Corporate Governance Demystified
PRESCRIPTIONS AND PROSCRIPTIONS
Chairperson, Excellence Enablers
Former Chairman, SEBI, UTI and IDBI
Conventional wisdom has it that relatives, unlike friends, are not entities that you choose. Transacting with relatives or related parties is clearly not free from substantive or procedural issues.
Recent meetings of the Audit Committees (ACs) of several corporate Boards have devoted considerable manhours to agonising over the manner in which they will measure up to the expectations arising out of the tightened regulations relating to Related Party Transactions (RPTs). To understand the nature and the dimensions of the problem, it is necessary to briefly touch on some of the prescriptive arrangements that have been put in place.
Even prior to the recent tightening of the regulations, ACs, more often than not, went through the motion of approving RPTs, without being entirely satisfied that all the approvals were based on evidence, analysis and judgement. At a superficial level, the only two aspects to be examined are whether the transaction in question is in the ordinary course of business, and is at arms length. In the case of a large number of transactions, the first criterion was easily established since these were transactions identical, except perhaps in volume and price, to transactions that had been approved earlier. On occasion, when a new type of transaction was presented to the AC, the level of scrutiny was a little more intense.
The more problematic element of the approval process was the determination whether a transaction was priced at arms length. Here again, the theory is sound, and cannot be questioned. All that it requires is for the AC to examine whether the pricing of the transaction between the 2 related parties would have been the same had they been unrelated parties. In practice, several other considerations emerge. In a large number of cases, one of the 2 related parties has been providing goods or services to the other related party for many years. Should a competitor suddenly surface, and offer a better price, it is necessary for the management, and for the AC, to exercise judgement on whether the new (unrelated) party can ensure the supply of goods and services in a non-disruptive manner, and whether the quality considerations that should inform the selection process are in place.
Notwithstanding all the adverse notice that RPTs have attracted from time to time, it is necessary to recognise that these transactions are not illegal. If the intention was to completely phase out RPTs, the law and the regulations would have had express provisions to that effect. Fortunately, neither lawmakers, nor Regulators, have travelled down that path, since the element of disruption that it would give rise to, in the normal conduct of business, would be very high.
At the same time, it is recognised that RPTs need to be subjected to scrutiny, because, in the absence of scrutiny, conflict of interest can, and will, rear its ugly head. Off the record conversations with members of the AC will reveal that this item comes up for discussion, and decision, towards the tail end of AC meetings, when the normal tendency is to take the agenda note as read, and accord approval. Occasionally, the minutes of the meeting would read as confessional statements (unintended), since they would state in as many words that the management had certified that the transactions were in the ordinary course of business, and at arms length, and approvals would be accorded on that basis.
All regulations present opportunities to the mischievously inclined, to find loopholes therein, or to entirely skirt the procedural requirements, leading to approval. With evidence of this kind surfacing in the recent past, the Regulator has taken upon itself the unpleasant task of further tightening the prescriptive arrangements, making unconscionable conduct by management and in ACs far less practicable.
To begin with, the definition of related parties has been significantly enlarged. While for reasons of space, it is not proposed to detail all the additions, it is necessary to point out that with the expanded definition, it has become difficult for managements, and for ACs, to keep track of not only the transactions, but also the entirety of related parties. What is worse, the regulations presently provide that even transactions in which the concerned corporate entity is not a party, would have to be approved by the AC, if it is between a subsidiary and one of the related parties. The presumption that adequate knowledge and bandwidth would reside in the AC, to keep track of all these transactions, and to approve them on merits, is indeed a very big ask.
It is readily conceded that if RPTs that are not bona fide are enabled to be put in place, the minority shareholders would be the ones to suffer. To address this, regulations now provide for the approval by shareholders of more categories of transactions.
One of the major pain points which has got corporate entities, especially the larger entities, up in arms, is the requirement that RPTs exceeding a value of Rs 1000 crores would, of necessity, have to be taken to the shareholders for approval. Large corporates have complained that this ceiling of Rs 1000 crores would not make sense in their cases, since it would represent a very small percentage of the annual consolidated turnover of the listed entity. The alternative suggested is to prescribe only in percentages, and not in absolute numbers, so that neither the larger corporates, nor the smaller corporates, suffer from the lack of a level playing field.
