Archive for year: 2021
Case Study I – Related Party Transactions – [Case 1]
In our series of case studies on corporate laws, we present to you our first case study on Related Party Transactions. Readers and viewers are invited to share their views and solutions in the comment section below –
Case Study 1- Related Party TransactionsComplete Guide to Sale and Leaseback Transactions
A guide to concepts, taxation, and accounting aspects of sale and leaseback transactions.
– Qasim Saif (finserv@vinodkothari.com)
Contents
Sale and Leaseback transaction. 2
Unlocking value, the hidden value of asset 2
Taxation of SLB transactions. 3
Example of GST Calculations on Sale and Leasebacks. 6
Accounting of Sale and leasebacks. 7
Transfer of asset does not qualify as sale. 10
Transfer of asset qualifies as sale. 10
Sale at a discount or premium.. 10
Example of Sale and Leaseback Accounting under Ind AS 109. 11
Accounting Entries at Inception. 12
Sale and Leaseback transaction
A Sale and Leaseback (SLB) is a special case of application of leasing technique. Lease is a preferred mode of using the asset without having to own it. In case of leases, the lessee does not own the asset but acquires the right to use the asset for a specified period of time and pays for the usage.
SLB is a simple financial transaction which allows selling an asset and then taking it back on lease. The transaction thus allows a seller to be able to use the asset and not own it, at the same time releasing the capital blocked by the asset.
SLB allows the lessee to detach itself with legal ownership yet continuing to use the asset as well. In effect there is no movement of asset however on paper there is a change in the title of the asset.
Sale and Leaseback transactions are globally common in the Real estate investment trusts (REITs) and Aviation industry.
Advantages to the Lessee
Unlocking value, the hidden value of asset
As is evident from the mechanics of SLB above, SLB results in taking the asset off the books of the lessee and results in upfront cash which could be used for paying off existing liabilities. Hence this does not impact the existing lines of credit the lessee may be availing.
SLB can help entities raise finance for an amount equal to fair market value of the asset which may be significantly higher than its book value. Though there might be taxation challenges attached to it in Indian context. Nevertheless, SLB may bring about a financial advantage as well wherein a high-cost debt can be substituted with a low-cost lease liability.
Most of the assets considered for SLB have been used by the lessee for a substantial period of time and the value of the physical assets may be insignificant. Hence SLB is sometimes referred to as junk financing.
Tax Benefits
SLB may sometimes lead to tax benefits as well (we shall see this in detail in the sections below). This has been one of the major drivers of SLB transactions in India and has its own downsides as well. One of the major pitfalls to SLB is the danger of excess leveraging; the lessee may tend to overvalue the asset. Considering that SLB is a mode of asset-backed lending but the asset has may not have much value and the lessee may exercise discretion on the application of funds poses threat of misuse of the product.
Legal issues in SLB:
The legal validity of SLB was discussed by the U.S Supreme Court in the landmark ruling of Frank Lyon and Company[1]. In Frank Lyon’s case the bank took the building on SLB. Under the lease terms the bank was liable to pay rentals periodically and had the option to purchase the building at various times at a consideration based on its outstanding balance. The bank took possession of the building in the year it was completed and the lessor claimed deductions on depreciation, interest on construction loan, expenses related to sale and lease back and accrued the rent from the bank.
The Commissioner of Internal Revenue denied the claims of the petitioner on the grounds that the petitioner was not the owner of the building and the sale and leaseback was a mere financing transaction. The Hon’ble Court held that –
Where, as here, there is a genuine multiple-party transaction with economic substance that is compelled or encouraged by business or regulatory realities, that is imbued with tax-independent considerations, and that is not shaped solely by tax-avoidance features to which meaningless labels are attached, the Government should honor the allocation of rights and duties effectuated by the parties; so long as the lessor retains significant and genuine attributes of the traditional lessor status, the form of the transaction adopted by the parties governs for tax purposes.
The fundamental principle is that the Court should be concerned with the real substance of the transaction rather than the form of the same. If there are reasons to believe that the form of the transaction and its real substance are not aligned, the Court must not be simply concerned by the form of the transaction nor by the nomenclature that the parties have given to it.
In India too, the legality of SLB transactions have been questioned in several cases; sometimes the transactions have come out clean while in some cases, SLBs were considered an accounting gimmick.
The legality of SLB transactions and analysis of various judicial pronouncements on the same, have been discussed in detail in our write up “Understanding Sale and leaseback”
Taxation of SLB transactions
Tax aspects specifically direct tax acts as a major motivation behind such transactions, SLB provides a creative playground for finance professionals to structure transactions in a manner that can lead to substantial benefit to the entity, and taxation acts as a major tool at their disposal.
Direct Tax Aspect
Though tax benefits have been a motivator for SLB transaction, the same has also been the reason for near wipe-out of SLB from Indian markets.
During the 1996-98 period one of the most infamous cases was the sale and leaseback of electric meters by state electricity boards (SEBs). For SEBs it made perfect sense as it amounted to cheap borrowing by the cash starved SEBs who had practically no other source of borrowing.
For leasing companies and others looking for a tax break, it was a perfect deal as there was 100% write off in case of assets costing Rs 5000 or less. Thus, an electric meter will qualify for 100% deduction. Several SEBs had undertaken such transactions in those days. Obvious enough the sole motive was tax deduction no one would care about the value, quality, existence etc of the meters. In some cases, the asset was bought on 30th March to be used only for a day, assets revalued heavily at the time of sale to leasing companies etc. Lease of non-existing assets such as electric meters, computers, glass bottles, tools, etc, lure of depreciation allowances caused the tax authorities to come down hard on sale and leaseback transactions calling them tax evading transactions. The whole fiasco of such sham transactions resulted in leasing going off the market completely. The burns of the past continue to linger even after a decade and half since SLB transactions were completely written off.
The most significant consideration in lease transactions is the depreciation claim. For tax purposes, depreciation is calculated on the block of the assets and not on the written down value of each asset separately.
Section 2(11) of the Income Tax Act, 1961 (IT Act) defines block of assets to mean
“”block of assets” means a group of assets falling within a class of assets comprising—
(a) tangible assets, being buildings, machinery, plant or furniture;
(b) intangible assets, being know-how, patents, copyrights, trade-marks, licences, franchises or any other business or commercial rights of similar nature, in respect of which the same percentage of depreciation is prescribed.”
The sale proceeds of the assets sold are deducted from the written down value of the block. In case of SLB transaction, assets are sold at higher than written down value, and the gain made on such a sale results in reduction in depreciable value of the block of assets. The reduction in depreciation will be allowed over a number of years. Similar would be the case in case the asset was sold at less than written down value, sale consideration would be reduced from the block of the assets.
Once the asset is sold and taken off the books of the lessee, the lessee is able to account for an immediate accounting profit without having to pay tax on it instantly. As under the block concept of depreciation, when the lessee sells the capital assets, the sale proceeds including the profits on sale are allowed to be deducted from the block of assets and hence there is no immediate tax on the accounting profits.
Also, typically the asset is recorded on historical costs which may be lower than the intrinsic value of the asset. SLB sometimes allows the entities to unlock the appreciation in value. However, it is not always necessary that the asset would have appreciated value. In some cases, the asset may have become junk completely.
