Majority of minority to ensure economic interest in transactions with related parties

SEBI’s proposal–came late, came correct

-CS Nitu Poddar, Tanvi Rastogi

corplaw@vinodkothari.com

Financial assistance to related entities is a quite a regular transaction. Considering the transfer of obligations, such transactions are subject to certain regulation under the Companies Act, 2013 (Act, 2013) and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR). However, despite the prohibitions and restrictions, there are several areas within the periphery of transactions with related parties which remain out of the ambit of law and therefore is beyond required checks. Following the proposal of changes in the provisions of RPT vide the report of the working group[1], SEBI has floated a consultative paper[2] on 06-03-2020 proposing certain changes to corporate guarantees being provided by a listed party on behalf of its promoter / promoter related entities, without deriving any economic benefit from such transaction.

In this article, we discuss the coverage of the current provisions, gap therein, need for the proposal and the proposed regime to bridge such gap.

Unrelated-related parties – remains unregulated

As compared to the Act, 2013, LODR has a wider definition of related party where it additionally covers related parties under AS-18 / IND AS-24 and also such member of promoter and promoter group which holds 20% of the total shareholding of the listed entity. Despite such wide definition, practically speaking, there may be several interested entities of the promoter which gets excluded from the technical criteria of being a related party due to absence of required shareholding and consequently transactions with them can easily sail through without being subject to required approvals. As such, currently, a listed entity can grant loan, give guarantee / security in connection of loan to / on behalf of an entity, which technically is not a related party, but either is a promoter or an entity in which the promoter has vested interest against the interest of stakeholders of the lending company.

Existing provisions regulating financial transactions

Currently, section 177, 185 and 186 of Act, 2013 are the major provisions governing any financial transactions. Section 188 of the Act, 2013, does not cover financial transaction within its coverage and therefore the same get ruled out anyway. Section 177 provides for scrutiny of inter-corporate loans as well as approval and modifications of all related party transactions. The challenge of this section are that firstly, transactions with interested unrelated party gets ruled out and   consequently the committee is left with the duty of a post mortem scrutiny and not a prior scanning of the transaction. Sec 186 provides for limits of financial transaction i.e giving of loan, investment, guarantee, security in connection with loan and also keeps a check on minimum rates to be charged in case of loan. Transactions beyond the limits require approval by special majority of the shareholders. Sec 185 talks about granting of loan to directors and director-interested entities. While there is complete prohibition of granting of such loan to the director himself or his relative / firm, loan can be granted to interested-companies, subject to approval by special majority of shareholders of the lender company.

To get such approval is not a tough task in a company with high promoter-holding, and the promoters can easily get their transaction through. Unlike sections 188 and 184 where the voting rights of the interested parties are restricted in the general meeting and board meeting respectively, section 185 and 186 does not provide for any such restrictions.

As per Reg 23 of LODR, related party transactions, which includes financial transactions as well, requires approval of shareholders by majority. This approval is by the majority of the minority as all entities falling under the definition of related parties cannot vote to approve the relevant transaction irrespective of whether the entity is a party to the particular transaction or not.

Proposed amendment – need and proposal 

It is to be noted that whenever there is a transaction with a promoter related entity, there may be a potential threat to the interest of the non-promoter group / minority shares. Accordingly, approval of the majority of such minority is to be essentially sought to ensure that the resources of the company are not been siphoned away / wrongly used / alienated by the promoters and that the interest of such minority is secured. As mentioned above, in the existing regime, question of approval from such majority of minority arise only for material RPTs under LODR.

Hence, all such transactions which does not fall under the category of “RPT” and / or “material” remains unguarded and thus putting the corporate governance of the company at stake.  SEBI, in its report on working group of RPT[3], has clearly put forward its intent to curb such influential transactions by the promoter / promoter group and to revise the definition of related party itself. Once the said proposal is made effective, all transactions with promoter / promoter group will be a RPT. However, inspite of such revision in the definition of RPT, only material transactions will require approval of minority shareholders.

