Differential Voting Rights
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This article has been written by Ritika Khare, a BLS LLB graduate from Government Law College, Mumbai.

Introduction

Can different shareholders in the same company have different kind of voting rights, based on mutual consent? This has become an important question in the modern startup world, where it is believed that there can be genius founders or wizards who should be able to control the future of a company even when their shareholding is greatly diluted to raise money for growth. This is how Mark Zuckerberg retained control over Facebook even as his shareholding in Facebook reduced far below 50%. 

There is no doubt it will be very popular in India, especially with promoter driven and family driven companies. But what are the rules here? Let’s jump into that.

Well known companies like Alibaba, Facebook and Google have structured their shareholding in dual category, including, Class A and Class B shares, differentiated on the basis of distinct voting rights and dividend payments, generally which provides founders, executives and family, the ability to control majority voting power with a relatively small percentage of total equity. Multiple share class issuance involves issuance of one class to the general public, while the other is offered to company founders, executives and family.  

The number of companies opting for a dual-class structure is booming. Technology startups to be specific are mostly utilising the strategy of differential voting rights strategy to retain control over their assets. Google is trending example of the strategy which annoyed so many for boasting market capitalisation amongst the top worldwide, by issuing Class B shares to founders which is 10 times the amount of votes as ordinary shares class A shares sold to the public.

Dual-class shares with differential voting rights (DVRs) are used by companies to allow promoters and founders to retain management control of the company even when they don’t own a majority of the shares. In 2004, Google went public with a dual-class equity share structure in which stock held by the founders had ten votes per share, while stock held by the public had one vote per share. As a result, Google’s founders collectively held 66.2 percent of shareholders’ total voting power while holding only 31.3 percent of the total shares.

Since Google’s IPO, other companies have gone public with similar capitalisation structures. LinkedIn in 2011, followed by Facebook and Groupon in 2012, and more recently, Lyft and UBER, (and soon to go public Pinterest), have all issued shares with DVRs. The firm Alibaba chose to list in New York instead of the Hong Kong exchange principally because it was allowed to list multiple class of shares with DVRs.

In India, dual-class shares were first used by Tata Motors in 2008, but since then, only five companies have used this equity structure primarily because it was frowned upon by India’s market regulator SEBI. However, in an about-face, SEBI recently issued a White Paper in which it stated that dual-class shares were a practical way for emerging technology companies to raise critical capital without fear of loss of ownership. It proposed that firms be allowed to keep dual-class share structures with DVRs for five years after the initial public offering (IPO). In response, IndiaTech, a lobby of technology-based startups in India backed by founders of Ola and MakeMyTrip, proposed that the sunset period for which companies be allowed to keep stocks with differential voting rights be extended to 20 years.

SEBI, however, released a consultation paper on Issuance of shares with differential voting rights[1], for public comments and pursuant to the comments received as per requisite timeline, SEBI released Framework for issuance of Differential voting rights[2]. The consultation paper, however, recommends that both fractional rights (FRs) and superior rights (SRs) be allowed.

Differential Voting Rights IPOs

  • In foreign countries 

In 2017, a total of 195 companies went public on U.S. exchanges. 23, or 19%, had dual-class structures with unequal voting rights.Last year, a total of 246 companies went public on U.S. exchanges. Out of which 15, or 11%, had dual-class structures with unequal voting rights[3].


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Foreign Companies which issued dual-class shares are: 

Alphabet (the parent company of Google), Berkshire Hathaway, Box, Comcast, Fitbit, Ford Motor Company (which was allowed to float dual-class shares in 1956 despite it being against American Stock Exchange rules), Groupon, LinkedIn, Netflix, UPS, Wayfair, Zynga.

  • In India 

Tata Motors issued DVR shares in the year 2008, Pantaloons retails and Gujarat NRE Coke Limited in the year 2009, Jain irrigation systems limited in the year 2011. The DVR mechanism in India is quite unique. It is also possible to issue shares with inferior voting rights which is less than one vote per share. Both the classes of shares are listed in India, whereas precedents from the US and regulations from HK and Singapore permit listing of the ordinary shares and shares while the multiple rights, held by the founders, remain unlisted[4] (except a few cases such as Alphabet).

