Chytanya S Agarwal*
Using a Law and Economics approach, this essay argues that the regulatory framework of Differential Voting Rights (DVRs) in India is not Kaldor-Hicks efficient. Despite the potential benefits of DVRs, the current regulations considerably restrict the adoption of DVRs by companies. At the same time, they overlook similar non-share-based structures, leading to increased agency costs. To rectify this two-sided inefficiency, the author suggests a balanced solution: easing the regulations for share-based DVRs while expanding their scope to cover non-share-based arrangements.
Introduction
In corporate governance, the default rule is of ‘one share, one vote,’ that is, shareholders are apportioned voting rights proportionate to their share ownership (Kraakman et al., pp.79-80). While this proportionality between cash flow and voting rights aligns the firm’s management with economic performance, it can have its own costs. These costs come from a trade-off between short-term opportunism and long-term planning for the company (Kraakman et al., p.81). To mitigate such costs, a deviation from this norm comes in the form of shares carrying differential voting rights (‘DVRs’), called ‘dual-class shares’ in foreign jurisdictions. Put simply, DVR shares give disproportionate voting rights to the shareholders vis-à-vis other shareholders.
In this essay, using a Law and Economics approach, I argue that the regulatory framework of DVR shares in India is not Kaldor-Hicks efficient. I develop this argument in the following steps. Firstly, I outline the existing regulatory provisions that restrict the issuance of DVR shares in India. Secondly, I explain the agency costs and payoffs associated with DVRs. Thirdly, I show how the regulatory framework hinders Kaldor-Hicks efficiency. This inefficiency is two-sided: it increases both Type I and Type II errors, leading to higher agency costs and lower benefits from DVRs. Lastly, I acknowledge the limitations of my analysis and conclude that, as a policy, the regulatory framework governing DVRs should be relaxed, though their scope must be widened to cover non-share-based DVR arrangements.
I. The Current Regulatory Framework of DVRs in India
As per the Statement of Objects and Reasons of the Companies Act, it is enacted to ‘facilitate’ the raising of share capital by companies through the “issue of equity shares with [DVRs].” The default rule of ‘one share, one vote,’ embodied in Section 47 of the Companies Act, is subject to Section 43. Per Section 43(a)(ii), incorporated companies limited by shares are permitted to issue DVRs for raising share capital. Such issuance is governed by the Companies (Share Capital and Debentures) Rules, 2014, Rule 4 of which provides a long list of conditions to be fulfilled for such issuance of DVR shares to be valid. As of now, the regulatory framework restricts the issuance of DVRs in India in at least three ways.
Firstly, regulations are unclear on whether DVR shares can be issued through an Initial Public Offering (‘IPO’). Illustratively, the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, (‘ICDR Regulations’) lacks a provision allowing a company to issue DVR shares during its IPO. Similarly, the Securities Contracts (Regulation) Rules, 1957 (‘SCRR’), which provides for thresholds for the minimum offer and allotment of each class of shares to the public, is silent on the IPO of DVRs. Rather, per SEBI, the SCRR makes DVRs difficult to issue. This is because, under Rule 19, a corporation must list all classes of its shares. It leaves unclear if the company can list any one class of shares and leave the other class of shares unlisted and offered preferentially to the management. This limits the discretion of companies to preferentially allot DVR shares.
Secondly, the regulatory framework prohibits the issuance of superior rights (‘SR’) shares. Normally, DVR shares give disproportionate voting rights to the shareholders in the form of either SR or inferior/fractional rights (‘FR’). Only FR shares are permitted by SEBI. Per Regulation 41(3) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR’), no listed entity shall issue SR shares in any manner. However, an exception has been made in favour of technology-intensive companies, and preferential issuance of SR shares for founders. Only in special economic zones (called International Financial Services Centres or ‘IFSCs’), SR shares are permitted. Under Regulation 12 of the IFSC Authority (Issuance and Listing of Securities) Regulations, 2021, IPO of SR equity shares is permitted in IFSCs provided it has been authorised by a special resolution, and if the SR equity shares shall have the same face value as the ordinary shares. However, this is only an exception and not the norm.
