DVRs Instruments: Regulatory Framework

Recently, on March 20, 2019, SEBI had released a consultation paper on equity shares with Differential Voting Rights (‘DVRs Instruments’) submitted by the a Group for public comments (“Report”).

Based on the recommendations of Primary Market Advisory Committee and the public comments, SEBI vide its press release dated June 27, 2019 approved introduction of a new framework for issuance of DVRs Instruments with superior rights shares (‘SR Shares’) by an unlisted company proposing to list its shares by way of an Initial Public Offering (“IPO”). Issuance of DVRs Instruments with fractional rights shares (‘FR Shares’) is not yet notified under SEBI regulations.

Further, Companies Act, 2013 (‘the Cos Act’) also contains various provisions for issuance of DVRs Instruments. Under the Cos Act, there is no specific restrictions for issuance of DVRs Instruments with SR Shares or FR Shares. Provisions for issuance of DVRs Instruments by unlisted company are not very stringent as there is reduced risk for adversely affecting interests of minority shareholders. However, provisions for issuance by DVRs Instruments for listed company are restrictive and stringent for protecting interests of minority shareholders. So lets understand key regulatory requirement for issuance of DVRs Instruments.

Regulatory Framework for issuance of DVRs Instruments:

The Companies Act 2013 (“the Cos Act 2013”)

Under the Cos Act, 2013, any company proposing to issue DVRs Instruments needs to comply with various conditions as mentioned in Rule 4 of Companies (Share Capital and Debentures) Rules, 2014 (“Rule 4 of Cos Rules”). Some of the key requirements of Rule 4 of Cos Rules is as under:

• Authorisation under Law, Management and Shareholders: Issuance of DVRs instruments needs to be authorized by issuing company’s Articles of Association. Further, the Board of Directors of the issuing company also needs to approve such issuance. Further, approval of shareholders is also required to be obtained by issuing company. Such approval shall be obtained by way of postal ballot in case of listed company and in case of companies other than listed company, can be obtained at a general meeting;
• Restriction of overall ceiling limit for voting power: DVRs Instruments shall not carry voting power higher than 74% of the total voting power, including voting power with DVRs Instruments holders at any point of time;
• Periodic adherence to Compliance: Issuer Company shall keep regular adherence to compliance under the provisions of Companies Act, 2013 such as regular reporting of financial statements and annual return, repayment of deposits along-with interest on or before due dates, redemption of preference shares or debentures on time, discharge of statutory dues on time and no default in any committed rewards to shareholders.
• No penal action has been taken against company by any Court or Tribunal during last three preceding financial year of any offense under the Reserve Bank of India Act, 1934, the Securities and Exchange Board of India Act, 1992, the Securities Contract Regulation Act, 1956, the Foreign Exchange Management act, 1999 or any special Act, under which such companies being regulated by sectoral regulators.

Further, the Cos Act 2013 does not allow issuer company to convert its existing equity shares capital with ordinary voting rights into equity shares with DVRs Instruments and vice-versa. Thus, any issuance of DVRs Instruments shall be fresh issuance whether for capital or as incentive in the form of bonus or rights issue. In addition to above, there is requirement of making detailed disclosures by the board of directors for reporting details of the issue of DVRs Instruments.

 New SEBI framework:

As discussed above, SEBI by notifying new framework for issuance of DVRs Instruments with SR Shares has amended relevant provisions of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“SEBI ICDR Regulations”) and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“SEBI LODR Regulations”) laying down various criteria for a company to issue such DVRs Instruments with SR Shares, which intends to list its equity shares on the stock exchange.

As of now, SEBI has only allowed issuance of DVRs Instruments with SR Shares for companies engaged in providing intensive technology, information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition (“Technology Sector”), to get listed on the stock exchange. Accordingly, any company in sector other than Technology Sector is not allowed to list their equity shares, if DVRs Instruments have been issued by such company.

Accordingly, any private limited company / unlisted public limited company (“Unlisted Company”) engaged in Technology Sector, if proposes to list its ordinary equity shares on the main board of stock exchange(s) (“Eligible Unlisted Issuer Company”), shall comply with New SEBI Framework, in addition to conditions under the Cos Act 2013.

