The law relating to Related Party Transactions(RPTs) got murkier and tougher under SEBI Regulations - An analysis of the Amendments made in recent times
SEBI has in the year 2021 put through, inter alia, several amendments to the SEBI(Listing Obligations and Disclosure Requirements)(LODR)Regulations 2015 with critical changes being made which pertain to the domain of RPTs. Some of the changes rung in have already become operational from the onset of the Calendar year 2022 whilst some will apply come April,1, 2022.Some changes will also kick in prospectively from April,1, 2023.
The changes made in particular on the subject of RPTs encapsulate the entire gamut of the subject with the ramifications ranging from a conceptual shift in the definition to an RPT to extending the requirement of approving RPTs being made the responsibility of the Independent directors of the company who are part of the Audit Committee constituted by the Board , a departure from the earlier requirement that such approvals shall be accorded by the entire Audit Committee.In this exposition we shall endeavor to make a deep dive into the understandingof the nuances of the changes , some of which Corporate Inc. shall indeed find difficult to grapple with, arduous as they are .The amendments have , in a manner of speaking, literally set the cat amongst the pigeons , and raised the bar on corporate Governance several notches up.
Concept of "Related party" gets extended
Proviso has been added to the definition of the term under Regulation 2(zb)through notification dated 9.11.2021 which becomes operational from 1.4.22 which widens the contours of the term. Any person or entity who forms a part of the Promoters or promoter group of the listed company shall be considered as a related party.This extension is rational given that in the context of a company, a promoter has perforce to be a related party.
Further any person who holds beneficially, twenty or more percent of the equity capital whether directly or indirectly shall be deemed to be a promoter. Effective from 1.4.2023, the above threshold shall be lowered to ten percent.
The above definition as before shall not apply in respect of units issued by a Mutual fund which is listed on the Stock Exchange.
"Related Party Transaction"- Substitution of Regulation 2(zc)
The existing definition is being substituted prospectively from 1.4.2022 to refer to:
a)a transaction involving transfer of resources or services or obligations as between the listed company or its subsidiaries on the one hand and a related party of the listed company or its subsidiary on the other hand .
It follows from the above that a transaction between the subsidiary of the listed company and a related party of the listed holding company would also be related partytransaction where the subsidiary is concerned.
b)orthe listed company or any of its subsidiaries on the 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 company or any of its subsidiaries. This clause will come into effect from April,1, 2023.Thus even if the transaction between the company or its subsidiary is not with a related party but the transaction is likely to benefit a related party of the listed company or the subsidiary , it would fall within the ambit of the definition. To illustrate the point, suppose the company enters into a transaction with a party which is unrelated to it in any manner but the result of the transaction is likely to benefit, say the director of the listed company or its subsidiary in any manner or even if the purpose of the transaction is to benefit the director, the transaction would not escape the test of scrutiny as an RPT.
One can therefore visualize from the above amendments that the conceptual reach of an RPT would spread wide and far like the tentacles of an octopus.
It follows from the above that listed companies and their subsidiaries will have to seek declarations from now onwards from theirdirectors and related parties to cover relationships and transactions of the above genre so that they could be subjected to approval of the Audit Committee.
Our apprehension is that the implications of the changes referred to in clause (b) are so open-ended that often times, companies will have to strain every sinew to conjure and capture relationship of the kind contemplated in the said clause.
As before, the absence of consideration will not stand in the way of classifying the transaction as an RPT and the transaction could either be a one-off or a group of transactions in a contract.
Exceptions to RPTs
The Working Group constituted by SEBI to review the Regulations relating to RPTs had suggested in its Report submitted to SEBI in December 2020 that certain transactions which do not confer on the related party concerned, any special benefits or privileges should not be treated as RPTs notwithstanding that the transaction is one which inter alia, involves an interface between two related parties. Based on the above rationale, transactions of the following genre
shall not be considered as RPTs:
a) Issue of specified securities on a preferential basis provided that the issue is in conformity with the requirements of the SEBI (Issue of Capital and Disclosure Requirements)(ICDR)Regulations, 2018.
b) the following corporate actions by a listed company which are uniformly applicable to all the shareholders in proportion to their shareholding:
i) Payment of dividend
ii) sub-division or consolidation of securities
iii) issuance of securities by way of a rights issue or bonus issue.
iv) buy-back of securities
v) acceptance of fixed deposits by banks/NBFCs at terms uniformly applicable /offered to all shareholders, members of the public subject to disclosure of the same along with disclosure of RPTs every six months to the Stock Exchanges in the format specified by SEBI.
The above exclusions are perfectly justified, given the fact that the related party participating in the above corporate actions would not draw any extra mileage or advantage which would be over and above the other participants in the exercise. This will also forestall the possibility of a transaction involving, say payment of dividend by a partly owned listed Subsidiary to its shareholders including the Holding company being subjected to approval of shareholders twice over once for the vanilla declaration of dividend and again as a material RPT in the event that the quantum of dividend payable to the Holding company should exceed the threshold of materiality. As the Holding company cannot vote affirmatively for the payment of dividend, there could be a theoretical possibility of the resolution for the approval of the RPT not being able to muster the required majority from the minority shareholders. The same possibility could also exist in the case of a bonus /rights issue or in a buy-back scheme in which the holding company also participates.