Ever since the question of approval of RPTs by the AC came into being in the Companies Act, 2013, the question has been raised whether approval of transactions, as distinct from audit of transactions, should be within the remit of the AC. Since no alternative could be easily identified, and it would have been next to impossible to take all such transactions to the shareholders for approval, the AC has remained the authority for clearing these transactions. The new element in the regulations is that all these transactions need to be approved by only the Independent Directors (IDs) in the AC. Across the board, the view generally expressed is that IDs, notwithstanding their intelligence and industriousness, are part-time functionaries, who will not have all the information and expertise required to accord approval. To get around this, some have suggested that all such transactions could be got vetted by an outside expert agency, so as to give comfort to the IDs that they are on the right course, when it comes to approving these transactions. This facile suggestion does not address the question whether law envisages the outsourcing of thought process on a continuous basis to an external agency which has no fiduciary responsibility qua the company or its shareholders.
To make matters procedurally cumbersome, the regulations now stipulate all the aspects that an AC should go into before it accords approval to these transactions. If any AC seriously looks at all these aspects in respect of all RPTs, it is reasonable to presume that meetings of AC would last several days. One outcome could be that it would be difficult to find members for the AC, since Directors will not be able to commit the time required for such detailed scrutiny lasting several days.
The regulatory stance proceeds, not surprisingly, on the distrust of the management, the Board, and also the AC. It is therefore provided that in regard to some categories of transactions, the prior approval of shareholders should be sought. The fact is that the average shareholder is not interested in matters of this nature being taken to him/her for approval. It also places a premium on their ability to create the time to understand these proposals, as also the expertise that is required for the purpose. Institutional investors are better placed when it comes to the ability to apply their mind to these transactions, should they choose to do so. However, the behaviour pattern of institutional investors has demonstrated that almost without exception, they rely on the recommendations of proxy advisory firms. Shorn of all details, the resultant situation is that the views of the proxy advisory firms would override the decisions of the AC and the Board. This clearly is an unacceptable proposition.
The well-intentioned regulations also have some unintended consequences. For example, an overseas subsidiary transacting with a related party would have to get the transaction approved by the AC of the India-based parent company. In matters of taxation, a question could arise on whether India or the overseas location of the subsidiary company is the place of effective management (POEM). With RPT approvals required to be accorded from India, an assessing authority could well contend, in spite of the presence of a Board in the overseas location, that decisions are being taken in India, and therefore the benefit of an overseas location in taxation matters would not be available. These are matters which should be addressed sooner rather than later.
Regulations should normally be free from the possibility of constructive or creative interpretation. RPTs will, from April 1, 2023, include transactions between “a 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”. In this context, attention needs to be paid to words such as “the purpose and effect of which is to benefit a related party….”. While the stated purpose would be evident from the nature of the transaction, any hidden purpose that resides in the minds of those putting through the transaction would not be known to the members of the AC. Not being mind readers, the members of the AC could clear proposals, which later reveal a divergence between the stated purpose, and the actual purpose. This could expose them to the unfavourable attention of agencies that come in with the wisdom of hindsight.
There is yet another possible negative fallout of the new regulations. The auditing profession, which is now at the receiving end of increasingly adverse orders, could raise questions on the genuineness of the purpose and effect of the transaction. Self-preservation is not a behavioural aspect unknown to any profession. If their judgement is being challenged, as is being increasingly done now, it is not unlikely that in order to prevent future challenges, they could point to the problematic nature, imaginary or real, in some of these transactions.
It is useful to embrace an excellent tool that has often been talked about, but never implemented. The reference is to regulatory impact assessment. The nature of the new RPT regulations cry out for regulatory impact assessment being undertaken. Absent this, the ease of doing business, which is a professed aim, could suffer serious setbacks.
What then does the future hold for the corporates? Regulations being non-negotiable, and not a matter of choice, have to be complied with. Therefore, while implementing the new regulations, corporates must continue to engage with the Regulator on the need for pragmatism, without sacrificing principles. As for the Regulator, there must be the realisation that tweaking regulations to factor in practical difficulties will bode well for the regulated universe that they purport to preserve, protect and promote.
Corporate Governance Specialists | Adding value, not ticking boxes | www.excellenceenablers.com