Related-Party Transactions: Mischief Via Subsidiaries Must Be Fixed, Says SEBI’s Working Group
More often than not, governance controversies at corporate India have manifested themselves in the form of related-party transactions. For instance, loans of over Rs 3,000 crore by Jet Airways Ltd. to its subsidiary JetLite, real estate leasing and crew accommodation services provided by promoter companies to IndiGo, non-disclosure of Aditya Medisales—a promoter entity and a key distributor of Sun Pharmaceutical Industries Ltd.—as a related party. These are only a few recent instances of RPTs where audit committee or shareholder approval was allegedly not taken by companies, mostly on grounds that the law didn’t require so. That’s set to change.
A working group, set up by the market regulator in November last year, has suggested sweeping changes to the listing regulations to tighten the regulatory regime for RPTs. Incidentally, only two months ago, the Ministry of Corporate Affairs had diluted the RPT provisions under Companies Act, 2013. It had removed the monetary threshold for shareholder approval for transactions relating to sale and purchase of goods, lease etc.
Stakeholders are getting mixed signals because the ministry has taken a number of steps to clearly indicate that they want to liberalise the regime, Bharat Vasani, partner at Cyril Amarchand, said. First, they removed the monetary threshold, which means only transactions above 10 percent of the annual consolidated turnover would require shareholder approval. In November 2019, the Company Law Committee recommended decriminalisation of offence relating to related-party transactions and advocated just a monetary penalty, Vasani pointed out.
If it’s an unlisted company, the CLC (company law committee) recommended Rs 5 lakh and for a listed company, Rs 25 lakh. People will consider this as a cost of doing business in India and virtually, thousands of crores of related-party transactions will be undertaken by paying a nominal monetary penalty.Bharat Vasani, Partner, Cyril Amarchand Mangaldas
So, I’m not sure which direction we’re going, Vasani said. The MCA joint secretary is also on the board of Securities and Exchange Board of India—both agencies come under the Ministry of Finance. So, I do not know why these contradictory signals, he added.
There needs to be a consistency in the approach of the two agencies, otherwise it’s going to compound the issue and create a lot of confusion in the markets. However strong SEBI regulations might be, the confusion is enough to make the regulations inefficient when it comes to implementation.Umakanth Varottil, Associate Professor, National University of Singapore
SEBI Working Group: Key Proposals
The working group, led by Kotak Mahindra Capital’s Ramesh Srinivasan, has suggested:
- Promoter and promoter group entities, irrespective of their shareholding, should be considered as related parties. Presently, promoter entities holding 20 percent or more in the listed entity are considered as a related party.
- Any entity who, directly or indirectly, holds 20 percent or more in the listed entity should be considered as a related party. There is no such condition in the listing regulations presently.
- The materiality threshold for shareholder approval for a related-party transaction needs a relook—it should be Rs 1,000 crore or 5 percent of annual total revenue, total assets or net worth on a consolidated basis—whichever is lower. Presently, only transactions exceeding 10 percent of annual consolidated turnover need shareholder approval.
- Tighter scrutiny of RPTs undertaken by a subsidiary with the related parties of the listed entity or its subsidiaries. To this effect, it has proposed mandatory approval of the audit committee when:-
- The listed entity or any of its subsidiaries transacts with a related party of the listed entity or any of its subsidiaries, or
- The listed entity or any of its subsidiaries transacts with any entity—as long as the purpose or effect of the transaction is that it benefits a related party of the listed entity or any of its subsidiaries.
- Shareholder notice for RPT approval must disclose whether the audit committee unanimously approved the transaction, a justification why the transaction benefits the listed entity, whether the transaction relates to loans, inter-corporate deposits, advances, investments by listed entity or its subsidiary.
Here are the edited excerpts from Vasani and Varottil’s interview
The working group has sought to address instances where the listed entity could transfer its assets or value to a subsidiary in India or overseas and this subsidiary then transacts with the related parties of the listed entity—to, let’s say, move the assets out of the consolidated entity. Presently, such a transaction by an unlisted subsidiary with the related parties of the listed entities does not require audit committee or shareholder approval except in material sale or lease transactions. What kind of abuses have you seen as a result of this?
Vasani: It has been exploited quite extensively by the players in the market—unfortunately by taking legal opinions to protect themselves. While this will certainly plug the loophole which is currently there in the regulations, it will increase the compliance burden because if you are covering the transactions at a subsidiary level, the audit committee of listed company will have an enormous burden of ensuring that the large number of transactions which were hitherto outside the purview of the scrutiny, would also get added. I welcome the step, but I’m also concerned a bit whether it will lead to a phenomenal increase in the workload of the audit committee.
Varottil: It is a good recommendation because it considers the group as a whole on a consolidated basis—the listed company and its subsidiaries and related parties within any of these entities will be captured within the purview of this particular provision or regulation. The benefits do outweigh the costs involved but at the same time, I don’t think the audit committee procedures should be made so onerous that they become meaningless.
If this proposal is accepted, a transaction which crosses the materiality threshold would require the approval of the shareholders of the listed company even though the listed company is directly not a party to the transaction; only the subsidiary is.Umakanth Varottil, Associate Professor, NUS
The audit committee should determine whether a transaction benefits a related party. How practical is this proposal by the working group?
Vasani: I would treat this provision like GAAR (General Anti-Avoidance Rules) under the income tax law. The attempt here is to capture even transactions with entities which normally would not come under regulatory scrutiny because of opaque structures. So long as the objective is to benefit a related party of the listed entity, they would like to capture this transaction. My dilemma is that this responsibility is on the audit committee—it’s a very complex analysis. Perhaps they will have to take help of external experts. Undoubtedly, it will create certain practical challenges.
Varottil: The intent is to cover indirect transactions. If the listed company or its subsidiary enters into a transaction with a third party, which indirectly then benefits the related party, then this provision will kick in. Ultimately, the question is going to be who decides whether this transaction was intended to benefit the related party? At the outset, it's going to be the audit committee but this is a very subjective criterion. If the audit committee takes a call which the regulator does not agree with, then we are probably going to see litigation surrounding that. Of course, it’s difficult to lay down quantitative standards here but at the same time, we must prepare ourselves for considerable litigation on this.
The working group has suggested enhanced disclosures to shareholders. Will these be meaningful?
Vasani: If I was in the working group, I would have added one more provision that if there was a difference of opinion in the audit committee, what was the minority view? The shareholders need to know this. That should also be added. Logically each and every item of the proposed information should have always been provided to the shareholders for them to make an informed decision on a particular transaction. This information is currently not provided to the shareholders, and because of that, SEBI is required to legislate on it. It’s very unfortunate because it speaks of failure on the part of the management.