[Mythri is a student at National Law University Jodhpur.]
On 29 May 2024, the Securities and Exchange Board of India (SEBI) sent an advisory note to merchant bankers that private equity investors in companies preparing for an Initial Public Offering (IPO) must relinquish their special rights from the contract and charter documents of the company before the updated draft red herring prospectus (UDRHP) is filed with SEBI. This advisory necessitated the cancellation of the contractual privileges that private equity (PE) investors typically enjoy.
While SEBI, in a more recent advisory dated 24 June 2024 retracting their previous advisory, stating that “[a]ll special rights granted to shareholders under [the articles of association, shareholders’ agreement] or through any arrangement or agreement shall lapse on the date of listing,” it is important to analyze the implications of such a mandate on private equity investors, especially in case of unforeseen last-minute issues or changes in the IPO roll-out.
Understanding Special Rights
While special rights are not defined by SEBI in the SEBI (Listing Obligations and Disclosure Requirements), 2015 (LODR Regulations), a Consultation Paper released by SEBI on 21 February 2023 provides some guidance on what may be considered as special rights. Special rights are essential contractual provisions designed to protect the interests of investors who commit significant capital to companies. They include protections such as veto power, nomination rights, anti-dilution provisions, and various other controls designed to safeguard their substantial investments and influence over the company’s strategic decisions. These rights generally make a company more attractive for investment.
The ability of special rights to prevent investor share dilution and to preserve early investors' proportionate ownership and influence in the event of subsequent funding rounds is one of its principal benefits. With veto power or board involvement, these rights also provide investors a voice in strategic choices, empowering them to direct the business towards expansion and profitability in line with their financial objectives.
Furthermore, special rights enable a more seamless exit strategy by offering features like first refusal and tag-along rights, which guarantee investors can profit from their investment on favourable conditions. Essentially, these rights are tactical instruments that enable private equity investors to optimize their return on investment while guaranteeing the stability and long-term prosperity of the business.
It is pertinent to note that this is not the first instance where SEBI has altered the functioning of special rights in an IPO scenario. On 14 June 2023, SEBI amended the LODR Regulations to insert Regulation 31B.
Regulation 31B of the LODR Regulations mandates that any special rights given to shareholders of a listed company must be approved by shareholders through a special resolution in a general meeting at least once every five years from when these rights were first granted. For special rights that were already in place when this Regulation 31B came into effect, they must also be subjected to shareholder approval within five years from the date that Regulation 31B came into force, i.e., 15 July 2023. This move by SEBI ensured that no single investor would have a ‘continuing right’ – that the special rights they are given will be subject to a five-year review. Critics of Regulation 31B argue that its blanket approach to periodic shareholder approval may compromise the intent behind these rights. They contend that such regulations fail to distinguish between rights that enhance governance and those that consolidate control disproportionately. This lack of nuance could potentially discourage long-term investments by diluting assurances to strategic shareholders who seek stability and protection through negotiated terms.
The Impact of SEBI’s Recent Advisory
The SEBI advisory requires PE investors to forgo these special rights at the stage of filing the UDRHP, rather than upon the listing of IPO shares. Typically, shares are listed within a month of filing the updated DRHP, barring any delays or shelving of the IPO by the company itself. SEBI’s objective is to ensure that no PE investor or any other stakeholder has special or superior rights over public shareholders once the company goes public. The rationale is to prevent the creation of a superior class of shareholders post-IPO, which contradicts the principles of equitable shareholder treatment in a listed company.
However, the timing of the termination of these rights poses a significant issue for PE investors. If the IPO does not materialize for any reason—such as unfavorable market conditions or internal management decisions—PE investors would lose their protective mechanisms prematurely, leaving them vulnerable during this critical period. Once special rights are removed from the shareholder agreements (SHAs) and articles of association, reinstating them can be challenging.
Further, from a corporate governance perspective, special rights serve several crucial purposes.
First, they can provide checks and balances on management decisions, ensuring that major corporate actions are scrutinized, and decisions align with broader shareholder interests. For instance, veto rights can prevent actions that might be detrimental to minority shareholders or the company’s long-term stability.
Second, these rights can attract strategic investors who bring expertise or resources critical to the company’s growth but require assurances that their interests will be protected. This is especially relevant in industries where specific technical knowledge, or operational insights are integral to success.
However, the integrity of governance and shareholder trust may be compromised if listed businesses do not grant specific rights to their investors. Minority shareholders would not have protection from decisions that could weaken their interests or create unbalanced governance if these rights were not granted. Without guarantees of influence and security, strategic investors—who are vital for providing knowledge and funding—may be reluctant to get involved.
These problems are exacerbated in the case of PE investors, since there is an absence of statutory safeguards in place for them. Without statutory backing, these contractual protections that private equity investors were afforded in their SHAs become their primary method of risk minimization. Special rights provide a safety net, ensuring that investors can maintain their control and protect their interests until the company goes public. The premature cancellation of these rights means that investors are left vulnerable during the critical period leading up to the IPO. If the IPO fails to materialize or gets significantly delayed, the investors lose their protective mechanisms without the compensatory liquidity event of a successful IPO.
This reliance becomes especially precarious in jurisdictions like India, where the Supreme Court’s judgement in Vodafone International Holdings BV v. Union of India has already introduced restrictions on the enforceability of certain clauses in SHAs. This additional layer of uncertainty complicates the enforceability and reliability of contractual rights that private equity investors heavily negotiate to secure their investments. Additionally, without their special rights, investors have limited recourse to influence major decisions or prevent actions that could devalue their investment. Investors will now have to bear the brunt of any negative developments without the safety and control their special rights previously provided to them.
Practically speaking, PE investors face greater risks in the absence of regulatory safeguards, which may discourage them from allocating capital to Indian markets. The influx of vital investment required for economic growth and development will be hampered by this circumstance.
Recommendations and Conclusion
While SEBI reversed on its decision with respect to PE investors’ special rights, if such a situation were to arise in the future, SEBI could permit the conditional retention of key special rights until IPO, subject to shareholder approval or specific conditions that ensure these rights are used for strategic oversight rather than operational control. SEBI could further mandate enhanced disclosure requirements, ensuring that all potential investors are fully informed about the governance structure and the role of PE investors. This would assist SEBI in fostering an attractive investment climate in India, encouraging the influx of essential capital for economic growth and development.
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