CROSS JURISDICTIONAL STUDY BETWEEN INDIA AND JAPAN ON DUAL CLASS SHARES
– Nishtha Goyal
The debate on dual class shares is about a century old with equally convincing arguments on both sides. Through this paper the author aims to study and critically analyze dual class structures in specifically two countries, India and Japan. Japan has been chosen because it has the third largest stock exchange in the world and can be used to draw useful lessons and implications for India. The paper begins by introducing the concept and giving its historical development. Then the paper summarizes the debate on these shares. The paper then throws some light on the jurisprudential development in both the countries. Towards the end, the author analyses the current framework of both the countries and the reasons for the same and finally concludes the paper.
WHAT ARE DUAL CLASS SHARES?
When a single company issues various kinds of shares they are called a dual class shares (hereinafter referred to as DCS). Shares can differ on the basis of voting rights and dividends. Generally, the rule, one share is equal to one vote, is followed globally. However, in case of DCS one share might be equal to no vote, a fractional vote or multiple votes. Essentially, the voting rights are not proportionate to the economic interest one has in a company. The weighted voting shares are given to the founders and limited or no voting rights shares are opened to the general public .
HISTORY AND CURRENT FRAMEWORK
DCS are not new and first came into existence in the later half of the nineteenth century. They have a much concrete and longer history in the West vis-a-vis the Asia Pacific Region. However this is rapidly changing. Many countries are increasingly allowing for DCS structures in their laws to lure listings from companies in innovative sectors and high technology. For instance Hong Kong was forced to reconsider its stance on DCS after it lost, what would have been one of its largest technologies IPO, the Alibaba IPO to the New York Stock Exchange in 2014. This increase also parallels the wave of high profile IPOs of technology companies like Google, Facebook, LinkedIn, Snap Inc etc.
ARGUMENTS FOR AND AGAINST DCS STRUCTURES
The debate on DCS has been going on for almost a century now. It make to the headlines time and again. For example Snap Inc, gave no voting rights to investors in its IPO valued at $3.4 billion in 2017. In the following year, Spotify did away with an IPO all together and after its share listing allowed its owners to retain control. Interestingly, Mark Zuckerberg has 60 % of voting rights in Facebook while having less than 1% of its stock.
Protects the Founders– The holders of super voting rights and the founders of the company are protected from the uncertainties of the market. This allows them to be in control of the operations and function to materialize their vision for the company. In the long run, they are able to bring benefits to all the shareholders and their worries about the hostile takeovers can be put to bed. Many companies would simply rule out the option to go public if they cannot retain the control in their company. Hence, DCS facilitates ease and flexibility in raising funds.
Lower Price– The small investors which do not aim to participate in the management of the company can benefit since such shares are generally offered at a lower price or with higher dividends. The investor has the option to chose shares which closely align with his purpose of investment.
Protects the Founders and Managerial Entrenchment-The absolute power given to the founders renders the rest of the shareholders powerless. The management becomes so entrenched in the company that even if it is mismanages the company, nothing can be done about it. Moreover, the founders have proportionally a lesser economic interest and their bad decisions are likely to affect them less. The founders would be inclined to pursue value maximizing actions for their private benefit since there is a disjunction between the economic interest and voting power. There is also difficulty in establishing accountability.
Strategic Investors– They are investors who buy shares in a company for strategic reasons like control. They act as an overseeing external force and can step in and take over the management in times of crisis. Companies with DCS structures are highly unattractive to such investors and this deprives the shareholders of support and a fallback option.
Destroys shareholder democracy– The legal outcome or consequence of shareholder primacy is “one share-one vote”. It is a foundational principle of corporate governance. The reason for this is that as residual claimants the shareholders have the established and undoubted interest in maximizing the company’s value and should hence have equal voting rights.
DEVELOPMENT OF DCS IN JAPAN AND INDIA
The Commercial Code of Japan which was previously effective provided for various classes of shares to be listed. However, all listings in the market have been for common shares only. In 2004, Inpex Corporation, a privatized oil company became the only exception when it issued shares with the veto rights (also called the golden shares).
