Reconsidering Related Party Regulations: Critical Analysis of SEBI (LODR) Regulations 2021

[By Chaitanya Gupta]

The author is a student of Jindal Global Law School.

 

Introduction

Related parties are important to corporate transactions because the parties have a pre-existing special relationship. Such transactions include business deals, series of contracts, etc. These relationships that exist prior to the transaction may appear in the form of parent-affiliate companies, parent-subsidiary companies, transactions between family members, and others.

Usually, such transactions are employed for illegal, profit-making purposes, like fraudulently diverting resources and earnings (tunnelling). It can have severe consequences like affect shareholder dividends/profits, create a negative perception about the company’s governance, and hamper the growth of the company. Nevertheless, in certain circumstances, RPTs can benefit the company. Oftentimes, RPTs can cut transaction costs and creating operational efficiency. In fact, in some cases it has been observed that companies operating in groups, can save on operational costs, share risks, and improve productivity.

RPTs in India

In India, there is a peculiar pattern of ownership, i.e., a high concentration of ownership in the hands of particular individuals or families, and a large number of companies that are grouped under the ownership of one family or particular individuals. Thus, one promoter group often owns a group of companies. This pattern is bound to create conflicts between this promoter group and the minority shareholders. The rationale behind such conflicts is that the promoter groups tend to divert resources and profits for their benefit, so as to avoid proportional distribution of profits. The most common way to achieve this is to engage in ‘self-dealing transactions’, wherein finances are driven towards another company owned by the promoter group.

Latest disclosure requirements and its problems

The Indian corporate law regime qua RPTs is captured in Ss.2(76) and 188 of the Companies Act 2013. This regime is extended by SEBI’s Listing Obligations and Disclosure Requirements (LODR) 2015, the amendment of which came in force on April 2022 and 2023. It was formulated to incorporate the recommendations made by the Working Group Report of January 2020. One of the significant changes made is that RPTs require prior shareholder approval, as opposed to ex post facto approval. The primary argument of this article is to determine if SEBI cast the net too wide with the current disclosure requirements.

Definition of ‘RPTs’

As per the latest LODR, the definitions of ‘related parties’ and RPTs were expanded, and the threshold of transaction value for shareholder approval was lowered. A related party thus includes a person/entity in possession of 20% equity shares or above, either directly, or on a beneficial interest basis. This 20% threshold fell down to 10% on 01.04.2023.

Such a pure shareholding threshold to determine who is a related party precludes them from approving the transaction and would disenfranchise several investors. Financial investors like LIC, and the Indian Government would not be exempt from this disenfranchisement if they crossed these thresholds. The chances that investors will get disenfranchised double when the threshold goes down to 10%. This reduction arguably has no legal basis. The 20% threshold was grounded in the rationale of the Working Group Report, to deter shareholders with ‘significant influence’ from voting on material RPTs, and this Report does not endorse the further reduction to 10%.

Nevertheless, some transactions have been exempted under these new guidelines. Transactions that directly and equally affect all shareholders or investors will not come under the fold of RPTs. However, the Reg.2(1)(zc) provides a finite list of such exempted transactions, viz., rights or bonus issue, buy-back of securities, dividend payment, and consolidation of securities.

This change brings routine transactions under the purview of material transactions that require shareholder approval and/or audit committee scrutiny. Thus, transactions in the ordinary course of business, between affiliate companies of a large group or conglomerate are also scrutinised. This subjects routine transactions to auditory approvals, which not only obstructs the transaction but also unnecessarily burdens the audit committee. Even instances of real estate transactions that occur at below fair market value, while may trigger alarms of an abusive RPT; are a day-to-day transaction within conglomerates to promote struggling companies.

While this may be a fair trade-off to create excessive audit scrutiny, lest an abusive RPT slips through the cracks, the additional burden on the committee creates an environment where all transactions do not get sufficient deliberation. Even though the exempted transactions are exhaustively listed, it raises uncertainty about other corporate actions and, whether transactions other than those exempted require prior shareholder approval or auditory scrutiny?

The 1000 crore threshold

These regulations have also stipulated a new monetary threshold of INR 1000 crore. RPTs that are beyond this limit need to be reported, so as to be subject to shareholder scrutiny. This new threshold is an absolute limit compared to the erstwhile provision, which had a threshold of 10% of the annual turnover of the company.

This threshold can arguably be ultra vires of As.14 and 19(1)(g) of the Constitution. By virtue of the SEBI Act, SEBI will come under the definition of ‘the State’ as under A.12, and therefore its actions would be amenable to challenges of fundamental rights violation. The Khoday Distilleries case provides that regulations, specifically delegated legislations, can be struck down for being ‘manifestly arbitrary’ on the anvil of A.14. In fact, such delegated legislations are accorded less immunity than statutes of the legislature.

