In its board meeting held on 23 October 2016, the Securities and Exchange Board of India (“SEBI”) highlighted the issue of compensation arrangements agreed to by private equity (“PE”) firms with the promoters, directors and key managerial personnel (collectively, the “management”) of investee companies that are listed on the stock exchange, and certain corporate governance issues that emerged from these. SEBI observed:
Instances of private equity funds entering into compensation agreements with promoters, directors and key managerial personnel of listed investee companies, based on performance of such companies have recently come to light. However, when such reward agreements are executed without prior approval of shareholders, it could potentially lead to unfair practices.
Pursuant to its earlier decision, SEBI yesterday issued a Consultative Paper on “Corporate Governance Issues in Compensation Agreements” wherein it proposed that the management of a listed company shall enter into such compensation arrangements only with the prior approval of the board of directors as well as the shareholders (by way of an ordinary resolution). This is proposed to be implemented by introducing a new provision to Regulation 26 (“Obligations with respect to directors and senior management”) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (the “LODR Regulations”).
Comments are due on the Consultation Paper by 18 October 2016.
It is entirely understandable why PE firms would enter into differential compensation arrangements with the management of listed companies in which they invest. As SEBI’s consultation paper notes, the private equity firms “would share a certain portion of the gains above a certain threshold limit made by them at the time of selling the shares and also subject to the conditions that the company achieves certain performance criteria and the employee continues with the company for a certain period”. Such arrangements are similar to earn-outs in M&A deals whereby the management of the companies will be incentivized to increase value to the shareholders in the expectation that they will be rewarded more handsomely for boosting the company’s performance.
From a corporate governance perspective, such compensation arrangements bring along both merits and disadvantages. On the one hand, they may benefit shareholders because the management would be incentivized to enhance the performance of the company. If that results in advantages to the PE firms and the management, that would consequently benefit minority shareholders as well by increasing shareholder value as a whole. On the other hand, such arrangements may introduce risks in that they may not only motivate management to act on a short-term basis (or such other time period as may be consistent with the PE firms’ own intended holding period in the company), but that they may also lead to “unfair practices” (using SEBI’s terminology) as they may create distorted incentives to management that may make them act in their own interests rather than in the broader interests of the company and the shareholder body as a whole. This brings us to the need for, and manner of, regulating such compensation arrangements.
At one level, it may be argued that there is no need for regulating such compensation arrangements. After all, the company itself may not be a party to such arrangements as they are entered into between the PE firms as shareholders and the management (who may invariably also be shareholders themselves). No obligations are undertaken by the company, and there is no outflow of funds from the company in fulfilment of the compensation arrangements. In that sense, they do not fall within the purview of a related party transaction (“RPTs”) as regulated by section 188 of the Companies Act, 2013 and regulation 23 of the LODR Regulations. But, that might be too simplistic an approach, given that despite the lack of participation by the company, the arrangements might give rise to governance issues in terms of management incentives that might have an overall impact on shareholders. Regulating such arrangements is a good idea, but the more important question relates to the nature and extent of regulation.
Based on SEBI’s concerns expressed so far in relation to these arrangements, the element of transparency is vital. Hitherto opaque arrangements ought to be brought into the open, as sunshine is the best disinfectant. To that extent, it is apt for SEBI to necessitate a disclosure of such arrangements as shareholders have full information regarding their nature as well as the precise terms. This enables them to make an informed assessment of the incentives under which the management of the company may be operating. Either such disclosure can be necessitated on a standalone basis, such as by compelling management’s disclosure to the stock exchange as and when such arrangements are entered into, or the disclosure can be made to the board of directors, which in turn includes it in the board’s report provided to shareholders. The approach of immediate disclosure to the stock exchange may be desirable given its timely nature.
The more tricky issue here is the need for, and benefit of, obtaining shareholder approval for such transactions. Arguably, since the company is not directly a party to such transaction, there is no underlying reason in corporate law as to why the shareholders must approve. If at all, the board can approve the transaction, and factors such as board independence, directors’ duties and other similar corporate governance measures would ensure that the board adopts a fair and independent attitude while considering such arrangements. Moreover, the requirement of obtaining shareholders’ approval through ordinary resolution does not add any benefit, but only increases the costs. For instance, in case of companies with promoters (a significant population in the Indian stock markets), it may not be difficult for the shareholder resolution to be carried through with ease. If the requirement of shareholder resolution has to be meaningful, then it would be necessary to stipulate that the persons who are party to the compensation arrangements should be disallowed from voting in the transaction, as they are effectively “interested shareholders”). Hence, shareholding voting must be made necessary only if such safeguards are introduced, failing which they are unlikely to introduce the protection intended.
Overall, SEBI’s proposals are welcome in that some oversight is required over such compensation arrangements, but as discussed above, the nature and extent of regulation may require further consideration if the corporate governance objectives are to be met.