Lastly, corporate jurisprudence largely supports a textualist view and this holds true for DVRs. This line of argumentation is visible in three Indian cases that dealt with DVRs – Anand Jaiswal v. Jagatjit Industries, AK Doshi v. SEBI, and Zycus Infotech v. CIT – which dealt with the validity of the issuance of DVRs under Section 86 of the Companies (Amendment) Act, 2000. In their reasoning, the concerned Tribunals and Company law Boards upheld the issuance of DVRs primarily only because it had an explicit mention in the Act. Conversely, in the absence of any explicit permission in the statute, DVRs wouldn’t have been permitted. Consequently, it is arguable that the IPO of DVRs is not legally permissible unless expressly permitted by an authoritative source. As of now, by virtue of the restrictive regulation, DVRs are not offered to the public and are only held as unlisted and untradeable assets in India.
II. The Costs and Payoffs of DVRs
Periodically raising equity through IPOs reduces the overall control of the firm’s founders/promoters. The main purpose of DVRs is to prevent such dilution. Such insulation is justified on the grounds of enabling the founders to pursue their idiosyncratic business ideas, preventing short-term profiteering, and entrenching the long-term interests of the company. This is based on the concept of principal costs, namely, that shareholders may inefficiently exercise their voting rights due to rational apathy, lack of information, and profit-seeking. This provides protection to the company’s managers and minority shareholders from uninformed shareholder decisions. Per Rydqvist, DVRs lead to one kind of cost (viz., agency costs) and two kinds of benefits (viz., surplus protection and surplus extraction).
While ‘one share, one vote’ aligns the interests of the management with the interests of the shareholders. This gets diluted to some extent in companies with DVRs where the shareholders’ control over the management is reduced. This leads to agency costs which are captured in the increased cost incurred by a shareholder to obtain a certain quantum of voting rights in companies with DVRs vis-à-vis companies with proportional voting (Rydqvist, pp.49-50). At the same time, DVRs ensure surplus protection through takeover defence which vests at least 50 per cent of voting rights in the incumbent management to entrench the status quo (Rydqvist, pp.50-51). This prevents interference from uninformed shareholders and prevents myopic behaviour. Moreover, DVRs allow for surplus extraction by price-discriminating different classes of shareholders and increasing the value of shares without diluting the management’s voting rights (Rydqvist, pp.51-53). Whether the agency costs exceed the benefits (i.e., surplus protection + surplus extraction) derived from DVRs is a case-specific analysis. Consequently, two possibilities exist when any company issues DVRs:
- Agency Costs ≤ Surplus Protection + Surplus Extraction (⸫ Net benefit is positive)
- Agency Costs ≥ Surplus Protection + Surplus Extraction (⸫ Net benefit is negative)
III. Inefficiencies of the DVR Regulatory Framework
As put by Kraakman, the goal of corporate law is to maximise social welfare in the sense of “pursuing Kaldor-Hicks efficiency within acceptable patterns of distribution” (Kraakman, footnote 87). A Kaldor-Hicks improvement is one where those who are better off can compensate those who are made worse off. As noted by Rauterberg, Kraakman equated aggregate welfare maximisation with the pursuit of Kaldor-Hicks efficiency. Despite its fair share of criticism, which goes beyond the scope of this article, Kaldor-Hicks efficiency is still accepted as a metric for ascertaining whether a statute or judgement of corporate law is welfare-maximising. Hence, in this article, we assess whether the regulatory framework of DVRs in India is Kaldor-Hicks efficient. If it is not, then the regulatory framework fails to maximise aggregate welfare and, thereby, does not satisfy one of the goals of corporate law. We can break down Kaldor-Hicks efficiency into four parts:
- There must be an ‘improvement’. For an improvement, the net benefit (i.e., benefits minus costs) must be positive.
- At least one party must be made better off relative to others.
- Such a better-off party should, in theory, have the ability to compensate the worse-off parties to the transaction.
- Such improvement must be preferred over other forms of improvement, i.e., nobody would prefer other improvements over a Kaldor-Hicks improvement.
My argument is that the DVR regulations decrease surplus protection (by over-restricting DVRs) and increase agency costs (by being agnostic to non-share-based DVRs). Cumulatively, this reduces the net benefit accruing from DVRs, rendering Kaldor-Hicks efficiency more difficult to achieve.
