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Corporate Governance: Miles Travelled and Miles to go

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Book released on January 24, 2024

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Inviting you to delve into a sweeping 700-pager book that unfolds the intricate tapestry of Corporate Governance as concept, providing a comprehensive and enlightening treatise on its evolution across diverse areas. Some of the salient features of this book are 

  • Runs over 700 pages of text, divided into 9 parts, consisting of 25 chapters.
  • Coverage of the complete ecosystem of corporate governance including the board and its committees, independent directors, auditors, proxy advisors, and shareholders. 
  • Extensive coverage of conflicts of interest which forms the major area of concern in corporate governance with detailed analysis of regulations on related party transactions.    
  • Covers information symmetry and corporate transparency as one of the key targets of effective corporate governance, with substantial coverage on insider trading and ensuring confidentiality and the flow of information from companies to the stock exchanges.
  • Several chapters are supported by extensive,well-classified FAQs.
  • Global coverage with an Indian focus, to allow readers to put the regulations into a wider context and understand international best practices.
  • Sustainability and business responsibility covering detailed analysis of obligations relating to ESG, climate change and directors’ liability for the same, sustainability financing, and CSR.
  • Use of technology in corporate governance like the use of AI in boardroom decisions.

In addition to the contents, the book has been designed in an e-book format to provide additional benefits to readers such as –

  • Hyperlinked text allowing access to the net resources
  • Eco-friendly, as we save paper and print
  • Cost effective -note that the subscription charges to our premium section are nominal, and not for this book but for all the materials/text that we put in the premium section
  • Reader’s ease of access – you may refer to the book using your handheld device, laptop, and at any point or place
  • Ease of searching and referencing – text search, string search capabilities of PDF versions may be deployed
  • Timely updations – we may, at intervals that we determine, update the text – therefore, you will be reading the last updated version, whereas print publications take long time to be revised. Notably, in the dynamic space of corporate governance, regulatory information itself may change frequently enough

Here’s a sneak peek into the contents of the book

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AGENDA – Felicitation meet-cum-Panel Discussion on Corporate Governance

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Felicitation Meet and Panel Discussion on Corporate Governance – from 1988 to Now

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Agenda for the Panel Discussion

About the Book

Live on Youtube

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Growing relevance of Audit Committee and IDs

For boosting corporate governance framework

– Pammy Jaiswal, Partner | pammy@vinodkothari.com

Background

In the era where the regulators are constantly bringing amendments to secure the stake and protect the interest of shareholders (including the stakeholders), it becomes imperative to understand the role, function and relevance of one such board committee being the ‘Audit Committee’ (hereinafter referred to as the ‘AC’) which has been given the responsibility to oversee and monitor several crucial matters after the board of directors. These functions are in the nature to ensure transparency and accountability (pillars of corporate governance) to a large extent. It has been seen in several cases in the past that lapses on the part of this committee often leads to major scams and corporate scandals.

In this paper, the author has tried to explain the idea and intent of the law makers behind introducing the concept of the AC, its expected role and function in ensuring and boosting corporate governance given the terms of reference suggested under applicable laws in India with a brief global comparison.

The entire Paper as was published by SSRN can be read here

Governance by technology: The future of corporate governance

– Pammy Jaiswal, Partner and Payal Agarwal, Senior Executive | corplaw@vinodkothari.com

‘Corporate governance’ (‘CG’) is difficult to define but easy to describe. It is understood by the principles and practices that are comprised in it, under regulations, standards and best practices. Corporate governance continues to evolve, for reasons not difficult to understand. First, companies, over time, have become immensely powerful in an ever-integrated and networked economy. Two, experience with operation of companies over time have given precedents of misuse of managerial power,  conflicts of interest, opacity in reporting, lack of balance in meeting diverse stakeholder needs, and lately, ESG concerns. Every major corporate scandal leads to a fresh thinking on corporate governance principles, which is quite understandable for an adaptive process. The key objectives of corporate governance are accountability, transparency, objectivity, responsibility, etc. Globally, the concept of CG has been explained widely, just as under the OECD Principles on Corporate Governance[1] explains it to be ‘a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined.’  Further, the UK Corporate Governance Code 2018[2] also refers to the definition coined by the Cadbury Committee which defined the aforesaid term to mean ‘the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. The shareholders’ role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place.