Requirements under New SEBI Framework are divided into 2 parts, viz.

Part I: Prior to filling Red Herring Prospectus for IPO;

Part II: Upon listing of ordinary shares on the stock exchange.

Let us understand each parts of SEBI requirements in detail:

Part I: At the time of issuance of DVRs Instruments with SR Shares, prior to filling Red Herring Prospectus (“RHP”) for IPO:

Prior to filling Red Herring Prospectus for listing ordinary equity shares, at the time of issuance of DVRs Instruments, Eligible Unlisted Issuer Company, shall comply with provisions of Regulation 6 of SEBI ICDR Regulations. Key requirements to be followed for same is as under:

• Authorisation for issuance of DVRs Instruments with SR Shares: The issue of DVRs Instrument to be authorized by a special resolution passed at a general meeting of the shareholders of the issuer, where the notice calling for such general meeting specifically provides for –

1. 1. the size of issue of DVRs Instruments;
   2. ratio of voting rights of DVRs Instruments vis-à-vis the ordinary shares;
   3. rights as to differential dividends, if any;
   4. sunset provisions, which provide for a time frame for the validity of such DVRs Instruments;
   5. matters in respect of which the DVRs Instruments would have the same voting right as that of the ordinary shares.

• Minimum Period of holding: Prior to filling RHP, DVRs Instruments shall have been held for a period of at least 6 months;
• Eligible Holder: DVRs Instruments shall be issued to only promoter/founder of the issuer company who hold executive position in the issuer company. Further, such promoter / founder shall not be part of promoter group whose collective net worth is more than INR 500 crores. While determining the collective net worth, value of investment held by such promoter/ founder in the issuing company shall not be considered;
• Voting Rights: DVRs Instruments shall carry voting rights in the ratio of minimum 2:1 and maximum 10:1 compared to ordinary equity shares and such ratio shall be in whole numbers only;
• Features of DVRs Instruments: Face value of DVRs Instruments shall be same as the ordinary equity shares. Further, only one class of DVRs Instruments are allowed to be issued. Except for the voting rights, there shall be no other variation in the feature of DVRs Instruments and ordinary shares;

Part II: Upon listing of ordinary equity shares on the stock exchange(s):

Upon listing of an ordinary shares on the stock exchange, DVRs Instruments can also be listed on the recognized stock exchange. Key provisions in these regards are as under:

• Promoters Contribution: SEBI Regulations provides for minimum public holding of 25% for a listed company to maintain. The holding of DVRs Instruments by promoters / founder would be considered for the calculation of promoter’s contribution in the proportion of their economic rights. So effectively, controlling power of the public shareholders for their holding would be lower than their economic holding and likewise, controlling power of promoters would be higher than their economic holding in such listed company.
• Listing and Lock-in of DVRs Instrument: Upon listing of DVRs Instruments on the main board, same shall be under lock-in until, 3 years from the date of commencement of commercial production or date of allotment of equity shares under IPO; or date of conversion of DVRs Instruments into ordinary equity shares, whichever occurs later. Further, until conversion into ordinary equity shares, holder of DVRs Instruments is not allowed to transfer or create any pledge on such DVRs Instruments.
• Further Issuance of DVRs Instruments: Further issuance can only be made by way of rights issue, bonus issue or split of shares to existing DVRs Instrument holder. Terms of such additional issue to remain same as original issue. Further, rights issue of DVRs Instruments shall be non-renounceable. Such additional issue of DVRs Instruments shall be under lock-in until the time same are converted into ordinary equity shares.
• Enhanced Corporate Governance: Stricter corporate governance norms to be followed in terms of appointment of independent directors in board / committees as under:
  • Board of Director —————————————-> 50%;
  • Audit Committee —————————————> 100%;
  • Nomination and Remuneration Committee ——-> 66.66%;
  • Stakeholders Relationship committee ————–> 66.66%;
  • Risk Management Committee ———————–> 66.66%

