Regulating Upside Arrangements: Hit or Miss? – An Indian Perspective

Article by Priya Gupta

Private Equity Investment sector has been on the low since the last decade expect the recent revival of optimism in the industry. Possibly naming it a remarkable year, investments are predicted to have hit a high of $28-29 billion in 2018. However, the fact of PE investments being sluggish in India cannot be overlooked as investors express concerns over uncertainty on account of upcoming elections and the pandemoniac state of affairs that might flow through it. One such issue garnering attention is the current regulation exercised over Upside sharing arrangements by Securities Exchange Board of India (SEBI).

Upside sharing or compensation arrangements are contracts entered between the investor and key managerial personnel or promoter of the listed company to share a certain portion of the revenue made by the investor at the time of its exit. Such agreements are incentive instruments for the employees and/or management of the listed companies.

SEBI, has recently come to terms with regulating such arrangements by bringing them under the approval based regime of its shareholders. The amendment requires a company to obtain approval from the shareholders before executing compensation arrangements and disclose previously entered agreements. It also places a bar on interested parties to vote on these approvals. In a consultative guideline, it was revealed that such a strict public shareholder approval system would be required to avoid unfair trade practices mainly due to the price sensitive nature of the contract.

However, the question arises as to the required extent and type of regulation needed to strike an adequate balance between better governance and investor incentive. One of the major issue holding such amendment in the negative is SEBI’s deviation from the basic principle of capital markets being built around disclosures. Public shareholders themselves have to be aware of the information available to make an informed decision before exit. A comparative jurisdictional analysis would reveal that this norm is already settled in UK & U.S. This is because of the fact that an approval system invites unnecessary compliance cost and a lower motivation for firms to become listed. Additionally, companies try to devise mechanisms of avoidance by moving the capital market activity to a favorable jurisdiction rendering the entire object futile. It is to be understood that the regulation brings ambiguity especially for companies interested in Initial Public Offers. Keeping in mind that time is of essence in the market, significant PIPE deals (private investment in public enterprises) could be in a blockage awaiting approval.

Besides, the determining criteria applied by the shareholders might be highly unfitting. As per the new law, any related or interested party is not allowed to cast a vote owing to conflict of interest. It is interesting to note that SEBI presumes that a related party will include a promoter which might not always be the case. A similar approach has seen to run in the country in terms of the Insolvency Code as well. After all, “Not all conflicts of interests are problematic and need to be addressed.” Keeping in mind that India does not attract active practices by shareholders, it is possible that importance of a compensation arrangement might not be understood. For instance, if a PE investor strongly believes in the incentive program, and the company is in dire need of an investment, shareholders taking a decision to the contrary would yield a negative result for the company.

Often the reason for non-approval would be higher reward sharing fee which a shareholder might not be able to evaluate in terms of market standards. It is also not that SEBI has set a base percentage which could serve a scale as seen in other jurisdictions especially like the “two and twenty” arrangement. As a result, this ignorance would also play out in situations where the fee is higher than usual and the shareholders assess it as nominal.

It is not denied that Private Equity is a market in need of dire governance. The basic problem identified is the link between ownership and management. The complications seem to intensify when a compensation arrangement is introduced by the investor who is himself looking for a short term exit.  Many claim that a key managerial personnel would focus on making a short term goal so as to earn a major compensation and relieve themselves within a span of few years hampering larger interests of the public and the market.

SEBI regulation has completely overlooked this problem with the current law lying short of even correct jurisprudence. Analysis would indicate that SEBI chose the approval method by considering these reward arrangements as nothing short of managerial remuneration. Section 197 of The Indian Companies Act 2013 mandates for shareholder approval for the remuneration amount that any managerial personnel may withdraw. Such an approach seems to be flawed as compensation arrangements are contracts entered between the manager and the investor. A company is not made a party to the contract as the payment is not made from companies account. Therefore, treating the compensation received as some form of remuneration is fundamentally incorrect.

The correct approach then would be to lay down a harmonized approach starting with changing the approach to disclosure based as already discussed above. The second step then ideally should be to build this disclosure system. The controversial definition of a “related-party transaction” should be done away with so as to allow the companies accepting PE investments to themselves draft a policy and define  what types of transactions will be considered related-party and how will they be treated.  This policy can then be made subject to approval of the shareholders, based on which managers may act in the future to avoid possible violations.

SEBI should set out the maximum and minimum amount of fee that could be charged by the managers so as to keep the amount received in line with Industry norms. Additionally, a scale down arrangement should be set so as to curb short term practices. By setting a prescribed minimum annual rate of return, constant firm performance could be maintained for longer terms.

With the growing consciousness towards corporate governance, especially in the wake of continuous scams in the country, there is a need to implement a corporate governance code at the earliest. United Kingdom, has already with its notification in July 2018 finalized the fundamental review of the code which propagates for highest level of disclosure as a key requirement for a company’s success.

The ignorance exercised by SEBI in regulating Private Equity investments have led to unregulated violations in the past. Therefore, 2018 should be considered as an ideal year for review to understand the huge role that these investments will hold in the future. However, till the above suggestions are not implemented, Private Equity Regulation will be considered to be big miss.

About the Author: Priya Gupta is a 4th year B.A. LLB (Hons.) student from Gujarat National Law University, India.