Team Vinod Kothari & Company
Securities and Exchange Board of India (Listing Obligations and Disclosure Requirement) Regulations, 2015 (‘Listing Regulations’) as well as Companies Act, 2013 (‘Act, 2013’) specify the role of the audit committee and mandates the audit committee to mandatorily review certain matters. Among the matters to be reviewed by the audit committee, section 177 of the Act, 2013 provides for review of inter-corporate loans and investments. Additionally, under Regulation 18 read with Schedule II and Regulation 24 of the Listing Regulations, the audit committee shall review the utilization of the loans/advances given to subsidiaries which exceed a certain threshold and shall also review the financial statements of its unlisted subsidiary.
The intent of audit committee review is to provide an independent view of the strength, objectivity and transparency of long-term investments made by the company and financial exposures taken by the company into other entities. Additionally, the audit committee may also review whether the loans/investments are still serving the purpose that they were intended to achieve, and whether the health/fair value of the loans and investments has substantially been affected over time. The audit committee’s review may also become the basis for strategic decisions on continuing the said financial exposures.
In case of subsidiaries, they are a part of the extended enterprise led by the holding entity. The holding entity puts in capital and other resources into subsidiaries. The subsidiaries are engaged in specific activities/verticals based on the business model of the enterprise. The subsidiaries may make further downstream investments and thus, create a network, once again, within the larger group objective of the enterprise. However, the review by the audit committee ensures that the subsidiaries are serving the larger group objective that they were designed to serve.
The following is a guideline as to what should be the perspective of the review and the specific areas of concern for such loans and investments which are placed for review/scrutiny before the audit committee; when such review is to be made etc. Further, the perspective and purpose of the audit committee is different while reviewing the loans and investments to its subsidiaries and that given to others.
Relevant provisions of Listing Regulations:
“The audit committee of the listed entity shall review the financial statements, in particular, the investments made by the unlisted subsidiary.”
Para A of Part C of Schedule II:
“The role of the audit committee shall include the following:
- Scrutiny of inter-corporate loans and investments.
- reviewing the utilization of loans and/ or advances from/investment by the holding company in the subsidiary exceeding rupees 100 crore or 10% of the asset size of the subsidiary, whichever is lower including existing loans / advances / investments existing as on the date of coming into force of this provision”
Parallel provisions of Companies Act, 2013:
“Every audit committee shall act in accordance with the terms of reference specified in writing by the board which shall, inter alia, include:
(v) Scrutiny of inter-corporate loans and investments;
Clarification on the terms loans, advances and investment
Need to review inter corporate loans and investments by the audit committee:
Inter corporate loans and investments made by the company implies a long term financial exposure. Generally speaking, unless the company is into the business of making investments, the inter-corporate investments are not directional investments; they are strategic in nature. Similarly the inter-corporate loans, except in case of companies engaged in the business of lending, are not intended for reaping interest income. Therefore, the review of these long-term financial exposures to be taken by the audit committee is to ensure that these outlays of funds do not lead to long-term resources of the entity being diverted to a purpose which is not congenial or related to the corporate objective. The objective also includes review of the health and integrity of these loans and investments. Where required, disinvestment calls may also have to be taken based on review by the audit committee.
While the law requires the audit committee to review the inter-corporate loans and investments, there seems to be no reason for excluding the review of guarantees/ securities provided by the company in connection with the loan.
Need to review investments in and made by the unlisted subsidiaries:
The holding company invests in the capital of subsidiaries. While the need for reviewing the investment in subsidiaries does not come from the Companies Act, 2013, the Listing Regulations specifically requires the listed holding company to review the investments of its unlisted subsidiaries. The investments made by the subsidiaries are indirect investments of the holding company itself. Where the subsidiaries are listed entity, the investments made are subject to similar review by their audit committee. However, in case of unlisted subsidiaries, there is less likelihood that the subsidiary will have its own audit committee. Irrespective, the audit committee of the holding listed entity is entrusted with the responsibility of monitoring and reviewing the investments made by such subsidiaries. The audit committee of the holding company has to review such investments to understand if there is any diversion from the objectives of the investment. Further, in case of downward investment by the subsidiary, the audit committee shall review whether the larger objective of the holding company is being served.
Need to review loans given to unlisted subsidiary
The audit committee the holding company is required to review whether the loans granted by it to its subsidiary is being utilized for the approved purpose or not. Any case of diversion of funds has to be brought to the notice of the audit committee since any sort of funding to the subsidiary is always with an intent of expanding or stabilizing the operations of the holding company. Further, the audit committee while reviewing needs to check whether the terms on the loan are reasonably fair and at arm’s length.
