Tuesday, December 2, 2014

SEBI’s Proposal for a Dividend Policy

Last week, media reports indicated that SEBI is considering imposing a requirement on listed companies to come out with a dividend policy that will compel (or at least nudge) profitable cash-rich companies to distribute their profits to shareholders. The introduction of more stringent requirements on companies to state their dividend policies will introduce a great deal of transparency on this count. But, at the same time caution must be exercised not to curb the business decision-making process of companies which is left to the management and boards who possess the necessary knowledge and expertise.

The analysis must begin with the separation of powers between the board and the shareholders. Since boards are vested with the powers of management, they are naturally best-placed to determine whether the profits of the company are to be distributed or to be ploughed back into the business. Hence, within the scheme of company law, the board propose dividends which are then to be approved by shareholders. Shareholders effectively possess only a veto over the decision on dividend. They can reject the dividend or reduce its rate, but they cannot increase the dividend over and above what the board has proposed.

Given this scenario, if SEBI’s proposal brings about transparency as to dividend declaration by companies through the need for specifying their policy, that would be beneficial to the markets. Shareholders then have the necessary information about dividend declaration without necessarily impeding the flexibility of the boards to adopt any policy as they deem fit. But, if SEBI’s diktat is likely to impose obligations on boards to distribute excess cash through profits, that would be undesirable.

The question of compelling profitable companies to distribute their hordes of cash is not a new one: it has been daunting global companies like Apple for the last few years with activist investors applying pressure on them to distribute profits either through dividends or buyback of shares. The use of market mechanisms to compel companies to distribute profits is understandable. Investors may either impose discounts on companies that horde cash profits, exit such companies or even put pressure on companies through activist investors. They may in turn be aided by informational intermediaries such as proxy advisory firms.

What SEBI must avoid is a prescriptive approach towards dividend declaration, in terms of imposing rules or guidelines on when to distribute profits, or how much. Historically, the law has operated in somewhat converse fashion. Companies are not allowed to distribute all their profits in the form of dividend, and are compelled to transfer some part of the profits towards reserves, as it were “to save for a rainy day”. This philosophy continues in section 123 of the Companies Act, 2013 as well. So, now to force companies to distribute their profits would be at variance with this principle. Hence, as dividend declaration is dependent upon the cash needs of the companies business it must be a matter left to the management and boards to decide (of course with the required level of transparency and checks and balances required by corporate law and governance norms).

The usual concern when companies do not distribute profits is that they may be instead be utilised in a manner that adversely affects minority shareholders, such as by enriching management (e.g. executive compensation) or the controlling shareholders (e.g. related party transactions). However, other mechanisms in corporate law effectively address these concerns of transactions that enrich insiders at the risk of outside shareholders. Imposing tighter regulation on dividend declaration is an area where the regulator must tread carefully and with circumspection.

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