On 20th March, SEBI released a Consultation Paper on Issuance of shares with Differential Voting Rights, and invited public comments on the Consultation Paper by 20th April. The Consultation Paper recognises that the issue of shares with differential voting rights (or dual class shares) is relevant for tech companies, especially start-ups.
Nasscom made the following submission to SEBI on the Consultation Paper:
I. Background
In India, the Companies Act, 1956 was amended in 2000 to allow issuance of shares with differential rights under Section 86.[1] In June 2009, the Securities and Exchange Board of India (SEBI) prohibited issue of shares with ’superior voting rights’ by listed companies, in order to “avoid the possible misuse by the persons in control to the detriment of public shareholders”[2]. Later, section 43 of Companies Act, 2013 (Companies Act) allowed public as well as private companies to issue shares with differential rights as to voting, divided or any other particular.
However, SEBI regulations in 2015 specifically provided that the 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.[3] In the same year, the Ministry of Company Affairs (MCA) relaxed the framework for private companies to issue Differential Voting Rights (DVRs) irrespective of their profitability track record, asset size and without any limitation on the types of DVRs, if their Articles of Association (AoA) so provided.[4] Accordingly, the regulatory framework with respect to DVRs in India can be understood as being relaxed for private companies, conditional for unlisted public companies and very restrictive for listed companies.
Globally, the use of dual class shares has increased. One-fifth of companies listed on the US stock exchanges last year consisted dual-class shares. Further, out of 195 companies that went public on the US exchanges, 101, or 81%, were one share one vote, while 23, or 19%, had dual-class structures with unequal voting rights[5]. Hong Kong and Singapore, which were opposed to the listing of dual-class shares, have recently allowed their listing, albeit with safeguards against risks such as expropriation and entrenchment.
DVRs are an attractive option for new-age or technology-driven companies as it allows for innovation and risk-taking by founders. NASSCOM represents the Indian Information Technology and Business Process Management (IT-BPM) industry having global revenues of USD 181 billion in FY 2018-19 and directly employing about 4.1 million people. In the last FY, there were eight new unicorns in India[6], with over 2,500 patents filed in digital technologies alone and 400 Artificial Intelligence (AI) start-ups in India securing an investment of $150 million in 5 years.[7] The total tech start-ups in India are over 7,700 with over 1,200 new tech start-ups added in 2018 alone.[8] It is, therefore, important and timely that a suitable framework is enacted to attract the start-ups to eventually list on the Indian stock exchanges.
II. Comments
- We welcome the intent behind SEBI’s consultation paper to incentivise companies to list on Indian exchanges by enabling them to raise capital without necessarily diluting management control. We welcome the recognition that some of the current conditions for listing on an Indian exchange are particularly onerous for technology led asset light companies where business models may not focus on initial profitability and where debt may not be an appropriate source of capital.
- Fractional Rights (FR) shares are already permitted to be listed. The consultation paper recommends permitting companies with Superior Rights (SR) shares to list and provides conditions of the SR and FR shares. The actual issue of DVRs and its success would depend on the market. DVRs would have limited impact unless promoters have the commercial bargaining power to raise funds while holding superior voting rights. We do not yet see private companies using the tool of DVRs. This demonstrates lack of commercial bargaining power and perhaps to some extent lack of appreciation of the enabling regulatory framework already available under the Companies Act.
- Further, while DVRs may protect the founders and promoters, do dual class shares result in increase in long-term value creation? The US based Council of Institutional Investors (CII), using data on 1,762 Russell 3000 companies over nine years, did not find material evidence of the same.[9] However, this topic is a subject of much debate. The argument on the other side is that non-voting or low-voting shares are very useful and they allow those who control the company—whether it be the family in a family-owned business or the visionary founders of a successful technology company—to retain control without having to bear excessive risk.[10] The important thing is to ensure this does not result in inferior outcomes for other shareholders. The ability of the regulatory regime to create and enforce appropriate governance structure so as to ensure that DVRs are not abused is therefore central to the issue.