Scope of ‘loans’ to be reviewed by audit committee:
The audit committee of the listed entity is required to scrutinize inter-corporate loans availed/ granted by the listed entity. Inter- corporate loans for the purpose of review shall include-
- Inter-corporate guarantees given by the listed entity;
- Inter-corporate security provided by the listed entity;
- Loans with terms and conditions substantially at variance with the loans ordinarily provided;
- Guarantees with terms and conditions substantially at variance with the guarantees usually provided;
- Loans other than in the ordinary course of business
Loans/ guarantees which are granted or security provided in the ordinary course of business or to exempted categories need not be reviewed by the audit committee.
Scope of ‘Investments’ to be reviewed by audit committee:
Investments as are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets held as stock-in-trade are not ‘investments’.
Investments which shall be reviewed by the audit committee of the listed entity will include strategic investments made with the motive to earn yield or regular investment income. Investing the funds reduces the investible funds of the entity, funds available for business and therefore it is necessary to review the same. Investments should not be restricted to investments in securities only. Investment in the assets/property should also be covered within the ambit. Certain investments, as specified here under, need not be included within the ambit:
- Trade investments made by the listed entity or its unlisted subsidiary;
- Investments made in the ordinary course of business;
- Statutory investments made under applicable law;
Specific concerns for review by the audit committee:
The perspective of the audit committee is different while scrutinizing loans and investments of the listed entity as well as while reviewing the investments made in/by the unlisted subsidiary. For this purpose the following points should be included by the audit committee in its review –
1. Specific concerns for loans to other entities
- Purpose of loan, how does it serve the business interest of the company;
- Tenure of loan;
- Where the company has raised any money by issuing any shares/ debentures, does the giving of the loan amount to utilization of issue proceeds for a purpose other than that disclosed in the offer document;
- Rate of interest appropriate in view of credit risk of investee;
- Security interest and liquidity;
- Whether the loan is being serviced or has become impaired;
- Whether the quality of the borrower has deteriorated;
- Whether repayment happens as per stated repayment schedule;
- Whether there exists a scope for premature repayment;
- Whether there exists any reason to opt for premature repayment;
- If loan is not to a related party, how and why the transaction emanate;
- Whether the loan has been extended on reasonably fair terms and conditions and at arm’s length.
2. Specific concerns for investment in other entities
- Purpose of investment, how does it serve the business interest of the company;
- Whether there has been any diversion in utilizing the investment of the company from the objects and purposes approved by the audit committee;
- Whether the subsidiary has made any downstream investment and whether such downstream investment is at par with the objectives of the investment of the company
- Performance of investment – in terms of yield, returns;
- Likely performance of the investment in future;
- Liquidity of the investment;
- Any reason to seek liquidation/ exit from investment.
- Specific concerns in case of subsidiaries
While many of the above may not be relevant in case of subsidiaries, the following areas of concern shall be looked into by the audit committee in case of loans and investment made:
- Whether the loan is being utilized for the purposes approved by the company;
- Is there any diversion in the end use of the loan;
- Covenants of the loan, particularly, with a view to ensure that there are no chances of diversion of funds from the purpose for which they are purportedly intended to be provided.
- Whether there has been any diversion in utilizing the investment of the company from the
objective and purposes approved by the audit committee;
- Whether the subsidiary has made any downstream investment and whether such downstream investment is at par with the objectives of the investment of the company;
- Whether the investment made is a fit case for impairment considering the performance of the investee company.
On-going review by audit committee:
As per Regulation 24(2), investments of the unlisted subsidiary shall be reviewed by the audit committee of the holding listed entity at the time of review of financial statements of the unlisted subsidiary. Financial statements are prepared annually; therefore, the review shall be done on an annual basis for the investments made by unlisted subsidiaries during the year.
Further, as per Clause 9 of Para A, Part C of Schedule II to Listing Regulations the loans/ investments of the listed entity shall be subject to scrutiny by its audit committee before making investment/disbursing loans, to the extent possible or after the same have been made.
Furthermore, the holding company also reviews the following in case of its unlisted subsidiary, on an on-going basis:
- Whether the subsidiary has sufficient accumulated reserves while considering its performance;
- Whether the dividend policy of the subsidiary is in line with the larger objectives of the holding company;
- Whether the subsidiary has large amount of surplus lying in its books so as to enable it to plan a buy back.
Format for reporting to the audit committee
There is no specific format for reporting the performance / status report to the audit committee for enabling the committee to review the same. However, the same may be reported in the following manner:
|Sr. No||Particulars of investment / loan
[Name of the party, date of investment or loan, purpose, tenure, etc.]
|Concerns||Amount involved||Performance / Update|
|Whether Secured or unsecured|
|What is the yield|
|Whether liquid or illiquid|
|Market price of the securities|
|Whether there is any potential risk associated with the investment /loan|
|Servicing / repayment schedule|
|Any change in the credit rating of the investee company|