The mandatory listing of shares having superior voting rights raises certain concerns with respect to start-ups, hostile takeovers, and corporate governance.
The Ministry of Finance, through its notification dated 19th March, 2020, introduced fresh amendments to the Securities Contracts (Regulation) Rules, 1957 (hereinafter “SCRA Rules”). The key amendment is concerning Rule 19 of SCRA Rules, which states the requirements with respect to the listing of securities on a recognised stock exchange. Through this amendment, the following proviso is inserted after the second proviso of Rule 19, sub-rule (2), clause (b) of SCRA Rules:
“Provided also that the applicant company, who has issued equity shares having superior voting rights to its promoters or founders and is seeking listing of its ordinary shares for offering to the public under this rule and the regulations made by the Securities and Exchange Board of India in this regard, shall mandatorily list its equity shares having superior voting rights at the same recognized stock exchange along with the ordinary shares being offered to the public”
Accordingly, the amendment mentioned above (hereinafter “amendment”) provides that in case a company seeks to list its ordinary shares, then it shall be mandatorily required to list its equity shares having superior voting rights (hereinafter “SR”). Notably, the investors, promoters, Private Equity funds, etc. hold SR in order to retain significant voting rights and raise capital without losing control. By way of this amendment, such SR would be subjected to listing, and subsequently tradable in the secondary market. The mandatory listing and further trading of these SR undoubtedly affects the approach regarding start-ups, hostile takeovers, and corporate governance.
Effect on Start-ups
The promoters of start-ups usually wish to hold control over the company as the interests of the management are more closely tied with the company rather than the interest of well-diversified shareholder. At the same time, listing of shares would be preferable to raise capital from the public. Accordingly, SR seems to be an attractive route for start-ups to achieve these dual-objectives. However, the arrangement of SR bears greater risk in the earlier law, because prior to the amendment, the trading of such SR was not permissible. Consequently, the promoters or investors who were holding SR would not be able to generate liquidity of their capital through the stock market in case of any business menace.
The amendment in SCRA Rules by mandating the listing of these SR provides a liquidity position to the promoters and other investors. They may, by discharging their stake in the stock market, get absolved from any further risks. Thereby, the amendment permits the promoters to have control over the company by retaining SR as well as reduce the risk of their investment in case of adverse situations.
However, such a scenario may raise a possible concern for shareholders of the company as well. The amendment certainly provides an exit opportunity to the promoters. However, it is to be noted that in most cases, such promoters will take exit positions from SR only if they believe that the company is in extreme business risk and there is no prosperous existence conceivable. Consequently, they will be shifting the burden of their business risk to public investors, which would be unjust and detrimental to the interest of those shareholders. Thus, the amendment provides an effective framework for start-ups in India. However, at the same time, it may also nurture critical consequences for the shareholders’ interest.
Effect on Hostile Takeovers
The central impact of shares with differential voting rights is that such shares place control in the hands of those who have SR. SR as a takeover defence may help to protect the controlling position of the promoter. Consequently, this protects the company from any unsolicited and hostile takeovers. Prior to the amendment, the promoters could hold SR and retain substantial control, as there was no need to list these securities. In such a scenario, the prospective acquirer would not have been in a position to pursue any unsolicited takeover because it could not acquire SR from the secondary market. Such acquirer would have been required to approach management of the company for making any sort of takeover offer. Thereby, the earlier law firmly restricted any hostile takeover, in case the promoters hold majority control through SR.
The amendment discontinues this setup by requiring mandatory listing of SR. Accordingly, even if the management has SR, these are now subjected to listing and are freely tradable in the stock market. As a result, the prospective acquirer can make any unsolicited takeover bids through stock exchange. The acquirer can directly acquire SR through stock exchange without the consent of the management. Arguably, it can be said that SR will be traded at a substantial premium, which would make it difficult for the acquirer to acquire those shares. However, the battle for corporate control inflames tremendous fervour in companies to get the target at any cost. Large Conglomerates induce enormous passion for corporate control even at a substantial premium, as illustrated in the L&T-Mindtree takeover battle. Hence, the amendment provides a convenient platform for making hostile bids, opening up a window for hostile takeovers in India.
Effect on Corporate Governance
Capital appreciation is the most imperative determinant for institutional investors investing in a company. Since shares with superior voting rights would be traded at a substantial premium in the stock market, the conceivable benefit from capital appreciation attached to such SR will surge. Thereby, the business judgement of institutional investors would motivate them to buy SR. Consequently, the SR in the hands of institutional investors has dual implications on corporate governance, contingent upon whether such investors will exercise voting rights attached to the SR or turn into passive investors, as per their prudence.
In a situation where institutional investors holding SR are not attracted to exercise any control over the company, the mere objective of gaining capital appreciation turns them into passive investors. As affirmed by Marc Goergen and Luc Renneboog,
“[I]nstitutional investors are the most important category of shareholders. However, they tend to follow passive strategies and often do not exercise the votes attached to their shares. The passive stance adopted by institutions increases the already significant power of directors.”
When institutional investors holding SR are tempted to follow a passive stance, the shareholders’ power will diminish at the general meeting as their significant voting rights remain unexercised. Moreover, this will also secure directors’ position (in case the directors also hold considerable voting power) even in the instance of inferior corporate performance, as they can impede monitoring actions by other shareholders to restructure the board. Thereby in this state of affairs, the amendment seems to be a cog in the wheel in the virtuous governance of the company.
Conversely, there may be a scenario where institutional investors, if vested with substantial voting rights through SR will use such rights in a manner that is beneficial to the other shareholders by averting directors from evading their duties. This will reduce Managerial Opportunism and enhance corporate governance in the company. Hence, the amendment significantly impacts corporate governance by providing scope to institutional investors to acquire such SR.
The author is a student at the Institute of Law, Nirma University, Ahmedabad.
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