[Ritvik Mishra is a final-year law student at OP Jindal Global University, Sonipat]
Regulation 31 B of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR Regulations’) provides that any special rights granted to the shareholders of a listed company require the approval of shareholders by way of special resolution in a general meeting, once in every five years from the date of granting of such special rights. It further provides that special rights existing on the date of coming into force of this regulation, will be subject to shareholder approval within a period of five years.
The term “special rights” has not been defined anywhere under the LODR Regulations. However, the memorandum released by the Securities and Exchange Board of India (‘SEBI’), provides some guidance as to what the regulator regards as special rights. These include nomination rights, veto rights, affirmative voting rights etc. Nomination rights, for instance, allow the shareholder to appoint a nominee director to the board of directors of the company. Veto rights with regard to certain matters, on the other hand, allow the shareholder to single-handedly block a transaction that is not in his interest. Rights such as these are often provided to make the company more attractive for investment.
SEBI however took issue with the perpetual existence of these rights with shareholders even after the significant dilution in their shareholding. According to the regulator, this was contrary to the principle of equitable treatment of shareholders according to Regulation 4 of the LODR Regulations. However, there seems to be an issue with regard to three aspects of this amendment- first, a mismatch between the actual enactment and the rationale underlying it, second, the understanding in relation to its scope of application and third, the incorrect conflation of protective special rights with superior rights. On an elaboration of these issues, it will be seen that Regulation 31 B suppresses protective rights given to certain shareholders in the company, despite the fact that these rights have been acknowledged by the Securities Appellate Tribunal (‘SAT’) to be of importance for the good corporate governance of a company.
Uncovering the Mismatch between the Enactment and its Rationale
On referring to the memorandum published by SEBI, where it recommended the enactment of Regulation 31 B, we can ascertain the rationale behind enacting this provision. In this document the regulator states that public institutional shareholders have increasingly voiced their concerns against the grant of special rights to the “promoters/founders/certain body corporates of the company”. This shows that the regulator intended to stop the misuse of special rights by the promoter, founders or related entities. However, Regulation 31 B applies to these special rights irrespective of whom they are granted to. This means that special rights are going to be treated in the same manner whether they are granted to a promoter or a public shareholder, which causes problems for the latter.
There is a clear difference between the consequences of granting special rights to the Promoters, Founders or Related Entities and to certain public shareholders. In case of the former, special rights may serve the purpose of tightening the control of the promoter over the company, but for the latter they may often serve the purpose of ensuring good corporate governance of the company and protecting public shareholders from the whims and fancies of the promoter. Given the different purposes served by these rights when they are held by different people, treating them the same way can have the disastrous consequence of adversely affecting the special rights given to certain shareholders of the company to protect their interests in it.
A Problematically Broader Scope of Application
On reading the memorandum, it is clear that SEBI only took issue with the continuation of special rights granted to pre-IPO shareholders post-listing even after a decrease in their shareholdings. According to the regulator, special rights contained in Shareholder’s Agreement are generally terminated before listing, only nomination and information rights continue to exist, which too are subject to shareholder approval. Regulation 31 B is a step in the right direction, only insofar as it intends to regulate such pre-IPO special rights which were supposed to be terminated post-listing. However, SEBI seems to have overlooked the fact that special rights are granted not only to pre-IPO shareholders, but are often granted post-listing and that these are not limited to just nomination and information rights.
There are numerous instances where special rights have been granted post-listing. In 2013, Etihad purchased a stake in Jet Airways and the Shareholder’s Agreement governing the transaction gave Etihad a right to appoint two nominee directors to the board of Jet Airways. In Clearwater Capital Partners decided to convert their Foreign Currency Convertible Bonds held in Kamat Hotels into equity, special rights like nomination rights and veto-rights in matters of changes in capital structure, winding up and so on were granted. The lack of consideration for the existence of such instances is not without consequences.
