Did SEBI Kneel To ‘Royalty’?

The Securities and Exchange Board of India’s decision to delay the implementation of shareholder approval for royalty payments is yet another tug-of-war between the market regulator and the Ministry of Finance. The Indian economy needs both foreign direct investments as well as foreign portfolio inflows – one cannot exist at the cost of the other. This uncertainty does not augur well for investor confidence in India.

SEBI’s proposal that companies need shareholder approval to pay over 2 percent of revenues in royalty was welcomed by investors, as it was lower than the 5 percent cap recommended by the Uday Kotak Committee on Corporate Governance. However, after deciding to implement the regulation with effect from April 1, 2019, SEBI postponed the implementation date to June 30, 2019, a little less than a week before the regulation was set to kick in.

The Concern On Royalty

The regulatory intervention over royalty payments was much needed. In several instances, royalty payments made by Indian companies needed to be justified.

In February 2019, Jubilant FoodWorks Ltd., which is the master franchisee of Domino’s in India, Nepal, Bangladesh, and Sri Lanka, had to withdraw its decision to pay a royalty to its promoters just a few hours after the announcement, in the face of immediate investor push-back.
Havells’ promoters were paid a royalty for the brand until April 2016 despite the company bearing advertisement and other brand-building costs.
Malvinder Singh and Shivinder Singh, the erstwhile promoters of Fortis Healthcare Ltd., unilaterally announced that the dues recoverable from them, worth over Rs 500 crore, would be adjusted against royalty for the Fortis brand.

For 30 MNCs, royalty outpaced revenues and profits from 2013 to 2017 and began to temper in 2018, as the profitability of these companies improved.

The aggregate royalty paid out by these 30 MNCs during the financial year ending in 2018 was Rs 7,823 crore, which averaged at 3.2 percent of these companies’ revenue and 17.4 percent of their pre-tax pre-royalty profit.

The Pushback By Industry

SEBI appears to have delayed the implementation of the regulation following representation by industry bodies.

That the regulation will become effective from April 2019 was known for a few months, therefore, the last-minute delay to June 30, 2019, raises questions on whether the regulation will be quashed entirely.

Reports suggest that industry is concerned that the shareholder approval for royalty payments will increase administrative costs and require management time, may result in shareholders not approving the resolution, and is limited to listed companies. Also that the Finance Ministry, having disbanded the royalty payment thresholds in 2009, is not in support of this renewed stance.

That Indian MNCs benefit from global brands, technology, and other product developments cannot be disputed. SEBI understands this and does not intend to stop royalty and brand fee payments – it has only asked companies to seek shareholder approval. Investors too are discerning – resolutions for royalty payments presented by Castrol India Ltd. and Nestle India Ltd. in 2019 passed with a dominant majority. Fear of lack of investor support for such payouts could only be attributed to the royalty payouts being inexplicably large.

There are 16 MNCs that paid over 2 percent of revenues in royalty during the financial year ending in 2018.

While total outflow on account of royalty was Rs 7,823 crore, the bulk of the payout is concentrated.

Maruti Suzuki India Ltd. accounts for almost half the total royalty paid out by the 30 MNCs.

The ‘Unease’ Of Doing Business

To attract FDI flows and technology transfers, the government had relaxed rules regarding royalty payments and technology collaborations – it did away with all thresholds. But that was in 2009. In 2019, the Indian economy is vastly different. One of the risks IiAS had raised in December 2012 was the possibility of a steadfast step-up in royalty payments without a commensurate increase in revenues or margins, and this played out in subsequent years.

Given the number of licenses, and the paperwork it takes to start and shut down a business in India, the ease of doing business is a legitimate concern. The World Bank’s Doing Business 2019 report pegs India 77th out of 190 countries in the EODB list.

While India’s rank has improved from the previous year, it is not something to be proud of. India ranks lower than several smaller economies such as Kyrgyz Republic (70), Slovenia (40), and Azerbaijan (25).

But how far should we extend the argument of ease of doing business? Does that mean that every step towards better corporate governance is automatically construed as another impediment to doing business?

In Doing Business 2019, India ranked seventh on 'Protecting Minority Investors', which has been the result of the reforms on the governance agenda and the empowerment of investors through new regulation, including bringing in class action suits. Paradoxically, sudden delays in implementation of stronger corporate governance reforms, or deviations from the stated agenda is likely to reduce India’s score and be counter-productive to India’s its overall rank in the Doing Business index.

Regulatory Back-And-Forth Not Good For Investor Confidence

The announcement of regulations and their rolling back, or delays in their implementation, does not augur well for investor confidence in India. SEBI’s delay in implementation of the shareholder approval for royalty payments isn’t the first instance of a rethink. Earlier, recommendations towards the voting by majority of minority shareholders on related party transactions ping-ponged between SEBI and the Ministry of Corporate Affairs. Only once this was settled did SEBI put out regulations that were far more balanced and supported investor interest.

Push-back on norms that improve corporate governance standards is yet another classic (perceived) dichotomy between the importance of FDI vis-à-vis foreign portfolio inflows. But, economic growth cannot favour one at the cost of another. While the tug-of-war between SEBI and the government is necessary for balanced regulation, last minute impediments create uncertainty. SEBI and the Finance Ministry need to align themselves on the corporate governance agenda for the longer-term interests of all stakeholders.

Hetal Dalal is chief operating officer at Institutional Investor Advisory Services.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.