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CLC recommends major reforms in corporate laws for ease of doing business

– MCA’s move to standardise, streamline and digitize

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

The Report of the Company Law Committee – 2022 (“CLC Report”) has proposed various important amendments to the existing Companies Act, 2013 (“the Act”) and some in the Limited Liability Partnership Act, 2008 (“LLP Act”). The recommendations touch a wide array of elements under the Act – be it the association/ cooling period of directors, auditors, KMPs, etc. or corporate actions such as mergers, transfer of unclaimed monies to IEPF on account of buyback etc., de-clogging of NCLTs for restoration of company’s name after having been dissolved as defunct, setting up of specialized company law Benches of NCLT for dealing with matters of economic importance such as corporate restructuring, and specialized IBC cases or cases involving public interest. The recommendations also seek restoration of some meaningful provisions of the erstwhile CA 1956.While some suggestions pertain to ease of compliances and moving towards digitization with respect to certain compliances of a company, others pertain to building a robust corporate governance framework including alignment of the law with various provisions with SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“Listing Regulations”).
This is the 3rd CLC Report in the series of recommending changes to the 2013 Act, several reforms in the Act had been suggested in past by the CLC Report 2016, Committee to Review Offences Under Act of 2018 and CLC Report 2019. A brief summary of the issues under hand and the recommendations along with proposed amendments have been provided for as an Annexure to the CLC Report itself, and therefore, we find it useful to discuss only some of the recommendations which require analysis.
Applicability
The Committee report, if accepted by the Government, will potentially lead to an Amendment Bill, and therefore, there will be an enactment by a law of the Parliament. Once passed, it is expected that several of the amendments will require extensive rule-making, as there are references in several provisions to “class or classes of companies”. Thus, while we get a broader view of the direction into which the law will move, but as they say, the devil lies in the detail. We will get to know the details, hopefully divine and not devilish, only when the Bill is available for review.

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Enhanced Corporate Governance and Compliance Function for larger NBFCs

– Anita Baid, Vice President | finserv@vinodkothari.com

RBI has been concerned with the adverse regulatory arbitrage posing systemic risk in the NBFC sector. In order to align the regulatory provisions with the objective of preserving financial stability and reducing systemic risks, a scale based regulatory framework has been introduced which is to be effective from October 1, 2022. The SBR is a calibrated and graded regulatory framework proportional to the systemic significance of NBFCs.

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Managing significant transactions & arrangements with subsidiaries

– Decoding Regulation 24 of Listing Regulations

By Payal Agarwal and Himanshu Dubey | corplaw@vinodkothari.com

Updated as on 27th October, 2021

The seamless flow of information between a holding company and its subsidiaries is imperative for effective governance on the level of a group. Since listed companies in India often function with complex structures having a lot of subsidiaries, it is not feasible for the holding company to deliberate upon all the matters of its subsidiary. Therefore, if not all, at least the significant transaction of the subsidiaries shall be placed on the board of the holding company. Regulation 24 of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘Listing Regulations’) provide for the same. The same though sounds commendable but is also surrounded by various practical difficulties while its implementation. Sometimes the compliance with the aforesaid provision becomes merely perfunctory. If too much is reported to the holding company, the relevance is lost while if too less is reported then the materiality is lost.

Need of fostering corporate governance requirements with respect to subsidiaries

In the normal course of business, it is very common for companies to have subsidiaries. However, the significance of such subsidiaries on the overall performance of the holding company varies. In case of listed companies, since the interest of the public at large is at stake, it becomes imperative that such stakeholders shall not only be informed about the listed company but also its subsidiaries. Ofcourse, the level and depth of information shall vary depending upon the significance of the subsidiaries as well as the significance of transactions being undertaken by such subsidiaries. Considering the aforesaid, Regulation 24 of the Listing Regulations requires the listed holding company to ensure corporate governance in its unlisted subsidiaries in certain ways. One of such ways is provided under sub-regulation (4) of Regulation 24 (Regulation) which says that the management of the unlisted subsidiary shall periodically bring to the notice of the board of directors of the listed entity, a statement of all significant transactions and arrangements entered into by the unlisted subsidiary.

