Royalty Payments and Corporate Governance

In the past, the
corporate governance discourse pertaining to Indian companies has revolved substantially
around family owned businesses and government-owned (public sector) companies.
Another type of companies that is quite prevalent in the corporate scenario,
but usually does not receive specific attention, is Indian listed subsidiaries
of multinational companies (MNCs). A significant governance issue in respect of
such MNC subsidiaries has now been highlighted due to the unintended
consequences of a change in regulation pertaining to foreign investment and
foreign exchange.
Earlier, the
Government had imposed restrictions (including limits) on the amount of
royalties and trademark fees that Indian companies could pay under foreign
collaboration agreements. However, in December 2009, these restrictions
were removed
, and Indian companies were free to make these payments to
foreign collaborators without any restrictions or limits. The purpose of this
change was to ease such payments from a foreign exchange perspective. The
matters that transpired since have sparked off major concerns from the point of
view of corporate governance and minority shareholder protection in Indian
listed companies that are subsidiaries of MNCs.
The Institutional
Investor Advisory Services (IIAS), a proxy advisory firm, has issued a recent
report
that indicates a spurt in royalty payments by Indian listed MNCs to
their parent companies. This has also attracted follow-up discussion and
commentary (see Business
Standard
and Spicy
IP
). What emerges is that since the liberalization in December 2009,
royalty payments have increased substantially despite the lack of commensurate
increase in revenues and the faster increase in revenue and margins of local
competitors. The net result of these efforts is that what would have otherwise
been paid out as dividend pro rata to all shareholders is now being paid out as
royalty only to the parent company (controlling shareholder). This operates to
the detriment of minority shareholders in such listed companies. The discussion
also indicates a lack of transparency in the manner in which such payments are
made, which also does not require any specific shareholder approval under
current law.
Such royalty
payments are a classic case of related party transactions (RPTs) between the
company and a controlling shareholder. As we have previously
lamented
, the regulation of RPTs in India is far from the desirable.
Current corporate governance norms only require appropriate disclosure in the
financial statements, a responsibility imposed on the auditors and the audit
committee. One way of approaching the issue is to consider disclosure as
fulfilling an important function because investors can then decide their
further course of action depending on the nature of disclosures. However, there
are problems with disclosure as the sole option. First, disclosures can sometimes
lack meaning if they are not appropriately and accurately made. Second,
disclosures tend to acquire an element of standardization over a period of time
thereby leaving investors with little information to distinguish among
companies that make the royalty payments.
Due to the failure
of disclosure as an adequate option, it is necessary to consider other
possibilities through amendment to corporate governance norms. Essential among
them is the need for a committee of independent directors to specifically consider
and approve such royalty payments (or any other material RPTs for that matter)
after specifically expressing their views on the impact of such transaction on
the interest of minority shareholders. Another option would be to mandate
shareholder approval for such royalty payments (or other RPTs), wherein the
recipient of the royalty payment (i.e. the parent company) must be required to
abstain from voting in view of the conflict of interest.

Unless such checks and
balances are introduced, the minority shareholders in such MNC subsidiaries
will be exposed to considerable risk that the parent companies will likely
treat the Indian listed companies as if they are merely arms of themselves.

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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