the same dividend rights as ordinary shares.

DVRs under the Companies Act, 2013

Section 43(1) of the Companies Act (which replaced the Old Act) is similar to Section 86 of the Old Act and allows the issuance of equity shares with differential voting rights. However, Section 47 of the Companies Act provides that every member of a company limited by shares and holding equity share capital therein, shall have a right to vote on every resolution placed before the company.

Thus, it gives every shareholder of a company the right to vote on every resolution presented before the company, in proportion to his/her share of the paid-up equity share capital. However, section 47 of the Companies Act is subject to section 43 of the Companies Act which, means that companies can issue shares with differential voting rights, notwithstanding the implicit ‘one-share-one-vote’ requirement under section 47 of the Companies Act.

Until August 16, 2019, Rule 4 of Companies (Share Capital and Debentures) Rules, 2014 (“SCDR”) set out certain additional requirements to be complied with by companies which wish to issue shares with differential rights as to dividend, voting or otherwise. These requirements were that (i) the company’s articles of association should authorise the issuance of shares with differential rights; (ii) the issue of shares is authorized by an ordinary resolution passed at a general meeting of the shareholders; (iii) the shares with differential rights shall not exceed 26% (twenty six per cent[3] of the total post-issue paid up equity share capital including equity shares with differential rights issued at any point of time; and (iv) (d) the company having a consistent track record of distributable profits for the last 3 (three) years[4].

The erstwhile 26% (twenty six per cent) limit on the number of DVRs that can be issued was based on debatable policy considerations. The need to have a 3 (three) year track record of profitability restricted the number of companies eligible to issue shares with DVRs.

SEBI’s Consultation Paper on Issuance of DVRs

On March 20, 2019, SEBI released a consultation paper (“Consultation paper”) on the issuance of DVRs to address the “increasing debate about the need to enable issuance and listing of shares with DVRs in India”. Amongst other things, the paper highlighted the benefits and need for DVRs in light of India’s “high growth phase, which requires companies to raise capital to sustain this growth.” Furthermore, since some companies with asset light models prefer equity over debt capital, issuance of “shares with superior voting rights (“SRs”) to founders and/or shares with lower or fractional voting rights (“FRs”) to private or public investors may be seen as a viable option to raise equity capital.

In the Consultation Paper, SEBI proposed to regulate issuance of DVRs under two broad heads, namely, (i) “issuance by companies whose equity shares are already listed on stock exchanges, and (ii) issuance by companies with equity shares not hitherto listed but proposed to be offered to the public.” In a move towards protecting and promoting the rights of founders/promoters of a company, SEBI noted its assent for permitting the issuance of SRs and FRs, especially for “new technology firms which have asset light models, with little or no need for debt financing.” Recognising the fact that retaining the founders’ interest and control in technology companies is integral to the success of the company, issuance of DVRs will allow for growth of the business and thereby for all shareholders. The Consultation Paper also examined the rules and requirements for issuance of DVRs across various jurisdictions. The proposed regime for India borrows heavily from the regulations in vogue in jurisdictions abroad.

Some of the key proposals of the Consultation paper with respect to companies with unlisted equity shares are as follows:

Eligibility: SR shares can be issued only to the promoters of an unlisted company. An unlisted company where the promoters hold SR shares shall be permitted to do an Initial Public Offer (“IPO”) only the ordinary equity shares, provided the SR shares are held by the promoters for more than one year prior to filing of the draft offer document with SEBI.

Subsequent issue of SR shares: A company shall not be permitted to issue SR shares in any manner whatsoever, including by way of rights issue or bonus issue, once its ordinary equity shares have been listed.

Face value of SR shares: The face value of a company’s SR shares shall be the same as of that of the ordinary equity shares.

Lock-in of SR shares: All SR shares shall remain under a perpetual lock-in after the IPO.

Pledge of SR shares: No encumbrance shall be created over SR shares including pledge, lien, negative lien, non-disposal undertaking, etc.

Voting and Other Rights on SR shares: The SR shares shall be treated at par with the ordinary equity shares in every respect, including dividend, except with respect to voting rights.

The voting rights available to SR shares shall not exceed the ratio of 10:1, i.e. (ten votes for every SR share held). This ratio has to be in whole numbers from 2:1 to 10:1. A ratio once adopted by a company shall remain valid for any subsequent issuances of SR shares. A company can issue only one class of SR shares.

Initial disclosures: The company shall disclose, in the offer document, the names of all holders of SR shares, with complete details of all special rights that have been provided to them. No change in the terms of the SR shares, which are favourable to the SR shareholders, shall be permitted post-IPO, other than the sunset clause.

