18 November 2021
Background
After a prolonged and anxious wait, on November 9, 2021, SEBI finally notified its far-reaching amendments to the regulatory regime for Related Party Transactions (“RPT”). The amendments[1] to the RPT regulatory regime under the SEBI (LODR) Regulations, 2015 (“LODR”), have their genesis in the Report of the Working Group on RPTs (“WG Report”), which was issued by SEBI on January 27, 2020.
While the amendments notified by SEBI have made some material modifications to the proposals of the WG Report, the amendments have still caused considerable anxiety in India Inc.
India Inc has already started gearing up to face the ‘new normal’ – once the amendments come into force on April 1, 2022. In this article, the authors will provide a bird’s eye view of the amendments, and their practical implications.
Inclusion of “Promoter” within the definition of “Related Party”
One major unexplainable lacuna in the definition of related party in Section 2(76) of the Companies Act, 2013 (“Act”), is that a “promoter” [as defined in Section 2(69) of the Act] or a person or entity belonging to the promoter/ promoter group is not included within the definition of “related party”.
SEBI is now proposing to plug this vital loophole for listed companies, by including any person/entity belonging to the promoter/ promoter group within the definition of “related party”. This is a step in the right direction, and will ensure that transactions entered into between the listed entity and its promoters will not escape the regulatory net.
Further, the definition of “related party” has been amended to include any person/entity holding equity shares [either directly or on a beneficial interest basis as provided under Section 89 of the Act] amounting to:
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20% or more [w.e.f. April 1, 2022]
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10% or more [w.e.f. April 1, 2023]
Given that the thresholds are not restricted solely to direct holdings, companies will have to carefully evaluate the declarations made under Section 89 of the Act, to determine whether any person/entity satisfies the thresholds on a beneficial interest basis.
Broader definition of “RPT”
SEBI has amended the definition of “RPT” under Regulation 2(1)(zc) of the LODR, to cover transactions undertaken at the subsidiary level, which were previously escaping regulatory scrutiny. Now, even transactions undertaken between two subsidiaries will be an “RPT”, and will be subject to the listed entity’s approval.
Further, w.e.f. April 1, 2023, a transaction between the listed entity or any of its subsidiaries on one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries will also be an ‘RPT’. While this “catch-all” provision has been borrowed from the UK Premium Listing Rules, SEBI has not provided any test for evaluating the ‘purpose and effect’ of the transaction.
Given that the ‘purpose and effect’ test will be applicable w.e.f. April 1, 2023 only, SEBI should suitably clarify its scope and ambit, so that compliance officers of listed companies have greater clarity on how this determination must be made, and do not face practical difficulties in identifying such transactions.
Audit Committee approval for transactions undertaken at subsidiary level
Perhaps the most contentious aspect of the amendments is the requirement of obtaining approval of the Audit Committee of the listed entity, for transactions undertaken between two or more subsidiaries of the listed entity. SEBI’s action is in the context of a few recent corporate scandals where high-value malignant related party transactions were undertaken at a subsidiary level to escape regulatory scrutiny.
Now, Audit Committee approval will be required if the value of the transaction (either individually or taken together with previous transactions during a financial year) exceeds 10% of the annual consolidated turnover of the listed entity, as per its last audited financial statements.
In accordance with Section 2(87) of the Act, a “subsidiary” will also include an overseas subsidiary, which is incorporated under the laws of a foreign jurisdiction. By virtue of the amendments, the approval of the Indian holding company will be required even for transactions undertaken between two or more overseas subsidiaries of the listed entity. Let us understand the implications of this with a practical example.
Company X [Indian listed holding company] has unlisted foreign subsidiaries incorporated in UK (“UK Subsidiary”) and France (“French Subsidiary). The UK Subsidiary and the French Subsidiary propose to enter into a transaction that exceeds the 10% turnover threshold. This transaction between two overseas subsidiaries cannot go through unless it receives prior approval of the Audit Committee of the listed entity i.e. Company X.
The amendments may hence result in a situation of ‘conflict of laws’ – where the Audit Committee of an Indian listed entity has a veto power over transactions entered into by two foreign companies, which are incorporated under the laws of a foreign jurisdiction, and are bound by the requirements of their domestic law. Such a foreign jurisdiction may impose legal obligations that are not in consonance with the Indian regime.
For instance, under Sections 173 and 174 of the English Companies Act, 2006, the directors of the UK Subsidiary will have a duty to exercise ‘independent judgment’, and ‘reasonable care, skill and diligence’. Given their fiduciary duty towards the UK subsidiary and their obligations under English Company Law, such directors may not be able to bless the transaction solely on the basis on the approval granted by the Audit Committee of the holding company. Further, as France is a civil law country, the Board of the French subsidiary may have to comply with requirements that are completely alien to the Indian regime.