To avoid the same revenue has introduced following provisions in the IT act, in order to restrict undue benefits being passed by use of sham SLB transactions:
Section 43 (1) provides for treatment of sale and lease back transactions for tax purposes, the relevant extracts are reproduced below –
“Explanation 3.—Where, before the date of acquisition by the assessee, the assets were at any time used by any other person for the purposes of his business or profession and the Assessing Officer is satisfied that the main purpose of the transfer of such assets, directly or indirectly to the assessee, was the reduction of a liability to income-tax (by claiming depreciation with reference to an enhanced cost), the actual cost to the assessee shall be such an amount as the Assessing Officer may, with the previous approval of the Joint Commissioner, determine having regard to all the circumstances of the case.”
“Explanation 4A.—Where before the date of acquisition by the assessee (hereinafter referred to as the first mentioned person), the assets were at any time used by any other person (hereinafter referred to as the second mentioned person) for the purposes of his business or profession and depreciation allowance has been claimed in respect of such assets in the case of the second mentioned person and such person acquires on lease, hire or otherwise assets from the first mentioned person, then, notwithstanding anything contained in Explanation 3, the actual cost of the transferred assets, in the case of first mentioned person, shall be the same as the written down value of the said assets at the time of transfer thereof by the second mentioned person.
Explanation 3 and 4A of Section 43 (1) restricts the consideration at which the lessor purchases the assets to written down value of the asset as appearing in the books of the lessee before it was sold and taken back on lease. The explanation explicitly states that the sale value for such sale and lease back transactions will be ignored and depreciation will be allowed on the first seller’s depreciated value. Take, for instance, A purchased machinery for Rs. 10 crores from B, though the WDV in the books of B is Rs. 2 crores. A can claim depreciation on Rs. 2 crores and not on Rs. 10 crores.
The said provisions removes any motivation for the lessor to carryout transactions at inflated values. Hence preventing junk financing to enter into SLB transactions.
Goods & Service Tax
Pre-GST indirect taxation regime acted as a major road block in the development of leasing industry as a whole, the legal differentiation as well as non-availability of credit among central and state taxes made leasing transactions costly.
Introduction of GST is playing a key role in development of leasing industry, from a stage where it had nearly become extinct. We have further discussed GST implications on leasing.
The Sale
The first leg of the transaction would involve sale of Assets by lessee to lessor.
In terms of section 7(1)(a) “all forms of supply of goods or services or both such as sale, transfer, barter, exchange, licence, rental, lease or disposal made or agreed to be made for a consideration by a person in the course or furtherance of business;”
The taxability under GST arises on the event of supply accordingly the sale of capital assets for a consideration would fall under the ambit of supply and accordingly GST shall be levied.
The Lease
The second part of transaction would lease back that is when the asset is leased back from buyer -lessor to seller lessee. The leaseback would be subject to GST like any other lease transaction.
The term lease has not been defined anywhere in GST Act or Rules. To classify a lease transaction as either supply of goods or supply of service, we have to refer Schedule II of the CGST Act, 2017 where in clear guidelines for classification of a transaction as either “supply of goods” or “supply of services” has been enumerated, based on certain parameters: –
- Any transfer of the title in goods is a supply of goods;
- Any transfer of right in goods or of undivided share in goods without the transfer of title thereof, is a supply of services;
- Any transfer of title in goods under an agreement which stipulates that property in goods shall pass at a future date upon payment of full consideration as agreed, is a supply of goods.
- Any lease, tenancy, easement, licence to occupy land is a supply of services;
- Any lease or letting out of the building including a commercial, industrial or residential complex for business or commerce, either wholly or partly, is a supply of services.
Place of supply
Undoubtedly, the SLBs do not involve movement of goods, the seller lessee continuous to be in possession of leased asset even after the sale. Hence, In the case of such sale, there is no physical movement of the asset from the premises of the lessee to the premises of the lessor. The ownership gets transferred in the premise of the lessee.
In terms of Section 10(1)(c) of the IGST Act, the place of supply of goods where the supply does not involve movement of the said goods whether by the supplier or the recipient shall be the location of such goods at the time of delivery to the recipient. Accordingly, the place of supply in this case will be same as the location of the supplier. Accordingly, the sale of the asset will be considered as an intra-state supply as per Section 8 of the IGST Act and will be subjected to CGST + SGST.
Disposal of Capital Asset
Applications of GST on disposal of capital assets is one of the major deterring factors of in SLBs. Section 18(6) of the CGST Act,2017 state that:
“In case of supply of capital goods or plant and machinery, on which input tax credit has been taken, the registered person shall pay an amount equal to the input tax credit taken on the said capital goods or plant and machinery reduced by such percentage points as may be prescribed or the tax on the transaction value of such capital goods or plant and machinery determined under section 15, whichever is higher:”
Entry no. (6) Of Rule 44 of CGST Rules, 2017: Manner of Reversal of ITC under Special Circumstances which reads as under: –
“The amount of input tax credit for the purposes of sub-section (6) of section 18 relating to capital goods shall be determined in the same manner as specified in clause (b) of sub-rule (1) and the amount shall be determined separately for input tax credit of central tax, State tax, Union territory tax and integrated tax:”
“……………..Clause (b) of sub rule 1 of same rules states that :
(b) for capital goods held in stock, the input tax credit involved in the remaining useful life in months shall be computed on pro-rata basis, taking the useful life as five years………….”
Generally, the lessor procures the capital Assets at WDV due to Income tax Act implication. In that case WDV as per Income tax act would be the transaction value.
Example of GST Calculations on Sale and Leasebacks
Let’s consider a numerical example: an Entity A enters into SLB arrangement with an Entity B. A sells its machinery to B for Rs. 5,00,000/- as on 31st May 2021. The entity had purchased the asset for Rs. 6,00,000/- as on 31st March 2019.
B then leases back the asset to A for a yearly rental of Rs, 1,00,000/- for 3 years term with a purchase option at the end of 4th year at Rs. 2,50,000. (Assumed to be exercised)
(GST @ 18%)
Sale of Asset
Disposal of assets
On disposal asset, GST will be charged on the selling price of the asset. However, the amount to be deposited to the government with respect to this sale transaction shall be higher of the following:
- GST on the sale consideration;
- ITC reversed on transfer of capital asset or plant and machinery based on the prescribed formula
Portion of ITC availed on the asset, attributable to the period during which the transferor used the asset:
6,00,000 * 18% * (5% * 8) = 43200
Remaining ITC = (6,00,000 * 18%) – 43200 = 64800
GST on the selling price = 500000 * 18% = 90000
Therefore, GST to be paid to the government is 90000, that is higher of the two amounts discussed above.
Leasing of asset
As mentioned above GST shall be chargeable to lease rental, at the rate similar to that charged on acquisition of leased asset. Accordingly, Entity B shall charge GST on rentals for an amount of Rs. 18,000/- (Rs. 1,00,000/- * 18%).
Further GST shall also be charged on sale of asset at the end of lease tenure for an amount of Rs. 45,000/-(2,50,000*18%).
Accounting of Sale and leasebacks
IAS 17 covered the accounting for a sale and leaseback transaction in considerable detail but only from the perspective of the seller-lessee.
