SEBI has been progressively tightening the regulatory regime surrounding transactions impacting listed entities – beginning with the implementation of the Kotak Committee recommendations on related party transactions (RPTs) through amendments to the LODR Regulations on May 9, 2018. Shortly thereafter, in November, 2019, SEBI constituted a Working Group (WG) to re-examine the RPT provisions of LODR Regulations, which resulted in the markets regulator notifying amendments on November 9, 2021, which took effect from April 01, 2022. These amendments brought about a paradigm shift by making the RPT approval and disclosure requirements applicable to listed companies in India very expansive and stringent.
SEBI through its Consultation Paper ‘Strengthening Corporate Governance at Listed Entities by Empowering Shareholders – Amendments to SEBI (LODR) Regulations, 2015’ (“LODR Consultation Paper”), dated February 21, 2023, has now, inter alia, proposed further restrictions on transactions, which may not involve listed entities directly, but impact or have the purpose and effect of impacting management and control of listed entities, or creation of a restriction or liability on listed entities (“Promoter / Shareholders Arrangements”) and we are covering this in this blog post. Other changes proposed in the LODR Consultation Paper relate to (i) special rights to shareholders; (ii) shareholders’ approval for business transfers; and (iii) board permanency.
Key Proposed Changes
The LODR Consultation Paper recognizes that there are certain agreements that Promoters/ shareholders enter into, either inter-se or with third parties, which (a) place restrictions on listed entities, without following due approval processes by the listed entities (since the listed entities are not party to such agreements); (b) provide no benefit to listed entities; (c) restrict the ability of shareholders to take decisions in the best interest of the listed companies; and (d) are against the fundamental principles of corporate governance and shareholder democracy since they are not disclosed to the public shareholders and the public shareholders have no say on the obligations being imposed on the listed entities.
This problem statement of low transparency and inadequate minority shareholder protection is being addressed in the LODR Consultation Paper through the following proposed changes:
- Disclosure Framework
(a) Insertion of New clause 5A in para A of Part A of Schedule III to the LODR Regulations, requiring that any agreement which, either directly or indirectly or whose purpose and effect is to impact the management or control of a listed entity, or impose any restriction or create any liability on a listed entity, shall be disclosed to the stock exchanges, irrespective of whether the listed entity is a party to such agreements. Such agreements are also required to be disclosed in the Annual Report of the listed entity from FY23-24 onwards for continuous disclosure.
(b) The disclosure requirement applies only to such agreements that have been entered into by “shareholders, promoters, promoter group, related parties, directors, key managerial personnel, any other officer of a listed entity or of its holding, subsidiary, associate company, solely or jointly with the listed entity or a third party”. They do not apply to agreements entered into by a listed entity in the normal course of business (such as purchase agreements and supply agreements), which are not otherwise disclosable.
(c) The disclosure is to be made by the Promoters/ shareholders to the listed company within 2 working days from the date of the agreement, and the listed company is in turn required to disclose the same to the stock exchanges within the timelines prescribed under Regulation 30. SEBI had in another consultation paper in November, 2022, proposed to tighten the timelines for such disclosure, which is under consideration.
(d) Subsisting agreements as on March 31, 2023, would be required to be disclosed to the listed entity by the parties (i.e. promoters, shareholders, etc.), by May 31, 2023. The listed companies would have to disclose the same to the stock exchanges by June 30, 2023, and in the Annual Report for FY22-23.
- Approval Requirements
(a) Any agreement which imposes or has the effect of imposing any restriction or liability on a listed entity, whether or not the listed entity is a party, would require the approval of the Board of Directors, which would be required to provide its reasoned opinion on whether such agreement is in the economic interest of the listed entity.
(b) Such agreements will not be effective unless and until approved by the shareholders of the listed entity (approval through special resolution and ‘majority of the minority’ shareholders).
(c) Existing Promoter/ Shareholder Arrangements are to be placed before the board, and thereafter before the shareholders in the first AGM/ EGM of the listed company held after April 01, 2023, for ratification – future obligations arising out of such agreements will be contingent upon ratification.
The proposed amendments are intended to enhance corporate governance regime by mandating transparency and parity of information for public shareholders and requiring enhanced approvals from public shareholders, including majority of public shareholders. While the objectives are laudable, the proposed framework is at times ambiguous and at other times contradictory, with unintended consequences.
- Inconsistent drafting – clarity needed
While the intent of the proposed change appears to require disclosure of agreements (i) inter-se between “shareholders, promoters, promoter group, related parties, directors, key managerial personnel, any other officer of a listed entity or of its holding, subsidiary, associate company” or (ii) between such persons and a third party, the proviso to the proposed clause 5A is not happily drafted, as it appears to require that the counter-party is either the listed entity or a third party, and does not cover inter-se agreements between the aforementioned persons. This needs to be clarified.
- Extremely wide scope
The LODR Consultation Paper has sought to create a distinction between disclosure and approval requirements, by requiring disclosure of agreements (i) which impact or have the effect of impacting management or control over listed entities; and (ii) which have the impact of imposing any restriction or liability of listed companies, and limiting approval requirement to the latter. Since the above scope is wide in amplitude, without reference to the nature, magnitude or materiality of these restrictions/ liability, any and all agreements at the shareholder level, having any impact on a listed entity, will trigger the specified disclosure and approvals.
