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Ms. Avantika is a 3rd year LL.B. student at Campus Law Centre, Faculty of Law, Delhi University
The pathway to stock market listings for startups seems to be picking up momentum, with many startups filing offer documents in the last two months. Among these, Ola Electric Mobility was one, having recently filed the draft red herring prospectus (DRHP) with the market regulator, Securities and Exchange Board of India (SEBI). However, an analysis of the DRHP reveals multiple governance issues in the company. The offer document presents a complex landscape for any potential investor, with the draft prospectus highlighting 77 risk factors. This situation prompts us to consider the necessity for enhanced governance standards for startups or public unlisted companies intending to list in the future, as the existing framework primarily targets improved corporate governance for companies that are already listed. One potential avenue for improvement is revising the framework related to related-party transactions for unlisted companies, which is the most significant shortcoming in this area.
Related party transactions have evolved into a channel for diversion of significant funds, amounting to thousands of crores of rupees, particularly within the Indian business landscape. This trend is notably pronounced in the context of family-owned businesses, where such transactions serve as a means to siphon off substantial funds. Intricate structures are devised, involving interlinked transactions among multiple entities operating under the common influence of promoters who engage in related party transactions, such as inter corporate loans, cross collateralization and other such arrangements. The case of the Malvinder Mohan Singh and Shivinder Mohan Singh (former promoters of Religare Enterprises Ltd., Fortis Healthcare, and Ranbaxy) serves as a stark example of how related party transactions can be used to divert substantial funds, particularly in family-owned businesses.
Implications of the Distinct Definitions
The term “related party” holds distinct definitions under the Companies Act 2013 (Companies Act), and SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (LODR regulations). A pivotal development unfolded in 2022 when the definition of ‘related party’ under the LODR regulations was amended to include “all promoter and promoter group entities without any threshold”. The revised definition now explicitly encompasses all promoter and promoter group entities without any predefined threshold. However, the definition of “related party” under the Companies Act does not specifically include “promoter and promoter group entities.”
The absence of alignment between these two distinct definitions presents considerable challenges and issues. To begin with, this non-alignment allows issuers to circumvent disclosing transactions with promoter group entities, providing a deceptive or incomplete disclosure of related party transactions to investors in the offer document. The reason is that there is no requirement to provide any disclosure regarding transactions with “promoter group entities” under SEBI (Issue of Capital and Disclosure Requirements) Regulations 2018 (ICDR regulations) when a company proposes to get listed. The definition of “related parties” with which the issuer company has entered into any “related party transactions” and disclosed as such in the financial statements is determined in accordance with the requirements under the Companies Act and does not include any transactions with “promoter group entities”.
Secondly, this also enables circumventing the approval process for transactions with promoter group entities that would otherwise be subject to an approval mechanism, similar to other related party transactions. This could result in companies planning to get listed engaging in unethical transactions and siphoning off of funds by as transferring assets to other associated firms, providing or writing off loans, and selling assets to interconnected related entities under the common influence of a promoter, all at prices significantly below the market price. Furthermore, any such interconnected transactions with promoter group entities not subject to shareholder approval before listing and not disclosed in the financial statements or the prospectus may adversely affect the market upon discovery and disclosure of such transactions after listing. This could lead to a post-listing decline in the share price of a listed company, resulting in the diminution of shareholders’ value.
Suggestions and Proposed Amendments
In light of these challenges, one amendment that regulators may consider for ensuring better disclosures to investors is to include “promoter group companies” within the definition of “group companies” in ICDR regulations. ICDR regulations prescribe certain disclosure requirements concerning “group companies” to be made in the offer document and is defined in Regulation 2(t) as:
“group companies”, shall include such companies (other than promoter(s) and subsidiary/subsidiaries) with which there were related party transactions, during the period for which financial information is disclosed, as covered under the applicable accounting standards, and also other companies as considered material by the board of the issuer.”
It can be proposed to include all “promoter group entities” as “group companies” or mandate the inclusion of all “promoter group companies” as companies considered material by the issuer company for identification as a “group company.” However, it is important to note that while such an amendment could improve disclosure, it may not address the issue comprehensively because of two reasons. Firstly, the existing disclosure requirements for “group companies” under the ICDR regulations is limited. Secondly, this may not solve the problem of bypassing the approval mechanism for related party transactions. Therefore, the most effective solution would be an amendment in the definition of “related party” under the Companies Act to include all promoter and promoter group entities within the ambit of “related party.”
The concept of the “promoter group” is not well understood in the context of unlisted companies under the Companies Act. Consequently, it may not be able to include any requirement concerning promoter group entities without defining the promoter group construct under the Companies Act. Therefore, the optimal resolution entails amending the Companies Act’s definition of “related party” to explicitly include all promoter group entities within its scope.
Conclusion
To ensure enhanced corporate governance and to regulate transactions for public unlisted companies seeking to get listed, amending the “related party” construct under the Companies Act 2013 becomes imperative. This holds the key to fostering enhanced governance for companies in the process of becoming publicly listed entities, offering the potential for superior oversight and disclosures in the context of a public offering. It is high time regulators strengthen norms not only for already listed companies but also for unlisted public companies, ensuring a comprehensive and robust regulatory framework.
