Tuesday, November 26, 2013

Guest Post: New Regime of Corporate Governance: Heading Towards “Hung” Companies – Part 1

[The following post is contributed by The following post is contributed by Nivedita Shankar, who is a Senior Associate at Vinod Kothari & Co. She can be reached at nivedita@vinodkothari.com.

The views expressed herein are solely those of the guest author and cannot be ascribed to the other contributors of this Blog]

The OECD in its report titled “Guide on Fighting Abusive Related Party Transactions in Asia” commented: “Abusive related party transactions have increasingly become a challenge to the integrity of Asian capital markets”. In fact, this very report also recommended that the voting system should be such that majority of the disinterested shareholders should approve the related party transactions in general meetings. Such a practice is already followed in Malaysia, Hong Kong and Singapore.

Although such a recommendation is noble, yet the serious repercussions that it may give rise to have been grossly overlooked. The point on independent shareholders voting in general meetings was highlighted by SEBI in its consultative paper under the head "Abusive RPTs" in point 11.25(d). The main reason for proposing this was to ensure that the approval of major Related Party Transactions (“RPTs”) is done only by disinterested shareholders. The Companies Act, 2013 (“Act, 2013”) has incorporated similar provision under section 188 wherein related parties have to abstain from voting on any related party resolution in general meeting. Effectively, this shall mean that only disinterested shareholders shall vote on any resolution. This section is yet to be enforced.

The resultant imbalance in giving power to minority

Corporate governance is seen as a tool to control any abuse by a related party but in companies in India, the majority control rests with the promoters. Thus, even corporate governance becomes a tool in the hands of majority solely.

Clause 49 of Equity Listing Agreement in its list of recommendations to be included in the annual report of listed companies, requires disclosure of only such materially significant related party transactions that are apprehended to have potential conflict with the interest of the company at large. The discretion has of course been left to the management, which in effect controls the company in most cases. Such a loose approach means that majority shall always have an upper hand in cases of corporate governance also. This seems to have remained the general rule that has governed corporate India for a long time – that of the majority ruling the company. The reactive step in corporate governance to allow only disinterested shareholders to vote has extended the approach to such a precarious situation.

Abusive RPTs

This term is mainly used to signify the tactics adopted by majority shareholders, who in turn are related to each other to divert the funds of the company. Thus, what is rightfully the company’s gets diverted to other fronts owned by the promoters or major shareholders of the company. The term came to the forefront with the string of scams in the last decade. Section 188 of the Act, 2013 prohibits any such related party from voting on any related party transaction.

The phrase “such related party” may give an impression that only the member who is directly related to the resolution being passed shall abstain from voting in the general meeting. Such a belief defies the very basis of any related party transaction. Related party concept is pervasive in nature and transcends across a particular contract. When the very basis is sharing of an economic interest, it can by no means be concluded that only direct interest in the transaction shall be prohibited from voting in general meeting.

Special resolution and non-voting majority – a “hung” company in the making

The section 188 of Act, 2013 deals a double whammy by also prescribing special resolution for according approval for a related party transaction. The very step of allowing only disinterested shareholders to vote in itself is enough to give rise to serious apprehensions regarding passing of any RPT and to add to that, special resolution has also been prescribed.

Effectively this tilts the corporate balance on the side of the minority. So envisage a scenario of 60% shareholding in the hands of majority, which in turn are related. If now the company was to enter into a transaction covered under section 188 of Act, 2013, then the 60% majority are prohibited from voting in the general meeting, which would mean that the remaining 40% disinterested shareholders shall only vote. Since, approvals under section 188 are to be taken by special resolution, then 30% approval of disinterested shareholders would be required. In this way, any shareholder holding 10% or more in the company can create complete havoc and make functioning by companies very difficult. Such errant shareholders can impede any such RPT from being passed, which by no means can be good news for companies. Passing of special resolution itself is deterrent to abuse of majority power. On top of that to also give the power to pass resolutions completely in the hands of disinterested shareholders can result in a “hung” company, similar to a hung parliament. If this was to happen, then how at all will companies function?

Sadly, this does not seem to have been well thought of by the Government and committees which drafted/made recommendations to the law.

At arm’s length price

Proviso to section 188 of Act, 2013 also mentions that where transactions are done at arm’s length price, then nothing contained in section 188(1) of Act, 2013 shall apply. By the term arm’s length, explanation to section 188(1) means such a transaction in which there is no conflict of interest. Such an exemption shall hardly be of any help in case of transactions with subsidiaries. The very concept of “subsidiary company” is exercise of majority control by the holding company and any transaction with subsidiary company by the holding company can never be at arm’s length price.

This makes passing of resolutions involving the holding and subsidiary company difficult in the subsidiary company. The situation becomes even more difficult in case of wholly owned subsidiary company.     

At arm’s length price – issues with secretarial audit

Section 92 of Act, 2013 requires the practicing company secretary to certify that the company has complied with all laws applicable to it. The fact that this is not a well drafted provision has been debated widely.

In the context of RPT, even if we were to consider a scenario of any RPT to have been done at arm’s length price, it may still be difficult to see such transactions through. The presumption in case of transactions with subsidiaries is that the same is not at arm’s length price. Wholly owned subsidiaries mainly thrive on the transactions with their holding companies. Under such circumstances, transactions at arm’s length price can only be a distant possibility. Determination of arm’s length price is subjective and consequently difficult for any auditor to also certify one as such.

Any violation of section 188 can also lead to disqualification for appointment as a director under section 164 of Act, 2013.  

(to be continued)

- Nivedita Shankar

1 comment:

vswami said...

At the first blush, to put across one's instant and spontaneous reactions, there are seen to be very good, rather extra - strong, reasons to drive / persuade anyone to believe that the new regime of 'corporate governance' sought to be ushered in by the so-believed -brand- new -legislation is not going to even remotely help in accomplishing what has been the pet "Talk of the Town (Nation !)" in recent times. At best, there are ample valid reasons to intelligently foresee that it is going to turn out / prove itself, in the long run, as just yet another piece of legislation (Corporate Code !)churned out as a fond pastime / hobby ; but pushing further off / away the vociferously proclaimed objective of "GOOD" governance to an unpredictable future. In a nut shell, "hung" corporate is expected to be the new but never thought of / aimed at by-product of the brand new code; NOT THE EXPECTED / PLANNED by-product given the brand name of,- Good Governance.