[By Muskan Madhogaria, Lavanya Bhattacharya and Srishti Gupta]
The authors are students of Jindal Global Law School.
Introduction
The Securities and Exchange Board of India (“SEBI”) recently by way of a Consultation Paper dated 21st February 2023, proposed mandatory disclosure requirements for listed entities by amending Regulation 30 of the LODR along with certain other shareholder approval mechanisms. This has prompted several suggestions for consideration, some of which are discussed in this paper.
What amounts to ‘impact’?
Listed entities are required to disclose agreements that have an ‘impact on the management and control’ of their businesses, but the use of the word “impact” lacks a threshold value to avoid imposing unnecessary compliance burdens on companies. Under such a broad scope, investors are prone to receiving information that is irrelevant and distracting to their investment and voting decisions. Additionally, listed entities must ensure that the information they disclose is not misleading, false, or deceptive and does not omit anything that may affect the interpretation of such information.
Discrepancies with the Pre-Existing Framework
Under Regulation 30 of the LODR, any disclosure requirements must meet the standard of materiality laid down in Clause 2(e) of Chapter II. This requires the listed entity to provide accurate and timely disclosure on all significant matters, including the financial situation, performance, ownership, and governance of the listed entity. However, it’s uncertain whether agreements that ‘impact management or control’ or impose any restrictions or liabilities would always be deemed material to the company. In cases where such agreements don’t meet the materiality standard, the listed entity won’t be liable for informing its shareholders about them. SEBI should also clarify the distinction between transactions covered under this regime and the Related Party Transactions (RPT) regime and adopt a more nuanced approach that is able to harmonize the pre-existing regulatory framework to better compliance.
It is also important to note that SHAs typically include change in control clauses as they can provide important protections and mechanisms for shareholders in the event of a change in ownership or control of the company. However, the specific terms of these clauses can vary widely depending on the preferences of the shareholders involved and the nature of the company’s business and ownership structure. Whether a particular SHA requires disclosure of change in control should be pertinent to decide whether such disclosures are to be made to the shareholder.
Additional Compliance and Regulatory Burden
The board or audit committee members will be held responsible for determining whether a detailed opinion on the proposed agreements requiring disclosure is necessary for seeking shareholder approval. This expanded role of evaluating these agreements would primarily be assigned to the audit committee, independent directors, and the Board, as executive directors are usually representatives of the promoter group, which would inevitably increase the regulatory burden on them.
Insufficient Time Period for Disclosure
Compared to the US and UK frameworks, which allow for up to 4 business days and 21 calendar days, respectively, the 24-hour time period is very short and puts a burden on both the listed entity and the shareholders to ensure timely disclosure. Industry standards suggest that the time period for such disclosures should be reasonably extended to allow for more thoughtful and informed decision-making by shareholders.
Obtaining Shareholder Approval for Agreements That Impose a Restriction or Liability
Agreements of such nature are typically subject to incorporation into the company’s AoA, which itself requires shareholder approval. Creating a double requirement for shareholder approval in all those situations will only add to the compliance burden. 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. Consequently, this renewed shift of power shall be susceptible to challenges such as the risk of decision-making errors and shifting of agency costs by retail shareholders upon institutional shareholders.
For any agreement that might really inflict restrictions or obligations, regardless of whether the listed entity is directly engaged, the proposed update also demands shareholder approval. While this is a good corporate governance measure, applying it retrospectively to existing agreements could create compliance issues. Shareholders may have vested interests in past agreements and revisiting them now could cause complications for the company, especially if significant business decisions have already been made based on these agreements. However, for agreements that provide protective rights or board seats to the listed entity and are not already included in the company’s articles of association, disclosure and approval will be required at the first AGM or EGM meeting after April 01, 2023. Future obligations arising from such agreements will depend on shareholder ratification.
Status of Special Rights issue to Directors in the United States and key takeaways for SEBI
Stock markets work on the basic principle that all shareholders are created equal. Therefore, any special rights that are negotiated at the PE stage usually fall away post listing. However, it is usual for some governance rights to be negotiated to remain in effect after a company goes public. Private equity investors may request a position on the board or observer rights, and sometimes they retain veto power in specific situations after the IPO.