The Companies Law of Japan which replaced the Commercial Code of Japan in 2005 introduced some fundamental changes w.r.t different classes of shares. According to Article 108 of the act a company can issue more than one type of share under its articles of association and is called a “shurui kabushiki hakkou kaishi…”
In response to the act, the Comprehensive Improvement Programme for Listing System 2007 was published by the Advisory Group on Improvements to Tokyo Stock Exchange (hereinafter referred to as TSE) and was adopted in 2008. The new Listing System Improvement FY 2008 eased the regulations; however existing companies were prevented from issuing a DCS. It defines ‘shares classified with respect to voting rights’ as shares with no, higher or lower voting rights vis a vis other shares. The TSE has the discretion to allow DCS deciding on a case to case basis taking into consideration the interests of the existing shareholders.
In 2014, Cyberdone became the first company with a DCS structure to be listed on the TSE. The CEO and the president of the company, Yoshiyuki Sakai, and two other foundations for which he acts as a representative director, held the class B shares which gave 10 times as many voting rights.
In the same year, TSE again examined its rules in the backdrop of Cyberdone’s listing. The two important highlights of the amendments are
1. Necessity and Appropriateness- DCS should be necessary when looked at from the perspective of the shareholders and the structure used should be appropriate to achieve this necessary purpose.
2. Sunset Clause- After a certain period of time if the necessity ceases to exist, DCS will convert into common shares.
DCS have been in India for two decades now and are commonly referred to as differential voting rights (hereinafter referred to as ‘DVRs’). It was introduced through an amendment to Section 86 of the Companies Act, 1956. Subsequently, most companies started issuing shares with inferior or limited voting rights. For example Tata Motors gave 1/10 voting rights per share and a 5% extra dividend.
In 2009, the Securities Exchange Board of India (hereinafter referred to as ‘SEBI’) issued a circular prohibiting the issue of superior voting rights or weighted stock. However it said nothing in relation to inferior voting rights. Companies continued to issue shares with inferior voting rights and no dividends.
In 2013, the currently applicable Companies Act, 2013 was introduced. Section 43(a)(ii) which is pari materia with Section 86 of the 1956 act after amendment dealt with DVRs.
In 2014, SEBI issued the SEBI (Issue and Listing of Debt Securities Regulations)(Amendment), 2014. Rule 4 of the regulation gave certain additional requirements like authorization under articles of association, 3 years of profitability etc to issue DVRs.
In March 2019, a consultation paper on ‘Issuance of shares with Differential Voting Rights’ was released by SEBI. The paper recognized the importance of DVR’s in the backdrop of the growing economy and startups in India. The paper said that businesses are looking to expand and DVR’s facilitates this process without the perpetual fear of loss of control and ownership. The paper also looked at other countries like USA where the stock exchanges have strived to ensure maximum flexibility of the entrepreneurs. The paper further threw lights on the various advantages like lower price, stability in the control and management, flexibly to the entrepreneurs and disadvantages like lack of knowledge amongst general public, no recourse to minority shareholders, aversion to strategic investors etc.
The Primary Market Advisory Committee of SEBI and market participants were called to comment and give their feedback on this paper.
Finally, in June, 2019 a resolution passed at a SEBI board meeting which accepted and rejected some of these suggestions. This resolution can summarize the current Indian position.
1. Only tech companies can issue shares with superior voting rights in their IPO’s. Such shares can be issued to the promoters only.
2. The ownership of such shares cannot be transferred and there will be a perpetual lock in period till they are converted to the ordinary shares.
3. Total voting rights of holders of DVRs including their regular equity shares should not exceed 74% voting rights.
4. To enhance corporate governance, half of the Board of Directors will be Independent and two-thirds members of all the committees should be independent. Also, the audit committee be independent.