• Coat Tail Provisions: DVRs Instrument holder to be treated as ordinary equity shareholder in terms of rights to vote for following decisions:
  • appointment or removal of independent directors and/or auditor;
  • transfer of control by promoter to another entity;
  • related party transactions, involving a DVRs Instrument holder;
  • voluntary winding up of the company;
  • changes to the Articles of Association or Memorandum of Association, except any change affecting the DVRs Instrument holder;
  • initiation of a voluntary resolution process under the Insolvency Code;
  • utilization of funds for the purposes other than business activities;
  • substantial value transaction based on materiality threshold as specified under these regulations;
  • passing of special resolution in respect of delisting or buy-back of equity shares; and
  • other circumstances or subject matter as may be specified by the Board, from time to time
• Sunset Period: DVRs Instruments shall be compulsorily converted into equity shares with ordinary rights upon occurrence of any of the following events:
  • upon expiry of sunset period of 5 years from the date of listing of ordinary shares;
    • Such sunset period can be extended by another 5 years by passing shareholders resolution. However, holder(s) of DVRs Instruments shall not be eligible to participate in voting for extension of its holding term;
  • Demise of promoter/founder in executive capacity holding DVRs Instruments;
  • Resignation of promoter/founder from executive position in the issuer listed company;
  • Cessation of control by holder of DVRs Instruments upon merger or acquisition;
  • Sale of DVRs Instruments post end of lock-in period but prior to any event happening above

Analysis of regulatory framework:

SEBI by allowing DVRs Instruments with SR Shares has ensured strict conditionalities attached to it not only prior to issuance of same but also post issuance.

1. Although SEBI does not have regulatory authority over Unlisted Company(ies), conditionalities laid down under SEBI ICDR Regulations would still need to be complied with by such an Eligible Unlisted Issuer Company, at the time of issuance of DVRs Instruments with SR Shares, if such company intends to apply for IPO listing.
2. Such Eligible Unlisted Issuer Company will have to adopt IPO route for listing of equity shares and thus, will not be eligible to seek relaxation from applicability of Rule 19(2)(b) of the Securities Contracts (Regulation) Rules, 1956 (“SEBI SCRR”) as mentioned in Circular No. CFD/DIL3/CIR/2017/21 dated March 10,2017 (“SEBI Circular”) as amended from time to time. SEBI Circular provides for listing of Unlisted Companies (if subsidiaries of listed companies) by adopting demerger route through Scheme of Arrangements.
3. The word ‘intensive’ in relation to various categories of companies engaged in Technology Sector is subjective term. There are no tests / parameters prescribed for identifying whether a company is using intensive technology as required.
4. Under the Cos Act 2013, issue of DVRs Instrument shall be authorized by ordinary resolution passed by shareholders. However, if company issuing DVRs Instrument proposes to list its shares via IPO, then, under SEBI ICDR Regulations, special resolution would need to be passed at the time of issuance of DVRs Instruments.
5. There is no clarity on whether collective net-worth of promoter group needs to be continuously maintained below threshold limit of INR 500 Crs, even after issuance of DVRs Instruments. Considering there is minimum holding period of 6 months for DVRs Instruments, prior to filling RHP, there could be events where collective net-worth of DVRs Instruments holder or its Promoter Group might increase beyond INR 500 Crs in the gap period of 6 months. In such scenario, at the time of filling RHPs for IPO, it may cause some practical difficulties in respect of reconciliation of collective net-worth of the promoter group.
6. Under the Cos Act 2013, there is restriction on any company to convert its DVRs instrument into ordinary equity shares and vice-versa. However, SEBI LODR Regulations requires compulsory conversion of DVRs Instruments into ordinary equity shares upon expiry of sunset period or occurrence of various events such as demise, resignation by holder of DVRs Instruments, cessation of controlling right over company upon acquisition or merger of issuer listed company or sale by holder of DVRs Instruments as discussed above. Here, in order to avoid non-compliance with any regulations, various restructuring modes such as buyback of shares, selective capital reduction, may be caried out.
7. By restricting voting rights of DVRs Instruments to 74% of the total voting rights, SEBI has prevented unanimous voting approval by holders of DVRs Instruments that may affect rights of shareholders holding ordinary equity shares.
8. Coat tail provisions ensures that all the shareholders (including holders of DVRs Instruments) would be treated at par based on their economic rights, in relation to certain decisions affecting rights of minority public shareholders. This not only restricts rights of holders of DVRs Instruments but also ensures protection of interest of all the shareholders.
9. By increasing number of Independent Directors in board and committees as mentioned above, SEBI has ensured stricter corporate governance and an independence of business decisions. However, it may sometimes act as hinderance in ease of doing business by causing delay in decision making, which may be time sensitive.
10. Capital Restructuring for an Unlisted Company from regulatory point of view:
    1. Issuance of DVRs Instruments by newly incorporated company:

