– CS Aisha Begum Ansari | CS Pieyusha Sharma | corplaw@vinodkothari.com
SEBI (LODR) (3rd Amendment) Regulations, 2021 | Corrigendum dated August 6, 2021
NSE Circular dated December 22, 2021 | BSE Circular dated December 22, 2021
Detailed write-ups:
1.Recent amendments relating to independent directors
2.SEBI notifies substantial amendments in Listing Regulations
Ridhima Jain | Executive | corplaw@vinodkothari.com
As in case of life, so also in business, risks are unavoidable. However, large organisations cannot afford to have a casual and pro-tem approach to risk management, as severity of some of the risks may cause significant erosion to shareholder value, even to the extent of affecting the solvency and liquidity of companies. Therefore, every company has to methodically identify, analyse, grade, mitigate and manage risks comprehensively. As size and complexity of organisations have increased, so also the need for proper risk management.
Risk management policy may be taken as a perfunctory compliance, and therefore, may be just a document that sits on the website of the company. On the other hand, a proper approach may be to use the risk management policy as the contextual document which assimilates the company’s approach to risk management, and may continuously act as the guide to the executive management.
Risk refers to the uncertainty in transactions undertaken by an organisation, which may be measured in terms of deviation from predetermined targets or probability of loss or inadequate profits. Risk often ranges from financial to non financial risks. Financial risks have an immediate bearing on finances of an organisation and may be in the form of credit risks, liquidity risks, operational risks or obsolescence risk. On the other hand, non-financial risks may be classified as strategic risks, compliance risks, fraud risks and reputation risks. Risk, by its very nature, is an inherent part of every business and its intensity only proliferates with the paced-up globalisation and digitalisation. This becomes evident from the increasing importance of the risk management function at the strategy making table of the concerned entities.
In this article, the author dwells on the importance of risk management framework for any organisation and also discusses the components of an ideal risk management policy. What goes in a risk management policy holds a fair amount of significance as the entire risk management framework is structured on the basis of the policy formulated in this regard.
In this context, risk management refers to the process followed by an organisation to identify, understand and evaluate the risks faced by it and effectively mitigate the detected risks. It may be construed as a macro process comprising various micro processes like risk identification, risk analysis, risk assessment and risk mitigation.
The rise in importance of risk management may be attributed to the realisation that any transaction may be fruitless if the underlying risk goes unrecognised. Unrecognised risks are more dreadful than recognised risks and any risk for which the organisation is not prepared for, may become unmanageable at the later stage of the process. An efficient risk management framework also facilitates development of a robust contingency plan and helps save costs, which the organisation may have spent on firefighting the risk.
Failures arising out of poor risk management have persistently resulted in downfall of big corporates. Examples may include Nokia, which failed to determine appropriate strategy for their business and surrendered to strategic risks or Satyam Computers which failed to manage fraud risks. Certainly, regulators like the RBI have imposed monetary penalties on NBFCs and banks for their inability to effectively address compliance risks. Such actions are not limited to monetary penalties, as in case of Srei Infrastructure Finance Limited the regulator took the company to the NCLT to initiate a resolution process against it.
It is important to approach risks in a suitable manner as it serves the spirit underlying the risk management framework. The manner of approaching risk is an organisation specific element, driven by numerous factors such as risk faced by the industry in which it operates. Even after determining risks faced by an industry, the risk approach would be influenced by the functioning model of the particular organisation. For instance, a bank’s risk mitigation strategy may be primarily focussed on credit risks whilst a trading company may focus on operational risks. However, a trading company having international operations may give equal weightage to currency and legal risks.
Even though the risk approach of an organisation differs, an ideal approach should determine key risks after considering both external and internal influencing factors. Along with, for efficient management of risk, the approach should undertake a “top-down approach” by which management philosophy is clearly communicated to the grass root level employees as well as a “bottom-up approach” by which risks detected by employees at each level are communicated to the top management. The two-way approach will lead to fostering a risk aware culture throughout the organisation.
The primary responsibility of the risk management function may be reposed on the board of directors or the risk management committee. Apart from the companies mandatorily required to formulate a risk management committee, other companies may also formulate such committee to give undivided attention to the risk management function. Also, companies may formulate sub teams whose main role may be to handle specific risks which may be significant for the company. For instance, an organisation engaged in the FMCG segment may constitute a commodity risk management team for managing volatility in commodity prices. Further, an organisation may constitute a separate policies or separate committee altogether for specific risks. For instance, an organisation may formulate business risk and assurance committees to specifically review business and strategic risks.
All in all, an organisation’s approach towards risk management is primarily influenced by the importance it gives to the risk management function and relevance of the risks to its operations. Accordingly, risk management policy of the organisation should be framed to reflect the approach adopted by it towards the risks faced by it.
