An Insolvency Resolution Process sans Claims – A Defunct Process?

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Introduction

Under the provisions of Insolvency and Bankruptcy Code, 2016 (IBC), the determining criteria for insolvency is a definite default, rather than financial sickness or ‘inability to pay’ . While the latter is certainly suggestive of a larger state of insolvency, where the company may be unable to pay its outstanding debts, the former does not necessitate  the same. Hence, the likelihood of an application for initiation of CIRP on the basis  of an isolated event of default/ non-payment, sans a financial stress in the company, cannot be ruled out.

Owing to such uncertainty, it may so happen that an application, initiated on the basis of such an isolated event of default, is admitted before the adjudicating authority without any other cases of defaults by the company. Naturally, there would be no claims to file except that of the applicant. If it were to happen, it forces one to ponder as to how CIRP will proceed, and if at all there is something to resolve.

CIRP without claims?

As per the Code, CIRP commences after an application has been admitted by the AA. Once an application is admitted by the AA, an Interim Resolution Professional is appointed, who is responsible for invitation and collation of claims, and subsequent constitution of the committee of creditors (‘CoC’). All decisions with respect to the corporate debtor’s business are thereafter taken with the approval of CoC, including approval of Resolution Plan or passing of a resolution for liquidation of the Corporate Debtor.  Hence, it can be said that the CoC, constituted on the basis of the claims, drives the CD through the process till revival/ liquidation, as the case may be.

However, in a rather odd situation, when no claims are received after the initiation of CIRP, how will the IRP constitute CoC? In essence, when no claims are received by the Interim Resolution Professional (‘IRP’) after the initiation of CIRP, the questions that would arise are (aside, the broader question as to whether there was at all a need for resolution, will remain) – how is the CIRP likely to proceed, how will IRP constitute CoC, and most importantly, what is it for which the IRP should invite resolution plans? Does non-receipt of any claims by the creditors prove that the Corporate Debtor is, in fact, not a defaulter?

Books of the corporate debtor/public announcement

At the first instance, the books of the corporate debtor will assist in determining whether at all the CD has liabilities (financial/operational, otherwise). It may be the case that the CD does not have any liability at all (besides that pertaining to the creditor who filed the application). In such a case, attempts can be made by the CD and the Creditor to arrive at an agreement among themselves, instead of proceeding with CIRP and having the CD jammed in a situation of Moratorium.

However, there may be cases where the books acknowledge liabilities but there are no claimants. This might pose practical difficulties for the IRP because if no claims are received, the constitution of CoC would become impossible which in turn would lead to the CIRP coming to a complete halt. Occurrence of such a situation might necessitate the following actions to be taken by the IRP-

  • sending of individual mails, requesting claims, to the Financial creditors so that, at least, a CoC can be constituted.
  • ensure that the public announcement, inviting claims of creditors, are made in accordance with the manner laid down in the CIRP Regulations and in newspapers with wide reach.
  • if, in case, no claims are received despite of efforts being made by the IRP, a final attempt should be made by the IRP by way of re-issuance of public announcement

Say, even after these efforts, no one shows up. There is a stage set, but there are no creditors to run the show. In such cases, what can the IRP do? We can explore the following alternatives.

Section 12A of Insolvency and Bankruptcy Code, 2016

Prior to section 12A of the Code, the withdrawal of an admitted insolvency resolution process was not expressly provided for. However, in view of reasons like a post-admission settlement or restructuring, the need to allow such withdrawal was realised – Section 12A of the Code enables withdrawal of the applications filed under Section 7, 9 or 10 of IBC, post its admission, if the committee of creditors (CoC) approves of such withdrawal by a voting share of at least ninety percent.

The very fact that section 12A mandates the approval of CoC as a precondition for withdrawal, there is no occasion to apply the said provisions before the constitution of CoC. A deeper reading of section 12A further indicates that the application for withdrawal must be filed by the very applicant who initiated the process. The reason is simple, the cause initiated by one cannot be withdrawn merely by virtue of a majority of others. Thus, the fact that withdrawal can be done only at the behest of the original applicant and with the consent of at least 90% CoC members maintains the much required trade off.

However, in the given state of affairs, the devil lies in the fact that no claims have been received so as to constitute the CoC. Further, to assume that the applicant who, at the first place, initiated the application, and thereafter chose to remain missing in action would initiate the withdrawal process, seems rather bizarre.

Even if one were to assume the possibility of withdrawal application by such a creditor, would the very filing be construed as a mere pressure tactic for recovery of claims?  If yes, the same would attract penal provisions under the Code, and as such the Applicant would be liable for the consequences.

Knocking the Doors of NCLT

From the above discussion, we understand that a situation as such would indeed put the IRP/ RP in a pickle. Another probable way out could be an application being filed by the IRP/ RP under section 60 (5) of the Code thereby praying for annulling the process or directing the original applicant to file an application under section 12A.

Further, in Swiss Ribbons (P) Ltd. v. Union of India (Supra)[1],  the Hon’ble Supreme Court made it clear that “at any stage where the committee of creditors is not yet constituted, a party can approach the NCLT directly, which Tribunal may, in exercise of its inherent powers under Rule 11 of the NCLT Rules, 2016, allow or disallow an application for withdrawal or settlement…….”

Thus, on the strength of the aforesaid order and the power and jurisdiction in section 60 (5), the IRP/ RP may take necessary steps before the Hon’ble Bench.

Such entanglement would leave the IPR/ RP in the middle of the sea, so to say that he can neither continue the CIRP in absence of the CoC, nor proceed for withdrawal as per section 12A.

Corporate Debtor – a Defaulter or no

Another line of thought that arises in the given facts  could be whether the Corporate Debtor can be construed as a ‘defaulter’. In the given case, since no claims are received after the initiation of CIRP, can it be assumed that the Corporate Debtor has not defaulted in the payment of dues of any other creditor except for that of the applicant. Based on this assumption, can it be said that the CD is not a defaulter?

The above straight jacket assumption would not hold good as it is important to note that another probable situation that could arise is that the default of other creditors is apparent from the books of accounts of the Corporate Debtor. In such cases, if no claims are received by the IRP, the IRP may, in furtherance to the mandatory public announcement, send a mail to the banks/ financial creditors, inviting claims from them so that at least the CoC can be constituted and the CIRP can proceed.

While the above situation is a rather odd one, it would indeed be an interesting situation to understand the possible course of action that the IPs could resort to, and the role of the Adjudicating Authorities in such cases.

[1] Swiss Ribbons (P) Ltd. v. Union of India (Supra)

RBI eases norms on loans and advances to directors and its related entities

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Payal Agarwal, Executive, Vinod Kothari & Company ( payal@vinodkothari.com )

RBI has recently, vide its notification dated 23rd July, 2021 (hereinafter called the “Amendment Notification”), revised the regulatory restrictions on loans and advances given by banks to directors of other banks and the related entities. The Amendment Notification has brought changes under the Master Circular – Loans and Advances – Statutory and Other Restrictions (hereinafter called “Master Circular”). The Amendment Notification provides for increased limits in the loans and advances permissible to be given by banks to certain parties, thereby allowing the banks to take more prudent decisions in lending.

Statutory restrictions

Section 20 of the Banking Regulation Act, 1949 (hereinafter called the “BR Act”) puts complete prohibition on banks from entering into any commitment for granting of loan to or on behalf of any of its directors and specified other parties in which the director is interested. The Master Circular is in furtherance of the same and specifies restrictions and prohibitions as below –

 

*since the same does not fall within the meaning of loans and advances for this Master Circular

Loans and advances without prior approval of Board

The Master Circular further specifies some persons/ entities that can be given loans and advances upto a specified limit without the approval of Board, subject to disclosures in the Board’s Report of the bank.  The Amendment Notification has enhanced the limits for some classes of persons specified.

Serial No. Category of person Existing limits specified under Master Circular Enhanced limits under Amendment Notification
1 Directors of other banks Upto Rs. 25 lacs Upto Rs.  5 crores for personal loans

(Please note that the enhancement is only in respect of personal loans and not otherwise)
2 Firm in which directors of other banks interested as partner/ guarantor Upto Rs. 25 lacs No change
3 Companies in which directors of other banks hold substantial interest/ is a director/ guarantor Upto Rs. 25 lacs No change
4 Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors Upto Rs. 25 lacs Upto Rs. 5 crores
5 Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors of other banks Upto Rs. 25 lacs Upto Rs. 5 crores
6 Firm in which such relatives (as specified in 4 or 5 above) are partners/ guarantors Upto Rs. 25 lacs Upto Rs. 5 crores
7 Companies in which relatives (as specified in 4 or 5 above) are interested as director or guarantor or holds substantial interest if he/she is a major shareholder Upto Rs. 25 lacs Upto Rs. 5 crores

Need for such changes

The Master Circular was released on 1st July, 2015, which is more than 5 years from now. Considering the inflation over time, the limits have become kind of vague and ambiguous and required to be revisited. Moreover, the population all over the world is facing hard times due to the Covid-19 outbreak. At this point of time, such relaxation can be looked upon as the need of the hour.