- DVR’s appeal as a tool for start-ups to list in India would largely depend on other conditions pertaining to listing and appetite of investors. Even though jurisdictions such as Hong Kong and Singapore have considered dual class share structures as a means to attract global companies to list on their stock exchanges, there is no certainty that there will be a sudden flow of such listings. In the past, SEBI has undertaken several measures to boost the start-up sector and to allow those companies to list on various segments of the stock exchange and also through various instruments, but the success of such measures has been in doubt. Hence, while the DVR structure is a useful one, it is necessary to be cautiously optimistic regarding its ability to attract a greater number and quality of listings.
III. Suggestions
- Rules under the Companies Act: Relax the following conditions related to issue of DVRs:[11] a. Company having consistent track record of distributable profits for the last three years [Rule 4(1) (d)]: As recognised in the consultation, this condition is a barrier for issue of DVR shares. We suggest that unlisted public companies without the track record of distributable profits for the last three years should allowed to issue DVR shares and adequate safeguards should be provided so that the DVRs in the form of SRs are not subsequently abused. In the absence of profitability track record, track record based on operating revenue, market capitalisation, net worth and/or liquidity position may be considered. b.Restriction on issue of differential rights till five years from the end of the financial year in which such default, as stated under Rule 4 (1) (g), was made good: The possibility of such default is not entirely unexpected and may not reflect governance issues. We suggest that the regulations should be reviewed to distinguish between various degrees of defaults in terms of their materiality and nature and the tenure based restriction should be accordingly reframed.
- SEBI’s listing requirements – Relax the following conditions:[12]
a. The promoters of the issuer shall hold at least twenty per cent of the post-issue capital [14(1)]: This can be a barrier for companies who have already undergone few rounds of dilution during pre-listing stage and thus post issue the promoters may hold much less than the prescribed threshold. The QIBs also find it a barrier if they are required to get locked-in under the above criteria. Therefore, we suggest a downward review of this threshold.
b. IPO Entry Norm I (commonly known as “Profitability Route”) [6(1) (a) and (b)]: The net asset criteria and the three year average pre-tax operating profit criteria do not appear to be appropriate for asset light and internet based business models and largely rules out non QIB entry route of listing on the main board of the stock exchanges even for such mature start-ups. We suggest that this may be reviewed and in the absence of profitability track record, track record based on operating revenue, market capitalisation, net worth and/or liquidity position may be considered.
c. Listing on Innovators Growth Platform (IGP) [Chapter X]: SEBI has over a period of time relaxed the listing and IPO requirement for technology start-ups on the The consultation paper does not discuss this. However, the consultation paper mentions on page 19 that “All SR Shares shall be held in dematerialized form and shall be listed on the main board platform of the recognized stock exchanges.” Now, IGP is not a main board platform.[13] We suggest that companies with SR shares and/ or FR shares who are otherwise eligible to list on the IGP should be explicitly allowed to list and issue public offer on the IGP. The IGP should become an attractive platform for technology led start-ups, including those having DVR shares.
3. Definition of Promoter for the purposes of DVRs: The current definition of promoter is fairly expansive.[14] The purpose of SR shares is to enable the entrepreneurs who have promoted the company to retain management control and raise capital. We suggest that the SR should be available only to the promoters who are in the entrepreneurial role and not to the investors. In this context, the consultation paper’s example of Hong Kong is worth emulating. Hong Kong’s equivalent of SR shares are the Weighted Voting Rights (WVR) shares and these WVRs can be issued to “An individual with active executive role in the business and has contributed materially to the growth of the business. Each of the beneficiaries should be a director on the board at IPO. The beneficiaries of the WVR should hold at least 10% of economic interest in total issued share capital.”