Through the proposal in the consultative paper, SEBI intends to move a step ahead of what the working group discussed. SEBI now proposes to require all guarantee transactions, irrespective of the materiality to be approved by the majority of minority shareholders. Additionally, the directors of lending company are required to establish and record “economic interest” in granting of such guarantee.

Essence of voting by majority of minority

It is no approval, if the person seeking approval and granting approval is the same. In corporate democracy, approval is essentially ought to be sought from the class of people whose rights seem to be prejudiced from transaction proposed in the interest of another class. Reg 23 of LODR and sec 188 of Act, 2013 already recognises such majority of minority approval wherein all the related parties of the company refrain from voting.

Significance of “economic interest”

Any prudent mind would require risk and reward, benefit and burden to be shared proportionately. It is absolutely irrational to say that a listed company is extending guarantee / security in connection with loan but has no benefit in return.

It is to be noted that charging of guarantee commission or charging of interest is not to be misunderstood as presence of economic interest. There are charged only to keep the transaction at arm’s length. However, the exposure of the lender company is the amount of loan / amount guaranteed.

Few examples of embedded economic interest in a transaction can be as follows:

  1. A holding company extending loan to its wholly-owned subsidiary for funding acquisition of land for building of plant may be benefitted by the figures of such subsidiary at consolidated level;
  2. A listed company guaranteeing on behalf of another unrelated-related entity which is the customised raw material provider of the lending company

Different scenarios of financial transaction considering the proposal of SEBI:

S. No. Transaction between Existing provision Proposed amendment Analysis
1

 

Two unlisted companies Section 186 / 185, if  applicable Unlisted companies are not covered No Impact
2 Listed company with its related party – beyond materiality threshold Section 186 / 185, if  applicable and Reg 23- shareholders’ approval through resolution where no  related  party  shall  vote  to  approve Ensuring the economic interest + Prior  approval  from  the shareholders on a “majority of minority” basis Irrespective of the materiality, where there is any transfer of financial obligation, prior approval of unrelated shareholders will be required
3 Listed company with related party not within materiality threshold No requirement for shareholders’ approval Ensuring the economic interest + Prior  approval  from  the shareholders on a “majority of minority” basis Irrespective of the materiality, where there is any transfer of financial obligation, prior approval of unrelated shareholders will be required
4 Listed company with unrelated related party[4] No requirement prescribed under law

Open issues

  1. While the proposed amendment is absolutely on-point and timely amendment in the wake of several corporate scams in the recent past being witnessed by the country, however, it will achieve its intent if the same is not kept limited to guarantee / security in connection with loan, but also extended for granting of loan to such unrelated-related entities;
  2. Also, the list of entities is kept vague in the Paper (promoter(s)/ promoter group/ director / directors relative / KMP etc) and may be better clarified in the amendments, however, the intent seems to be quite clear to include any promoter / promoter group / management related entity;
  3. Lastly, it is not clear as to who should refrain from voting for majority of minority voting – all promoter / promoter group entities / all related parties of the listed entity;

 

[1] https://www.sebi.gov.in/reports-and-statistics/reports/jan-2020/report-of-the-working-group-on-related-party-transactions_45805.html

[2] https://www.sebi.gov.in/reports-and-statistics/reports/mar-2020/consultative-paper-with-respect-to-guarantees-provided-by-a-listed-company_46234.html

[3] SEBI Report on working group of RPT dated 27th January, 2020 ibid

[4] Includes promoters which may not fall under definition of related party – like promoter not holding any shareholding in the company

Read our article on proposed changes by working group of SEBI on Related Party Transactions here: http://vinodkothari.com/2020/01/expanding-the-web-of-control-over-related-party-transactions/

Read our articles on the topic of related party transactions here: http://vinodkothari.com/article-corner-on-related-party-transactions/

Recent Developments in Corporate Laws

In its stride to achieve transparency, good governance, and ease of doing business, the Government has time and again introduced amendments, proposed new ideas in the corporate laws. The very recent example of such changes are (a) Changes in RPTs proposed in LODR; (b) Minority Squeeze outs under Companies Act; and (c) introduction of Winding-up Rules, 2020.