Amendments to Regulation 23
A proviso is being added under Regulation 23(1)in substitution of the earlier Explanation which has the effect of reducing the threshold for a material related party transaction to an absolute figure as opposed to the previous threshold.
New threshold for determining materiality unrealistic for large conglomerates
Effective from April,1, 2022,an RPT shall be considered material if the transaction entered into either individually or taken together with previous transactions during the financial year exceeds rupees one thousand crores or ten percent of the annual consolidated turnover of the listed entity as per the annual consolidated financial statement of the company, whichever is lower. Thus the ten percent threshold will become irrelevant for the larger companies and the moment the transaction value breaches the figure of rupees one thousand crore, it would be deemed material, necessitating approval of the shareholders.The new threshold laid down may appear to be minuscule in respect of large conglomerates which have consolidated topline exceeding several lac crores of rupees as in the case of Reliance Industries, ITC Limited. Besides, pegging the limit to an absolute number without considering the impact of inflation in future years makes the new threshold appear to be inadequate. Murmurs of disquiet have already surfaced from the large companies against the above change and it is appropriate to seek a review of the above measure.
All RPTs and material modifications thereto to have previous approval of Audit Committee-Proviso under Regulation 23(2) runs contrary
Regulation 23(2) provided earlier that all RPTs shall require previous approval of the Audit Committee. The above Regulation is being altered effective from April,1, 2022 to provide that subsequent material modifications shall also have the approval of the Committee.
What is a "material modification" is not being articulated and it is left to the Audit committee to define "material modifications" and disclose the same as part of the company's policy on materiality of RPTs and on dealing with RPTs.
What could be considered as "material modifications" to an RPT
Given that the concept of "material modifications" is being left open-ended for determination by the Audit Committee, it would be appropriate to visualize as to what modifications could be brought within the realms of materiality. Typically in a commercial contract, variations in significant terms such as terms of delivery, credit period, extension of the warranty period and the like could be bracketed as being material modifications.
The Audit committee of the listed company would do well to articulate on this aspect and document the events of "material modifications" in its policy relating to RPTs.
It is also pertinent to note that any material modification which is subsequent to the entering into an RPT that breaches the thresholds of materiality as elaborated above would also attract the attention of the company's shareholders and significantly the parties that are parties to the RPT shall not have the right to vote affirmatively thereon as stated in Regulation 23(4).
Proviso under Regulation 23(2) makes the Independent directors who are part of the Audit Committee responsible for approving RPTs-Runs contrary to the Mother Clause
A proviso has been added to Regulation 23(2)which has taken effect already from January,1, 2022 to stipulate that approval to RPTs would be accorded only by Independent directors who are part of the Audit committee.
We have observed in Regulation 23(2)above that all RPTs and subsequent material modifications shall require approval of the Audit Committee. Regulation 18 espouses the need for a company to constitute a qualified and Independent audit Committee which will operate in accordance with the terms of reference to be approved by the Board.
The responsibility for granting approval to RPTs shall be the collective onus of the Audit Committee.
Considering the above, the proviso under Regulation 23(2) shifting the onus of approval on the Independent directors who are members of the Committee for grant of approvals to RPTs, represents a dichotomy in the Regulation.The fact that Regulation 23(3)elsewhere contemplates the involvement of the entire Audit committee in matters relating to RPTs is bound to cause confusion as to whether it would be the Independent directors alone who would be responsible for RPTs or whether the Audit Committee would discharge the responsibility for approvals for RPTs.
If the former proposition were to hold, it would have been appropriate to classify the group of Independent directors who are members of the Audit committee who will call the shots as a "Sub-group of Independent directors for approval of RPTs". This has not been unfortunately done. Either way, our considered view is that SEBI should clear the air on this issue , given that one leg of the Regulation namely the fact that Independent directors who are members of the Committee shall grant approvals has already been set in motion effective from January,1, 2022 whereas the other amendments made to Regulation 23(2) which contemplate the involvement of the entire Committee have prospective application from April,1, 2022.
Shifting the onus of approvals to Independent directors for RPTs makes them carry out an "executive" function
The requirement to make Independent directors who are part of the Audit Committee responsible for granting approvals for RPTs, in our view, is like a sword that cuts both ways. Firstly, by definition "Independent directors" are expected to perform a non-executive function, act independently and provide the required balance to the Board to ensure that it functions independently and does not lean towards interests that are vested and contrary to the interests of the company.
Viewed against the above perspective, making the Independent directors responsible for approving RPTs is anathema to their perceived roles. It is fundamentally erroneous to call upon them to perform an executive role which they will, willy-nilly, perform while approving RPTs.
Further approving RPTs calls for the application of commercial skills which the Independent Directors who are in the Committee may not possess. The other negative to this concept is that Independent directors are never involved nor are they expected to be involved in the company's business, given that they visit the Board Room once in a quarter if not more frequently. It would be preposterous to also assume that they shall the commercial flair to clear RPTs.