       As all the conditions laid under Rule 4 of Cos Rules, needs to be complied with prior to issue of DVRs Instruments, a newly incorporated company cannot issue DVRs Instrument. If any company proposes to enter into any arrangements to form a new private joint venture with any prospective investor, such newly formed private joint venture cannot restructure its capital by issuing DVRs Instrument at the time of incorporation.

    2. Issuance of DVRs Instruments to Body(ies) Corporate:

       There are no restrictions on Unlisted Company to issue DVRs Instruments to Body(ies) Corporate if such Unlisted Company is not intending to list its shares via IPO route. Holding of DVRs Instruments shall be authorized by board / management of such Body(ies) Corporate.

    3. Issuance of DVRs Instruments with non-voting rights:

       Section 43 of the Cos Act 2013, provides that a company can issue shares with differential rights as to voting, dividend or otherwise. The term ‘otherwise’ is not defined and can be interpreted to have wider meaning. As per Section 47 of the Cos Act, 2013, every member of the equity shareholder shall have right to vote on every resolution placed before the company. Such right to vote shall be proportionate to their share capital in the company. However, provisions of section 43 and section 47 does not apply to private limited companies, if memorandum of association (“MOA”) and articles of association (“AOA”) of the company specifically provides for same. Accordingly, a possible view could be that if MOA and AOA of the Private Limited Company provides for issuance of non-voting equity shares, same can be issued. However, similar view cannot be adopted for deemed public limited company which are incorporated as private limited companies.

Recent deals of infusion of capital with no voting rights:

• • In the recent past, in the month of March, 2019, Amazon has invested an amount of INR 4,040.26 Crs for 49% stake in Witzig Advisory Services Pvt Ltd (“Witzig”) with a combination of 2 classes of equity shares i.e. 17% stake in Class A equity shares with voting rights and 32% stake in Class B equity shares with no voting rights. Witzig is a joint venture firm controlled by Samara Capital and has acquired ‘More’ chains of super market from the Aditya Birla Group. Essentially such kind of variation in class of equity was followed to adhere to FDI provisions.
  • Further, as on August 2019, Amazon has acquired 49% stake for an amount of INR 1,500 Crs in Future Coupons Limited, a holding company of Future Retail group company, engaged in retail merchandise products. Acquisition has been made through its group entity viz. NV Investments Holdings LLC in the combination of 2 classes of equity shares as to voting and non-voting for an estimated deal value of INR 1,500 Crs. This again is to comply with FDI norms regarding retaining of controlling power with Indian promoter in a business of multi-brand retail business. 

As provisions for DVRs Instruments are more flexible for Unlisted Companies, it performs great aid in providing freedom of conducting day-to-day affairs of operations for such companies alongwith raising capital.  Further, until the time such Companies are listed, DVRs Instruments plays vital role for various transactions restructuring from tax and regulatory perspective as well. The move of SEBI by introducing new framework for issuance of DVRs Instruments with SR Shares is a welcome move. An attempt has been made to ensure balance between interest of promoters/ founders as well as investors. India is buzzing with new start-ups and considering India is resource-rich country, with talent pool of capable people, more and more incentives should be introduced for ease of doing business for Start-ups. Start-ups companies in India have already started filling RHPs for IPO. Alphalogic Techsys Limited is one such company that has listed its equity shares via IPO and is engaged in providing services in relation to technology consulting services. New framework by SEBI is undoubtedly a boost for startups engaged in Technology Sector to list their equity shares and raise funds from public with an insulation to promoters/founders of such startup from facing any hostile takeover at-least for initial 10 years of listing, using DVRs Instruments as reward for such founders/ promoters. It would be interesting to see how companies are coming up with new structures around DVRs Instruments restructuring. 

For detailed discussion on the above subject, please feel free to connect at contact@devadhaantu.in