Impact of the phrase ‘Substantial interest’ vs ‘Major shareholder’

The Master Circular uses the term “substantial interest” to generally regulate in the context of lending to companies in which a director is substantially interested.

The relevant places where the term has been used are as below –

Completely prohibited Allowed with conditions
Section 20(1) of the BR Act – for companies in which directors are substantially interested Para 2.2.1.2. of Master Circular – for companies in which directors of other banks are substantially interested – upto  a limit of Rs. 25 lacs without prior approval of Board

 
Para 2.1.2.2. of Master Circular – for companies in which directors are substantially interested Para 2.2.1.4. of Master Circular – for the companies in which the relatives of directors of any bank are substantially interested – upto Rs. 25 lacs without prior approval of Board After amendment, the para stands modified as – for the companies in which the relatives of directors of any bank are major shareholders – upto Rs. 5 crores without prior approval of Board

While the Amendment Notification itself provides for the meaning of “major shareholder”, the meaning of “substantial interest” for the purposes of the Master Circular has to be taken from Section 5(ne) of the BR Act which reads as follows –

  • in relation to a company, means the holding of a beneficial interest by an individual or his spouse or minor child, whether singly or taken together, in the shares thereof, the amount paid up on which exceeds five lakhs of rupees or ten percent of the paid-up capital of the company, whichever is less;
  • in relation to a firm, means the beneficial interest held therein by an individual or his spouse or minor child, whether singly or taken together, which represents more than ten per cent of the total capital subscribed by all the partners of the said firm;

The above definition provides for a maximum limit of shareholding as Rs. 5 lacs, exceeding which a company falls into the list of a company in which director is substantially interested. The net effect is that a lot of companies fall into the radar of this provision and therefore, ineligible to take loans or advances from banks.

However, the Amendment Notification provides an explanation to the meaning of “major shareholder” as –

“The term “major shareholder” shall mean a person holding 10% or more of the paid-up share capital or five crore rupees in paid-up shares, whichever is less.”

This eases the strict limits because of which several companies may fall outside the periphery of the aforesaid restriction. Having observed the meaning of both the terms it is clear that while ‘substantial interest’ lays down strict limits and therefore, covers several companies under the prohibition list, the term ‘major shareholder’ eases the limit and makes several companies eligible to receive loans and advances from the bank subject to requisite approvals thereby setting a more realistic criteria.

The BR Act was enacted about half a century ago when the amount of Rs. 5 lacs would have been substantial, but not at the present length of time. Keeping this in mind, while RBI has substituted the requirement of “substantial interest” to “major shareholder” in one of the clauses, the other clauses and the principal Act are still required to comply with the “substantial interest” criteria, thereby, keeping a lot of companies into the ambit of restricted/ prohibited class of companies in the matter of loans and advances from banks.

Other petty amendments

Deeming interest of relative –

The Amendment Notification has the effect of inserting a new proviso to the extant Master Circular which specifies as below –

“Provided that a relative of a director shall also be deemed to be interested in a company, being the subsidiary or holding company, if he/she is a major shareholder or is in control of the respective holding or subsidiary company.”

This has the effect of including both holding and subsidiary company as well within the meaning of company by providing that a major shareholder of holding company is deemed to be interested in subsidiary company and vice versa.

Explanations to new terms –

The Amendment Notification allows the banks to lend upto Rs. 5 crores to directors of other banks provided the same is taken as personal loans. The meaning of “personal loans” has to be taken from the RBI circular on harmonisation of banking statistics which provides the meaning of personal loans as below –

Personal loans refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).

Other terms used in the Amendment Notification such as “major shareholder” and “control” has also been defined. The meaning of “major shareholder” has already been discussed in the earlier part of this article. The meaning of “control” has been aligned with that under the Companies Act, 2013.

Concluding remarks

Overall, the Amendment Circular is a welcoming move by the financial market regulator. However, as pointed out in this article, several monetary limits under the BR Act have become completely incohesive and therefore, needs revision in the light of the current situation.

 

Home Buyers under IBC & Case Studies

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Ever since the Jaypee and Amrapali cases, home buyers have been under the scanner. From orders of the Hon’ble Supreme Court to multiple amendments in the Insolvency and Bankruptcy  Code, measures have been taken to protect the interest of the home buyers. While earlier, the home buyers were treated as ‘other creditors’, that is, neither operational nor financial, with the landmark ruling in Chitra Sharma v. Union of India, there status as financial creditors was established – the same also found place in the Code by way of amendments in section 7 of the Code.

In this presentation, we discuss the provisions w.r.t. Home Buyers under the Code and a detailed case study of the Amrapali Case and Jaypee Infratech Case.

Home Buyers under IBC & Case Studies

A Regulatory Affair: Fair Value Discovery in Preferential Share Issues

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Payal Agarwal, Vinod Kothari and Company ( payal@vinodkothari.com )

The recent cases of intervention by the stock market regulator and stock exchanges in preferential allotment of listed companies have brought to fore an important but fundamental point. That is,  with a price band fixed under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘ICDR Regulations’), and considering the liquidity in listed (and frequently traded) shares, whether there is a need for an independent valuation report, has become a question of great interest. Since the issue is currently under litigation will want to say that it will be interesting to see the evolution of jurisprudence on this important issue. While the issue is of relevance to minority shareholders, but it also touches a key issue in valuation as to whether there is a fair value beyond the quoted value of a company whose shares are not infrequently traded.

Further, there might be scenario, where a preferential allotment triggers an open offer under SEBI (Substantial Acquisition of Shares and Disclosure Requirements) Regulations, 2011 (“SAST Regulations”).  The SAST Regulations provides formula for determining offer price, which establish a clear nexus between the price of shares offered under preferential allotment and price of shares under open offer as per SAST Regulations. Given that the pricing of open offer is influenced by the pricing under preferential allotment, should the price under the ICDR Regulations be accepted or fair valuation of shares should be sought in order to ensure fair compensation to shareholders?

At this stage of discussion, it becomes important to look into the relevant provisions and the meaning of “fair value” and understand how fair it is to have a preferential allotment without ascertainment of such fair value by an independent valuer.

 

Regulatory provisions with respect to preferential allotment

Preferential allotment in listed companies are governed by the following provisions –

  • Section 42 of the Companies Act, 2013 [“Companies Act”], read with Rule 14 of Companies (Prospectus and Allotment of Securities) Rules, 2014
  • Section 62(1)(c) of the Companies Act. read with Rule 13 of Companies (Share Capital and Debentures) Rules, 2014
  • Chapter V of ICDR (Regulation 164)

Preferential offers under section 62(1)(c) can be made to any person, if so authorised by a special resolution passed in general meeting if the price of such shares is determined by way of a valuation report of a registered valuer. However, if one goes through allied Rule 13 of SCD Rules, it becomes clear that the companies whose shares are listed on a stock exchange are not required to obtain a valuation report from a registered valuer. The said rules clearly bring out a distinction between preferential offers made by a listed company versus those made by unlisted companies. Sub-rule (2) specifically states that for companies whose shares are listed on a recognised stock exchange, the requirements under the relevant SEBI regulations (ICDR Regulations) will apply, while the unlisted companies will be governed by the provisions of the Companies Act; and sub-rule (3) states that the price under the preferential allotment shall not be less than the price determined on the basis of valuation report of registered valuer. Hence, it becomes clear that in case of a listed company, as per section 62 and rule 13, there is no requirement of a valuation report, per se. Instead, the legislature has left it to be regulated by SEBI regulations. Therefore, one will have to look for what ICDR says.

Reg. 164 of ICDR lays the floor limit of the price, which is to be calculated as the higher of average of weekly high and low of volume weighted average price of related equity shares quoted on a recognised stock exchange for –

  1. 26 weeks preceding the relevant date
  2. 2 weeks preceding the relevant date

The Regulation does not call for an independent valuation report. This must be read in contradistinction to regulation 165, which deals with pricing of infrequently traded shares. Reg. 165 rather specifically requires an independent valuation.

Requirement of independent valuation under regulatory provisions

 

The above clearly demonstrates that the regulations have consciously exempted listed entities from seeking an independent valuation where listed shares are frequently traded. The regulations, in fact, draw a timeframe to extract weighted averages of the market prices to ensure that the fluctuations in prices, if any, are ironed out and the resultant price is the even price at which the market has transacted during that period. This, admittedly and reasonably too, is based on the assumption that ‘market’ is the best reflection of a fair price which a willing seller and a willing investor are ready to deal in. This view can also be substantiated with similar stipulations in other laws and valuation standards.