The above-mentioned requirement was earlier applicable only to material unlisted subsidiaries but pursuant to amendment applicable w.e.f. April 1, 2019, the requirement has now been made applicable to all the unlisted subsidiaries of the listed holding company. However, the requirement though seems unequivocal, it comes with certain anomalies and practical difficulties. The author tries to present an analysis of the Regulation so as to answer the anomalies coming in the way of its practical implementation.

Applicability to subsidiaries

It is very common for a large corporate group to have various subsidiaries which in turn have various subsidiaries under them i.e. step down subsidiaries, from the angle of the ultimate holding company. The possibility of the holding company being listed and the subsidiaries including step down subsidiaries being unlisted is very high. This kind of a structure is very common and can be seen in most of the major corporate groups in India. Since the Regulation talks about subsidiaries, a question might pop up whether it only includes the immediate subsidiaries or the step down subsidiaries as well.

Given the purpose of the Regulation of enhancing corporate governance in the subsidiaries and also the fact that the shareholders interested in the listed company shall be aware of the business being undertaken by the subsidiaries as well. The principle behind this is that on the consolidated level, the performance of the holding company gets affected by the performance of its subsidiaries including its step down subsidiaries. Therefore it is pertinent to have some degree of supervision over them in terms of corporate governance though they are unlisted. Considering this rationale, there seems to be no purpose of excluding the step down subsidiaries from the purview of this Regulation. Hence, the Regulation will  be applicable to both immediate and step down unlisted subsidiaries. Let us understand the applicability of the Regulation under different cases enunciated below:

 

Case 1: since both the immediate subsidiary and the step down subsidiary are unlisted, the Regulation will apply to both of them and significant arrangements or transactions entered into by them will be reported to the ultimate holding company.

Case 2: since the subsidiary itself is a listed company and the Regulation clearly states that it applies to unlisted subsidiary. Therefore, the Regulation will not apply to the subsidiary. Going further, the step down subsidiary is unlisted, but the holding company just one level above is listed. Therefore, the Regulation will apply to unlisted step down subsidiary in relation to its immediate holding company. The ultimate holding company at the top will not be required to note or review the significant transactions or arrangements of the step down subsidiary under the Regulation.

Case 3: since the subsidiary is unlisted, the Regulation will have to be complied in relation to it. However, going forward to the listed step down subsidiary, since it is itself listed with the stock exchange, the Regulation will not apply as it is applicable only to unlisted subsidiaries.

Issues to address

Regulation 24(4) of the Listing Regulations reads as below –

“The management of the unlisted subsidiary shall periodically bring to the notice of the board of directors of the listed entity, a statement of all significant transactions and arrangements entered into by the unlisted subsidiary.”

The following may be require to be identified –

While a plain reading entails the aforesaid questions, a deep analysis of the provisions and on consideration of the practical implications, further issues/questions may arise which have been dealt with at relevant places in this write-up.

Meaning of Transactions or Arrangements

The first question that arises while complying with the requirements of Regulation 24(4) is the identification as to what constitutes transaction or arrangement. While the term ‘transaction’ is not defined, the meaning of the same may be construed from Regulation 2(1)(zc) of the Listing Regulations and Indian Accounting Standard (Ind-AS) 24, defining the term “related party transaction” (RPT) .

The term has been defined as –

A related party transaction is a transfer of resources, services or obligations between a reporting entity and a related party, regardless of whether a price is charged.

Accordingly, the term transaction may be understood to be “a transfer of resources, services or obligations between two parties”. Similarly, arrangements shall mean a plan or programme for undertaking or understanding to undertake such transactions in future.

