By Palash Moolchandani
Introduction
The infamous fallout between the promoters of Indigo Airlines in 2019 brought to light a number of lapses in corporate governance within the organization.[1] The uncovering of these problematic circumstances started the dialogue on related party transactions and regulatory framework in India, which went on to become the heart of the entire issue.[2] Since then, it has been argued that there is a need for a more stringent regulatory regime.[3] The primary reason for which is that, in various instances, entities with the help of complex structures used to comply with the letter of the law while completely negating it in its spirit.[4] Therefore, to enhance the quality of disclosures and to further protect the interest of minority shareholders, the SEBI formulated a Working Group to review the policy space concerning related party transactions in India. The group released its report on 27th January 2020, suggesting some significant amendments in the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”).
This article discusses the suggested amendments in detail and also highlights their impact on listed entities and investors if such amendments are incorporated into the regulation.
Analysis of the recommendations made by the Working Group
- Definition of ‘Related Party’
As per the current LODR regulations, ‘related party’ within its scope includes any persons/entities holding 20% or more of a listed entity, either as a promoter or part of the promoter group of such entity.[5] The working group has suggested doing away with this subjective classification and instead recommended, including all promoters or persons/entities belonging to the promoter group within the definition of the related party. The rationale behind enlarging the scope of this definition is that a promoter or a person/entity belonging to the promoter group could exercise control over a listed entity irrespective of the shareholding it holds.
Further, the working group has also recommended including any person/entity, holding (directly or indirectly) 20% or more shareholding of a listed entity within the definition of ‘related party.’ The reason for such inclusion of a person/entity holding a substantial amount of shareholding is that it can exercise significant influence over the decision making of such an entity. This provision is in alignment with various advanced jurisdictions like the U.K., where a person/entity holding 10% or more of shareholding is deemed as a related party.
- Definition of ‘Related Party Transactions’
The Working Group observed that the current definition of ‘related party transactions’ under regulation 2(zc) of LODR needs to be broadened to include transactions that are undertaken with the intent of avoiding regulatory compliance by the use of unconventional, complex structures. Thus, in order to enlarge the scope of ‘related party transactions,’ it is suggested to include all transactions which, directly or indirectly, benefit the related party. It is asserted that an introduction of such a ‘catch-all’ provision would certainly help in regulating frivolous transactions with un-related parties, undertaken with an intention to benefit the related party.
Conversely, the introduction of such a provision could impose an additional burden on companies as it would be difficult for them to identify transactions that benefit a related party. Further, the working group has also suggested the exclusion of corporate transactions that are individually regulated by SEBI, such as preferential allotment or payment of dividends.
- Materiality Thresholds with regard to prior approval from shareholders
Currently, Regulation 23(1) of LODR mandates prior approval of shareholders before undertaking transactions whose value exceeds 10% of the annual consolidated turnover. These transactions are known as ‘material’ related party transactions. The Working Group, after reviewing data consisting of transactions that involved shareholder approval of the 500 top listed companies, came to the conclusion that the prescribed threshold of 10% to determine ‘materiality’ of a transaction is relatively high. Moreover, the Working Group also took into consideration instances where entities earned high revenues but still obtained a low net-worth. In such instances, entities undertaking related party transactions would not require prior shareholder approval as the value of such transactions may only account for a minor proportion of the entity’s total revenue, even though it is significant to its total net worth.
Therefore taking into account the above issues, the Working Group has concluded that a related party transaction would be considered material and would further be subject to the prior approval of the shareholders if it exceeds Rs 1,000 crore or 5% of annual total revenue, total assets or net worth. This recommendation is in alignment with listing regulations of the U.K. and Singapore, where transactions that exceed the 5% ceiling are subject to shareholder approval.
It is asserted that such a provision would certainly expand the regulatory net as the number of transactions requiring shareholder approval would rise. However, such a provision would increase the compliance burden on listed entities, which may further act as an impediment to undertake legitimate transactions.
- Approval of Related Party Transactions by the Audit Committee
The existing framework for constituting an audit committee for all listed entities is provided under Regulation 18 of the LODR. However, the regulation does not specify the kind of information which needs to be put forth before the audit committee while seeking approval for any related party transaction. Therefore, the working group has proposed a format that specifies the kind of information that needs to be placed before the audit committee while seeking approval for any related party transaction. The Working Group also suggested separate disclosures of related party transactions with a single party to avoid clubbing or netting of transactions of similar types.
