ESG concerns in corporate governance in India

Sikha Bansal, Partner (sikha@vinodkothari.com) and Payal Agarwal, Executive (payal@vinodkothari.com)

Introduction

ESG (where, E stands for Environment, S for Society, and G for Governance) is a term that has earned a lot of attention in the recent years. Related terms used are ESG investing, ESG reporting, ESG rating, etc. – all focussing on and circumscribing same factors.

The ESG analysis is sought as a measure of responsible investing, and goes beyond the traditional method of using only financial factors for evaluation of an investment or potential investment.  ESG, in essence, recognises financial relevance of various non-financial elements which impact business in several ways. With sustainable development being the desirable result of whatever we do, efforts have been made to incorporate ESG issues in the analysis of the business performance as a whole.

In context of the same, we have tried identifying ESC concerns in India, in relation to corporate businesses. While in India, we have already something called ‘business responsibility reporting’, we need to see if this sufficiently captures the spirit of ESG and where it stands vis-à-vis global practices.

What is ESG?

Before we go on to the question why we need ESG, we need to understand what ESG, and also, why and how it has assumed so much of importance.

The emergence of ESG dates back to earlier years of 2000s. A report titled Who Cares Wins: Connecting Financial Markets to a Changing World[1], highlighted the emerging ESG issues and made several recommendations, including – (i) financial institutions should commit to integrating environmental, social, and governance factors in a more systematic way in research and investment processes, (ii) the companies a leadership role by implementing environmental, social and corporate governance principles and polices and to provide information and reports on related performance in a more consistent and standardised format, and (iii) investors shall explicitly request and reward research that includes environmental, social and governance aspects and to reward well-managed companies. Further, the report recommended that the financial analysts shall not only focus on ESG risks and risk management, but also consider ESG issues as a potential source of competitive advantage. The report also identified the following drivers through which good management of ESG issues can contribute to shareholder value creation[2].

Later, UNEP FI, in its 2005 Report[3], highlighted the distinction between ‘value-driven’ vs. ‘values-driven’ investment, and observes, “ESG considerations are capable of affecting investment decision-making in two distinct ways: they may affect the financial value to be ascribed to an investment as part of the decision-making process and they may be relevant to the objectives that investment decision-makers pursue.” This report noted that, the movement towards mainstream consideration of ESG issues in investment decision-making is a response of variety of factors, including, increasing evidence of the nexus between performance on ESG issues and financial performance, reputational concerns, consumer pressure, public opinion, introduction of corporate environmental reporting obligations, etc.[4]

Some institutional investors believed that environmental, social and governance (ESG) issues were not relevant to portfolio value, and were therefore not consistent with their fiduciary duties. However, in report titled “Fiduciary Duty in the 21st Century[5], issued by UN agencies and PRI[6], it was clarified that the assumption is no longer supported, and that, failing to consider long-term investment value drivers, which include environmental, social and governance issues, in investment practice is a failure of fiduciary duty. The said report identifies critical importance of incorporating ESG standards into regulatory conceptions of fiduciary duty, for mainly three reasons – firstly, ESG incorporation is an investment norm; second, ESG issues are financially material; and thirdly, policy and regulatory frameworks are changing to require ESG incorporation.

Presently, there are several organisations, projects and reports focussing on ESG issues. These organisations may be governmental as well as independent. For instance, Global Reporting Initiative (GRI)[7] has formulated several standards[8] for sustainability reporting. See also, OECD (2017), Investment governance and the integration of environmental, social and governance factors.

Pillars of ESG

ESG, as stated above, has 3 pillars – Environmental, Social and Governance Each of these pillars comprises of several factors which would be a ‘parameter’ in ESG analysis.

  • “environmental” pillar focusses on creating a sustainable environment, where parameters such as impact of a company’s activities on the climate, company’s liability towards the environment, creating eco-friendly products, etc are checked and measured;
  • “social” aspect focusses on creating value for the society, by laying emphasis on the human rights issues, workplace health and safety, labour training and management, interaction with communities, customer relationship etc;
  • “governance” aspect covers issues on the corporate governance of a company and has two main elements: corporate structures, and corporate behaviour.

We have compiled a list of such factors[9] as below –

ESG Reporting

EU law requires large companies to disclose certain information on the way they operate and manage social and environmental challenges. EU’s directive, 2014/95/EU also called the non-financial reporting directive (NFRD), acknowledges that disclosure of non-financial information is vital for managing change towards a sustainable global economy by combining long-term profitability with social justice and environmental protection and lays down the rules on disclosure of non-financial and diversity information by large companies[10]. The Directive amends the accounting directive 2013/34/EU (by inserting Article 19a) so as to mandate inclusion of non-financial statement containing information to the extent necessary for an understanding of the undertaking’s development, performance, position and impact of its activity, relating to, as a minimum, environmental, social and employee matters, respect for human rights, anti-corruption and bribery matters, etc.

It further provides, “Where the undertaking does not pursue policies in relation to one or more of those matters, the non-financial statement shall provide a clear and reasoned explanation for not doing so.”

The EU has issued its guidelines to help companies disclose environmental and social information, and published guidelines on reporting climate-related information. Also, EU has also launched a public consultation on the review of the NFRD[11].

The OECD Report of 2017[12] compiles ESG reporting requirements (voluntary as well as mandatory) across the world by institutional investors, and by way of corporate disclosures. The report observes that the reporting requirements are usually voluntary (“comply or explain”) and are not prescriptive on the methods or metrics to be used.

The Financial Reporting Council (FRC) of UK released a discussion paper – “A Matter of Principles: The Future of Corporate Reporting” (2020). The discussion paper proposes a network of interconnected reports based on objectives rather than a single comprehensive annual report. The proposals include 3 reports – Business report, the full Financial Statements and a new Public Interest Report. It also focuses on widening the definition of materiality so that it does not remain limited to accounting standards only, but covers other wider range of activities that affect a company significantly. Section 6 of the this Report deals extensively with non-financial reporting, stated to include information relating to employees, suppliers, customers, the community, the environment and human rights.

In a study, “The consequences of mandatory corporate sustainability reporting: evidence from four countries (2015)”, it has been observed that even though the regulations often allowed companies, via comply or explain clauses, to choose not to make greater disclosure, there was a 30%-50% average increase in ESG disclosure as a result of the regulations being introduced (albeit from a low starting base). The greatest increase came in the first year of the regulations coming into force. All three types of disclosure – environmental, social and governance – increased.  The findings, therefore, suggest that, contrary to popular belief that an increase in disclosure regulation imposes significant costs on companies and, therefore, has a negative impact on shareholders, the reality is that improved disclosure creates value for companies, not destroys it.

ESG Rating

Investors, institutional institutions, etc. would generally make use of ESG information for investment decisions through ESG ratings provided by ESG rating agencies[13]. This assessment and measurement often forms the basis of informal and shareholder proposal-related investor engagement with companies on ESG matters[14]. ESG factors can provide valuable insights into possible current and future environmental and social risks and opportunities for corporate entities, given the impact and dependence entities have on the environment and society. These ESG issues in turn have the potential to lead to a direct or indirect financial impact on the entity’s profits and investment returns[15].

See Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris, for an elaborate discussion on ESG rating and indices and the methodologies adopted for the same. The paper also compiles ESG Criteria as used by major index providers as follows[16]

Even though there are countries where ESG Reporting has been initiated as a voluntary or mandatory measure, the requirement of ESG rating has not been found to be mandated in any country by way of explicit regulations on the same.  However, institutional investors, proxy advisor firms etc., are largely using these ratings while making investment decisions as part of making socially responsible investment.

ESG in Indian Context

The Indian legislation has been trying to cover the various aspects of ESG in a fragmented manner.

For instance, the board’s report shall disclose the conservation of energy, technology absorption, etc.[17] The aspects have to be dealt with in detail – the company shall disclose steps taken or impact on conservation of energy, steps taken to utilise alternate sources of energy, capital investment in energy conservation equipments, efforts towards technology absorption, etc. Besides, a director owes a fiduciary duty towards the community as well as for the protection of the environment[18]. Also, CSR activities include various socio-economic activities, required to be disclosed separately in the annual report[19]. However, the closest requirement is that of Business responsibility Reports (BRR) which has been mandated from ESG perspective only, as discussed below.

What is Business Responsibility Report (BRR)?

BRR or Business Responsibility Report can be said to be the foremost step in India in promoting non-financial reporting in India, on a mandatory basis. The initiative was one of the responses to India’s commitment towards the United Nations Guiding Principles on Business & Human Rights (UNGPs) and Sustainable Development Goals.

The BRR is based on the 9 principles in line with the ‘National   Voluntary   Guidelines   on   Social, Environmental and Economic Responsibilities of Business’ (NVG)[20] issued by MCA. The guidelines state that the companies should not be just responsible but also socially, economically and environmentally responsible. Through such reporting, the guidelines expect that businesses will also develop a better understanding of the process of transformation that makes their operations more responsible. The NVG were further revised and the MCA formulated the ‘National Guidelines on Responsible Business Conduct’ (NGRBC)[21]. The said guidelines stipulated that the businesses should –

  • conduct and govern themselves with integrity in a manner that is Ethical, Transparent and Accountable,
  • provide goods and services in a manner that is sustainable and safe,
  • respect and promote the well-being of all employees, including those in their value chains,
  • respect the interests of and be responsive to all their stakeholders,
  • respect and promote human rights,
  • respect and make efforts to protect and restore the environment,
  • when engaging in influencing public and regulatory policy, should do so in a manner that is responsible and transparent,
  • promote inclusive growth and equitable development, and
  • engage with and provide value to their consumers in a responsible manner.

The Securities and Exchange Board of India (SEBI), in 2012[22], through its listing conditions mandated the top 100 listed entities by market capitalisation to file BRR from ESG perspective. This was extended to top 500 companies in FY 2015-16[23]. The coverage has been extended to 1000 companies now[24]. In the year 2020, MCA issued Report of the Committee on the Business Responsibility Reporting, and SEBI issued a Consultation Paper on the format for Business Responsibility and Sustainability Reporting (BRSR, suggesting that BRR shall be renamed as BRSR). See our detailed analysis of the recommendations made in these reports.

See also, our earlier article on BRR. The eventual development in BRR framework is shown below –

BRR – Identifying ways to improve

ESG has no statutory definition, per se. We have tried identifying possible factors, based on various reports, indices, etc. which would reflect a holistic ESG perspective of an entity.

