SEBI had implemented the Kotak Committee recommendations on Related Party Transactions (RPTs) by making amendments to the Listing Obligations and Disclosure Requirements Regulations, 2015 (“LODR”) on May 9, 2018. In less than two years, in November 2019, SEBI constituted a Working Group (WG) to re-examine the RPT provisions of the LODR, against the backdrop of new corporate scandals, which surfaced, where certain abusive RPTs were undertaken by the listed entity at a subsidiary level, which were not captured by the LODR provisions. The WG Report addressed this loophole and made several recommendations, which were examined by the author in his blog article titled “SEBI Working Group on Related Party Transactions: Will the net be cast too wide?” published on February 5, 2020.
In this Blog, the author wants to share his deeper reflections on some of the recommendation made in the WG report. The author argues that this WG report requires a more detailed scrutiny by the SEBI, before it is enacted into a law, by amendments to the LODR. Both these blogs should be read together to get a complete picture of the changes proposed in the WG report.
The WG report has suggested the following changes in the LODR to significantly tighten the RPT regulatory framework:
a.) WG has proposed a modification in the definition of “Related Party” to include within its scope any person or entity belonging to the promoter or promoter group of the listed entity, irrespective of its shareholding. As per the current requirement, such person or entity is required to hold 20% or more shareholding in the listed entity, which is proposed to be omitted. This would significantly enlarge the scope of the definition of related party under Regulation 2(zb) of LODR.
b.) WG has proposed modifications in the definition of “Related Party Transactions” under Regulation 2(zc) of LODR by:
i. Covering transactions between the listed entity or any of its subsidiaries on the one hand and a related party of the listed entity or any of its subsidiaries on the other.
ii. The listed entity or any of its subsidiaries on the one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiary.
This GAAR type “catch all” provision, borrowed from the UK Premium Listing Rules, has far reaching consequences in the Indian context, under other laws, which appear to have not been adequately examined by the WG.
Firstly, if this provision is introduced, then the Audit Committee of the listed entity in India will be called up to examine and approve the related party transactions entered by its overseas subsidiary. Further, the Audit Committee of the listed entity in India may also have to examine the RPTs of its foreign subsidiary with another foreign entity, which may have been incorporated in a different jurisdiction.
The changes proposed in WG report has three major legal/tax implications:
- Whether examination and approval of related party transactions of an overseas subsidiary by the Audit Committee of the listed entity in India will create any adverse tax consequences for the overseas subsidiary of the listed entity under Section 6(3) of the Income Tax Act, 1961 ? As per the explanation to the said Section, “Place of Effective Management” (“POEM”) means a place where key management and commercial decisions that are necessary for the conduct of business of an entity as a whole are, in substance made. If a view is taken by the IT Department that POEM of overseas subsidiary is in India, by virtue of the approvals given to RPTs by the Audit Committee of the listed entity in India, then it will make the income of such overseas subsidiary liable to tax in India. While one can always argue that such examination of RPTs by the Audit Committee of listed entity in India was only to comply with the local regulations and it should not be perceived that key management and commercial decisions of subsidiary are taken in India. But it certainly has the potential of creating a dispute with the Tax Authority.
- Changes proposed in the LODR with regard to review of transactions of overseas subsidiaries by the listed entity in India could make those provisions, extra-territorial in operation. Whether such an extra-territorial operation of a regulation (when the Parent SEBI Act enacted by Parliament is purely domestic in its operation) is constitutionally valid under the scheme of Article 245 of the Constitution is a question mark. The Judgment of the Constitution Bench of the Supreme Court of India, in the case of “[1]GVK Industries Ltd. Vs Income Tax officer” while interpreting Article 245, has held that any law made by Parliament with extra-territorial aspects or causes will be valid only when such extra-territorial aspects have impact on or nexus with India and such nexus with India must be real and not illusory or fanciful. Further, the liberty given by Article 245 of the Constitution is only for laws made by Parliament. While what SEBI is proposing is to bring such extra-territoriality in the LODR, which is a delegated legislation and it will not have the same status as the law made by Parliament. Therefore, the constitutional validity of such extra-territorial aspects of the proposed amendments to the LODR is doubtful. SEBI can always argue that it has framed the LODR provisions for the listed entity in India and since the accounts of the overseas subsidiary are consolidated with the parent company in India under Section 129 of the Companies Act, 2013 as per the applicable Accounting Standards, it is entitled to examine the related party transactions of those subsidiaries which could have material impact on the shareholders of the listed entity in India.