Per Om Kumar, ‘non-classification arbitrariness’ is assessed under the ‘proportionality test’, and ‘classification arbitrariness’ is assessed under ‘Wednesbury principles’. The former tests if the means adopted are proportional to achieve the desired object, and the latter determines if the means share a sufficient nexus with the object. In the context of SEBI trying to protect the interests of minority shareholders and maintaining high standards of corporate governance, does this threshold create a disproportionate impact on large listed companies, thereby making it arbitrary?

While it can be claimed that the aim of ensuring rights to minority shareholders and the maintenance of corporate governance could be achieved by scrutinising transactions that would not have been examined previously, it could be argued that such equal treatment of companies of all scales, would disproportionately impact the larger corporate entities. The NSIRIAA case held that in challenges concerning A.14, the ‘effect’ of the law should weigh heavier than the ‘object’ to be achieved by that law. Per contra, there is jurisprudence offering more latitude to laws governing economic activities, especially by according more deference to SEBI. Consequently, the vires of this threshold is questionable.

Alternative Approach

Alternatively, there is an approach that claims that these regulations were necessary given the Indian corporate regime and shareholding patterns. The new definition of ‘related parties’ had to be made broader because often, the control over the company is not measured by shareholding, and a lower threshold would help in capturing the Indian family-oriented business models of interlinked corporate entities. Even the Asian Roundtable Guide advises that RPTs should be broadly defined to capture all transactions that present even a slight risk of abuse.

Lastly, the Working Group Report highlighted that simply having a 10% turnover threshold to determine ‘material’ RPTs allowed many transactions to escape scrutiny. Therefore, using this threshold in conjunction with the 1000 crore one, provides for more transparency considering the growth of Indian businesses, and some of their adaptations to avoid the 10% threshold.

While deference has been given to the wisdom of SEBI, it has cast its net too wide in this particular instance. This wide net will bring too many transactions to the scrutiny of the audit committee and warrant several prior shareholder approvals that companies and conglomerates would be unable to transact day-to-day business. While SEBI may have bona fide intention, its regulations may need some review.

Jurisdictional comparative

Hong Kong

The corporate structures of public companies in Hong Kong are very similar to India’s. Almost all companies are characterised by concentrated ownership, with such owners possessing more than 20% equity, while playing an active role in management. Additionally, businesses in Hong Kong are often characterised as ‘family-affairs’, where family shareholders dominate such public companies, and the public only owns a small percentage of shares (minority). Consequently, RPTs occur very frequently in Hong Kong; they are often referred to as ‘connected transactions’. Almost two-third of all connected transactions expropriated company resources to the detriment of minority shareholders.

The Listing Rule 14A defines a ‘connected person’ as an owner with more than 10% equity, and the transaction with their ‘associate’, who may be a family member with whom the connected person transacts. This wide definition captures a lot of transactions, which includes loans, sale-purchase of securities, goods and services, etc. This Rule operates by dividing connected transactions in three categories, (1) low value transactions that need not be reported or approved; (2) transactions that must be publicly announced and reported, but do not require shareholder approval; and (3) transactions that must be reported, announced and approved by a majority of independent shareholders. As such, Hong Kong provides a comprehensive framework to capture all significant abusive RPTs.

Singapore

Singapore follows a similar RPT model as Hong Kong. It also has a hierarchy of RPTs. Announcement of RPTs is necessary for transactions worth more than 3% of all company assets, and transactions worth more than 5% warrants announcement and shareholder approval. At the same time, companies can obtain a general approval from shareholders to for recurring RPTs, which gives a blanket approval.

Conclusion and suggestions

It is thus evident that the latest LODR regulations take into account too many transactions, and create arbitrary thresholds. India requires a more comprehensive and robust system of reporting, announcing and seeking approvals with respect to RPTs that suit its promoter concentrated ownership pattern. From the Hong Kong and Singapore experience, creating a hierarchy of related-party transactions will help in sifting out transactions based on value, while maintaining symmetry of information across investors, promoters and all shareholders. These disclosures could be pegged to turnover values, or assets so that they uniformly impact all companies.  Thus, a division based on value, will help out over-burdened audit committees, and alert shareholders when significant transactions are about to take place. Thus disclosures should have an explanatory statement by the Board of Directors must be attached to when presenting the RPT for approval.

The further decreased threshold of 10% could be omitted, and the Government could be exempted from the class of related parties despite its share of ownership in companies, since it is estopped from acting arbitrarily due to A.14. A larger list of exempted transactions could be provided, since the latest regulations cover very routine transactions, and also cover corporate actions covered by other legal provisions. Mergers, acquisitions, restructuring are all transactions that are covered by Ss.230-232 Companies Act, yet by virtue of Regulation 2(1)(zc) they are included in the list of possibly abusive RPTs.

Such suggested amendments to these RPT regulations will help catch these abusive transactions, as it will bring focus the regulatory work of minority shareholders and the audit committee. If these amendments are not made, regulators or scrutinisers will continue to miss the wood for the trees, which will create disproportionate compliance burdens.

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