In light of the these amendments/ proposed amendments, it becomes important to understand its impact on the already existing set-up. A brief analysis of the aforementioned topics has been discussed here

SEBI tightens its norm on resignation of auditors

– Priya Udita

resolution@vinodkothari.com

OVERVIEW

Observing that a lot of statutory auditors of the companies are abruptly resigning before completing their tenure either due to lack of cooperation or lack of information provided by the company, SEBI has taken the matter in its hand to strengthen the norms. Consequently, SEBI issued a Consultation Paper[1] on policy proposals with respect to resignation of statutory auditors from listed entities (‘Paper’) dated July 18, 2019. The Paper discussed the policy proposal with the twin objective of strengthening disclosures to the investors and clarifying the role of the Audit Committee. Our analysis of the Paper can be assessed here.

Based on the policy proposal and public comments, SEBI issued circular on Resignation of statutory auditors from listed entities and their material subsidiaries (‘Circular’)[2] dated October 18, 2019 defining compliance to be followed by the listed entity and its material subsidiary while appointing or reappointing the auditors.

KEY AMENDMENTS

  1. Applicability:

The Circular is applicable on listed entities and its material subsidiaries. The material subsidiaries can be a listed or an unlisted entity. However, it is interesting to comprehend the applicability of the Circular on the debt listed companies (analysed below in our comment section).

Further, the Circular has come into force with immediate effect from the date of its notification.

  1. Exception:

The provisions of this Circular  is inapplicable in case the auditor disqualified under section 141 of the Companies Act, 2013.

  1. Compliance for limited review or audit review while appointing or reappointing the auditors:
  2. Within 45 days from the end of quarter of a financial year- the auditor shall issue the limited review/ audit report for such quarter before resignation.

For Example: if the auditor resigns on May 28, 2019 then the auditor is required to submit limited review of quarter ending on June 30, 2019.

  1. Resignation after  45  days  from  the  end  of  a  quarter  of  a  financial year- then the auditor shall issue the limited review/ audit report for such quarter as well as the next quarter before resignation.

For Example: if the auditor resigns on August 25, 2019, then the auditor needs to issue limited review/audit report of quarter ending on September 30, 2019 as well as December 30, 2019.

  1. However, if the auditor has signed the limited review/ audit report for the first 3 quarters of a financial year- then the auditor shall issue the limited review/ audit report for the last quarter of such financial year as well as the audit report for such financial year before the resignation.
  2. Role of Audit Committee

Though the SEBI (Listing and Disclosure Obligations) Regulation, 2015 (‘SEBI LODR Regulations’) laid down the broad role of the audit committee inter alia the appointment, remuneration of the statutory auditors, but, there was not much for the audit committee to delve once the auditor resigns. Thus, with the intention to further enhance the role of audit committee, SEBI has laid down following procedures:

  1. For the auditors:
  2. In case of conflict with the management of the listed entity due to lack of cooperation or non-availability of information, the auditor can approach the chairman of the audit committee of the listed entity.
  3. Where the auditor proposes to resign, all concerns with respect to the proposed resignation, along with relevant documents should be given to the audit committee.
  4. Further where the proposed resignation is due to non-receipt of information/explanation from the company, the auditor will have to inform the audit committee of the details of information asked and not provided by the management.
  5. For the Audit Committee:
  6. In case of concern raised due to non-availability of information, audit committee must receive such concern directly and immediately without specifically waiting for the quarterly audit committee meetings.
  7. On receipt of information from the auditor relating to the proposal to resign, the audit committee/board of directors must deliberate on the matter as soon as possible but not later than the date of the next audit committee meeting and communicate its views to the management and the auditor.
  8. Disclaimer by the auditor:

Where the auditor does not receive the information demanded for the purpose of auditing, an appropriate disclaimer in the audit report must be provided in accordance with the Standards of Auditing as specified by ICAI/NFRA.

