Indian Law Updates August 2019

Recent amendments relating to issue of shares with differential voting rights (DVRs), ESOP’s and DRR

On 16th August 2019, the Ministry of Company Affairs (MCA) notified the Companies (Share Capital and Debentures) Amendment Rules, 2019 (the Rules), which brought in certain amendments with regard to the issue of shares with differential rights, ESOP’s and the requirement on maintaining debenture redemption reserves.

DIFFERENTIAL VOTING RIGHTS (DVRS)

Section 43 of the Companies Act, 2013 (the Act) enables the issue of shares with differential rights as to dividend, voting, or otherwise, provided that Rule 4 of the Companies (Share Capital and Debentures) Rules 2014 is complied with.

Amendments as per Notification

  • Shares with differential voting rights can now constitute up to 74% of the total voting rights in the company. Earlier, these shares could not constitute more than 26% of the total voting rights.
  • The requirement of having distributable profits for the last three years in order to issue equity shares with differential rights has been done away with.

Application to Private Companies

As per the MCA Notification of June 5th, 2015, Section 43 is not applicable to private companies if their memorandum and articles of association so provide. Therefore, even prior to this Notification, private companies which have exempted themselves from the Section 43 and 47 can therefore, issue shares with differential voting rights in accordance with the relevant provisions of the Companies Act, 2013.

Unlisted Public Companies: Unlisted Public Companies do not have the flexibility to exempt themselves from Section 43 or 47 of the Companies Act, 2013. Therefore, these amendments do represent a significant change. Hence, unlisted public companies which do not have a track record of distributable profit, can now issue equity shares with superior voting rights for the promoters. This will now enable many e-commerce companies which are not profitable to issue DVR’s to their founders so as to maintain control despite being diluted due to multiple rounds of funding.

Further, the ability for DVR’s to constitute up to 74% of the share capital may help founders of such companies retain control while availing funding from financial investors, who are primarily focused to increase their economic value of their investment, rather than in the voting rights.

Listed Companies

In addition to the requirements under the Companies Act, listed companies are to comply with SEBI regulations and therefore are only permitted to issue shares with inferior (or fractional) voting rights.

However, keeping in line with the market reality of fund raising and the promoter founder protection, the SEBI board in June has approved a framework for issue of differential voting rights shares. This framework enables issue of “SR Shares” or superior voting rights shares by ‘tech companies’ to the promoters. The new framework prescribes SR Shares to have voting rights in the ratio of a minimum of 2:1 and a maximum of 10:1 compared to ordinary equity shares.

However, this framework is still to come into effect and therefore will need to be separately examined upon the amendments being notified.

Analysis:

Given the market trend of ‘scaling up’ and the requirement for additional capital to operate businesses, this Notification provides Promoters of companies to retain control even as they raise equity capital from investors.

Having said this, at this stage, the primary benefactors of these amendments are promoters of (a) unlisted public companies, and (b) private companies being converted into public companies or for listing of their securities.

Employee Stock Options

The Rules exclude a promoter, any person belonging to a promoter group or a director (directly or indirectly) holding more than 10% from being entitled from the definition of an ‘Employee’. Therefore, such persons are not entitled to ESOPs under the said provisions.

This restriction for the aforementioned persons is however not applicable to startup entities for a particular period of time as set out below.
Amendment

  • Time period for the exemption has been increased from 5 years to 10 years from the date of incorporation for startup companies.

This amendment will enable startup entities to provide incentives to promoters/ directors of startup entities through ESOP’s for a longer duration (i.e. 10 years).

Debenture Redemption Reserves (DRR)

The Companies Act, 2013 prescribes certain reserves for companies which have issued debentures to maintain so as to ensure timely redemption of such debentures. However, given the liquidity constraints being faced by Indian corporates, the debenture redemption reserve (DRR) requirements for various categories of companies has been relaxed as follows:

  • For public issues and private placement of debentures by listed companies, including NBFCs and HFCs, no DRR is required to be maintained;
  • For private placement of debentures by unlisted NBFCs and HFCs, no DRR is required to be maintained
  • In the case of issuances by all other unlisted companies, a DRR of 10% of the outstanding debentures payable is required to be maintained.

[HAVE INTENTIONALLY NOT ADDED THE 15% DEPOSIT]