Shareholders, Beware Of These RPT Hacks Companies Use
On paper the safeguards are plenty but in reality companies often find cracks to hide RPTs.
In the battle for good governance India Inc. keeps tripping on three letters—RPT. Related Party Transactions. This even though India today has among the most stringent laws and regulations pertaining to the disclosure and approval of related party transactions.
The Companies Act, 2013 includes a detailed section on RPTs and subsequently market regulator Securities and Exchange Board of India also tightened the listing regulations.
As a result, all transactions with a related party have to be approved by the listed company’s audit committee. Those transactions that are not at “arm’s length” or in the “ordinary course of business” also need board approval. If the RPTs breach certain monetary thresholds laid out in company law, then they need shareholder approval. SEBI requires that any “material” transaction (10 percent or more of annual turnover) must also be approved by shareholders.
At all stages—whether audit committee approval, board approval or shareholder approval—the related party is not permitted to vote on the transaction. Though, SEBI permits a related party (not interested in the transaction) to cast a negative vote in a shareholder's resolution.
On paper the safeguards are plenty but in reality companies often find cracks to slip RPTs through without board or shareholder approval, say experts.
Large Indian companies are promoter-led and somehow I believe that promoters have still not gotten over the fact that their companies are publicly listed, they still believe that they own these companies. And they would like to get something more than the dividend other shareholders get.Bharat Vasani, Partner, Cyril Amarchand Mangaldas
These are the more common routes via which RPTs escape shareholder scrutiny.
1. Label the RPT as at arm’s length and in the ordinary course of business. Arm’s length has a general definition under company law but ordinary course of business is not defined.
2. Do large transactions such that they are not in the same financial year, to sidestep shareholder approval under SEBI’s material transactions requirement.
3. Often RPTs are hidden in restructurings such as a merger.
4. Often RPTs are routed through 100 percent subsidiaries of the parent company.
5. The ownership of the related party is kept opaque and web-like to avoid identifying it as a related party.
Despite the hacks, the legal provisions have ensured that more RPTs are being put to vote and due to shareholder engagement fewer are being voted out. Yet...
In many companies, the house the promoter stays in is owned by the company and the office is owned by promoter. We will continue to see that for a long time. Till we get that out of the way, I will say that there is still work to be done.Amit Tandon, Co-founder, IiAS
Watch the full discussion with Bharat Vasani and Amit Tandon here:
Read edited excerpts here:
We have stringent laws and regulations on RPTs. Yet several blue chip companies have shown governance lapses and subsequent stock price declines. What has gone wrong?
Bharat Vasani: I think, undoubtedly, India is the strictest regime if you compare it with others jurisdictions. In fact most lawyers from London believe that we are over-legislated on the issue of related party transactions. The government has amended this provision (Section 188) almost three times, since the Companies Act, 2013 has come in and SEBI has amended the provisions multiple times since 2015. But the problem is that India Inc. is a promoted-led society. Large Indian companies are promoted-led and somehow I believe that the promoters have still not gotten over the fact that their companies are publicly listed, they still believe that they own these companies. And they would like to get something more than the dividend other shareholders get.
I have been seeing all my career that every company has couple of related party transactions which keep coming up for approval. Now, transactions between large companies which are at arm’s length, I don’t complain about, but transactions with a promoter group company is a matter of concern. We need to differentiate between a whole host of transactions which come up to the audit committee for the approval. It may be very routine, I am just giving you one example- Tata Motors buying steel from Tata Steel, negotiated on very strict conditions, on arm’s length basis and at market price. That’s fine. But when the transaction is with the promoter individual and their family members and their private companies, that is the major problem. And I believe despite the stringent regulations bright corporate lawyers have been able to find escape routes.
One of the major escape route, I will tell you. Section 188 has let open one major gateway which is that if the transaction is in the ordinary course and is at arm’s length, it need not get shareholder approval. And SEBI has kept 10 percent of annual consolidated turnover of the entire entity as the definition of ‘material’ - which in my opinion is a very, very high limit. So, most of the transactions go below that limit and then you don’t have to go through shareholders. Of the various party related transactions even today large numbers of transactions are going outside of the purview of the approval of shareholders and that’s really the problem.
It’s not just promoter culture. Whether in the case of a promoter-led company like Sun Pharma, where the promoter owned the main distribution agency for Sun, or in the case of a widely held company like IL&FS, which was found to indulge in poor lending practices with group companies, it is a fairly widespread problem across the companies.