Impact of DVRs on the growth of company 

A company may choose to issue shares with differential voting rights for obtaining investments without offering voting rights to the investor and thereby avoiding any attempts at a hostile takeover. Similarly, an investor intending to invest into a public listed company, may avoid the implications of the SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011 (Takeover Code) on acquiring a substantial portion of the voting rights in a company. The Takeover Code requires an acquirer to make an open offer to the public in the event that the acquirer intends to acquire such number shares which amount to more than 25% of the total voting rights in the company. By subscribing to a large number of shares with differential voting rights, an investor may get entitled to receiving higher returns on investment without having to undertake an open offer as mandated under the Takeover Code.

Shares with differential voting rights are favourable to private companies which do not have abundance of dispensable funds or distributable profits and are susceptible to a hostile takeover. Issuance of shares with differential voting rights affords an opportunity to such private companies to broaden their capital base without having to lose control over or management of the company.

The most imperative purpose which proves to be the biggest advantage of the issuance of DVRs is that it goes a long way in the protection of rights of the minority stakeholders. The management of company does not get diluted by the ingress of increasing number of shareholders. The management and control remain in the hands of handful of skilled members and yet the company can satisfy its ever-increasing capital requirements without much complexity. Its straightway affects the structuring of the company in a positive manner It prohibits any harmful impact in the skeleton of policies, rules and regulations which a company decides for its functioning, due to enlargement of the membership. Since, the administration and control of the company is in safe hands the chances of hostile takeovers and related threads are reduced. 

DVRs if given a comprehensive glance, seems to be a perfect device for passive investors. It is an ideal investment strategy for those who want to earn more dividends without much painstaking. Sometimes the technicalities involved in the whole investment procedure is very difficult for any investor to comprehend, in such a case DVRs prove to be a boon for these credulous investors. Moreover, the holders of DVRs enjoys all other rights such as bonus shares, rights shares etc., which the holders of equity shares are entitled to, subject to the differential rights with which such shares have been issued. 

In the past decade, India has witnessed a tremendous surge in entrepreneurial efforts, especially in the technology space; and one of the key issues faced by founders is to raise funds for growth without diluting control. SEBI’s attempt to address this concern, by improving access to the Indian capital markets through a regulated DVR regime, is timely. However, it will be successful, only if the Companies Act requirement of a three-year track record of distributable profits is relaxed for technology / start-up companies.

Framework for issuance of differential voting rights shares 

SEBI has approved the SR – Shares Framework in the backdrop of the ongoing debate on listing of Indian companies with shares having differential voting rights (DVRs) and the need for relaxing existing regulations to permit technology – based companies to access domestic capital markets with the promoter or founder of such company retaining control, akin to structures seen in the United States of America, Hong Kong, and other internationally recognized stock exchanges. In recent times, both the Hong Kong Stock Exchange and the Singapore Stock Exchange have permitted listing of companies having shares with DVRs. However, both exchanges permit only ordinary equity shares carrying one vote per share to be listed and offered to the public. Other classes of shares that carry DVRs cannot be offered to the public and must be held by shareholders as unlisted and untradeable.  

A company with SR – Shares that intends to undertake an initial public offer of its ordinary shares (Issuer Company, and such initial public offer an IPO) is required to comply with certain eligibility conditions in addition to those prescribed under the existing Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 (SEBI ICDR Regulations). Set forth below are the key eligibility related proposals mooted by SEBI: 

 (i) the Issuer Company must be a technology – based company, i.e., intensive in the use of technology, including information technology, biotechnology, nanotechnology, data analytics or intellectual property in order to provide products, services, or business platforms that create substantial value addition; 

(ii) the member holding SR – Shares (SR Shareholder) should be a part of a promoter group whose collective net worth does not exceed INR 5,000 million. For the purpose of determining the collective net worth of the promoter group, the investment of the SR Shareholders in the shares of the Issuer Company are not to be considered; 

(iii) the SR – Shares can be issued only to promoters or founders of the Issuer Company who hold executive position(s) in the Issuer Company; 

(iv) the SR – Shares should have been held by the promoters or founders of the Issuer Company for a period of at least six months before the filing of the red herring prospectus in connection with the IPO; and

(v) the issue of SR – Shares should have been authorized by a special resolution passed at a general meeting of the shareholders. 

The total voting rights exercised by SR Shareholders cannot exceed 74 per cent of the total voting share capital of the Company and no SR – Share can carry more than ten votes for every SR – Share held. Additionally, SR Shareholders will be treated at par with shareholders holding ordinary shares in all matters, except in relation to voting rights. 

