Friday, October 2, 2015

The Differential Dividend Story

[The following guest post is contributed by Siddharth Raja, Founding Partner of Samvad Partners. Views are personal.]

A previous post on this Blog raises some interesting questions – although this author believes that analysis is both incomplete and, indeed, not purely academic. While the above blog post only addressed one aspect of the issue, the larger question is this: whether a dividend can be paid only to some shareholders and not to all; and, what role does a contractual provision enabling a “waiver” play in relation to the issue of a differential dividend? This post seeks to analyse these matters.

Financial investors rely heavily on “liquidation preference” clauses.  Such clauses constitute a contractual measure to order the priority upon which a portfolio company is expected to distribute moneys to its shareholders different from a typical proportionate distribution – upon the occurrence of a “liquidity” or distribution event that has resulted in the company in question receiving cash proceeds, typically, as a result of profits it has made upon a sale of its assets (or, some such valuable rights).  Within such a construct, the investors place themselves – contractually – ahead (or, in most cases, first) in the order of priority in respect of any such distribution from the company. This enables them the right to receive before any others, especially the equity shareholders, the proceeds of any distribution of moneys that the company might make. 

One of the methods companies utilize to effect such a distribution is the dividend route.  However, the initial legal presumption inherent in dividend distribution is that members of the same class of shares are entitled to proportionately equal dividends, i.e., on a pari passu basis amongst themselves (in the absence of an agreement to the contrary amongst, and binding upon, the members of that class).  It is for this reason – priority in distribution – amongst others, that investors in India choose to hold preference shares as opposed to equity shares. 

In other words, the holder of a preference share is able to both contractually, as well as legally, avail himself of a superior and enforceable right to receive, ahead of any payment to any other class of shareholders, moneys a company may resolve to distribute.  The characterization of such a right as one of a preference share and its holder, in contrast to that of an ordinary equity share leaves no room for doubt or different analysis.

The issue, however, becomes more acute within the same class of preference shareholders – that we will examine from the following paragraph onwards and which forms the crux of this post. 

Obviously, if there are several classes of preference shares themselves, then it is conceivable that one class of preference shares may have superior rights to another class of preference shares. That way of ordering does not militate against the principle of equality of shareholders holding the same type or class of shares. In fact, as noted in a leading commentary, where shares are expressly divided into separate classes (thereby necessarily contradicting the presumed equality between shares), it is a question of construction in each case as to what the rights of each such class are.[1]

Viewed thus, while analyzing the various legally available avenues open to a company to distribute returns to its preference shareholders, two issues arise for consideration, depending on which method is adopted:


1. Can the terms of issue (or a company’s articles of association) prescribe that, within the same class of preference shares, one preference shareholder (or a separate group therein of such preference shareholders) will have a differential right of dividend, such that it, in effect, gets a higher liquidation or distribution preference?


2. Can a preference shareholder(s) waive – and, in some cases, waive permanently – its right to a preferential dividend in favour of a particular preference shareholder who is to get a higher liquidation or distribution preference, again of a member within the same class.    

These are not purely academic issues. In the case of a company which has raised several rounds of financial investment (ecommerce or marketplace companies are good examples), it is not uncommon to ask: can one investor give (by waiving his dividend rights) the benefit of a differential treatment to another investor who is contractually to secure a higher “liquidation preference”?   And whether this avenue of distributing returns to just an institutional investor holding preference shares is legally tenable as against other shareholders, including equity shareholders? 

I will deal with the first issue.  Prima facie all shares rank equally, unless the terms of its issue (or the company’s charter documents stipulating the rights of each share class) provides for a priority of one or some shares over others in the same class.  Section 106 of the Companies Act, 1956,[2] enables a minimum 3/4ths majority of the holders of a particular class of shares (which majority can also be obtained via a special resolution passed at a class holders meeting) to consent to a variation in “the rights attached to the shares of [such] class”, provided the terms of issue does not prohibit such a variation; or the company’s memorandum or articles of association has an express provision enabling such variation – the yet-to-be-notified Section 48 of the Companies Act, 2013 is in pari materia with this provision. 

Although the law typically encounters differential rights between different classes of shares as a matter of a class right (i.e., one class’s rights are superior than another class, say, for instance, as regards return of capital), it is not uncommon to find and, indeed, nothing which legally prevents – I argue – such differential rights even within the same class, but as between different holders of such shares as a matter of a shareholder’s right qua the particular shares of that class they hold. 

Implicit in Section 106 is the right of a class of shares, through a prescribed majority, to provide for variations in the share rights of its class, which must mean, therefore, that some such shareholders could have a superior right (say, a further preferential right to dividend), while other ‘non-entitled’ shareholders do not possess such rights – since the variation contemplated is as regards the rights attached to a class of shares, such variation could conceivably be more favourable to one or a group of shareholders therein and not to the other shareholders of the same class, if the requisite consent in accordance with law has been obtained. This position is underscored by the fact that the consent mechanism in Section 106 of the 1956 Companies Act (and, by extension, Section 48 of the 2013 Companies Act) is specifically predicated on what is provided for as regards differential rights, in the terms of issue of such shares or in the charter documents.  In other words, such terms of issue or the charter documents could, at the very first instance, validly provide for a differential rights basis even between or amongst the holders of the same class of shares – and, hence, a subsequent variation to the same or different effect is also permissible.  To the extent a shareholders’ agreement exists among and binding upon the members of that class, the differential rights ought best to be then incorporated into the terms of issue, or in the charter documents, so as to keep expressly in line with these statutory provisions relating to variation of class or shareholder rights.  In effect, I am arguing that a variation of a class right extends even to a variation in a shareholder’s right within that class. That would seem obvious under Section 106, but stating it in these terms, also recapitulative.