Meaning of fair valuation under various applicable laws

Meaning of fair value under applicable accounting standards –

 

Ind AS 113 deals with the fair valuation of equity shares.  This Ind AS defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, and thus considers fair value to be “a market based measurement and not an entity specific measurement.”

Clause 18 of the Ind AS 113 provides, “If there is a principal market for the asset or liability, the fair value measurement shall represent the price in that market.”

Meaning of fair value under the Income Tax Rules

Rule 11UA (1)(c) of the Income Tax Rules provides for the fair value of shares listed in a stock exchange.

It renders the transaction value of such shares to be the fair value in case the transaction has been done through stock exchange. Otherwise, the fair market value of such shares are taken to be –

“(a)the lowest price of such shares and securities quoted on any recognized stock exchange on the valuation date, and

(b)the lowest price of such shares and securities on any recognized stock exchange on a date immediately preceding the valuation date when such shares and securities were traded on such stock exchange, in cases where on the valuation date there is no trading in such shares and securities on any recognized stock exchange”

Meaning of fair value under the Valuation Standards

Rule 18 of the Companies (Registered Valuers and Valuation) Rules, 2017 requires the registered valuer to follow such valuation standards as prescribed by the Central Government. For valuation with effect from 01st July, 2018, all registered valuers are mandatorily required to apply the ICAI Valuation Standards in their valuation assignments for the purposes of the Companies Act, 2013.

The definition of ‘fair value’ under ICAI Valuation Standard (101) is the same as that in IndAS 113, that is, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the valuation date. IVS 101 further states that fair value assumes that the price is negotiated in a free market. The ICAI Valuation Standards recognises three approaches for valuation, being – market approach,  income approach, and cost approach.

Where the assets to be valued are traded in active market, the market approach is followed for valuation purposes.

Paragraphs 18-20 gives guidance over the valuation as follows –

“18. A valuer shall consider the traded price observed over a reasonable period while valuing assets which are traded in the active market.

  1. A valuer shall also consider the market where the trading volume of asset is the highest when such asset is traded in more than one active market.
  2. A valuer shall use average price of the asset over a reasonable period. The valuer should consider using weighted average or volume weighted average to reduce the impact of volatility or any one time event in the asset.”

The stipulations as above clearly reflect that for quoted shares, fair valuation is based on quoted prices only. Given that IVS too refers to ‘traded prices’, a registered valuer would rely on such traded prices to arrive at a fair value. It may be reiterated that ICDR uses a ‘range’ of time so as to spread out the fluctuations in prices, which has been similarly captured in the IVS.

One may argue that the price of a company’s shares can be tampered with, by the company as per its whims and wishes. However, for a listed company, whose every information is readily available on public domain, does such an argument hold good? In view of the strict regulatory surveillance constantly placed by SEBI and stock exchanges on listed companies, this does not seem to be a possible scenario.

Valuation in respect of infrequently traded shares

The aforesaid logic and arguments may not hold good in case of shares that are infrequently traded or are unlisted. As indicated above, the applicable rules/regulations and standards prescribe a different methodology to arrive at fair values of such shares. For instance, regulation 165 of ICDR requires the minimum price in case of infrequently traded shares to be determined on the basis of valuation as per applicable parameters. Also, the SAST Regulations requires the offer price in case of infrequently traded shares to be determined by way of valuation taking into account various valuation parameters such as comparable trading multiples, book value and such others.

To reiterate, such distinction made out between frequently traded and infrequently traded shares clearly buttresses the views here.

Conclusion

The chances of a listed company acquiring a fair deal without falling into the formalities of fair valuation does not seem to be a scarce event. Listed companies are well governed under the provisions of ICDR Regulations as regards pricing of shares under preferential allotment. To ensure shareholder protection, ICDR already prescribes a minimum threshold based on average quoted prices. The prices depend on the market price of related equity shares quoted and traded on stock exchanges. Further, fair value of equity shares depend on market value of such shares and there does not seem to be chances of much disparity among the price under ICDR versus that as determined by way of fair valuation.

 

Proxy advisors and their role in corporate decision making on questions of law

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Sharon Pinto, Manager, corplaw@vinodkothari.com

Concept of proxy advisors

Proxy advisors are research based entities that formulate recommendations on the decisions of companies which require shareholder approval. SEBI (Research Analysts) Regulations, 2014 (‘SEBI Regulations’), defines proxy advisors “as any  person  who  provides  advice,  through  any  means,  to institutional investor or shareholder of a company, in relation to exercise of their rights in the company including recommendations on public offer or voting recommendation on agenda items”. Thus, these advisory firms guide shareholders to make sound investment decisions and exercise their voting rights effectively. Matters that require shareholder approval under the Companies Act, 2013, are of significant importance and include decisions pertaining to appointment of directors (including managing director, whole-time directors, independent directors), manager, approval of their remuneration, alteration of Articles or Memorandum of Association of the company, etc. The clientele of the proxy advisory firms includes institutional investors, who are usually not privy to the affairs of the company. Thus, they may rely on the recommendations issued by the said entities. As in case of certain companies the shareholding/voting rights of such investors may be considerably large, the recommendations of a proxy advisory firm may substantially affect the decision-making by the investor, and in turn, the affairs of the company.

As per Regulation 2 (1) (m) of SEBI (Investment Advisors) Regulations, 2013, ‘investment advisor’ means a person who is engaged in the business of providing investment advice for a consideration. However, a proxy advisor is into recommending voting decisions to shareholders, and are not into recommending whether an investor or a potential investor should or should not make/keep an investment.

Investment advisors are entities that specifically provide financial advice. They undertake research in order to provide advice relating to investment decisions of their clients, separating them from proxy advisors, who provide voting recommendations on agenda items, which may also include approval of public offer by the shareholders. Thus, the role of proxy advisors does not entail provision of financial advice.

In this article, the author deliberates on the role of proxy advisors and the issues concerning their functioning, the enforceability of the recommendations, while perusing the position of applicable laws in India as well as in the global context.

Effect of proxy advisor recommendation on corporate decisions

The role of proxy advisors is of a benign nature. They perform the function of educating investors of the right corporate governance practices on the basis of the research undertaken by them. Thus, they may act as catalysts in strengthening corporate governance. However, the downside to the process is the possibility of concentration of power with the proxy advisors and lack of regulatory overview or safeguards w.r.t. their opinions. Since the guidelines are based on best governance practices, they may go beyond the provisions of law. Further, the recommendations and guidelines thus issued are not subject to regulatory overview or approval. They are solely the views of the advisory entities and may thus differ on the grounds of interpretation or factual information. Thus, the said recommendations and guidelines must be used as a tool for further analysis by the investor and thereafter making independent decisions and not as views of the regulator, on account of the proxy advisors being licensed market intermediaries. The below figure shows an analysis of the effect of negative voting recommendations of the proxy advisor on the resolutions pertaining to related party transactions, appointment of non-executive directors, independent directors and other significant corporate decisions:

The current provisions applicable to proxy advisory entities in India do not prescribe for prior interaction of the firms with the company. While the same may act as a safeguard for the freedom of proxy advisory entities to express their opinions, the recommendations of the advisory entities may lack the consideration of necessary facts or information in order to give a comprehensive picture of the proposed decision of the company.

Concerns stemming from voting guidelines and recommendations of proxy advisors and existing regulatory framework

As the regulatory framework governing proxy advisors is still evolving, certain issues relating to the functioning of the proxy advisors and the guidelines and recommendations issued by them require further regulatory oversight. The existing regulatory framework and safeguards in place have been discussed below with respect to the said concerns.

India

Proxy advisory firms operating in India are required to obtain a license under the afore-mentioned SEBI Regulations. They are also required to mandatorily adopt a code of conduct as prescribed under the SEBI Regulations. The SEBI Regulations have set forth provisions relating to registration, eligibility criteria, management of conflict of interest, adoption of code of conduct among other matters. 

  • Conflict of interest

Conflict of interest is a major concern in case of proxy advisory firms providing other services like consultancy services to the company in addition to being advisors to its investors. Thus, it may give rise to biased opinions which are reflected in the recommendations of the advisory entity, resulting in negative impact on the shareholder interest. Chapter III of the SEBI Regulations deals with management of conflict of interest and disclosure requirements which mutatis mutandis applies to proxy advisors.

As per Regulation 15 (1) of SEBI Regulations, the entities are required to maintain internal policies and procedures governing the dealing and trading by any research analyst for addressing actual or potential conflict of interest arising from such dealings or trading of securities of the subject company. The said Regulations further prescribe restrictions on the dealings by employees of the advisory firms. Regulation 17 provides for the conditions on the compensation received by research analysts, wherein the compensation is required to be reviewed by the board of the research entity and is to be independent of the brokerage services division. Further, the SEBI Regulations prescribe for restriction on publication and distribution of reports of a subject company in which the research analyst has acted as a manager or co-manager.