I. If Agency Costs ≤ Surplus Protection + Surplus Extraction
In this case, the first criteria of Kaldor-Hicks efficiency, viz., positive net benefit is satisfied. Herein, over-restricting DVR shares would lower (or negate) any net benefits that accrue from it. Ideally, the regulation of DVRs should either raise the benefits or lower the agency costs. Over-regulation increases Type I errors or (false positives), reducing the net benefit.
This argument is further supported by the following comparative evidence. Per Yan, financial centres of Asia, particularly Hong Kong, Singapore, and Shanghai, provide for mandatory safeguards against DVRs in the form of ex-ante mechanisms such as sunset clauses. This regulatory sword has proven double-edged in practice – while it ensures investor protection, it has a chilling effect on DVRs, leading to a very low percentage of IPOs of DVR shares in these jurisdictions (Yan, p.31).
As observed in the 2019 SEBI Consultation Paper on DVRs, the regulatory framework of these Asian centres is more lenient than in India. In fact, the SEBI mooted for the adoption of the safeguards (such as coat-tail provisions, sunset clauses, etc.) practised in these foreign jurisdictions (pp.7-9, 17-24). Yan’s argument can be suitably transposed in the Indian context. Arguably, due to its more restrictive regulatory framework, at present, only five companies offer DVR shares in India. The over-regulation of DVRs has deterred its adoption by companies, leading to a very small fraction of companies offering DVRs in India. Consequently, any benefits (i.e., surplus protection + extraction) that may accrue from DVRs are negated. This outcome is inefficient since it potentially reduces, or even makes negative, any net benefits that may accrue from the issuance of DVRs.
2. If Agency Costs ≥ Surplus Protection + Surplus Extraction
In this case, the first prong of Kaldor-Hicks efficiency, viz. positive net benefit, is not satisfied. Herein, for a positive net benefit, the regulatory framework must either reduce the costs or raise the benefits of DVRs. In this regard, I argue that the regulatory framework is insufficient for reducing such agency costs. This is because DVRs can be conferred not just through shares but also through other approaches that are not linked to equity shares. In fact, DVRs are only a subset of a larger genus called dual-class structures which are not covered by the existing regulatory framework. This regulatory indifference towards non-share-based DVRs increases Type II errors (or false negatives).
This argument is supported by Shobe’s work on dual-class companies in the US context. Per Shobe, a dual-class structure can be created either by shareholding or by contract-like arrangements. Such dual-class arrangements include: First, shareholder agreements whereby founders or promoters of the company retain the right to nominate a specified number of directors to the company’s Board (Shobe, p.1359). This confers a differential voting right that is not based on shareholding. Second, this can be achieved through ‘pyramids’ where top-tier firms own a majority of shares in middle-tier firms, which in turn own a majority of shares in lower-tier firms. In this manner, the top-tier firms can assert control over lower-tier firms even with a minority shareholding. Lastly, certain contractual arrangements allow for the unbundling of cash flow rights and voting rights. This allows shareholders to alienate their voting rights while retaining the right to earn dividends from their shares. Resultantly, voting rights can be alienated or even accumulated to create a dual-class structure.
Not accounting for these non-share-based structures leads to a piecemeal approach to the regulation of DVRs, which increases the costs accruing from Type II errors. This narrow approach makes the current regulations deficient in reducing the agency costs created by dual-class structures. Minimisation of agency costs is necessary to achieve a positive net benefit, particularly when the agency costs exceed the benefits of having DVRs.
IV. Conclusion
In conclusion, to correct this dual-sided inefficiency, the legal requirements for the issuance of DVR shares should be made less onerous (by, for instance, permitting listing and IPO of SR shares) while the ambit of the DVR regulations should be extended to cover non-share-based arrangements (such as pyramids and shareholder agreements). A possible limitation of this two-fold solution is that its components can counteract each other – relaxation of the regulatory framework can increase agency costs whereas widening the ambit of the regulations can lower both surplus protection and surplus extraction. While this is a plausible counter-argument, it ignores that the two solutions operate in different spheres. The first solution reduces Type I errors by relaxing the regulation of share-based DVRs; the second solution reduces Type II errors by regulating non-share-based DVRs. Thus, due to their unrelated nature, the two solutions do not lower or nullify each other.
*Chytanya is a III year law student at National Law School of India University and editor at Law School Policy Review