How effective is the present framework of BRR can be understood by way of the following table:

BRR vs ESG – Hits and Misses

Hits Misses
Climate change Carbon emissions
Resource use , sustainable sourcing Green building
Environmental protection and restoration Biodiversity and land use
Renewable energy Discharge of effluents
Water use ————-
Energy efficiency —————
Clean tech —————-
Safety of employees, customers Privacy and data security
Skill upgradation training Financial product liability
Labour management ————
Practice against child labour, sexual harassment, forced labour ————
Protection of human rights ————-
Satisfactory redressal of customer complaints ————
Stakeholder engagement ————
Ethics and bribery Board structure
Anti competitive behaviour Executive pay
Unfair trade practices Codes and values
—————– Tax transparency

 

Most of these gaps in the present BRR format are covered under the proposed BRSR. The BRSR has provisions for reporting on the carbon emissions of a company, discharge of other effluents by the company, and reporting relating to the privacy and data security of the customers etc. Also, the BRSR defines the scope of reporting for every item very precisely.

However, matters such as financial product liability and various aspects of governance still needs a dedicated space.

NSE Study of BRR Reporting in India

A study of NSE, while conducting the ESG analysis of Indian companies, has checked the disclosures provided under the BRR framework by the companies as part of its ESG analysis.

Some significant findings of the study has been pointed below:

  • Among the nine principles, the least number of sample companies responded positively for disclosures on principle 7 (i.e., public advocacy). It had the lowest score on all four measures.
  • One of the recurring reasons for not framing a policy on the principle 7 is that there is no specific/ formal policy on public advocacy. However, companies have stated that they indirectly covered aspects of principle 7 under other policies. This may be attributed to the fact that in India, advocacy, if at all done, is done in a non-transparent manner.
  • The second worst response was with respect to the principles relating to ‘respect and promoting human rights’ and ‘engagement and providing value to customers and consumers’. Once again, probably, these concepts are yet to be assimilated in our system.
  • Higher positive responses were found across principle 1 (ethics), principle 3 (employees), principle 4 (stakeholder), principle 6 (environment), and principle 8 (growth and equitable development – social responsibility). This can be attributed to the fact that some of these policies flow from various legal mandates in India. Hence, most companies have formal policies to comply with the law on these principles.

The study highlights that companies have largely scored better on policy disclosures followed by governance factor, compared to environment and social factors. This can be attributed to the fact that governance reforms have transformed into laws by various regulatory agencies within India, in the last two decades. Similarly, many policies have been mandated to be prepared by regulatory authorities. Hence, companies have scored higher on policy disclosure parameters.

Closing Thoughts

The BRR Reporting in India, in terms of key areas, goes a long way in presenting a holistic ESG scenario. Some structural changes in the extant format may facilitate better reporting.

Further, the Indian companies are found to perform well in the governance related matters, in comparison to the environmental and social factors, admittedly for the presence of various statutory requirements and regulatory supervision on the governance requirements of a company. However, the companies need to improve their environmental and social scores as well.

[1] December, 2004. The Report was a joint initiative of financial institutions which were invited by United Nations Secretary-General Kofi Annan to develop guidelines and recommendations on how to better integrate environmental, social and corporate governance issues in asset management, securities brokerage services and associated research functions. See also, “Who Cares Wins” : One Year On” – A Review of the Integration of Environmental, Social and Governance Value Drivers in Asset Management, Financial Research and Investment Processes, published by the International Finance Corporation.

[2] Refer, page 12 exhibit 9 of the said Report

[3] A legal framework for the integration of environmental, social and governance issues into institutional investment”

[4] Refer, page 24 of the said Report.

[5] The website is https://www.fiduciaryduty21.org/ . The report has been last updated in the year 2019.

[6] Principles of Responsible Investing (PRI) is a United Nations-supported initiative, launched in 2006 by UNEP Finance Initiative and the UN Global Compact.It  is a network of international investors working together to put the six Principles for Responsible Investment into practice. The PRI were devised by the investment community and reflect the view that environmental, social and governance (ESG) issues can affect the performance of investment portfolios and therefore must be given appropriate consideration by investors if they are to fulfill their fiduciary (or equivalent) duty. In implementing the Principles, signatories contribute to the development of a more sustainable global financial system.

[7] GRI was founded in Boston in 1997 following public outcry over the environmental damage of the Exxon Valdez oil spill.  The aim was to create the first accountability mechanism to ensure companies adhere to responsible environmental conduct principles, which was then broadened to include social, economic and governance issues. The first version of what was then the GRI Guidelines (G1) published in 2000 – providing the first global framework for sustainability reporting. The following year, GRI was established as an independent, non-profit institution. In 2016, GRI transitioned from providing guidelines to setting the first global standards for sustainability reporting – the GRI Standards.

[8] The GRI standards can be accessed here https://www.globalreporting.org/standards/

[9] The list is a compilation of the various factors identified by various organisations and reports such as, PRI, MSCI Research, NSE-SES report on ESG analysis of 50 Indian companies, etc.

[10] EU rules on non-financial reporting only apply to large public-interest companies with more than 500 employees. This covers approximately 6,000 large companies and groups across the EU.

[11] See here.

[12] OECD (2017) Investment governance and integration of environmental, social and governance factors

[13] Some well- known ESG rating providers include: (a) Dow-Jones Sustainability Index, (b) S & P Global Ratings, (c) MSCI ESG Research etc.

[14] https://corpgov.law.harvard.edu/2017/07/27/

[15] S&P Global Ratings: Exploring Links To Corporate Financial Performance

[16] Source: Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris

[17]Companies Act, 2013, section 134(3)(m), read with rule 8 of the Companies (Accounts) Rules, 2014

[18] Ibid, section 166.

[19] Ibid, section 135 read with Companies (Corporate Social Responsibility Policy) Rules, 2014.

[20] 2011. A refinement of earlier Corporate Social Responsibility Voluntary Guidelines 2009, released by the Ministry of Corporate Affairs in December 2009.

[21] 2019. See Press Release.

[22] CIR/CFD/DIL/8/2012 dated 13th August, 2012

[23] See update, and notification.

[24] See notification.

SEBI proposes stringent guidelines for IDs in a listed company

-Independence becomes stricter!

Payal Agarwal | Executive (corplaw@vinodkothari.com)

Introduction

The concept of independent directors was first introduced in the Desirable Corporate Governance Code issued by the Confederation of Indian Industry[1] followed by the recommendation in the Corporate Governance Committee constituted by SEBI and headed by Mr. Kumar Mangalam Birla[2] (Kumar Mangalam Birla Committee). Later in the year 2000, SEBI incorporated the recommendations of the Kumar Mangalam Birla Committee under Clause 49 of the Listing Agreement[3]. Independent directors have always been regarded as the means to strengthen the corporate governance framework in a public or a listed company.

 

Keeping in mind the intent of the lawmakers to introduce the requirement for having Independent Directors (IDs) on the board of certain companies, it is understood that SEBI cannot accept a situation where the IDs themselves turnout to either be ineffective for strengthening the corporate governance or act against the interest of the public shareholders. Therefore, with the intent to further strengthen the role and responsibility of IDs, SEBI has introduced a Consultation Paper[4] (Paper) on review of regulatory provisions related to IDs on 2nd of March, 2021. Through this Paper, SEBI has proposed to make stringent regulatory changes in the provisions of the Listing Obligation and Disclosure Requirements Regulations (LODR/ Listing Regulations) relating to

  • eligibility criteria of IDs,
  • role of Nomination and Remuneration Committee (NRC),
  • composition of Audit Committee (AC) and Nomination and Remuneration Committee (NRC)
  • appointment and removal procedure of IDs

The Paper is open for public comments till 1st April, 2021.

This write up critically covers the proposed changes and discusses on the proposed impact of on the working of a company including the corporate governance aspects.  The proposed changes are discussed below under the relevant heads.

1.      Widening the criteria for independence

Currently, Regulation 16(1) of the Listing Regulations provides the definition of “independent director”. SEBI proposes to broaden the criteria of “independence” by expanding the outreach of the restrictions given under the said Regulation and at the same time standardising the cooling off period provided therein.

The Paper proposes two amendments in the independence criteria of IDs in addition to the extant definition:

  • KMPs and employees of companies falling under the promoter group of the listed entity & relatives of such KMPs should not be eligible to act as an ID until a cooling off period of 3 years has passed.

This will be in addition to the existing fetter on the KMP and employee of the listed entity, its holding, subsidiary or associate company.

  • Another proposed amendment is with regard to increasing of the cooling-off period in Regulation 16(1)(iv) and Reg 16(1)(v) of the Listing Regulations.

Currently, the Regulations specify a cooling-off period of 2 years in case of material pecuniary transaction between a person or his relative and the listed entity or its holding, subsidiary or associate company. This is proposed to be increased to 3 years to make it similar to the other provisions of Regulation 16 where a cooling-off period of 3 years is required to be satisfied.

Rationale behind the proposal:

This proposal aims to make the independence criteria more broad so that there is no way by which the promoter group entities can take undue benefit due to any loopholes in the language of law.

On the other hand, the proposal for increasing the cooling off period is for making the same uniform all through the independence criteria.

2.       Dual voting approach introduced for appointment / re-appointment /removal of IDs

The Paper proposes to bring a major change in the procedure of appointment/ re-appointment as well as removal of IDs. Here, let us mention that the IDs are required to be recommended by NRC before their appointment is approved by shareholders in the general meeting. In the present scenario, the IDs are required to be appointed by way of a shareholders’ resolution by simple majority. In case of re-appointment, a special resolution is required to be passed by the shareholders.

  • The proposed procedure for such appointment/ re-appointment is via “dual approval” from shareholders, as follows:
  • An ordinary resolution by shareholders (Special Resolution in case of re-appointment) and
  • A resolution by “majority of minority”

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

In a situation where either of the two resolutions fail, the company may either propose another person as ID, or put the same proposal for a second vote

  • Such second vote can be done only after a cooling period of 90 days but within a maximum period of 120 days
  • Such second vote should be passed by a special resolution in which all shareholders can take part
  • Further, the proposal makes the requirement of shareholder’s approval a pre-condition for every appointment of ID.
  • In cases of any casual vacancy of IDs, the Listing Regulations currently provides a time period of upto 3 months or next Board Meeting, whichever is later, for filling up the vacancy. SEBI proposes to limit the time upto 3 months from such vacancy to appoint another ID.

A similar concept of dual voting approach has been prescribed by SEBI for the removal of IDs as well.

Rationale for such proposal

SEBI has, in its consultation paper, specified that the present system of appointment of IDs may be influenced by the promoters – in recommending the name of ID and in the approval process by virtue of shareholding. This may hinder the “independence” of IDs.

Additionally, considering that the primary duty of IDs is to protect the interest of minority shareholders, there is a need for minority shareholders to have greater say in the appointment / re-appointment process of IDs.

Therefore, SEBI has proposed the “dual approval” model in line with the legislative requirements of Israel and UK, especially in interest of the minority shareholders.

Since, the ID may be removed through a simple majority, the promoter may have significant influence in the removal process by virtue of shareholding. So, the “dual approval” model has been proposed to be extended to govern the removal of IDs as well.