In addition to other disclosures, following w.r.t. whether the research analyst or research entity or his associate or his relative has any, will form part of the research report:         

                              

As per SEBI procedural guidelines for proxy advisors issued on August 3, 2020, proxy advisors are required to disclose conflict of interest on every specific document where they are giving their advice. Further, the disclosures should especially address possible areas of potential conflict and the safeguards that have been put in place to mitigate possible conflicts of interest. They are also required to establish clear procedures to disclose, manage and/or mitigate any potential conflicts of interest resulting from other business activities including consulting services, if any, undertaken by them and disclose the same to clients.

 

  • Material misstatements and factual errors

 

Proxy advisors are required to additionally disclose in their reports the  extent  of  research  involved  in  a  particular  recommendation  and  the  extent  and/or effectiveness of its controls and procedures in ensuring the accuracy of issuer data in accordance with Regulation 23 of the SEBI Regulations. Further, the above-mentioned procedural guidelines issued by SEBI state that proxy advisors shall ensure that the recommendation policies are reviewed at least once annually. They shall further disclose the methodologies and processes followed in the development of their research and corresponding recommendations to their clients.

Regulation 20 of the SEBI Regulations, has prescribed the following with regard to contents of the Report:

  1. Research analyst or research entity shall take steps to ensure that facts in its research reports are based on reliable information and shall define the terms used in making recommendations, and these terms shall be consistently used.
  1. Research  analyst or  research  entity that  employs  a  rating  system  must  clearly  define the meaning  of  each  such  rating  including  the  time  horizon  and   benchmarks  on  which  a  rating  is based.
    1. If a research report contains either a rating or price target for subject company’s securities and the research analyst or research entity has assigned a rating or price target to the securities for at least  one  year,  such  research  report  shall  also  provide  the  graph  of  daily  closing  price  of  such securities for the period assigned or for a three-year period, whichever is shorter.

 

  • Interaction with the subject company

 

Regulation 23 of the SEBI Regulations, stipulates a proxy advisor to disclose the policies and procedures for interacting with issuers, informing issuers about the recommendation and review of recommendations. The afore-mentioned SEBI procedural guidelines for proxy advisors state that the proxy advisor shall have a stated process to communicate with its clients and the company. Further, proxy advisors shall share their report with their clients and the company at the same time. The said ‘sharing policy’ is required to be disclosed by proxy advisors on their website. Timeline to receive comments from company may be defined by proxy advisors and all comments/clarifications received from the company, within the said timeline, shall be included as an addendum to the report. If the company has a different viewpoint on the recommendations stated in the report of the proxy advisors, then proxy advisors, after taking into account the said viewpoint, may either revise the recommendation in the addendum report or issue an addendum to the report with its remarks, as considered appropriate.

  • Difference of opinion

The views of proxy advisors as discussed herein are solely based on their research and interpretation not subject to the approval of any regulator. Further, the benchmarks set by the entities are based on highest corporate governance principles, hence they may surpass the requirement of law.

The procedural guidelines issued by SEBI state that they shall clearly disclose in their recommendations the legal requirement vis-a-vis higher standard they are suggesting if any, and the rationale behind the recommendation of higher standards.

The Report of the Working Group dated July 29, 2019, formulated by SEBI on issues concerning proxy advisors has proposed for proxy advisors to send an unedited response of the company to all its subscribers. In case a company is not satisfied with the response, it may write again to proxy advisors and in case the response is still not acceptable, the Company concerned may approach SEBI under the SEBI Regulations seeking SEBI’s intervention. However, mere differences based on opinion, which are backed with authentic public data and analysis, cannot be the basis of any complaint or litigation. Litigation should not be initiated merely because an opinion is not favourable to the management of a company, especially if opportunity had been given by proxy advisors to the company and the same has been duly addressed. Thus, an objection may only be raised by companies in case of abuse of power by the proxy advisors by violating the Code of Conduct as mandatorily prescribed under SEBI Regulations. A mere case of difference of opinion basis different interpretations, which is not on account of factual misstatement or lack of material facts, cannot be the basis of contention.

United States of America

Under the Securities Exchange Act of 1934 (‘Exchange Act’), Securities and Exchange Commission (‘SEC’) regulates the proxy solicitation process for publicly traded equity securities. SEC also regulates the activities of proxy advisory firms that are registered with SEC as investment advisers under the Investment Advisers Act of 1940 (Advisers Act). As per the SEC’s Interpretation and Guidance on Applicability of Proxy Rules on Proxy Voting Advice, it has stated that proxy voting advice should be considered a solicitation, subject to the federal proxy rules because it is “a communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.”

  • Conflict of interest

SEC in its Guidance on Investment Advisor’s use of Proxy Advisors states that an investment adviser’s decision regarding whether to retain a proxy advisory firm should also include a reasonable review of the proxy advisory firm’s policies and procedures regarding how it identifies and addresses conflicts of interest. Since proxy voting advice has been considered as solicitation, relevant federal proxy rules shall apply. Solicitations that are exempt from the federal proxy rules’ information and filing requirements remain subject to Rule 14a-9 of General Rules and Regulations of Exchange Act. Accordingly, the provider of the proxy voting advice should consider whether, depending on the particular statement, it may need to disclose about material conflicts of interest that arise in connection with providing the proxy voting advice in reasonably sufficient detail so that the client can assess the relevance of those conflicts in order to avoid a potential violation of the aforesaid rule.

SEC has proposed amendments to regulate proxy advisors which shall be mandatory from December 1, 2021. As per the said amendments, any person providing proxy voting advice within the scope of proposed rules, who wishes to utilize the exemption in either Rule 14a–2(b)(1) or (b)(3) must include in their voting advice (or in any electronic medium used to deliver the advice) prominent disclosure of: 

  1. Any information regarding an interest, transaction, or relationship of the proxy voting advice business (or its affiliates) that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction, or relationship; and 
  2. Any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction, or relationship

 

  • Material misstatements and factual errors

 

Rule 14a–9 prohibits any proxy solicitation from containing false or misleading statements with respect to any material fact at the time and in light of the circumstances under which the statements are made. In addition, such solicitation must not omit to state any material fact necessary in order to make the statements therein not false or misleading. As per the SEC amendments mentioned above, entities providing proxy voting advice, in case of failure to disclose material information regarding proxy voting advice, ‘‘such as the proxy voting advice business’s methodology, sources of information, or conflicts of interest’’ could, depending upon particular facts and circumstances, be misleading within the meaning of the rule. It has been further stated that, the amendment does not make mere differences of opinion actionable under Rule 14a–9.

 

  • Interaction with the subject company

 

SEC amendments in Rule 14a of the Exchange Act, 1934, provide certain exemptions with respect to filing requirements of the proxy rules subject to the condition that registrants that are the subject of proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients. 

The amendments also provide for safe harbour rules specifying policies and procedures of the proxy advisors may include conditions requiring registrants to –

  1. file their definitive proxy statement at least 40 calendar days before the security holder meeting 
  2. expressly acknowledge that they will only use the proxy voting advice for their internal purposes and/or in connection with the solicitation and will not publish or otherwise share the proxy voting advice except with the registrant’s employees or advisers.

 

  • Difference of opinion

 

While Rule 14a-9 of Exchange Act, 1934 states that no solicitation subject to this regulation shall be made by means of any proxy statement or other communication, written or oral, containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact, the same is not applicable in case of difference of opinion. However, since as per the proposed SEC amendments, entities will be required to make their proxy voting advice available to the registrants at or prior to the time when such advice is disseminated to the proxy voting advice business’s clients, the same shall provide a fair opportunity for representation to the registrant companies.

United Kingdom

As per the Directive (EU) 2017/828, a proxy advisor is a legal person that analyses, on a professional and commercial basis, the corporate disclosure and, where relevant, other information of listed companies with a view to informing investors’ voting decisions by providing research, advice or voting recommendations that relate to the exercise of voting rights. The Proxy Advisors (Shareholders’ Rights) Regulations 2019, came into force on 10th June, 2019. The Proxy Advisors (Shareholders’ Rights) Regulations in part implement the revised Shareholders Rights Directive (Shareholder Rights Directive II).

  • Conflict of interest

The Proxy Advisors (Shareholders’ Rights) Regulations, 2019, under Regulation 5, state that the proxy advisor must take all appropriate steps to ensure that it identifies any actual or potential conflict of interest or any business relationship that may influence the advisor in the preparation of research, advice or voting recommendations. Further, such a conflict of interest or business relationship is required to be identified without delay after the time at which it arises. In case of identification of an actual or potential conflict of interest, the proxy advisor must disclose the fact to its clients together with particulars of the conflict of interest or business relationship concerned, in addition to a statement of the action it has undertaken to eliminate, mitigate or manage the conflict of interest or business relationship concerned.