Minimum public shareholding: The company shall comply with the minimum public shareholding requirements in terms of the Securities Contracts (Regulation) Rules, 1957 (“SCRR”) for the ordinary equity shares that will be listed. Post-listing, the voting rights with the promoters through the SR shares and ordinary equity shares shall not exceed 75% (seventy five per cent) of the total voting rights.

Coat - tail provisions: Post-IPO, the SR shares shall be treated as ordinary equity shares in terms of voting rights (i.e. one SR share one vote) in the following circumstances:

1. provisions relating to appointment or removal of independent directors and/or auditor;
2. in case there is a change in control of the company;
3. any contract or agreement of the company with any person holding the SR shares, in excess of the materiality threshold prescribed under regulation 23 of the SEBI (Listing Obligations and Disclosure Requirement) Regulations, 2015 (“LODR Regulations”);
4. voluntary winding up of the company;
5. any material changes in the company’s Article of Association or Memorandum, including but not limited to, undertaking variation in the voting rights of the shareholders, changing the principal objects of the company, granting special rights in favour of a particular shareholder or shareholder groups and such other items as may be prescribed by the SEBI;
6. initiation of a voluntary resolution plan under the Insolvency and Bankruptcy Code, 2016;
7. extension of the validity of the SR shares post completion of 5 (five) years from date of listing of ordinary equity shares; and
8. any other provisions notified by SEBI in this regard from time to time.

Sunset clause/ Conversion of SR shares: The SR shares shall automatically convert into ordinary equity shares on the 5th (fifth) anniversary of the listing of the ordinary shares of the company i.e. they shall lose their superior voting rights and each SR share shall be entitled to a single vote as if it were an ordinary equity share. The validity of the SR shares can be extended by another 5 (five) years with the approval of shareholders by way of a special resolution in a general meeting where all members vote on a “one-share-one vote” basis irrespective of the nature of their shareholding. The promoters, however, may do an accelerated conversion of their SR shares into ordinary equity shares at any time prior to the 5th (fifth) anniversary or such extended period.

The SR shares shall be compulsorily converted into ordinary equity shares in the event of a merger or acquisition of the company or whenever these are sold by the identified promoters who hold such shares or in the case of demise of the promoter(s). Transfer of SR shares amongst promoters or persons of the promoter group(s), even though they are inter-se transfers between persons acting in concert, shall not be permitted.

Listing and trading: All SR shares shall be held in dematerialized form and shall be listed on the main board platform of the recognized stock exchanges. For listing of SR shares, exemption will be granted from Rule 19(2)(b) of SCRR. The SR shares, however, cannot be traded except upon conversion into ordinary equity shares.

Post - Issue Disclosures: The shareholding pattern to be filed by the company with the stock exchanges shall provide the details of both ordinary equity shares and SR shares in the format specified by SEBI and the stock exchanges.

We have omitted the proposals of the Consultation paper relating to issuance of DVRs by companies whose equity shares are already listed on stock exchanges since the framework finally approved by SEBI only provides for the issuance of DVRs by companies with unlisted equity shares.

Statutory Amendments provided by SEBI’s Consultation Paper

The Consultation Paper highlighted a few statutory provisions that might require to be amended in order to accommodate the framework surrounding issuance of DVRs:

SCDR:

1. Rule 4(1)(d) of SCDR, which requires a company to have a consistent track record of distributable profits for the previous three years in order to be eligible to issue DVR Shares might have to be amended if SEBI wishes to permit companies without a consistent track record of distributable profits to issue DVRs.

SEBI (Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”):

2. The ICDR Regulations do not have a provision for a company to have dual class shares at the time of IPO. The ICDR Regulations will need to be amended to allow SR shares to be held by the promoters’ post the listing of the company’s ordinary equity shares. Further, provisions with respect to issuance of FR shares post the listing of the company’s ordinary equity shares through modes such as Rights/ Bonus/ follow on would need to be incorporated.
3. ICDR Regulations need to be amended to include provisions relating to coat-tail; sunset clause in case of SR shares; restrictions on transferability of SR shares, differential dividend related disclosures in case of FR shares, etc.

