Sebi's new RPT rules highlight the problems of tracking such transactions

In February 2019, as regulators stepped up scrutiny of corporate governance and business practices in the fraud-hit housing finance company, Dewan Housing Finance Corporation, the resignation letter of one of the independent directors cited allegations of illegal related party transactions (RPTs) involving promoter group companies. Inte­rest­ingly, in its communication to the stock exchange, the company cited “personal reasons” for the resignation of the independent director.

Few months later, in Novem­ber 2019, in another fund-crunched group, Zee Enter­tainment Enterprises, one of the independent directors resigned from the board citing “several instances of poor corporate governance”. Among the reasons mentioned, key ones were guarantees given to subsidiary companies without approval from the board and high level of outstanding receivables from related companies.

That RPTs are susceptible to use and abuse by promoter groups and businesses to siphon off funds is something regulators, policymakers, investigators and board members have been acutely aware of for many years. As a result, the regulatory scrutiny over such transactions has progressively increased over the years. But so has the pushback from companies and business to enhance oversight, citing higher compliance burden, which, they argue, goes against the grain of declared government policy of making it easier to do business.

The script was no different when in November last year, the Securities and Exchange Board of India (Sebi) effected changes in RPT rules (see box). These changes play out over the next two financial years, with the process beginning in April 2022.

With barely a month or so to go for the new rules to come into effect, business lobby groups have upped noise levels on how the added compliance requirements, especially for large business conglomerates with multiple subsidiaries, would slow down the pace of doing business. Experts, however, point out that India’s guide rails for regulating RPTs are in line with global best practices — based on the four pillars of disclosure, prohibition of certain transactions, board approval and shareholder approval.

What tilts the balance is the volume of related transactions that businesses undertake, especially in fast-emerging economies with high levels of corporate ownership concentration. Data from OECD Factbook on Corporate Governance, 2021, points out that corporate ownership of three largest shareholders in 28 out of 45 large jurisdictions was at more than 50 per cent of the company’s equity, with countries such as the Un­ited States, Australia, Finland, Canada and United Kingdom showing the least ownership concentration ranging between 33 and 36 per cent. “In the case of India, the ownership concentration of the promoter group goes above 70 per cent for listed groups,” said Kaushik Dutta, director, Thought Arbitrage Research Institute, a Delhi-based think-tank, citing the OECD Factbook. The skewed ownership concentration becomes a challenge as promoters and promoter groups often take concerted actions that hold the potential of abuse, he adds.

Experts say the practical challenge in regulating RPTs is this: To determine if a transaction could potentially benefit a related party at any leg of the transaction can be extremely difficult for the management and for independent directors, with the conclusions seemingly subjective.

“Self-regulation and integrity are the key to any related party transaction and the fate of compliance is in the hands of individuals only,” said J Sundha­resan, a board strategist and compliance expert.

Corporate governance experts point out that the biggest challenge for regulators to curb misuse is figuring out non-disclosure of RPTs. “When there is no disclosure at all, or incorrect disclosure, how will the regulator even know that there is any RPT?” asked Shri­ram Subramanian, founder-director, InGovern Research Services, a proxy advisory firm.

Disclosures and transparency in RPTs are the best disinfectants against their abuse, according to experts. “It is surprising that corporate India thinks that these place additional compliance burdens. This is a bogey …. all these years, companies have chosen to hide RPTs by channelising them through subsidiaries, or by giving loans, Inter Corporate Deposits, and so on, which will now need disclosures,” Subramanian said.

Many independent directors and audit committee members are wary of the enhanced responsibilities for them in the new regulations. Most agree that tightening the rules was par for the course, and something they anti­cipated. “In the recent past, there have been a number of cases in which promoters of large corporations have engaged in multiple related party transact­ions by siphoning money to shell foreign companies that were floated as subsidiaries or associate companies,” said Vijaya Sampath, advocate, and an independent director on several boards. “Unfortunately, as always, the majority who comply with the law have to suffer extra scrutiny and processes because of the misdeeds of a few,” she added.

The way forward, according to Shailesh Haribhakti, chairman, Shailesh Haribhakti Associates, is for boards, managements and promoter groups to realise that digital processes and expert guidance are being harnessed all round to ensure compliance in letter and spirit. “The regulators and exchanges are as equipped with digital analytical tools as corporate India is. Information asymmetry or suppression is no longer viable,” said Haribhakti.

Avoidance of conflicts, arm’s-length valuations and business purpose-driven costs create a perception of value in the investing ecosystem, he added.

Haribhakti’s advice to boards is: Be Digital, Diligent, transparent with Disclosures, and Docu­ment thoroughly. “These four Ds of RPTs will clean the Augean stables and permit an evolution of high value discovery by the investing ecosystem,” he said.

Sampath raises a point of practice. She said requiring only independent directors to approve RPTs seems like overkill. “Does this mean that non-independent directors who have no interest in a particular transaction cannot be trusted to give an impartial view on RPTs, putting a question on the fiduciary duty of the director’s responsibility?” she asked.

Dutta is of the view that the overall impact of the changes being brought by Sebi could be mixed. Any regulatory tightening, according to him, should try to balance the competing interests of transparency and burden, which in this case seems missing. Experts pointed out that the revised framework has chosen not to provide any exemption to transactions done in the ordin­ary course of business and on an arm’s length basis. Further, audit committees, typically in large compan­ies that have a large network of subsidiaries and associate firms, could find it difficult to deal with the new requirements.

A principles-based approach, as followed in developed jurisdic­tions, calls for scrutiny of tra­nsa­ctions entered into between promoter groups. However, some experts feel extending the regulations to transactions entered into with subsidiaries goes against the principles of good governance. “The effectiveness of the regulation lies in effective and fast enforcement actions, tracking of suspect transactions using predictive mechanisms to red-flag transactions that can cause harm,” said Dutta.