As Ind AS 116/IFRS 16 has withdrawn the concepts of operating leases and finance leases from lessee accounting, the accounting requirement that the seller-lessee must apply to a sale and leaseback is more straight forward.
The graphic below shows how SLB transactions should be accounted for:
Criteria for Sale
IFRS 16/Ind AS 116 state that
“ An entity shall apply the requirements for determining when a performance obligation is satisfied in Ind AS 115 to determine whether the transfer of an asset is accounted for as a sale of that asset.”
Accordingly, when a seller-lessee has undertaken a sale and lease back transaction with a buyer-lessor, both the seller-lessee and the buyer-lessor must first determine whether the transfer qualifies as a sale. This determination is based on the requirements for satisfying a performance obligation in IFRS 15/Ind AS 115 – “Revenue from Contracts with Customers”.
The accounting treatment will vary depending on whether or not the transfer qualifies as a sale.
The para 38 of Ind AS 115/IFRS 15- Performance obligations satisfied at a point in time, provides ample guidance on determining whether the performance obligation is satisfied.
The para states that:
“If a performance obligation is not satisfied over time in accordance with paragraphs 35– 37, an entity satisfies the performance obligation at a point in time. To determine the point in time at which a customer obtains control of a promised asset and the entity satisfies a performance obligation, the entity shall consider the requirements for control in paragraphs 31–34. In addition, an entity shall consider indicators of the transfer of control, which include, but are not limited to, the following:
(a) The entity has a present right to payment for the asset—if a customer is presently obliged to pay for an asset, then that may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset in exchange.
(b) The customer has legal title to the asset—legal title may indicate which party to a contract has the ability to direct the use of, and obtain substantially all of the remaining benefits from, an asset or to restrict the access of other entities to those benefits. Therefore, the transfer of legal title of an asset may indicate that the customer has obtained control of the asset. If an entity retains legal title solely as protection against the customer’s failure to pay, those rights of the entity would not preclude the customer from obtaining control of an asset.
(c) The entity has transferred physical possession of the asset—the customer’s physical possession of an asset may indicate that the customer has the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset or to restrict the access of other entities to those benefits. However, physical possession may not coincide with control of an asset. For example, in some repurchase agreements and in some consignment arrangements, a customer or consignee may have physical possession of an asset that the entity controls. Conversely, in some bill-and-hold arrangements, the entity may have physical possession of an asset that the customer controls. Paragraphs B64–B76, B77–B78 and B79–B82 provide guidance on accounting for repurchase agreements, consignment arrangements and bill-and-hold arrangements, respectively.
(d) The customer has the significant risks and rewards of ownership of the asset—the transfer of the significant risks and rewards of ownership of an asset to the customer may indicate that the customer has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. However, when evaluating the risks and rewards of ownership of a promised asset, an entity shall exclude any risks that give rise to a separate performance obligation in addition to the performance obligation to transfer the asset. For example, an entity may have transferred control of an asset to a customer but not yet satisfied an additional performance obligation to provide maintenance services related to the transferred asset.
(e) The customer has accepted the asset—the customer’s acceptance of an asset may indicate that it has obtained the ability to direct the use of, and obtain substantially all of the remaining benefits from, the asset. To evaluate the effect of a contractual customer acceptance clause on when control of an asset is transferred, an entity shall consider the guidance in paragraphs B83–B86.”
It shall be noted that no single criteria can be taken as a determining factor for concluding that sale has taken place. Each criterion should be individually assessed every case. Needless to say, substance of the transaction should be adjudge based on principles set.
The criteria set out in the para 38 specified above can be summarised as follows:
- There is a present right to payment has been established.
- The legal tittle of the asset is transferred. It shall be noted that this shall not conclusively determine sale, rather a to be considered in consonance with another criterion.
- Physical possession of the asset has been transferred. Now this is a matter of discussion, as under SLB, the possession never leaves the seller. However, in our view even in case of symbolic transfer of possession the criterion can be said to be satisfied subject to the condition that buyer-lessor has an ability to direct the use of asset. Hence, an entity should ensure that the buyer-lessor is not bound by sale agreement or otherwise to leaseback the asset.
- Significant risk and reward attached to ownership are transferred to the buyer
- The buyer has accepted the asset
Transfer of asset does not qualify as sale
If the transfer does not qualify as a sale the parties account for it as a financing transaction. This means that:
- The seller-lessee continues to recognise the asset on its balance sheet as there is no sale. The seller-lessee accounts for proceeds from the sale and leaseback as a financial liability in accordance with Ind AS 109/IFRS 9. This arrangement is similar to a loan secured over the underlying asset – in other words a financing transaction
- The buyer-lessor has not purchased the underlying asset and therefore does not recognise the transferred asset on its balance sheet. Instead, the buyer-lessor accounts for the amounts paid to the seller-lessee as a financial asset in accordance with Ind AS 109/IFRS 9. From the perspective of the buyer-lessor also, this arrangement is a financing transaction.
Transfer of asset qualifies as sale
Where the transfer qualifies as sale, there can be further two situations:
- Sale at Fair value
- Sale at discount or premium.
Sale at Fair Value
If the transfer qualifies as a sale and is on fair value basis the seller-lessee effectively splits the previous carrying amount of the underlying asset into:
- a right-of-use asset arising from the leaseback, and
- the rights in the underlying asset retained by the buyer-lessor at the end of the leaseback.
The seller-lessee recognises a portion of the total gain or loss on the sale. The amount recognised is calculated by splitting the total gain or loss into:
- an unrecognised amount relating to the rights retained by the seller-lessee, and
- a recognised amount relating to the buyer-lessor’s rights in the underlying asset at the end of the leaseback.
The leaseback itself is then accounted for under the lessee accounting model.
The buyer-lessor accounts for the purchase in accordance with the applicable standards (eg IAS 16 ‘Property, Plant and Equipment’ if the asset is property, plant or equipment or IAS 40 ‘Investment Property’ if the property is investment property). The lease is then accounted for as either a finance lease or an operating lease using IFRS 16’s lessor accounting requirements.
Sale at a discount or premium
The accounting methodology shall remain the same, However, Adjustments would be required to provide for the discounted or premium price.
These adjustments would be as follows:
- a prepayment would be recorded in order to provide for adjustment in regard to sale at a discount
- Any amount paid in excess of fair value would be recorded as an additional financing facility and accounted for under Ind AS 109.