  1. Obligations of the listed entity/material subsidiary
  2. The listed entity/its material subsidiary are required to ensure that the new compliance is included in the terms of appointment at the time of appointment or reappointment of the auditors. In case of existing auditors, the appointment letter is needed to be modified to give such effect.
  3. The listed entity/its material subsidiary need to obtain the information about the auditor’s resignation in a format as specified in the Circular. Further, the listed entity has the obligation to ensure disclosure of the same under Sub-clause  (7A)  of  Clause  A  in Part  A  of Schedule  III under Regulation 30(2) of SEBI LODR Regulations.
  4. The listed entity/material subsidiary will provide all the relevant document or information as required by the auditor during the period from its proposal to resign and submission of the limited review/audit report.
  5. The listed entity will disclose the views of the audit committee to the stock exchange as soon as possible and not later than later than twenty four hours after the date of such audit committee meeting.

ANALYSIS

Firstly, we need to understand the current regulatory provisions governing the resignation of the auditors and the need felt by SEBI to issue this Circular.

Section 140(2) of the Companies Act, 2013 along with the Companies (Audit and Auditors) Rules, 2014 mandates the auditor to file a statement in a prescribed form to the company and to the Registrar citing reasons for resignation, within 30 days from the date of resignation. In addition to that, sub-clause (7A) of Clause A in Part A of Schedule III under Regulation 30(2) of the SEBI (LODR) Regulations prescribes that the listed entity shall disclose detailed reasons of the resignation to the stock exchange within 24 hours of such resignation. ICAI’s auditing standards (SA-705) enumerates that in a situation where the possible effects on the financial statements of undetected misstatements are both material and pervasive such that a qualification of the opinion would be inadequate to communicate the gravity of the situation, the auditor can resign. According to the Rule 5 of National Financial Reporting Authority Rules, 2018 (‘NFRA Rules’), every auditor of the entities covered by these rules are required to file an annual return in form NFRA 2 with the authority giving details with respect to the audit as well as resignations given in the past 3 years.

Though the law provided these rules and regulation, the rising trend on abrupt resignations by the auditor citing reason as ‘pre-occupation’ were leaving the investors vulnerable to various threats. Due to resignation of the large audit firms, SEBI was forced to review its listing and disclosure obligations. In order to enhance accountability of auditors and protect the investors from the insecure environment due to abrupt resignation, SEBI felt the dire need to regulate such resignations and took the step in a right direction by issuing this Circular.

OUR COMMENT

The Circular was much needed as the rules governing the resignation of auditors across different forums were inadequate. The Circular, in addition to regulation of abrupt resignation, will give a helping hand to the auditors especially in case of lack of cooperation by the management, if any, faced by them. This will ultimately benefit SEBI to look into the matter for potential fraudulent or vulnerable transactions. Further the enhancing role of the audit committee is commendable.

However, the Circular has few gaps such as the applicability of Circular on debt listed entities. Now, there can be various scenarios. Suppose the listed entity ‘A’ has a material subsidiary ‘B’. The Circular will be applicable where ‘B’ is unlisted but a material subsidiary of ‘A’. The question arises where ‘B’ is a debt listed entity only, whether the Circular will be applicable? In our view, the Circular will be applicable in the instant case since B is a material subsidiary.

Further, it is important to note that the intimation requirements under the Circular are two-fold and both are parallel to each other serving different intents. In the first part, the listed entity has to inform the stock exchange within 24 hours of the resignation as per Sub-clause (7A) of Clause A in Part A of Schedule III under Regulation 30(2) of SEBI LODR Regulations, whereas in the second part the audit committee is required to inform the stock exchange as soon as possible from the date of resignation but not later than date of next audit meeting.  The intimation under the second part will carry the views of the audit committee on the concerns raised by the auditor before resignation whereas the intimation under Regulation 30 is an intimation of a material event. We shall be coming out with our set of FAQs on the Circular discussing the same at length from various perspectives.

[1] See the paper here.

[2] See the Circular here.

 

Core competencies of Directors: the new disclosure requirement for listed entities

By Munmi Phukon

Principal Manager, Vinod Kothari & Company

munmi@vinodkothari.com

Introduction

How does a person get into the board of directors of a listed entity? Simply because he happens to be a majority shareholder, or the son of the promoter, or a morning-walk friend of the promoter? Or, is it that a listed company is expecting supervisory leadership to come from a body consisting of individuals with diverse skills and competencies? What are those key competences and skill sets required from directors, and which of the company’s directors possess which of these abilities? These are questions that listed entities and their stakeholders might have either not put before themselves, or even if considered, may not have had structured answers to these questions. However, come this year, every listed entity shall give a list of core skills/ expertise/ competencies of the Board members, and come next year, the names of the directors who actually possess such skills/ expertise/ competencies.