SR – Shares are required to be listed on the stock exchanges after the Issuer Company has completed an IPO. All SR – Shares are to be subject to lock-in restrictions after completion of the IPO until such time that the SR – Shares have been converted to ordinary shares of the Issuer Company. Inter-se transfer of the SR – Shares among the promoters of the Issuer Company is not permitted during such lock-in period, and no pledge or other encumbrance can be created on SR – Shares. 

An Issuer Company is required to ensure that the audit committee constituted by its board of directors comprises only independent directors. Additionally: (a) the board of directors of such Issuer Company must consist of at least 50 per cent independent directors, and (b) other committees constituted by the board of directors must have independent directors constituting at least two thirds of its members. 

After the consummation of the IPO, the voting rights of an ordinary shareholder of the Issuer Company and an SR Shareholder will be considered to be identical in the following circumstances:  appointment or removal of an independent director or the statutory auditor of the Issuer Company;  voluntary transfer of control of the Issuer Company by the promoter in favour of another entity; approval of related party transactions, as defined under the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (SEBI Listing Regulations), involving an SR Shareholder; voluntary winding up of the Issuer Company; approval of any changes to the memorandum of association or the article of association of the Issuer Company, other than such changes that would affect the SR – Shares; initiation of a voluntary resolution plan under the Insolvency and Bankruptcy Code, 2016; utilization of funds for purposes other than in the ordinary course of business by the Issuer Company; approval of material transactions as determined in accordance with the materiality threshold prescribed under the SEBI Listing Regulations; approval of delisting or buy-back of shares of the Issuer Company; and such other provisions as may be notified by SEBI from time to time.

SR – Shares shall stand mandatorily converted into ordinary shares on the fifth anniversary of the listing of SR – Shares, unless extended for an additional period of five years by way of a resolution passed by the shareholders of the Issuer Company. It is pertinent to note that SR Shareholders will not be permitted to vote on such resolution. The SR – Shares Framework, however, does not specify if such resolution for extension of the SR – Shares must also be a special resolution. SR – Shares automatically convert into ordinary shares upon the occurrence of certain material events including death or resignation of the SR Shareholder, or a merger or acquisition that results in the SR Shareholder relinquishing control over the Issuer Company.  

POTENTIAL AMENDMENTS TO VARIOUS SEBI REGULATIONS 

In order to give effect to the SR – Shares Framework, certain amendments are required to be made to the SEBI Listing Regulations, Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover Regulations), and Securities Contracts (Regulations) Rules, 1957 (SCRR). Accordingly, set forth below are some of the key amendments that may be expected: 

  1. Pursuant to Rule 19(2)(b) of the SCRR, companies that have multiple classes of equity shares at the time of undertaking an IPO must make an offer of each such class of equity shares to the public during the IPO. Additionally, the minimum dilution and subscription requirements prescribed under the SCRR must be met for each class of equity shares issued by the company. Considering that as per the SR – Shares Framework, SR – Shares would be listed on the stock exchanges without the requirement of being offered to the public for subscription, suitable amendments will have to be made to the SCRR. 
  2. Regulation 3 of the Takeover Regulations requires an acquirer who acquires shares or voting rights in a listed company to make an open offer and public announcement thereof, when such acquisition, taken together with shares or voting rights already held by such acquirer and persons acting in concert with the acquirer, gives the acquirer the right to exercise 25 per cent or more of the voting rights in such listed company.  The conversion of SR – Shares into ordinary shares of the Issuer Company at the end of the prescribed term of five years, or upon the occurrence of certain events as highlighted above, may result in an increase in the voting rights exercisable by non-promoter shareholders (holding ordinary shares of the Issuer Company) beyond 25 per cent, triggering open offer and public announcement obligations. Accordingly, SEBI will be required to amend Regulation 10 of the Takeover Regulations to exempt non-promoter shareholders having 25 per cent or more voting rights due to the conversion of SR – Shares into ordinary shares from undertaking an open offer and a public announcement thereof under the Takeover Regulations. 
  • Amendments to the SEBI Listing Regulations Regulation 41(3) of the SEBI Listing Regulations prohibits a listed company from issuing shares in any manner that might confer on any person superior rights in relation to voting or dividend vis-à-vis the rights attaching to equity shares that have already been listed. Accordingly, SEBI will be required to amend Regulation 41(3) of the SEBI Listing Regulations to permit listing of SR – Shares. 

Demerits of DVRs worldwide including India

DVRs can be seen as downright unfair. They hand over power to a select few, who are then allowed to pass the financial risk onto others and create an inferior class of shareholders. Managers holding super-class stock can spin out of control with few constraints placed upon them. Families and senior managers, regardless of their abilities and performance, can entrench themselves into the operations of the company. Finally, dual-class structures may allow management to make bad decisions with few consequences.