Further to this, the requirement of approval of shareholders as a precondition before appointment of any ID is pursuant to the current practice, wherein an ID is appointed as an additional director by the Board of a company, to be subsequently ratified by the shareholders in the ensuing AGM. Such a practice creates a significant time gap between the appointment of an independent director and approval of shareholders, which is not in the best interest of especially the minority shareholders. Therefore, SEBI seeks to do away with this time lag by inserting the requirement of prior approval of shareholders.

3.       Resignation of IDs

Through the Paper, it becomes clear that the intention of SEBI is to strictly monitor the resignation of the IDs where the real cause of resignation should be clearly known in place of the apparent cause the company and ID may try to show.

The Paper provides for a cooling off period of 1 year in two cases:

  • Where the ID resigns on account of discretionary reasons of pre-occupation, other commitments or personal reasons – Mandatory cooling period of 1 year before joining another Board as an ID;
  • Similar cooling period of 1 year in case of transition from ID to WTD in the same company.

Further, the Paper also proposes that the complete resignation letter of the outgoing ID needs to be disclosed to the stock exchange.

Rationale for such proposal

The cooling off period of 1 year before transition of an ID as a WTD in the same company has been proposed to ensure there is no compromise in the independence of the director during his term as an ID.

It is observed that IDs often resign for reasons such as pre-occupation, other commitments or personal reasons and then join the boards of other companies. There is, therefore, a need to further strengthen the disclosures around resignation of Independent Directors.

4.       Role of NRC in selection of candidates for the role of ID

The NRC is required to recommend the persons to be appointed as IDs in the board of the company. Though the Listing Regulations already requires the NRC to formulate criteria regarding such appointment, the role of NRC, in practice, does not suffice the intent of law properly. Therefore, vide the Paper, SEBI has prescribed the following procedure for selection of candidates for the role of NRC.

  • Evaluate the balance of skills, knowledge and experience
  • On the basis of above evaluation, prepare description of required roles and capabilities required for that particular appointment of ID
  • Identify the suitable candidate fitting the said description
  • For identifying persons, NRC may
    • use services of external agencies
    • May consider candidates from wide variety of backgrounds ( for diversity)
    • And consider time commitment of appointees
  • The person identified and recommend to the Board should possess capabilities as per description.

Rationale for such proposal

While the law requires NRC to lay down detailed criteria of qualifications and attributes for directors, apparently there is a lack of transparency in the process followed by NRC. There is therefore, a need to prescribe disclosures regarding the process followed by NRC for selection of candidates for the post of ID.

5.       Modification in composition of NRC and AC

The Paper also seeks to bring in some changes in the constitution of NRC and AC. The following changes are proposed to be made:

  • NRC to comprise of 2/3rds of ID ( presently alteast one-half IDs required)
  • AC to comprise of 2/3rds of IDs and 1/3rds of Non-executive directors(NED) that are not related to promoter (presently, the AC requires atleast 3 members of which atleast 2/3rds shall be IDs)

Rationale for such proposal

Considering the importance of the Audit Committee with regard to related party transactions and financial matters, it is proposed that audit committee shall comprise of 2/3rd IDs and 1/3rd Non-Executive Directors (NEDs) who are not related to the promoter, including nominee directors, if any.

6.       Enhanced disclosure requirements

The Paper proposes various sorts of enhanced disclosures under different headings. Disclosures leads to transparency which is an important principle to be kept in mind under the arena of corporate governance. The various proposed disclosures has been discussed below:

  • Appointment/re-appointment/ removal of ID subject to second voteNotice calling shareholders’ meeting shall specify reasons for second vote on the same proposal despite failure of the first resolution.
  • Notice for appointment of IDThe notice calling a meeting of shareholders for the purposes of appointment of an ID shall disclose the following:
    • skills and capabilities required for the role;
    • how the proposed appointee fits the role;
    • Channels for searching appropriate candidates
    • Category of person who have recommended the name (in case of recommendation by person)
  • Disclosure on resignation of IDsWhere an ID resigns from a company, the entire resignation letter along with a list of present directorships and members in committees needs to be disclosed to the stock exchanges.

7.       Remuneration of IDs

The consultation paper has made various proposals in relation to the remuneration of IDs. The proposals include the following:

  • Removal of profit-linked commission
  • Increase in sitting fees
  • Issue of ESOPs with long vesting period

Rationale for such proposal

The removal of profit linked commission and increase in sitting fees is proposed with a view that the remuneration to IDs should be on the basis of their value and time-commitments to the company, without linking the same to the profits of the company. This would lead to IDs getting a fixed fee, without having any stake in the long-term growth of the company.

The concern with this approach – that profit or performance linked commission may encourage short-termism and lead to conflicts, may be addressed by permitting ESOPs to IDs (instead of profit linked commission) with a long vesting period of say, 5 years.

Our analysis on the removal of profit-linked commission and substitution of same with ESOPs has been dealt with in our other article and may be referred.

 

Conclusion

The proposed changes are extremely significant and will have a remarkable impact on the corporate governance of listed entities. While on one hand, more transparency may be achieved by means of amendments like enhanced disclosure on resignation, appointment, selection of candidates as IDs, etc, however, proposal relating to dual voting may not serve to achieve the purpose due to the presence of the option for second round of voting. Of all, the proposals seek to check the interference of promoters at all levels of corporate governance and ensures much more independence to the IDs where the IDs will be independent in both letter and spirit. However, in some areas, the proposed requirements seems to be very much stringent, which may hinder the idea of “ease of doing business”.

 

[1] http://www.nfcg.in/UserFiles/ciicode.pdf

[2] http://www.nfcg.in/UserFiles/kumarmbirla1999.pdf

[3] https://www.sebi.gov.in/legal/circulars/feb-2000/corporate-governance_17930.html

[4] https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html

SEBI’s move to allow stock options to independent directors – Whether a threat to independence?

Aanchal Kaur Nagpal (corplaw@vinodkothari.com)

 

It is said that when morality has a fight against profit, it is rarely that profit loses. Humans are always looking for more and quite often give in to their greed. This is the underlying rationale when it comes to safeguarding the independence of an independent director– to cut off anything that would lure them to compromise the interests of the company.

At the same time, given the crucial role they play in corporate governance and the increasing expectations for ensuring a balance between stakeholders’ interests and ensuring an independent insider’s view on the company’s affairs, they need to be sufficiently compensated for the time they spend and the risk-taking they do as directors.

While adequate compensation is crucial, there is a fine line to be drawn between ‘compensation’ and ‘pecuniary interest’. A balance is required to be maintained where IDs are paid remuneration in fair proportion to the value they bring to an organization while also not compromising their ability to pass an independent judgement.

Currently, IDs receive remuneration in the form of sitting fees and profit-linked commission[1] subject to certain limits. Currently, they are not permitted to receive stock options under the Companies Act as well as LODR regulations. It is felt that a stock option will put the ID to a position of a shareholder, and there may, therefore, be an alignment of the interest of the IDs with those of the shareholders. This is presumed to threaten the independence of IDs. However, SEBI, vide its Consultation Paper on Review of Regulatory Provisions related to Independent Directors dated 1st March, 2021[2] (Consultation Paper) , has proposed a radical change to the conventional remuneration structure of IDs in India by allowing stock options to be granted to IDs.

In this article, the author attempts to analyse whether SEBI’s move to allow grant of options to IDs as a form of their remuneration, will truly threaten the sanctity of their independence.

We have analyzed the Consultation Paper at length in our article.

Law regarding ESOPs to IDs in India

As discussed above, ESOPs are not permitted to be granted to independent directors. The prohibition comes from both – the Companies Act as well as LODR regulations. According to regulation 17(6)(d), Independent directors shall not be entitled to any stock option. As per section 149(9) of the Companies Act, 2013, notwithstanding anything contained in any other provision of this Act, but subject to the provisions of sections 197 and 198, an independent director shall not be entitled to any stock option and may receive remuneration by way of fee provided under sub-section (5) of section 197, reimbursement of expenses for participation in the Board and other meetings and profit related commission as may be approved by the members.

Therefore, it is established, that currently, Indian laws expressly and absolutely prohibit granting stock options to independent directors. Further, voting power of more than 2% being held by an ID along with his/her relatives is also prohibited. However, this is in case of listed entities and prescribed unlisted public companies.

The problem regarding remuneration to IDs vs remuneration to EDs

Remuneration to IDs

Currently, the following provisions are existent with respect to remuneration to IDs –

  • According to section 149(9) of the Companies Act, 2013,

Notwithstanding anything contained in any other provision of this Act, but subject to the provisions of sections 197 and 198, an independent director shall not be entitled to any stock option and may receive remuneration by way of fee provided under sub-section (5) of section 197, reimbursement of expenses for participation in the Board and other meetings and profit related commission as may be approved by the members.

  • As per section 197(5) of the Companies Act, 2013 read with rule 4 of the sitting fees to any director for attending Board or Committee meetings or for any other purpose, as may be decided by the Board, should not exceed Rs. 1 lakh. Further, IDs should not be paid sitting fees that is less than that paid to other directors.
  • As per section 197(1)(ii) of the Companies Act, 2013,

The remuneration payable to directors who are neither managing directors nor whole-time directors shall not exceed, –

(A) one per cent. of the net profits of the company, if there is a managing or whole-time director or manager;

(B) three per cent. of the net profits in any other case.

  • A director or manager may be paid remuneration either by way of a monthly payment or at a specified percentage of the net profits of the company or partly by one way and partly by the other.

The diagram below sums up remuneration that may be paid to an ID:

Thus, the sources of remuneration to IDs have been limited along with further restrictions to the amount of remuneration permitted to be paid. Whereas in case of executive directors, the permissible amount of remuneration is much higher along with lesser restrictions.

The role of both counterparts is paramount and none of the two can undermine the role of the other. However, the compensation received by IDs has been lower than that paid to executive directors. Although the latter are involved in the day to day management of a company’s affairs, the former pitch in their rich expertise, knowledge and unbiased view. Therefore, there should be a way to align or proportionate the remuneration drawn by IDs with executive directors.

However, on the contrary, executive directors are included in the definition of ‘officer in default’ and have a higher liability than that of IDs.

International Practices

As per the Cadbury Committee Report,

On fees, there is a balance to be struck between recognising the value of the contribution made by nonexecutive directors and not undermining their independence. The demands which are now being made on conscientious non-executive directors are significant and their fees should reflect the time which they devote to the company’s affairs. There is, therefore, a case for paying for additional responsibilities taken on, for example, by chairmen of board committees. In order to safeguard their independent position, we regard it as good practice for non-executive directors not to participate in share option schemes and for their service as non-executive directors not to be pensionable by the company.

According to National Foundation for Corporate Governance[3]

To secure better effort from non-executive directors, companies should: • Pay a commission over and above the sitting fees for the use of the professional inputs. The present commission of 1% of net profits (if the company has a managing director), or 3% (if there is no managing director) is sufficient. • Consider offering stock options, so as to relate rewards to performance. Commissions are rewards on current profits. Stock options are rewards contingent upon future appreciation of corporate value. An appropriate mix of the two can align a non-executive director towards keeping an eye on short term profits as well as longer term shareholder value.