The yet-to-be-notified Section 48 of the 2013 Companies Act, in fact, goes one step further – the proviso to sub-section (1) stipulates that if the variation by one class of shareholders of their rights affects the rights of any other class of shareholders, a similar consent must be obtained from such other class – meaning thereby, within the same class, differential rights as between shareholders are contemplated in the mechanism under the statute, if that provision is adhered to either in its original terms or in its charter, or via a modification in line with the proper and stipulated majorities.  Any transferee of such ‘entitled’ shareholders’ shares will succeed to such rights on the principle of assignment of a contractually agreed to provision that is also in compliance with the ‘variation’ principle in Sections 106 / 48, as the case may be.

The second issue on ‘waiver’ raises questions that do not fit well with the above analysis. It is one thing to mention ‘waiver’ effectively as a right of a person (namely, the shareholder concerned), and then proceed to discuss how that is to be legislated in various documents and analyze its consequences vis-à-vis the company concerned along with the company’s rights – that is what the blog post above-mentioned does.  But, that begs the question of a dividend right (or a crystallized entitlement once declared) being a share or a class right, especially in the context of the nature of the underlying share, whether equity or preference.  In the latter case, dividend is one of the distinguishing characteristics of the type or class of share itself.  If so, it would sit better – I argue – with the analysis of the issues under # 1 above of a share or class right, that the differential basis in the treatment of the receipt of the dividend as envisaged through such a ‘waiver’ of any dividend entitlement, be actually captured through the terms of issue itself or in the charter documents, or through a variation in due form and proper majority according to the law specifically so providing for such variations.

Undoubtedly, any such ‘waiver’ contractually agreed to ought to be binding as a matter of mutual agreement; and, so, if the effect of receiving a differential dividend is still achieved whether through the ‘variation’ or original terms route under # 1 above, or through the ‘waiver’ mechanism, the legal consequence is the same as to its intended effect.  So, the issue is moot and are we not splitting hairs? 

Except that the concept of ‘dividend’ itself under Indian law seems to militate against using the ‘waiver’ route.  The point is driven home if we were to consider this question: what happens if between interim and final dividend (where the holder has waived its dividend rights), the share is transferred and the shareholder who waived its right to a dividend is not the same shareholder now holding the share which carries with it an inherent right to dividend once declared?  Only if the transferee has accepted the transfer of shares subject to the ‘waiver’ of dividend, will such ‘waiver’ bind him – else not, on the basis of dividend being a share right; a position underscored in Section 123 of the 2013 Companies Act (Section 205 in the 1956 Companies Act) as it relates to the declaration and payment of dividends.  In other words, in order to have the ‘waiver’ operate subsequently especially so as to confer a differential right in favour of one holder or some holders, as against others, it would be prudent to incorporate such a differential basis into the terms of issuance or charter document itself via a variation’ properly done, rather than rely on a ‘waiver’ that may conceivably not bind all subsequent holders since a waiver is a shareholder right or benefit and not a share or class right. 

The question is however moot whether a skillfully drafted ‘waiver’ binding a subsequent transferee can be displaced by such a subsequent holder on the basis he did not take the share subject to a right which he knew not, or ought not to be fixed with the knowledge of – or if the ‘waiver’ is intended to operate only as a one-off. 

I would only end by saying that if certainty in the law is the safest house for the corporate lawyer as regards the rights and benefits of his client, then a differential dividend is best incorporated in the terms of issue or the charter document itself, rather than through the use of ‘waivers’.

- Siddharth Raja

[1] Paul L. Davies, et al, Gower and Davies’ Principles of Modern Company Law, 8th Edn., London: Sweet & Maxwell, 2008, pg. 823.
[2] This provision of the 1956 Companies Act is still in force as the corresponding provision, Section 48 of the Companies Act, 2013, is yet to be notified as the National Company Law Tribunal is yet to be established.


Anonymous said...

I am a little unclear as to your conclusion. Very simply put, are you saying that a shareholder cannot waive dividend on ordinary equity shares? If dividend is a right that inheres in a shareholder, and by waiving dividend on a one-time basis, the shareholder isn't looking to permanently alter his rights or even bind a transferee, is the shareholder or the company violating company law?

Siddharth Raja said...

I should clarify -- waiver is an inherent contractual right. Unless something in the law prevents it, it will exist. I find nothing in the law that prevents a waiver of a dividend as a matter of right. So as a one-off waiver is fine. That's no violation of the law. However, if a waiver is meant to operate for the future (i.e., more than just as a one-off), my argument is that may not work legally. To achieve such an objective, it would be best to amend the terms providing for such differential right. Trust this clarifies, Siddharth Raja.

Anonymous said...

So can we conclude that we can create two different classes within the same class if Section 106 is complied with?

Siddharth Raja said...

Wont the creation of two different classes be two different classes of shares, not within the same class? Anyways, I think the question is moot. If one creates differential rights, those are different classes of rights and thereby, best done at the level of different classes of shares. Sec. 106 ought to be complied with.