2011

An Assignment for the subject EQUITY MARKETS,Sem 4, BFM,Khalsa College,Mumbai Trevor Luis Dsouza Roll no 6.(B2-FM09)

[DIFFERNTIAL VOTING RIGHTS]

DVR Shares are like ordinary Shares but with different voting rights usually issued for avoiding hostile takeovers and acquisitions, voting rights are diluted but are compensated usually with a higher dividend. In 2009 SEBI has made an amendment to the listing agreement which has affected issuance of DVRs

Differential Voting Rights (DVR)

DVR shares are like ordinary equity shares but with differential voting rights. They are listed and traded in the same manner as ordinary equity shares. However, they mostly trade at a discount as they provide fewer voting rights compared to ordinary equity shares. Companies generally compensate DVR investors with a higher dividend. Having voting power without commensurate economic interest in a company poses the threat of (a) Mismanagement (since the board may be easily replaced); (b) Misuse of voting power as little or no financial loss may be incurred; and (c) Poor corporate governance. Companies issue DVRs for reasons such as prevention of a hostile takeover and dilution of voting rights. However, this also helps strategic investors who do not want control but are looking at a reasonably big investment in a company. At times companies issue DVR shares to fund new large projects, as due to the fewer voting rights, even a big issue does not trigger an open offer. They have been allowed in India since 2001 they decouple economic interest and voting rights. DVRs mostly trade at a discount because 1) The fewer voting rights they enjoy 2) The liquidy of DVRs are generally far lesser However in international market the DVRs trade at 10 - 15 % discount whereas in India it is far high. Shares with Differential Voting Rights A Strategic Tool WHY DIFFERENTIAL: Shares with differential voting rights (DVR) are shares which differential voting rights than ordinary shares.

If offers with differential voting rights allow investors to earn better return in lieu of surrendering their voting rights, it allows a company to dilute its equity without matching dilution in the promoters stake. Shares with DVR comes to the managements rescue at the time of take-over threats. DVR can be used to thwart hostile takeovers since, for all practical purposes, they decouple economic interest (dividend rights) and voting rights. Shares with DVR are mainly targeted at passive investors. In most cases, small or retail investors, hardly exercise their voting rights or know enough to influence corporate actions. They look only for economic returns when they invest in a company and are not interested in running it or having any say in its management. So, they give away their voting rights in favour of those investors who run the company and have management control. In a situation like that prevailing in India, where minority retail investors do not intend using their voting rights in a company, such shares allow investors to acquire shares at lower prices with prospects of higher dividends in return for surrendering their voting rights. Companies can issue shares with lower voting rights to public shareholders. That would automatically bump up the promoters voting rights. Investors are compensated for lower control, so companies give them higher dividends. LEGAL REQUIREMENT: Section 86 of the Companies Act permits the issue of equity shares with DVRs, subject to conditions prescribed under the Companies (Issue of Share Capital with Differential Voting Rights) Rules, 2002 The Companies Act permits a company to issue shares carrying differential voting rights when, among other conditions, the company has distributable profits and has not defaulted in filing annual accounts and returns for a minimum of three financial years preceding the year of offer. The issue of such shares cannot exceed 25 per cent of the total issued share capital of the company. Under Rule 2 (a) differential voting rights includes rights as to dividend or voting; and financial year means financial year as defined under Section 2 (17) the Companies Act.

Conditions: Rule 3 says that every company limited by shares may issue shares with differential rights as to dividend, voting or otherwise, if: 1. It has distributable profits in terms of Section 205 of the Companies Act, 1956 for three financial years preceding the year in which it was decided to issue such shares. 2. It has not defaulted in filing annual accounts and annual returns for three financial years immediately preceding the financial year in which it was decided to issue such share. 3. It has not failed to repay its deposits or interest thereon on due date or redeem its debentures on due date or pay dividend. 4. Its Articles of Association authorize the issue of shares with differential voting rights. 5. It has not been convicted of any offence arising under, Securities Exchange Board of India Act, 1992, Securities Contracts (Regulation) Act, 1956, Foreign Exchange Management Act, 1999. 6. It has not defaulted in meeting investors grievances.

7. It has obtained the approval of share holders in General Meeting by passing a resolution as required under Section 94 (1) (a) read with Section 94 (2) of the Companies Act. 8. It has obtained approval of share holders through Postal Ballot if it is a listed public company 9. The notice of the meeting at which resolution is proposed to be passed is accompanied by an explanatory statement stating: (a) the rate of voting rights which the equity share capital with differential voting right shall carry; (b) the scale or in proportion to which the voting rights of such class or type of shares will vary; (c) the company shall not convert its equity capital with voting rights into equity share capital with differential voting rights and the shares with differential voting rights into equity share capital with voting rights; (d) the shares with differential voting rights shall not exceed 25% of the total share capital issued;

(e)

(f)

that a member of the company holding any equity share with differential voting rights shall be entitled to bonus shares, right shares of the same class; the holders of the equity shares with differential voting rights shall enjoy all others rights to which the holder is entitled to excepting right to vote as indicated in (a) above.

