Relationship Agreements: Keeping The Majority In Check!
Imagine Mukesh Ambani signing an agreement that determines his relationship with Reliance Industries or Azim Premji signing a relationship agreement with Wipro! Sounds novel doesn’t it? Well that’s what SEBI is proposing! It recently issued a consultation paper on Corporate Governance, that proposes significant changes to clause 49 and other corporate governance measures. On page 30, proposal 11.26. SEBI suggests laying down the fiduciary duty of controlling shareholders to the company and its minority shareholders. It also proposes a relationship agreement between the company and the controlling shareholder specifying the duties and responsibilities of controlling shareholders. Now this maybe the first you heard of Relationship Agreements – but UK has already experimented with them. They were mandatory till 2004 and are not about to make a comeback! To understand whether Relationship Agreements will work in India, it's useful to understand how they’ve worked in the UK. To do that i spoke to Simon Wong, a visiting fellow at the LSE. He is also a partner at investment firm Governance For Owners and Robin Ogle, Partner at Slaughter And May.
In 2003 Anil Agarwal, his family and his holding company Volcan entered a Relationship Agreement with Vedanta Resources before the company’s UK listing. The agreement included autonomy to Vedanta, that any transactions between Vedanta, the Agarwal family and Volcan would be at arms length, that at all times there would be a majority of Independent Directors on Board, that Vedanta would follow principles of good governance and so on. Up to 2004, all controlled companies wanting to list in the UK had to sign relationship agreements with the controlling shareholder.
Agarwals, Volcan & Vedanta
Autonomy to Vedanta
Transactions to be at arms length
Board to have majority Independent Directors
Vedanta to follow principles of good governance
Ogle: They were very similar. You look at a lot of them they say very similar things and they are phrased in broad terms. Their principles about the typical contents would be requiring engagements between controlling shareholder and the company to be handled on an arms length basis or no more commercial terms. There would be broad statements about how the controller wouldn’t use its influence to prevent the company from complying with the Listing Rule obligations. There would typically be some Sections which would deal with appointments to the Board and how many independent directors there might be. There would be description of how many Directors connected with the controller there could be and depending quite on the business empire that the controller had. There might be some Sections about non-compete so that the minority shareholders would know that the company would operate as a proper arms length commercial enterprise and wouldn’t be dependent on the business of the controller, wouldn’t be subject to value extraction by the controller in favor of itself or the rest of its empire.
Wong: It has continued even though it was abolished as a requirement in 2004. Many companies, as a matter of best practice, did continue to enter into these agreements. It provided some comfort but there is always the question of verification. However you also expect that the controlling shareholder would continue to exert influence. The key issue certainly is with respect to related party transactions and there minority shareholders feel a bit more vulnerable and would like to see sufficient protection.
Ogle: It did comfort the market as a whole. And we got rid of them really because in that environment at those times, which were very different from where we are today, if you look at markets then and markets now and the regulatory system we had then and what we are in now, what we got rid of is part of a de-regulatory approach. So we went from a straight rules based regulation to much more of a principles based regulation. New principles were being introduced which, taken together with disclosure, risk factors and the role of the investment bank in an IPO were thought sufficient to give comfort to the market as a whole that the company would be run on an independent basis.
Last October, UK’s FSA proposed bringing Relationship Agreements back. The discussion paper suggests that premium listed issuers, with a controlling shareholder or one that holds 30 percent or more of the voting rights would have to sign Relationship Agreements. The agreements would be similar to the pre-2004 ones with an additional requirement that a controlling shareholder must not influence the day-to-day operations.
The FSA has also proposed that all premium listed controlled companies must have a board that consists of a majority of independent directors or an independent Chairman. Only Independent Directors would approve material changes to a Relationship Agreement and Independent Directors would be elected via a new dual voting process that gives independent shareholders more say. Lawyers say these proposals have been prompted by recent boardroom battles in companies with significant shareholders such as UK listed Indonesian resource company BUMI that has witnessed a pitched battle between Nathan Rothschild owner of 12 percent of BUMI and the powerful Bakrie family that has a 47 percent stake.