Amit Tandon: Absolutely it is widespread, but I would kind like to make a point which is that with regard to has happened to RPTs and after those regulations have come in, sure it has not addressed all the problems. You do see issues like Sun Pharma, but one of the reasons it is out is the regulations. One of the positive consequences of this whole thing has been that the companies are explaining more. They are engaging far more with investors and I would say for some of them it’s also deterrence now. They do realise given the fact that investors are focused on RPTs. they should ask maybe it is the right thing to do or should we just hold back. I would like to put that on table. Having said so, whether it works, and all for the instances, certainly not. Are there loopholes which companies exploit? Bharat just mentioned two of them, what is in the ordinary course and what is at arm’s length. It kind of gives companies some leeway in terms of how they are doing it. There are another few issues which- one is that who is a related party and who is not? I think, while SEBI has tried to address that issue, a lot of that is still (grey). According to me, you have to define it in terms of where is the economic interest, rather than just asking are you on the board of the company.
And finally, there is also this distinction which companies have now started making when they start to vote on RPTs, between related parties and interested parties. When you look at the data and often see how shareholders have voted, you say look promoters hold 45 percent but how is it that only 22 percent have voted, and their view is that look while we hold 45 percent, 23 percent is interested and the remaining is not interested. So we need to get our arms around that and be consistent in terms of what is interested and what is related.
You are saying that the definition of related party itself needs to be widened to cover other relationships as well which otherwise escape notice?
Amit: I rather use the word comprehensive rather than widening.
Also, SEBI requires that if you are a related party, whether you are interested in that particular transaction or not, you must abstain from voting unless you are voting negatively.
Bharat: Yes and that is the change the Kotak Committee brought about. So, if there is fight between two brothers and one brother votes against the transaction (proposed by the other brother) he can do so within the SEBI regulations. Otherwise in past he was prevented from doing so.
Amit: I have a different point, when we look at the data, even in listed companies; people have taken the view, so I don’t think so they are making the distinction between listed and unlisted companies.
I have detailed the approval process. The loophole or escape hatch is that companies find a way to declare these RPTs to be at arm’s length and in the ordinary course of business and hence only need audit committee approval. They don’t need board approval, they don’t need shareholders approval.
Bharat: The second major issue as I told you is the definition of material - 10 percent of the annual consolidated turnover for the relevant financial year. So, if you do one RPT in March and the next in April, they are in two separate financial years and effectively in the span of one month you have done more than the 10 percent of the turnover but still it will not be regarded (as material) because the SEBI definition is with regard to financial year. Also, 10 percent has to be calculated with regard to your consolidated turnover which is a very high number. If you see some of the large listed companies, the consolidated number is very high. The Companies Act has kept a lower limit in terms of threshold values but Companies Act has provided a major gateway in arm’s length and ordinary course.
What I have found in a large number of promoted companies, the board normally accepts the management’s argument without insisting on an external opinion that this transaction is in the ordinary course. You take a very broad view, if the transaction is in the main objects of the company, and you know main object clause is so widely drafted, then it can be considered in the ordinary course. But what if the company has not started that business ever and is starting it for first time, but still the lawyer has given opinion that it is in the main objects of the company and hence can be considered in the ordinary course of business.
Arm’s length is defined. So how are boards assessing whether the RPT is at arm’s length or not? Are they getting a third party to certify that? Are they doing open bids? Are there ways to make sure that the price or terms that they are getting are competitive? How are they making sure that arm’s length is truly arm’s length or not?
Amit: On arm’s length, there are two ways in which you can do it- one is you get two or three people to bid for the project, the other is that you do benchmarking. Both of them are right and there are issues with both of them. We have seen companies selling their head office - who is it going to be sold to? And how do you determine whether it is at the right price? Is it just that you looked at the ready reckoner and said this is the price and therefore I am going to go with it, which is what a benchmark will give you and you could say it is at arm’s length.
Companies are supposed to have RPT policies defined by the board. How many companies are putting down their understanding of arm’s length in those polices, in detail, and then abiding by them?
Amit: I would say not enough.