4. Corporate Governance: We have highlighted the importance of an appropriate governance regime in our Comments section. Concerns around related party transactions are addressed in Companies Act and some concerns around abuse of SR provisions are addressed in the recommendations of the DVR group. However, the recommendations are largely silent on the need for increased disclosure and accountability obligations for the Companies which issue DVR shares. We suggest that the same should be drafted and released for public consultation at an appropriate stage. Reference may be made to some of the useful provisions existing in other jurisdictions which we have provided as an Annexure.
5. Taxation: Section 56(2) (viib) of the Income Tax Act, 1961 treats income from selling shares in unlisted companies over their fair market value as taxable. As SR shares are proposed to be under lock-in and may only be transferred by way of conversion into ordinary equity shares, it would be important to clarify the tax treatment of the same. We suggest that the SR shares should be treated same as ordinary equity shares for the purpose of taxation. Though this not a matter for SEBI to determine but it is important to note that if the tax treatment results in uncertainty it would directly impact the attractiveness of the DVR shares.
IV. Specific suggestions on the recommendations of SEBI’s DVR Group
| Sn. | DVR Group Report[15] | Suggestion(s) | Rationale |
| 1. | Conditions Precedent: The report suggests two preconditions viz. (i) authorisation in Articles of Association (AoA) and (ii) authorisation by a special resolution at general meeting as required by SEBI through regulations to be notified in this regard. | Needs clarification. | The issue of DVRs by unlisted companies is currently regulated by the MCA. It is not clear if the proposed requirement of complying with the proposed SEBI regulations are meant to be applied to unlisted companies. If this is indeed the recommendation, at what stage would these apply? |
| 2. | Issue of FR by listed Companies: First issue of FR Shares: Companies which are already listed may issue FR shares. | FR Shares should be permitted to be issued both at the IPO and the FPO stage. | The consultation paper proposes FR share issue be permitted as an FPO but it seems to suggest that FR shares would not be permitted to be issued at the IPO stage. The rationale for this is not evident. Prohibiting this seems to be restrictive. |
| Sn. | DVR Group Report | Suggestion(s) | Rationale |
| 3. | Voting and Other Rights on FR Shares: The FR Shares shall not exceed a ratio of 1:10. However, at any point of time, the company can only have one class of FR Shares. | The requirement to have only one class of FR at any point in time should be relaxed. It would be useful to explicitly clarify that the FR shares which might have been issued prior to listing will be permitted to be listed and traded. Zero voting rights should not be permitted, at least at this stage. | The requirement to have only one class of FR Shares at a point in time might be suitable in the initial stage. Given the possibilities in creating variations in FR shares it might be useful to consider providing a roadmap to review this after a few years. Zero voting rights shares may technically not be “equity shares”. In any case, it would be prudent to watch the developments globally and observe the progress on DVRs without zero voting rights, before considering the merits of permitting such shares in India. |
| 4. | Issuance of SR shares by an unlisted company which proposes to list on a stock exchange: Voting and Other Rights on SR Shares: On certain matters to be notified by regulations, the SR Shares would be treated as having only one vote. The initial list of the same is set out in the “coat-tail” provisions. | The “coat-tail” provisions recommended in the report should be reviewed. The point “any other provision notified by SEBI in this regard from time to time” should be removed. | 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 certain conditions. One such condition in the consultation paper is “in case there is a change in control of the company.” It is not clear under what situation would this require exercise of voting rights. This should be clarified. The clause “any other provision notified by SEBI in this regard from time to time” is a cause for concern as it brings in an element of uncertainty with respect to the rights embedded in the SR shares. Promoters and investors enter into business with a given understanding of the SR shares. SEBI should not have the ability to change this for the SRs once they are issued. Further any changes in the coattail provisions would be significant and should be approved by the SEBI Board and therefore should not be available for modification through this residual clause. |
| Sn. | DVR Group Report | Suggestion(s) | Rationale |