UK

According to UK Corporate Governance Code[4] (para 34),

Remuneration for all non-executive directors should not include share options or other performance-related elements.

In exceptional cases where equity is granted, companies should gain shareholder approval prior to grant and the acquired shares should be held for at least 1 year from the director’s departure from the Board.[5]

Thus, in UK, the same is discouraged and not prohibited. The UK Corporate Governance Code represents key corporate governance recommendations of best practice for companies and does not have a statutory force.

The International Corporate Governance Network allows equity-based remuneration to non-executive directors. [6]

Australia

As per Australian Corporate Governance Principles and Recommendations – (only recommendatory and not mandatory)

Equity-based remuneration to non-executive directors: it is generally acceptable for non-executive directors to receive securities as part of their remuneration to align their interests with the interests of other security holders. However, nonexecutive directors generally should not receive options with performance hurdles attached or performance rights as part of their remuneration as it may lead to bias in their decision-making and compromise their objectivity.

France

According to the Corporate Governance Code of listed corporations by Afep-Medef[7], the principles for determination of compensation of non-executive directors, state that it is not desirable to award variable compensation, stock options or performance shares to non-executive directors. If, despite this, such awards are granted, then the Board must justify the reasons for this and the director cannot be considered to be independent.

USA

In USA, no express guidelines were found to prohibit share options to independent directors.

However, compensation policies of various companies filed with the SEC include stock options, restricted stock units and equity compensation granted to independent directors or outside directors (directors that are not employees of the Company).

Policies can be viewed here –

What can be seen is that global governance norms have mixed views with respect to stock options to IDs.

Are IDs really independent in the first place?

There are various contentions that can question whether IDs are in fact independent at all.

Appointed by the Board

IDs are appointed by the Board of Directors. Although the appointment requires the approval of the shareholders as well, IDs are nominated by the Board or the Nomination Committee. The nomination is then recommended to the shareholders for their approval. Additionally, where promoters hold majority stake in a company, such appointment may be approved and dominated by them. Thus, expecting and ID to be independent of persons who are in fact behind his/ her appointment is a question in itself. Thus, if an ID truly requires to be independent, then he/ she should be appointed by an independent third party. Various changes have also been proposed with respect to appointment, reappointment and removal of IDs, which have been discussed in our article at length.

Profit related commission

IDs are paid commission that should be related to the profit. Thus, their income is dependent on the progress/ growth of the Company making the independent director ‘interested’ in the Company.

The cons of ESOPs

While the global precedence does not expressly prohibit ESOPs, there still lies an anomaly whether ESOPs would make an ID interested in a company.

Additional methods for fair compensation are needed on one hand but on the other, the independence of an ID cannot be compromised. If ESOPs are granted, IDs will become interested as shareholders and would dwell upon the short-term prosperity of a company since share price at the end of the vesting period would be what would matter to them. They would therefore compromise a long-term return along with interest of other stakeholders. There would be too much pressure on short-term performance mostly compromising the long-term good of the company.

Profit related commission to IDs

Profit related commission is contingent in nature and is a way of sharing risks and rewards. Such commission depends and is proportionate to the profitability of the other party and thus aligns the interests of the parties involved the arrangement.

Indian laws allow IDs to be paid by way of profit related commission. The same can be paid up to a maximum of 1% of the profits of the company in that financial year. This means that the amount of income of the ID, in the form of commission, will directly depend on the amount of profit in that financial year. If the company performs better in a particular financial year, the profit will be higher and in turn the proportionate commission of the ID in that financial year will be higher. This shows that the interests of the ID will be rather short term than long term. The ID will only be concerned about the short-term performance of the company for the years he is an ID since his income would be directly dependent on the same, irrespective of any event hampering or damaging the Company in the long run. Therefore, the permissible form of remuneration to IDs by Indian laws, in reality, adversely affects the independence of an ID.

Profit related commission versus ESOPs

Consequently, there arises a question on how the defense of independence can be used against ESOPs alone if IDs are allowed to receive profit related commission.

ESOPs, as compared to commission, would be a better way to remunerate IDs, when it comes to protecting the interests of Company. Where profit related commission makes the ID interested in the short term performance of the Company, ESOPs provide a longer performance goal. Stock options ensure a balance between the short term and medium term performance of a company.

Profit related commission depends directly on the immediate preceding year (i.e. just one year) while ESOPs depend on a relatively longer time frame (more than one year at the least- tenure of the ESOPs can be decided and controlled by the company).

Thus, if companies are allowed to pay profit related commission to IDs, restrictions on allow ESOPs are unwarranted considering the fact that the latter would be a preferred option to align the interests of the IDs with the medium term performance of a company.

Here, the intention behind granting such ESOPs would be to enable IDs to focus on the medium term/ long term performance of the company rather than retention which is usually the rationale behind ESOPs.

However, the maximum limit for granting such ESOPs as well as maximum shareholding should be monitored to avoid IDs from holding huge stakes in companies. Further, ESOPs with longer vesting periods should be allowed, where the exercise period falls after the expiry of tenure of the ID, to ensure ID’s focus on the long term growth of the company.

SEBI’s Consultation Paper to allow stock options –

SEBI contended that linking remuneration to profit or performance linked commission ensures that IDs have ‘skin-in-the-game’ which may encourage short-termism and lead to conflicts between the interests of the IDs and the overall interest of the Company. A better approach would be to instead permit ESOPs to IDs with a long vesting period (say, 5 years,) as this would ensure alignment of interests of the company and IDs. The rationale is that remuneration to IDs should be on the basis of their value and time-commitments to the company, without linking the same to the profits thereof. This would lead to IDs getting a fixed fee, without having any stake in the long-term growth of the company.

Additionally, the limit on the sitting fees to IDs, is also proposed to be increased.

Accordingly, recommendations will be sent to MCA for modification of the existing remuneration structure under the Companies Act as well.

Conclusion

Thus, SEBI is headed in the right direction to allow ESOPs to IDs and is highly welcomed. This would ensure that IDs are rightly compensated for the value they offer while also ensuring that long term interest. However, various checks should be placed by regulators for monitoring the same so as to safeguard the independence of the ID.

 

[1] While the existing requirement under sections 149(9) and 197(3) of the Companies Act, in case of remuneration to non-executive directors, was to pay them upto a percentage of profits, the amendments made by CAA 2020 (section 32) have delinked the compensation and the profits, permitting companies to pay remuneration by way of “minimum remuneration”, that is, irrespective of adequacy of profits (proviso to section 149(9) inserted and amendment to section 197(3))

[2] https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html

[3] http://www.nfcg.in/UserFiles/ciicode.pdf

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

[5] You may check pay pratices in Europe through this report- https://infokf.kornferry.com/rs/494-VUC-482/images/191206-KF%20-%20NED%20report%202019%20-%20LR%20SPREAD%20mail.pdf

[6] https://www.icgn.org/sites/default/files/ICGN%20NED%20Guidelines%20%282010%29_%20Oct%202013print2_0.pdf

[7] https://afep.com/wp-content/uploads/2018/06/Afep-Medef-Code-revision-June-2018-ENG.pdf

 

 

 

SEBI aligns disclosure formats with amended PIT Regulations

Carries out certain clarificatory modifications.

By CS Aisha Begum Ansari, Assistant Manager, Vinod Kothari & Company aisha@vinodkothari.com

 

Securities and Exchange Board of India (‘SEBI’) had specified the formats for disclosures under Regulation 7 of SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT Regulations’) on 11th May, 2015[1] and thereafter revised the formats on 16th September, 2015[2].

SEBI has revisited the formats and carried out further modifications to align the format with amendments in the PIT Regulations and certain edits for clarification purpose, vide circular dated 9th February, 2021[3] with immediate effect.

This article provides a gist of the amendments carried out in the formats. Before discussing the amendments, a brief synopsis of various disclosure requirements under regulation 7 of PIT Regulations is as under:

Form Relates to Applicable to Disclosure requirement Time limit
Form B Initial disclosure KMP/ director/ promoter/ member of the promoter group Disclose the holdings in the company as on the date of appointment or becoming a promoter Within 7 days of appointment or becoming a promoter
Form C Continual disclosure Promoter/ member of the promoter group/ designated person/ director Disclose the number of securities traded, if the value of securities traded exceeds Rs. 10 lakhs in a calendar quarter (whether in one transaction or series of transactions) Within 2 trading days of such transaction.

 

 

Form D (Indicative format) Disclosure by Connected Person (event based) Other connected persons Disclose the holdings and trading in the securities of the company As determined by the company

Details of amendment in the formats

The major amendments in the revised formats under PIT Regulations are as under:

Form Field in the Form Erstwhile format Revised format Remarks
Form B Field w.r.t. “Category of Persons” The details were sought from promoters, directors, KMPs and such other person mentioned in regulation 6(2) The details will be sought from promoters, members of the promoter group, directors, KMPs, immediate relatives and such other person mentioned in regulation 6(2) Members of the promoter group is added in the revised format to align with regulation 7.
Form C

 

Field w.r.t. “Category of Persons” The details were sought from promoters, directors, employees and such other person mentioned in regulation 6(2) The details will be sought from promoters, members of the promoter group, designated persons, directors, immediate relatives and such other person mentioned in regulation 6(2) Members of the promoter group and designated persons are added in the revised format to align it with regulation 7.
Form C Newly inserted: Note (ii) under sub-heading-1[4] No particular note regarding value of transaction The note explains that the value of transaction excludes taxes, brokerage and any other charges. Regulation 7(2)(a) of the Regulations states that the concerned person is required to give disclosure, if the value of the securities traded exceeds Rs. 10 lakhs in a calendar quarter.

 

The note is provided to clarify that the value of securities is exclusive of taxes, brokerage and other charges.

Form D Newly inserted: Note (ii) under sub-heading-1[5] No particular note regarding value of transaction The revised format defines the value of transaction which excludes taxes, brokerage, any other charges. Regulation 7(3) of the Regulations states that the connected person is required to give disclosure as and when required by the company.

 

The note is provided to clarify that the value of transaction to be disclosed should be exclusive of taxes, brokerage and other charges.

Form B, C and D

 

Sub-field w.r.t “Type of Security” under the following Fields:

a.           Securities held prior to acquisition/ disposal

b.          Securities acquired/ disposed

c.           Securities held prior to acquisition/ disposal

The format sought the details of the following securities:

a.       Shares

b.       Warrants

c.       Convertible debentures, etc.

Details will be now sought for the following securities:

a.       Shares

b.       Warrants

c.       Convertible debentures

d.       Rights entitlements, etc.

SEBI, vide circular dated 22nd January, 2020[6], introduced the concept of dematerialized rights entitlements. Pursuant to the circular, the rights entitlement are also traded on the secondary market platform of the stock exchange.