SCRR:

4. The SCRR prescribes the minimum offer and allotment to public under an IPO. As per rule 19(2)(b) of SCRR, this works out to at least 25% (twenty five per cent) of each class or kind of equity shares/ debenture convertible into equity shares issued by the company, if the post issue market capitalization of company is less than or equal to rupees 1,600 crore (Rupees one thousand six hundred crore). However, if the post issue market capitalization of the company is more than rupees 1,600 crore (Rupees one thousand six hundred crore) but less than or equal to rupees 4,000 crore (Rupees four thousand crore), at least such percentage of each class or kind of equity shares/ debenture convertible into equity shares issued by the company equivalent to the value of rupees 400 crore (Rupees four hundred crore), has to be offered to the public. If the post issue market capitalization of company is above rupees 4,000 crore (Rupees four thousand crore), then at least 10% (ten per cent) of each class or kind of equity shares / debenture convertible into equity shares issued by the company, has to be offered to the public.
5. A company with multiple classes of equity shares at the time of undertaking an IPO, is required to make an offer of each such class of equity shares to the public in an IPO. The minimum dilution and minimum subscription requirements as prescribed under rule 19(2)(b) of SCRR have to be met separately for each class of equity shares. In addition, a company with multiple classes of equity shares at the time of an IPO does not have an option of listing only one or some of the classes and should mandatorily list all classes of its equity shares, including equity shares with DVR. In light of the abovementioned regulatory framework and the challenge in successfully concluding an IPO for each class of the equity shares, till date, no company has undertaken an IPO with multiple classes of equity shares in India.
6. In light of the above rule, rule 19(2)(b) of the SCRR must be amended to permit companies with multiple classes of shares to list one or more classes of shares to the exclusion of other classes of shares, so that SR shares held by promoters can remain unlisted while ordinary shares can be listed.

LODR Regulations:

7. Regulation 41(3) of the LODR Regulations states that a listed entity shall not issue shares in any manner which may confer on any person, superior rights as to voting or dividend vis-à-vis the rights on equity shares that are already listed. The aforementioned regulation needs to be amended to allow SR shares to be held by the promoters post-IPO of its ordinary equity shares and also allow additional dividend for FR shares.

SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“Takeover Code”):

8. The Takeover Code applies to both direct and indirect acquisitions of voting rights. The lapse of superior voting power and conversion of SR shares into ordinary equity shares will increase the relative quantum of voting rights held by the other shareholders and decrease the relative quantum of voting rights held by those who held the SR shares. Therefore, regulation 10 of the SEBI Takeover Code should be amended to clarify that any increase beyond the threshold of entitlement to voting rights would not trigger an open offer obligation in the hands of the person acquiring voting rights beyond such threshold by reason of the lapse of superior voting power and conversion of SR Shares into ordinary equity shares provided that there is no attendant change in control in favour of the person crossing such threshold.
9. Any change in voting rights due to extinguishment of voting right on SR shares should not require disclosure under regulation 29 of the Takeover Code. The format of disclosure under regulation 30 of the Takeover Code also needs to be modified to provide for separate disclosure of voting rights for SR shares, FR shares and ordinary equity shares and consolidated voting right.
10. In case of open offer, offer need to be made for 26% (twenty six per cent) of outstanding ordinary equity shares and 26% (twenty six per cent) of the outstanding FR shares. The pricing of open offer for ordinary equity shares will be based on trading price of ordinary equity shares and pricing of FR shares will be based on trading pricing of FR shares.

Securities and Exchange Board of India (Buy Back of Securities) Regulations, 2018 (“Buy Back Regulations”):

11. Pursuant to regulation 6 of the Buy Back Regulations through the tender offer, a company can buy back its shares or other specified securities from its existing securities holders on a proportionate basis. Further, 15% (fifteen per cent) of the number of securities proposed to be bought back by the company is required to be reserved for small shareholders.
12. Buy Back Regulations should be amended to clarify that (i) company will be required to buy back both ordinary equity shares and FR shares. Allocation of buy back amount between ordinary equity shares and FR shares will be in the proportion of paid up capital of the company. For this purpose, SR shares will be deemed to be part of ordinary equity shares, and (ii) the current reservation of 15% (fifteen per cent) for small shareholders would apply to both small shareholders holding FR shares and small shareholders holding ordinary equity shares.
13. The Buy Back Regulations must be amended to provide for spill over between buy back for ordinary equity shares and FR shares in case of undersubscription in one category and oversubscription in another category. In case shares tendered in one of the categories is less than the number of shares to be bought in that category, companies must be permitted to buy back additional shares from the category where shareholders have shown interest to tender shares in excess of the maximum permissible limit, subject to compliance with minimum public shareholding norms prescribed under SCRR.
14. Pursuant to regulation 5(iv)(c)(i) of the Buy Back Regulations, in the event of a buy-back of securities through a tender offer, the explanatory statement must include the maximum price at which the buy back of shares shall be made. Additionally, pursuant to rule 17 of the SCRR read with Section 68 of the Companies Act, a company is free to choose the method for undertaking the buy back and is further required to include the basis for arriving at the buy back price in the explanatory statement.
15. Buy Back Regulations should be amended to permit, in case of companies that have issued SR shares, FR shares and ordinary equity shares, to price the SR shares and ordinary equity shares with identical price, while FR shares can be priced differentially. However, companies must be mandated to include justification for pricing FR shares differentially.
16. The provisions in relation to proportionate allocation amongst ordinary shares and FR shares as applicable in buy back through tender route will apply mutatis mutandis to buy-back through stock exchange mechanism. Regulation 15 of the Buy Back Regulation will apply separately for buy-back of ordinary equity shares and FR shares. In case of buy-back through book building process, separate book building process would be carried out for ordinary equity shares and FR shares.

