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Ashwini Panwar (Mr) and Priyanshi Aggarwal (Ms)

equity inequality – freepik
Reference Date |  Version February 01, 2024| 1.0
Keywords Differential rights, voting rights, equity shares, share capital, listed companies
Legislation(s)
  • The Companies Act, 2013;
  • Companies (Share Capital and Debentures) Rules, 2014;
  • Securities and Exchange Board of India – Framework for issuance of Differential Voting Rights (DVR) Shares
Jurisdiction India

Introduction

The rights of shareholders are determined based on the instruments they hold against capital (whether in the form of share capital, debt, or hybrid) invested. The Companies Act, 2013 (‘Companies Act’) allows a private company limited by shares to have varied kinds of share capital – not just equity share capital and preference share share capital. Such flexibility allows private companies to structure their share capital so that relevant persons (whether founders or appropriate authorities in the case of public-private participation projects) can exercise management control concerning critical matters, even while their ownership level dips.

However, public unlisted companies and publicly listed companies may have only two kinds of share capital – namely, equity share capital and preference share capital. Within the category of equity share capital, such equity shares may have voting rights or differential rights as to dividend, voting or otherwise by prescribed rules.

The flexibility available to private limited companies concerning the kinds of share capital they may have is attractive. Such flexibility must be evaluated based on the legal landscape, which would become applicable should the company change its status to a public or a listed public company, and attendant tax implications.

This article compares the regulatory framework concerning the issuance of equity shares with differential rights in the case of a public unlisted company, public listed company, and private company to present the legal landscape in this domain.

Private Company Limited by Shares

  • A private company limited by shares may state in its memorandum or articles of association that the requirement of having only two kinds of share capital shall not apply to it. Such a provision enables the private company to have flexibility about the kinds of share capital, such as a ‘golden share’ with veto rights regarding certain critical matters.
  • If a private company limited by shares elects to abide by the requirement of having only two kinds of share capital, then it would be required to follow the provisions under Section 43 of the Companies Act read with the Companies (Share Capital and Debenture) Rules, 2014 if it wishes to issue equity shares with differential rights as to dividend, voting or otherwise. Accordingly,
    • The Articles of Association of the company must authorise the issuance of such equity shares with differential rights as to dividend, voting or otherwise.
    • In this regard, an ordinary resolution must be passed at the shareholder’s general meeting.
    • The voting power in respect of shares (i.e., preference and equity) with differential rights of the company should not exceed seventy-four per cent of the total voting power, including voting power in respect of equity shares with differential rights issued at any time.
    • The company should not have defaulted in filing financial statements and annual returns for three financial years immediately preceding the financial year in which it decides to issue such shares.

“financial statement” in relation to a company includes—

(i) a balance sheet as at the end of the financial year;

(ii) a profit and loss account, or in the case of a company carrying on any activity not for profit, an income and expenditure account for the financial year;

(iii) cash flow statement for the financial year;

(iv) a statement of changes in equity, if applicable; and

(v) any explanatory note annexed to, or forming part of, any document referred to in sub-clause (i) to sub-clause (iv)

Provided that the financial statement, with respect to one person company, small company, dormant company and private company (if such private company is a start-up), may  not include the cash flow statement;

  • The company should have no subsisting default in payment of a declared dividend to its shareholders or repayment of its matured deposits or redemption of its preference shares or debentures that have become due for redemption or payment of interest on such deposits or debentures or payment of dividends.
  • The company should not have defaulted in the payment of dividends in respect of preference shares or repayment of any term loan from a public financial institution or State level financial institution or scheduled bank that has become repayable or interest payable or dues concerning statutory payments relating to its employees to any authority or default in crediting the amount in Investor Education and Protection Fund to the Central Government.

However, upon expiry of 5 years from the end of the financial year in which default was made good, the company may issue shares with differential rights as to dividend, voting or otherwise.

  • The company should not have been penalised during the last three years for any offence under the Reserve Bank of India Act, 1934, the Securities and Exchange Board of India Act, 1992, the Securities Contracts Regulation Act, 1956, the Foreign Exchange Management Act, 1999 or any other special Act, under which such companies being regulated by sectoral regulators (i.e., regulators such as the Airport Economic Regulation Authority, Petrol and Natural Gas Regulatory Board, etc.).
  • The explanatory statement to be annexed to the notice for the general meeting should include particulars, which include particulars such as the total number of shares, details of differential rights, reasons for issue, basis for arriving at the price, change in control (if any), etc.
  • Conversion of existing equity share capital into equity share capital with differential voting rights and vice versa is not permissible. However, rights regarding shares of any particular class may be varied in the manner prescribed under Section 48 of the Companies Act and rules thereunder.
  • The Board report should disclose details of such issuance, such as the total number of shares, details of differential rights, price, change in control (if any), etc.
  • It is important to note that holders of equity shares with differential rights would enjoy all other rights, such as bonus shares, rights shares, etc., which the holders of equity shares are entitled to, subject to the differential rights with which such shares have been issued. Such differential rights may be superior or inferior to the rights of the holders of equity shares.