There may also be situations where the Board of the foreign subsidiary is in favour of entering into a transaction with another foreign subsidiary, but the transaction does not receive the approval of the Audit Committee of the Indian listed entity. Such situations may severely compromise the autonomy of the Board of the foreign subsidiary.
While it can be argued that the foreign subsidiary is also owned and controlled by the Indian listed entity, one must not lose sight of the cardinal principle of ‘separate legal existence’ enshrined in Salomon v. Salomon.[2] In accordance with the Salomon principle, a subsidiary also has an independent legal existence from that of its parent, and an independent Board of Directors, who owe a fiduciary duty to the subsidiary only, and not to the parent.
In this regard, it is instructive to refer to the celebrated decision of the Supreme Court (“SC”) in the Vodafone case[3], where it was held that “the legal position of any company incorporated abroad is that its powers, functions and responsibilities are governed by the law of its incorporation”. Further, it was held that the fact that a parent company exercises shareholders’ influence on its subsidiaries cannot obliterate the decision-making power or authority of the subsidiary’s directors, and the directors owe a duty to the subsidiary only, and not to the parent.
The veto-power of the Audit Committee may severely impinge on the independent decision-making authority of the directors of foreign subsidiaries, and may also be in conflict with the laws under which the foreign subsidiary has been incorporated. Such an extra-territorial application of Regulation 23 of the LODR would make the Boards of such overseas subsidiaries “functus officio”, when it comes to approval of RPTs.
In accordance with the tests laid down by the SC in the GVK Industries case[4], the provisions of the LODR may also be open to judicial scrutiny, on the ground that such extra-territorial applicability of Regulation 23 does not have a ‘real or substantial’ nexus with India, and thereby violates Article 245 of the Constitution. It is also doubtful whether a delegated legislation framed by SEBI can provide for such an extra-territorial applicability.
“Material Modification” of RPTs
The Audit Committee now has an obligation to grant prior approval for “material modifications” of an RPT. However, the amendments do not provide any definition of what would constitute a “material modification”, and only state that the Audit Committee shall define “material modifications”, and disclose it in the RPT Policy of the listed entity. Leaving this determination solely on the Audit Committee may be counter-productive, as the amendments do not provide any bright-line tests for making this determination.
Materiality threshold
SEBI has revised the materiality threshold for obtaining shareholder approval, to cover transactions that exceed Rs. 1000 Crore or 10% of the annual consolidated turnover, whichever is lower. While the Rs. 1000 Crore threshold may bring many more transactions within the ambit of shareholder approval, SEBI has made a material change to the recommendations of the WG Report.
The WG Report recommended that the materiality threshold should be amended to 5% of the annual total revenues, total assets or net worth, on a consolidated basis or INR 1000 Crore, whichever is lower. A 5% threshold would have captured an even larger number of transactions within the net of shareholder approval, thereby adding to the anxiety of India Inc.
SEBI has also not incorporated a “net worth” based criteria under Regulation 23(1). Given that Section 188 of the Act prescribes a “net-worth” based materiality threshold for certain RPTs – SEBI could have adopted a similar criteria for specific RPTs.
Unlike the Act, SEBI has also not chosen to provide any exemption to transactions done in the ordinary course of business and on an arm’s length basis.
Concluding Thoughts
Along with affecting the Board autonomy of foreign subsidiaries, the amendments may further disproportionately increase the workload of the Audit Committee of listed entities. From January 1, 2022, only the independent directors of the Audit Committee can approve RPTs.
The independent directors will now have an obligation to scrutinise transactions entered into between two or more foreign subsidiaries, which are governed by a different company law regime. It may be unfair to expect independent directors to familiarise themselves with the requirements of a plethora of foreign laws, prior to approving complex transactions executed between foreign subsidiaries.
While some provisions may lead to corporate governance challenges and will require companies to adopt a carefully calibrated approach, there are many amendments which are in consonance with industry demands. For instance, excluding preferential allotment, rights issue, buyback of securities, etc., from the ambit of Regulation 23 of the LODR is a step in the right direction, as such transactions are in any case regulated under the SEBI (ICDR) Regulations, 2018. Further, mandating periodic RPT disclosures is also a welcome step, and would provide greater transparency to minority shareholders, whose interests must be safeguarded.
All in all, with the objective of protecting minority interest, the amendments bring about a paradigm shift in the RPT regime, and once again places RPT regulation at the forefront of India’s battle for good governance. It has certainly increased the compliance burden on listed companies.
For further information, please contact:
Bharat Vasani, Partner, Cyril Amarchand Mangaldas
bharat.vasani@cyrilshroff.com
[1] Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) (Sixth Amendment) Regulations, 2021.
[2] Salomon v. Salomon, [1897] AC 22.
[3] Vodafone International Holdings v. Union of India, (2012) 6 SCC 613.
[4] GVK Industries v. Income Tax Officer, (2011) 4 SCC 36.
