SEBI’s discussion paper on the introduction of dual-class shares has divided opinions, reports Mithun Varkey

Dual-class shares is a topic that divides opinions globally. It is no different in India, which has vocal opponents and passionate supporters for it. The Securities and Exchange Board of India’s (SEBI) 20 March discussion paper on allowing dual-class shares, or differentiated voting rights (DVR) as the regulator has named it, has ignited debates among capital markets practitioners, founders and investors.

Founders love dual or multiple classes of shares because it allows them to raise equity funding without diluting control, while investors prefer the traditional one share, one vote structure that gives them a proportionate say in the business.

Though dual-class share structures have been around for a long time, they were used very rarely. In the US, which has long allowed different classes of shares, some of the early adopters of the structure were family-owned companies that sought to keep control within the family with limited shareholding. Ford Motors, which went public in 1956, was one early adopter.

Newspaper publishers also realized the value of dual-class shares in ring-fencing their editorial department from the demands of prying shareholders. Famously, the New York Times issued dual-class shares when it went public in 1969, helping the paper keep its managerial and editorial independence over the years.

However, in the past couple of decades, dual-class voting rights have taken on new life as technology entrepreneurs realized their value in helping them retain control over their businesses, even after diluting their shareholdings in multiple rounds of equity funding. Google was among the first of the tech companies to give outsized power to its founders, Facebook followed suit and SNAP, the company that owns Snapchat, took it to the next level by introducing a third class of shares with no voting rights as it went public in March 2017.

Even as more and more companies adopted multiple-class shares in the US, the rest of the world, even major financial centres such as London, Hong Kong and Singapore, fended off demand from issuers, citing concerns over corporate governance and the need for minority shareholder protection.

With rising demand from issuers and growing competition between global stock exchanges in the highly globalized financial markets, lawmakers and regulators are being forced to abandon their steadfastness and embrace change.

Hong Kong Stock Exchange made the leap in 2018 when it allowed dual-class offerings, what it calls weighted voting rights, and its regional rival Singapore Stock Exchange followed suit the same year.

It would be hard for Indian regulators to hold back domestic bourses from allowing multiple classes of shares for much longer, and SEBI has set the ball rolling with the discussion paper. Indian regulations currently do not allow companies to issue shares with superior voting rights, however, they allow listed companies to offer lower voting rights that usually come with higher dividends.

Is India ready?

“There is a strong case for allowing shares with superior voting rights in India, especially for technology companies,” says Shinoj Koshy, a New Delhi-based partner with L&L Partners. “Most technology startups have no access to debt funding because of their asset-light business model. And after multiple rounds of private equity funding, the founders are left with little control in a business they founded and built.”

voting rightsRameesh Kailasam, CEO of Indiatech, a lobby group for Indian consumer internet companies, says, “Introducing DVRs is only one step towards providing a level playing field for Indian founders, and bringing them on par with their global peers. When companies reach a certain scale, listing in India is difficult because of the current regulations, so there have been demands from founders and investors to ease listing requirements, and allowing DVRs is a part of the changes recommended.”

However, there are strong and valid arguments against DVRs and there are some vocal opponents. Sandeep Parekh, the managing partner of Finsec Law Advisors, is one such voice.

“We [India] are not yet ready for it,” says Parekh. “If anything, the problem in India is that promoters have too much control. On average Indian promoters own more than 45% shareholding in listed companies. So, the argument that promoters are not adequately empowered is a fallacious premise. What India actually needs is more fragmented shareholding.”

voting rightsAnkit Kashyap, a partner at Sidley Austin in Singapore, says, “The use of superior voting rights may be relevant in certain specific companies such as technology companies where the promoter’s role is critical to the growth of business [take the example of Facebook, where Mark Zuckerberg is synonymous with the company itself], but I don’t believe that the markets will welcome DVR offerings by companies in most other industries.”

Koshy says a workaround would be to introduce DVRs for a limited number of sectors, startups or asset-light companies. Hong Kong, for instance, allows differential voting rights exclusively for innovative companies or biotech companies.

Kailasam argues that these startups are unique because their business models are different from the traditional companies with factories and hard assets. They are focused on customer acquisition and it is hard for them to be profitable without substantial investment.

“There is also strategic value in supporting these startups. If you want to produce the next big names out of this part of the world … you will have them, but they will not be listed here and their holding companies will be based somewhere else. The trillion-dollar funding that should come to India will never come,” Kailasam says.

Parekh believes that there is no reason to make exceptions for select industries. “Only superior voting rights are banned, companies can issue shares with lower voting rights if they want,” he says.

“Investors value voting rights a lot. Tata Motors’ shares with inferior voting rights, even though they have higher dividends, are trading at nearly 50% discount, which shows that public markets think voting rights are valuable,” Parekh says.

