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:
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.
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”).
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.
Paper by 18 October 2016.
Analysis
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.
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.
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.
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.
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.
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.
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.
Paper to regulate these compensation arrangements through the legal framework for
RPTs, but on a standalone basis.