Hollinger International is the best scenario of negative effects of dual-class shares. Former CEO Conrad Black controlled all of the company’s class-B shares, which gave him 30% of the equity and 73% of the voting power. He ran the company as if he were the sole owner, exacting huge management fees, consulting payments and personal dividends. Hollinger’s board of directors was filled with Black’s friends who were unlikely to forcefully oppose his authority. Holders of publicly traded shares of Hollinger had almost no power to make any decisions in terms of executive compensation, mergers and acquisitions, board construction poison pills or anything else for that matter. Hollinger’s financial and share performance suffered under Black’s control.

Proponents of dual-class shares also argue that DVRs protect new emerging companies from hostile takeovers. Founders of new technology companies feel they are vulnerable to capital-sharks and risk losing control over the firms they have founded in their search for capital. But these fears appear to be exaggerated given that there are other ways to prevent such takeovers. LinkedIn and Facebook, for example, have corporate charters with staggered boards which can only be repealed by an 80-percent shareholder vote—a difficult threshold. In staggered boards, the terms of the board of directors are staggered to prevent more than a small fraction of the board being replaced at any one time. These boards provide effective protection against hostile takeovers making use of dual-class shares redundant. Another effective strategy is the use of a “poison-pill” which involves allowing the founders to buy shares at huge discounts, or having preferred stock that is convertible to common shares should the company be threatened with a hostile takeover.

Experiences of US companies that have had dual-class structures illustrate why such structures can be detrimental to shareholders. In a capitalist system, the primary purpose of a corporation is to produce goods and services that maximise shareholder wealth. In such a system, dual-class share structures with differential voting rights result in disproportionate voting and economic rights. This results in management being unaccountable to market discipline, allowing them to divert funds to benefit themselves and indulging in unprofitable empire building and value-destroying acquisitions. 

SEBI should be extremely cautious about permitting dual-class shares to be listed on the exchange. In a rapidly evolving financial economy like India, corporate governance is an area of critical importance. Sustainable businesses are essential for the country’s growth and prosperity, and the discipline and control imposed by outside shareholders on a company’s management are crucial to developing sustainable businesses.

Conclusion 

The contentions for and against double class structures regularly appear to be comparative, changing just in tone contingent upon which side the declarant underpins. To an adversary of double class, the majority of the highlights that make the structure bothersome are frequently precisely the highlights that make a supporter of the structure contend that it is valuable. As one faultfinder unexpectedly remarked, “the benefit of a double class offer structure is that it ensures pioneering the board from the requests of customary investors. The impediment of a double class offer structure is that it shields innovative administration from the requests of investors[5].

Differential shares is not a new concept, neither in India or across the world. The response received even after the existence of such shares in almost all the economies is ambivalent. The reasons for such response s are manifold. Shares with lower voting rights trade at a discount in the stock market along with shares with higher voting rights. Thus, the opportunities are minimal in such shares, for increased income from capital appreciation. As a result, individual shareholders do not respond very enthusiastic, while invariably interest in control is shown by larger or institutional investors. Higher dividends are rarely sufficient compensation for the loss of control in such a situation.

Restructuring of the equity shares to one class alone is liable to criticism on the ground of excessive regulation. The freedom to adopt a convenient capital structure provides companies with the option  to devise optional capitalisation strategies. Market forces step in and ensure that the company does not proceed along that path, where such strategies do not make proper business sense, as has been a case in many countries. The end result is that the structure that is best suited and most desirable for the particular needs of the corporation is achieved, thereby maximising the efficiency of the individual corporation as well as that of the economy which it operates. 

END NOTES

[1] https://www.sebi.gov.in/reports/reports/mar-2019/consultation-paper-on-issuance-of-shares-with-differential-voting-rights_42432.html

[2]  https://www.sebi.gov.in/search.html?searchval=differential%20voting%20ri

[3] https://www.cii.org/files/2018Y%20IPO%20Stats%20for%20Website.pdf

[4] https://www.sebi.gov.in/reports/reports/mar-2019/consultation-paper-on-issuance-of-shares-with-differential-voting-rights_42432.html 

[5] Andrew Hill, Enrolment Open for an MBA in Murdoch, Fin. Times (July 18, 2011), http://www.ft.com/cms/s/0/2fda9e8e-b176-11e0-9444-00144feab49a.html#axzz2IYIKmzDt

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