[By Owais S. Khan]
The author is a student of Government Law College, Mumbai.
Introduction:
On 11 October, 2024 the Securities & Exchange Board of India (SEBI) in the matter of Royal Orchid Hotels Ltd. (ROHL), imposed a monetary penalty upon ROHL, its Directors/ Promoters and the Chief Financial Officer (CFO) of the Ksheer Sagar Developers Pvt. Ltd. (KSDPL) under Section 11 of the SEBI Act, 1992 for violating multiple provisions of SEBI Act, the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR Regulations) and SEBI (Prohibition of Fraudulent and Unfair Trade Practices relating to Securities Market) Regulations, 2003 (PFUTP Regulations).
The order held that ROHL has misrepresented its consolidated financial statement, by classifying KSDPL as an associate company, despite being its subsidiary. This inflated the consolidated profit of ROHL, thereby enabling the directors/ promoters of ROHL, to offload their holdings and making a considerable gain on the basis of the profit, which was calculated on the basis of a misrepresentation. The scrip price of ROHL, also recorded a jump due to the wrong classification.
The present article inter alia deliberates on firstly, the evolution of control and significant influence in determining the relationship of a company with the holding company, secondly, the relevance and application of the Indian Accounting Standards (IndAS) in determining this relationship and finally attempts to examine the impact of this order in broadening the scope of control and matters concomitant thereto.
Control vs Significant Influence:
Section 2(87) of the Companies Act, 2013 (Act) defines that a company shall be deemed to be a subsidiary of the holding company if the holding company exercises or controls over more than one-half of the total voting power of subsidiary OR controls over the composition of the Board of the Directors (BoD). This establishes a holding – subsidiary relationship. Similarly, according to Section 2(6) of the Act, an associate company is the one in which another company has a significant influence, but is not a subsidiary of the company having influence.
In the ROHL matter, as per the Articles of Association (AoA) of KSDPL, the BoD of KSDPL would consist of 5 members, 3 of which would be appointed by ROHL. This dominance over the BOD was construed as a control, and KSDPL was initially declared as a subsidiary of ROHL. However, being a subsidiary of a listed company, KSDPL was under an obligation to appoint independent directors as per Sec. 149 of the Act. Thus, 2 independent directors were appointed on the board of KSDPL, taking the strength to 7. This resulted in ROHL having 3 members on the board out of 7. This change was interpreted to be a loss of its control over the composition of the BoD of KSDPL, classifying it as an associate company in the consolidated financial statement of ROHL.
The term Control has been defined in the Act under Section 2(27) which shall include the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner. Also, in the Subhkam Ventures, it has been held that to determine control, the person must be on the driver’s seat, wherein he owes a proactive and not a reactive role. It is power by which one can command the company to do, what he desires it to do. Control is a positive power and not a negative power. Similarly, it has been an explicit legal position that the power to control the composition of the BoD is a necessary element of holding-subsidiary relationship in Vodafone International Holdings B.V vs. Union of India.
Despite this limitation of control over the composition, SEBI held KSDPL to be a subsidiary of ROHL, owing to special rights which were conferred in favour of ROHL under the AoA of KSDPL. These were the rights to appoint the chairman of the BoD of KSDPL, and the right of the chairman to exercise a casting vote in case of a tie. SEBI held that this provides a virtual control to ROHL, to influence the decision-making power of the BoD, with the chairman, as a nominee of ROHL, exercising its power in favour of ROHL.
Associate vs Subsidiary in light of Ind AS
SEBI held that holding-subsidiary relationship is determined not only by virtue of the definitions in the Act, but also by the accounting standard under Ind AS 110 and shall not be dependent on the number of independent directors.
SEBI, in its order relied on Ind AS 110, in determining the control of ROHL over KSDP, taking the following factors into consideration for determining the control of the investor over the investee.
- Relevant activities and ability to direct the relevant activities: As per the Memorandum of Understanding (MoU), ROHL was conferred with the operational authority of KSDPL and all the key personnels managing the operations of KSDPL, including its CFO, were employees of ROHL, satisfying the criteria to control the relevant activities and decision making.