“In India, DVR shares with inferior voting rights by listed companies are already permitted, though seldom used – there have been five offerings of fractional voting rights since 2009, which trade at a very high discount of between 35-45%,” Kashyap points out.

“Given the recent corporate governance issues raised in Indian listed companies, most institutional investors will not likely have an appetite for shares that do not provide for proportionate voting rights,” he says.

voting rightsHowever, Kailasam argues that fractional rights and DVRs are two different models and can’t be equated. “Unlike fractional rights DVRs have sunset clauses and certain safeguards that take away superior rights in the case of certain important decisions.”

Koshy says research shows that investors will give up control in return for superior financial returns and if the founders have compelling business ideas and the ability to execute.

But, Kashyap points out that the US dual-share class listings are boosted by other factors, such as the depth of US capital markets, better valuations for certain types of businesses from US investors and access to a more global investor base.

Safety measures

SEBI, in its paper, proposed certain safeguards such as a coat-tail provision and a sunset clause. In the sunset clause, SEBI proposes that superior rights shares will be converted to ordinary shares after five years, but these can be extended by another five years with the approval of shareholders by way of a special resolution in a general meeting. The superior rights shares will get converted into ordinary equity shares in the event of a merger or acquisition of the company or whenever the shares are sold or transferred by the identified promoters who hold such shares and in the case of their death.

The coat-tail provisions in the paper provide that shares with superior rights shall be treated as ordinary equity shares in terms of voting rights in provisions relating to appointment or removal of independent directors and the auditor, in cases of change of control of the company, voluntary winding up, material changes in the articles of association or memorandum, related-party transactions, initiation of a voluntary resolution plan under the Insolvency and Bankruptcy Code, and extension of the sunset clause.

“The SEBI report proposes sunset clauses and coat-tail provisions as safeguards for shares with superior rights and while the proposed sunset clause is initially limited to five years, it comes with an option to extend it for another five years upon approval by shareholders. There is a risk that such extension may be used in perpetuity and as such the maximum term should be limited by SEBI,” says Kashyap.

An argument that is made in favour of SEBI’s proposal is that the lack of DVRs could be a disadvantage for Indian stock exchanges that are looking to woo Indian startups to list.

There is a lot of competition between exchanges and Indian exchanges need to be able to provide DVRs to stay competitive. “That is the only argument to introduce DVRs,” says Parekh.

However, Kashyap points out that “there haven’t been any technology company listings out of India lately and, given the depth of private markets, there are none expected in the near future so there hasn’t been any loss of business as such to the US, Hong Kong or Singapore.

“There have been a couple of tech listings in Hong Kong using the new dual-class structure, but none in Singapore. We believe that dual-class share listings may continue to be used by certain well-known technology companies but it will not be an attractive investment proposal for most issuers. Investors will continue to evaluate dual-class securities offerings with caution and it may not have mass appeal,” he adds.

Kailasam says, “There are at least five Indian startups that want to list in India but are waiting for SEBI to ease listing rules and introduce DVRs.”

What’s ahead

Parekh believes that India should first introduce measures to improve shareholder protection, such as the introduction of class action lawsuits, contingency fees for lawyers and third-party funding of litigation, before DVRs are introduced.

Kashyap does not expect DVRs to be used widely in India. Though it will continue to have a niche appeal, “it would be interesting to see how the product evolves”, he says.

“SEBI has an informal two-month deadline to present its suggestions in front its board. The Ministry of Corporate Affairs has to make the necessary amendments in share issuance rules to allow DVRs. In all, the process is likely to be completed by the fourth quarter of 2019,” says Kailasam.

“We are at a stage where we are building the big companies of the future now and it is the right time for us to take the stake. We shouldn’t end up regretting not introducing DVRs a few years later, like, for instance, Hong Kong.”

SEBI’s Action plan

Highlights of the regulator’s DVR discussion paper

  1. Shares with superior rights (SR) can be issued only to the promoters of a company by an unlisted company.
  2. Companies with SR shares will be permitted to do an IPO of ordinary shares provided the promoters have held the SR shares for more than one year before filing the draft offer document with SEBI.
  3. Companies will not be permitted to issue SR shares to any person after listing, including to the promoters.
  4. A company whose SR shares and ordinary equity shares are already
    listed shall be permitted to issue shares with fractional rights.
  5. All SR shares shall remain under a perpetual lock-in after the IPO.
  6. No third-party interest may be created over the SR shares through pledge, lien, negative lien, non-disposal undertakings and any such instrument would be void ab initio (void from the outset).
  7. SR shares shall be of a maximum ratio of 10:1 (ten votes for every SR share).
  8. A company can issue only one class of SR shares.
  9. SR shares will be eligible for the same dividend and other rights as ordinary equity shares, except for superior voting rights.
  10. The voting rights with the promoters through the SR shares and ordinary equity shares shall not exceed 75% of the total voting rights.