Using Fairness Opinions By IFAs To Improve India’s RPT Framework

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Through the Sixth Amendment to the SEBI LODR Regulations, the SEBI modified the criterion for materiality in securing shareholder endorsement for RPTs under Regulation 23(1A) and 23(2)(b) of the SEBI LODR. One of the important aspects of this amendment deals with the added responsibilities of the Audit Committee. The Audit Committee is mainly regulated by Section 177 of the Companies Act and Rule 6 and 7 of the Companies (Meetings of Board and its Powers) Rules, 2014. As per Rule 6, every listed and public company with certain conditions that have been listed in the rule, must have an Audit Committee. The composition of such a committee must consist of at least 3 directors and Independent Directors must form the majority. Regulation 23(2) of the SEBI LODR now requires all related party transactions and all material modifications to such transaction to be approved by the audit committee. Moreover, the proviso also requires approval from only those members of the audit committee who are independent directors. However, even though the audit committee greatly improves checks and balances for related party transactions. There are two issues that still remain. These issues are (a) possibility of transaction being undervalued to circumvent SEBI LODR and (b) issues with the independence, competence and bandwidth of Independent Directors.

Usage of fairness report to avoid undervaluing of transaction

The first issue deals with the company undervaluing the transaction so that the transaction is not labelled as material and the requirement of getting shareholder approval is circumvented. In order to ensure that the same does not happen, it should be compulsory for the company to mandatorily obtain an opinion from IFAs about the fairness of the valuation of a transaction. All listed companies could be asked to appoint an Independent Financial Advisers who conduct a thorough audit of all transactions which are above the materiality threshold in order to assess their fair valuation and ensure that the same is not a related party transaction.

In case the company already discloses the transaction to be a material related party transaction, the IFA can still conduct an audit to create a fairness opinion which will be disclosed to the shareholders who can then make an informed opinion while voting as after the amendment, in any case they have to approve every material related party transaction. Moreover, in order to regulate certain transactions which are below the materiality threshold, the minority shareholders can be given the right to request an independent valuation or fairness opinion for related party transaction with a threshold of requiring at least 5% of shareholder voting in affirmation. Such a move would also empower the minority shareholders to combat the second agency problem relating to the conflict between majority and minority shareholders. This method has already been successfully implemented in France.

In light of the approval of shareholders becoming mandatory, it is important to see how investors, who are not promoters of the company cast their vote. As per a study published in Economic and Political Weekly covering the voting breakup from 2017-2020 by institutional investors in top 11 of the Nifty 50 index, it could be seen that the institutional investors disagreed with the resolutions which were also favoured by the promoters in less than 1% of the cases. Coming to retail investors, in another research, it was noted that only about 25% of the retail investors participate in voting and only 1% of resolutions are vetoed by retail investors. However, their decisions followed the feedback given by Institutional Investor Advisory Services [‘IiAS’] which is a leading proxy advisory firm operating in India. It was found that shareholder support is higher when IiAS recommends shareholders to approve the RPT. When this is taken into account, the fairness report of the IFA becomes even important as a detailed study regarding the valuation will complement the amendment of requiring shareholder’s approval for material RPTs. This is because the shareholders will now be empowered with knowledge along with rights to be able to make an informed decision while voting.

Using fairness reports to deal with the issues relating to Independent Directors

The second issue deals with the independence, expertise and workload of Independent directors. As noted by Dr.Umakanth Varritol, sometimes the Independent Directors do not possess the requisite experience or skills to perform the monitoring function. Even if it assumed that the same is dealt under Section 177 where there is a requirement of the Independent Directors that are appointed to the Audit Committee must have the ability to read and understand the financial statements. There still remains the issue of the Independent Directors having too many duties already which makes it difficult for them to efficiently perform this added function. Similarly, other than being overburdened, a person can be an independent director for up to 7 companies. Usually, experienced individuals are known to hold the position of Independent Directors in several companies. In this case, having an IFA to provide a fairness report will significantly reduce the work that the Independent Directors to do while making sure that the RPTs are supervised by them. To conclude even if Independent Directors do not have the required experience, bandwidth or independence to research and investigate the RPTs in order to make an informed decision. The IFAs will undertake the same and ensure that the Independent Directors as well as the shareholders have the required information to do so.

Framework for implementing IFAs

Such an IFA should be independent of the listed entity, its management, and related parties involved in the transaction to ensure impartiality and objectivity. The fairness report to be submitted as per existing regulations must include a comprehensive due diligence on the parties, an opinion on the financial aspects through benchmarking similarly transactions, checking the compliance status with existing RPT Regulation as well as recommendations for corrective action, if required.

To strike a balance between maintaining regulatory compliance and not overburdening listed entities with excessive auditing requirements, an additional threshold can be implemented for IFA review of RPTs. This approach ensures that only transactions with a higher likelihood of undervaluation or potential misconduct will be subject to mandatory IFA audits. The addition threshold could be based on the thresholds brought in by the recent Sixth Amendment as well as the risk profile where parities with a history of regulatory non-compliance, transactions with unusually complex structures, or a frequent number of RPTs could be put under greater scrutiny. By implementing an additional threshold, IFAs can focus on RPTs that warrant closer examination, making the audit process more efficient and cost-effective while maintaining the objective of preventing undervaluation and circumvention of the new RPT threshold.

One potential concern when employing IFAs to assess the fairness of RPTs is ensuring the IFAs' own fairness and independence. To address this issue, the SEBI must also enact regulations to govern the IFAs as well the process of their selection.

Using the fairness opinions of is already considered a part of the best practices in several jurisdictions. IFAs also have to be compulsorily appointed by listed companies in Singapore as the Singapore Exchange [‘SGX’] requires a fairness opinion when the company proposes to enter into a related party transaction with its director, chief executive officer or controlling shareholder or any of their respective associates, and the size of the transaction exceeds certain prescribed thresholds, the board is required to appoint an independent financial adviser. In the United States of America, since the case of Smithv. Van Gorkom in the Delaware Supreme Court where it was rules that the directors were negligent for not obtaining a fair valuation from independent advisors. The Courts of Delaware have routinely requested for fairness opinions in several varying circumstances. Similarly, a leading American self-regulating organization, Financial Industry Regulatory Authority [‘FINRA’] also mandates a fairness opinion and lists down it’s requirements under Rule 5150. Under SECRule 13e-3, the SEC also mandates regulations for fairness opinion as a disclosure requirement when a company is going private.

Therefore, to summarise, in order to ensure that the agents of the company do not misuse their power. It is important to give more teeth to independent bodies. The main recommendation made above is to involve more parties with no conflict of interest to audit. The recent amendments ensure that the SEBI LODR is more robust. However, in order to ensure that the regulations are complied with, it is important to have an independent body ensuring the same. The same becomes extremely important for Related Party Transactions especially now given that the Audit Committee, the Independent Directors and the Shareholders, all three of them have added responsibilities and liabilities for making RPTs more compliant. The implementation of IFAs will ensure that the issues relating to their competency and independence are resolved to a greater extent and make RTPs more fair.

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