Example of Sale and Leaseback Accounting under Ind AS 109
A sample spreadsheet calculations for the below example can be accessed here
Calculations
| Particular | Amount | Remarks |
| Sale considerations | ₹ 10,00,000.00 | |
| Carrying Amount | ₹ 5,00,000.00 | |
| Term | 15 | year |
| Rentals/year | ₹ 80,000.00 | year |
| Fair Value of Building | ₹ 9,00,000.00 | |
| Incremental borrowing rate | 10% | |
| PV of rentals | ₹ 6,08,486.36 | |
| Additional Financing | ₹ 1,00,000.00 | Sale Consideration – Fair Value |
| Payments towards Lease Rentals | ₹ 5,08,486.36 | PV of Rentals – Additional Financing |
| Ratio of PV of rentals and Payment towards lease Rentals |
16% | |
| Yearly payments towards Add. Financing | ₹ 13,147.38 | Rental X Ratio |
| Yearly payments towards Lease Rental | ₹ 66,852.62 | Rental – Payment toward Add. Fin. |
| ROU of Asset | ₹ 2,82,492.42 | Carrying Amount X [Payments towards Lease Rentals/Fair Value of Building] |
| Total Gain on sale | ₹ 4,00,000.00 | Fair Value – Carrying Amount |
| Gain recognised Upfront | ₹ 1,74,006.06 | Total Gain X [(Fair Value of Building-Payments towards Lease Rentals) /Fair Value of Building] |
Rental Schedule
| NPV | NPV | |
| ₹ 5,08,486.36 | ₹ 1,00,000.00 | |
| Year | Lease Rentals | Additional Financing |
| 0 | ||
| 1 | ₹ 66,852.62 | ₹ 13,147.38 |
| 2 | ₹ 66,852.62 | ₹ 13,147.38 |
| 3 | ₹ 66,852.62 | ₹ 13,147.38 |
| 4 | ₹ 66,852.62 | ₹ 13,147.38 |
| 5 | ₹ 66,852.62 | ₹ 13,147.38 |
| 6 | ₹ 66,852.62 | ₹ 13,147.38 |
| 7 | ₹ 66,852.62 | ₹ 13,147.38 |
| 8 | ₹ 66,852.62 | ₹ 13,147.38 |
| 9 | ₹ 66,852.62 | ₹ 13,147.38 |
| 10 | ₹ 66,852.62 | ₹ 13,147.38 |
| 11 | ₹ 66,852.62 | ₹ 13,147.38 |
| 12 | ₹ 66,852.62 | ₹ 13,147.38 |
| 13 | ₹ 66,852.62 | ₹ 13,147.38 |
| 14 | ₹ 66,852.62 | ₹ 13,147.38 |
| 15 | ₹ 66,852.62 | ₹ 13,147.38 |
Accounting Entries at Inception
| Buyer-Lessor | ||
| Building | ₹ 9,00,000.00 | |
| Financial Asset | ₹ 1,00,000.00 | |
| Bank | ₹ 10,00,000.00 | |
| *Lease accounted as per Finance or operating lease accounting | ||
| Seller-Lessee | ||
| Bank | ₹ 10,00,000.00 | |
| ROU | ₹ 2,82,492.42 | |
| Building | ₹ 5,00,000.00 | |
| Financial Liability | ₹ 6,08,486.36 | |
| Gains on Asset Transfer | ₹ 1,74,006.06 | |
[1] 435 U.S. 561 (1978)
Re-appointment of Independent Directors: An Analysis
Sharon Pinto, Manager, corplaw@vinodkothari.com
Introduction
Proxy advisors are entities that undertake research on corporate governance norms and practices followed across different corporates. They formulate their policies based on their research and appropriately established benchmarks. The proxy advisory firms play a role in strengthening the corporate governance as investor clients access the reports and recommendation of the said advisory firms while forming their opinions. As investors due to their vast shareholding may not be privy to the working of the company, they may rely on the analysis done by the proxy advisors and their recommendations. We have discussed the scope of guidelines issued by proxy advisors in a separate article[1].
While such reports and guidelines as mentioned above can act as a guidance for the investors to take a sound decision, the legal standing of the report can be considered a hiccup in the said process as the same does not obtain regulatory approval. We have discussed the scope and legal validity of such guidelines in a separate article.[2]
One such guideline has been issued w.r.t. re-appointment of Independent Directors under Section 149 (10) of the Companies Act, 2013 (‘the Act’). The said contention has been a question of interpretation with different practices being followed by various companies. In this article we have discussed the interpretation of the said provision while stating the process of re-appointment of Independent Directors (‘IDs’).
Pre-requisites for appointment of IDs
Section 149 (6) of the Act read with Rule 5 of the Companies (Appointment & Qualification of Director) Rules, 2014 states the criteria that shall determine the independence of the director proposed to be appointed. In case of an entity with its specified securities listed on the stock exchange, the conditions set forth by Regulation 16 (1) (b) of SEBI (Listing Obligation and Disclosure Requirements) Regulations (‘SEBI Regulations’) shall also be fulfilled in order to be eligible for appointment as an ID. The said provisions under the Act and SEBI Regulations entail certain pecuniary limits which are necessary to ascertain any monetary relationship of the director with the company, which may affect their independence. As the given criteria is a pre-requisite at the time of appointment of a director, it shall also be mandatory to be fulfilled at the time of re-appointment. Thus, if an ID continues to be eligible as per the said conditions, they shall be proposed to be re-appointed for a second term in the company.
Pursuant to the SEBI (Listing Obligation and Disclosure Requirements), 2021 (Third Amendment Regulations), the criteria of independence prescribed under Regulation 16 (1) (b) has been revised aligning the same with the provisions of the Act. However, while the Act provides for the period of 2 immediately preceding financial years for determining whether the person or his relatives have any material pecuniary relationship with the company, the revised SEBI Regulations now prescribe for a period of 3 immediately preceding financial years for determination of the same.
Further, the conditions prescribed under the Act relating to holding of any interest or security, indebtedness, any guarantee or security provided in connection to indebtedness of a third person or any other pecuniary relationship with the company or its holding or subsidiary or associate company have also been inserted in the SEBI Regulations, which provide for stricter period of compliance of the said conditions. While, the relatives may be employees in the entities stated above, they are prohibited from holding the position of a KMP. As the criteria of independence is to be observed even in the case of re-appointment, these conditions will ensure the independence of the ID.
In addition to the criteria of independence, the existing IDs of the company are required to abide by the code of conduct prescribed under Schedule IV of the Act. Any breach of the code by the directors shall make them ineligible for continuing in the position of ID of the company.
Performance Evaluation
The re-appointment of an existing director for a second term, in addition with the establishment of their independence shall also be subject to performance evaluation. The Act under Section 178 (2) states that the Nomination and Remuneration Committee (‘NRC’) of the company shall formulate a criteria for determining the qualifications, positive attributes, independence for appointment of a director. Further the committee shall also establish a criteria for the evaluation of performance of the Board as well as individual directors. Thus on the basis of such performance evaluation and establishment of independence and possession of requisite skills by the director, the NRC shall recommend the appointment or in case of an existing director, re-appointment of the said director to the Board.
SEBI[3] has detailed an elaborated process to be followed by NRC for selection of ID, including more transparent and enhanced disclosures regarding the skills required for appointment as an ID and how the proposed candidate fits into that skillset. As per the Third Amendment Regulations, the said additional disclosures stating the skills and capabilities required for the role and the manner in which the proposed person meets the requirements, will be required to be provided in the notice in the case of re-appointment of an ID. Thus, NRC of the company will be required to undertake an assessment determining whether the person proposed to be re-appointed as the ID possesses the skills required for the position in addition to performance evaluation even in the case of re-appointment.
SEBI under Regulation 17 (10) of the SEBI Regulations has stated that the performance evaluation of the IDs shall be done by the entire Board of Directors where the concerned ID shall not participate in the said discussion. The Board shall consider performance of the director in addition to fulfilment of independence criteria similar to the provisions stipulated under Companies Act, 2013 as discussed above. Thus the director proposed to be re-appointed has to satisfy the afore-mentioned dual conditions.