 

Thus, SEBI has added the requirement to give details of rights entitlement.

Form C and D Sub-field w.r.t.  “Transaction type” under the Field “Securities acquired/ disposed” The format sought the nature of transaction which included:

a.       Buy

b.       Sale

c.       Pledge

d.       Revocation

e.       Invocation

The options for nature of transaction will now include:

a.       Purchase

b.       Sale

c.       Pledge

d.       Revocation

e.       Invocation

f.        Others (to be specified)

The transaction can be other than purchase, sale or pledge of securities, e.g. gift of securities. Accordingly, the person will have to specify the nature of transaction in the disclosure.
Form C and D Newly inserted: Field w.r.t. “Exchange on which the trade was executed” under sub-heading- 1 No field for details of stock exchange In the revised format, a new field has been inserted to mention the stock exchange on which the securities were traded. In the earlier format, there was a field to mention the stock exchange on which derivatives were traded, but not for the trade in securities. The new insertion is made to align the format for trading in securities with that of trading in derivatives.

 

Conclusion and actionables

The revised formats issued by SEBI will reflect the information of trade in more appropriate manner and is surely a welcome move.

The listed companies will be required to amend the Forms annexed to their Code of Conduct for Prevention of Insider Trading in order to align them with the revised formats.

Further, SEBI vide circular dated 9th September, 2021[7], automated the continual disclosures under regulation 7(2) of the Regulations by providing the manner of system driven disclosures. Pursuant to the circular, the listed companies will be required to comply with existing system for giving disclosure till March 31, 2021. Accordingly, the listed entities will have to amend the Form C annexed to their Code of Conduct and continue to give disclosure in the said form till 31st March, 2021.

 

Our other material can be accessed through the below links:

  1. Guide to PIT Documentation

http://vinodkothari.com/2019/02/guide-to-pit-documentation/

  1. Highlights of 2nd Amendment to PIT Regulations

 http://vinodkothari.com/2019/07/highlights-of-2nd-amendment-to-pit-regulations/

  1. Amendments in SEBI(PIT) Regulations, 2015 : From April, 2019 to July, 2020

http://vinodkothari.com/2020/07/recent-amendments-in-pit-regulations/

 

[1] https://www.sebi.gov.in/legal/circulars/may-2015/disclosures-under-sebi-prohibition-of-insider-trading-regulations-2015_29783.html

[2] https://www.sebi.gov.in/legal/circulars/sep-2015/revised-disclosure-formats-under-sebi-prohibition-of-insider-trading-regulations-2015_30680.html

[3] https://www.sebi.gov.in/legal/circulars/feb-2021/revised-disclosure-formats-under-regulation-7-of-sebi-prohibition-of-insider-trading-regulations-2015_49068.html

[4] Details of change in holding of securities of promoter, member of the promoter group, designated person or director and immediate relatives of such persons and other such persons as mentioned in Regulation 6(2) under Form C

[5] Details of trading in securities by other connected persons as identified by the company under Form D

[6] https://www.sebi.gov.in/legal/circulars/jan-2020/streamlining-the-process-of-rights-issue_45753.html

[7] https://www.sebi.gov.in/legal/circulars/sep-2020/automation-of-continual-disclosures-under-regulation-7-2-of-sebi-prohibition-of-insider-trading-regulations-2015-system-driven-disclosures_47523.html

 

SEBI amends ICDR Regulations to relax certain FPO norms

Amendment of lock in requirements for excess promoter’s contribution seems unclear.

-By Aisha Begum Ansari, Assistant Manager,

Vinod Kothari & Company aisha@vinodkothari.com

Introduction 

SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) mandates that the promoters of the issuer company shall maintain ‘Minimum Promoters’ Contribution’ (“MPC”) which shall be locked-in for a stipulated period of time. However, the requirements of MPC and lock-in is not applicable if the funds are raised through following modes:

  1. Rights issue
  2. in case of a IPO/FPO – where the issuer does not have any identifiable promoter;
  3. in case of a FPO – on a condition that the equity shares of the issuer are frequently traded for a period of atleast three years and the issuer is dividend paying company.

SEBI, in its agenda of Board Meeting dated 16th December, 2020 to discuss amendment in ICDR Regulations[1] proposed to do away with the MPC and lock-in requirements for a listed company making an FPO, where shares are listed for past three years, without linking it to its dividend paying capacity.

The rationale for the proposed amendment was that an issuer raising funds through an FPO, is already a listed company and has fulfilled the obligation of MPC at the IPO stage. Further, all the information/ disclosures about the issuer is available in the public domain and the investors willing to subscribe in the FPO have sufficient knowledge to take an informed decision.

Thus, SEBI vide notification dated 8th January, 2021[2] issued SEBI (Issue of Capital and Disclosure Requirements) (Amendment) Regulations, 2021 (“Amendment Regulations”).

De-coding the Amendment Regulations:

  1. Non-applicability of MPC requirement

SEBI substituted the existing clause (b) of regulation 112 of the ICDR Regulations, wherein it removed the criterion of dividend paying capacity as a determining factor for MPC and the subsequent lock-in requirements. It further inserted the additional compliance of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (hereinafter referred to as “LODR Regulations”) and that the issuer should have redressed at least 95% of the complaints received from the investors.

The said amendment can be understood with the help of following diagram:

  1. Non-applicability of lock-in requirement

Regulation 115 of ICDR Regulations mandates that the certain portion of specified securities held by the promoters shall be locked-in for the periods stipulated in the said regulation.

SEBI, in its Board meeting, considered that if the MPC is done away with, the lock-in requirements may not arise. Therefore, SEBI deleted the existing proviso after clause (c) of regulation 115 of ICDR Regulations. However, deleting the said proviso has brought ambiguity in compliance with the lock-in requirements which is explained as under:

  • The existing proviso after regulation 115(c) states that the excess promoters’ contribution as provided in the proviso to regulation 112(b) shall not be subject to lock-in.
  • Clause (a) of sub-regulation (1) of regulation 113 which deals with MPC states that the promoters shall contribute either
  1. upto 20% of the proposed issue size; or
  2. upto 20% of the post-issue capital
  • The existing proviso to regulation 112(b) states that if the promoters subscribe in excess of the higher of the two options mentioned above, then the price for such excess subscription shall be determined in terms of pricing guidelines for preferential issue under regulation 164 or the issue price, whichever is higher.

Since, the promoters were contributing in excess of the option given to them, SEBI exempted the lock-in requirements for such excess subscription.

Now suppose, if the promoters subscribe to 5% of the issue size, even if the MPC requirement is not applicable to them, whether such contribution shall be subject to lock-in? And if yes, the lock-in shall be applicable for what period?

Pursuant to the proviso after regulation 115(c) being deleted, following interpretations arise:

Interpretation 1: Such subscription shall not be required to be locked-in at all, since the intention of SEBI, as mentioned in the agenda of Board Meeting, was to do away with the lock-in requirement.

Interpretation 2: Such subscription shall be required to be locked-in for a period of 1 year, because such subscription is in excess of MPC i.e. it is in excess of zero contribution required and as per regulation 115(b), the excess promoters’ contribution shall be under lock-in for a period of 1 year.

This can be understood with the following diagram:

  1. Non-applicability of lock-in requirements in case of equity shares issued on a preferential basis pursuant to any resolution of stressed assets or a resolution plan.

SEBI, in its agenda of Board Meeting dated 16th December, 2020 to discuss recalibration of threshold for Minimum Public Shareholding norms, enhanced disclosures in Companies which undergo CIRP[3], proposed to do away with the lock-in requirements of equity shares issued on a preferential basis pursuant to any resolution of stressed assets under a framework specified by RBI or a resolution plan approved under IBC, 2016.

The rationale for the proposed amendment was that as per rule 19A(5) of Securities Contracts (Regulations) Rules, 1957[4], if the minimum public shareholding (hereinafter referred to as “MPS”) falls below 10% due to CIRP, such listed companies are required to bring MPS to at least 10% within a period of 18 months and to 25% within 3 years from the date of such fall.

As per regulation 167(4), the equity shares issued on a preferential basis pursuant to any resolution of stressed assets or a resolution plan, shall be locked-in for a period of one year. Thus, any allotment to the Resolution Applicant (RA) is locked in for a period of one year. Such lock-in of shares does not facilitate dilution of promoter shareholding to achieve MPS requirement.

Therefore, SEBI inserted the new proviso after regulation 167(4) whereby it relaxed the lock-in requirement of specified securities to the extent to achieve 10% public shareholding. This can be understood with the following diagram:

Conclusion:

Even though SEBI has tried to relax the MPC and lock-in requirements in case of issue of specified securities pursuant to FPO and resolution of stressed assets or a resolution plan, it has created ambiguity in the relaxation of lock-requirements in case of excess promoters’ contribution in case of FPO. SEBI should review the Amendment Regulations and undo the deletion of existing proviso after regulation 115(c) of ICDR Regulations to retain the exemption.

Table containing the relevant provisions of ICDR Regulations before and after the amendment.

Before Amendment After Amendment
Chapter IV: Further Public Offer, Part III: Promoters’ Contribution
Regulation 112: Requirement of minimum promoters’ contribution not applicable in certain cases
The requirements of minimum promoters’ contribution shall not apply in case of:

a)   an issuer which does not have any identifiable promoter;

b)   where the equity shares of the issuer are frequently traded on a stock exchange for a period of at least three years and the issuer has a track record of dividend payment for at least three immediately preceding years:

Provided that where the promoters propose to subscribe to the specified securities offered to the extent greater than higher of the two options available in clause (a) of sub-regulation (1) of regulation 113, the subscription in excess of such percentage shall be made at a price determined in terms of the provisions of regulation 164 or the issue price, whichever is higher.

Explanation: The reference date for the purpose of computing the annualised trading turnover referred to in the said Explanation shall be the date of filing the draft offer document with the Board and in case of a fast track issue, the date of filing the offer document with the Registrar of Companies, and before opening of the issue.

The requirements of minimum promoters’ contribution shall not apply in case of:

a)     an issuer which does not have any identifiable promoter;

b)    where the equity shares of the issuer are frequently traded on a stock exchange for a period of at least three years immediately preceding the reference date, and the issuer has a track record of dividend payment for at least three immediately preceding years:

(i)     the issuer has redressed at least ninety five per cent of the complaints received from the investors till the end of the quarter immediately preceding the month of the reference date, and;

(ii)   the issuer has been in compliance with the SEBI (LODR) Regulations, 2015 for a minimum period of three years immediately preceding the reference date:

(iii) Provided that if the issuer has not complied with the provisions of the SEBI (LODR) Regulations, 2015, relating to composition of board of directors, for any quarter during the last three years immediately preceding the date of filing of draft offer document/ offer document, but is compliant with such provisions at the time of filing of draft offer document/ offer document, and adequate disclosures are made in the offer document about such non-compliances during the three years immediately preceding the date of filing the draft offer document/ offer document, it shall be deemed as compliance with the condition:

Provided further that where the promoters propose to subscribe to the specified securities offered to the extent greater than higher of the two options available in clause (a) of sub-regulation (1) of regulation 113, the subscription in excess of such percentage shall be made at a price determined in terms of the provisions of regulation 164 or the issue price, whichever is higher.

