In the second of three articles on the necessity to improve corporate governance, Shubi Arora writes about the need to tighten regulations with respect to affiliate transactions and preferential warrants.
In addition to analyzing Indian law when it comes to shareholder meetings and voting procedures as discussed in Part I of this series, the Asian Corporate Governance Association (ACGA) White Paper on Corporate Governance also analyzed the Indian regime with respect to affiliate transactions and preferential warrants. It concluded that that current regulations are weak and must be overhauled if minority shareholders are to be afforded adequate protection.
To be sure, transactions with affiliated entities often serve legitimate purposes. However, in India, where many businesses are old family-owned establishments, the inherent desire to run the business for the benefit of the family coupled with a weak regulatory regime is a recipe for potential abuse. An obvious flaw when it comes to affiliate transactions is that Indian laws do not contain any requirement for independent shareholder approval when it comes to material affiliate transactions. Also, disclosure requirements for such transactions are limited. Further, even if certain actions are prohibited, penalties for non-compliance are usually nominal.
According to the ACGA, the lack of effective rules in this area can lead to abuse and negative consequences for investors in India. For instance, companies could (1) spin off valuable assets from listed companies to unlisted private entities for the benefit of controlling shareholders, (2) spin off investments in groupf companies to a holding company, valuing the investments at a steep discount, and then buy back shares of the holding company from the market, or (3) shift new business to unlisted private entities and let an affiliate listed company pay for operational costs. The temptation to exploit the lack of effective rules is compounded when the business is family-owned. For instance, controlling shareholders may seek to spin-off assets to appropriate large amounts of wealth for personal or family use or to effect inter-generational transfers of wealth.
In an effort to remedy the deficiencies within the existing regime, the ACGA recommends that (1) independent shareholders approve material transactions above certain limits, (2) disclosure requirements for material transactions be enhanced, (3) independent financial advisors and board committees determine whether material transactions are fair and reasonable to all shareholders, (4) independent directors exercise their duties more diligently, and (5) companies with numerous related transactions establish related-party transaction committees to evaluate such transactions.
Closely related to the issue of affiliate transactions is that of preferential warrants. The ACGA notes that warrants are typically issued as a sweetener and accompany a rights issue or a new issue of bonds or preferred stock. However, in India this is rarely the case. Rather, warrants are offered to controlling shareholders on a preferential basis.
The only obstacle to issue warrants is that 75% of the company’s shareholders vote in favor of the proposal. However, since all shareholders (including interested shareholders, who might own a significant percentage of the equity) are allowed to vote, this threshold is often easily met. Further, since votes are almost always counted by a show of hands and proxies are neither allowed to speak nor vote on a show of hands, the voices of even large shareholders, such as institutional investors, who might be against such issuance are often not heard. Not only can companies easily issue preferential warrants, but they can do so at deep discounts because the pricing formula under current Indian regulations is based on historic prices. This, coupled with long life spans for issued warrants, allows parties to lock in large profits when the warrants are exercised.
As with affiliate transactions, the ACGA recommends several reforms. In particular, it recommends that (1) the issuance of preferential warrants and other securities be prohibited except in limited circumstances, and (2) companies overhaul the manner in which they use warrants and limit their application in a manner that forms a part of a wider issue of debt or equity securities.
Again, the ACGA’s recommendations must not be discounted. Abuses with respect to Indian corporate governance practices challenge the integrity of Indian markets when it comes to investors, both domestic and foreign. This is best avoided as India becomes an increasingly important financial center.
This is the second of a series of three articles on corporate governance. Part I of the series can be found here.
Shubham 'shubi' Arora is a Texas based Attorney working for Akin Gump Strauss Hauer & Feld LLP.