Guest Post – Differential Shares

The following is a guest post by Mr. V. Umakanth. Mr. Umakanth is a well known scholar on corporate law and corporate governance, especially in relation to India. He was formerly a Partner at Amarchand Mangaldass and is presently at the National University of Singapore. He is the principal contributor to the Indian Corporate Law blog.

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The latest review of companies’ legislation in India has already witnessed a span of more than 5 years. Although there was a glimmer of hope that the process will fructify with the enactment of a new legislation, the recent report of the Parliamentary Standing Committee on Finance on the Companies Bill, 2009 suggests that the process is only likely to be elongated further. This is because several recommendations of the Standing Committee run counter to proposals contained in the Bill, thereby requiring a fundamental debate on some of the issues. One such issue pertains to the question of whether Indian companies can issue shares with differential rights, a matter this post will focus on.

Traditionally, public companies in India have been permitted to issue only two classes of shares, viz. preference shares and equity shares, while private companies possess the flexibility to issue different classes of shares. All equity shares in public companies are generally required to carry same rights without any discrimination among equity shareholders.

However, this changed nearly a decade ago with an amendment to the Companies Act, 1956 (specifically to Section 86) and with the promulgation of the Companies (Issue of Share Capital and Differential Voting Rights) Rules, 2001. The regulatory changes permitted public companies to issue equity shares with differential rights as to voting or dividend.

The logic behind such an enabling regime was to provide companies with an option to raise finances from investors by decoupling economic rights (e.g., dividend) from control rights (e.g. voting). For example, companies could issue shares with higher dividend and lower voting rights to outside shareholders primarily keen on greater returns, while they could issue shares with lower dividend and higher voting rights to insiders (such as promoters) primarily keen on reinforcing their control over the companies. However, under the relevant rules, only companies that comply with certain stringent conditions are eligible to issue such shares; the conditions include a 3-year profitability track-record, no failure to repay debts or pay dividend and no default in meeting investors’ grievances. The shares with such differential rights cannot exceed 25% of the total share capital issued.

Due to the onerous nature of these conditions, it has not been received favourably by the Indian industry. In fact, until 2008 no leading Indian company had undertaken an issuance of shares with differential rights when Tata Motors came up with a rights offering to finance its acquisition of Jaguar-Land Rover from Ford, a deal which was announced earlier that year. The company issued a new class of equity shares named ‘A’ Ordinary Shares, which carried dividend rights at 5 percentage points greater than other equity shares while it carried only 1/10^th voting rights compared to other equity shares.

On the one hand, shares with differential rights constitute an effective tool for companies to raise finances on favourable terms, and are therefore popular with the corporate sector. Several high profile companies in other economies too have put this tool to effective use, with Google and New York Times being prime examples. On the other hand, the idea of shares with differential rights is not without its critics. They argue that coupling of economic rights and control rights is essential to strengthen the corporate governance framework, and also that a decoupling will enable promoters to amass excessive control without concomitant economic interest so as to stifle minority interests. It is no wonder, they say, that the instrument of shares with differential rights is on its decline in certain jurisdictions as Europe which are moving towards a stringent one-share-one-vote rule.

Given the dichotomy of views differential shares generate, they have been subject to close regulatory scrutiny in India. The judiciary, when confronted with the issue (albeit in a single instance thus far), has adopted a somewhat liberal attitude. In Anand Pershad Jaiswal v. Jagatjit Industries Limited, MANU/CL/0002/2009, the Company Law Board (CLB) seemed favourable to the issue of shares to insiders that enhanced their control rights without the same economic rights. Unfortunately, the CLB did not have the opportunity to delve into the details of the issues raised in that matter or interpret the legal provisions because it was settled through a consent order.

The Securities and Exchange Board of India (SEBI) has, on the other hand, adopted a more stringent approach in protecting the interests of minority investors. In July 2009, SEBI amended the listing agreement to introduce a new condition whereby listed companies are now prohibited from issuing “superior rights as to voting or dividend vis-à-vis the rights on equity shares that are already listed”. SEBI’s effort adds a qualitative element to the analysis. Apart from a determination of whether shares have a “differential” element from other equity shares, there is a need for a determination of whether the new shares are “superior” to existing shares. If superior, the issue of new shares will not be permitted. On its face, while SEBI’s amendment appears to strike at the root of possible abuse of the differential shares mechanism by ensuring that promoters of companies do not confer greater control rights on themselves, it creates unnecessary obstacles to genuine transactions involving issue of shares with differential rights to outsiders. This confusion prompted Tata Motors, that continues to be one of few companies accessing the mechanism, to approach SEBI for a ruling on whether their existing issue of Ordinary ‘A’ shares is protected within the new dispensation under the listing agreement. Although SEBI’s response to Tata Motors was favourable, several questions remain unanswered, as discussed here.

Matters appeared to be heading towards a dead-end and it was almost as if the above debate is only of academic value because the Companies Bill, 2009 proposes to eliminate the concept of shares with differential rights. It seeks to revert to the pre-2001 position where all equity shares ought to carry similar rights, in a sense following the trend adopted by countries in Europe. More recently though, the relevance of this debate has been resuscitated because the Standing Committee has suggested that the Government must re-examine the Bill due to the overwhelming suggestions received to permit the issue of differential shares. It is therefore clear that the issue is back on the anvil and will need to be considered further.

While the substantive part of this post seeks to outline the various twists and turns in the legal position (existing and proposed), it is reflective of another phenomenon. We find that in a span of a decade, the law has undergone a significant number of changes resulting in some uncertainty as to the precise legal position. Despite the fervour generated by the issue, very few companies have in fact adopted the route of issuing differential shares, a fact that hardly comes as a surprise.