Further Analysis on Compensation Agreements

[The following guest
post is contributed by Rohit Sharma,
who is a Research Associate at Vinod Kothari & Co.
Two earlier posts on
this topic are available here
and here.]
Introduction
The Securities and Exchange Board of
India (SEBI) drew attention to the issue of compensation arrangements that take
place between the private equity investors (PE) and the promoters, directors
and key managerial person (KMP) (the ‘management’) of listed entities (investee
companies), and certain disclosure issues arising from these arrangements. SEBI
felt that such agreements are not desirable and shall not be entered into in
case of listed companies. There is a need to scrutinise such agreements between
the management and the PE as these agreements hamper the principle of
transparency and disclosure in the governance of listed entities. Therefore,
SEBI has come out with a consultative paper with a proposal to mandate disclosure
of all such agreements between the private equity and the management.
What
is a Compensation Agreement?
A compensation agreement is an
agreement between the PE and the management of the listed entities whereby the
PE agrees to share an agreed proportion of the profits above a certain
threshold limit made by them at the time of selling the shares, and which are also
dependent on the fact that the company attains a performance criteria. These rewards
are a proportion of the profit earned by such PE through the management’s extra
effort that enables the PE earn such high returns. Hence, such an agreement can
also be termed as a reward agreement. The management of the company will
therefore be willing to enter into such agreements, as they will be incentivised
to enhance the value of the shares.
SEBI felt that as these agreements
between the PE and the management of the listed entities will lead to
aggressive measures being taken by the management of the company, it may lead
to a downfall in overall shareholder value. The management may give preference
to their personal interest over the shareholders’ interest as a whole. Such compensation
agreements carry both advantages and disadvantages. The advantage is that the
management will strive to enhance the performance of the company in return for
the extra incentive provided by the PE. Also, the shareholders will benefit if
the PE benefits from the same, as the share price will rise. However, this
extra effort from the management could be for a short period (the time period
could be until the PE holds the shares of the company); after the PE exits, the
extra incentive that of the management will also disappear. Also, this may lead
to unfair practice as the management is obtaining a distorted incentive, which
may lead them to act in their own interests before that of the company and the
shareholders.
SEBI’s
Paper
In this background, SEBI issued a Consultative
Paper on Corporate Governance Issues in Compensation Agreements
, which
highlighted the aforesaid issue and proposed to curb the same by advising that
the management of the listed companies should enter into compensation
arrangements only after obtaining the prior approval of the board of directors
and also the shareholders (by passing an ordinary resolution). SEBI proposes to
add the following sub-regulation (6) to Regulation 26 (pertaining to
obligations with respect to directors and senior management) to the SEBI
(Listing Obligations and Disclosure Requirements) Regulations 2015 (the ‘LODR
Regulations’):
“No
employee, including key managerial personnel, director or promoter of a listed
entity shall enter into any agreement with any individual shareholder(s) or any
other third party with regard to compensation or profit sharing unless prior
approval has been obtained from the Board as well as shareholders by way of an
ordinary resolution”.
What SEBI was referring to can be
explained with an example: PE firms make a pact with a promoter to transfer 20%
of the profit earned beyond a 30% internal rate of return on the sale of shares.
The 20% incentive to the promoters is given by the PE as a reward for handling
the day-to-day business in such a way that the share price has grown enough to
help investor enjoy such returns.
Also, SEBI denounced that such
practice has to be regulated as because such arrangements are not considered
prudent, to which SEBI stated:
It is felt that
such agreements are not desirable and hence it is necessary to regulate such
practices. One view is that there is no place at all for such side agreements
in case of listed companies. Another view is that the focus may be on the
principle of disclosure and transparency in governance of listed entities.
The exit of certain investors from
PVR Limited could be a case that bought SEBI’s attention towards these types of
arrangements. An ‘Incentive Fee Structure’ was signed between the MD and CEO of
PVR, which was not disclosed to the shareholders or the stock exchanges based
on the consideration that any such payments to the MD will not be made from the
books of PVR. The MD was to receive additional 20% of the amount received by
the investors in excess of 30% return on their investments. Also, the
compensation limits of the promoters as described in the Companies Act, 2013
(which imposes a limitation of 11% of the net profits of the company or the
limits specified in Schedule V of the Act depending on the profitability of the
company)
is not breached as the act uses the language “remuneration
payable by a public company
”.
Conclusion
An argument can be made for not
regulating such a compensation arrangement because the company itself is not
involved in this arrangement. It is between the PE being the shareholder and
the management who could themselves be holding proportionate number of shares.
Neither is the company made liable for any payments nor is there any financial
outflow from the company in any manner in respect of these arrangements. Hence,
they do not fall within the purview of a related party transaction as regulated
by section 188 of the Companies Act, 2013 and regulation 23 of the LODR
Regulations. But, this is not a viable option because although there is no
financial outflow from the company, the incentive generated by the management through
this agreement gives rise to governance issues which could financially affect
the shareholders of the company. Therefore, a disclosure for the same
arrangement is necessary for the shareholders to have full information
regarding the nature of the arrangement.
This new provision, if inserted, will
in some ways be disconcerting to the management of the listed entities, as
their side agreement with the PE may be taken away even if they try to improve
or enhance the company’s performance. These rewards shall lead to aggressive
measures being adopted by the management leading to huge risks being taken by
the management which in return can erode overall shareholder value. However,
these agreements are not illegal and they merely create a reward arrangement
for the management of the investee company. SEBI’s proposal for obtaining an ordinary
resolution by such management before entering into such agreements with the PE is
appropriate and would help in ensuring full disclosure and transparency for the
benefit of the shareholders.
– Rohit Sharma

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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