In the battle for good governance, India Inc. keeps tripping on three letters – RPT. Related-Party Transactions. This, despite the fact that India has one of the most elaborate set of rules and regulations for disclosures and approval of RPT by both listed and unlisted companies.
Historically, the Companies Act, 1956 did not specifically regulate RPTs. It had provisions that only restricted certain types of transactions.
The Companies Act, 2013 (CA, 2013) enacted Section 188, which for the first time began regulating certain types of transactions between companies and its “related parties” (as defined in CA 2013), and provided for the approval of such transactions (exceeding a prescribed monetary threshold) by non-related parties.
The Ministry of Corporate Affairs (MCA) regulates transactions between two unlisted companies, while SEBI looks at transactions when at least one of the parties to the transaction is a listed entity. Listed companies are required to follow stricter rules because public money is at play.
However, it appears that the regulators are still struggling to find a balance that satisfies two apparently contradictory objectives:-
- Protection of stakeholder interest from abusive RPTs.
- Facilitating “ease of doing business” by not disproportionately increasing compliance burden of companies.
In principle, one may agree with the SEBI’s stand that since it regulates transactions of listed entities in which there is substantial public interest, it is entitled to prescribe a more stringent set of regulations than those provided under CA, 2013. However, the fact remains that there are large unlisted companies with significant public interest at stake, as these unlisted companies are systemically important and have significant borrowings from banks and other public institutions.
Both the MCA and SEBI have changed their provisions with respect to regulating RPTs multiple times over the last five years. Yet, the regulatory architecture continues to remain in a state of flux.
“U” turns in regulatory architecture for RPTs:
Section 188 of the CA, 2013 came into force on April 1, 2014. The MCA has been diluting the rigours of RPT provisions ever since by issuing various clarificatory circulars and also amendments to CA 2013 and the Rules. It changed the special resolution requirement to an ordinary resolution (2015 Amendment). Further, the MCA circular dated July 17, 2014, clarified that only concerned related parties could not vote on the resolution for approval of RPT. It also clarified that the schemes of arrangement under Section 230-234 of CA, 2013 need not comply with Section 188. This circular goes against the scheme of Section 188 and its legal validity is doubtful. Moreover, Section 188 exempts transactions in the “ordinary course of business” and at “arm’s length” without adequately defining those terms. Many transactions are therefore escaping shareholder scrutiny. Companies have been seeking “convenient legal opinions” to treat certain transactions as being in the ordinary course and at arm’s length to avoid shareholder scrutiny.
The MCA recently amended the Rules and removed the numerical threshold of Rs 100 crore for approval of RPT by the shareholders. The Company Law Committee (CLC), constituted by the MCA, in its November 2019 report has recommended decriminalisation of RPT offence under Section 188 of CA, 2013, and has proposed only monetary penalty of Rs 25 lakh for listed companies and Rs 5 lakh for unlisted companies.
SEBI, too, has not been with steady with respect to framing regulations for brand royalty payments. In May 2018, it amended the Listing Obligations and Disclosure Requirements (LODR) to provide that any royalty payment exceeding 2% of the annual consolidated turnover would be deemed to be material RPT and would require shareholder approval (Kotak Committee had recommended a threshold of 5%). Then it revised the threshold to 5% of annual consolidated turnover with effect from June 27, 2019, and also granted extra time till July 1, 2019.
SEBI Working Group Report on RPTs:
SEBI implemented the Kotak Committee recommendations by making amendments to the LODR on May 9, 2018. In less than two years, in November, 2019, SEBI constituted a Working Group (WG) to re-examine the RPT provisions of LODR. The WG met five times in less than one month and produced the Report. Recommendations made by the WG seem to suggest that the regulator is not entirely convinced that the current provisions relating to RPT are adequate to curb the menace of abusive RPT. Recent corporate governance scandals involving the use of subsidiaries to enter into abusive RPTs may have aggravated the regulator’s anxiety.
The WG report has suggested the following changes in LODR to significantly tighten the RPT regulatory framework:
1. WG has proposed a modification in the definition of “Related Party” to include within its scope any person or entity belonging to the promoter or promoter group of the listed entity, irrespective of its shareholding. As per current requirement, such person or entity is required to hold 20% or more shareholding of the listed entity, which is proposed to be omitted. This would significantly enlarge the scope of the definition of related party under Regulation 2(zb) of LODR.
2. WG has proposed modifications in the definition of “Related Party Transactions” under Regulation 2(zc) of LODR by:
i. Covering transactions between the listed entity or any of its subsidiaries on the one hand and a related party of the listed entity or any of its subsidiaries on the other.
ii. The listed entity or any of its subsidiaries on the one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiary.