 

Items not considered as transaction/ arrangement

There are various line items in the financial statements which does not arise out of any transaction or arrangement but as a result of accounting entries. Such line items such as deferred tax expenditure, provisions for future liabilities, unrealised gains or losses, etc do not involve any contract, result into any transfer and does not involve two or more parties. Therefore, these fail to contain the basic features of transaction and should not require reporting.

On the other hand, there are certain off-balance sheet items such as guarantee, or derivative transactions. The component of “transfer” may not be present from the early stage but may arise in due course. Moreover, these arise out of contracts and constitute transactions. Therefore, the same should be reported at the values as recognised in the books of accounts.

Assessment of Significance

The second step that comes after identifying the transaction/arrangement is the assessment of significance. For the purpose of Regulation 24(4), a transaction or arrangement is significant if it individually exceeds or is likely to exceed ten percent of the total revenues or total expenses or total assets or total liabilities, as the case may be, of the unlisted subsidiary for the immediately preceding accounting year.

The criteria of significance as provided above requires that the threshold needs to be checked against different parameters “as the case may be”. The parameter to be checked will depend upon the nature of the transaction. Therefore, depending upon the nature of the transaction, the significance shall be assessed against the threshold determined on the basis of figures under relevant head as explained below:

 

There may be instances where the transaction does not affect any one parameter in isolation but  two or more of the parameters i.e. revenue, expenses, assets or liabilities together. In such cases, an issue may arise as to which parameter has to be considered. In such cases, all the parameters applicable to such a transaction shall be considered. 10% threshold of all such applicable parameters shall be determined and the lowest of such threshold shall be applied for assessment of significance of such transaction.

For example, S Ltd, the subsidiary of A Ltd, has entered into a transaction with Z Ltd, involving sale of goods. Such transaction involves revenue and therefore, significance of such transaction has to be assessed as a percentage keeping the total revenue of the preceding accounting period as the base for deriving such percentage. Say for example, the revenue of S Ltd is Rs. 100 crore in the preceding financial year. Therefore 10% of it will be Rs. 10 crores. Hence, if the value of the transaction being entered by  S Ltd with Z Ltd exceeds Rs. 10 crores, the same will qualify as a significant transaction for the purpose of the Regulation.

However, consider another example in which S Ltd has entered into an arrangement which impacts both the assets and expenses of the Company (creation of a new capital asset involving a huge outflow of cash). In such a case, both the assets and expenses being involved, the significance of the transaction has to be assessed for each of the bases individually and the one that hits the requirement at the lower end shall be taken for assessment of significance. Say for example, the assets and the expenses of S Ltd in the preceding financial year was Rs. 500 crores and Rs. 150 crores each. In such a case, thresholds shall be calculated based on both the figures and the lower of the two shall be the one that will determine the significance of the transaction. In the instant case, the thresholds are Rs. 50 crores and Rs. 15 crores, therefore the lower of the two i.e. Rs. 15 crores will be the one that will be considered. Hence, if the amount of transactions being undertaken exceeds Rs. 15 crores, it will qualify as a significant transaction.

 

Basis for assessment – standalone or consolidated?

Having settled with the parameter to be considered for various transactions, another question that may tweak our mind is whether the total revenues or expenses or assets or liabilities, as the case may be , has to be considered on a standalone basis or on a consolidated basis for the subsidiary. Here, one has to consider the fact that the compliance of the provision has to be ascertained by the listed holding company. Any company, which is a subsidiary of the subsidiary company, ultimately becomes the step-down subsidiary of the listed holding company thereby attracting Reg 24(4) of the Listing Regulations for reasons as discussed above and reporting its significant transactions or arrangements to the board of the listed company. In view of the same, an inference may be drawn that the aggregate figures for the preceding financial year shall be taken on a standalone basis, and not on a consolidated basis. This will also help in getting a clear picture and involving only those transactions that are actually significant for the subsidiary.

Determination of significance: Transactions/Arrangements based on contract

It is a very general phenomenon in companies to enter into contracts with different parties. Such contracts often extend to years and give rise to transactions. A common ambiguity that may arise in such cases is on determining the amount of such transaction for the purpose of the Regulation. Let us understand this scenario with some examples.

