August 19, 2012

Tough Exit for PE Players

Akil Hirani

Word on the Street in the week of August was that Tata Motors is looking to raise north of $700 million in the form of shares with differential voting rights (DVR). Though several commentators focussed on the dilution that the new issue promises, it is also noteworthy that Tata is marching ahead with DVRs at a time when there remains significant uncertainty about their future in India.

The Companies Act, as originally drafted in 1956, contained a blanket prohibition on shares with differential voting rights and went so far as to prescribe a regime for the termination of such structures. That prohibition was undone in 2000, when the law was amended and new SEBI rules were subsequently promulgated, providing for differential rights as to voting and dividend, subject to certain conditions. The Company Law Board, in 2009, cut down a challenge by shareholder to super-voting rights as a form of oppression, thereby offering judicial blessing for the new regime. A handful of companies, including most notably Tata Motors, went ahead with issuance of DVR shares.

Then came the regulatory flip-flop. In July 2009, SEBI amended the BSE and NSE listing agreements to prohibit the issuance of shares with "superior" voting or dividend rights than those already listed. The regulatory apparatus' quixotic approach to the DVR led to an ostensibly bifurcated regime: unlisted companies can offer shares with voting rights equal, inferior and superior to the one-share, one-vote norm, but listed companies can only offer equal or inferior shares.

But there were-and are-still questions: Can listed companies issue preference shares, which have superior dividend rights? What if a company wants to issue shares with inferior voting rights, but superior dividend rights as compensation? What is the baseline for the superiority comparison? If a listed company has already issued shares with "inferior" rights, could it now only issue shares at that level?

Understandably curious about what the new regulation meant for them, Tata Motors approached SEBI seeking a clarification. The Board responded with its informal guidance earlier this year, whereby it permitted the further issuance of Tata's DVRs. But SEBI's guidance applied only to Tata and market observers have been left to read tea leaves, speculating about whether others could do the same. (The consensus appears to be no, leaving many of the questions above without clear answers.)

The questions, however, do not end there. The language in Section 86 of the Companies Act, which expressly provides for differential voting and dividend rights, has been changed in the Companies Bill, 2009, now before the Lok Sabha. The bill speaks only of a company's ability to issue "equity share capital." Moreover, Section 41 of the bill provides that every shareholder's voting rights "shall be in proportion to his share in the paid-up equity share capital of the company." Similar language exists in Section 87 of the Companies Act, but an attempt to achieve a harmonious reading of both Section 86 and 87 leads to the conclusion that DVRs are permitted under the current regime. But can the same be said about the new bill? The answer, at best, remains uncertain.

All this suggests two problems. First, as is hopefully apparent, India suffers from an unnecessarily complex regulatory apparatus concerning DVRs. It takes three levels of an analysis-the Companies Act, SEBI regulation and the listing agreement-to get to an answer on whether a company can issue such shares. After all that, one is still left with some uncertainty.

Second, it is far from clear that such heavy regulation is necessary. There has been a decades-long debate in the business and legal community concerning the benefits and drawbacks of differential voting. Opponents of share structures, for example, argue that it entrenches the interests of management and founding families and thus flies in the face of shareholder democracy and sound corporate governance. This argument has particular resonance in the Indian market, given the prominent role of promoters.

These concerns, however, are not exclusive to India. William Ripley, a controversial political economist at Harvard, argued in 1927 that non-voting stock was the "crowning infamy" of a series of measures intended to disenfranchise the public. The argument then ran as it does now: Issuing voting stock to promoters and other insiders and non-voting stock to the public enabled promoters to raise considerable capital without giving up control. Ripley’s arguments did not fall on deaf ears. The NYSE began restricting the issuance of non-voting stock in 1926 and ultimately announced a full ban in 1940.

After hundreds of differential voting or so-called dual-class issues in the early decades of the 20th century, DVR issues were largely held in abeyance until the 1980s, when they remerged-with regulatory sanction-primarily as a tool to prevent hostile takeovers. They were also used elsewhere to circumvent curbs on foreign investment, further confirming the wider utility such structures may have, depending on a company's unique circumstances. Most recently, however, such structures have been defended precisely on the grounds that they are usually attacked: that they ensure management (or promoter) control of a company.

Take Google as an example. The company boasts of a dual-class stock structure, whereby B shares have 10 times the voting power of A shares. The company's two founders and CEO own some 90% of the B shares and, together with other executives and directors, control roughly 60% of votes. Google defended the structure on the basis that it insulated management from the quarter-to-quarter financial expectations, instead allowing them to focus on long-term growth. Crucially though, it frankly acknowledged the reality of management control. "The main effect of this structure is likely to leave our team ... with increasingly significant control over the company's decisions and fate," the founders said in a letter at the time of their IPO in 2004. "New investors will fully share in Google's long-term economic future but will have little ability to influence its strategic decisions through their voting rights."

Unsurprisingly, Google's structure has drawn fierce criticism from corporate governance watchers who underscore its pointed rejection of shareholder democracy. To be fair to Google, however, it is difficult to deny that shareholders went into that particular investment with their eyes wide open.

Perhaps more importantly, however, there is some evidence that demonstrates that such dual-class structures will be unified when the circumstances warrant. A 2005 European Central Bank working paper, for example, concluded that dual-class shares are temporary structures maintainable only until the point when a company needs new equity capital for further growth. Thus, unification will likely be an option for firms that are more equity capital dependent or seek to boost share value.

The unification last month of Canadian auto parts manufacturer, Magna International's dual-class share structure provides a telling example. Public shareholders were fed-up of living with the steep discount at which their shares traded, compared with super-voting shares. Frank Stronach, the company's legendary founder, was willing to give up his super-voting shares, but only for a $990 million premium. Some 75% of shareholders accepted the deal, notwithstanding the vocal objections of large institutional investors, and today the company's market capitalization has grown in excess of the premium paid.

The United States, the European Union and others with sophisticated capital markets have each looked at the question of differential voting. Some even banned it earlier this century, before reversing course. Each, however, has recognized that investors can always vote with their feet and that individual investors may be willing to be disenfranchised as long as their stock performs well. When circumstances change, the evidence suggests that shareholders sought unification and that promoters have accepted it, all without the need for heavy regulation.

It may be, of course, that the Indian market does require a different regulatory prescription, but this is far from apparent. As the country takes additional steps to reform its capital markets by drawing from the experiences of other markets, as the Takeover Regulations Advisory Committee recently did, it would be worthwhile to ask whether DVRs framework need another look. The current regulatory frame is a triumph of regulatory complexity-and it may all be unnecessary to boot.

(Views of the Authors are personal and do not reflect the views of the firm)

latest News

  • Prohibit MPs and MLAs from practicing as lawyers: BJP leader to BCI

    In a letter to the Chief Justice of India (CJI), Dipak Misra, Supreme Court Judges, Justice Kurian Joseph and Justice M B Lokur have expressed their s...

    Read More
  • Venkaiah Naidu defeats Gopalkrishna Gandhi to become the 13th Vice President of India

    Vice-Presidential election on Saturday was comfortably won by NDA nominee and former Union Minister Venkaiah Naidu, who was elected as the 13th Vice P...

    Read More
  • Qatar signs $8bn Typhoon fighter jet deal with the UK

    On December 11, Qatar signed a multi-billion-dollar deal to buy 24 Typhoon fighters from Britain, its second major defence agreement during the worst ...

    Read More