POSITION PREVAILING IN INDIA: TATA Motors DVR: In 2008, Tata Motors became the first Indian company to make a rights issue carrying differential voting rights (DVR). Tata Motors DVR shares have one-tenth of the voting rights of the ordinary shares and were are being offered at a discount of Rs. 35 per share. These shares are also entitled to a 5 per cent higher rate of dividend over the normal shares. Earlier, SEBI had disallowed DVRs with superior voting and dividend rights in July 2009 to protect interests of minority shareholders. As per the SEBI guidelines, existing DVR holders can have superior dividend rights along with their existing rights. SEBI said Tata Motors can issue fresh DVR via bonus/rights on same terms. Also, the company can issue fresh DVRs via follow on public issue (FPO) and preferential issue route. According to the market regulator, Tata Motors can covert Convertible Alternative Reference Securities (CARS) and employee stock ownership plan (ESOPs) into DVRs under existing terms. Pantaloons Bonus Issue: Pantaloon, Indias leading retailer, is the first to issue bonus shares with a DVR option. The company made a bonus issue of 1:10 shares with differential voting rights. Although there is no fund-raising involved in a bonus issue of shares, the idea is get the markets familiar with such instruments and create another alternative to raise funds in the future. Global angle: While DVR is a well-accepted instrument used by blue-chip companies in international markets to raise funds, even after a decade of governments notification, the concept is yet to become popular in India. A clutch of foreign companies, prominent among them are Google, Ford Motors, and Berkshire Hathaway have raised funds through DVR issues.

CURRENT LEGAL POSITION - SPECIFICALLY FOR LISTED COMPANIES: SEBI has introduced a new rule that will effectively reduce the desire of companies to issue shares with DVR. SEBI has made a small amendment to the listing agreement that has a very wide impact. It has said that a company shall not issue shares that have either superior voting rights or higher dividend entitlements, compared to the ordinary shares listed on the exchange. The rule is effective from July 21, 2009. The new rule prevents companies from issuing shares with higher voting rights. A situation wherein the promoter will want shares with lower voting rights is very unlikely. So, promoters will most likely never want to apply for DVR shares. For example: Tata Motors issued DVR shares which had lower voting rights (one-tenth of the ordinary shares) but gave shareholders 5% more dividend. This will not be possible any longer .exept that companies that have issued DVRs before the rule has been passed can keep the current DVR stakeholders getting the priveledges as well as bonus whichever might be the case. Companies can now compensate only by offering a higher discount to the market price. This may not work very well since Investors have not really been able to understand this aspect well, partly to do with estimating the appropriate discount. Also, price fluctuations of the ordinary shares, when the issue is open, play havoc with subscriptions. If companies cant give higher dividends on DVR shares, investor interest will wane further. In effect, SEBIs move has made DVR shares unattractive to both promoters and shareholders. SEBIs intentions must have been to prevent promoters from misusing this facility to easily get control over a company or to get higher dividends. That may be a valid concern, but could have been dealt with in a different manner. WHY ANY RETAIL INVESTOR SHOULD PUT HIS MONEY IN DVR SHARES: There are only two DVRs available on the stock exchanges one of Tata Motors and second is of Pantaloon. A comparison of their share price movements for the last five months and Dividend Yield is as under:

Share Price - 31/12/2009 Share Price - 28/05/2010 % Change Last Dividend announced Dividend Yield on CMP

Tata Motors Ordinary DVR Share Share 782 496 750 509 -4.09% +2.62% 15.00 2.00% 15.50 3.05%

Pantaloon Ordinary DVR Share Share 381 287 369 271 -3.15% -5.57% 0.60 0.16% 0.70 0.26%

