The argument against differential voting rights is too strong to be dismissed. At a time when corporate practices are on the mend, the issuance of DVRs may just turn the clock back.
The debate on dual class shares (DCS) or shares with differential voting rights (DVR) – in India and globally – is largely centred around new-age technology companies that are currently unlisted, of reasonable size and with a set of external investors (typically, private equity). While these companies grow quickly – at a much faster pace and with greater intensity – the vision of their entrepreneurs remains critical to the on-going success of the venture.
Therefore, DCS (or DVR) supporters see a need to create structures that allow such companies to raise equity, yet keep the entrepreneur in-charge. Detractors of DCS believe that their issuance compromises the overall corporate governance agenda.
Exchanges see their role as facilitators of trading – that is, ensuring scrip prices are market determined, trades properly executed and are fair. Exchanges do not necessarily see themselves as gatekeepers of market standards.
Therefore, most of them are playing the revenue card in this debate, under the guise of increasing the choice of instruments for investments leading to better market development. In July 2018, Singapore Stock Exchange (SGX) announced separate rules for initial public offerings (IPOs) of companies with dual class shares – against the backdrop of losing the listing of Manchester United Plc’s IPO.
Similarly, in November 2018, the Hong Kong Stock Exchange (HKEX) decided to reconsider its stance on DCS IPOs after Alibaba decided to list on the New York Stock Exchange (NYSE). SEBI, too, is afraid that large unlisted companies will be compelled to list elsewhere if Indian exchanges do not allow their listing for having DVRs.
DCS reduces the stewardship incentives of asset managers, leading to a weakening of the corporate governance ecosystem. In an environment where investors find it difficult to assert their rights as it is, issuing shares with fractional voting rights (one share will have less than one vote), or allowing promoters to hold shares with superior voting rights, further weakens investors and favours management entrenchment.
Global investments are steadily moving towards index funds. MorningStar estimates that a little less than $4 trillion moved to passive investing in the US in 2018 and Bloomberg estimates that if the trend of growing passive funds increases, 2019 will see US-passive funds aggregate over 50 percent of total investments.
Being long-term investors with a compulsion to invest in index stocks, these asset managers have an increased responsibility to avoid a corporate governance blowout. Even so, passive fund managers are less inclined to engage with companies; holding shares with fractional voting rights will dampen their enthusiasm to engage even more.
The other concern global investors raise is that the issuance of DCS reduces overall market valuations – since these shares will trade at a discount to ordinary shares. How the market will value the discount attributable to the voting rights is yet to be determined.
The Council of Institutional Investors (whose members manage assets upwards of $40 trillion), and the Asian Corporate Governance Association (whose members manage assets upwards of $30 trillion) have both decried the issuance of DCS.
Market index creators, used by asset managers for benchmarking their performance, are mindful of the voice of institutional investors. In 2017, S&P Dow Jones Indices announced that its S&P Composite 1500 and its components (which includes S&P 500) will no longer allow additions of companies that had DCS – it would, however, grandfather the current inclusions.
FTSE Russell, too, in 2017 announced that it would include only those companies that had at least 5 percent of their voting rights with public shareholders (free float). This restriction would apply to all index inclusions – companies currently included in the main indices will be grandfathered only for a 5-year period (till September 2022).
Companies including Snap Inc, whose public shares have no voting rights, cannot be part of these indices. This stance taken by the global indices will reduce the compulsion of index funds to invest in shares with fractional voting rights.
Indian indices are yet to take a forthright stance on DVRs – although Tata Motors Limited’s DVRs did form part of the NIFTY 50 until recently.
SEBI has been instrumental in pushing regulation towards better corporate governance practices in India. To that extent, even while drafting the consultation paper for issuance of DVRs, SEBI has been careful in differentiating between already-listed companies and companies that are going to be listed. It has created a sunset clause for superior voting rights – which cannot be issued by already listed companies – and created coat-tail provisions that equate all shares when voting on resolutions that materially impact non-controlling shareholders.
Above all, SEBI has enforced its minimum public voting rights of 25 percent for companies issuing DVRs.
In its theoretical construct and intent, SEBI has attempted to facilitate the listing of new-age technology companies – though the issuance of DVRs is not restricted and is applicable to all companies – with safeguards to protect the interest of shareholders.
Yet, we have often seen a vast difference between the intent of regulation and the actual implementation. Listed public sector enterprises (including banks) often violate regulation (example: board composition norms, minimum public shareholding norms) and there are little repercussions for such violations.
Companies too are not far behind in walking the fine path – several of them follow the letter of the law rather than the spirit. In doing so, it is impossible to take legal action for violations and investors are compelled to use their engagement (and influence) to effect change, or else live with compromised corporate governance practices.
Class action suits were supposed to provide a suitable remedy to investor grievance, but the implementation of these provisions has proved difficult – resulting in no class action suit being filed against a listed company almost four years after the regulation was notified. There are several reasons why India ranks 163 of 190 in Enforcement of Contracts in the World Bank’s Doing Business Report 2019.
The strength of the corporate lobby must not be underestimated. Under the garb of ‘ease of doing business’, the corporate lobby has attempted to thwart several measures that improve corporate governance practices. It has managed to get SEBI to delay the implementation of the resolution seeking shareholder approval for royalty payments over 2 percent of revenues. It has also managed to get SEBI to rescind regulation that required companies to disclose and file with stock exchanges any default on bank loans (not just capital market instruments).
Recent media reports suggest that the corporate lobby wants to extend the sunset clause period from the recommended five years to 15-20 years. Let’s leave aside the argument that even the Government of India gets re-elected every five years.
The weak enforcement environment, the strength of the corporate lobby, and the regulation-compelled voting participation of institutional shareholders all argue against the issuance of DVRs. Yet, SEBI will likely allow companies to issue DCS. If it must, it should put a hard stop to the sunset clause at five years, rather than allow roll-overs through a shareholder vote.
SEBI must allow only those companies with a sizeable institutional shareholding (over 26 percent) to issue DVRs: for companies with a sizeable retail shareholding, the voting power is already diffused – issuing DVRs will diffuse the voting power even more.
The overall corporate governance ecosystem in India is improving. Asset managers are accepting their stewardship role and recognising the value of their engagement with investee companies. But with 2/3rd of companies being promoter owned and the average promoter ownership at 49%, the corporate governance levels are still driven by controlling shareholders rather than an institutional mechanism.
In this context, the issuance of DVRs is likely to challenge investors’ ability to effectively influence corporate actions.The author is COO, Institutional Investor Advisory Services. Views expressed are personal.