Process of re-appointment
Section 149 (10) of the Act has specified the process of reappointment of an ID. It states that a director shall be eligible for re-appointment by passing of a special resolution. Thus we may infer that in order to be re-appointed as an ID, a special resolution is required to be passed. Regulation 17 (11) of SEBI Regulations provides for stating recommendation of the Board for every for every special item of business in the explanatory statement annexed to the notice. As discussed above, Board on the basis of performance evaluation carried out and the recommendation of the NRC shall recommend the re-appointment of the ID. Criteria of independence being a pre-requisite for such re-appointment as established herein, the director shall be considered as an additional independent director until approval of shareholders is obtained at the general meeting of the Company.
Further, SEBI vide its consultation paper on Independent Directors[4] had proposed prior approval of shareholders for appointment and re-appointment of IDs, while stating that the existing procedure entails proposal of candidate by the NRC and appointment/re-appointment by Board which is subsequently approved by shareholders by an ordinary resolution in case of appointment whereas special resolution in case of re-appointment. Accordingly, seeking prior approval of shareholders is not a pre-requisite at present.
After end of first tenure of the ID, the office of director shall cease. Accordingly, Board will approve appointment as additional director till ensuing AGM and propose re-appointment as an ID for second term of upto 5 consecutive years.
As discussed above, re-appointment after the end of the tenure is required to be considered akin to fresh appointment of the person, thereby necessitating the confirmation with criteria of independence, assessment of skills and capabilities and the manner in which such appointee continues to meet the requirements of the company. Therefore, the Board has a power to appoint the person as an additional ID, whose appointment shall thereafter be approved at the general meeting.
Timeline for re-appointment
In order to understand the timeline in the case of re-appointment, we will have to consider the revised Regulation 17(1C) SEBI Regulations. Regulation 17 (1C) provides for approval of appointment of a person as a director of the company to be done within the next general meeting or 3 months, whichever is earlier. Since, re-appointment on account of end of term results into fresh appointment, the same shall also apply in case of re-appointment of an ID. Further, Regulation 25 (2A) has now provided for a special resolution to be obtained in case of appointment as well as re-appointment. The same prescribes for the mode of obtaining approval but is silent on the timeline, to be followed, requiring reference to Regulation 17 (1C). For a better understanding of the same, let us look at the following cases.
Case 1: Re-appointment of a person as an ID before the end of his/her tenure:
- The NRC of the company will be required to follow the due process for evaluation of the person for re-appointment as stipulated under the revised provisions and recommend the same to the Board.
- The Board will thereafter confirm on the skills and capabilities as required for the position and that the proposed appointee possesses the same and provide disclosure of the same to the shareholders in the notice for re-appointment.
- At the ensuing general meeting the company may re-appoint the person as ID for a second term by passing a special resolution with effect from the date immediately following the last day of the current tenure.
Case 2: Re-appointment of a person as an ID post the end of tenure:
- Since the tenure of the ID has been terminated, the office of the ID will stand vacated and the Board will be required to appoint the person as an Additional Director (Non-executive, ID category).
- The process as mentioned under points a & b above in relation to assessment of the candidate and requisite disclosures to be done will be required to be followed.
- As per Regulation 17(1C), shareholder approval for the re-appointment will be required to be obtained within 3 months of appointment by the Board as an additional ID or next general meeting, whichever is earlier.
Effect of re-appointment by the Board
The provisions of the Act mandate the shareholders to approve appointment of IDs at general meeting but does not mandate appointment from the date of general meeting. ‘Independent Director’ is the nature of directorship and ‘Additional Director, Non-Executive’ is the category of directorship. It cannot be inferred that the said director was not independent from the date of Board resolution appointing him as Additional Director till the date of general meeting. Therefore, the effective date of appointment can be considered from the date of Board resolution or any subsequent date prescribed by the Board.
The recent changes in the provisions as stated above will result in reducing the gap between appointment of an ID on the Board of the company and approval of the said appointment by shareholders. While it is seen that some companies take up the re-appointment of the IDs by way of postal ballot before the end of tenure in case there exists a gap between the AGM and the end of term, the same shall be construed as a good governance practice, as prior approval of shareholders has not been mandated by law on account of the same not being specifically stated. Thus in case of re-appointment post end of tenure, the same cannot be viewed as a violation of provisions.
Conclusion
The ambit of proxy advisors in India is as prescribed under SEBI regulations and guidelines issued in this regard. While they may issue guidelines based on the best governance practices as established by them and recommend the same to the investors, there is a need to incorporate a check for discerning the nature and scope of such guidelines, so the investor may have a clear view of the propositions put forth. With the process of appointment of IDs being enhanced in the manner specified above, in addition to the newly inserted disclosure requirements, will make the appointment/re-appointment process of IDs more transparent and effective while ensuring greater conformity of their independence.
Related presentation – https://vinodkothari.com/2021/08/ensuring-board-continuity-and-balance-of-capabilities/
[1] https://vinodkothari.com/2021/06/scope-of-proxy-advisors-to-issue-general-voting-guidelines/
[2] https://vinodkothari.com/2021/07/proxy-advisors-corporate-decision-making/
[3] https://www.sebi.gov.in/media/press-releases/jun-2021/sebi-board-meeting_50771.html
[4]https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html
Scope of Proxy Advisors to issue general voting guidelines
Sharon Pinto, Manager, corplaw@vinodkothari.com
Introduction
The right to vote on decisions of the Company is one of the most significant rights of the investors. Proxy advisors are entities that enable shareholders to function this right effectively. They undertake research on corporate governance practices across various entities and formulate their policies in order to establish benchmarks of the best practices. Based on the said benchmarks, the proxy advisors also provide voting recommendations to the client investors. SEBI had formulated a working group[1] for determining issues relating to proxy advisors in November, 2018 and reviewing the existing provisions of SEBI (Research Analysts) Regulations, 2014 (‘SEBI Regulations’), that govern proxy advisory entities in India.
We have in our previous articles deliberated the concept of proxy advisors and their role in corporate democracy[2] as well as analysed the above-mentioned report of the working group[3] [4]. In recent times, there has been huge hue and cry regarding the certain voting recommendations put forth by proxy advisors. As the advisors have significant influence over institutional investors and may thus affect the voting results, it is necessary to understand the legal ambit of such guidelines and recommendations issued by these entities.
In this article we have discussed the scope of proxy advisors while ascertaining the legal validity of their opinions. The guidelines issued on re-appointment of ID have been discussed in a separate article.
Scope of Proxy Advisors
- International practices
1.USA
Investment advisors are required to be registered with the United States Securities and Exchange Commission (‘SEC’) under the Investment Adviser Act of 1940 and Rules[5] made thereunder. Rule 204A-1 of the said Act has prescribed that the investment advisors establish, maintain and enforce a written code of ethics that, at a minimum, includes:
“(1) A standard (or standards) of business conduct that you require of your supervised persons, which standard must reflect your fiduciary obligations and those of your supervised persons;
(2) Provisions requiring your supervised persons to comply with applicable Federal securities laws;
(3) Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically as provided below;
(4) Provisions requiring supervised persons to report any violations of your code of ethics promptly to your chief compliance officer or, provided your chief compliance officer also receives reports of all violations, to other persons you designate in your code of ethics; and
(5) Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.”
