Related party contracts pose challenges

Last Updated: Sun, Dec 20, 2009 19:00 hrs

A guide on fighting abusive related party transactions published by the Organisation for Economic Co-operation and Development (OECD) has raised some interesting possibilities in the appointment of independent directors and pattern of voting on such transactions.

Independent directors are the primary tool for Indian policy regulating corporate governance in Indian listed companies, in terms of Clause 49 of the listing agreement prescribed by the Securities and Exchange Board of India (SEBI) for every listed company to sign with stock exchanges. Under the listing agreement, the composition of the board of every listed company is regulated – if the board has an executive chairman or a chairman related to the promoter, one half of the board ought to comprise independent directors. In other cases, one-third of the board ought to comprise independent directors.

While we take the office of the independent directors as a panacea for all evil (everything in Clause 49 revolves around them), the listing agreement has made no incision in relation to their appointment. Noting that in most cases independent directors are nominated and elected by the controlling shareholder, the OECD report finds that the use of "a nomination committee consisting of majority-shareholder-recruited directors, is not necessarily sufficient to avoid a ‘rubber stamping’ culture".

This has been the central problem in India too. The authors of Clause 49 and its administrators have completely been immune to the fact that even an independent director holds office only at the pleasure of the general body of shareholders. If the independent director is a painfully interfering participant, he can be removed at will by the majority shareholders. That legal position ensures that independent directors do not involve themselves in the company’s affairs beyond a certain point, and therefore hold office.

While the OECD report recommends a concept of "cumulative voting" for the office of the independent director – where one would have to deduct the negative vote from the positive vote, in Indian circumstances, the suggestion would carry little value. At general meetings, voting by ballot is barely insisted upon by any shareholder, and in the case of postal ballot, shareholder participation in the election exercise is abysmally low.

The subject of voting, in the case of not only the appointment of independent directors but also in the case of approving related party transactions, has not been given attention in India. The controlling shareholder recommending the related party transaction to the listed company, in which public money is invested, can freely vote on the transaction, both at the board level and at shareholder level (if general company requires the nature of that transaction to be approved by shareholders – being a related party transaction by itself does not necessitate shareholder approval).

While one-off transactions may get a lot of discussion and focus at board meetings, an innocuous agreement that leads to a series of ongoing multiple transactions over many years only has a one-time approval requirement in law. Indeed, the Audit Committee would review such transactions and report them to the shareholders, but whether such transactions ought to be even carried out, is practically covered by a one-time approval process.

Interestingly, the OECD report commends the Indian Accounting Standards in its scope of coverage of related party transactions. However, this has little meaning for shareholders since their vote is not really required for such transactions (as is the case in other jurisdictions) and the board of directors has a free run to decide. Even if the director nominated by the shareholder interested in the related party transaction abstains from voting, the independent directors who hold office at the pleasure of the controlling shareholder generally do not prove themselves to be significantly effective.

Indian policy-makers have focussed their attention on corporate actions such as delisting where the majority shareholder’s vote is to be disregarded for computing the requisite approval thresholds. However, ongoing decisions that could bleed the company and thereby the public shareholder’s resources do not have similar oversight.

(The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.)  

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