This is a “catch all” provision, borrowed from the UK Premium Listing Rules. However, its implications in the Indian context will be very different. Companies will encounter many practical challenges in identifying such transactions and coming to the conclusion that the purpose and effect of such transaction is to benefit a related party. It would make the task of the audit committee very onerous. The Audit Committee may rely on the advice of independent experts like accounting and legal firms to form an opinion that the purpose and effect of any such transaction is to benefit a related party of listed entity or any of its subsidiary, particularly when the listed entity has a large number of subsidiaries in and outside India.
3. WG has recommended that the revised definition of RPT should exclude certain corporate actions like payment of dividend, issue of securities on a preferential basis, rights issue, bonus issue, buyback of securities, etc. Consensus view in the legal circle is that such corporate actions, which are separately regulated by SEBI, were always outside the purview of RPT regulatory framework.
4. WG has also proposed a significant enlargement in the level of disclosures to the audit committees and to the shareholders. Logically, compliance officers should have provided those details in any case. It is unfortunate that the regulator has to step in to legally mandate it.
Changes Proposed in Materiality Threshold:
The WG has proposed a very important change in the materiality threshold. As against the current prescription of 10% of annual consolidated turnover, it is now proposed to lower the threshold to Rs 1,000 crore or 5% of annual total revenue, total assets or net worth (on a consolidated basis) of the listed entity, whichever is lower. This revised lower threshold is in line with what is prescribed in other jurisdictions like the UK, Singapore, etc. However, in the UK Listing Rules, transactions in the Ordinary Course of Business are carved out.
Further, the word “prior” has been added in Reg. 23(4) to make it abundantly clear that “ex-post facto” approval of shareholders will not be permissible. Also, any material modification will require prior approval of the audit committee of a listed entity.
This would lead to many more transactions of listed companies, requiring prior approval of the shareholders. It would also correspondingly increase the compliance costs of listed entities and many legitimate transactions may get captured in the enlarged regulatory net.
To alleviate the burden on the audit committees, it is proposed that if only the subsidiary of a listed entity is a party, but not the listed entity, then prior approval of the audit committee will be required only if the value of the transaction exceeds 10% of the annual total revenue, total assets or net worth of subsidiary, on a standalone basis. The net worth criteria will not apply if it is negative.
Similarly, in Reg. 23(4), it is proposed that prior approval of shareholders of the listed entity shall not be required for a RPT to which the listed subsidiary is a party, but the listed entity is not a party, if such listed subsidiary is not exempt under Reg. 23.
It is obvious that the regulator is trying to balance the compliance burden on listed entities against the need to prevent abusive RPTs.
It appears that both the MCA and SEBI are traveling in opposite directions, in their bid to devise a regulatory framework to prevent abusive RPTs.
The MCA framework appears to be not very robust, particularly when the MCA has removed the numerical threshold of Rs 100 crore in the Rules and issued various circulars to dilute the rigour of its original provisions. Again by providing a gateway of “ordinary course of business” and “arm’s length”, most transactions go outside the purview of shareholders’ scrutiny.
SEBI’s new prescription may result in significant increase in the workload of the audit committee and overall compliance burden of the listed companies. It seems that the recent unfortunate episodes of using subsidiary route to undertake RPTs which are not in the best interests of the minority shareholders, have led the WG to suggest a GAAR like remedy to bring all abusive RPTs in the regulatory net.
Such regulatory flip-flops are undesirable given that both the MCA and SEBI are under the common control of the Ministry of Finance. Stability in legal regime is desirable. Unfortunately, the regulatory tendency seems more reactive than proactive with respect to corporate governance issues coming to the surface. More often than not, changes in the regulatory architecture are only brought about post some corporate governance scandal coming to the fore.
Over the years, burden on audit committee has significantly increased. Four audit committee meetings every year get consumed by quarterly results. Most audit committees are complaining about onerous responsibilities and increased workload. In addition to duties cast under the CA, 2013 and LODR, audit committees are also required to monitor the whistle-blower mechanism and compliance related to Insider Trading Regulations.
The composition of audit committees is heavily loaded in favour of Chartered Accountants and financial experts. Many transactions require domain knowledge of the industry in which the companies are operating. It is important that the composition of an audit committee is suitably altered to provide for appointment of industry experts.
The conflict between the insatiable urge to take advantage of every loophole in the regulations and the anxiety of the regulators to plug every loophole in the regulatory architecture seems unending. Going by past experience, the WG report is certainly not the last word on this subject.