 

  • Material misstatements and factual errors

 

Regulation 4 of the Proxy Advisors (Shareholders’ Rights) Regulations, 2019, prescribes minimum information to be disclosed relating to preparation of research, advice and voting recommendations, as given below:

Similar to the legislation in India, the policies and procedures are required to be reviewed at intervals of no more than twelve months beginning with the date on which it was last updated.

 

  • Difference of opinion

 

Adoption of Code of Conduct is not mandatory under the Proxy Advisors (Shareholders’ Rights), 2019, provided the proxy advisors provide a clear and reasoned explanation of reasons for not doing so. The provisions prescribe a person may submit a complaint to the Financial Conduct Authority (FCA), in case of contravention of any requirement. Further, the Code of Conduct is required to be updated at an interval of not more than twelve months.

Australia

Under the Australian regime, only the proxy advisors providing financial services are required to obtain a license referred to as Australian Financial Services (AFS) license, under the Australian Corporations Act, 2001. Thus, the obligations set forth under the said Act are not applicable to proxy advisors that undertake research and provide voting recommendations.

  • Conflict of interest

In case of proxy advisory firms providing financial services pursuant to Australian financial services (AFS) license, one of the obligations under Section 912A of the Corporations Act stipulates that the proxy advisors are to have adequate arrangements in place for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken in the provision of financial services.

 

  • Interaction with the subject company

 

On the same lines as the amendments proposed by SEC, in the consultation paper issued by the Treasury of Australian Government in April 2021, it is proposed that proxy advisers will be required to provide their report containing the research and voting recommendations for resolutions at a company’s meeting, to the relevant company before distributing the final report to subscribing investors. It has also been proposed that the advisory entities will be required to notify their clients on how to access the company’s response to the report, by providing a website link or instructions on how to access the response elsewhere. Thus, at present there is no requirement of prior engagement with the subject company.

 

  • Difference of opinion

 

Section 912D of the Corporations Act of Australia states that a licensed financial advisor is obligated to lodge a written report with the ASIC in case of a breach of the obligation prescribed under the Act, as soon as practicable but not later than 10 business days after becoming aware of the breach.  However, as proxy advisory entities are currently not required to obtain a license under the Corporations Act, the said provisions are not applicable to them.

ASIC in its review of proxy advisor engagement practices dated June 2018, recommended that if a subject company discovers a matter that is materially false or misleading in a proxy adviser report, the company should:

  • notify the proxy adviser of the matter promptly and seek a correction
  • consider whether it would be appropriate to respond to the matter by way of an ASX announcement or other communication to investors.  

Closing thoughts with respect to tightening of norms relating to proxy advisors

Fair disclosure of information: Proxy advisory entities have garnered more attention in recent years. They have an increased influence over institutional investors and thus have the power to affect the functioning of companies on the basis of the voting recommendations they provide. It is thus necessary that fair and complete disclosure relating to the facts and interpretation of the proxy advisor entity be stated. While certain advisory firms state a disclaimer in their reports, mentioning the fact that the views of the report are not approved by the regulatory authorities, but based on their own benchmarks, the same is not a requirement specified under the regulations governing the entities.

Regulatory oversight of adherence of code of conduct: While it is mandatory for the proxy advisory entities to adopt a code of conduct under the SEBI Regulations, there should be a regulatory oversight on the adherence of the said Code. Further, there is a requirement of placing a fiduciary responsibility on the proxy advisory entities as the guidelines and recommendations published by them are available in the public domain and may affect the opinions of the shareholders of the company. Therefore, the same is required to be unbiased and must state a fair representation of the facts involved. Further, it may be stipulated that, in cases where the proxy advisor is taking a view based on an interpretation of law, which might differ across market participants, the proxy advisor shall specifically state so, and advise the client to take an independent view.

Representation of the subject company: Currently, SEBI procedural guidelines require that the proxy advisors share the report with their clients and the subject company at the same time.  However, as per the amendments proposed in the US and Australian regulatory framework, proxy advisors would be required to provide their report to the subject company prior to the issue of the same to its clients. The same may fill the gap arising out of incomplete or obsolete information. Hence, it may be more relevant if the draft report is shared with the subject company before the same is shared with the client/investors; such that a consolidated report, including the views and interpretations of the subject company, may be issued to the shareholders/clients. This would ensure – (i) a fair opportunity to the subject company to rebut the views/interpretations taken by the proxy advisor, (ii) that the shareholder’s views are not pre-conditioned by the sole views of proxy-advisors, as they do not get the views of the subject company at the first instance. As a matter of reasonable checks, the shareholders may be given the right to seek for the draft report shared by the proxy-advisor with the subject company.

Responsibility of institutional investors – The institutional investors should appropriately weigh on the views of the proxy advisors and the subject company, and ultimately make their own independent analysis of the facts in hand to decide on the issue. 

Other articles on proxy advisors:

  1. Dance of Corporate Democracy: The rise of proxy advisors

http://vinodkothari.com/wp-content/uploads/2017/03/Dance_of_Corporate_democracy-_rise_of_proxy_advisors-1.pdf

  1. SEBI prescribes stricter regimes for Proxy Advisors; Issues procedural guidelines to be followed in addition to Code of Conduct

http://vinodkothari.com/wp-content/uploads/2020/08/SEBI-prescribes-stricter-regime-for-proxy-advisors.pdf

  1. SEBI revisits regulatory framework for Proxy Advisors

http://vinodkothari.com/wp-content/uploads/2019/08/SEBI-revisits-the-regulatory-framework-for-Proxy-Advisors.pdf

  1. Scope of Proxy Advisors to issue general voting guidelines

http://vinodkothari.com/2021/06/scope-of-proxy-advisors-to-issue-general-voting-guidelines/

Global securitization enroute to pre-Covid heights

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– Abhirup Ghosh (abhirup@vinodkothari.com)

The pandemic disrupted life economies across the globe, and so did it to securitization transactions. However, increase in vaccinations across the globe has had a positive impact on the most of the structured finance markets world-wide, but potential new variants continue to be a threat.

This write-up reviews the performance of securitization across the major jurisdictions.

Read more →

Understanding Silent Period for listed entities

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By CS Aisha Begum Ansari (aisha@vinodkothari.com)

Introduction

When you go silent, you may be doing a soul searching, as for example, in meditational techniques. However, in case of listed entities, silent period is a period just before declaration of financial results, to ensure that there is no accidental leakage of confidential information. Silent period is different from “trading window closure” that most corporate professionals in India are familiar with. However, this article discusses the relevance of silent period, as a subset of the trading window closure, and its relevance to listed entities in India. While exploring the topic, the author also makes a study of the global laws around silent period.

Why silent period?

Insider trading is a ‘white collar’ crime that seeks to exploit the unpublished, non-democratic information (that is, what is not available in public domain) to the advantage of a select few, and to the disadvantage of the market in general. Since, it is a fraud upon the market in general, it has always been a significant topic for the securities market regulators around the globe. In India, Securities and Exchange Board of India (‘SEBI’) has framed the regulatory framework to curb the insider trading called as SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regulations’).

The material inside information is generally accessed by the top executives and employees of the company. To avoid the exploitation of such information, the company prohibits them from trading in its securities while having access to such information.  The preventive framework of insider trading does not just end by prohibiting the employees from trading; it also needs to ensure that such material inside information is not leaked outside the organization. There are many ways used by the insiders to leak such information such as sharing the same on social media, sharing of information during analyst or institutional investor meets, etc.

Silent period is different from trading window closure. Silent period is when the company’s top executives, say that CEO, CFO etc. will refrain from doing public communications altogether. The intent is to ensure that there is no interaction with investors or public at large, so as to avoid unintended slippage of information. Currently, SEBI regulations do not require companies to mandatorily observe a silent period; therefore, companies may choose to adopt this practice by way of their Code of Fair Disclosure.

What is silent period?

A silent period (also known as quiet period) is a stipulated time during which a company’s senior management and investor relation officers do not interact with the institutional investors, analysts and the media. The purpose of the silent period is to preserve the objectivity and avoid the appearance of the company providing insider information to select investors. During the silent period, the company does not make any announcements that can cause a normal investor to change their position on the company’s securities.

Is it different from trading window closure?

Trading window closure period (also known as blackout period or closed period) refers to the period during which the employees of the company who have access to material inside information are prohibited from trading in the securities of the company. In some of the developed countries, the securities market regulators give a freehand to the companies to decide the period during which the trading window shall be closed. In India, the PIT Regulations provide that the companies shall close the trading window from the end of the closure of the financial period for which results are to be announced till 48 hours after the disclosure of financial results to the stock exchanges. For any other material inside information, SEBI has given the responsibility to the compliance officers of the companies to close the trading window when the employees can reasonably be expected to have possession of inside information.