- Exposure or right to variable returns: ROHL had rights over management fees of KSDPL as a percent of its turnover and also as percent of earning over the gross profit. Thus, it was held that ROHL had exposure to variable returns, thus recognizing its control.
- Ability to use the power to affect return: With the control over the BoD and the terms of MoU and AoA, ROHL was held to be a decision maker having the ability to use its power to affect the returns of KSDPL.
The author advocates that the Act providing for control of at least 20% shareholding to exercise significant influence in another entity needs to corroborated with other grounds laid down in Ind AS 28 relating to investment in associate companies like representation in BoD, participation in policy making, material transactions, etc. to resolve this Associate/ Subsidiary relationship enigma.
Implications for Posterity:
The order can surely be hailed as one of the most significant adjudications in determining the holding- subsidiary relationship between companies, by relying not solely on the Act and the AoA, but also the MoU, the Operational and Shareholder Agreements and the Ind AS.
Firstly, the order brings new dynamics to the jurisprudence of control. Thus, the power to appoint chairman and the power to exercise casting vote through a nominee has also been included within the ambit of control. Thus, the companies must take the same in consideration in formulating the AoA or the shareholder’s agreement. This also assumes great importance for associate/ joint venture companies.
Similarly, the classification of control as De Jure and De Facto in Arcellormittal India, is surely a sigh of relief for the Private Equity Investors as the Affirmative voting Rights under the Shareholding Agreement remains outside the ambit of Control, thereby preventing them from being titled as a “promoter” and saving oneself form the manifold security and listing regulations. Thus, the author advocates that it is high time that the rights are incorporated in the agreements with a farsighted approach to ensure that they remain outside the ambit of control.
Secondly, it reflects that the holding- subsidiary relation does not depend solely on the shareholding pattern. KSDPL was held as the subsidiary of ROHL, despite ROHL holding only 50% of Shares of KSDPL. This contravenes the stand taken in GL Sultania & Anr vs. SEBI, wherein it was held that if one company holds 50% of the equity capital of the other entity, it cannot be considered as the subsidiary of the former. Even the definition provides for more than one- half. Thus, the MoU and the Agreements too, plays an imperative and crucial role in determining control.
Thirdly, the recognition of SEBI’s jurisdiction to examine the compliance of a company with the accounting standard. Regulation 4(1) of LODR Regulations states the information shall be prepared and disclosed in accordance with the applicable standards of accounting. This confers the power upon SEBI, to ensure the disclosure as per the accounting standards. This was also recognized in the Oasis Securities Ltd. & Ors vs. SEBI.
Fourthly, the ambit of offense of fraud under PFUTP Regulations is also expanded by this order whereby misrepresenting the subsidiary as associate in the financial statement, was held to be a fraud as the same resulted in inflation of profit and affected the decision of the investors.
Finally, the order serves a strong reminder, that market abuse, despite the presence or absence of mens rea, shall not be tolerated in the Rule of Law as was also held in SEBI vs. Kanaiyalal Baldevbhai Patel.
Way Forward:
This order of SEBI is a quintessential of juxtaposing and balancing between the point of law and point of facts, awarding priority to the later, highlighting the growing imperativeness of the rights conferred over the shareholders and its implications therein.
The author fully supports the order as at several instances the number game or the complex shareholding pattern disables the regulators from determining the mind behind the corporate veil and has resulted in court expanding the ambit of control. This order is also in consonance with the judgement of the Hon’ble Supreme Court in Shamrao Vithal Co-op Bank Ltd. vs. Kasargod Panduranga Mallya wherein while determining control, it was held that Control implies a supervisory power, not limiting itself only to the shareholding pattern. Also, the Delhi High Court in Oriental Industrial Investment Corporation vs. Union of India & Ors. has held that control can be exercised not only by virtue of being a majority shareholder, but also by virtue of certain special rights conferred by AoA. The order makes a bold move by not restricting to the number game, and determining control on the basis of the pragmatic realities of the corporate governance and framework which surely deserves appreciation.