Additionally, the group recommended that entities, while undertaking RPTs that are recurring in nature, should disclose the exact time period within which such transactions would be completed. Further, the status of such recurring transactions would also be subject to an annual review by the audit committee.
It is asserted that such an amendment would ease the burden on the audit committee and would certainly enhance the uniformity and disclosure standard within the listed entities while undertaking related party transactions.
Critical Analysis
The recommendations put forth by the Working Group, if adopted, would definitely tighten the regulatory net surrounding related party transactions. However, Prof. Umakanth Varottil, in his seminal work, has argued that the hypothesis that strict regulation of RPTs would consequently amount to a “good law” is inaccurate.[6] On pragmatic application, evidence that contradicted this hypothesis was uncovered and it was found that the Indian regulatory regime had encountered certain roadblocks owing to the overly strict legal control over RPTs. Further, the corporate culture and the Rule of Law norms prevalent in the country equally play an important role in determining the efficacy of RPT regulations.
At first blush, the recommendation of capturing transactions that directly or indirectly benefit the related party appears sound in theory. However, audit firms might face many practical difficulties in implementing such a provision because firstly, the Working Group has not provided any parameters or standards which can be used to identify transactions that might benefit the related party. Secondly, in the absence of any established parameters, the decision by the audit committee on whether a particular transaction benefits a related party or not becomes very subjective. It is asserted that following such a subjective criterion might potentially lead to future litigation.
Additionally, the Working Group’s recommendation of prior shareholder approval of transactions that exceed 5% of “annual” total revenue, total assets, or net worth is a welcome step in increasing transparency and market integrity. However, the Working Group failed to consider that entities can easily avoid this provision of mandatory shareholder approval by entering into large transactions in a manner by which they do not fall in the same financial year. For example, an entity can enter into one RPT in March and the other one in April so that both of them will be in separate financial years. This way, they would effectively be able to undertake two RPTs within the span of one month and also avoid mandatory shareholder approval.
Concluding Remarks
It is patently apparent that in order to strengthen our corporate governance regime, policies concerning related party transactions require a few amendments. The changes suggested by the Working Group will have a significant impact on reporting and disclosure standards generally followed by the industry. This would mainly be due to the changes recommended in definitions of ‘related party’ and ‘related party transactions.’ Moreover, such a change would help in averting transactions that are carefully undertaken to avoid the regulatory net by using complex structures. However, changes like this could pose practical challenges for the audit committees, especially while determining whether a particular transaction in question, directly or indirectly benefits the related party or not. Overall, it is expected that the suggestions recommended by the Working Group would support SEBI’s endeavour to consistently strengthen the corporate governance regime in India.
The author is currently enrolled in the third year of their law degree from the National Law University Odisha.
[1] Anurag Kotoky, IndiGo’s billionaire owners’ feud over governance lapses heads to court, the print (Oct. 2, 2019, 2:06 PM), https://theprint.in/economy/indigos-owners-feud-over-heads-to-court/300006/.
[2] Apoorva Mandhani, All about related party transactions that are at the heart of IndiGo promoters’ spat, the print (Jul. 23, 2019, 10:32 AM), https://theprint.in/theprint-essential/all-about-related-party-transactions-that-are-at-the-heart-of-indigo-promoters-spat/266333/.
[3] Ashima Obhan, Related Party Transactions: How close is too close?, Mondaq (Dec. 2, 2019), https://www.mondaq.com/india/shareholders/870562/related-party-transactions-how-close-is-too-close.
[4] Ajit Warrier, Law on Related Party Transactions- Need for reform?, Mondaq (Aug. 8, 2019), https://www.mondaq.com/india/corporate-and-company-law/834636/law-on-related-party-transactions-need-for-reform
[5] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg 2(zb).
[6]Dan W. Puchniak & Umakanth Varottil, Related Party Transactions in Commonwealth Asia: Complicating the Comparative Paradigm, SSRN Electronic Journal (February 2019), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3332131.
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