RETURN OF RELATION AGREEMENTS
Controlling Shareholder: 30% or more of voting rights
To sign a relationship agreement with company
Clauses similar to pre-2004 requirements
Addition: Controlling shareholder must not influence day to day operations
RETURN OF RELATION AGREEMENTS
Board must have majority Independent Directors/Chairman
Only IDs to approve material changes in relationship agreements
Independent Directors to be elected via dual voting process
Wong: There have been a few controversies where you see companies in the mining sector listed in London where there was an impression that the controlling shareholder was too dominant and perhaps imposed its will on the board. And coupled with that is the fact that these companies are on indices and as a result passive investors will be required to hold shares in them. So in that sense, there was a perception that shareholders are quite vulnerable and that additional protection would be needed.
Ogle: The consent requirements that the FSA is thinking about would be pretty similar with one key distinction which is that there is proposed to be a new rule about how the controller should not be able to influence operationally the day-to-day conduct of the company. And that probably goes a step beyond where we have been so far.
Wong: There are other changes as well, as you may be aware, in addition to a Relationship Agreement. There is a proposal that companies with controlling shareholders should have, for example, a majority of independent directors. So it should be looked as a sweet protective measures rather than just this. I would agree with you that perhaps in itself the Relationship Agreement may not be doing that much more and if anything I actually have a concern with respect to the new provision which Robin pointed out about controlling shareholders committing not to be involved in day-to-day operations and you would imagine that in some companies, for example a successful tech company, where the founder is still involved you would expect that sort of guidance and involvement.
Doshi: But why do you need a Relationship Agreement to determine a strong Board or a Board independent in character? For instance, in India, we have separate measures that require listed companies to have a minimum number of independent directors on Board depending on whether the Chairman is an Executive or Non-executive Chairman. These things can be done outside a Relationship Agreement, there can be enough rules, regulations and laws that monitor and supervise how related party transactions are done. Taxation looks at this as well. So I am just trying to understand whether a relationship agreement does things that other laws, rules and regulations don’t? Can they offer safeguards that cannot otherwise be provided in a system or are they just an agreement that makes everybody feel better but doesn’t really achieve much?
Wong: There are some interesting features of relationship agreements such as when the controlling shareholder pledges to refrain from exercise his/her influence. For example saying that the Directors that I appoint will not decide on any sort of related party transactions or that I will limit the percentage my shares will carry in a shareholders meeting vote. So those are actually interesting features that could provide comfort and they are not specified in the current proposal.
Inspired by UK, India’s securities market regulator SEBI has also proposed to lay down specific fiduciary responsibilities of controlling shareholders and consider the feasibility of mandating Relationship Agreements. The regulator explains this move by saying there have been instances where the controlling shareholders have used the company to steer their personal interests sacrificing the overall interest of the company, mostly through abusive RPTs. The consultation paper also has proposals to curb such abusive RPTs by requiring the approval of a majority of the minority. SEBI has introduced similar safeguards in its regulations on schemes of arrangement. These actions combined point to a reining in of the majority, but will that work in India?
‘There have been instances where the controlling shareholders have used the company to steer their personal interests sacrificing the overall interest of the company, mostly through abusive RPTs...’
SEBI’s Recent Proposals
RPTs to require approval of majority of minority shareholders
Schemes of Arrangement need approval by majority of minority shareholders
Ogle: I think it will be quite a challenge and one of the things you buy when you are buying into a company with a promoter is you are buying the skills of that promoter. So there is a tension between buying into a key individual and saying actually I want the company to be run completely independently as if there wasn’t one. And you need to achieve that balance. Disclosure is obviously important but to guard against abuse, it will be useful to have some measures which give comfort to the independent shareholders that there interest is going to be protected.
Wong: I think it is probably unrealistic because as you both mentioned, they are often the driving force behind the company. What is interesting is, you are seeing developments globally where countries such as Brazil for example who are seeing companies now with some disperse ownership are starting to say- wait a second, may be we want a stronger owner because we think they are committed, they think longer term etc. So I think there is an interesting debate going on globally. What you are concerned about is not necessarily the influence of the controlling shareholder but the abuse of that power vis-à-vis the minorities. And in that sense may be protections that provide greater comfort to minority shareholders for example just stronger rights for them in related party transactions; more frequently, immediate disclosure of material related party transactions or even one of two seats that they will occupy themselves or they will nominate directors to those seats could provide a more effective protections.
Doshi: I have no doubt that none of these proposals are going to go down well in India. Our promoter culture brooks no interference but SEBI seems determined to at least get all stakeholders to rethink how good governance ought to be approached. And luckily for SEBI the tide in many countries is turning against big business and dominant shareholders.