Do we really need dual-class shares?

The recent roll-out of stewardship codes empowers shareholders, forcing managements to change behaviour

Every once in a while an idea takes hold which is supposed to be the panacea for a specific problem plaguing the local equity markets. Share buy-backs were seen to be the perfect tonic for reviving anaemic secondary markets in the late 90s: but markets began their secular uptick not when buy-backs were permitted in 1998, but a few years later when earnings picked-up steam. Dual-class shares are seen to be an answer to moribund IPO markets today. That investors should have more flexibility in raising money and investors in deploying funds is a given. But to argue that dual-class shares alone can bring the zip back to the IPO markets is dubious.

Dual class shares refer to different types of shares issued by the same company. These shares typically differ with respect to voting rights (hence these are also called DVRs) or right to dividends. Their rationale is that they allow a set of shareholders — usually the founders, to control boardroom (and voting) decisions, even as they dilute their economic interest in the firm to raise growth capital — and investors get to participate in the company's expansion.

Indian regulations permit such issuances, and four companies issued these — Tata Motors, Jain Irrigation, Pantaloon Retail and Gujarat NRE Coke. Tata Motors, the most credible name, offers a 5 per cent higher dividend to compensate for the one tenth voting right these shares carry vis-à-vis ordinary shares. These were issued at a 10 per cent discount to the shares, but now trade at 45 per cent discount to these. The liquidity too is much lower; it is no surprise that these don't find favour with investors.

Illustration by Ajay Mohanty

In contrast, in the US, the discount is shallow at about 2 per cent. Further, the US market is replete with marquee names that have issued DVRs — Google/Alphabet, Facebook, Alibaba, Berkshire Hathaway have all issued shares with DVRs. Today so strong is the link between DVRs and technology companies, that Snap Inc., was able to get away with issuing shares without any voting rights. And so high has the clamour for such technology shares been, that both the Hong Kong and the Singapore exchanges have recently changed regulations to permit listing of DVRs.

Ajay Tyagi, chairman, Securities and Exchange Board of India (Sebi), in a question and answer session with Prithvi Haldea at the recently concluded Association of Investment Bankers of India summit, has made clear the Board is reviewing DVRs and may well come out with a comprehensive set of guidelines, to help companies issue such shares. After all, PayTM, Ola and Flipkart are just the dose the primary market could do with. And if the 'promoters' in US and China can eat their cake and have it too, then why not those in India? But thankfully, he was circumspect as there are intractable issues at hand.

First, is the separation of ownership and control. A founder with 10 per cent equity and 10 votes per share, has more say than all other shareholders put together (see table).

The cushion that the DVR provides encourages managements to step down from the quarterly treadmill to focus on the long term. This freedom, it is believed, is what encourages founders to list their company rather than keep them private. Conversely, it can be argued that this can just as well lead to entrenched managements who are unchecked when they undertake value destroying transactions. The PE investors in Flipkart shuffled the management deck. How can the DVR shareholders effect such a change if they have no vote?

Two, how do you contain this only to technology? The old economy firms are all embracing technology — car manufacturers are gravitating towards electric cars, oil majors at fracking, banks sophisticated analytics, and the lines between the new and the old is rapidly blurring. If regulations can’t, what prevents a towel manufacturer from taking advantage? And that cannot be the purpose.

Three, the appropriate safeguards in the form of a sunset clause are seen as striking the right balance between letting founders run their businesses, and the dissipating benefits that such shares offer. These are structured to convert a superior vote share into an ordinary share at a pre-determined period (say, five years from listing) or event (say, the founder stepping aside). But a fixed period assumes that industries mature in a specific year or that their business model will not change or that the founder alone is responsible for its success: Paypal has done wonderful after its promoters stepped down.

Further, the sunset clauses are effective in the US because controlling investors have a fiduciary duty to all shareholders and a well-worn class action suite mechanism — and the huge price discount for DVRs in the Indian market reflects this reality.

Another safeguard is in terms of specifying resolutions on which the founders have super-majority a vote and those where the vote is equalised (compensation) or even done away with (related party transactions). But this collapsible voting power, complicates decision taking for investors.

Four, the fear that they will list overseas without listing in India may have merit, but the one example Rediff.com holds a lesson: Fashions are fickle.

Finally, the Indian equity markets have steadily moved up the ranks in protecting minority investor interest. The Ease of Doing Business ranks India at #7 (in protection of the minority investor). The journey has been hard-fought with regulations — the Companies Act and Sebi Listing Obligations and Disclosure Requirement, and stock exchanges steadily raising the governance standards and disclosure norms. This has resulted in a steady flow of domestic and international money comforted in the improved transparency and rights that shareholders have gained. The recent roll-out of stewardship codes further empowers shareholders, forcing managements to change behaviour. The DVRs risk jeopardising India’s rank and alienating investors.

Just four issues over 10 years and none in the last eight, steep price discount to ordinary shares, sallow trading volumes. Such shares are clearly unloved. There are many products where markets need to be cranked to get them going: DVRs is clearly not one of them.

The author is with Institutional Investor Advisory Services India Limited. 

Views are personal. 

Twitter: @amittandon_in