Institutional Shareholder Services (‘ISS’) is a registered investment advisor which provides general proxy voting guidelines[6] on various resolutions put forth at the meetings of investors. However, the following disclaimer forms part of the document:
“The Information has not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), or a promotion or recommendation of, any security, financial product or other investment vehicle or any trading strategy, and ISS does not endorse, approve, or otherwise express any opinion regarding any issuer, securities, financial products or instruments or trading strategies.”
Similar guidelines and policies have been issued by Glass Lewis & Co.[7] stating that these proxy voting guidelines are grounded in corporate governance best practices, which often exceed minimum legal requirements. Accordingly, unless specifically noted otherwise, a failure to meet these guidelines should not be understood to mean that the company or individual involved has failed to meet applicable legal requirements.
- Australia
Proxy advisers in Australia hold Australian financial services (AFS) licenses for only a portion of the services they provide – giving advice to wholesale investors on votes that relate to dealings in financial products. Providing voting recommendations on other matters (such as director elections and remuneration reports) does not require an AFS licence.
Further, as per the provisions of Section 912A of the Corporations Act, 2001 proxy advisors shall:
- do all things necessary to ensure that the financial services are provided efficiently, honestly and fairly;
- have adequate arrangements in place for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken in the provision of financial services;
- have adequate resources (including financial, technological and human resources) to provide the financial services and to carry out supervisory arrangements;
- maintain the competence to provide those financial services.
ASIC in its ‘Review of proxy advisor engagement practices’[8] has stated that a draft report shall be provided to the Company for fact-checking or where clarification is sought from the company, proxy advisers should endeavour to provide sufficient time for the company to consider the request and respond. Further, if it is intended that a draft report will be provided to the subject company, proxy advisers may wish to consider doing this in a controlled way, for example, without communicating recommendations or opinions that would be included in the final report. This may reduce disagreements between proxy advisers and companies as to whether errors reported by companies relate to fact or opinion. In case proxy advisors propose to recommend ‘against’ recommendations, ASIC has recommended that they shall notify companies of such recommendations and explain the reasons for those recommendations, to assist companies in understanding concerns held by the proxy adviser and responding to investors in the context of those concerns.
Further, proxy advisors are recommended to disclose the following in their reports:
- the nature, extent and outcome of engagement with the subject company;
- a summary of the subject company’s view on a particular issue where that view is different from the proxy adviser’s, or any additional information that has been provided by the company as a result of engagement.
At present, there is no prior engagement of the proxy advisors with the client. Similar provisions have been stated under SEBI Regulations and procedural guidelines which are applicable to proxy advisors operating in India, which state that the report shall be provided to the company and the client at the same time.
However, as per the consultation paper issued by The Treasury in April 2021[9], it has been recommended that the proxy advisors in Australia shall provide the report to the corporate entities prior to issuing of the same to clients. Further, communication with the company prior to issue of report in order to diminish any factual errors or mis-interpretation has also been proposed.
- Europe
The discussion paper on proxy advisory industry[10] issued by European Securities and Market Authority (ESMA), state that European proxy advisors generally tend not to develop their own guidelines but follow client’s policies or general recommendations. The voting policies and guidelines prepared are based on the relevant corporate governance standards. In the majority of cases these policies are usually formulated through a bottom-up process where information is collected from a diverse range of market participants (including issuers) through multiple channels. This policy can be fully adapted to local circumstances in a given country, or can incorporate more general beliefs about what constitutes good governance. Corporate governance codes, listing rules, company law, local regulations, new market trends, practices and academic research are used to create a set of guidelines against which corporate disclosures can be benchmarked. Moreover, it is a common practice for proxy advisors to integrate feedback from clients and, if available, issuers.
It further states that, certain proxy advisor may hold roundtables with various industry groups or other experts are also a way of receiving information and hearing different perspectives. Some proxy advisors are open for discussion about their policies and guidelines throughout the year while others are only open for discussion after the general meeting session. Proxy advisors, have to make sure voting policies and guidelines are sufficiently flexible to be applicable to the circumstances of each jurisdiction, sector and issuer. There may be issues arising on the accuracy, independence and reliability of the ultimate voting recommendations/proxy advice.
- United Kingdom
Proxy advisors that have their registered office or head office in United Kingdom or European Economic Area or in Gibraltar or provide proxy advisor services through an establishment located in the United Kingdom, are governed by the Proxy Advisors (Shareholders’ Rights) Regulations, 2019[11].
Following are the some of the provisions prescribed under the said regulations:
- Where proxy advisors provide services in accordance with a code of conduct, they shall disclose the following:
- a reference to the code of conduct, by means of which any person may readily view it;
- a report on the manner in which the code of conduct has been applied; and
- in case of any deviation from any of the recommendations contained in the code of conduct, a statement which specifies the recommendations concerned, explains the reason for departing from them, and indicates any measures adopted instead of them.
Further, where the proxy advisors where no such code of conduct has been adopted, the proxy advisors must provide a clear and reasonable explanation for not doing so.
- The proxy advisors are also required to provide the following disclosure w.r.t. assurance about accuracy and reliability of information:
- the essential features of the methodologies and models applied for the provision of those services;
- the main sources of information used for the provision of those services;
- the procedures put in place to ensure that firm’s research, advice and voting recommendations are of an adequate quality and are prepared by staff who are suitably qualified to prepare them;
- whether national market, legal, regulatory and company-specific conditions have been taken into account, if yes how;
- the essential features of the voting policies applied for each market;
- whether there is a dialogue with the company which is the object of research, advice or voting recommendations, or with persons who have a stake in that company, if yes, the extent and nature of the dialogue; and
- policy regarding the prevention and management of potential conflicts of interest.
- Functioning of proxy advisors in India
Proxy advisors are governed by SEBI Regulations. The entities functioning as proxy advisors or research analysts are required to obtain a certificate of registration from the Board under these regulations. The regulations have stipulated the following w.r.t. contents of the report published by the advisory firms:
- Research analyst or research entity shall take steps to ensure that facts in its research reports are based on reliable information and shall define the terms used in making recommendations, and these terms shall be consistently used.
- Research analyst or research entity that employs a rating system must clearly define the meaning of each such rating including the time horizon and benchmarks on which a rating is based.
- If a research report contains either a rating or price target for subject company’s securities and the research analyst or research entity has assigned a rating or price target to the securities for at least one year, such research report shall also provide the graph of daily closing price of such securities for the period assigned or for a three-year period, whichever is shorter.
Further, the procedural guidelines issued by SEBI for proxy advisors[12] states that the report of the proxy advisors shall be shared with its clients and the company at the same time. The timeline for receiving comments from the Company may be defined by the proxy advisors and all comments/clarifications received from the company, within timeline, shall be included as an addendum to the report. It also states that if the company has a different viewpoint on the recommendations stated in the report of the proxy advisors, then proxy advisors, after taking into account the said viewpoint, may either revise the recommendation in the addendum report or issue an addendum to the report with its remarks, as considered appropriate.