Explanation: The reference date for the purpose of computing the annualised trading turnover referred to in the said Explanation shall be the date of filing the draft offer document with the Board and in case of a fast track issue, the date of filing the offer document with the Registrar of Companies, and before opening of the issue.

Regulation 115: Lock-in of specified securities held by promoters
The specified securities held by the promoters shall not be transferable (hereinafter referred to as “locked-in”) for the periods as stipulated hereunder:

a)  minimum promoters’ contribution including contribution made by alternative investment funds, or foreign venture capital investors, as applicable, shall be locked-in for a period of three years from the date of commencement of commercial production or from the date of allotment in the further public offer, whichever is later;

b)  promoters’ holding in excess of minimum promoters’ contribution shall be locked-in for a period of one year:

c)  The SR equity shares shall be under lock-in until their conversion to equity shares having voting rights same as that of ordinary shares, provided they are in compliance with the other provisions of these regulations.

Provided that the excess promoters’ contribution as provided in the proviso to clause (b) of regulation 112 shall not be subject to lock-in.

The specified securities held by the promoters shall not be transferable (hereinafter referred to as “locked-in”) for the periods as stipulated hereunder:

a)   minimum promoters’ contribution including contribution made by alternative investment funds, or foreign venture capital investors, as applicable, shall be locked-in for a period of three years from the date of commencement of commercial production or from the date of allotment in the further public offer, whichever is later;

b)  promoters’ holding in excess of minimum promoters’ contribution shall be locked-in for a period of one year:

c)  The SR equity shares shall be under lock-in until their conversion to equity shares having voting rights same as that of ordinary shares, provided they are in compliance with the other provisions of these regulations.

Provided that the excess promoters’ contribution as provided in the proviso to clause (b) of regulation 112 shall not be subject to lock-in.

Chapter V: Preferential issue, Part V: Lock-in and Restrictions on Transferability
Regulation 167: Lock-in
(4) The equity shares issued on a preferential basis pursuant to any resolution of stressed assets under a framework specified by the Reserve Bank of India or a resolution plan approved by the National Company Law Tribunal under the Insolvency and Bankruptcy Code 2016, shall be locked-in for a period of one year from the trading approval (4) The equity shares issued on a preferential basis pursuant to any resolution of stressed assets under a framework specified by the Reserve Bank of India or a resolution plan approved by the National Company Law Tribunal under the Insolvency and Bankruptcy Code 2016, shall be locked-in for a period of one year from the trading approval.

Provided that the lock-in provision shall not be applicable to the specified securities to the extent to achieve 10% public shareholding.

Our other related material:

  1. http://vinodkothari.com/2020/10/eligibility-and-disclosures-under-rights-issue-rationalized/
  2. http://vinodkothari.com/2020/06/sebis-measures-towards-resuscitation-of-financially-stressed-companies/
  3. http://vinodkothari.com/2018/09/key-amendments-sebi-icdr-reg-2018/
  4. http://vinodkothari.com/2019/01/sebi-amends-icdr-regulations-2018/http://vinodkothari.com/2019/01/sebi-amends-icdr-regulations-2018/
  5. http://vinodkothari.com/2018/09/sebi-icdr-regulations-2018-key-amendments/

 

 

[1] https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/meetingfiles/dec-2020/1608617470064_1.pdf#page=1&zoom=page-width,-18,797

[2] https://www.sebi.gov.in/legal/regulations/jan-2021/securities-and-exchange-board-of-india-issue-of-capital-and-disclosure-requirements-amendment-regulations-2021_48704.html

[3] https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/meetingfiles/dec-2020/1608621922552_1.pdf#page=1&zoom=page-width,-18,801

[4] https://www.sebi.gov.in/legal/rules/feb-1957/securities-contracts-regulations-rules-1957_34671.html

 

Law relating to collective investment schemes on shared ownership of real assets

-Vinod Kothari (finserv@vinodkothari.com)

The law relating to collective investment schemes has always been, and perhaps will remain, enigmatic, because these provisions were designed to ensure that enthusiastic operators do not source investors’ money with tall promises of profits or returns, and start running what is loosely referred to as Ponzi schemes of various shades. De facto collective investment schemes or schemes for raising money from investors may be run in elusive forms as well – as multi-level marketing schemes, schemes for shared ownership of property or resources, or in form of cancellable contracts for purchase of goods or services on a future date.

While regulations will always need to chase clever financial fraudsters, who are always a day ahead of the regulator, this article is focused on schemes of shared ownership of properties. Shared economy is the cult of the day; from houses to cars to other indivisible resources, the internet economy is making it possible for users to focus on experience and use rather than ownership and pride of possession. Our colleagues have written on the schemes for shared property ownership[1]. Our colleagues have also written about the law of collective investment schemes in relation to real estate financing[2]. Also, this author, along with a colleague, has written how the confusion among regulators continues to put investors in such schemes to prejudice and allows operators to make a fast buck[3].

This article focuses on the shared property devices and the sweep of the law relating to collective investment schemes in relation thereto.

Basis of the law relating to collective investment schemes

The legislative basis for collective investment scheme regulations is sec. 11AA (2) of the SEBI Act. The said section provides:

Any scheme or arrangement made or offered by any company under which,

  • the contributions, or payments made by the investors, by whatever name called, are pooled and utilized solely for the purposes of the scheme or arrangement;
  • the contributions or payments are made to such scheme or arrangement by the investors with a view to receive profits, income, produce or property, whether movable or immovable from such scheme or arrangement;
  • the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors;
  • the investors do not have day to day control over the management and operation of the scheme or arrangement.

The major features of a CIS may be visible from the definition. These are:

  1. A schematic for the operator to collect investors’ money: There must be a scheme or an arrangement. A scheme implies a well-structured arrangement whereby money is collected under the scheme. Usually, every such scheme provides for the entry as well as exit, and the scheme typically offers some rate of return or profit. Whether the profit is guaranteed or not, does not matter, at least looking at the definition. Since there is a scheme, there must be some operator of the scheme, and there must be some persons who put in their money into the scheme. These are called “investors”.
  2. Pooling of contributions: The next important part of a CIS is the pooling of contributions. Pooling implies the contributions losing their individuality and becoming part of a single fungible hotchpot. If each investor’s money, and the investments therefrom, are identifiable and severable, there is no pooling. The whole stance of CIS is collective investment. If the investment is severable, then the scheme is no more a collective scheme.
  3. Intent of receiving profits, produce, income or property: The intent of the investors contributing money is to receive results of the collective investment. The results may be in form of profits, produce, income or property. The usual feature of CIS is the operator tempting investors with guaranteed rate of return; however, that is not an essential feature of CISs.
  4. Separation of management and investment: The management of the money is in the hands of a person, say, investment manager. If the investors manage their own investments, there is no question of a CIS. Typically, investor is someone who becomes a passive investor and does not have first level control (see next bullet). It does not matter whether the so-called manager is an investor himself, or may be the operator of the scheme as well. However, the essential feature is there being multiple “investors”, and one or some “manager”.
  5. Investors not having regular control over the investments: As discussed above, the hiving off of the ownership and management of funds is the very genesis of the regulatory concern in a CIS, and therefore, that is a key feature.

The definition may be compared with section 235 of the UK Financial Services and Markets Act, which provides as follows:

  • In this Part “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
  • The arrangements must be such that the persons who are to participate (“participants”) do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions.
  • The arrangements must also have either or both of the following characteristics—
  • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
  • the property is managed as a whole by or on behalf of the operator of the scheme.
    • If arrangements provide for such pooling as is mentioned in subsection (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single collective investment scheme unless the participants are entitled to exchange rights in one part for rights in another.

It is conspicuous that all the features of the definition in the Indian law are present in the UK law as well.

Hong Kong Securities and Futures Ordinance [Schedule 1] defines a collective investment scheme as follows:

collective investment scheme means—

  • arrangements in respect of any property—
  • under which the participating persons do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management;
  • under which—
  • the property is managed as a whole by or on behalf of the person operating the arrangements;
  • the contributions of the participating persons and the profits or income from which payments are made to them are pooled; or
  • the property is managed as a whole by or on behalf of the person operating the arrangements, and the contributions of the participating persons and the profits or income from which payments are made to them are pooled; and
  • the purpose or effect, or pretended purpose or effect, of which is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive—
  • profits, income or other returns represented to arise or to be likely to arise from the acquisition, holding, management or disposal of the property or any part of the property, or sums represented to be paid or to be likely to be paid out of any such profits, income or other returns; or
  • a payment or other returns arising from the acquisition, holding or disposal of, the exercise of any right in, the redemption of, or the expiry of, any right, interest, title or benefit in the property or any part of the property; or
  • arrangements which are arrangements, or are of a class or description of arrangements, prescribed by notice under section 393 of this Ordinance as being regarded as collective investment schemes in accordance with the terms of the notice.

One may notice that this definition as well has substantially the same features as the definition in the UK law.

Judicial analysis of the definition

Part (iii) of the definition in Indian law refers to management of the contribution, property or investment on behalf of the investors, and part (iv) lays down that the investors do not have day to day control over the operation or management. The same features, in UK law, are stated in sec. 235 (2) and (3), emphasizing on the management of the contributions as a whole, on behalf of the investors, and investors not doing individual management of their own money or property. The question has been discussed in multiple UK rulings. In Financial Conduct Authority vs Capital Alternatives and others,  [2015] EWCA Civ 284, [2015] 2 BCLC 502[4], UK Court of Appeal, on the issue whether any extent of individual management by investors will take the scheme of the definition of CIS, held as follows:  “The phrase “the property is managed as a whole” uses words of ordinary language. I do not regard it as appropriate to attach to the words some form of exclusionary test based on whether the elements of individual management were “substantial” – an adjective of some elasticity. The critical question is whether a characteristic feature of the arrangements under the scheme is that the property to which those arrangements relate is managed as a whole. Whether that condition is satisfied requires an overall assessment and evaluation of the relevant facts. For that purpose it is necessary to identify (i) what is “the property”, and (ii) what is the management thereof which is directed towards achieving the contemplated income or profit. It is not necessary that there should be no individual management activity – only that the nature of the scheme is that, in essence, the property is managed as a whole, to which question the amount of individual management of the property will plainly be relevant”.

UK Supreme Court considered a common collective land-related venture, viz., land bank structure, in Asset Land Investment Plc vs Financial Conduct Authority, [2016] UKSC 17[5]. Once again, on the issue of whether the property is collective managed, or managed by respective investors, the following paras from UK Financial Conduct Authority were cited with approval:

The purpose of the ‘day-to-day control’ test is to try to draw an important distinction about the nature of the investment that each investor is making. If the substance is that each investor is investing in a property whose management will be under his control, the arrangements should not be regarded as a collective investment scheme. On the other hand, if the substance is that each investor is getting rights under a scheme that provides for someone else to manage the property, the arrangements would be regarded as a collective investment scheme.

