SEBI has recently revised the materiality threshold for obtaining shareholder approval for related party transactions (“RPTs”) under Regulation 23(1) of the SEBI (LODR) Regulations, 2015 (“LODR”), to cover RPTs that exceed INR 1000 crore or 10% of a listed entity’s annual consolidated turnover (as per the last audited financial statements), whichever is lower.
The revised materiality threshold has come into effect on April 1, 2022, and this change assumes significance, as prior to April 1, 2022, there was no absolute numerical threshold for RPTs that require shareholders’ approval.
This also raises the question as to whether an absolute numerical threshold of INR 1000 crore could potentially be considered as violative of Article 14 of the Indian Constitution.
In this post, the authors aim to probe deeper into this constitutional aspect and examine some of the arguments that can be made from both sides of the spectrum.
Problems posed by the revised materiality threshold
The unintended consequences brought about by an absolute numerical threshold of INR 1000 crore can be illustrated with the following example. Let us take a situation where Company A has an annual consolidated turnover of INR 10,000 crore. The INR 1000 crore materiality threshold will amount to 10% of Company A’s consolidated turnover. On the other hand, Company B has an annual consolidated turnover of INR 2,00,000 crore, and the materiality threshold of INR 1000 crore will amount to only 0.5% of its consolidated turnover. This begs the question as to whether it is constitutionally permissible to put a relatively small-sized transaction of Company B through the same requirement of obtaining shareholder approval as Company A?
In this context, it is pertinent to note that SEBI has also made significant amendments to the definition of “related party” and “RPTs” under LODR. Along with covering persons/entities belonging to the promoter/promoter group, the amended definition of ‘related party’ also includes any shareholder holding 20% or more equity shares in a listed entity. This would in turn include even a financial investor who holds a 20% equity stake.
The definition of ‘RPT’ has been amended to inter alia cover a “transfer of resources, services or obligations” between the “listed entity or any of its subsidiaries on one hand and a related party of the listed entity or any of its subsidiaries on the other hand”. As per the revised definition, even a transaction between two unlisted subsidiaries of a listed entity will be regarded as an RPT.
Significantly, SEBI has amended Regulation 23(4) of the LODR to specify that a “prior approval” of the shareholders is required for an RPT, and an ex post facto approval or ratification of the shareholders would not be permissible. Further, as per Regulation 23(4), no related party shall vote to approve the shareholder resolution for an RPT, irrespective of whether it is a related party to the particular transaction or not.
This results in a situation where every material RPT would require approval of the ‘majority of the minority shareholders’ of the listed entity, as the LODR inter alia prohibits the holding company, the promoters and any shareholder who holds a stake of 20% or above from voting to approve a material RPT.
This may result in unintended consequences where RPTs entered into as a part of the inter-connected business operations of a listed entity are stalled, until prior shareholder approval is obtained at the forthcoming AGM. For instance, a routine RPT entered into between the listed holding company and its subsidiary, for supply of raw material, sourcing of components etc may be stalled, leading to business continuity risks.
Could it be argued that the requirement of obtaining prior shareholder approval, which poses substantial business continuity risks, and subjects two companies with markedly different consolidated turnover to the same requirement of obtaining prior approval of the ‘majority of the minority shareholders’ – suffers from the vice of over-inclusion and is thus violative of Article 14?
Is the revised materiality threshold of INR 1000 crore arbitrary?
SEBI is the securities market regulator and a statutory authority which exercises powers and performs functions under the SEBI Act, 1992 (“SEBI Act”) and the Securities Contracts (Regulation) Act, 1956 (“SCRA”). There can be no manner of doubt that SEBI is ‘State’ within the meaning of the said term under Article 12 of the Constitution, and is subject to the discipline of Article 14 in exercise of its powers and functions under the SEBI Act and the SCRA, including the power to frame regulations. Thus, the revised materiality threshold of INR 1000 crore framed by SEBI in exercise of its power to frame/amend regulations is open to constitutional challenge if it violates the equality code enshrined under Article 14.
The equality code under Article 14 prescribes substantive and not only formal equality. The Supreme Court in the case EP Royappa v State of Tamil Nadu held that arbitrariness of state action is sufficient to constitute a violation of Article 14.
In Khoday Distilleries Ltd. v. State of Karnataka, it was held that Article 14 acts as a guarantee against arbitrary action, and delegated legislation can be struck down under Article 14 if it is ‘manifestly arbitrary’. Further, the SC has held that a piece of subordinate legislation does not carry the same degree of immunity which is enjoyed by a statute passed by the legislature.
In Sharma Transport v. Govt. of Andhra Pradesh, it was held that a delegated legislation can be shown to be manifestly arbitrary, if it is established that the delegated legislation is framed in a manner that is capricious, or without adequate determining principle, or is done without sound reason or judgment.
These tests have also been reiterated in the context of plenary legislation in the landmark judgment of the Supreme Court (“SC”) in Shayara Bano v. Union of India, which held that ‘manifest arbitrariness’ is something that has been done by the legislature “capriciously, irrationally and/or without adequate determining principle”.
For the purpose of differentiating RPTs that require prior shareholder approval and those which don’t, SEBI has used the numerical yardstick of INR 1000 crore or 10% of the annual consolidated turnover (as per the last audited financial statements) of the listed entity, whichever is lower. SEBI has not undertaken to classify listed companies that will be covered by this regime. This aspect assumes significance since the analysis involved in undertaking a review of Article 14 violations differs in classification and non-classification cases.