There are several agreements that are otherwise regulated and permitted in terms of the other applicable SEBI regulations such as SEBI (SAST) Regulations, 2011 (SAST Regulations). Hence agreements, such as: (i) promoter voting arrangements between persons who are already in control of a listed company, which is exempt from an open offer requirement under the SAST Regulations; and (ii) voting pool arrangements for ‘majority of minority’ votes between two minority shareholders or investors (holding less than 25% collectively), which does not trigger an open offer under the SAST Regulations or otherwise require shareholder approval, would require the listed entity’s board’s opinion and shareholders’ approval to be effective. The applicability of these provisions need to be harmonized with the existing regulatory framework.
- Interpretational issues vis-à-vis RPT provisions
These provisions need to be aligned with other provisions of the LODR Regulations, particularly Regulation 23 relating to RPTs. The proposed amendments include transactions/ agreements entered into by the promoters, shareholders, directors, KMPs, etc., with the listed entity, which are also covered under the definition of RPT, resulting in ambiguity on which framework will apply. Although ‘majority of minority’ applies in both cases, the requirements under this proposal appear more stringent – (i) there are no materiality thresholds applicable (unlike Regulation 23, which contemplates only ‘material’ RPTs requiring shareholder approval); and (ii) special resolution of shareholders’ is required (instead of ordinary resolution under Regulation 23). In a further contradiction, an agreement imposing any restriction on a listed company to which the listed entity is a party will need shareholder approval only if it exceeds the materiality thresholds, but if the listed entity is not party to such agreement but its promoters are, shareholder approval will be required without regard to its materiality.
Similarly, the proposed framework has a carveout from approval requirements, for transactions in the ‘normal course of business’, which is absent in Regulation 23 – it could be argued that the ‘normal course of business’ carveout should be read into the RPT provisions. Pending clarity from SEBI on these aspects, once the regulations are issued, it would be prudent to apply the higher of the two standards.
- Practical challenges
(a) Implementation Challenges
Certain difficulties would arise in implementation, such as: (a) promoters/ promoter group, related parties, directors, etc., would now need to seek specific legal advice at the time of entering into any agreement, which have provisions related to the manner of exercise of their board or shareholder level voting rights in the listed entity, even if the listed entity itself is not a party thereto; (b) other promoters/ promoter group shareholders of a listed entity would not be able to vote on the ‘majority of minority’ vote on said agreements, even if they are not party to such agreements.
(b) Enforceability risks in strategic M&A transactions
Agreements at the shareholder/ promoter level would not be effective, without shareholders’ special resolution and majority of minority approval. This would present an enforceability risk in promoter-driven M&A agreements, such as framework agreements for transactions involving re-structuring of a listed company’s business through slump sale or scheme, which may be entered into between promoter entities of a listed company with a third party. Whether such agreements will be without effect (including key clauses such as exclusivity, standstills, obligation to support the transaction at board and shareholder levels) until the shareholders of the listed entity have approved by special resolution and majority of minority, which are necessarily obtained at a later stage under the current framework for slump sale and schemes, remains an open question. A harmonious reading of these amendments would be that any restriction/ liability would not be enforceable against the listed company (while still being enforceable between the parties inter-se), pending such approvals.
(c) Shareholder rights of financial investors
This proposal has implications on financial investors in listed companies who have existing agreements that are subsisting as on March 31, 2023. In case of such agreements, which have protective rights relating to listed entities or the right to a board seat or any other rights which contemplate a restriction on listed entities, and where such rights are not already incorporated into the AoA, these would need to be disclosed to the listed entity, and approved by the board and shareholders of the listed entity at the first AGM/ EGM after April 01, 2023. Future obligations arising out of such agreements will be contingent upon ratification.
(d) Enhanced responsibility on Independent Directors/ Audit Committee
Inclusion of a ‘purpose and effect’ test akin to the ‘purpose and effect’ test included by SEBI in the definition of RPT in Regulation 2(zc) of the LODR Regulations, without guidance on the scope and nature of restrictions/ liabilities sought to be covered, will make parties more cautious. Parties will disclose all agreements to the listed entity, and the board/ audit committee members will be hard pressed to assess whether they are required to provide a detailed opinion on such agreements and put it up for shareholder ratification. This would increase the scope and role of the audit committee, independent directors and Board. Since executive directors are often promoters/ promoter group or their nominees, the responsibility for this assessment is likely to fall upon independent directors and audit committee members. This would further increase the regulatory burden on audit committees.
The proposed amendments are a step in the right direction to extend corporate governance and corporate due process requirements to restrain transactions designed to circumvent existing disclosure and approval requirements. However, in the absence of any specific guidance on nature, type and magnitude of the “restrictions and liabilities” that SEBI intends to apply these provisions to, the net has been cast far too wide and at times over-engineered and is tantamount to swatting flies with a sledgehammer.
In view of the issues raised and the contradictions highlighted above, some consideration is required on SEBI’s part. SEBI may consider clarifying the distinction between transactions sought to be covered under this regime and the RPT regime, and may consider adopting a more nuanced approach. The disclosure requirement in the proposed clause 5A can be retained as-is, in that agreements which impact management or control or impose a restriction or liability on listed entities are required to be disclosed to ensure complete transparency. But the approval requirement can be made applicable to only such agreements which meet certain materiality thresholds or other objective criteria/ categories in relation to the restrictions or liability they impose, like in the case of RPTs (instead of the present proposal of any and all agreements needing approval).