A Ltd., a subsidiary of B Ltd., enters into a rent agreement with X Ltd. The rent agreement extends to 5 years at a total value of Rs. 30 lakhs i.e. at a monthly rent of Rs. 50,000 per month. Now what shall be considered as the value of transaction for the purpose of the Regulation, Rs. 30 lakhs or Rs. 50 thousand? In our view, the total amount attributable to that particular financial year shall be considered for the purpose of the Regulation. In the instant case, assuming that the contract is effective from October 1, 2021, the amount shall be Rs 3 lakhs (rent during the FY 2020-21). Therefore, for assessing the significance of the transaction, the amount of Rs. 3 lakhs shall be compared against the threshold.

In the same case above, even if there has been no specific tenure of the contract but it rather would have only discussed monthly payment of Rs. 50 thousand as rent, still the amount payable in total throughout that financial year shall be taken and not the monthly rent.

The underlying principle is that the total amount of that transaction attributable to that financial year shall be considered as the amount of transaction for assessing significance under the Regulation.

Reporting: decoding the meaning of management and periodicity

Meaning of management

Regulation 24(4) says that “the management of the unlisted subsidiary shall periodically bring to the notice of the board of directors of the listed entity xxxxxxxxx”. This again comes up with two questions: who constitutes management and what shall be the periodicity for bringing significant transactions or arrangements to the notice of the board of the listed holding company.

Going by the general meaning as well as the intent and purpose of this requirement, the board of directors of the subsidiary as well as the KMPs/other senior executives just a level below the Board should be taken to constitute ‘management’.

Periodicity of reporting

Coming to the question of periodicity, the same has not been specified in the Listing Regulations itself, but left to the discretion of the board. However, the intent of the Regulation is to enhance corporate governance in the subsidiaries. Hence the periodicity should be reasonable enough to capture such a purpose.

Here, one may note that Regulation 17(2) of the Listing Regulations requires the board of the listed company to meet at least four times a year. Further, under Regulation 33, financial results are placed before the board quarterly which also includes results of its subsidiaries (since the results have to be submitted on both standalone and consolidated basis). Therefore, in consonance with the same, the list of significant transactions or arrangements of the subsidiaries should also be placed before the board of the listed company, if not more frequently, at least on a quarterly basis.

De-minimis exemptions – can a leeway be created?

Regulation 24(4) of the Listing Regulations, though very significant in terms of enforcing corporate governance requirements and ensuring transparency in respect of the unlisted subsidiaries of the listed company, may sometimes prove extraneous in the spirit of law. There may be cases where the subsidiary as a whole may be too small to have any significance on the accounts of the holding company.

A classic example of the same may be in case of a company, as a listed holding company, having a paid-up capital of Rs. 50 crores or above, having a subsidiary with total asset size of Rs. 1 crore. In this case, the total assets of the subsidiary amounts to mere 2% of the total asset size of the listed company. Here, a transaction involving purchase/ sale of an asset of Rs. 10 lacs will fall within the meaning of a significant transaction for the subsidiary company, however, will have a minimal impact on the listed holding company.

In such cases, going by the letter of the law, such transactions, even though having no significant impact on the listed entity as such, will have to be placed before the board thereby creating an unnecessary compliance burden producing no meaningful results.

A possible leeway that may be created as a make-through to provide certain de minimis exemptions on the basis of certain amounts or percentages. For example, a listed company may approve through its board and audit committee, that any transaction undertaken by a subsidiary, which amounts to not greater than 2% of the turnover or the paid-up capital or the networth of the listed company, will not be required to be reported to the board of the listed company.

However, while putting such de minimis exemptions, utmost care has to be taken to ensure that the self-approved exemptions do not turn out to completely erode the intentions of the law. Further, the requisite approvals have to be obtained and properly documented so as to avoid falling into a legal moss at a later stage.