Regulation 31 B does not distinguish between special rights granted pre-IPO and those granted post-listing. This means that it will be applicable even in the latter case, depicting a scope broader than what was envisioned of it. This, as discussed, adversely affects special rights given to certain investors investing in the company post-listing for the purpose of protecting their investments and ensuring good corporate governance.
Special rights held by investors pre-IPO are terminated to ensure that the existing shares of the company rank equally with the shares to be issued in the IPO. Nomination and Information rights are allowed to exist post-listing subject to shareholder approval. The requirement of shareholder approval in this case arises from the fact that, insofar as the shares hold nomination and information rights, they do not rank equally to other shares in the public issue and thus require the approval of other shareholders. However, the consideration for rights granted post listing are different.
In its order in the matter of Kamat Hotels, SEBI stated that the purpose of such rights was to enable the investor to ensure checks and balances on the management of the company. Keeping this in mind, there seems to be no relevance of equality in the ranking of shares and thus no valid reason for the requirement of shareholder approval in case of special rights granted post-listing. To the contrary, the requirement of shareholder approval jeopardises the certainty of the availability of these protections by placing them under periodic scrutiny.
A Problematic Conflation with Superior Voting Rights
While stressing on the need of periodic shareholder approval for special rights in the memorandum, the regulator in paragraph 4.3.5 states that, under the LODR Regulations, “even superior voting rights granted to promoters / founders have a sunset clause (maximum of 10 years after listing…”. This shows that in the regulator’s understanding there is some similarity between superior voting rights and special voting rights, which justifies the requirement of shareholder approval for the latter. However, this is not the case.
Shares with superior voting rights were introduced to enable promoter/founders, who were instrumental in the success of a company, to retain decision making powers in the company. These clearly give control over the affairs of the company by providing higher voting power than the ordinary shares held by other shareholders. The relationship of special rights with control, however, is not that simple.
SEBI usually viewed the provision of special rights as amounting to an acquisition of control. However, the Securities Appellate Tribunal (“SAT”) disagreed with this approach. In Subhkam Ventures, the Tribunal stated “control” to be a proactive and not a reactive power and that a special right granted to an acquirer would only amount to control if it put him on the “driving seat” of the company. Special rights, therefore, would only amount to control in circumstances where they give proactive powers to an acquirer and not where they merely enable him to ensure checks and balances on the management of the company and ensure good corporate governance. While, the Supreme Court held that Subhkam should not be treated as precedent, this position later changed in Arcelor Mital India Pvt. Ltd. v. Satish Kumar Gupta where the Court itself relied on the test for “control” laid down in Subhkam. The SAT in VCPL v. SEBI, relying on the Supreme Court decision in Arcelor Mital, revived the precedent value of Subhkam and stressed on the importance these rights have for ensuring good corporate governance. This, as argued below, reveals serious problems in text of Regulation 31 B.
Regulation 31 B, in the treatment accorded by it to special rights, seems have to conflated reactive special rights with proactive special rights. While, the latter are similar to superior voting rights justifying the requirement for periodic shareholder approval, the former are essential for ensuring good corporate governance in the company and protecting an investment. Treating them in the same manner adversely affects an investor’s ability to protect his investment by subjecting him to the uncertainty of shareholder approvals.
Concluding Thoughts
While Regulation 31 B has been enacted with the broad purpose of shareholder empowerment, there seem to be certain fundamental flaws in the provision which adversely affect the rights given to some shareholders. First, there seems to be a mismatch in the provision and its rationale, which causes it to apply to not just promoter entities but also public shareholders. Second, the provision overlooks the practice of granting special rights post-listing. Third, the provision conflates special rights with superior voting rights.
The adverse effect of the provision will be felt by long-term investors investing privately into listed companies. These investors while negotiating for such rights will have to consider the possibility of such rights being nullified five years later owing to an unfavourable vote by other shareholders in the company. This will negatively affect investments into listed companies as investors will realise that they might not be able to rely on the protective rights negotiated by them when the management of the company becomes unreliable. To avoid this, it is suggested that a proviso is added to Regulation 31 B that exempts special rights granted to public shareholders from shareholder approval when they do not amount to control.