In the above para, one is referring to a new provision under Para C of Schedule V pertaining to the contents of corporate governance report which reads as follows:

“C. Corporate Governance Report: The following disclosures shall be made in the section on the corporate governance of the annual report.

XXX

(h) A chart or a matrix setting out the skills/expertise/competence of the board of directors specifying the following:

(i) With effect from the financial year ending March 31, 2019, the list of core skills/expertise/competencies identified by the board of directors as required in the context of its business(es) and sector(s) for it to function effectively and those actually available with the board; and

(ii) With effect from the financial year ended March 31, 2020, the names of directors who have such skills / expertise / competence.

Importance & objectives of having a diverse Board

The importance of a diverse and skilled Board is recognised around the world. It is more than a necessity considering the complex and dynamic business environment. The Board is the set of leaders who provide comprehensive guidance, support and direction to the company towards its success. The objective of having skilled Board is manifold considering the involvement of public money, be it of the public shareholders, lenders or other creditors. Stakeholders are concerned about the attitude of the firm towards corporate governance as a diverse set of individuals collectively known as Board cannot take a casual approach on the management of the firm sitting on the pile of public money. Therefore, it is always required for the NRC to have a clear view as to what is being expected from the directors, what would be the set of skills, competencies, expertise, knowledge etc. that would be possessed by the directors, whether the same is broad based and also, to ensure an effective evaluation mechanism.

What does law require?

Till the amendments in the Listing Regulations coming into force, Regulation 36 required disclosure of the nature of the expertise in specific functional areas of a proposed appointee including a person seeking re-appointment to the shareholders. Further, Rule 5 of the Companies (Appointment and Qualification of Directors) Rules provided the qualification of the independent directors as persons who shall possess appropriate skills, experience and knowledge in one or more fields of finance, law, management, sales, marketing, administration, research, corporate governance, technical operations or other disciplines related to the company’s business.

The new requirement of disclosure has been framed based on the Kotak Committee Recommendations whose rationale was primarily based on the fact that the existing requirement of law was not sufficient to the shareholders for their adequate analysis whether the Board of the company has sufficient mix of diverse expertise/ skill- sets.

The broad parameters[1]

The Board is responsible for shaping the future of the organisation within its fiduciary characteristics. Therefore, identifying the key competencies of the Board members is very much essential to ensure that the qualified persons undertake this cardinal role. Globally, identifying the key competencies of Board members is considered as the step towards a successful Board. Broadly, the parameters for identifying key competencies or skill- set can be categorised as follows:

Industry knowledge/ experience

Having experience in and knowledge of the industry in which the organisation operates is one of the key competencies of a Board member. This is required for achieving the objectives of the organisation while operating effectively, responsibly, legally and sustainably. The Board members are required to demonstrate an understanding of-

  • the relevant laws, rules, regulation policies applicable to the organisation/ industry/ sector and level/ status of compliances thereof by the organisation
  • the best corporate governance practices, relevant governance codes, governance structure, processes and practices followed by the organisation
  • business ethics, ethical policies, codes and practices of the organisation
  • the structures and systems which enable the organisation to effectively identify, asses and manage risks and crises
  • international practice

Technical skills/ experience       

To assist with the ongoing aspects of Board’s role, the members are required to possess technical/ professional skills and specialist knowledge. The directors need to be able to obtain, analyse, interpret and use information effectively to develop plans and take appropriate decisions. In order to assess possession of such skills, the person will be required to have knowledge about-

  • how to interpret financial statements and accounts in order to assess the financial health of an organisation
  • the sources of finance available to an organisation and their related merits and risks
  • how to assess the financial value of an organisation and potential business opportunities
  • importance of information technology in the organisation
  • marketing or other specific skills required for the effective performance of the organisation