Conclusion

The requirement under Regulation 24(4) enhances corporate governance standards in subsidiaries which were otherwise unlisted and exempted from such scrutiny. It allows the listed holding company to exercise due diligence in significant transactions entered by subsidiaries. However, in certain cases, the requirement becomes redundant due to absence of any material effect of subsidiary’s transactions on the overall performance of the holding company due to minimal asset size or revenue. Therefore, the idea of exempting subsidiaries below a certain threshold in terms of asset size or revenue of the listed company can be thought upon.The market regulator may also take a step to bring this as an amendment to the law, so as to ensure reduction of extra-compliance burden as recently suggested by FM Nirmala Sitharaman in her speech on the 53rd Foundation day of ICSI.

 

Read our other article on the subject –

‘Material Subsidiary’ under LODR Regulations: Understanding the metrics of materiality:

https://vinodkothari.com/2021/05/understanding-metrics-of-materiality/

Financial transactions with promoter entities become part of CG disclosure

SEBI’s move to strengthen transparency

Pammy Jaiswal| Partner| Vinod Kothari and Company

corplaw@vinodkothari.com

Background

It has always been interesting to see how SEBI takes various steps to increase the level of transparency for augmenting the level of corporate governance in a listed company. Recently, SEBI notified the changes under the SEBI Listing Regulations on 6th May, 2021, which contained several significant changes to enhance corporate governance (hereinafter referred to as CG), like specifying the scope of the risk management committee or intimation of recordings and transcripts for analyst meetings[1]. Following the said notification, SEBI, on 31st May, 2021, came up with a circular[2] dealing with enhanced disclosures under CG report to be submitted to the stock exchange under Regulation 27 (2) of the SEBI Listing Regulations by adding Annexure IV to the existing formats.

The new requirement coming out from this circular is extremely significant since it aims at revealing almost all types of financial transactions (to say almost 24 types of permutations) which the company has entered into with its close connections and which may have the highest chances of involving any conflict of interest.

 

 

In this write up we have tried to critically discuss and examine the requirements emanating from the said circular.

Scope and time of applicability

  • Annexure IV which contains the new disclosures will have to be filed by the listed entities which have listed their specified securities.
  • The same is to be filed on a half yearly basis starting from the first half year 2021-2022, i.e., for the half year ended 30th September, 2021.
  • While Regulation 27 (2) only talks about quarterly filings within 21 days from the end of the quarter, therefore, there is no explicit time period within which this new annexure will have to be filed with the exchange from the end of the half year.
  • The disclosure will not only cover the financial transactions undertaken during the half year ended 30th September, 2021, but also cover all outstanding financial contracts which the entity has entered any time in the past.

Financial Permutations covered

 

Critical Aspects

While the format under the new annexure may seem to be simple in terms of presentation, however, it has various aspects related to it which needs to be discussed. Owing to the extent of disclosure required, listed companies will have to consider and understand every part under the format before feeding the details. Some points which need to be discussed include the actionable, the meaning of the entities controlled by the promoters, the meaning of direct and indirect accommodation, distinction between a LoC and a co-borrowing arrangement, and last but not the least the ‘affirmation’ on the economic interest of the company.

Actionable on the part of the listed entity

  • Identify the entities
    • This identification process may reveal that companies have a large number of interested entities falling under these 4 types of entities.
  • Identify transactions
    • After having prepared the list of entities that are included under the 4 categories, the next step will be to identify the financial transactions which include loan, guarantee or security in connection with the loan to the entities under the list.
  • Identify outstanding balances
    • Once the entities and the transactions entered into with them have been identified, listed companies will have to identify the outstanding balance as on the date of the report.
    • Since the transactions involve providing guarantee or security as well, there can be a situation that companies will have to look for both on and off-balance sheet items to come to the actual outstanding balance for the purpose of reporting.

Entities controlled by Promoters/ PG

While the meaning of the term promoter and PG is well defined under SEBI ICDR Regulations, the question that may arise is which entities will be considered to be controlled by the promoters or the PG. The meaning of control here has to be taken form SEBI Takeover Regulations, which defines it as a right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or PAC, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.

As per the definition of PG, entities which have a substantial stake (20%) held by the promoters or by common group pf shareholders are covered under the said definition of PG. However, if one has to identify the entities which are controlled by PG, it may cover even larger number of companies.