Public Unlisted Company

  • A public unlisted company may have a share capital of only two kinds: equity and preference share capital. If such a company wishes to issue equity share capital with differential rights, it would be required to follow the provisions under Section 43 of the Companies Act, read with the Companies (Share Capital and Debenture) Rules, 2014.
  • The process and provisions applicable for issuing equity share capital with differential rights are the same as those relevant to a private company that elects to abide by the requirement of having only two kinds of share capital.

Public Listed Company

  • A publicly listed company in the specified sector may have a share capital of only two kinds: equity and preference share capital. The specified sector presently is tech companies that are intensive in using technology, information technology, intellectual property, data analytics, biotechnology, or nanotechnology to provide products, services, or business platforms with substantial value addition.
  • If such a company wishes to issue equity share capital with differential rights, then it would be required to follow regulation framed in this regard by the Securities and Exchange Board of India and to the extent not inconsistent with the foregoing provisions, Section 43 of the Companies Act read with the Companies (Share Capital and Debenture) Rules, 2014 as well.
  • A public listed company may issue equity shares with differential rights, provided such differential rights are superior voting rights compared to all other equity shares issued by such company (‘SR equity shares’).
  • The superior voting rights are required to be in the ratio of at least 2:1 and up to a maximum of 10:1 but will be treated as ordinary equity shares (i.e., one share, one vote) in respect of the following circumstances:

i. appointment or removal of independent directors and/or auditor;

ii. where a promoter is willingly transferring control to another entity;

iii. related party transactions in terms of these regulations involving an SR shareholder;

iv. voluntary winding up of the listed entity;

v. changes to the Articles of Association or Memorandum of Association of the listed entity, except any change affecting the SR equity share;

vi. initiation of a voluntary resolution process under the Insolvency Code;

vii. utilization of funds for purposes other than business;

viii. substantial value transaction based on materiality threshold as specified under these regulations;

ix. passing of special resolution in respect of delisting or buy-back of shares; and

x. other circumstances or subject matter as may be specified by the Board from time to time.

  • The SR equity shares can only be issued to promoters/ founders holding an executive position in the company. The SR equity shares have to be issued before filing the draft red herring prospectus and held for at least three months before the filing.
  • There can only be one class of SR equity shares. The face value of these SR equity shares shall be the same as that of ordinary shares. A special resolution at a general meeting of the shareholders must authorise the issuance of SR equity shares.
  • SR equity shares are required to be converted into ordinary shares with the same voting rights on the fifth anniversary of the listing of ordinary shares of a listed entity. SR equity shares may be valid for up to five additional years by passing a resolution to that effect. SR shareholders are not permitted to vote for such a resolution.

The holders of SR equity shares may convert their SR equity shares into ordinary equity shares at any time before the five-year or extended period, as the case may be.

  • SR equity shares are also listed on Stock Exchanges after the issuer company makes a public issue. However, SR equity shares shall be under lock-in after the IPO until their conversion to ordinary shares. In case of early conversion of SR equity shares to ordinary shares, the shares shall continue to be under lock-in for three years after listing for SR equity shares considered for Minimum Promoter Contribution (twenty percent shareholding post-issue) and one year for SR equity shares in excess of Minimum promoter contribution.
  • Transfer of SR equity shares among promoters is not permitted. No pledge/ lien shall be allowed on SR equity shares.

Takeaways

  • If a private company limited by shares wishes to issue equity shares with differential rights, it would be advisable to incorporate a provision in the memorandum or articles of association to state that the requirement of having only two kinds of share capital shall not apply to i Without such a provision, issuing equity shares with differential rights would require compliance with the Companies (Share Capital and Debenture) Rules, 2014, as mentioned above.
  • Equity shares with differential rights would work well in situations where;
    • The investor’s interest is limited to only pecuniary interest – in such cases, equity shares with inferior or no voting rights may be preferred.
    • Promoter requires superior voting rights to retain control in relation to decision-making – this becomes more relevant in the case of asset-light companies.
    • Public interest is involved, and the public authority wants to retain decision-making control regarding certain matters.
  • Even though it would appear attractive to issue equity shares with differential rights, evaluating the need for such instruments would be advisable, considering the company’s specific requirements and the tax implications thereof.
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Ashwini Panwar (Mr) and Priyanshi Aggarwal (Ms)

Associate at Alaya Legal
Associate at Alaya Legal

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