Wednesday, October 5, 2016

Compensation Arrangements between Private Equity and Company Management: Corporate Governance Issues

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.[1] 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.

[1] It is just as well that SEBI has not attempted in its Consultation Paper to regulate these compensation arrangements through the legal framework for RPTs, but on a standalone basis.


Anonymous said...

Dear Sir,

Are there any similar provisions monitoring compensation agreements in other jurisdictions like U.S.A. and Germany ?

Anonymous said...

Going by the media coverage of the private arrangement between Ajay Bijli and Multiples PE, I understand that the arrangement was disclosed to the Board of PVR. This was done in compliance with Regulation 26(5) of the LODR. I am reproducing Reg 26(5) here:

"Senior management shall make disclosures to the board of directors relating to all material, financial and commercial transactions, where they have personal interest that may have a potential conflict with the interest of the listed entity at large.
Explanation.- For the purpose of this sub-regulation, conflict of interest relates to dealing in the shares of listed entity, commercial dealings with bodies, which have shareholding of management and their relatives etc."

The LODR stops at disclosure to the Board. The Board is in no way legally compelled to make this disclosure public in the Board Report. Secondly, and more crucially, this disclosure is crucial because it admits that there could be a potential conflict between the personal interest of the director and the Company. If that is the case, then there is a clear violation of Section 166(4) because the director in question has clearly placed himself in a situation where there is a potential conflict of interest and is thus in breach of his fiduciary duties to the Company.

However, before we bring such a charge, we need to consider how the duty to avoid conflict of interest has been interpreted historically and here we may run into a problem. Historically, conflict of interest has been used to clamp down on transactions carried out by the director and entities connected to the director. It has also been used to regulate undue gains being made from business opportunities that should have been availed by the Company in the first place.

Therefore, I am not sure whether the duty to avoid conflict of interest can be re-engineered to regulate such a situation. Would be happy to know your thoughts.

Umakanth Varottil said...

I am not aware if there are similar provisions in laws of US and Germany. Having said that, when it comes to executive compensation arrangements generally, Indian law is comparative strict, although other countries are clamping down in different ways as well.

As for conflict of interest, it is a debatable position. Since the transaction is between the manager/director and a shareholder (i.e. private equity firm), it may not technically create a conflict of interest situation vis-a-vis the company. In other words, the director has not done anything that might prefer his/her own interest over that of the company, since the company is not involved at all. It is probably for this reason that SEBI has found it necessary to regulate it directly through a separate mechanism altogether rather than to address through either conflict of interest or related party transactions.

Anonymous said...

I was thinking of a scenario where the director is pushed to take decisions which he normally would not have taken. For instance, the director may take high risk decisions to show growth in the short term before the PE firm exits so as to entitle himself to benefits under the compensation arrangement. Would this not bring about a conflict between his personal interest (getting the benefits) and his duty to the Company (to act in good faith and take decisions after applying due care and skill)?

Anonymous said...

I was referring to conflict of interest (benefits under the compensation arrangement) and duty to principal (duty to act with reasonable care, skill and diligence). If a compensation arrangement influences the director to take undue risks to drive up short term growth (before the PE firm exits), there is a clear case of the director putting his personal interest over and above his duty to the Company.

The argument that the director's decisions were not driven by the incentives would not hold good because he deliberately placed himself in a situation which rendered his interest conflicting with his duty. Would that not be actionable for breach of fiduciary duties?

Anonymous said...

Dear Sir,
i am not able to get here the issue of RPT'S. as to what is the relation between PE Firm and the management of the listed company as.

Umakanth Varottil said...

@Anonymous. In relation to the situations described above, it would depend on the facts and circumstances of each case whether there was a conflict and whether the director was so motivated by the conflict. These would perhaps have to be decided as a matter of breach of directors' duties. In that sense, not only would this have to be decided by the courts (ex post), but it would also have to be on the facts. What SEBI is seeking to do here is to set up a rule (ex ante) that introduces checks and balances that prevent any distorted incentives from affecting the actions of directors.

As to the last question, the relationship between the PE firm and the management is purely contractual. The issue of RPTs may not apply here if the company itself is not a party to such a relationship.