The Securities Exchange Board of India (SEBI), through a Master Circular dated 12th July 2023, took its first concrete steps to regulate the emerging industry of Environmental, Social, and Governance (ESG) ratings. In the master circular, targeted at ESG Rating Providers (ERPs), SEBI specified 14 parameters to arrive at ESG ratings, divided into three pillars, namely, Environmental (‘E’), Social (‘S’), and Governance (‘G’), and subdivided into factors and data points.
Upon a closer look at the data points specified in the circular, one would notice the unequivocal focus on Related Party Transactions as an indicator of sound governance within a listed entity. The article intends to examine the reasoning behind such importance being given to RPTs and look at past instances of misuse of RPTs which justify SEBI’s stance. Further, the authors attempt to identify shortcomings in the current framework governing RPTs and suggest pertinent changes that can alleviate concerns surrounding RPTs and further empower RPTs to act as an authoritative indicator of corporate governance standards.
‘Governance’ under ESG Ratings
The current master circular provides for the conferring of ESG Ratings upon listed entities on a scale of 0-100, which shall be divided into the ESG Score and the Parivartan Score, with the latter solely focusing on the progress made by the entity in implementing ESG standards and improving its compliance readiness, which is computed based on pre-specified rating parameters provided in the master circular.
Interestingly, the ‘Governance’ pillar of these ratings has dual functions. It acts as a key indicator of listed entities’ exposure to ESG risks and also determines the entities’ ability to identify, manage, and comply with other ESG standards. Related Party Transactions (RPTs) have been given primacy as an indicator of sound governance within a listed entity. Specifically, the proportion of votes of non-promoter shareholders against RPTs along with the detailed disclosure of RPTs entered into by an entity and the nature of the same have been ascertained to be parameters of unequivocal significance for ESG Rating.
Why are RPTs a key indicator of sound corporate governance?
A hallmark of sound governance is the effective redressal of conflicts that arise within an organization. In India, where promoters extend a heavy influence over a company, it is common to see differences arise between such promoters and minority shareholders. One of the common reasons behind such conflicts is the utilization of RPTs by a listed entity. Although the law provides for Independent Directors (IDs) who should play a key role in assessing RPTs and approving them, experience shows that IDs are often not truly ‘independent’ in their conduct. Considering the potential of conflict, SEBI held that a company’s ability to solve them is often an indicator of the soundness of governance within the company, justifying the reliance on RPTs as a key data point for ESG ratings.
What are RPTs?
To understand what RPTs are, it is essential to understand what related parties are. Indian Accounting Standards define related parties as parties that can significantly control the financial and operational decisions of the other party, for example, an entity controlled by a close relative of a promoter. Transactions between such parties are termed related party transactions.
Defining Abusive RPTs
In many instances, RPTs are exploited to funnel out the funds provided by the shareholders and give them to related parties. Further, explanations for these dubious transactions are often not provided, which blinds the smaller shareholders from making informed decisions. Such use of RPTs is thus referred to as abusive RPTs. These transactions ultimately break the confidence of the public, stall the economic growth of the company in the equity market, and revenue losses to the regulatory authorities. Hence, it is vital to properly administer and control the RPTs undertaken by companies, and thus the robustness of the laws regulating them forms an integral part of corporate governance.
Abusive RPTs and India
In India, the number of family-run businesses is relatively high, and consequently, the business ties between them are closer, making the frequency of transactions with known parties higher. However, the line between dealing with a familiar face and draining the shareholders’ funds for personal gain in such businesses also becomes very thin, and RPTs are often misused to execute these malafide intentions.
One such widely discussed fraud that utilized RPTs as a medium was the Satyam Scam (2008), - Satyam Computer Services Ltd. attempted to acquire two Maytas companies in exchange for an unjustifiable amount, which deal was ultimately shot down by whistle-blowers and tumbling share values. It was later discovered that one of the shareholders of Satyam Computer Services Ltd. was a majority shareholder in both the to-be acquired companies and the whole transaction was a futile attempt to cover up the falsified statements of the company, including the overstatement of assets and profits and the understatement of total debt.