| 5. | Listing and Trading of SRs 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. | This recommendation appears to be contradictory to the recommendation in the appendix and needs to be clarified. As SR shares cannot be traded except upon conversion to ordinary equity shares, there does not appear to be a compelling case for them to be listed. | The appendix on page 21 states: “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.” |
| 6. | Sunset Clause/ Conversion of SR shares: The validity of the SR Shares can be extended by another 5 years with the approval of shareholders by way of a special resolution in a general meeting where all members vote on one-share-one-vote basis irrespective of the nature of their shareholding. The SR shares shall get 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. | We suggest that a choice be given to companies to incorporate a sunset period for SR shares which may be between 5-10 years from the time of listing of companies with SR shares. Transfer of SR shares within promoters may be permitted subject to appropriate safeguards. | There does not appear to be a compelling evidence to suggest that a fixed five year sunset clause is the right threshold. The clause aims to balance incentivising promoters and without diluting investors’ interest. Our concern is that a fixed tenure based sunset clause might achieve neither. The five year duration might be insufficient to protect promoter’s vision of the businesses where gestation period is long. On the other hand, from an investor perspective, economic returns are a distant possibility in the initial stages of the business and they would not be comfortable with losing their ability to exert shareholding rights in proportion to their equity exposure. The paper prohibits transfer of SR shares within the promoter group. This may be reviewed by addressing the related concerns through adequate safeguards on the lines as done in Singapore.[16] |
| Sn. | DVR Group Report | Suggestion(s) | Rationale |
| | Appendix 1 | | |
| 7. | Rule 4(1) (d) of the Companies (Share Capital and Debenture) Rules, 2014, “the company must have a consistent track record of distributable profits for the last 3 years” in case it desires to issue DVR Shares. The Consultation paper suggests that “The extant provision should be amended to clarify that SEBI standards on to be listed companies as covered under Regulation 6(2) of the SEBI ICDR Regulations would be applicable in case of companies without a consistent track record of distributable profits.” | The recommendation needs some clarification. | It is not clear how Regulation 6(2) of the SEBI ICDR Regulations would be suitable in case of issue of DVRs as this requires allotment of at least seventy five per cent of the net offer to QIBs. SR can only be issued to promoters so the above condition does not seem to be appropriate and for issue of FR shares – to ensure seventy five per cent of the net offer to qualified institutional buyers- appears to be an onerous requirement. |
| | | | |
Annexure
We recommend that while drafting the corporate governance requirements, SEBI consider the following:
- Just as the consultation paper requires FR shares to be listed and traded on stock exchanges with a separate identifier from ordinary equity shares, SR shares too should carry a separate identifier. A similar ‘stock marker’ requirement is prescribed in the Hong Kong Exchange (HKEX) Listing Rules.[17]
- In order to ensure that share-holders understand the full implications of investing in a company with SR shares, it is not enough that the offer documents mention the names of all holders of SR shares and the complete details of the rights provided to them (‘initial disclosures’ on p. 18 of the DVRs-Group Report’). The company should be obligated to also include the disclaimer that the company is controlled through SR shares on the first page of all listing documents and other documents required by SEBI (similar to the disclosure requirement under HKEX Listing Rules).
- Another corporate governance standard from the HKEX Listing Rules which SEBI may consider is mandating every listed company with SR shares to establish an internal Corporate Governance Committee for the purpose of reviewing compliance, identifying any potential conflict of interest between the company and/or its subsidiaries on one hand and the SR shareholders on the other hand and reporting the same to the board of directors, and submitting periodic reports to SEBI. However, we caution that SEBI should also consider whether some of the proposed obligations on the Corporate Governance Committee overlap with existing obligations on listed companies, and modify them accordingly.
- In Feb 2018, the SEC Advisory Group’s Investor as Owner Subcommittee recommended that in its offer documents, a company should use terms which clearly distinguish between the stock carrying ordinary voting (one vote one share) rights vis-à-vis DVR shares. This will help bring more clarity in the disclosures.[18]
- We also recommend to SEBI to monitor disputes involving DVR shares to identify what problems arise with the application of existing rules so that SEBI can accordingly review the disclosure requirements with a view to improving them. A similar recommendation has been given by the SEC Advisory Group.