Similar to the regulatory provisions in USA, the proxy advisors registered in with SEBI shall abide by the code of conduct prescribed under Regulation 24 of SEBI Regulations.
As the views of proxy advisors are based on the best corporate governance practices and research thereon, they are required to clearly disclose in their recommendations the legal requirement vis-a-vis higher standard they are suggesting if any, and the rationale behind the recommendation of higher standards.
Legal position of guidelines issued by proxy advisors
- Research oriented
Proxy advisors undertake extensive research of the corporates to determine and set benchmarks. As evident from the global scenario and the working of proxy advisors in India as discussed above, one can opine that such guidelines are formed on the basis of the research undertaken by the said entities.
2.Interpretation of law
The said guidelines are a manifestation of the best governance practices that the companies may strive to achieve, which may at times exceed the prescribed legal requirements. They form the basis of opinions of the proxy advisory firms and are specifically the views of the issuing firms. Thus, the opinions of the advisory firms may be subject to other interpretations.
3.Generality of policies
Due to the generality of the guidelines issued, certain factual or practical factors may not be considered if the said guidelines are applied to the agenda items of various companies. The case to case specific factors, company or director backgrounds, etc may not be considered while applying the policies and hence may not depict a comprehensive view of the decision of the company.
4. Lack of overview by regulator
Since, these guidelines are not subject to approval of regulators, they are solely the opinions of the proxy advisory firms. Hence, a deviation from these guidelines cannot be construed as non-compliance of the prescribed laws. There is thus a need for including a statement to the said effect to establish a comprehensive standing of the recommendation or guidelines issued.
Safeguards against misleading statements
The procedural guidelines[13] issued by SEBI state that in case the proxy advisors have provided their recommendation based on higher standard, the rationale and such higher standard along with the legal requirement shall be clearly stated in the report published. Further, they shall provide their to the clients and the company simultaneously and are required to add as an addendum to their report, the comments and clarification received by the company in case of difference of opinions.
The report of the Working Group stated above recommended that if the proxy advisors have a different interpretation from the company and the same is not on the basis of factual errors, the proxy advisors are not obligated to publish both view-points, in case the company has enough resources to publish their response.
In case of any dispute arising between the proxy advisor and the corporate, which is a violation of the code of conduct prescribed under the SEBI (Research Analyst) Regulations, 2014, the same may be referred to SEBI. However, the same shall not be a means to refute the interpretation of the proxy advisor, rather only cases of misuse of power in violation of the said code of conduct can be reported to SEBI. However, there is no statutory requirement prescribed for including a disclaimer in the report of the proxy advisor stating that the views mentioned in the report are solely of the advisory firm and there may exist other interpretations as the said report is not sanctioned by any regulator.
Conclusion
It is necessary that the investors take an independent view bearing into mind the scope of the guidelines while considering the voting recommendations of the proxy advisors. They must also be aware of the scope of policies issued by the advisory firms. While the concept of proxy advisors acts as a tool for strengthening corporate governance and enabling investors to take sound investment decisions, there is a need for establishing better safeguards for portraying a clear picture to the investors so that they may formulate independent views.
[1]https://www.sebi.gov.in/reports/reports/jul-2019/report-of-working-group-on-issues-concerning-proxy-advisors-seeking-public-comments_43710.html
[2]https://vinodkothari.com/wp-content/uploads/2017/03/Dance_of_Corporate_democracy-_rise_of_proxy_advisors-1.pdf
[3] https://vinodkothari.com/wp-content/uploads/2020/08/SEBI-prescribes-stricter-regime-for-proxy-advisors.pdf
[4]https://vinodkothari.com/wp-content/uploads/2019/08/SEBI-revisits-the-regulatory-framework-for-Proxy-Advisors.pdf
[5]https://www.ecfr.gov/cgi-bin/text-idx?SID=e0ff318417c1a2b70a9ea2ce5f0307aa&mc=true&node=pt17.5.275&rgn=div5
[6] https://www.issgovernance.com/file/policy/active/asiapacific/Asia-Pacific-Regional-Voting-Guidelines.pdf
[7] https://www.glasslewis.com/wp-content/uploads/2020/11/US-Voting-Guidelines-GL.pdf?hsCtaTracking=7c712e31-24fb-4a3a-b396-9e8568fa0685%7C86255695-f1f4-47cb-8dc0-e919a9a5cf5b
[8] https://www.asic.gov.au/media/4778954/rep578-published-27-june-2018.pdf
[9] https://treasury.gov.au/sites/default/files/2021-04/c2021-169360_consultation_paper.pdf
[10] https://www.esma.europa.eu/sites/default/files/library/2015/11/2012-212.pdf
[11] https://www.legislation.gov.uk/uksi/2019/926/made
[12] https://www.sebi.gov.in/legal/circulars/aug-2020/procedural-guidelines-for-proxy-advisors_47250.html
[13] https://www.sebi.gov.in/legal/circulars/aug-2020/procedural-guidelines-for-proxy-advisors_47250.html
Dividend restrictions on NBFCs
– Financial Services Division (finserv@vinodkothari.com)
As regards NBFC-ND-NSI, the applicable regulatory capital requirement, as mentioned in Annex I[4] of the Notification, seems to suggest that if there is a breach of leverage ratio at any time since 2015, the NBFC is disqualified. This however, does not seem to be the intent of the regulator. The meaning of the aforesaid restriction should be that the provision became applicable from 2015; however, it should not be leading to a conclusion that a dividend distribution will ensure that there is no breach of leverage ratio at any time in the history of the said NBFC. We are of the view that each of the ratios (CRAR or Leverage of Adjusted Net worth, as the case may be) need to be observed ideally at the time of distribution (last three FYs including the year for which dividend is declared), and even conservatively, during the year in question.