- One can argue that review of RPTs of overseas subsidiary by the listed parent in India would amount to “cross-jurisdictional piercing of the corporate veil”, as the legal status of the overseas subsidiary as a separate legal entity could get diluted and its Boards of Directors could become “functus officio”, when it comes to approval of RPTs. Is such piercing of veil justified, given the well-established principles laid down by the Courts in this regard? Is it then permissible to provide for such piercing of the corporate veil under a delegated legislation like the LODR,, when the parent SEBI Act is silent on this issue? Will it not lead to the violation of the provisions of the local Companies Act of the jurisdiction, where such a subsidiary is incorporated? Such provision directly impinges on the autonomy of the Boards of such overseas subsidiaries to enter into contracts. SEBI can argue that the proposed changes to the LODR are not piercing the corporate veil of the subsidiary but merely giving an oversight to the parent company’s Board over the related party transactions of its subsidiary and otherwise the freedom of subsidiary’s Board is well protected and hence the provision is fair and reasonable.
These are clearly some unintended consequences of the proposed amendments that SEBI needs to examine more closely.
This is in addition to the practicality of implementing such a regulation, which will further increase the already high compliance burden of the Audit Committees of listed entities. For a large corporate with hundreds of subsidiaries, it will make the task of compliance officers of such companies unenviable.
The WG has also recommended that the revised definition of RPT exclude certain corporate actions such as the payment of dividend, issue of securities on a preferential basis, rights issue, bonus issue, buyback of securities, etc., which most lawyers believe were not covered under the extant provisions of the LODR. However, these exemptions are not enough. SEBI needs to further exempt the following transactions from the ambit of RPT regulations:
- There is little justification in regulating RPTs that are a part of the Schemes of Arrangements, requiring NCLT approval under Sections 230-232 of the Companies Act, 2013. In any case, there is a separate SEBI circular to protect minority interests in such transactions.
- Similarly, those RPTs that are a part of resolution plans, approved by the NCLT under Section 31 of the Insolvency & Bankruptcy Code, 2016, need to be expressly carved out as the minority interest is well protected in such cases.
- Transactions covered by specific SEBI regulations like the SEBI (ICDR) Regulations, 2018, or the Buyback Regulations, the Takeover Code or the Delisting Regulations need to be carved out as the minority interest is once again well protected under these regulations.
- RPTs that are executed pursuant to the Orders passed by a Competent Court or those covered under the final arbitration award of the Arbitral Tribunal need to be exempted.
- RPTs that are executed, pursuant to the Orders of the Competition Commission of India, under the provisions of the Competition Act, 2002, need not be regulated under the LODR.
Concluding Thoughts :
The recent unfortunate episodes related to the use of “subsidiary route” to undertake RPTs, which are not in the best interests of minority shareholders of listed entities, may have led the SEBI WG to recommend changes in the LODR to provide for examination of related party transactions of unlisted subsidiaries of listed entities. The proposed LODR changes have several legal, constitutional and tax implications, when it comes to transactions of overseas subsidiaries, which need closer examination. Apart from significantly increasing the compliance burden of listed entities, some recommendations are just not practical to implement, particularly for a large corporate with a number of subsidiaries. Hence, it is hoped that the WG Report (on which the Regulators seems to have hit a “pause” button due to the ongoing pandemic) is more closely examined to prevent any unintended tax and other consequences on listed entities and their unlisted overseas subsidiaries.
[1] Reported at (2011) 4 SCC 36.