[1] Section 88 which prohibited issuance of shares with disproportionate rights as to voting, dividend, capital or otherwise for public companies was repealed.
[2] https://indiacorplaw.in/2009/06/sebis-recent-primary-market-reforms.html
[3] Regulation 41(3) of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, see: https://www.sebi.gov.in/sebi_data/attachdocs/1441284401427.pdf
[4] See: http://ebook.mca.gov.in/notificationdetail.aspx?acturl=6CoJDC4uKVUR7C9Fl4rZdatyDbeJTqg3XHmN4i4mFb+v2wWhMvQoFl3eswTvMpsUXuos3GgfEKn09tuz49q3PlG3lBdaM9Ff
[5] https://sociable.co/business/why-dual-class-stock-structure-popular-tech-companies/
[6] https://www.cnbctv18.com/startup/year-of-unicorns-8-indian-startups-crossed-1-billion-in-valuation-in-2018-1790451.htm
[7] https://www.moneycontrol.com/news/business/startup/flexiloans-adopts-ai-and-deep-learning-tech-in-its-lending-business-3047781.html
[8] https://www.businesstoday.in/technology/news/good-news-india-added-1200-new-tech-startups-in-2018-8-enter-unicorn-club/story/286640.html
[9] Multi-Class Stock and Firm Value, Does Multi-Class Stock Enhance Firm Performance? A Regression Analysis, 2017, see: https://www.cii.org/files/publications/misc/05_10_17_dual-class_value_summary.pdf
[10] If founders could not issue non-voting or low-voting shares, they would often be forced to hold all or most of their wealth in the company to maintain control, which would subject them to substantial risk. It might also cause them to forego attractive investment opportunities because the new financing would dilute their voting control, or push them to choose debt rather than equity financing even when debt financing would be less beneficial. By issuing non-voting stock, however, the founders can secure new capital without diluting the founders’ stake. This allows founders to diversify their private wealth, as well as secure outside financing, without losing control of the company. See: Shapiro Lund, Dorothy, “Nonvoting Shares and Efficient Corporate Governance” (2017). Coase-Sandor Working Paper Series in Law and Economics. 834. https://chicagounbound.uchicago.edu/law_and_economics/834
[11] Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2014 prescribes certain conditions to be fulfilled by companies (other than private companies who are exempt) for issuing shares with differential rights. See Rule 4(1): https://www.sebi.gov.in/sebi_data/attachdocs/apr-2017/1492085873402.pdf
[12] SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, https://www.sebi.gov.in/legal/regulations/mar-2019/securities-and-exchange-board-of-india-issue-of-capital-and-disclosure-requirements-regulations-2018-last-amended-on-april-05-2019-_41542.html
[13] Regulation 292 of SEBI’s ICDR Regulations provides the conditions for companies listed on IGP to migrate to the main board.
[14] Refer Section 2 (69), Companies Act, see: http://www.mca.gov.in/SearchableActs/Section2.htm
[15] Note: We have not quoted the recommendation verbatim for the sake of brevity and to ensure that only the points where we have made suggestions are mentioned.
[16] Listing Framework for Dual Class Share Structures. Rule 210(10) (f) in Singapore allows transfer of multiple voting shares within ‘permitted holder group’ without requiring approval by shareholders through the enhanced voting process. See: http://rulebook.sgx.com/net_file_store/new_rulebooks/s/g/SGX_Mainboard_Rules_June_26_2018.pdf
[17] https://www.hkex.com.hk/-/media/HKEX-Market/Listing/Rules-and-Guidance/Listing-Rules-Contingency/Main-Board-Listing-Rules/Equity-Securities/chapter_8a.pdf?la=en
[18] https://www.sec.gov/spotlight/investor-advisory-committee-2012/iac030818-investor-as-owner-subcommittee-recommendation.pdf
