Legal Capsule by Economic Law Practice

SEBI Framework on Superior Voting Rights

INTRODUCTION

In a previous edition of ‘India Update’ (Part 2 of 2019), given the backdrop of a hostile takeover

in  India’s  IT  sector,  we  had  analyzed  the  law in respect of hostile takeovers in India. In our analysis, we had taken note of the increasing calls for permissibility of dual class share structures in India to enable promoters to retain control over their companies without impinging their ability to raise capital.

After considering public comments, the Securities and Exchange Board of India (SEBI), at its board meeting held on June 27, 2019 proposed a framework (Framework) for the issuance and listing of shares with superior or differential voting rights (SR Shares) by  certain  companies on the stock exchange.

The Framework was implemented on July 29, 2019 and SEBI notified amendments to various regulations, namely:

• SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018
• SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015
• SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (Takeover  Code)
• SEBI (Buy-Back of Securities) Regulations,  2018
• SEBI (Delisting of Equity Shares) Regulations, 2009

THE CHEQUERED HISTORY OF DIFFERENTIAL VOTING RIGHTS IN INDIA

Green light under the Companies Act…

With effect from December 13, 2000, Section 86(a)(ii) of the Companies Act,  1956  permitted companies to issue shares with differential voting rights as to dividend, voting or otherwise in accordance with the rules prescribed under the Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2001. Thereafter, a number of companies (including Tata Motors  Limited  and Gujarat NRE Coke Ltd) had issued shares with differential voting rights.

Section 43(a)(ii) of the Companies Act, 2013 (which supersedes the Companies Act, 1956), read with Rule 4 of the Companies (Share Capital and Debentures) Rules, 2014 (SCAD Rules) permits companies to issue equity  share capital with differential rights as to dividend, voting or otherwise, subject to certain conditions.

…But red light for listed companies

However, on July 21, 2009, the SEBI issued a circular29 in terms of which it amended the Equity Listing Agreement to prohibit listed companies from issuing shares with superior rights as to voting or dividend vis-à-vis the rights on equity shares that are already listed. This closed the doors for listed companies  from issuing any shares with differential voting rights.

The SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (which superseded and incorporated the corporate governance provisions of the Equity Listing Agreement) continued the restriction on the issuance of the differential voting rights by listed companies through Regulation 41(3).

However, the Framework has now enabled certain companies that have issued SR Shares to list their ordinary shares on the stock exchange.

OVERVIEW OF THE FRAMEWORK

• An unlisted company which has issued SR Shares has now been permitted to list its ordinary shares on the stock exchange through an initial public offer (IPO).
• Certain key eligibility requirements for companies having SR Shares for an IPO are as follows:

Nature of Business	The company should be engaged in making intensive use of technology, information technology, intellectual property, data  analytics,  bio-technology or nano-technology for providing products, services or business platforms with substantial value addition.
Shareholding Criteria	The SR Shares should have been issued only to the promoters/founders,  who hold an executive position in the company.
Net Worth Criteria	The holder of the SR Shares is not part of a promoter group whose collective net worth (excluding their investment in the company) is more than INR 500,00,00,000.
Voting Right Criteria	The SR Shares have voting rights in the ratio of minimum 2:1 to maximum 10:1 compared to ordinary shares.
Dividend	SR Shares are to be treated at par with ordinary equity shares in respect of dividends

• Corporate governance requirements in relation to listed companies having outstanding SR Shares.
• Coat-tail provisions: The SR Shares shall be treated as ordinary equity shares in terms of voting rights (i.e. one SR share shall only have one vote) in the following circumstances post-IPO:

1. appointment or removal of independent directors and/or auditor
2. where a promoter is willingly transferring control to another entity
3. related party transactions in terms of these regulations involving an SR shareholder
4. voluntary winding up of the listed entity
5. changes to the articles of association or memorandum of association of the listed entity, except any change affecting the SR equity share
6. initiation of a voluntary resolution process under the IBC Code
7. utilization of funds for purposes other than business
8. substantial value transaction based on materiality threshold as specified under these regulations
9. passing of special resolution in respect of delisting or buy-back of shares
10. other circumstances or subject matter as may be specified by the Board, from time to time

• Mandatory conversion into ordinary shares: The SR Shares shall be converted into equity shares having same voting rights as that of ordinary shares on the 5th anniversary of  listing of ordinary shares of the listed entity. However, the SR Shares may be valid for up to an additional 5 years, after a resolution to that effect has been passed, where the SR shareholders are not permitted to  vote.  Further, the holders of the SR Shares may convert their SR Shares into ordinary equity shares at any time prior to the period.
• Automatic conversion into ordinary shares: The SR Shares shall be compulsorily converted into equity shares having voting rights same as that of ordinary shares on the occurrence of any of the following events:

1. demise of the promoter(s) or founder holding such shares
2. an SR shareholder resigns from the executive position in the listed entity
3. merger or acquisition of the listed entity having SR shareholder/s, where the control would no longer remain with the SR shareholder/s
4. the SR equity shares are sold by an SR shareholder who continues to hold such shares after the lock-in period but prior to the lapse of validity of such SR equity shares

• Exemption from open offer:  The  conversion of SR Shares into ordinary shares is exempted from the requirement of making an open offer if such conversion triggers the thresholds specified in the Takeover Code.
• Lock-in: The SR Shares will be under lock-in until conversion into ordinary equity shares. In case of early conversion of the SR Shares to ordinary shares, the SR Shares shall continue to be under lock-in for 3  years  after  listing  for  SR  Shares  considered   for   minimum  promoter contribution and for 1 year for SR Shares in excess of minimum promoter contribution. During the lock-in period, no transfer of SR Shares amongst the promoters is permitted.
• Pledge not permitted: No pledge or lien is permitted in respect of SR Shares.
• Amendments to SCAD: Following the implementation of the Framework, the Central Government has made the following changes in respect of companies proposing to issue shares with differential voting rights:

1. The requirement under Rule 4(1)(d) of SCAD which required a company having consistent track record of distributable profits for the last three years to be eligible to issue shares with differential voting rights has been omitted.
2. The requirement under Rule 4(1)(c) of SCAD which stipulated that shares with differential rights shall not exceed 26% of the total post-issue paid up equity share capital including equity shares with differential rights issued, at any point of time, has been increased to 74%.

OUR COMMENTS

The prohibition in relation to the creation of a pledge in respect of the SR Shares will likely dampen sentiments as it is standard for banks to require promoters to pledge their shares as security in order for the banks to extend working capital facilities to companies. Given that technology companies are, generally speaking, asset light, and the promoters are likely to be individuals without deep pockets (since the holders of SR Shares collectively should not have a collective net worth in excess of INR 500 crores), availing significant working capital facilities will likely prove to be a challenge for companies that have issued SR Shares.

However, the Framework for permitting issuance of SR Shares is a welcome step. This would enable promoters of professionally run technology companies retain control of their companies without inhibiting their ability to raise capital. Such dual class share structures have been adopted by a number of technology companies in western jurisdictions and the SEBI permitting Indian technology companies to issue SR Shares is a step in the right direction.