This implies that the capital gain in either case is more or less the same. The dividend yields are much higher in absolute percentage terms. For a long term investor who wants to hold the shares for a few years and earn dividend income, the dividend yield of the shares is very crucial. Benefits to the Investor: Pantaloon DVR share, even today is ruling at a discount of 32%. While Tata Motors DVR is ruling at a discount of 27%. In the case of Tata Motors, now we all know that you have 10% of the voting right plus you get 5% additional dividend whatever is declared for the ordinary shareholders. This DVR will be getting 5% more, 50 paise per share. Similar sorts of benefits are there in the case of Pantaloon. In most AGMs, the voting happens on a show of hands. In case of show of hands both the type of shareholders i.e., shareholders holding normal shares as well as shareholders holding DVR will be having the same rights because on show of hands it is the person which is counted as a one person one vote and not on the basis of the holding. If the voting has happened on poll or postal ballot you will be having the representation for the DVR and one share one voting right for the ordinary shareholder. In case of a companies like where you have the institutional presence, there is not much necessity of using the voting power by retail shareholders. In fact, the voting right is material and relevant for the institutional shareholder or large shareholders because they have the say that they can impress the management if they really feel that something is going wrong in the company. As a retail shareholder they have no say or very little say. So for a retail investor they must use this opportunity to move from the equity shareholders to this DVR if they have the plans of remaining invested for a limited period of time.

Why equity shares with differential voting rights have not caught the fancy of our corporates? It is true that despite the enabling regime for equity shares with differential voting rights, no company has evinced any interest. In fact, even in other countries where such a regime exists, it hasnt been a success. The reason perhaps is investor apathy more than corporate apathy. Investors after all may not like to miss the action and capital appreciation, especially in a takeover game that is possible if only they own shares carrying voting rights. A few crumbs thrown extra as recompense for forsaking voting rights is no big deal especially nowadays when dividend has ceased to be a major source of recompense for investors given the mind boggling premia forked out on shares. Private Companies should be exempted While the regulators' effort to balance the interests of majority and the minority shareholders is commendable, the rationale for limiting the ability to issue DVR shares by private companies or closely held public unlisted companies is not clear. Private companies merit less intensive regulation, as they are normally held by a closed group. Moreover, financial investors feel the need to contractually mandate tighter governance in private companies as against public companies, since the latter offers a ready exit and immediate liquidity. Not continuing to allow DVR shares in private companies may project India's regulatory environment as being regressive and inflexible. As regards widely-held companies, the proposed change in the Companies Act, and SEBI's letter regarding the amendment to the listing agreement, appears to protect shareholders from being marginalised through DVR shares. It seems to minimise diminution in value of a company's shares, when the economic interest of the shareholders is divorced from controlling/voting interest. Consequently, banning DVR shares in public companies appears to have a strong rationale. Nevertheless, the regulator may consider allowing DVR shares even in public companies in special cases for the protection of financial interests, such as protection of financial investors' interests or lenders' rights.

Recent News on DVR as of 8th of March 2011

SBI differential voting rights shares on anvil The State Bank of India (SBI) will finally get the legroom to expand credit without having to bother if the government shareholding has dipped below 51%, the minimum required to maintain majority control. Government managers say they will shortly allow Indias largest nationalised bank to issue shares with differential voting rights. This will allow the government to retain majority control over the bank as its shares will have superior voting rights, overriding the rights of ordinary shareholders. This will, however, need an amendment to Sebi listing rules introduced in July 2009 that forbade higher voting rights for any class of shares. Since the subject is sensitive, government officials were unwilling to go on record. But explaining the rationale, one of them said it made no sense to raise about R40,000 crore from the disinvestment of public sector companies in 2011-12 as projected in the Budget only to plough back about R10,000 crore or so to keep the government investment in the bank at above 51%. (Source: Indian Express) DVR and changes in future? The government may take a fresh look, at allowing corporates to issue shares with differential voting rights bearing higher votes than normal shares. Media Sources have said that the finance ministry may constitute an expert panel to assess the feasibility of reintroduction of superior voting right shares. One option being considered is to put in place strict riders for the issue of such shares by companies where the promoter holdings are low. The challenge for the government, however, is to resolve the conflict between two regulatory bodies the Company Law Board and SEBI. With the company law board favouring the move and SEBI opposing reintroduction after imposing a ban on issue of superior voting rights shares to protect minority shares from misuse of the instrument by promoters. Market watchers say that they have been seeing an increased interest among corporates for DVRs.

It is a very useful instrument for companies having small promoter holding, as it helps them tackle attempts of hostile takeover. In the past however, the instrument has not generated much interest among investors. Just before SEBI imposed a ban on the instrument, Tata Motors annd Pantaloon had hit the market with DVR issues, but could not generate much investor interest. It needs to be seen how corporate houses try to attract investor interest in DVRs, if they are allowed to access the instrument once again. In a Nutshell Simple proportionate empowerment of public shareholders by abolishing DVR shares may not result in attaining a real balance of interest in favour of shareholders of a public listed company. This is due to the generally apathetic approach of a widely dispersed shareholder population. Therefore, in addition to limiting the restriction on DVR shares to public listed companies, with suitable exceptions , the regulators also need to propose regulations which strike at the root of the problem - shareholder apathy.