By Jayant M. Thakur
Chartered Accountant
Background
Perhaps
a never-ending conflict in listed companies is the one between interests of
Promoters/management on one hand and the public shareholders on the other.
Promoters and members of the public are both shareholders and hence,
effectively have equal rights and benefits. However, Promoters are in charge of
company and would need oversight to ensure
that they do
not take any
undue benefit of such control. The key top executives who run the
company are also particularly relevant in professionally managed companies. The
conflict of interest here is that they may keep their interests above that of
shareholders. Thus, for example, they should not pay themselves excessive
remuneration. these are two of the
important of challenges in listed companies that are partly sought to be
addressed by good corporate governance measures. The Companies act, 2013, does
contain certain statutory provisions in this regard. A parallel set of
provisions with some differences are provided by SEBI in the SEBI (listing obligations and disclosure requirements)
regulations, 2015. Generally, it is expected that, in comparison with
parliament, SEBI would act as a more dynamic watchdog for protection in
particular of public shareholders. Hence, it is not surprising that SEBI has
sought to address a peculiar arrangement that is being adopted in connection
with investment in several companies by Private equity investors (“PE
investors”).
Nature of Concern Sought to be Addressed
PE
investors have a special role in listed companies. They usually are not such
substantial shareholders so as to be able to control the listed company.
However, their holding is sufficiently
big whereby they often have agreements with the
management/Promoters (“the management”) such that certain special rights are
given to them. What has now become an issue of concern is a side arrangement
many of such PE investors have entered into with the Promoters/ management of
listed companies. Essentially, what is provided in such arrangement is that the
PE investor will pay a share of profits made by it on its investment in the
listed company to the management. Usually, this share is from the excess
profits made by the PE Investor over and above a certain benchmark return.
Thus, for example, the PE investor may
agree to pay to the management 20% of the excess of profits over an internal
rate of return of 36% per annum. To take an example in figures, say, the PE
Investor had invested at a cost of Rs. 100 per share and sells the shares at
Rs. 500 after four years. The cost of Rs. 100 would require a sale price of Rs.
342 to give it an internal rate of return of 36% per annum. Thus, it would have an excess of Rs. 158. The
management would thus be given about Rs. 31.60 per share as 20% share of such
excess.
The
concern that has been raised is whether such arrangements are fair and whether
they require any regulation in terms of ensuring transparency, obtaining
approvals, etc.
SEBI has issued a consultation paper dated
4th October 2016 seeking views. While
one will have to wait for the outcome of this consultation and in what form the
regulatory requirements will be issued, the consultation paper is specific
enough to merit a study. The paper gives the specific clauses that SEBI
proposes to insert in the regulations. As will be seen later herein, the Scope
of the requirements are wider than the arrangements between management and the
PE Investor for sharing of excess profits.
Nature of Issues/Problems
There
can be several issues raised in respect of such agreements, some of which have
been highlighted in the consultation paper. One of course is, lack of
transparency – the public shareholders would not even be aware of such side
arrangements. There is a potential conflict of interest between the
management and the
public shareholders on account of
such arrangements. It is possible that the PE
investor may get
special treatment over the public
shareholders, though it may not be in violation of the law.
Another concern is that the management may
become focussed on short term goals which lead to price appreciation of the
shares, since this would help them get a share of the profits under such
arrangements.
In
a sense, the management would be able to get more compensation than otherwise
permissible to them under law. for example, Promoters are not entitled to
employees stock options. Further, there
are limits to remuneration that can be paid to managerial personnel under the
Companies act, 2013. Of course, the share is not paid out of the funds of the
company. Yet, the concern may be whether the spirit of such provisions is
defeated.
Analysis of the Proposed Amendments
In
regulation 26 of the SEBI (listing obligations and disclosure requirements)
regulations, 2015 (“the regulations”), a new sub-clause 6 is proposed to be
inserted as follows (emphasis provided):
“No
employee, including key managerial personnel, director or promoter of a
listed entity shall enter into any agreement with any individual shareholder(s)
or any other third party with regard to compensation or profit sharing unless
prior approval has been obtained from the
Board as well as shareholders by
way of an ordinary resolution”.