Securities and Exchange Board of India (Delisting of Equity Shares) Regulations, 2009 (“Delisting Regulations”):

17. The Delisting Regulations must be amended to clarify, in case of companies with FR shares and ordinary equity shares, separate reverse book building processes must be employed for determining the offer price of FR shares and ordinary equity shares.

Approved Framework for Issuance of DVRs (“Approved Framework”)

SEBI approved a framework for issuance of DVRs, along with amendments to relevant SEBI regulations to give effect to the framework, during a SEBI board meeting held on June 27, 2019. The Approved framework deviates from the proposals in the consultation paper in various respects and makes changes to the ICDR Regulations, the LODR Regulations, the Takeover Code, the Buy Back Regulations and the Delisting Regulations. The terms of the Approved framework are as follows:

Eligibility: Company having SR shareholders would be permitted to do an IPO of only ordinary shares to be listed on the main board, subject to fulfilment of eligibility requirements as per chapter II (part I) of the ICDR Regulations and the following conditions:

1. The issuer company is a tech company, which, as per the definition in the innovators growth platform[5], is 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.
2. The SR shareholder should be a part of the promoter group whose collective net worth does not exceed rupees 500 crores (Rupees five hundred crore). While determining the collective net worth, the investment of SR shareholders in the shares of the issuer company shall not be considered.
3. The SR shares have been issued only to the promoters/ founders who hold an executive position in the company.
4. The issue of these SR shares has been authorized by a special resolution passed at a general meeting of the shareholders with notice of specific matters such as (a) Size of SR issuance, (b) Ratio of voting rights of SR shares vis-à-vis ordinary shares, (c) Rights as to differential dividends, if any, (d) Sunset clause, and (e) Coat tail provisions (scenarios where SR shares would have same voting rights as ordinary shares).
5. SR shares have been held for a period of at least 6 (six) months prior to the filing of Red Herring Prospectus (RHP).
6. The SR shares have voting rights in a ratio, which is not less than the prescribed minimum 2:1 and not greater than the prescribed maximum 10:1, compared to ordinary shares. The ratio shall be in whole numbers only.
7. SR shares have the same face value as ordinary shares.
8. The company has only one class of SR shares.

Pre-issue disclosures: Company shall disclose names of all SR shareholders along with complete details of all special rights provided and the coat tail provisions in the offer documents required under ICDR Regulations.

Minimum promoter contribution: SR shares would be allowed towards computation of minimum promoter contribution requirement of ICDR Regulations.

Listing and Lock-in: SR shares shall also be listed on stock exchanges after the issuer company makes a public issue. However, SR shares shall be under lock-in after the IPO until their conversion to ordinary shares. In case of early conversion of SR shares to ordinary shares, the shares shall continue to be under lock-in in terms of chapter II (part IV) of the ICDR Regulations i.e. for 3 (three) years after listing for SR shares considered for minimum promoter contribution and for 1 (one) year for SR shares in excess of minimum promoter contribution. Transfer of SR shares among promoters shall not be permitted. No pledge/ lien shall be allowed on SR shares.

Rights of SR shares: SR shares shall be treated at par with the ordinary equity shares in every respect, including dividends, except in the case of voting on resolutions. The total voting rights of SR shareholders (including ordinary shares), post listing, shall not exceed 74% (seventy four per cent).

Enhanced corporate governance: In view of disproportionate voting rights conferred to promoters vis-à-vis their economic holding, companies having SR shareholders shall be subject to enhanced corporate governance as follows:

1. 2/3rd (two by three) of the board and committees (excluding audit committee) as prescribed under LODR regulations shall comprise of Independent Directors.
2. Audit committee shall comprise of only independent directors.