Behavioural competencies/ personal attributes

Displaying high standards of conduct, ability to take responsibility for their own performance etc. are some of the behavioural competencies which the directors are required to possess. Interpersonal skills such as good communication skills, relationship building capacity etc. will come under this category. In brief, the following will be sub- sets under this head-

  • Integrity and ethical standards
  • Mentoring abilities
  • Interpersonal relations
  • Managing people and achieving change
  • Curiosity and courage
  • Genuine interest
  • Instinct
  • Active contribution

Strategic expertise 

To create and implement effective strategies, a thorough knowledge of the strategic process is required. The ability to think strategically enables directors to propose ideas, options and plans that take advantage of available opportunities while reflecting a broad and future-oriented perspective. Having an understanding of the need for a clear vision and purpose to guide the strategy, models and methods of strategic analysis, option analysis the factors involved in successful strategy implementation by the directors is required for giving a strategic direction to the organisation. The sub- sets under this head may be as below:

  • Strategic thinking
  • Vision and value creation
  • Strategy Development
  • Strategy implementation and change

Mind- set or attitude

An ethical mind- set demonstrates a high standards of conduct. Further, professional attitude and independent mind- set enables director to provide the challenge and rigour required to help the Board achieve a comprehensive understanding of information and options, as well as high standards of decision-making. The head may be segregated into the following:

  • Ethical
  • Professional
  • Performance oriented
  • Independent
  • Aware of self and others

Other skills

Other skills may include decision making, communication, leadership, influencing, risk oversight, risk management, stakeholder relations etc. Good decision-making skills is required in order to arrive at a course of action in a timely manner that provides a clear direction and moves the organisation forward. Similarly, strong leadership skills enable directors to solve problems, cope up with the crises and change, and inspire others to follow them in pursuit of the values and goals of the organisation. The ability to build good networks and relationships within and beyond the organisation is important for the director to gain influence, have impact and progress organisational goals. The ability to communicate effectively through a variety of modes and channels and with a range of audiences is necessary for directors to work successfully with others and to fulfil their duties on the Board. Directors need to understand how to deliver effective leadership, build good stakeholder relations and develop a strategically aligned and values-based organisational culture in order to achieve good organisational performance. Therefore, the sub- sets hereunder may be-

  • decision making skills
  • communication skills
  • leadership skills
  • influencing
  • risk oversight
  • risk management skills
  • stakeholder relations

Suggestive format of reporting

Broad parameter Specific skills/ expertise/ competency

 

Director 1 Director 2 Director 3
 

 

 

 

 

 

 

 

Industry knowledge & experience

 

 

Understanding of the relevant laws, rules, regulation policies applicable to the organisation/ industry/ sector and level/ status of compliances thereof by the organisation

 

Understanding of the best corporate governance practices, relevant governance codes, governance structure, processes and practices followed by the organisation

 

Understanding of business ethics, ethical policies, codes and practices of the organisation

 

Understanding of the structures and systems which enable the organisation to effectively identify, asses and manage risks and crises

 

Understanding of international practice

 

Conclusion

The amendments require listing out of the key skills/ competencies of the Board as a part of the corporate governance report for FY 18-19. From subsequent FYs, the disclosure will have to be by way of a matrix signifying the directors actually carrying such skills. It is anticipated that such a disclosure will help the shareholders to analyse the diversity of expertise/ skill – sets of the Board. This is believed that disclosure of each of the skills against the directors will make them responsible for each of the skills. Therefore, a director will not be able to escape responsibility with the shield of immunity provided by law which is circumstantial.

 

[1] Source:

  1. https://www.asaecenter.org/resources/articles/foundation/2018/defining-board-competencies
  2. https://www.iod.com/Portals/0/PDFs/IoD%20Competency%20framework.pdf?ver=2017-10-06-135816-827
  3. https://www.effectivegovernance.com.au/services/director-skills-competency-assessment/
  4. https://aicd.companydirectors.com.au/resources/director-tools/practical-tools-for-directors/board-composition/key-competencies-for-directors
  5. https://www.effectivegovernance.com.au/services/director-skills-competency-assessment/