Sebi's new differential voting rights rules may hurt minority shareholders

The Securities and Exchange Board of India’s (Sebi’s) proposed structure of differential voting rights (DVRs) could be a major impediment to improving corporate governance practices by India Inc, say market participants. According to them, the new draft paper on DVRs provides for unequal voting rights that may violate the basic principles of corporate democracy. Certain sections of investors, too, have raised apprehensions before the market regulator, seeking review of the proposed norms.

The current regulatory framework doesn’t permit DVRs with higher or superior voting rights. If approved, companies will be allowed to issue shares with either fractional or superior voting rights. “Allowing superior rights to promoters would be a case of selling their shares and keeping them too, where despite being diluted, a founder is permitted to regain considerable voting rights (including a majority) in a company,” said a market participant who raised apprehensions before the market regulator.  

Sebi has proposed dual-class share framework with superior voting rights, where a certain share will have higher voting power than an ordinary share. This, however, will be restricted only to unlisted companies. While, listed companies will be permitted to issue shares with inferior voting rights, where a share will carry a fraction of voting power compared to an ordinary share. Besides voting power, these shares could carry other rights, like higher dividends.

The draft paper suggests that these shares can have a maximum voting ratio of 10:1. Total voting rights of the promoters cannot exceed 75 per cent of the voting rights of the company, including superior rights shares and ordinary shares held by them. So, the companies intending to issue superior rights shares can do that by amending their articles of association and passing a special resolution which requires just above 75 per cent of the voting rights to implement.

“In that case, minority shareholders, including financial investors holding less than 25 per cent of the voting rights (although having substantial economic interest), would have no ability to block such resolutions and their voting rights would be diluted, irrespective of their economic participation. This is akin to the expropriation of shares,” said the market participant cited above.

Legal experts, too, believe that issuance of DVRs and creating a class of shares with superior rights will significantly harm minority shareholders.

“The proposed rule provides one person with 10 per cent shares and 75 per cent voting rights, which could increase oppressive conduct by the promoter”, said Sandeep Parekh, founder of Finsec Law Advisors.

Parekh said this may trigger a regulatory race to the bottom. While western countries, especially the Anglo-Saxon countries have a strong minority protection mechanism as a counter-balance, the governance problem inherent in DVRs gets reduced. “Till we have a robust minority protection law and more muscular institutional shareholders, it is premature to introduce DVRs more widely,” said Parekh.

In India, five companies, including Tata Motors, erstwhile Pantaloons Retails and Gujarat NRE Coke, had issued shares with DVRs. In 2009, Sebi had directed stock exchanges to prohibit the use of DVRs.

Such structures are common globally with companies such as Facebook, Alibaba and Snapchat issuing dual-class shares. Snapchat, in particular, has issued so-called Class C shares held by promoters to retain 90 per cent voting power.

The new framework is essentially aimed at new technology firms which typically see high growth but burn a lot of cash and thus are required to raise capital at frequent intervals. “These (new-age) firms, continuously require to grow only through equity, which dilutes the founder’s stake, thereby, diluting control. In such cases, retaining the founder’s interest and control in the business is of great value to all shareholders,” Sebi said in the paper.

However, market participants rebutted these claims. Global evidence suggests that such structures only increase cost, entrenchment risk and reduce accountability. They believe that the new structure is prone to misuse by promoters and it could also affect the trust of retail investors.

“The proposal is going to be detrimental to the interests of minority shareholders in India. As such, institutional shareholder activism is absent. Short selling in shares is not smooth, so, there isn’t a fair discovery of prices where promoters and companies are unscrupulous,” said Shriram Subramanian, managing director, InGovern, a proxy firm. Abuse of DVRs by companies can severely shake the trust of retail investors in equity markets, said experts. “Even in markets like the US, many pension funds which are beacons of corporate governance are voting against dual-class share structures,” added Subramanian.

What are differential voting right (DVR) shares

• DVR shares or dual class shares give the holder more voting and dividend power than ordinary shares. They also give promoters a say to retain shares, giving decision-making rights.
• Recently, DVR shares gained traction in India with start-ups, including Flipkart, Oyo, Ola and Paytm.

Investors grievances over Sebi paper on DVR shares

• Shares having superior rights are contrary to the basic principle of corporate democracy which provides for “one share, one vote”
• Globally, several investors and advisory firms have objected to the “dual class” share structure
• The UK has abolished the dual class structure since 1960. Creating the same in India would diminish the attractiveness of India for FDI
•  SEC Commissioner Kara Stein in 2018 criticised dual-class companies as “inherently undemocratic, disconnecting the interests of a company’s controlling shareholders from its other shareholders”
•  Issuance of DVR shares with superior rights with a special resolution (75% majority) would be akin to expropriating the rights of minority shareholders when Section 236 requires 90% consent for a squeeze-out.
• DVR shares destroy economic value and trade at a significant discount to market
• The Sebi paper argues that founders of start-ups should be allowed to create such shares with superior rights; the global evidence suggests that such structures only increase cost, entrenchment risk and reduce accountability