Bharat: The audit committee’s perpetual dilemma is some major transaction, for example EPC contracts, which are highly complex and have several parameters and two parties may not be alike. To determine whether the pricing is arm’s length is very challenging. These days we are finding ultra conservative audit committee or board members who don’t want to take risk. They have insisted on a legal opinion for determining whether it is in the ordinary course and a chartered accountant for an opinion that the pricing is arm’s length. While legal opinion is given on basis that it is included in the objects of the company and so it is ordinary course, but for arm’s length I found that very rarely people go through income tax criteria given in Section 92 of Income Tax act. By and large, somehow managements have been able to get views that the transaction is at arm’s length. Some transactions are extremely complex and to say that the transaction is done at arm’s length, only experts with a domain knowledge of the industry can determine that.
I would recommend that this over insistence on financial literacy in audit committee—there has to be an amendment in the Companies Act to provide that one member of the audit committee has strong domain knowledge of the industry for him to decide on RPTs. A very sound engineer who has done hundreds of projects in life would say whether this EPC contract is done right and whether the capabilities of the two parties are identical. Getting the quotations in India is not very difficult.
Often prices are competitive but benefits are hidden in the terms and conditions of contracts. And this is exploited very often.
Amit: If you look at the composition of audit committee, we find that someone from family is sitting there as a member of audit committee.
But you’re supposed to have majority of independent directors, right? And a related party cannot vote on the transaction.
Amit: Yes,but if you have someone from the family and if you have a related party transaction, the conversation can become uncomfortable in the room. Therefore, we advocate that ideally the audit committee should not have members from the family.
Bharat: Knowing this problem, Ministry of Corporate Affairs, in all fairness, has amended that rule 15 of the Companies rules, which says that the related party representative has to vacate the room. He cannot be physically present in the room.
Amit: They abstain or they step out. But our view is that they should not have them on the committee to begin with.
We’ve discussed arm’s length. What about ordinary course of business. If the activity is listed in the objects of the company then can you say this is in the ordinary course of business? How easy or difficult is this to game?
Bharat: There are a couple of judicial pronouncements on what is ordinary course and what is not. For a hospitality sector like a hotel company -they would argue that buying property is ordinary course of business because my job is to acquire property. It is not just contracts for housekeeping, maintenance and catering. In every transaction, there will be an argument that this is in the ordinary course of business because I am required to do it for running of my business. But you don’t buy properties every day. Property transactions are worth hundreds of crore. For any related party getting in there, you can have a serious problem but I have seen lawyers comfortably signing on opinions saying that it is in the main objects of the company. No lawyer is ever prosecuted for giving wrong opinion.
Let me use an example for analysis. Take an aviation company has a contract with a simulation training business set up by the promoter. The rationale given is that in that part of the country there weren’t enough other third party services available for such pilot training. And to ensure regular training of pilots in an efficient, logistically friendly fashion, the best thing that could have been done was for the promoter to set up this simulation/training business. The listed aviation company has entered a 15-year contract with that simulation/training business - because the training business too needs to break even and needs a long contract without which it won’t make the investments
How should shareholders consider such a related party transaction? Should the promoter be setting up such a business and transacting with the main listed company? Is it a good thing the promoter is doing for the listed company, or else this service would have been difficult to get? Also how does one judge whether the terms of transactions are at arm’s length or not given there are no competing service available easily? Would this be in the ordinary course of business or not? Should it stay only with the audit committee approval? Should it come to the board? Should it also come to shareholders? Because how often do you set up a 15 year contract?
Amit: Unfortunately, there is no right answer. I would ask a few more questions to figure out whether it is in ordinary course of business.
The promoter says there is no competing service available in that geography, then how do you judge if this is at arm’s length?
Amit: The question at that stage to ask is why the company didn’t want to do it (set up the training service itself)? If you are giving a 15-year contract, you have visibility that you need the service for 15 years.
Maybe your pilots were not enough for that capacity. Maybe you wanted that capacity to service other airlines as well?
Amit: One of the obvious questions to ask is have some payments been made upfront, which are discounted, to pay for the facility.
How did we know this? It only stayed in realm of audit committee approval because it got classified as an at arm’s length and in the ordinary course of business transaction. It never came to the board and shareholders. Is this good practice or bad practice?
Amit: Something, which is as critical as this and not within the company, and is going to the promoter, is something which would make me extremely nervous. And the question to ask is, are you the best person to do it. We have seen that telecom companies have set up towers in their own entities. You have got a model there. You say that towers are not fully utilised. Vodafone, Idea and Bharti have come together to set up tower businesses.