In the United States, there existsa proper difference between dual class and single class IPOs since the former is subjected to more scrutiny. A dataset created by searching the IPO documents of around 1,870 companies in the United States that went public from 2000 to 2020 suggested that companies often grant disproportionate rights to shareholders through a combination of agreements. These control rights typically exist in tandem with other control rights relating to the board of directors, which allows insider shareholders to have the power not only to choose who sits on the board, but also to control their decision-making process. However, these shares are treated as single class in form and therefore subject to a lower threshold.
Empirical literature suggests that the option of issuing dual class shares has pushed a lot of companies to go public which would have otherwise been reluctant. They can exercise unequal voting structures to maintain control rights while transferring economic rights. Similar reasoning can be extended to single class shares with special voting rights. Hence, periodic approval by shareholders to monitor these rights seems to be a solution in the right direction.
It has been observed in US, that companies issue shares with special rights to skirt the restrictions that protect the public shareholders in dual class companies. SEBI must also create a higher governance mechanism for dual class IPOs which has recently been permitted. However, shares with special rights must be considered a sub-category of dual-class shares and subject to higher governance requirements.
Appropriate Approval mechanism
There could be certain drawbacks associated with the periodic approval mechanism that needs to be taken into consideration. Firstly, due to information asymmetry and lack of commercial knowledge shareholders may not be able recognize situations wherein the retention of these special rights may be necessary for the founder to ensure stability and long-term planning and secondly, most shareholders invest with the aim of maximizing profits and may not be able to make an informed opinion.
Special rights for Public Financial Institutions
A public financial institution may invest in two capacities: one, as a creditor and two as an investor. As a creditor, Public Financial Institution takes a lot of risk, and consequently it negotiates for special rights like board nomination rights to restrict the powers of a company. These rights are usually included as covenants to the loan agreement. In such a situation, a periodic approval may not be that effective. Instead, an event based sunset clause must be introduced. However, an extension of these rights should be an option that must be available to the company subject to shareholders resolution for a period of 5 years.
However, in case of investment as a qualified institutional buyer, a periodic approval of 5 years by shareholders may be more appropriate. However, the expertise and the benefits that accrue as a consequence of their investment and expertise must be properly conveyed to the shareholders to ensure that an informed decision can be taken.
Insufficient definition of ‘objects and commercial rationale’
Additionally, SEBI has proposed a new requirement for disclosure of ‘objects and commercial rationale’ for sale, lease, or disposal of whole or part of the undertaking outside the Scheme of Arrangement. However, much like the management and control test, SEBI has failed to incorporate an objective criterion to determine this disclosure requirement.
Enforceability risk with obtaining ‘majority of minority’ in addition to special resolution:
The proposed amendment suggests that agreements at the Shareholder/Promoter level shall not be valid unless adopted by special resolution of the shareholders and approved by the majority of the shareholders. This would provide an enforceability issue in promoter-driven M&A agreements, such as those for transactions involving the restructuring 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. It is unclear if such agreements will be ineffective until the shareholders of the listed firm have authorised them by special resolution and majority of minority, which must be secured later on according to the current framework for slump sales and schemes.
Concluding Remarks
Although SEBI has proposed these amendments with the aim of promoting good corporate governance practices such as enhancing transparency of listed entities and strengthening the rights of minority shareholders, certain technical drawbacks within the proposed framework detract from the existing principles of corporate governance. Furthermore, the new legislation also comes with the potential of increasing compliance burden by diverging from industry norms. At this juncture, it is imperative for SEBI to achieve a balance while implementing these stringent requirements by taking into consideration the grievances of corporate entities. In order to achieve this balance, SEBI must firstly issue guidelines on which agreements can be considered to have an impact on management and control by laying down objective standards , secondly, creating a clear distinction between single and dual class IPOs with specific carve outs for certain category of investors like Public Financial Institutions that require different compliance and governance requirements proportionate to the risk and finally, with respect to sale of assets outside the scheme of arrangement, a comprehensive guideline on what constitutes ‘objective and commercial’ rationale must be ascertained and onerous approval requirements must be watered down.