Silent period differs from the trading window closure in such a way that trading window closure prohibits the employees to trade in the securities of the company while having access to material inside information and silent period prohibits or restricts the company’s spokespersons to interact with the institutional investors or analysts. The purpose of trading window closure is to prohibit trading on the basis of inside information and the purpose of silent period is to prohibit communication of inside information illegitimately.

Duration of silent period

The PIT Regulations or any other regulatory framework in India do not provide for the requirements of silent period. So, the duration of silent period differs from company to company. Some companies specify the silent period as 20-30 days before the declaration of financial results till the date of disclosure and some companies align the silent period with the trading window closure period. The following table gives the synopsis of the practice followed by the Indian listed entities regarding silent period:

Name of the Company Practice followed
Mahindra & Mahindra Limited Silent period commences from 20 days before the declaration of financial results till the date of disclosure of results
Tata Consultancy Services Limited Quiet period starts 20 days before the declaration of financial results till the date of disclosure of results
HCL Technologies Limited Silent period is same as trading window closure period
Asian Paints Limited Silent period is observed between the end of the period and the publishing of the stock exchange release for that period
Wipro Limited Quiet period commences from 16th day of the last month of the quarter and ends with 48 hours after earnings release.
Infosys Limited Silent period is observed between the 16th day prior to the last day of the financial period for which results are required to be announced till the earnings release day.

Thus, it can be concluded that the silent period is smaller than the trading window closure period.

Analysts/ investors meets during silent period

Analysts/ investors meets can be a medium of leak of material inside information, therefore, the companies avoid interaction with them during trading window closure period. So, does it mean that companies completely abstain from interacting with the analysts and investors? While the answer may differ from company to company and the policies adopted by them for communication with analysts and investors. Some companies completely refrain from the analysts/ investors meets while some companies interact with them and discuss the past and historical information which is already available in public domain and general future prospects of the company, dodging the specific questions relating to the material inside information.

Guidelines for Investor Relations for Listed Central Public Sector Enterprises[1]

While the regulations framed by SEBI are silent about the silent period, the Guidelines for Investor Relations for Listed Central Public Sector Enterprises issued by the Department of Disinvestment, Ministry of Finance, Government of India, provides for the duration of silent period and obligations of the public sector enterprises in this regard. The Guidelines advise that the silent period should commence 15 days prior to the date of Board meeting in which financial results are considered and end 24 hours after the financial results are made public. The Guidelines requires the companies to abstain from meeting the analysts and investors and not communicate with them unless such communication would relate to the factual clarifications of previously disclosed information.

International practice with respect to silent period

Country Trading window closure period Silent period Analyst meet during silent period
United States of America (USA)[2] USA laws do not provide any specific timeline for trading window closure period. Thus, the companies are free to determine it There are two types of silent period prevalent in USA:

1.    When the company makes an Initial Public Offering (‘IPO’) – the Securities Exchange Commission (‘SEC’) mandates such companies to maintain a silent period from the date of registration with SEC which lasts till 40 days after the securities begin to trade on the stock exchanges. Such silent period is heavily regulated by the SEC.

2.    During finalization of quarterly results – the silent period is not clearly defined by SEC.

 During the silent period, the interaction with the analysts and investors is reduced. The companies either go completely silent or they speak about only past and historical information.
United Kingdom (UK)[3] Unlike USA, the UK laws prescribe the trading window closure period. Article 19.11 of Market Abuse Regulations specifies the period of trading window closure starting from 30 calendar days before the announcement of an interim financial report or a year-end report till the second trading day after announcement of financial report. UK laws do not comment anything about the silent period. Thus, the companies determine the silent period as per their own discretion.

 

 Since UK laws do not provide for silent period, the companies, as per their discretion, avoid interactions with the analysts and investors during such period.

 
Canada[4] Para 6.10 of National Policy on Disclosure Standards (‘Policy’) discusses about blackout period. It states that the company’s insider trading policy should specify the period which may mirror the quiet period. Para 6.9 of the Policy talks about quiet period. While the Policy does not prescribe the duration of quiet period, it states that the period should run between the end of the quarter and the release of a quarterly earnings announcement. The Policy states that the company need not completely stop communicating with the analysts and investors during the quiet period, but the communication should be limited to responding to inquiries concerning publicly available or non-material information.

Conclusion

After discussing the practices followed by the Indian listed companies and the regulatory framework of other developed countries, it can be concluded that the concept of silent period is not something new, though unregulated. Some companies align the silent period with the trading window closure period while some provide for lesser duration for silent period. Some companies completely abstain from interacting with the analysts and the institutional investors during the silent period whereas some prefer discussing the generally available information only.

[1]https://www.dipam.gov.in/dipam/downloadFile?fileUrl=resources/pdf/capital-market-regulation/IR_Guidelines_website.doc

[2] https://www.irmagazine.com/reporting/six-commonly-asked-questions-and-answers-about-quiet-periods

[3] https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32014R0596&from=EN

[4] http://ccmr-ocrmc.ca/wp-content/uploads/51-201_np_en.pdf

Other relevant materials of interest can be read here –

http://vinodkothari.com/2021/07/step-by-step-guide-for-disclosure-for-analysts-investors-meet/

http://vinodkothari.com/2021/05/sebi_defines_investors_meet/

http://vinodkothari.com/2020/11/sebi-proposes-enhanced-disclosures-for-meetings-with-analyst-investors-etc/

Independent Directors: The Global Perspective

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Ajay Kumar KV, Manager and Himanshu Dubey, Executive  (corplaw@vinodkothari.com)

Introduction

The role or failure of independent directors in preventing corporate scandals became one of the central themes in corporate governance in India, and when SEBI issued a Consultation paper proposing a dual approval process for the appointment of independent directors, there was a substantial concern among leading companies in the country. Following discussions, the SEBI board has eventually decided to drop the proposal for dual approval, and instead, go for approval by a special majority. The decision of SEBI to not implement dual approval has not been appreciated by several commentators including Mr. Umakanth Varottil. Therefore, there is a sizzling controversy on the mode of appointment of independent directors.

In this article, we have made a comparison of the legislative framework for independent directors, especially the process of appointment, across various jurisdictions.  While we note that some countries have moved to a dual approval process, the concept such as a database of IDs and a proficiency test remains an Indian aberration.

Independent Directors – Evolution in India

In India, the idea, or rather the need of having Independent Directors on the board of companies (especially those involving public interest) was acknowledged in the early 2000s through the SEBI Listing Agreement. Therefrom, the concept found a concrete legislative recognition in late 2013 as the Companies Act, 2013 took shape and character covering unlisted companies as well.

A snapshot of the concept’s evolution through guidelines and report to the Companies Act and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 is given below –

As compared to India, the western world was way ahead in the race- the concept of Independent Directors traces its inception as long back as in the 1950s when the murmurs of representation of small shareholders surrounded the corporate world. However, like in India, it took a long time for countries in Europe and North America to bring the concept within the regulatory framework. In the USA, the concept of Independent Director received regulatory recognition under the Sarbanes-Oxley Act, 2002. Thereafter the regulations issued by various stock exchanges took the lead.

Who is an Independent Director – The Indian Viewpoint

With all the hullabaloo about Independent Director, the natural question was ‘who is an independent director’; while the terminology was largely suggestive of the answer – “someone who is capable of putting forth an independent view about the business of the company”, it was crucial to define the term.

The definition of Independent Director from Section 149 of the Companies Act, 2013 (‘Act’) and Regulation 16 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR’). While unlisted companies are required to adhere to the requirement under section 149 of the Act; listed companies or those intending to be listed are required to abide by LODR too.

On the same lines as discussed above, LODR identifies an independent director as someone who is not related to the company, either as a promoter or director of the company, its group companies, who do not have a material pecuniary relationship with the company or its group, as well as someone who does not or has not been related to the company in any manner in the recent position, such that s/he could influence the decisions/ business of the company.