You are saying the aviation company, which is a listed company, could have set up the simulation facility themselves.
Amit: If they are worried about the fact that it is not going to be used, they could have spoken to others - that will you come in and join with us. You’ve got the technology provider who could easily have picked up the entire cost if you are guaranteeing it for 15 years. Those are questions to asked. Depending on the answers you get, you will be clear whether it is something to be nervous about or not.
Bharat: I’ll give you more examples. One very routine cost is crew uniforms. There are instances where crew uniforms have been procured through an entity set up by the promoter. He was also in the aviation business.
Second example - the largest cost for a civil aviation company is buying of aircraft and engines. Every audit committee will say that it is in the ordinary course of business. Most of the aircraft in the Indian aviation sector are leased aircraft. I have found examples where promoters have set up a company overseas where that company buys aircraft and leases it to the Indian listed company.
To return to my example - At the very minimum, should the shareholders of the company demand a vote on the RPT?
Bharat: I agree with that. Otherwise every contract will be required for the business of the company, if you start taking everything as in the ordinary course of business. Some routine contracts like purchase of uniforms or other things are being treated as ordinary course of business and routinely procured through entities which are related to promoters.
On the definition of ‘material’ - even if the gain to the promoter is Rs 50-100 crore, it is not an insignificant gain. It is at the cost of other shareholders.
Amit: All this is happening for the board to take a view. The question that they are competent to take a view is to be asked. Second, shareholders may or may not have information (to vote on it).
That’s a common complaint by companies. When these RPTs provisions were introduced several companies complained to me about the additional paperwork. And whether shareholders read it.
Bharat: This is the strategy. These days every company has started going for integrated reporting. You get a 600-page annual report and you are the missing the woods for the trees. You are overfed with information. So, the right information you are looking for, which is qualification in audit report, material related party transactions, you have to search. How many shareholders have the patience to go through a 650-page document to figure out right information? So, that is the real strategy—to make the document so bulky that nobody can read it.
Amit: One of the things we find is that companies are concerned about investors. They worry about it a lot. We also get calls from investors about RPTs, asking how we are viewing them. If you saw when the guideline on royalty payments changed, some companies went out and met investors for the first time.
Let’s explain what this was about. SEBI brought in the clause that if your related party transaction has to do with brand royalty payment and it is larger than 5 percent of turnover, you need to get approval of minority shareholders. So all companies suddenly took brand loyalty to below that threshold figure, so they would not need shareholder approval? And then the rule reversed.
Amit: Colgate remained at 5 percent. With Nestle, it was 3.8-4 percent. For some MNCs, it was down to 2 percent and back to 5 percent. As an investor, I believe some amount of royalty needs to be paid. Whether the right number is two, four, six, eight percent I don’t know. So, the companies were explaining to shareholders why they believe that four or 2.5 or five is right?
Many have been treating royalty payments also as in the ordinary course of business? So that it should not come to a shareholder vote.
Amit: That is the view which they had.
What business is not in the ordinary course of business?
Amit: Everything is in the ordinary course of business. Companies should have a policy. The other way to define it is that if for three years running, I am to buying something for Rs 100 crore and suddenly I have to buy it for Rs 350 crore - then there is a change and it is not in the ordinary course of business and you should go back to shareholders. Is there any policy which boards have? Are directors aware of it? I don’t think boards have policies even to define it.
The best of companies have put in policies though. If you look at their websites you will find corporate governance policies and under that a related party transactions policy.
Bharat: Audit committee is the the more worried lot. They are required to take the onus of approving those transactions and eventually some of transactions don’t go to the board. Audit committees have become vigilant. I wouldn’t say they are totally negligent. You will always find odd cases where they have sided with promoter and not bothered to ask the right questions.
Amit: When we looked at it in 2015, only six of the Nifty 50 companies had these policies. One of the reasons we brought in our document was to help companies think it through.
What about shareholders? Are they able to comprehend the RPT complexity? Have you noticed in the voting patterns whether shareholders are standing up for themselves or not?
Amit: If we look at the data for the last three years, we tracked about 500 related party transactions. Seven of them got defeated but there is a nuanced view. You would find 4-5 percent in which they have voted against. In other instances, there may be 20-25. For each of these companies, you do see a difference in terms of how they voted. Even in the same company when there are different related party transactions, you will see a difference in how the votes have fallen. Therefore, my assumption, reading the data, is that investors are getting a little bit more nuanced in how they understand some of these issues.