“Provided
that all such existing agreements
entered into prior to the date of notification and which may continue beyond
such date shall be
informed to the stock exchanges
for public dissemination and approval
obtained from shareholders
by way of an ordinary resolution in the forthcoming
general meeting. Provided further that in case approval from shareholders
is not received, all such agreements shall be discontinued “.
Thus, the proposed clause divides the requirements in two parts – one
for new agreements providing for such arrangements and the other for existing
agreements. It requires that such agreements shall require prior approval of
Board of directors and the shareholders by way of ordinary resolution. In case
of existing agreements that would continue in the future, the requirements will
be slightly different. The approval of Board of directors is not required.
However, disclosure to stock exchanges would have to be made. Further, approval of the shareholders by way of
ordinary resolution would have to be obtained in the forthcoming general
meeting of the company. If such approval is not received, then the agreement
for such arrangement would have to be discontinued.
The
requirement applies to such agreements as are described therein. Such agreement
would have to be with “employee, including key managerial personnel, director
or promoter of a listed entity” with “any individual shareholder or any other
third party”. The agreement should relate to “compensation or profit sharing”.
The term “key managerial personnel” would be as per the definition under the
Companies act, 2013.
Thus, on one hand, the type of agreement as well
the persons between whom the agreement may be made have been widely defined. On
the other hand, the definition is specific and hence would apply only to such
matters and between such persons as specified therein.
Non-Transparent Arrangements till now
As
stated above, there is presently no statutory requirement to disclose such
agreements to the public. hence, such arrangements may not be known even to the
Board of directors, much less to the
shareholders generally or the stock exchanges/public.
Requirements of Approval
The
requirements of approval are dual. One is from the Board of directors the second is from the shareholders by way of an
ordinary resolution. For agreements that are to come into force in the future,
such approvals would have to be prior to entering into such agreements and not
after they are entered into.
Covers Agreements for Compensation As Well As Share of
Profits
The
payment to the management may be in the form of compensation or share of
profits. These terms have not been defined and hence may have wide meaning.
This also widens the scope of the requirements from what appears to be the
intent.
Covers Agreements with Share- Holders As Well As Third
Parties
The
agreements may be with individual shareholders of the company or even with
third parties. This may once again result in a scope that is wider than may be
otherwise expected from a requirement that appears to be intended for
agreements with PE investors. For example, would any compensation by a
group/holding/associate company to any person in management be also covered?
Retrospective effect
Of
particular concern is the fact
that the requirements will effectively have a
retrospective effect. All existing agreements would be required to be disclosed
to the stock exchanges and also approved by shareholders. Failure to receive
such approval would result in a requirement to discontinue such agreement.
Comments
There
are valid objections raised for and against the requirements.
A
preliminary objection is as to whether such matters should be at all regulated.
Even if regulated, whether disclosures would be adequate to achieve the
objective. Even more, whether the approval of the shareholders serves any real
purpose and whether a group that should not have any say in such matters is
being given a right to veto such arrangements. The compensation/profits do not
go out of the pocket of the company or the shareholders. Indeed, the public
shareholders would also be benefitting in typical cases where the profit is out
of appreciation in the price of the shares.
On
the other hand, there may be a view that even such restrictions are not
sufficient. For one, there is no absolute bar on such agreements. There may be
a view that the conflict of interest that can result is substantial. Moreover,
such arrangements can be a subterfuge for payments for other consideration.
Further, it is often likely that the
Board/shareholders may be dominated by the Promoters. Unlike related party
transactions, where there are certain restrictions on voting on certain
shareholders, there are no such restrictions here.
Finally, of course, the new requirements may hit
existing arrangements hard. It is possible that existing agreements may have to
be shelved halfway if they do not receive approval and thus parties may be deprived
of the benefit particularly in respect of benefits that would have already
accrued to an extent.
All
in all, however, initiation of the debate is a step in the right direction and
at the very least, such arrangements would come to the knowledge of parties
concerned. One will have to see how the final draft of the requirements is
issued and then examine their impact.
