Tuesday, February 8, 2011

The Concept of an “Interested” Shareholder

Yesterday’s board meeting at SEBI was not expected to generate any substantial decision owing to the impending change of guard at the regulatory institution. True to expectations, key matters such as amendment to the Takeover Regulations and implementation of the Jalan committee report on stock exchanges and other market infrastructure institutions were deferred. However, SEBI expressed its policy stance on a significant matter, which, if accepted, will denote a paradigm shift in Indian corporate jurisprudence.

The relevant paragraph of the press release of SEBI’s board meeting is as follows:
4. Recommendation to MCA on related party transactions:

SEBI will recommend to the Ministry of Corporate Affairs to suitably amend Clause 166 of the Companies Bill, 2009 to disallow interested shareholders from voting on the special resolution of the prescribed related party transaction. This will protect small and diversified shareholders in listed companies from abusive related party transactions. This view was taken based on the learning from the investigation in the matter of Satyam Computer Services Limited.
Following the Satyam episode, numerous recommendations were made for strengthening the regime governing “related party transactions” (RPTs), particularly in listed companies. This is not surprising given the corporate structure of Indian companies, where group holding structures, pyramiding and tunneling are commonplace with significant influence wielded by controlling shareholders (or promoters). Given such structures, RPTs are inevitable.

However, the current legal regime appears to focus almost entirely on disclosure of RPTs. For example, there is great emphasis on disclosure of related party transactions in financial statements of companies, and most of the detail regarding disclosures is governed by the relevant accounting standards. There is little prohibition or restriction on the ability of companies to carry out RPTs. Moreover, there are arguably inherent deficiencies in current law being able to capture RPTs, and particularly with controlling shareholders. First, controlling shareholders are not subject to conflicts of interest. Unlike directors, company law allows controlling shareholders to vote on resolutions even in situations involving conflicts. Second, company law does not foist controlling shareholders with duties (such as fiduciary duties). In that sense, they can exercise their voting powers in their own interests rather than in the interest of the company, as they are not in any fiduciary capacity.

SEBI’s proposal in yesterday’s board meeting seeks to address the first issue above, i.e. to impose conflict of interest on shareholders. This is a welcome move because it addresses the realities of Indian corporate ownership structures where RPTs are rampant. In the post-Satyam scenario, the issue of RPTs has perhaps received less attention than it deserves. Spotlight has been thrown on other matters of corporate governance such as board independence, and role and liability of auditors. The proposals have arguably resulted in a scenario by which, if the recommendations of the Task Force are accepted, there would be regulatory micromanagement of corporate boards in India. SEBI’s current proposal does well to renew the focus back to the issue of RPTs.

Of course, like any legislative proposal, the devil lies in the detail. Questions will arise as to how to define an “interested shareholder”, “related party transactions” and whether there should be thresholds of materiality, and the like. If the proposal is accepted, these issues will have to be carefully framed and legislated.

Curiously enough, the impetus for introducing the concept of an “interested” shareholder has emanated from SEBI (as the securities regulator) rather than at the legislative level (involving company lawmakers). SEBI’s efforts have been consistent even in past practice where it required interested shareholders to abstain from voting: e.g. when it granted certain exemptions under the Takeover Regulations, when it issued the Delisting Guidelines (which require 2/3rds majority of disinterested shareholders), and in certain other orders it has passed where it expressed the desire to see disinterested shareholding voting (see one instance here). While SEBI possesses the power to regulate listed companies (and has been exercising this power as indicated above), its plea to the Ministry of Corporate Affairs signals an interest in universal applicability of the rule to even unlisted companies.

This proposal raises interesting issues involving corporate jurisprudence, but whether it will pass muster in Parliament is yet another matter.

(Update - February 18, 2011: Please also see Somasekhar Sundaresan's column in the Business Standard)

3 comments:

Somasekhar Sundaresan said...

Interesting issue here.

SEBI has been robust in its belief that the status of being listed would give SEBI jurisdiction to anything and everything that could be linked to "interests of the securities market".

The reference to MCA is puzzling. If SEBI continued the belief in the power it exercised to provide for ignoring the vote of the acquirer-shareholder for a delisting effort, it should have gone ahead and required listed companies to take all related party contracts to the general body for approval, with the conflicted shareholder being dis-entitled to vote. That the company in question is listed, and that the measure is in the interests of investors in the securities of these companies should have been sufficient.

If SEBI cannot issue such a direction, how could it have legislated to keep the acquirers out of the vote for a delisting resolution? Or, how does it direct listed companies on how to conduct themselves on other aspects of company law?

V. Umakanth said...

The following insightful comments were received from Professor Balasubramanian:

This is an important and crucial development that has come up not a
day too soon. This is a major missing link in our investor protection regime and, if acted upon, will go a long way in bringing our corporate governance standards a valuable notch closer to international best practices.