Another aspect that makes the above amendment by SEBI fundamentally flawed is that as all Independent directors are not part of an Audit Committee, by isolating Independent directors who are part of the Committee from the rest of the Independent directors, a wedge is being unwittingly driven into the body of Independent directors which could be dysfunctional over a period of time.
Thrust as they are with the executive responsibility, Independent directors may become overly cautious in granting their approvals to RPTs which has the potential danger of negating the commercial advantages that may emanate from an RPT, notwithstanding the conflict in interest that they lead to.
As mentioned earlier, Regulation 23(2) continues to speak about the responsibility of the Audit Committee being collective where RPTs are concerned. Thus splitting the responsibility of the Committee in a manner that makes independent directors responsible for approving RPTs and the Committee responsible for articulating on policy is analogous to separating the white and the yellow from an egg!or if you are an ardent Mumbaikar, trying to separate the dear old potato from the Vada!!. Accountability could be the victim due to the surgical dissection of responsibility within the Audit Committee.
For all the above reasons, our humble submission is that the status quo ante should be restored in so far as approving RPTs is concerned and the Committee should continue to be responsible.
Sub-clause (b) under the second proviso to Regulation 23(2) is contentious
A second proviso has been added to Regulation 23(2) which becomes operational from April,1, 2022.
Sub-Clause (a) under the Second Proviso as briefly touched upon earlier makes the Audit Committee responsible for defining "material modifications" and to incorporate the same in the company's policy for determination of RPTs.
Sub-clause(b) contemplates that an RPT to which a subsidiary of the listed company is a party but the listed entity is not a party thereto shall require the approval of the Audit Committee of the listed company if the value of the transaction exceeds ten percent of the consolidated turnover of the listed entity.
It is pertinent to note that in this instance, the absolute threshold of rupees one thousand crore about which we have spoken earlier shall not apply and the threshold shall be , as before, ten percent of the consolidated turnover of the listed company. Further the responsibility for approving the transaction will be that of the entire Audit committee and not that of the Independent directors who are part of the Committee.
The pitch on the above change becomes further queer, particularly if the transaction relates to an overseas subsidiary of the listed company. As the overseas subsidiary will be guided by the law which regulates companies in the Country of its origin, it is questionable whether the subsidiary will be obligated to follow the Indian law and place the matter for the approval of the Indian Holding company. Whether the reach of the Indian law will transcend geographical boundaries is debatable. Another fall out of the above is that by seeking the approval of the Holding company's Audit committee, the Subsidiary would be undermining the independence of its own Board.
These are questions, answers to which are not easy to come by.
Sub-clause (c) to Regulation 23(2) operational from April,1, 2023 makes the regime still stiffer
Sub-clause(c) to the Second Proviso under Regulation 23(2) becomes effective from April,1, 2023 and stipulates that an RPT to which the subsidiary of a listed company is a party but the listed company is not one, shall need the approval of the Audit Committee of the listed company if the value of the transaction exceeds ten percent of the annual standalone turnover of the subsidiary.
It is pertinent to note that both in sub-clauses (b) and (c )above the reference is to a Subsidiary of a listed company and not to a "material subsidiary" for the determination of which separate thresholds exist in the Regulations.Thus even a fledgling subsidiary which is in its embryotic stage of development will have to subject an RPT whose value exceeds its standalone turnover to approval by the Audit Committee of the Holding company.
Sub-clause (d) to Regulation 23(2) provides a saving against sub-clauses (b) and (c) above
The above sub-clause which kicks into operation clarifies that the prior approval of the Audit committee of the listed company shall not be required for an RPT to which the listed subsidiary of the company is a party but the listed entity is not a party , if Regulation 23 and sub-regulation (2) of Regulation 15 apply to the subsidiary, given that it is a listed company.
Explanation under Sub-clause (d)insulates RPTs entered into by the unlisted subsidiaries of the listed subsidiary and makes it necessary only to seek the approval of the Audit committee of the listed subsidiary.
Proviso under Regulation 23(4)exempts the requirement of seeking approval of the Holding company where the Subsidiary is listed
A proviso is being inserted effective from April 1, 2022 under Regulation 23(4) which provides that the prior approval of the Audit Committee of the Listed company shall not be called for in respect of an RPT to which its listed subsidiary is a party but not the listed holding company in case where the Regulation 23 and Regulation 15(2) apply to the listed subsidiary.
The above saving is obviously intended to avoid duplication of approvals both at the level of the Audit Committee of the Holding listed company and again at the level of the subsidiary since it would be obliged to seek the approval of its own Audit Committee by virtue of being a listed entity.
As may be observed from the above discussion, the revised Regulations for administering RPTs have become that much more arduous than the previous regime.SEBI have not exactly provided the rationale for introducing the above changes.Our surmise is that SEBI is desirous that the net over RPTs be made more wider so as to ensure that no abuse of any kind can be conceivably be perpetrated.
Posterity alone will tell us about the efficacy of the changes made. On our part we submit humbly that some of the inherent contradictions in the amendments be ironed out. RPTs have therefore once again descended into the Board Room as an Elephant and it is left to the adroitness of the company and its Audit committees to stay clear from troubled waters.