While ‘non-classification arbitrariness’ is tested based on the “proportionality” test, where the means are required to be proportional to the object, ‘classification arbitrariness’ is tested on the “rational nexus” test, where it is sufficient if the means share a ‘nexus’ with the object. The object sought to be achieved by the SEBI Act and the SCRA is to protect public investors and minority shareholders and ensure purity in administration of listed companies.
In this background, the crucial question that would arise for consideration is whether the absolute numerical threshold of INR 1000 crore, without considering a company’s size and the scale of the consolidated turnover as a benchmark, can be said to be an ‘adequate determining principle’. While the object of fixing an absolute numerical threshold may be legitimate, can it be argued that the disproportionate impact that it has on large listed companies is what makes it arbitrary?
In defence of the said amendment, it can be argued that the INR 1000 crore materiality threshold meets its objective that RPTs beyond a reasonable threshold are brought within the ambit of shareholder approval, and SEBI may rely on market data/surveys or other material that may suggest that currently very few RPTs are placed before the shareholders for approval, or that there is a greater need for regulation beyond the said threshold.
Thus, it could be argued that the revised materiality threshold aids the cause of corporate democracy by advancing the rights of minority shareholders, as a larger number of RPTs would be placed before the minority shareholders for approval, which would enable them to evaluate whether these transactions are genuinely in the company’s best interests.
This is especially important since in the case of State of Tamil Nadu & Anr. v National South Indian River Interlinking Agricultural Association, the SC has advocated that whilst undertaking a review of Article 14 violations, the emphasis ought to be on the “effect” of the law and not “object” or “objective” as has traditionally been suggested. The SC found that it was imperative to undertake a much more substantive review by focusing on the multi axle operation of equality and non-discrimination.
In this regard, reference may be made to the Preamble of the SEBI Act, 1992, which inter alia notes that the objective of the said Act is to – “provide for the establishment of a Board to protect the interests of investors in securities…”. The Preamble reaffirms that SEBI’s primary role is to safeguard the interests of the minority shareholders, and the INR 1000 crore materiality threshold promotes this objective by enabling minority shareholders to scrutinise more RPTs and have a greater say in relation to those transactions of a company where there is greater scope for a potential ‘conflict of interest’.
As an expert body established to protect the interests of minority shareholders, the courts are also likely to show a greater amount of deference to SEBI’s views on aspects that fall within its regulatory ambit. This approach was followed by the SC in its recent decision in Prakash Gupta v. SEBI, where it was observed that as an expert regulatory body for the securities market, SEBI’s views must be treated with a greater amount of deference.
Furthermore, SEBI could argue that the rationale behind the revised materiality threshold is to ensure that all RPTs above a certain value (i.e. INR 1000 crore) are placed before the shareholders for approval. Thus, the threshold has been determined on the basis of the value of the RPT, and not solely on the basis of the value of the consolidated turnover of the concerned listed entity.
Further, courts are likely to show a higher degree of deference to legislative judgment on matters concerning business or economic policy, as compared to matters concerning civil rights.As noted by a Constitution Bench of the SC in R. K. Garg v. Union of India – “laws relating to economic activities must be viewed with greater latitude and deference when compared to laws relating to civil rights”.
Further, in Subramanian Swamy v. CBI, it was held that a legislation does not become unconstitutional merely because there is an alternative view or another effective method which could achieve the objectives of the concerned policy, and that courts cannot substitute their views on what would be the best policy to bring about a particular objective.
Relying on the above judicial precedents, SEBI could argue that simply because an alternative view exists regarding what should be an appropriate threshold for classifying material RPTs, it is not open to the Court to substitute its views on SEBI’s legislative judgment as an expert body established to protect investors’ interests.
The road ahead
In the event the constitutional validity of the revised materiality threshold of INR 1000 crore is challenged before the court, there are compelling arguments that can be canvassed from both sides of the spectrum.
It will be interesting to see if the courts will agree to a judicial review of the change brought about by setting an absolute numerical materiality threshold for RPTs irrespective of the size of a listed company and the value of its consolidated turnover, or they would defer to SEBI’s judgment as an expert body in a policy matter.
 In exercise of its powers Section 11, sub section (2) of section 11A and Section 30 of the Securities and Exchange Board of India Act, 1992 (15 of 1992) read with Section 31 of the Securities Contracts (Regulation) Act, 1956, SEBI amended the SEBI (LODR) Regulations, 2015, vide the SEBI (Listing Obligations and Disclosure Requirements) (Sixth Amendment) Regulations, 2021.
 Regulation 2(1)(zb) of the LODR defines “related party”, and Regulation 2(1)(zc) defines “related party transaction”.
 As per Regulation 2(1)(zb) of the LODR, the 20% equity shareholding threshold for being categorised as a “related party” will be reduced to 10%, w.e.f. April 1, 2023.
 (1974) 4 SCC 3.
 (1996) 10 SCC 304.
 See Indian Express Newspapers (Bombay) Pvt. Ltd. and Ors. v. Union of India, (1985) 1 SCC 641.
 (2002) 2 SCC 188.
 (2017) 9 SCC 1.
 This was also highlighted in the SEBI Working Group Report on Related Party Transactions.
 2021 SCC OnLine SC 1114
 2021 SCC OnLine SC 485.
 See also, Chanchal Jain v. SEBI, (2010) 95 CLA 4, Delhi High Court.
 State of Gujarat v. Shri Ambica Mills Ltd., (1974) 4 SCC 656
 (1981) 4 SCC 675
 (2014) 8 SCC 682