Bharat: Till now, assuming the company has not followed in spirit Section 188 or SEBI provisions, what was the recourse? The National Company Law Tribunal is so heavily overburdened, unless somebody complains nothing happens. What will now happen is the thresholds for filing class section lawsuits have been lowered by the government of India last month. It is so low now that I see the possibility of shareholder activism for this in the future.
Even now, the nimblest of investor will get out. He will vote with his feet. Unless you are suffering post facto effects.
Amit: It is changing. Most of the people prefer to exit. But given the fact that institutional ownership is now at 36 percent and promoters own 50 percent, the moment you exit the stock it is a very steep decline. Lots of people at least prefer to engage, understand what the company will do, are they going to change their mind, will they get some comfort? And then they decide what they want to do. There is a one off - in one of the companies where they decided to take higher royalty, the stock corrected by about 12-14 percent. Then they withdrew the decision and the stock bounced back. That conversation is happening between investors and companies to a very large extent and far more time than in the past.
Bharat: There is a perceptible sense of fear in independent directors post some of the recent episodes where they tried to attach their bank accounts, particularly in real estate companies, and few other cases where they went after independent directors, despite the immunity given under the Companies Act. This has lead to some independent directors asking inconvenient questions in the board meetings and infact abstaining from voting on some of these issues and recording the dissent. I have seen instances where independent directors have recorded dissent for approving the related party transaction.
In your experience, what types of transactions should shareholders should be most wary of?
Bharat: If the companies is buying real estate from a promoter company or promoter family or company is selling real estate to promoter company or family. Any transaction of very sizeable amount, which is directly with promoter family or a company floated by promoter family, is certainly an issue that you need to be vigilant about, in terms of whether it’s at right pricing or not. Real estate is one sector where there is maximum scope (for grey). In some large deals like the civil aviation sector—the purchase of aircraft and engines which are very major things or contracts for catering, uniforms of crew or other stuff.
Amit: Cases where people merge businesses and use it to increase their shareholding. Multinationals have been doing it. Or when you give money to a 100 percent subsidiary and that subsidiary moves the money out and you have no control over that because giving money to a subsidiary-- no one says no. The subsidiary then takes approval from parent entity to move it out. .
Bharat: Corporate restructuring schemes under Companies Act, old Section 391 to 394 is now in new sections. The ministry of corporate affairs came out with a circular in 2014 that related party provisions will not apply to corporate restructuring. So, this major chunk of transactions which require detailed scrutiny, MCA has come out with a circular saying RPT provisions don’t apply to corporate restructuring.
Often promoters disguise RPTs via continuous changes in shareholding of the related party. So nobody can identify that company as a related party and hence that transaction never comes up for scrutiny at any level. Also, do you know of anyone punished for violating RPT provisions?
Bharat: There are provisions which have come up recently - Significant Beneficial Ownership provisions. This will reveal who is the ultimate beneficial owner of those web of companies and the person behind it. Many of these transactions will get caught and government has the power to confiscate the property under Benami Transactions Act. Under SBO rules, if within one year they don’t file ownership details the matter is reported to NCLT and then the entire property or the shares in question will get transferred to the Investor Education and Protection Fund. That’s why the SBO declaration has created so much scare in the market. Today, the maximum number of time law firms are spending are on advising on SBO filings.
It’s fair to say then that even though we continue to see a large number of cases of questionable RPTs legal provisions have helped reduce the number of instances. So, we are headed in right direction?
Amit: We are headed in the right direction. When we look at data about how the voting happened 4-5 years back, about 11 percent of transactions where voted against. Now, the number is down to 4 percent. Therefore, investors are getting much more comfortable because there is more disclosure and engagement. And there are fewer egregious RPTs because the consequences are very severe. People realise that just because you transferred property to yourself at a cheaper price the impact on the market capitalisation of the company will be much more than a few hundred crore than you will make on the side.
Bharat: Electronic voting has improved the percentage of voting at the AGMs and that has led to fear.
Amit: We are seeing a change. It has not plugged all the loopholes. There are people who will continue to do it. In many companies, the house the promoter stays is owned by the company and the office is owned by promoter. We will continue to see that for a long time. Till we get that out of the way, I will say that there is still work to be done.