5. Coat Tail Provisions- In respect of certain decisions it does not matter if you have superior voting rights, you will be treated and be allowed to vote at par with the equity shareholders i.e. 1 share, 1 vote. Example- appointing directors, changing control, changing object clause, voluntary winding up.
6. Sunset Clause-
Time Based Circumstances- After 5 years such shares will get converted into common shares. This period can be extended only once through a special resolution.
Event Based Circumstances- If promoter dies, resigns or merger or acquisition happens, whereby there is a change in the control of the company such shares will be converted into common shares.
In August 2019, SEBI issued Companies (Share Capital and Debenture) Amendment Rules, 2019 which among other things removed the 3 year profitability requirement.
Similarities and differences between the two systems
BACKDROP OF HOSTILE TAKEOVERS
The backdrop of allowing DCS in both the countries can somewhat be attributed to the hostile takeovers. Japan has seen a series of hostile takeovers and in India L&T’s hostile takeover of Mindtree got both the countries focusing and rethinking about the questions of control.
LACK OF DEMAND
Japan has only seen one DCS issue. In India, there have been 4 such issues however, all of them have been made before the new guidelines were released. In both the markets there is either a lack of demand or knowledge about DCS shares. Till now they haven’t properly unutilized.
INTERESTS OF SHAREHOLDER AND THE COMPANY
Japan has given a lot of primacy and consideration to the rights of the existing and the future shareholders in the 2008 rules and even in the 2014 amendments. The introduction of ‘necessary for shareholders’ and ‘appropriate’ thresholds centre the entire discussion around the welfare and benefit of shareholders. In India while there are many safeguards to ensure the welfare of shareholders there is also considerable flexibility and encouragement for the companies. The recent removal of the 3 year profitability requirement substantiates that.
DISCRETION TO REGULATORS
Japan gives a lot of discretion to the TCS on whether to permit a company to issue DCS shares or not. Again the introduction of the 2014 amendments give a lot of flexibility to the TCS as the terms ‘necessary’ and ‘appropriate’ are highly subjective. However in India there is not as much discretion to SEBI. There are detailed objective rules to issue DCS shares.
Why are these systems what they are today?
India is a developing economy and is in its growth phase. It has to ensure that it does not lose out on important IPOs to the other stock exchanges. 2017 and 2018 have been blockbuster years for India with regards to startup IPOs . India needs to provide a conducive environment to its tech startups to raise funds from the market without worrying about one of their biggest fears, loss of control to capitalize upon this opportunity. It is more focused towards the needs of these companies. Most of these companies are driven by the knowledge and expertise of the promoters. It would strengthen the position of Indian companies and promoters who have been identified by worldwide investors for acquisition to gain access to cutting edge technology and innovation. DCS structures have also led to the increased compliances and restrictions for the company to protect the interests of the shareholders. For example independent directors for increased transparency, the lock in period, coat tail provisions. However it is still a more balanced approach. Japan on the other hand is the world’s second largest developed economy and can focus a little less on the needs of companies and their growth potential. Hence it takes a cautionary and restricted approach. It is not willing to compromise on the welfare and benefit of the shareholders. This also explains Japan’s high discretion and control bestowed to the TCS.
The debate on DCS structures is still ongoing with no conclusive evidence to support either side. Arguments in favor of DCS are the ones which can also be used to criticize it. India and Japan, both are Asia Pacific countries which have newly introduced to DCS as compared to the Western economies. DCS structures and laws in both the countries are still developing even though the systems have been in place for quite some time. India being a developing country in its growth phase is open to the demands of its entrepreneurs and hence allows them to issue DCS shares as a safe option to raise more funds and retain control. Japan being a developed country, looks out for its shareholders and gives primacy to their interests and welfare.
The impact of these rules and regulations is yet to be seen. Any conclusions or implications for India vis-a-vis Japan would be a premature. Moreover, India has its unique set of problems like poor investment rights, lack of class the concrete studies and evidence.