In a more recent instance, Deloitte reported that McLeod Russel India Ltd., which had filed its statement showing a loss of Rs. 4.41 crore for FY 2020, was falsified as the company had not shown deposits exceeding Rs. 1821 crore by the promoters, bringing its total losses to a cumulative amount of over Rs. 1825 crore. There have been several instances where companies have faced severe backlash for misappropriation of funds using RPTs, such as Eveready, wherein in FY 2020 the auditors of the company resigned due to unaccounted RPTs such as inter-lending among the group, and Vedanta, where, in FY 2019, the equity share of the company plummeted by more than 25% when it was discovered that the subsidiary of the company had invested in a company whose majority stakeholder was also a significant stakeholder in Vedanta.
Challenges surrounding Abusive RPTs and suggestions for improving governance
Considering the increasing number of abusive RPTs, SEBI, through its SEBI Listing Obligations and Disclosure Requirement (LODR) and periodic amendments, has made the laws governing them more robust. However, the authors are of the opinion that certain lacunae persist despite the continuous efforts of SEBI to address possible loopholes in the regulations that have the potential to be exploited, which include:
1) Under-valuing of transactions to circumvent it being ‘material’ and mandatory to being approved by shareholders under the SEBI LODR, and
2) Members of the Audit Committee, i.e., the independent directors, often lack expertise or are overburdened, which impacts their ability to assess RPTs aptly.
The authors are of the opinion that both of these issues can be solved if the companies are mandated to appoint Independent Financial Advisors (IFAs) to verify and give fairness opinions regarding RPTs.
The first issue can be solved by appointing IFAs, who assess every transaction that may have already been declared RPT or those that are categorized as being ‘material’ under the SEBI LODR, and in the event of them being classified as RPTs, issue a fairness report that can be accessed by all shareholders to facilitate informed decision-making. Further, the shareholders could also request the IFA to assess any transaction that they suspect of being a RPT that does not otherwise constitute a ‘material transaction’, but has the potential of being undervalued.
The second issue relates to the expertise, workload, and autonomy of the independent directors. Section 177 of the Companies Act, 2013 provides that the audit committee shall consist of a majority of IDs, but research suggests that occasionally such IDs do not possess the requisite expertise required to assess transactions aptly; moreover, as the same individual can be the ID of up to seven companies, they may already be overburdened, and the appointment of an IFA can help deal with both issues.
To successfully implement such suggestions, it should be ensured that the IFAs are independent of both parties involved in the transaction and must have expertise in the matter. Further, a special threshold for mandatory assessment of transactions could be introduced for IFAs utilizing fairness opinions which are already regarded as one of the best practices across several jurisdictions, including France and Singapore.
Considering India’s experience with RPTs and their repeated abuse to misappropriate public money, keeping a close eye on their usage by listed entities makes sense for investors as well as for market regulators. Further, as has rightly been argued by SEBI, rating the standard of governance within a company is a daunting task, especially in the absence of widely accepted indicators. It is in such a context that the usage of RPTs as an indicator of sound corporate governance becomes important. The authors are of the view that such a usage addresses two major concerns.
Firstly, it increases scrutiny of a company’s usage of RPTs. ERP ratings, similar to credit ratings, allow the public at large to access details about the inner functioning of the companies they invest in. With the framework laid down by SEBI in its master circular, which requires the ERP to lay out detailed reasoning for each of the ratings, this objective gets strengthened further.
Secondly, it incentivizes companies to prevent the misuse of RPTs. Considering the fact that RPTs have been blatantly misused in the past to misappropriate public funds by promoters and majority shareholders of listed entities, opaqueness regarding the RPTs entered into by a company detrimental impacts market confidence. With ESG ratings focusing on RPTs as a key indicator of governance and more information being shared with the public, judicious utilization of RPTs will significantly contribute to a positive image of the company and boost market confidence.
In light of these considerations, the authors believe that the current stance of SEBI is a step in the right direction, and systematic redressal of loopholes and strengthening of ESG ratings, through enhanced scrutiny of data points like RPTs will yield positive results for all stakeholders.