Risk management policy may be construed as a document regulating risk management function in an organisation. Having discussed the importance of risk management, we understand that the function is imperative and flows through every department in an organisation. Every employee in the organisation should be made aware of the flow of risk management process which is ensured by a well documented risk management policy. In essence, such policy provides a comprehensive guide to the risk philosophy of the organisation. The policy lays down a foundation on which the whole enterprise risk management (‘ERM’) is built. Once the ERM has been set up, the policy facilitates integration and gives direction to efforts of all the personnel in the organisation towards achieving common risk management goals such as minimisation of adverse impacts of a project or exploring unravelling opportunities.
Considering the contents of risk management policy, the coverage of the policy should be broad to provide an enhanced scope towards the function. That is, the policy should provide for all the foreseeable risks that the organisation may face in its future.
Further, the policy should not simply be a document, incorporating or rather reiterating the regulatory requirements, but it should also encompass the probable risk areas. An ideal policy would include:
| Brief background of the organisation | Discussion of the background of the organisation would provide an enhanced understanding about the source of risks arising in the course of the business. |
| Objectives and importance of the policy | Whilst performing any activity, besides knowing what is to be done, it is equally important to understand why it is being done. Discussion on the objectives of the policy would give a vision to the reader and enhance the meaning to the upcoming contents of the policy. |
| Applicability and effective date | Prior to understanding any framework it is essential to understand the operations it covers and the date from which it is applicable. |
| Requirements as per the statute | An insight into the regulator’s expectations regarding risk management policy would significantly influence the policy of the organisation. For instance, the Companies Act, 2013 prescribes that the audit committee of a company shall evaluate the risk management systems. Similarly, the independent directors, as well, should provide independent judgment on issues like risk management and are responsible for integrity of the risk management system.
In this regard, SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘SEBI (LODR) Regulations, 2015’) also vests enormous responsibilities on the board of directors of the listed entity. Apart from framing a risk management plan, the board of directors are also responsible for defining roles and responsibilities of the risk management committee. Some of the mandatory compliances with respect to risk management policy are discussed in the forthcoming paragraphs. |
| Risks faced by the organisation | Categories of risks faced by the organisation along with particular risks and description thereof should be clearly specified in the policy. Such specifications would acquaint the reader about the intent behind the entire risk management framework. |
| Hierarchy of risk management | Establishment of such hierarchy is essential for an efficient risk management culture as it provides for an effective flow of risk information. Along with the structure, roles, responsibilities and accountabilities of the hierarchy elements should be clearly defined. More particularly, composition of risk management committee and particulars of appointment of the chief risk officer should be enunciated in the policy. A broad idea of an ideal hierarchy is shown in the following diagram.
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| Risk reporting | The policy should clearly specify as to which risks will be reported, how the risks will be reported and to whom the risks will be reported in the risk hierarchy. This may be seen as an important element of the whole framework as it is obvious that every risk arising may not have an impact on the organisation. Thus, reporting of such minor risks may waste time and effort of the personnel involved. |
| Treatment of different types of risks | The organisation may specify treatment of risk on the basis of classifications made by it. For this purpose, risks may be broadly classified as controllable or uncontrollable risks, inherent or residual risks. |
| Business continuity plan | The organisation should indicate development of such plans in its risk management policy. The plan should cover recovery plans after any major disruption faced by the organisation. A mention of such a plan would assure the policy users of the organisation’s preparedness of risks arising in all perceivable circumstances. |
| Risk management process | The central element of the framework typically involves the procedure for risk management in the organisation. Ideally the risk management process should be carried out in the following manner:
For instance, when considering fraud risks, firstly, lacunas in the organisational structure wherein fraud may be perpetrated are identified. The identified areas turn out to be the origin of fraud risk. Secondly, an analysis is made as to what is the probability that the risks will materialise. Any risk with high probabilities should be given due attention. Thirdly, the impact on the organisation when the risk materialises should be assessed. The output from this stage is used to prioritise risks according to their probability of occurrence and their impact. Finally, risks are mitigated by adopting a suitable risk mitigation strategy.
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| Risk management tools | The organisation may provide a description of the tools utilised by it in the process of risk management. Common tools used by the organisations are:
– Assessment matrix: The matrix highlights velocity of the risks faced by the organisation. It also suggests the impact of the potential risk in various functions of the department which are measured by assignment of specific scores. The criteria for assignment of scores may also be specified in the report.
– Stress tests – Organisations conduct stress tests to study the impact of risks getting materialised. Stress tests are mandated for banks and NBFCs in India.
– Risk registers: These are registers wherein all estimated risks and actual risks faced by the organisation are recorded along with their details such as their risk category, likelihood of occurrence, their impact and mitigation plan is suggested.