Ambit for covering directors and controlled entities for the purpose of disclosure

The ambit for making disclosures is very wide under Annexure IV. Therefore, it becomes imperative to pinpoint the entities related to the directors of the listed entity that are covered for the purpose of disclosure under the said Annexure. The same is represented below:

SEBI Listing Regulations refer to the definition of ‘relatives’ provided under Section 2(77) of the Companies Act, 2013.

In a situation where the directors do not have any direct control over the entity to whom the listed entity has extended the financial accommodation, but the control is with the relatives of such directors alone, the same should be enough to make the financial transaction be covered for the purpose of the disclosure under Annexure IV.

Leaving such transactions outside the disclosure will frustrate the whole intent of the said requirement since, it is very unlikely that a financial accommodation will be offered to an entity controlled by the director’s relative without any nexus or benefit to the directors altogether. There exists a possibility of the directors or their relatives indirectly gaining benefit or influencing transactions undertaken. Therefore, such transactions will also be required to be disclosed, given the intent of the disclosures.

Nature of book debt covered

As per the format of annexure IV, any other form of debt advanced is also required to be included for the purpose of the said disclosure. Looking at the intent of the disclosure, any book debt that is present in the books like merely selling of goods on credit should not be made part of this disclosure. In our view, only the book debt which has the color of an advance and which is in the nature to serve as a financial accommodation (for example selling of goods on credit for an unreasonable period of time or under unreasonable terms of understanding) is required to be disclosed.

Meaning of direct and indirect financial accommodation

As per the requirement, one of the biggest challenges for the listed entities will be to identify the connecting links or conduits through which these interested entities have been benefitted. Such transactions are generally camouflaged and put through layers to create smokescreen. These entities which are used to route the benefits to the interested parties are merely acting as a stopover. Therefore, it is extremely important to identify such transactions where there is a clear and direct nexus between flow of money from the listed entity to the intermediary and ultimately to the interested party. For instance, if a company raises preference share capital with the reason that it needs it for its own business operations, however, uses the funds so raised to on lend to another entity.

Difference between LoC and co-borrowing arrangement

The new requirement includes an LoC to be disclosed in the half yearly report. One needs to understand that providing a guarantee or giving an LoC by the listed company is nothing but to agree and provide financial accommodation to the borrower. It is significant to note that companies cannot disguise the LoC into a co-borrowing arrangement and therefore, avoid the disclosures to be made under Annexure IV.

Under a co-borrowing arrangement, if the listed entity is the co-borrower, then it should be getting the benefit or be a beneficiary of the loan being taken together with the interested party. Acting merely as a signatory to the co-borrowing agreement will make it no different from being considered as a guarantee or providing an LoC.

Affirmation for being in economic interest of listed company

One of most crucial and difficult part of the disclosure is the part requiring affirmation that loan (or other form of debt), guarantee / comfort letter (by whatever name called) or security provided in connection with any loan or any other form of debt is in the economic interest of the Company.

Some pointed issues under this are:

  • Who will give this affirmation?

The report on CG as per the SEBI circular (annex I, annex II and annex III) are required to be signed either by the compliance officer or the company secretary or the MD or CEO or CFO. However, Annex IV (which is the new requirement) requires the affirmation to be signed either by the CEO or CFO.

Further, the practicing professionals who provide their report on compliance with CG requirements and which has to be annexed with the CG report cannot be expected to dive into this question and scrutinize the reasoning provided by the company.

  • What will be the basis of this affirmation?

Further, it is imperative to note that the entities covered under this disclosure are mainly upstream entities which are either promoters or PG or controlled entities by them. Therefore, it becomes all the more difficult to justify the act of financial accommodation to be in the economic interest of the company. If it were a case of downstream accommodation (like subsidiaries, associates, joint ventures, etc.), it would have been much easier to form a basis to affirm that the same is serving the economic interest of the company since any profits in them will reflect in the consolidated financial results of the listed entity, however, the same reason cannot be for an upstream entity.

