Differential Voting Rights may after all reinforce an old evil

The likely outcome of the new differential voting rights framework is going to be a situation where some startups may choose not to use the DVR provisions to attract big capital while those that do seek to use these provisions are unable to attract big capital.

Restrictive policies in the pre-liberalisation era of the early 80s made hostile takeovers virtually impossible. In comparison, the hostile takeover of Mindtree by L&T Infotech was a walk in the park. It has been common for promoters in India to run companies with a single-digit shareholding.

Typically, government institutions like LIC and GIC who held a majority shareholding in these companies were passive spectators and voted along with management. Azim Premji enjoys tremendous respect for many reasons and one of them being that he has been a lone exception to this anomaly. He ran Wipro because he held a majority stake in the company.

Sometime in the early 80s, Indian promoter groups were in for a rude shock. Swaraj Paul of the Caparo Group made a bid to take over control of DCM and Escorts by using a then-recent guideline by the RBI that allowed NRIs to make portfolio investments in Indian companies whose shares were traded on stock exchanges.

A bitter no-holds-barred battle was fought where both parties lobbied the institutional shareholders, the Finance Ministry as well as the PMO. Paul repeatedly made the point that these industrialists were minority shareholders who wanted to run public-funded enterprises like their private estates. Finally, Swaraj Paul had to back off but this was an indication of things to come.

One of the running jokes was that the Birlas held more shares in Tata companies than the Tatas themselves. Quickly, groups like the Tatas began shoring up their shareholdings in their companies through various mechanisms including cross-holding within the group companies. The Tatas introduced a controversial plan where group companies had to pay heavy brand royalty to their holding company, Tata Sons, for use of the ‘Tata’ name.

These royalty payouts were partly used to acquire shares in the same companies that had to pay royalty! Imagine the Tatas holding a minority share forcing the majority shareholders in these group companies to pay a royalty to the holding company! It was a backdoor transfer of wealth from the majority shareholders to the minority promoter shareholders. Even Tata employees found it ludicrous and blatant.

The differential voting rights framework goes against this principle. Promoters with minority shareholding can continue to run companies with little or no accountability because of the disproportionate voting rights of their shares. It formalises the evil of yesteryears where promoters ran companies with very little shareholding. Founders get to legitimately own a disproportionate share of ownership by the virtue of starting up and subsequent investors need to pay an increasingly higher premium for similar ownership. This is sufficient to assure voting rights disproportionate to financial contribution.

One can, of course, argue that as long as the startup is private, an additional layer of disproportionate voting rights is not necessarily such a bad thing since the investors are well informed and financially sophisticated. To an extent, this argument is correct but this has the potential to slow down FDI. After all, who would want to put in a billion dollars into a startup with no say in running it? The likely outcome then is going to be a situation where some startups may choose not to use DVR provisions to attract big capital while those that do seek to use these provisions are unlikely to attract big capital.

I think we can live with the implications of a DVR framework pre-IPO but I strongly believe that as soon as a private company lists, all shares must become pari-passu and there should not be a sunset period of five years. No management must be given a free hand over public money even for a day.

The mechanisms that SEBI is instituting to prevent the management from running riot during this period like having additional independent directors, etc., is insufficient. We have seen multiple cases of serious fraud being committed even in companies with reputed independent directors. Why create a fundamentally unsound and vulnerable structure that serves no purpose in the first place and then put together some weak and unreliable safeguards?

In summary, a DVR framework is not such a great idea. However, it does not create much damage as long as it fulfils two conditions.

  1. This framework applies to new startups that are incorporated after 01 July when this framework becomes effective.
  2. All shares being pari-passu immediately after an IPO.

Allowing DVRs to continue for five years into an IPO is totally unacceptable and is a throwback to the old days when promoters treated public funds as their private estate with impunity.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)

(Edited by Saheli Sen Gupta)


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