Day-to-day control is not defined and so must be given its ordinary meaning. In our view, this means you have the power, from day-to-day, to decide how the property is managed. You can delegate actual management so long as you still have day-to-day control over it.[6]

The distancing of control over a real asset, even though owned by the investor, may put him in the position of a financial investor. This is a classic test used by US courts, in a test called Howey Test, coming from a 1946 ruling in SEC vs. Howey[7]. If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.

The financial world and the real world

As is apparent, the definition in sec. 235 of the UK legislation has inspired the draft of the Indian law. It is intriguing to seek as to how the collective ownership or management of real properties has come within the sweep of the law. Evidently, CIS regulation is a part of regulation of financial services, whereas collective ownership or management of real assets is a part of the real world. There are myriad situations in real life where collective business pursuits,  or collective ownership or management of properties is done. A condominium is one of the commonest examples of shared residential space and services. People join together to own land, or build houses. In the good old traditional world, one would have expected people to come together based on some sort of “relationship” – families, friends, communities, joint venturers, or so on. In the interweb world, these relationships may be between people who are invisibly connected by technology. So the issue, why would a collective ownership or management of real assets be regarded as a financial instrument, to attract what is admittedly a  piece of financial law.

The origins of this lie in a 1984 Report[8] and a 1985 White Paper[9], by Prof LCB Gower, which eventually led to the enactment of the 1986 UK Financial Markets law. Gower has discussed the background as to why contracts for real assets may, in certain circumstances, be regarded as financial contracts. According to Gower, all forms of investment should be regulated “other than those in physical objects over which the investor will have exclusive control. That is to say, if there was investment in physical objects over which the investor had no exclusive control, it would be in the nature of an investment, and hence, ought to be regulated. However, the basis of regulating investment in real assets is the resemblance the same has with a financial instrument, as noted by UK Supreme Court in the Asset Land ruling: “..the draftsman resolved to deal with the regulation of collective investment schemes comprising physical assets as part of the broader system of statutory regulation governing unit trusts and open-ended investment companies, which they largely resembled.”

The wide sweep of the regulatory definition is obviously intended so as not to leave gaps open for hucksters to make the most. However, as the UK Supreme Court in Asset Land remarked: “The consequences of operating a collective investment scheme without authority are sufficiently grave to warrant a cautious approach to the construction of the extraordinarily vague concepts deployed in section 235.”

The intent of CIS regulation is to capture such real property ownership devices which are the functional equivalents of alternative investment funds or mutual funds. In essence, the scheme should be operating as a pooling of money, rather than pooling of physical assets. The following remarks in UK Asset Land ruling aptly capture the intent of CIS regulation: “The fundamental distinction which underlies the whole of section 235 is between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value; and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can be either pooled or managed in common, in return for a share of the profits generated by the collective fund.”

Conclusion

While the intent and purport of CIS regulation world over is quite clear, but the provisions  have been described as “extraordinarily vague”. In the shared economy, there are numerous examples of ownership of property being given up for the right of enjoyment. As long as the intent is to enjoy the usufructs of a real property, there is evidently a pooling of resources, but the pooling is not to generate financial returns, but real returns. If the intent is not to create a functional equivalent of an investment fund, normally lure of a financial rate of return, the transaction should not be construed as a collective investment scheme.

 

[1] Vishes Kothari: Property Share Business Models in India, http://vinodkothari.com/blog/property-share-business-models-in-india/

[2] Nidhi Jain, Collective Investment Schemes for Real Estate Investments in India, at http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/

[3] Vinod Kothari and Nidhi Jain article at: https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html

[4] http://www.bailii.org/ew/cases/EWCA/Civ/2015/284.html

[5] https://www.supremecourt.uk/cases/docs/uksc-2014-0150-judgment.pdf

[6] https://www.handbook.fca.org.uk/handbook/PERG/11/2.html

[7] 328 U.S. 293 (1946), at https://supreme.justia.com/cases/federal/us/328/293/

[8] Review of Investor Protection, Part I, Cmnd 9215 (1984)

[9] Financial Services in the United Kingdom: A New Framework for Investor Protection (Cmnd 9432) 1985

 

Our Other Related Articles

Property Share Business Models in India,< http://vinodkothari.com/blog/property-share-business-models-in-india/>

Collective Investments Schemes: How gullible investors continue to lose money < https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html>

Collective Investment Schemes for Real Estate Investments in India, < http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/>

 

SEBI proposes liberal provisions for promoter reclassification

Shaivi Bhamaria | Vinod Kothari and Company

corplaw@vinodkothari.com

Introduction

Reg. 31A of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR Regulations’) lays down conditions pursuant to which promoters/ person belonging to promoter group of a listed entity can be reclassified as public shareholders. Reg. 31A (5) provides that if a public shareholder seeks to re-classify itself as promoter, it will have to make an open offer as per the provisions of SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011.

SEBI on November 23, 2020 has issued a Consultation Paper on Re-Classification of Promoter/ Promoter Group Entities and Disclosure of the Promoter Group Entities in the Shareholding Pattern[1] (‘Consultation Paper’) for public comments. At present SEBI has been granting relaxations from the requirements under reg. 31A of the LODR regulations on a case to case basis to promoters who have found reclassification difficult under current regulatory regime.  The said Paper has been issued on the basis of the recommendations of the Primary Market Advisory Committee (‘PMAC’) of SEBI in order to regularise the provisions relating to reclassification and minimise the need for providing relaxation on case-to-case basis.

Current Framework:

A summary of the present reclassification process is laid down below:

  1. The promoters/person belonging to promoter group seeking reclassification as public shareholders must satisfy the conditions laid down in reg. 31A (3) (b) of the LODR regulations;
  2. The listed entity must be in compliance with the conditions laid down in reg. 31A (3) (c) of LODR regulations;
  3. Promoters/person belonging to promoter group must make a request for re-classification to the board of directors of the listed entity. The request must contain the rationale for seeking re-classification and also a statement on how the conditions specified in reg. 31A (3) (b) are satisfied;
  4. The board after analysing the request must place the same along with its views, for approval of the shareholders in a general meeting. There should be a time gap of at least three months but not exceeding six months between the date of board meeting and the shareholder’s meeting;
  5. The request for re-classification should be approved in the general meeting by an ordinary resolution in which the promoter/ persons belonging to promoter group seeking re-classification cannot not vote to approve such re-classification request;
  6. Not later than 30 days from the date of approval by shareholders in general meeting, an application along with all relevant documents for re-classification must be made to the stock exchanges where the entity is listed. In case the entity is listed on more than one stock exchange, the concerned stock exchanges will jointly decide on the application.

Examples of case-to-case relaxation provided by SEBI

  1. Exemption from obtaining shareholders’ approval

In the informal guidance given to Alembic Pharmaceuticals Limited[2] SEBI had exempted the company from obtaining approval of shareholder for reclassification of 5 promoters as public shareholders inter-alia on the grounds that:

  1. The promoters cumulatively held 1.45% of the equity share capital of the company.
  2. They were senior citizens, leading independent lives and were not directly or indirectly connected with any activity of the company.
  3. They did not exercise any direct or indirect control over the affairs of the company, had never at any time held any position of key managerial personnel in the company.
  4. They did not had any special rights through formal or informal arrangements with the company or any promoter/person of the promoter group.
  5. They undertook that they would never be privy to any price sensitive information of the company

Further, in the informal guidance given to Gujarat Ambuja Exports Limited[3], SEBI had exempted the company from obtaining approval of shareholder for reclassification of one its promoters on the grounds that:

  1. the shareholding of the promoter was insignificant, constituting only 0.23% of the total paid up equity;
  2. Though being the son of a promoter, the said person was neither involved in the operations of the company nor was connected with the company.
  3. He did not exercise any direct or indirect control over the affairs of the company, did not have veto rights or special rights as to voting or control nor has any special information rights.
  4. Further the company had not entered into any shareholder agreement with him and he would never be privy to any price sensitive information of the company.

It is pertinent to note that SEBI in its interpretative letter had stated that the company would not be required to take shareholders’ approval, subject to compliance with the provisions of reg. 31A of LODR regulations. Reg, 31A of LODR regulations provide for shareholders’ approval, hence it was not very clear whether exemption from obtaining shareholders’ approval was granted or not.

Proposed amendments

1.      Relaxing the threshold of maximum voting rights allowed to be exercised by an outgoing promoter

At present reg. 31A (3) (b) (i) of LODR regulations provide that promoter/ persons belonging to promoter group seeking re-classification should not together hold more than 10% of the total voting rights in the listed entity.

The Consultation Paper proposes to increase the threshold of 10% to 15%, to enable those promoters who have shareholding of less than 15% but are no longer involved in the day-to-day control of the listed entity to opt-out from being classified as promoters, without having to reduce their share-holding.

2.      Suggestions for speeding up the process:

a.      Time limit within to place the reclassification request to be placed before the board

At present reg. 31A of LODR Regulations is silent on the time period within which the listed entity must place the reclassification request received from the promoter/ persons belonging to promoter group before the board, consequently as per SEBI’s data, in certain cases reclassification requests from promoter/ persons belonging to promoter group have not been placed before the Board, thereby ceasing the process in its initial phase.

To prevent this and streamline the process of reclassification, SEBI has proposed insertion of a time limit of one month receiving the reclassification request, within which the listed entity must place the same before its board of directors.

b.      Reduction in time period between board and shareholders meeting

As mentioned above, reg. 31A (3) (a) (ii) provides that the time gap between the meeting of the board at which the proposal for reclassification was accepted and the meeting of the shareholders, seeking approval for the same should be at least 3 months. The rationale behind the same was to give adequate time to the shareholders for considering the request of the promoter.

However, time gap 3 months resulted in an increase in the total time taken in the process. In order to increase both cost and time efficiency, the Consultation Paper proposes to reduce the minimum time gap from 3 months to 1 month.

3.      Extending the ambit of exemption from the procedure

a.      In case of reclassification is pursuant to an order/ direction of Government/ regulator

At present reg.  31A (9) provides exemption from the provisions of reg. 31A (3), (4) and (8)(a), (b) of LODR regulations in cases where re-classification of promoter/ persons belonging to promoter group is as per the resolution plan approved under s. 31 of the IBC, subject to the condition that the promoter seeking re-classification do not remain in control of the listed entity.