*The Notification has prescribed the same limits on quantum for a certain class of NBFCs, however, the draft guidelines had prescribed the limits based on the CRAR or adjusted net-worth of the NBFCs. (Refer Annex I of draft guidelines)
Background
The Reserve Bank of India (RBI) vide a notification dated 24th June, 2021[1] imposed restrictions on distribution of dividends by non-banking financial companies (‘Notification’). The restrictions cover both systemically important NBFCs as well non-systemically important ones. The guidelines have been issued in line with the draft guidelines for the declaration of dividends by NBFC issued in December 2020. Restrictions on dividend payout essentially force financial sector entities to plough back a minimal part of their profits, and therefore, result in creation of a profit conservation. Such restrictions are common in case of financial institutions world-over, and are also imbibed as a part of Basel III capital adequacy requirements. Similar restrictions exist in case of banking entities[2]. In case of NBFCs, such restrictions were proposed by the RBI vide Draft Circular on Declaration of Dividend by NBFCs dated December 9, 2020[3]. Dividend Payout Ratio (DP Ratio) is an important policy measure for companies for shareholder wealth maximisation. A conservative dividend distribution policy ensures churning of profits thereby ensuring organic growth of the net worth, and assisted by leverage, a return on shareholders’ funds higher than what the shareholders can fetch on distributed money. On the other hand, aggressive dividend distribution policy entails that profits be returned to the shareholders as there are less business investment opportunities, thus wealth of shareholders be returned. The foregoing arguments does not encompass stictict dividend payout criteria, but a broad policy objective which organisations seek to achieve. However, in the case of financial institutions like Banks and NBFCs the motivation of regulators to limit the dividend payout is from the perspective of prudential regulation. The limit on dividend distribution allows regulators to ensure that adequate capital conservation buffers are maintained at all times by the financial institutions. Most NBFCs follow very conservative dividend policies, and based on publicly available data, the DP Ratios of some of the NBFCs for FY 2019-20 are as follows:- Manappuram- 18.86%
- Cholamandalam- 12.78%
- Bajaj Finserv- 11.93%
- Muthoot Finance- 19.91%
- Tata Capital Financial Services- 32.96%
- DCM Shriram- 17.19%
Applicability
Who all are covered? The opening statement of the Notification provides that the Notification is applicable on all NBFCs regulated by RBI. Further, reference is made to the term ‘Applicable NBFCs’ as defined under the respective RBI Master Directions on NBFC-ND-SI and NBFC-ND-NSI. The concept of Applicable NBFC is relevant to determine the applicability of the provisions of the aforesaid RBI Master Directions. Accordingly, it can be understood that, along with the ‘Applicable NBFCs’, the following categories of NBFCs shall be covered under the ambit of the Notification-- Housing Finance Companies (HFCs),
- Core Investment Companies (CICs),
- Government NBFCs,
- Mortgage Guarantee Companies,
- Standalone Primary Dealers (SPDs),
- NBFC-Peer to Peer Lending Platform (NBFC-P2P)
- NBFC- Account Aggregator (NBFC-AA).
- NBFC-D (deposit taking NBFCs)
- NBFCs-ND (non-deposit taking NBFCs) (both SI and NSI)
- NBFC-Factor (both SI and NSI)
- NBFC-MFI (both SI and NSI)
- NBFC-IFC (both SI and NSI)
- IDF-NBFC
Computation of dividend payout ratio:
Besides the upfront conditionalities such as capital adequacy ratio, leverage ratio, etc., the stance of the present Notification is limitation on dividend payout ratio. Hence, the meaning of the DP ratio becomes important. The Notification defines the same as : ‘the ratio between the amount of the dividend payable in a year and the net profit as per the audited financial statements for the financial year for which the dividend is proposed.’ As we discussed elsewhere, the word “dividend” shall be restricted to only equity and CCPS dividend. Hence, dividend on redeemable preference shares shall be excluded. Also note that the word “profit for the year” refers to profits after tax. There is no question of adding the brought forward profits of earlier years, whether parked in reserves or retained as surplus in the profit and loss account. In case of companies adopting IndAS, there are always questions on what constitutes distributable profits – whether the gains or losses on fair valuation, taken to P/L are a part of the distributable profits or not. The relevant provisions of the Companies Act, viz., proviso to sec. 123 (1) shall have to be borne in mind.Eligibility Requirement and Quantum Restrictions
| Category | Eligibility Requirement | Quantum* |
| NBFCs (including SDPs) meeting prudential requirements | ● Complies with applicable regulatory capital adequacy requirements/leverage restrictions/Adjusted net-worth for each of the last three financial years including the financial year for which the dividend is proposed
○ For SPDs, minimum CRAR of 20% to be maintained for the financial year for which dividend is proposed. ● Net NPA ratio shall be less than 6% in each of the last three years, including as at the close of the financial year for which dividend is proposed to be declared.○ Calculation of NNPA ● Complies with the provisions of Section 45 IC of the RBI Act/ Section 29 C of the NHB Act, as the case may be, that is to say, has transferred 20% of its net profits to the regulatory reserve fund ● No explicit restrictions placed by the regulator on declaration of dividend |
● Type I NBFCs- No limit● CICs and SPDs- 60% ● Other NBFCs- 50% |
| NBFCs (other than SPDs) not meeting prudential requirements | ● Complies with the applicable capital adequacy requirements/ leverage restrictions in the financial year for which dividend is proposed to be paid● Has net NPA of less than 4% as at the close of the financial year. | 10% |
Reporting Requirements
NBFC-D, NBFC-ND-SIs, HFCs & CICs declaring dividend shall report details of dividend declared during the financial year as per the prescribed format within a fortnight after declaration of dividend to the Regional Office of the RBI/Department of Supervision of NHB, as the case may be. There seems to be a lack of clarity w.r.t. the disclosure requirement for NBFC-MFIs and NBFC-IDFs. Though they are covered under the definition of ‘Applicable NBFCs’ under the RBI Master Directions, however, they are not generally classified as NBFC-ND-SI. Hence, whether the disclosure requirement is applicable to them or not seems to create confusion. In our view, going by prudence, this must be adhered to by such systemically important MFI and IDFs as well. Accordingly, it can be inferred that the disclosure requirements shall not be applicable to following:- Mortgage Guarantee Companies,
- Standalone Primary Dealers (SPDs),
- NBFC-Peer to Peer Lending Platform (NBFC-P2P)
- NBFC- Account Aggregator (NBFC-AA).
- NBFCs-ND-NSIs
Comparison with the dividend regulations on Banks
| Criteria | Bank | NBFCs |
| Eligibility | Only those banks would be eligible to declare dividends who have a CRAR of at least 9% for preceding two completed financial years and the accounting year for which it proposes to declare dividend and Net NPA less than 7% | NBFC-ND-NSI with leverage upto 7 times and NBFC-ND-SI with a CRAR of not less than 15% for last three years (including the FY for which dividend is declared) and Net NPA less than 6% in each of the last three years |
| In case not meeting eligibility | In case any bank does not meet the above CRAR norm, but has a CRAR of at least 9% for the accounting year for which it proposes to declare dividend, it would be eligible to declare dividend provided its Net NPA ratio is less than 5% | In case any NBFC does not meet the above eligibility criteria for each of the previous three FY, but meets the capital adequacy for the accounting year, for which it proposes to declare dividend and has a Net NPA ratio of less than 4% at the close of the FY, it shall be allowed to declare dividend, subject to a maximum of 10% on the DP ratio. |
| Quantum | Dividend payout ratio shall not exceed 40 % and shall be as per the prescribed matrix | CIC’s and SPDs shall ensure the maximum dividend payout ratio does not exceed 60%, while the other NBFCs shall not exceed 50% of the DP ratio. For Type I NBFCs there is no limit. |
| Reporting | All banks declaring dividends should report details of dividend declared during the accounting year as per the proforma furnished by RBI | NBFC-Ds, NBFC-ND-SIs, HFCs & CICs declaring dividend should report the details of dividend within a fortnight after declaration of dividend to RBI/NHB, as may be applicable. |
Immediate Actionables
NBFCs, who already have a Dividend Distribution Policy in place, may have to amend the policy in line with the Notification. As per SEBI LODR Regulations, top 1000 listed companies are mandatorily required to have a dividend distribution policy. Further, NBFCs may also have voluntarily adopted a policy. The dividend distribution policy includes the following parameters:- the circumstances under which the shareholders may or may not expect dividend;
- the financial parameters that shall be considered while declaring dividend;
- internal and external factors that shall be considered for declaration of dividend;
- policy as to how the retained earnings shall be utilized; and
- parameters that shall be adopted with regard to various classes of shares