This was an important issue discussed in a recent round table held at the National Stock Exchange as well on their publication on Emerging
Corporate Governance Scenario in India, which I had the honour to edit with my industry veteran, Mr Deepak Satwalekar. In fact this measure is overdue by almost eleven years to the date: it had been made in the Report of the Government appointed Committee on Corporate Excellence(of which I had the privilege of being a member and having the
responsibility of drafting the report and piloting it first through a task force and then the committee itself) in January 2000 which was presented to the then Minister in charge Mr Arun Jaitely. Although the
entire report was accepted, and some of its recommendations had been implemented in stages, this important recommendation remained to be acted upon. Presentations had Since been made on this issue to several of the committees on governance that followed including those headed by Mr Naresh Chandra and Dr J J Irani (on whose recommendations the pending Companies Bill has largely been modeled); The Irani Committee did refer to this recommendation specifically in its report
and commended it as a good governance practice to be adopted by companies but stopped short of proposing legislation on the ground
that it would be difficult to implement.

As probably the first person to suggest and actively pursue this
proposal over the last decade, I am naturally delighted that at long
last SEBI has found it appropriate to support its legislation.
Obviously there will be resistance to such a major (although entirely
equitable) proposal which would bring about a significant curtailment of the freedom of controlling owners/executives to push through proposals of special interest to them but not to other shareholders in the same category. And the concerns will not be limited to domestic family/professional groups; very significantly, MNC
subsidiaries/affiliates may also protest since some of their valuable options such setting up new subsidiaries to compete with the extant companies and so on may well be more difficult to get through since their dominant votes would no longer count. The other vulnerability in the Indian context is the presence of large block holdings by institutional investors who may be used by unscrupulous promoters to
get through their resolutions.

My only regret at this otherwise welcome news is that SEBI decided to pass this entire matter to the government rather than acting on its own in respect of listed companies coming under its domain. While corporate legislation would cover all (including listed) companies, it may have been worthwhile if SEBI had decided to mandate this for listed companies through the usual listing agreement route, after due
process. There are examples elsewhere in the world where stock
exchanges have done this. Maybe some of our leading stock exchanges
could consider including this in a “Comply or Explain” list of best
practices to be followed by their listed companies, until it is
mandated either SEBI or the Government.

We must recognize though that it is not yet a case of “Mission
Accomplished” until it finds its way to legislation/ regulation; but
it certainly is an important milestone in the journey towards
achieving that goal.

Prof Bala
Dr N Balasubramanian
Visiting Professor of Corporate Governance, Indian Institute of
Management Bangalore and Ahmedabad, and
Former Founding Chairman, IIMB Centre for Corporate Governance and Citizenship

vswami said...

The subject write-up and the comments posted, as per my understanding, go to reinforce the view on the correct legal position that, - it is not within the powers of the SEBI, a mere regulatory authority, to validly tinker or tamper with any provision of the corporate law.

That cannot be otherwise; for, not even the government or the judiciary can, in exercise of the respective powers vested under the Constitution, do so.
As an eminent jurist, late Nani A Palkhivala, wrote (underlining supplied):
The Constitution of India provides for a just balance between the legislature, the executive and the judiciary. Each has a specific field to cover. The courts are there to maintain the most fundamental equilibriums of our society. They are the agency of a sovereign people to enforce the laws; also to expound the Constitution and to ensure that its mandates are respected.
The Supreme Court as well as the high courts of India is vested with the widest possible powers. But the courts can decide only questions of law. They cannot decide, and should never be called upon to decide, questions of opinion or belief or political wisdom. It is not the court’s role to be an extended arm of the executive.
(Source: Article – Dragging the Supreme Court into the political Arena –published in The illustrated Weekly of India, January 1993)
 (B) A statute is the edict of the legislature. The judiciary, as may be readily gathered from the case law, mostly on income-tax, has its power restricted and confined to ‘interpretation’. For this purpose, there are several principles or rules of interpretation, devised by courts themselves, to serve as aids. Even so, anyone of them can be rightly summoned to aid /assistance, and applied, provided the words or language used are so ambiguous as to lend scope for any doubt . Further that, the doubt must be real, not merely conjectural or fanciful. As such, in respect of any statutory provision, which is plain and unambiguous, admitting of no second meaning, the question of applying any such principle or rule for ‘interpretation’ needs to be employed. Especially, no extraneous considerations need to be applied.
Also my comments on an earlier post titled –‘Shareholders and Their Duties under Indian Law’ are of relevance to the context herein as well.
Aside: As is known, in the sensational Vodafone case the issues raised but pending final decision of court have been rested on the related concept of - ‘controlling interest’. In a recently reported tribunal case (ACIT vs. R.K.B.K Fiscal Services Ltd (ITAT Kolkata)) - the propositions as urged by the parties before the tribunal centred on the same concept have led to a new twist to the issues of controversy raised in the Vodafone case.