DIFFERENTIAL VOTING RIGHTS SHARES – AN INSTRUMENT WHOSE TIME HAS COME?

Differential Voting Rights
Shares (DVRS) are in the news again as SEBI has set up a committee to review
the law relating to them. It appears that SEBI may be considering removal of
some of the severe restrictions on them so as to make their issue easier. This
could bring life into this instrument that otherwise is more or less a dead
instrument due to regulatory constraints. 

This proposal has
surprisingly seen severe resistance even at this stage when the Committee is
merely set up. Opposition is of near paranoiac proportion. I submit that the
instrument by itself is useful and should be allowed with reasonable
conditions. It is of course not an instrument for all. It is not even anybody’s
case that this instrument will be very popular amongst corporate and/or
investors. But for many – companies, promoters and investors – it could work
well.

Let us first briefly
consider what DVRS are, what is broadly the current legal position, what are
the issues and opposition points and their possible answers and what could be
the way forward.

What
are DVRS?

DVRS are a variant of equity
shares. In other words, DVRS are equity shares. However, DVRS depart from
the usual equal-vote, equal-dividend features of ordinary equity shares.
Instead, they give differential voting and/or dividend rights. DVRS may thus
carry more – or less – voting rights than ordinary equity shares. Thus, for
example, one DVRS may carry just 1/10th voting right. 10 such DVRS would thus
carry one vote, compared to ordinary equity share which has one vote one share.
Or DVRS could carry more voting rights as for example, one DVRS having 10
votes.

Similarly DVRS could carry
more (or less) dividends than ordinary equity shares. DVRS could, for example,
be entitled to, say, 5% more dividends than ordinary equity shares. This helps
to compensate for lesser voting rights.Otherwise, such DVRS may carry all the
other features as ordinary equity shares. They may, for example, carry the same
rights on liquidation. There could be variants other than the normal
voting/dividends right however, this article focuses on variants of voting
rights and dividend rights only particularly in listed companies.

Legal provisions relating to DVRS

DVRS have always been
possible for private companies. However, flexible requirements for
public/listed companies have been a relatively recent phenomena. The provisions
relating to DVRS are contained in the Companies Act, 2013, rules made
thereunder, SEBI Regulations, circulars, etc. These have evolved over time.
Hence, the regulations are scattered and are cumbersome and time consuming.
Some features of the law can be summarised, albeit in a simplified manner.

Issue of DVRS would
generally require approval of shareholders by an ordinary resolution through
postal ballot. It generally would also require approval by SEBI. DVRS would
have to be offered to all shareholders proportionately – thus, DVRS would have
to be either in the form of right shares or as bonus shares. DVRS cannot be
more than 26% of the equity share capital. Existing equity shares cannot be
converted into DVRS.

Importantly, DVRS that have
right to a higher dividend or more voting rights than existing equity shares
cannot be issued. This restriction is obviously for protection of existing
shareholders whose rights would get diluted if new shares having more
dividends/voting rights are issued. These requirements end up being
restrictive, time consuming and even finally uncertain. This may also be one of
the major reasons why DVRS did not pick up in India and that the existing ones
are not successful. Even otherwise, the regulations for issue of DVRS are half
hearted. Most other provisions of law refer and provide for ordinary equity
shares and not DVRS. Thus, there is a legislative vacuum in respect of DVRS.
The Committee considering DVRS will thus need to recommend extensive amendments
to several laws.

DVRS
issued

Barely 5 companies have
issued DVRS in India. Except one, the other DVRS trade at prices that are at a
huge discount over the price of the corresponding ordinary equity shares. Tata
Motors DVRS, for example, trade at nearly 50% discount over the price of their
equity shares.

Future Enterprises Limited,
however, has its ordinary equity shares and DVRS trading at very small
differential. Part of this may be ascribed to the fact that their DVRS carry
25% less voting rights with right to 2% more dividends, as compared to ordinary
equity shares. The market liquidity of such DVRS is also generally poor.

Opposition
to DVRS and some possible responses

There has been severe
opposition to DVRS amongst certain circles, which is strong almost to the level
of being paranoiac/irrational. I submit that much of this opposition is
unjustified and can be refuted.