Also, merely earning an interest on loan granted or a commission on a guarantee or security or even on lending cannot act as a justification here since the earning interest or commission cannot be said to serve the economic interest of a company which is not even in the business of lending. Having said that listed NBFCs may have an upper hand in terms of providing justifications in this case.

Whether the same needs to be reviewed by the Audit Committee as well?

Regulation 18 of the Listing Regulations read with Part C of Schedule II as well as section 177 of the Companies Act requires that the audit committee needs to scrutinize the inter-corporate loans and investments. While the same is required and covers loans, there does not seem to be any reason to exclude provision of security or extending guarantee since it is given in connection with loan.
The management needs to show the audit committee how does the transactions covered for the purpose of the said disclosure are in the economic interest of the Company.

Comparison between section 185 of the Companies Act, 2013 and Annexure IV

Section 185 of the Companies Act, 2013 (Act, 2013) deals with the provisions to provide loan and related services to directors or the interested entities. While section 185 is more from an angle of regulated provisions, the extent of casting restrictions on providing loan to directors or its connected parties is divided into two parts. One is completely prohibited (to directors and to firms where the director or his relative is partner) and the other one is restrictive, which means, financial accommodation can be given subject to prior approval of the shareholders.

The new disclosure requirement has several similarities with section 185 which are given below:

Basis of comparison Section 185 Annex IV of SEBI Circular dated 31st May, 2021
Services covered Provision of loan, provision of guarantee or Letter of Comfort and providing security in connection with the loan Similar
Mode Direct as well as indirect Similar
Entities covered ·      director of company, or its holding company or any partner or relative of any such director;

 

·      any firm in which any such director or relative is a partner;

 

The aforesaid two bullets are completely prohibited

 

·      any private company of which any such director is a director or member;

 

·      any body corporate at a general meeting of which not less than twenty-five per cent. of the total voting power may be exercised or controlled by any such director, or by two or more such directors, together;

 

·      any body corporate, the Board of directors, managing director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company

Refer to figure 1 above.

While the format requires the financial accommodation made, if any, to the directors or their relatives or entities controlled by them, it will surely not include or have any disclosure relating to financing of directors since it is completely prohibited under section 185 of the Act, 2013.

Exclusions

The aforementioned disclosure shall exclude the reporting of any loan (or other form of debt), guarantee / comfort letter (by whatever name called) or security provided in connection with any loan or any other form of debt:

  1. by a government company to/for the Government or government company
  2. by the listed entity to/for its subsidiary [and joint-venture company whose accounts are consolidated with the listed entity.
  3. by a banking company or an insurance company; and
  4. by the listed entity to its employees or directors as a part of the service conditions.

While one of the exclusions is for a banking company, it is imperative note the following:
 SEBI (LODR) Regulation does not define the term “banking company” but the term “banks”.
 Section 5(c) of the Banking Regulation Act, 1949 (‘BR Act’) defines banking company as: “banking company” means any company which transacts the business of banking in India;”
 Further, section 5(d) of the BR Act defines company as: “company” means any company as defined in section 3 of the Companies Act, 1956 (1 of 1956) and includes a foreign company within the meaning of section 591 of that Act;”
 Public sector banks like State Bank of India, being a body corporate, do not fall under the aforesaid definition of banking company. However, it is engaged in the business of banking and should therefore, be excluded.

Accordingly, clarity on the same is still awaited from SEBI.

Concluding remarks

As stated in the beginning, SEBI’s move to increase the standards for CG has been extremely interesting. Further, considering the fact that listed companies have a limited amount of time to arrange for huge amount of information, this circular needs the immediate attention of the listed entities.

[1] Our write up on the same can be viewed here

[2] To view the circular, click here

Our other articles on relevant topic can be read here – http://vinodkothari.com/2019/07/sebi-amends-format-of-compliance-report-on-corporate-governance/

Corporate Governance & material price sensitive information – Need for listed entities to frame effective materiality policy

– Vinita Nair, Senior Partner | Shaivi Bhamaria, Associate Legal Advisor | corplaw@vinodkothari.com

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