Coat-tail provisions: Post-IPO, the SR equity shares shall be treated as ordinary equity shares in terms of voting rights (i.e. one SR share shall have only one vote) in the following circumstances:

1. Appointment or removal of independent directors and/or auditor;
2. In case where promoter is willingly transferring control to another entity;
3. Related party transactions in terms of LODR regulations involving SR shareholder;
4. Voluntary winding up of the company;
5. Changes in the company’s article of association or memorandum-except any changes affecting the SR instrument;
6. Initiation of a voluntary resolution plan under Insolvency and Bankruptcy Code;
7. Utilization of funds for purposes other than business;
8. Substantial value transaction based on materiality threshold as prescribed under LODR Regulations;
9. Passing of special resolution in respect of delisting or buy-back of shares; and

Any other provisions notified by SEBI in this regard from time to time.

Time based sun-set clause: The SR shares shall be converted to ordinary shares on the 5th (fifth) anniversary of listing. However, the validity of SR shares can be extended once by 5 (five) years through a resolution. SR shareholders would not be permitted to vote in such resolutions. SR shareholders can convert their shares to ordinary shares at any time prior to sun-set.

Event based sun-set clause: On the occurrence of following events, SR shares shall compulsorily get converted into ordinary shares.

1. In case of demise of the promoter(s) holding such shares;
2. In case SR shareholder resigns from the executive position in the company;
3. In cases of merger or acquisition of the company having SR shareholder where the control would be no longer with SR shareholder.

Whenever such shares are sold by the SR shareholder after the lock-in period but prior to time based sunset.

Subsequent issues: In case company decides issue of bonus or split of shares, SR shareholders shall be entitled for SR shares. Similarly, SR shareholder shall be entitled to SR shares in case of a rights issues. However, the rights of SR shares cannot be renounced by the SR shareholder. The ratio of voting rights of all such SR shares shall remain same as that adopted by the company initially. The time based sunset for such SR shares shall continue to be from the date of listing of ordinary shares of such company.

Post-issue disclosures: SR shareholding to be disclosed in periodic disclosure of shareholding pattern.

Deviations from the Consultation Paper

The Approved Framework does not provide for issuance of DVRs by companies whose equity shares are already listed on stock exchanges, even though the Consultation Paper did envisage such a possibility. The following proposals in the Consultation Paper also do not find a presence in the Approved Framework:

1. The Approved Framework has restricted the scope of issuance of DVRs to new listings made by tech companies.
2. The Consultation Paper did not permit for the issuance of SRs to any persons, including the promoters, by way of rights issue or bonus issue, once its ordinary equity shares have been listed. However, the approved framework has taken a different route and has allowed for issuance of SRs in the event that the company decides to issue bonus, split of shares or rights issues. It has been clarified that the SR shareholder will not be able to renounce these shares.
3. The Approved Framework has stated that post listing, the voting rights of the SR shareholders will not exceed 74% (seventy four per cent) of the total voting power as compared to the 75% (seventy five per cent) ceiling imposed in the Consultation Paper.
4. The Consultation Paper stated that the SR shares held shall remain under a perpetual lock-in after the IPO. However, the Approved Framework states that the SRs will be under lock-in till after the IPO till their conversion to ordinary shares. In the event of early conversions, the SRs share continue to be in lock in terms for 3 (three) years after listing for SR shares considered for minimum promoter contribution and 1 (one) year SR shares in excess of minimum promoter contribution in line with chapter II (part IV) of ICDR regulations. The Approved Framework has also clarified that the SR shares would be allowed towards computation of minimum promoter contribution requirement of ICDR Regulation.
5. The Approved Framework has divided the sunset clauses into two categories on the basis of the time and/or event that may lead to the invocation of this clause. In the Consultation Paper, there was no restriction on the number of times the validity of SR shares could be extended. The Approved Framework provides that the validity of SR shares can be extended once by 5 (five years). The Approved Framework also mandates the conversion of SRs into ordinary shares in the event of a SR shareholder resigning from the executive position in the company and when the merger/acquisition of a company having SR shares would lead to a loss of control in the hands of the SR shareholder. While the status of the sunset clause has largely remained the same, the approved framework has clarified the scope of the same.

Amendments to SCDR

On August 16, 2019, the government issued a notification to amend SCDR. Clause (d) of rule 4(1) of SCDR which requires a company to have a consistent track record of distributable profits for the previous 3 (three) years in order to be eligible to issue DVR shares was deleted. Clause (d) of rule 4(1) of SCDR which imposed a limit of 26% (twenty six per cent) on the percentage of shares with differential rights out of the total post-issue paid up equity share capital was amended and the aforesaid limit was increased to 74% (seventy four per cent).

 

This paper has been written by Vinod Joseph (Partner) and Radhika Kothari (Associate).

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