Much
of the fears and concerns can be dealt with if the DVRS are seen as just
another instrument whose value can be determined by informed parties using
relevant valuation models. Higher or lower dividend or voting rights would be
factored in the valuation. A company desiring to give lower voting rights can
compensate this loss by offering a lower issue price and/or with sweetener of
higher dividend rights. The point is that the market would generally take care
of the handicaps/advantages of differential rights by valuing the DVRS. Hence,
the opposition to DVRS would have to be considered in this light.

The core opposition to DVRS
is that it would help entrench existing management without their investing
money proportionate to their rights. Promoters and management would thus invest
lesser amount, take lesser risk and yet get higher control. This is
misconceived. Higher votes would result in higher price for such shares that
the promoters have to pay and lower price for the equity shares (DVRS) issued
to other shareholders. If investors consider the right to remove management as
very important to them, they will either pay a very low price for such shares
with lower rights or may not buy them altogether. So long as transparency is
maintained of the rights and disabilities on DVRS, the parties should be free
to work out the value amongst themselves either directly or through response to
public issue or through open markets.

It has been said that very
few companies have issued DVRS and these DVRS except 1 have badly performed.
The explanation for this can be several. One is educating the investors of this
instrument. Second is that the regulations themselves are complex and near
prohibitive. Finally, once again, the markets can be expected to take care of
the situation. If investors perceive that such instruments will give them
lesser return or have lower value, they will value them accordingly in the
market, as they would any other security. Banning or creating near prohibitive
conditions is not the answer.

Safeguards of corporate Governance and other provisions

Much has changed since the
time when the provisions relating to DVRS were introduced. We have extensive
corporate governance requirements and other new requirements that provide for
transparency and protection of various stakeholders. We have requirements
relating to a certain number of independent directors. The law provides for
extensive regulations relating to related party transactions. There are various
committees including Audit Committee, Nomination and Remuneration Committee,
etc. which look into certain issues. Shareholders earlier could rarely vote
because they could not attend general meetings physically since such meetings
were often held at remote or far off places. Postal ballot and electronic
voting has changed this situation a lot. Thus, there are many safeguards that
keep some check on majoritarian control.

Suggestions

As stated earlier, so long
as transparency is maintained and certain basic conditions are complied with,
DVRS should be allowed to be issued.

Rights on existing
instruments should not be changed without the approval of the holders. Take an
example. Presently a company has Rs. 10 crore of ordinary equity shares (1
crore equity shares of Rs. 10 each face value). Now, let us say the promoters
of the company hold 20 lakh ordinary equity shares of promoters. Thus, they are
entitled to 1/5th of the voting rights. If these 20 lakh ordinary equity shares
are converted into 20 lakh DVRS with each DVRS having 10 votes, the result
would be as follows. Total votes would be 280 lakh (200 lakh votes now held by
the promoters and 80 lakh votes by the others). The promoters would have 200
lakh votes which would be about 71%. Thus, their voting share jumped from 20%
to 71%. This results in loss of voting rights and thus value of the other
shareholders. This should not be permitted and the existing law does not permit
it.

In case of fresh issue, the
new shares should be offered to all. If it is proposed that the fresh issue is
to a special group, the issue should be transparently valued and the issue
price should not be lower than such price. SEBI could consider providing
formulae for this. The objective is that the value of existing shareholders
should not suffer because of such issue.

In the interim, till more
experience is gained, a cap can be placed on the number of DVRS. However,
unlike the present poorly drafted law that provides a cap on the maximum amount
of DVRS as a percentage of total capital, the cap should be on the maximum
voting rights that such DVRS carry. The cap of 26% of the capital could be
considered. The objective would be that the promoters/management, even if they
allot all the DVRS with higher voting rights to themselves, would be able to
hold only a certain maximum of voting rights through such DVRS.

Provisions could be made
whereby certain major decisions require approval by a higher majority. This
would give adequate say to a significant majority of shareholders. This will
help ensure that those in control with DVRS are not able to take such major
decisions that could affect the value of shareholders without their say. Like
certain preference shares, if there is no dividend paid for, say, 3 years, the
DVRS could be made entitled to voting rights.

Conclusion

Clearly, then, DVRS are an
instrument whose time has come. One hopes that, firstly, the Committee
wholeheartedly endorses this instrument. Further, it should propose extensive
rehaul of the various laws that deal with issue of securities and ensure that DVRS
are also provided for. They may also provide for conditions to ensure fair
play. In particular, there should be transparency and also education of
investors. Thereafter, the parties – companies, promoters and shareholders –
should be permitted to structure instruments as per their needs and desires and
at a value they mutually decide.