It is proposed to extend the said exemption to re-classification pursuant to an order/ direction of the Government/ regulator and/or as a consequence of operation of law since the re-classification is a natural consequence of the order/direction of the Government/ regulator.

b.      In case of reclassification of existing promoter pursuant to open offer

It is proposed to extend the exemption from procedure for re-classification to cases where the re-classification is pursuant to an open offer made in accordance with the provisions of SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011 (‘SAST regulations’), subject to the satisfaction of following conditions:

  1. The intent of the existing promoters to re-classify has been disclosed in the letter of offer
  2. The promoter/ persons belonging to promoter group being reclassified fulfil the conditions mentioned in reg. 31A(3)(b) and the listed entity fulfils the conditions stipulated at reg. 31A(3)(c) of LODR regulations.

The rationale behind the exemption being that in cases where intent of reclassification has already been mentioned in the Letter of Offer, the requirement of promoter making an application is a mere procedural formality since the fact of re-classification is already present in the public domain.

c.       Cases where the outgoing promoter is absconding / non-cooperating

Exemption from the procedure for re-classification, is also proposed to be granted in cases where, pursuant to an open offer, a listed entity intends to re-classify erstwhile promoter/ persons belonging to promoter group but the promoter/ persons belonging to promoter group are not traceable or are not co-operative, but the same can be done after the fulfillment of the following conditions:

  1. The listed entity should demonstrate that efforts have been taken to contact the promoters through issuance of notices in newspapers, stock Exchange websites etc.
  2. Such promoters seeking re-classification should not remain in control of the listed entity

4.      Disclosure of names of promoter group entities in the shareholding pattern

Reg. 31 of LODR Regulations mandates that all entities falling under promoter/ promoter group are to be disclosed separately in the shareholding pattern.

As a matter of practice, several companies do not disclose names of persons in promoter/ promoter group who do not hold any shares.

It is to be noted that pursuant to the SEBI (Listing Obligations and Disclosures Requirements) (Sixth Amendment) Regulations, 2018[4] SEBI had, by virtue of by insertion of reg. 31(4) required that all entities falling under promoter and promoter group be disclosed separately in the shareholding pattern of listed entities appearing on the website of the stock exchanges in accordance with the formats specified by the SEBI . However, since the provisions of the Regulations still did not explicitly require entities to disclose the entire list of promoter/ promoter group irrespective of their shareholding, companies continued the practice of disclosing only those promoter/ promoter group entities that held shares in the company.  A detailed write-up on this insertion in Reg 31(4) can be read here.

To fill this gap, it has been proposed that all entities falling under promoter and promoter group be disclosed separately even if they do not hold shares in entity. Further it is proposed that listed entities obtain a declaration on a quarterly basis, from their promoters on the entities/ persons that form part of the ‘promoter group’.

Disclosures of all entities falling under promoter/ promoter group irrespective of the fact whether they hold shares in the listed entity hold all the more importance in light of the recent SEBI circular on Automation of Continual Disclosures under reg. 7(2) of SEBI (Prohibition of Insider Trading) Regulations, 2015 (‘PIT regulations’). In order to facilitate System Driven Disclosures (‘SDD’)[5]  pursuant to the said circular, the listed entities are  required to disclose to the designated depository the PAN number/ Demat account number (for PAN exempt entities) of all Promoters and promoter group so that the system can capture any trade in securities made by such entities.

Conclusion

Exemptions provided in the consultation paper in cases of open offer and order/ direction of Government/ regulator lead to reduction in compliance burden on the listed entity, further the proposed amendments w.r.t reduction in time gap between the board meeting and general meeting and the setting of time limit for placing the application before the board will lead to streamlining the entire process and bring efficiency in the same.

The clarification w.r.t to disclosure of names of promoter group entities holding ‘Nil’ shareholding and obtaining quarterly declarations from promoter may add to the compliance burden of listed entities at once, but in our view, should be effective in the long run.

Specific comments/suggestions on the Consultation Paper can be made to SEBI on or before December 24, 2020.

 

[1] For full text of the consultation paper see:

https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/nov-2020/1606126221923.pdf#page=4&zoom=page-width,-15,71

[2] For full text of the informal guidance see:

https://www.sebi.gov.in/sebi_data/commondocs/Alembic-sebiletter_p.pdf

[3] For full text of the informal guidance see:

https://www.sebi.gov.in/sebi_data/commondocs/oct-2017/gujaratsebi_p.pdf

[4] See: https://www.sebi.gov.in/legal/regulations/nov-2018/securities-and-exchange-board-of-india-listing-obligations-and-disclosure-requirements-sixth-amendment-regulations-2018_41051.html

[5] Circular no. SEBI/HO/ISD/ISD/CIR/P/2020/168 dated September 09, 2020 available at:

https://www.sebi.gov.in/web/?file=https://www.sebi.gov.in/sebi_data/attachdocs/sep-2020/1599654391917.pdf#page=1&zoom=page-width,-16,559

Benevolent move of SEBI for a more democratic shareholder participation

-Effectiveness however doubtful!

Abhishek Saraf | Vinod Kothari and Company

corplaw@vinodkothari.com

Background

SEBI observed that under the current remote e-voting framework, the participation of the public non institutional shareholders/ retail shareholders (shareholders) is at negligible level. One of the reasons behind such low participation may be due to reluctance of the shareholders to register with multiple e-voting service providers (ESPs) which provide the e-voting facility to the listed entities. Shareholders may be finding it a tedious task to register with multiple ESPs for casting their vote and maintain multiple user IDs and passwords for the said purpose.

In view of the same and with the intent to increase the optimum utilization of the remote e-voting process by shareholders, SEBI came out with consultative paper[1] on 5th March 2020 to review the e-voting mechanism as provided by various ESPs.

Based on the public comments on consultative paper, SEBI vide its circular[2] dated 09th December 2020 decided to enable the facility of a singly log in credential for the purpose of e-voting for all demat account holders.

This article covers the circular along with our analysis on the probable impact which SEBI intends to achieve by way of easing and at the same time securing the remote-e-voting process for shareholders.

Existing Mechanism

The existing mechanism requires shareholders to register themselves with ESPs and have a separate login credential for each ESP to be able to cast their vote on resolutions proposed to be passed at the general meetings. The same can be explained better with the help of the following example:

Suppose a shareholder Mr. S holds shares in 3 companies and these companies appoint different ESPs for providing remote e-voting facility to vote on the resolutions proposed to be passed at their respective general meeting.

Now the shareholder shall register himself with all the 3 ESPs and have a separate login credential for each ESP to be able to cast his vote. Under the given situation, the shareholder may find it tedious and therefore, skip the whole process itself.  The notice calling the general meeting contains the instruction for logging in the portal of the Depository in the following manner:

SEBI’s move to increase remote-e-voting

With an intent to address the issue of negligible voting by the shareholders, SEBI has introduced a mechanism to make e-voting process more secure, convenient and simple for shareholders under which the shareholder will be allowed to cast their vote directly through their demat accounts/ Depositories/ Depositories Participants without having to go through the hassle of registering with various ESPs and maintaining a list of multiple user IDs and passwords. In the process, only a single login credential will be enough for the shareholders to participate in remote e-voting and register their vote in respect of any item.

The existing process as envisaged above will be replaced with a single doorstep which will be accessed by a single login credential under which the shareholder shall be allowed to vote without any further authentication by ESPs.

By taking the help of the above example, the new facility can be explained in the following manner-

Under the new facility, Mr. S does will not have to maintain login credentials for all the 3 ESPs but only have to register with the Depository either directly or through his demat accounts with Depsoitory Participants to have access to all the ESPs through a single log in without additional authentication with ESPs. This has been explained in detail below.

The facility shall be implemented in 2 phases.

Under Phase -1:

SEBI has instructed to implement the process as provided in Phase-1 within 6 months of the date of the circular (i.e. within 9th June 2021).

Shareholders with demat accounts have been provided the option to either directly register with Depositories to access the e-voting page of various ESPs through websites of the Depositories or accessing various ESP portals directly from their demat accounts, through the facility provided by the depository without any further authentication by ESPs, for participation in the e-voting process.

Under Phase-2:

SEBI has instructed to implement Phase 2 within 12 months from the completion of the process in Phase 1.

Under the 2nd phase, it has been proposed to further enhance the convenience and security of the system with the help of One Time Password (OTP) verification mechanism wherein the shareholders will be allowed to login through registered mobile number or E-mail based OTP verification as an alternate in place of logging through username and password for cases where shareholders have directly registered with the Depository

Further for logging in through demat account with the DPs, a second factor authentication using mobile or e-mail based OTP shall also be introduced after logging in.

While the SEBI circular requires implementation in two phases, the consultative paper was different on the following fronts:-

  • Consultative paper did not provide for implementation of the mechanism in a phased manner;
  • It was proposed that only the Depositories will be required to establish a dedicated helpline unlike the SEBI circular where both Depositories and ESPs are required to have a dedicated helpline;
  • The consultative paper proposed that the ESPs shall send details of the votes cast, to the shareholders, via SMS/ Email whereas the circular places the responsibility of sending a confirmatory SMS on the Depository based on the confirmation received from ESPs.
  • Sharing of necessary details and logs by Depositories with ESPs and sharing of electronic logs and other related information with respect to e-voting transactions with Depositories by ESPs as proposed in the consultative paper has been done away with in the circular.

To dos for Depositories and ESPs

Depositories

  • Accountable for authentication – The Depository has been made responsible to carry out the authentication of the shareholders and voting will be allowed by ESPs based on the Depository’s authentication.
  • Flash messages/ reminders – Another step taken to increase participation is SMS/ email alerts by the Depository to the demat account holders atleast 2 days prior to the date of the commencement of e-voting. The listed entity shall provide the details of its upcoming AGMs requiring voting to Depository who shall then send a SMS/ email alerts.
  • Dedicated helpline – Depositories to establish a dedicated helpline to resolve technical difficulties faced by shareholders relating to the e-voting facility

ESPs

  • Dedicated helpline- listed companies shall ensure that the ESPs engaged by them also provide a dedicated helpline in this regard.
  • Better Disclosure- To enable shareholders to take informed decisions while voting on any proposed resolution of a Company, ESPs has been instructed to provide web-link to the disclosures made by the Company on the stock exchange website and report on the website of the proxy advisors.

Conclusion

This framework for one stop log-in has only been made mandatory in respect of public non-institutional shareholders/ retail shareholders and the existing process may continue for all physical shareholders and shareholders other than individuals viz. institutions/ corporate shareholders. Further, SEBI’s perception on the current shareholder participation is based on its public consultation and is probably because, the shareholders are not taking the trouble of registering themselves with the various ESPs.

The step taken by SEBI towards a more democratic participation of the shareholders may be effective in the long run. However, its current effectiveness seems to be doubtful unless the shareholders for whom the same has been made, find it useful and be ready to implement the same.

 

[1] https://www.sebi.gov.in/reports-and-statistics/reports/mar-2020/consultative-paper-on-e-voting-facility-provided-by-listed-entities_46213.html

[2]https://www.sebi.gov.in/legal/circulars/dec-2020/e-voting-facility-provided-by-listed-entities_48390.html