– Department-wise risk summary: The organisation may, after identifying risks faced by it as a whole, further bifurcate into risks faced by individual departments. |
| Review of risk management tools | Apart from the regular risk reporting, the results derived from risk management tools may be reviewed periodically to ensure that any risk element does not go undetected. For example, there may be provisions for submission of a report on risk register on a half yearly basis. In this regard, formats for such submissions and a calendar accommodating timelines for all submissions may be incorporated in the policy. |
| Risk audit | Even though the risk management function is a complete function, its efficiency is enhanced when integrated with internal audit. Audit of the risk management framework provides an assurance regarding the framework and brings in light deficiencies in the framework. It also indicates the level of effectiveness of internal controls. |
| Periodicity of review | The intervals at which the policy will be reviewed should be clearly specified as well as a schedule should be attached to describe intricacies of the amendment. |
| Dissemination of the policy | The manner and channels used for disclosing the policy should be expressly mentioned. |
In addition to the aforesaid, it is mandatory to comply with the broad guidelines laid by the specific regulators governing an organisation which may be read as:
The Companies Act, 2013: Section 134(3)(n) of the Companies Act, 2013 prescribes that the report of the board of directors shall contain a statement regarding the risk management policy of the company. Such policy should contain all the elements of risk more particularly, elements of risk which may threaten the existence of the company.
Securities and Exchange Board of India: Regulation 17 of the SEBI (LODR) Regulations, 2015 reposes responsibility of framing and implementing the risk management plan on the board of directors of the company. Further, Schedule II of the Regulations prescribes that the risk management committee is responsible for laying down a detailed risk management policy which shall mandatorily include:
Also, the committee has the responsibility of overseeing implementation of risk management policy and periodic review of the same.
Reserve Bank of India: In the context of NBFCs, the regulator lays specific stress on liquidity risk management framework to be adopted by applicable For the purpose, a liquidity risk management policy is to be laid down by the board of directors of the NBFC which shall provide for:
Further, both banks as well as NBFCs are required to structure an asset liability committee to provide a balance between those two aspects of the organisation. However distinction lies in their framework as liquidity is the most stressed point in NBFCs, but in case of banks, the RBI has laid out a more comprehensive “risk appetite framework” which prescribes risks to be managed at an aggregated level and not to be restricted at a specific risk/function. Apart from other specifications, the framework requires risks to be considered from qualitative as well as the quantitative perspective. The prescribed framework aims to mitigate financial risks, more specifically, interest rate and liquidity risks.
The gravity of the framework can be derived by solely looking at the strict composition and quorum requirements of the risk management committee. In this regard, the RBI has also prescribed an “Internal Capital Adequacy Assessment Process” in line with the Basel norms, to be laid down at individual bank level as well as at the group level to analyse significant risks faced by the banks. This may be considered as the most meticulous prescription by a regulator regarding the risk management framework, the reason being obvious, that the banks play a pivotal role in the capital flow of the economy.
Insurance Regulatory and Development Authority of India: The regulator, vide its corporate governance guidelines for insurers, reposed the responsibility of laying down a risk management framework and a risk policy by the risk management committee of the insurer. Specific stress has been laid down on fraud risk management faced by the insurer.
From the foregoing, we derive that risk management plays a crucial role in an organisation’s functioning. Thus, it is essential to have a sound risk management system. Such a system arises from a well drafted risk management policy. It is safe to say that risk management policy is the first step towards building a risk management framework. However, merely establishing a risk management policy does not assure a sound risk management framework. The execution of the plan so laid down is an equally important aspect to be looked at.
Our other resources can be accessed below:
– 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.
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.
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.
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.
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.
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.
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.
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.
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.
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’.
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.
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.
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/
– Megha Mittal
The concept of Special Purpose Acquisition Companies (‘SPACs’) has gained significant attention and importance in India in recent times – from a subject preserved to select classes, the surge in transactions over 2020, has made it pave its way to every investor’s dictionary. And with all the spotlight that SPACs have attracted, the numbers seem to only lend to the hype. To begin with, the global SPAC IPO proceeds in 2020 alone is estimated to be $83 billion USD[1] with a total of 251 listings. This figure is further projected to grow to a massive 711 listings in 2021 with an average IPO size of USD 294.5 Million as on 15th August, 2021[2].
Globally, SPACs have become the investment vehicle of choice, more-so by startups looking for funding; and the US has been the flag bearer of the SPAC industry, leading from the front. Following shortly behind are economies like UK, Malaysia and Canada; and while India is playing catch-up, it seems to be speeding up quick enough, at least on the regulatory front.
For the uninitiated, a SPAC, often referred to as a Blank-check Company or a Shell Company, is a non-operating company with the admitted intent (read: special purpose) of acquiring of a potential target within a stipulated timeline[3].
In this article, while dealing with the basic regulatory framework via-a-vis SPACs, the author seeks to analyse the motivation(s) behind such transactions from all perspectives – the acquirer’s, the acquiree’s and the investors’.
SEBI’s move to strengthen transparency
Pammy Jaiswal| Partner| Vinod Kothari and Company
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.
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.
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.
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.
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.
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.
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.
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:
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.
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.
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;
o 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.
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:
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.
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/
Munmi Phukon & Ambika Mehrotra
The Securities and Exchange Board of India (SEBI) has issued an Advisory on 20th May, 2020[1] for listed entities advising them to evaluate the impact of the COVID 19 pandemic on their business and disseminate the same to stock exchanges.