The aforesaid is provided in Regulation 16 of LODR[1], which defines “Independent Director” as “a non-executive director, other than a nominee director of the listed entity, who:

  • who, in the opinion of the board of directors, is a person of integrity and possesses relevant expertise and experience;
  • who is or was not a promoter of the listed entity or its holding, subsidiary or associate company or member of the promoter group of the listed entity;
  • who is not related to promoters or directors in the listed entity, its holding, subsidiary, or associate company;
  • who, apart from receiving director’s remuneration, has or had no material pecuniary relationship with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, during the  [three]*  immediately preceding financial years or during the current financial year
  • none of whose relatives ;

[(A) is holding securities of or interest in the listed entity, its holding, subsidiary or associate company during the three immediately preceding financial years or during the current financial year of face value in excess of fifty lakh rupees or two percent of the paid-up capital of the listed entity, its holding, subsidiary or associate company, respectively, or such higher sum as may be specified;

(B) is indebted to the listed entity, its holding, subsidiary or associate company or their promoters or directors, in excess of such amount as may be specified during the three immediately preceding financial years or during the current financial year;

(C) has given a guarantee or provided any security in connection with the indebtedness of any third person to the listed entity, its holding, subsidiary or associate company or their promoters or directors, for such amount as may be specified during the three immediately preceding financial years or during the current financial year; or

(D) has any other pecuniary transaction or relationship with the listed entity, its holding, subsidiary or associate company amounting to two percent or more of its gross turnover or total income:

Provided that the pecuniary relationship or transaction with the listed entity, its holding, subsidiary or associate company or their promoters, or directors in relation to points (A) to (D) above shall not exceed two percent of its gross turnover or total income or fifty lakh rupees or such higher amount as may be specified from time to time, whichever is lower;]*

  • who, neither himself/herself nor whose relative(s) —
  • holds or has held the position of a key managerial personnel or is or has been an employee of the listed entity or its holding, subsidiary, or associate company [or any company belonging to the promoter group of the listed entity]* in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed;

[Provided that in case of a relative, who is an employee other than key managerial personnel, the restriction under this clause shall not apply for his / her employment.]*

  • is or has been an employee or proprietor or a partner, in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed, of —
    • a firm of auditors or company secretaries in practice or cost auditors of the listed entity or its holding, subsidiary, or associate company; or
    • any legal or a consulting firm that has or had any transaction with the listed entity, its holding, subsidiary, or associate company amounting to ten percent or more of the gross turnover of such firm;
    • holds together with his relatives two percent or more of the total voting power of the listed entity; or
    • is a chief executive or director, by whatever name called, of any non-profit organisation that receives twenty-five percent or more of its receipts or corpus from the listed entity, any of its promoters, directors or its holding, subsidiary or associate company or that holds two percent or more of the total voting power of the listed entity;
    • is a material supplier, service provider or customer or a lessor or lessee of the listed entity;
  • who is not less than 21 years of age.
  • who is not a non-independent director of another company on the board of which any non-independent director of the listed entity is an independent director

Evidently, the definition in India is very comprehensive compared to other major jurisdictions. Below we discuss and compare some major provisions in the definition of IDs in India, the USA and the UK –

Basis India USA[2] UK[3]
Material relationship The director shall, apart from receiving director’s remuneration, has or had no material pecuniary relationship with the listed entity, its holding, subsidiary or associate company, or their promoters, or directors, during the three immediately preceding financial years or during the current financial year;

 

None of the director’s relatives

[(A)is holding securities of or interest in the listed entity, its holding, subsidiary or associate company during the three immediately preceding financial years or during the current financial year of face value in excess of fifty lakh rupees or two percent of the paid-up capital of the listed entity, its holding, subsidiary or associate company, respectively, or such higher sum as may be specified;

 

(B) is indebted to the listed entity, its holding, subsidiary or associate company or their promoters or directors, in excess of such amount as may be specified during the three immediately preceding financial years or during the current financial year;

 

(C) has given a guarantee or provided any security in connection with the indebtedness of any third person to the listed entity, its holding, subsidiary or associate company or their promoters or directors, for such amount as may be specified during the three immediately preceding financial years or during the current financial year; or

 

(D) has any other pecuniary transaction or relationship with the listed entity, its holding, subsidiary or associate company amounting to two percent or more of its gross turnover or total income:

 

Provided that the pecuniary relationship or transaction with the listed entity, its holding, subsidiary or associate company or their promoters, or directors in relation to points (A) to (D) above shall not exceed two percent of its gross turnover or total income or fifty lakh rupees or such higher amount as may be specified from time to time, whichever is lower;]*

 The director qualifies as “independent” unless the board of directors affirmatively determines that the director has no material relationship with the listed company (either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company).

The references to “listed company” would include any parent or subsidiary in a consolidated group with the listed company

 The director has, or had within the last three years, no material business relationship with the company, either directly or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company;

 

The director has not received or receives additional remuneration from the company apart from a director’s fee, participates in the company’s share option or a performance-related pay scheme, or is a member of the company’s pension scheme
Employment The director neither himself/herself nor his relatives hold or has held the position of a key managerial personnel or is or has been an employee of the listed entity or its holding, subsidiary or associate company, [or any company belonging to the promoter group of the listed entity]* in any of the three financial years immediately preceding the financial year in which he is proposed to be appointed.

 

[Provided that in case of a relative, who is an employee other than key managerial personnel, the restriction under this clause shall not apply for his / her employment]*

 

 The director is not independent if the director is, or has been within the last three years, an employee of the listed company or an immediate family member is, or has been within the last three years, an executive officer, of the listed company.

The director has received or has an immediate family member who has received, during any twelve-month period within the last three years, more than $120,000 indirect compensation from the listed company, other than director and committee fees and pension or other forms of deferred compensation for prior service (provided such compensation is not contingent in any way on continued service).

 The director neither is or has been an employee of the company or group within the last five years
Promoter/director or related to them The director is or was not a promoter of the listed entity or its holding, subsidiary or associate company or member of the promoter group of the listed entity;

 

Who is not related to promoters or directors in the listed entity, its holding, subsidiary, or associate company;

 

 No director qualifies as “independent” unless the board of directors affirmatively determines that the director has no material relationship with the listed company either directly or as a partner, shareholder, or officer of an organization that has a relationship with the company. The director has close family ties with any of the company’s advisers, directors, or senior employees.
Cross-directorship The director is not a non-independent director of another company on the board of which any non-independent director of the listed entity is an independent director

 

 The director or an immediate family member is or has been with the last three years, employed as an executive officer of another company where any of the listed company’s present executive officers at the same time serves or served on that company’s compensation committee. The director holds cross-directorships or has significant links with other directors through involvement in other companies or bodies

 

One may find many similarities in the definition of IDs in foreign jurisdictions with that in India but as already mentioned above, the definition in India is one of the most comprehensive and meticulous ones.

Appointment/reappointment process of IDs in different jurisdictions

In India, the extant provisions require ordinary resolution to be passed by the shareholders for the appointment of IDs and a special resolution in case of re-appointment, based on the recommendation of the Nomination and Remuneration Committee (NRC) and the approval of the Board.

Earlier, SEBI had released a consultation paper w.r.t. regulatory provisions for Independent Directors which warranted a ‘dual approval’ for such appointment/ re-appointment as follows:

  • An ordinary resolution by shareholders (Special Resolution in case of re-appointment) and
  • A resolution by “majority of minority”

(Note: The Paper defined minority shareholders to mean shareholders other than the promoter and promoter group.)

However, owing to the response received thereafter, SEBI, in its Board Meeting held on June 29, 2021[4] (SEBI Board Meeting), disregarded the earlier proposal of a dual approval and instead decided that the approval of shareholders would be required by way of special resolution for both appointment and re-appointment

[SEBI, vide (Listing Obligations and Disclosure Requirements) (Third Amendment) Regulations, 2021 ( ‘Amendments’) notified on August 4, 2021, have amended the Regulation 25 providing that the appointment, re-appointment or removal of an independent director of a listed entity, shall be subject to the approval of shareholders by way of a special resolution. Thus, listed entities henceforth shall have to obtain the approval of members via a special resolution for the appointment as well.]*

In the USA, the NASDAQ Listing Rules provide that, where shareholders’ approval is required, the minimum vote that will constitute shareholder approval shall be a majority of the total votes cast on the proposal.

Akin to the NRC in India, the UK Corporate Governance Code of 2018 requires that the Board should establish a Nomination Committee, composed of majority independent non-executive directors, to lead the process for the appointment of all directors. Any appointment must be approved by the Board and shareholders of the company by way of an ordinary resolution.

However, as per the UK Listing Rules, the appointment of IDs is dependent on the existence of a controlling shareholding[5]. A snapshot of the manner of appointment is given below

Hence, approval is required from both the set of shareholders. If the company still proposes to appoint the same person as an independent director despite failing to receive the dual nod as discussed above, it can propose another resolution to elect the same person, but after 90 days from the date when the previous proposal was put to vote. This time the resolution will only require approval by the shareholders of the company[6].

Databank of Independent Directors & the Online Proficiency Test

One of the prerequisites to become an Independent Director in India is the inclusion of their name in the Databank of Independent Directors (‘Databank’) and passing an Online Proficiency Test (‘Test’) within a period of two years from the date of inclusion of name in the databank as per Section 150 of the Act, read with Rule 6 of the Companies (Appointment and Qualification of Directors) Rules, 2014. However, certain categories of persons have been exempted[7] from the requirement of passing the Test who possess requisite experience and expertise as prescribed;

The question, however, is whether such arduous and tedious criteria required for an appointment really ensure board independence and good governance practices. It is understood that the tenet behind such steps was quality control – it was to ensure that only persons with a certain minimum level of expertise & experience are appointed as Independent Directors.

Further, some previous instances of celebrity directorships were also to be discouraged since the role of IDs is to ensure good governance practices and upholding the interest of all the stakeholders as a whole including minority stakeholders. Therefore, it should not merely be used as a tool of publicity.

However, keeping in mind the seniority of the position of directors in companies as well as lack of precedent, the requirement of passing the test seems rather odd and brings anomalies in the IDs’ regulatory regime in India vis-à-vis the rest of the world.

Constituted Body for selection of candidates for the role of IDs

As per the extant laws in India, the NRC recommends the persons to be appointed as IDs on the board of the company. This committee oversees the functions of formulation and recommendation of remuneration of the directors and the senior management. It has been decided in the SEBI Board Meeting that the process to be followed by NRC while selecting candidates for appointment as IDs, shall be elaborated and be made more transparent including enhanced disclosures regarding the skills required for appointment as an ID and how the proposed candidate fits into that skillset.

[SEBI, via the Amendments, has added a new sub-clause after sub-clause (1) in Para A in Part D of Schedule II for implementing its decision on an elobaroted and transparent selection oricess of IDs.

The NRC of every listed entities shall, for every appointment of IDs,

  • evaluate the balance of skills, knowledge and experience on the Board and on the basis of such evaluation
  • prepare a description of the role and capabilities required of IDs.
  • ensure that the person recommended to the Board for appointment as an ID has the capabilities identified in such description.

For the purpose of identifying suitable candidates, the Committee may:

  1. use the services of an external agencies, if required;
  2. consider candidates from a wide range of backgrounds, having due regard to diversity; and
  3. consider the time commitments of the candidates

Thus, the NRCs of every listed company henceforth has to first formulate the description of the role of an ID after considering the skill sets and knowledge and experience required for acting as an ID of the company. This has also widened the scope of NRC as well as the responsibility for finding the right candidate for the position of an ID. The extant practice was to give disclosures in Corporate Governance Report and the Board report that forms part of the Annual Report of the Company.]*

Just like the NRC in India, companies in the USA have to constitute Compensation Committee as per the NASDAQ Stock Market LLC Rules [5605. Board of Directors and Committees] “Each Company must have, and certify that it has and will continue to have, a compensation committee of at least two members. Each committee member must be an Independent Director as defined under Rule 5605(a) (2).”

As per the NASDAQ Rules, director nominees must either be selected, or recommended for the Board’s selection, either by:

  1. Independent Directors constituting a majority of the Board’s Independent Directors in a vote in which only Independent Directors participate, or
  2. a nominations committee composed solely of Independent Directors.

The New York Stock Exchange Listed Company Manual (‘NYSE Manual’) vests on the nominating/corporate governance committee, the sole authority to retain and/or terminate any search firm to be used to identify director candidates, including sole authority to approve the search firm’s fees and other retention terms.

The UK Corporate Governance Code, 2018 states that the board should establish a remuneration committee of independent non-executive directors, with a minimum membership of three, or in the case of smaller companies, two. In addition, the chair of the board can only be a member if they were independent on appointment and cannot chair the committee. Before appointment as chair of the remuneration committee, the appointee should have served on a remuneration committee for at least 12 months.

Tenure and re-appointment of IDs

In India, one term of appointment of IDs is for a maximum of 5 years and can be re-appointed for another term. Such re-appointment has to be made by way of passing a special resolution. Further, the performance of Independent Directors is to be evaluated every year based on which the NRC recommends whether the said director shall be re-appointed or not. However, the question of such recommendation only comes when the tenure of the director comes to its end.

Furthermore, the UK Corporate Governance Code provides that all directors should be subject to annual re-election.  The code also considers the presence of an ID for more than nine years on the Board of a company as a threat to his independence.

In Singapore, Rule 720(5) of the SGX Listing Rules (Mainboard) / Rule 720(4) of the SGX Listing Rules (Catalist)[8] requires all directors to submit themselves for re-nomination and re-election at least once every three years.

The rule requires a re-nomination & re-election of all directors of the company at least once in 3 years and it helps to ensure that the assessment of independence happens once in every 3 years by members.

Cooling-off Period for appointment/reappointment of IDs

In India, a cooling-off period of 2 years is required in case of any material pecuniary transactions between a person or his/her relative and the listed entity or its holding, subsidiary, or associate company. The LODR has prescribed a cooling-off period of three years for Key Managerial Personnel (and their relatives) or employees of the promoter group companies, for appointment as an ID in the listed entity. However, relatives of employees of the company, its holding, subsidiary, or associate company have been permitted to become IDs, without the requirement of a cooling-off period, in line with the Companies Act, 2013.

[SEBI via Amendments has provided that an ID who resigns from a listed entity, shall not be appointed as an executive / whole time director  on the board of the listed entity, its holding, subsidiary or associate company or on the board of a company belonging to its promoter group, unless one year has elapsed from the date of resignation.]*

The NASDAQ Stock Market LLC Rules[9] (‘NASDAQ Rules’) have prescribed a cooling-off period of 3 years for the appointment of an independent director where such person has a relationship with the company as prescribed under the rule.

UK Corporate Governance Code, 2018[10] (‘UK Code’) provides that a person who has or had within the last three years, a material business relationship with the company, either directly or as a partner, shareholder, director, or senior employee of a body that has such a relationship with the company shall not be appointed as an Independent Director.

The Singapore Code of Corporate Governance, 2018[11] prescribes a cooling-off period of 3 years for the appointment of an independent director where such person has a relationship with the company.

Remuneration of Independent Directors

In India, offering stock options to Independent Directors is prohibited. On the contrary, as per the New York Stock Exchange Listed Company Manual (‘NYSE Manual’), Independent directors must not accept any consulting, advisory, or other compensatory fees from the Company other than for board service.

Further, the UK Corporate Governance Code 2018 provides that remuneration for all non-executive directors should not include share options or other performance-related elements. Independent directors shall not be a member of the company’s pension scheme.

The Singapore Code of Corporate Governance 2018 the Remuneration Committee should also consider implementing schemes to encourage non-executive directors (NEDs) to hold shares in the company so as to better align the interests of such NEDs with the interests of shareholders. However, NEDs should not be over-compensated to the extent that their independence may be compromised.

Fees payable to non-executive directors shall be by a fixed sum, and not by a commission on or a percentage of profits or turnover. (Appendix 2.2 Articles of Association)

Important determinants of Independence across jurisdictions

Determinants of Independence India USA UK Singapore
Present or past employment relationship Yes Yes Yes Yes
Relationship of close family members Yes Yes Yes Yes
Pecuniary relationship with company* Yes Yes Yes Yes
Cooling-off period Yes Yes Yes Yes
Restriction on Stock options Yes Yes Yes No
ID databank & Proficiency test Yes No No No

* Subject to specific monetary limits

Conclusion

The regulatory framework for Independent Directors in India has a lot of things in common with other jurisdictions around the world. However, the requirement of passing an online test for becoming eligible to be appointed as an Independent Director is something peculiar to India. The regulators across jurisdictions have been proactive in bringing changes to the Independent Director regime, to strengthen the corporate governance in listed companies. One may expect some of the above discussed benchmark practices in different foreign jurisdictions may soon be adopted in India as well.

Related presentation – https://vinodkothari.com/2021/08/ensuring-board-continuity-and-balance-of-capabilities/

[1] https://www.sebi.gov.in/legal/regulations/sep-2015/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirement-regulations-2015-last-amended-on-may-5-2021-_37269.html

[2]  https://nyse.wolterskluwer.cloud/listed-company-manual

[3]https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UK-Corporate-Governance-Code-FINAL.PDF

[4] https://www.sebi.gov.in/media/press-releases/jun-2021/sebi-board-meeting_50771.html

[5] A company is said to have controlling shareholder(s) if a shareholder/ an entity/ a group holds more than 30% voting power in the company

[6] https://www.mondaq.com/uk/acquisition-financelbosmbos/315598/new-dual-process-for-appointing-independent-directors-amendments-to-articles-of-association

[7] https://www.independentdirectorsdatabank.in/pdf/databank-rules/FifthAmdtRules_18122020.pdf

[8] https://rulebook.sgx.com/rulebook/board-matters-1

[9] https://listingcenter.nasdaq.com/rulebook/nasdaq/rules

[10] https://www.frc.org.uk/getattachment/88bd8c45-50ea-4841-95b0-d2f4f48069a2/2018-UK-Corporate-Governance-Code-FINAL.PD

[11] https://www.mas.gov.sg/-/media/MAS/Regulations-and-Financial-Stability/Regulatory-and-Supervisory-Framework/Corporate-Governance-of-Listed-Companies/Code-of-Corporate-Governance-6-Aug-2018.pdf

*[ The changes are applicable with effect from 1st January, 2022].