Last year, the Securities and Exchange Board of India (“SEBI”) introduced the Listing Obligations and Disclosure Requirements Regulations, 2015 (“Regulations”). These Regulations were brought in to provide for a consolidated flow of disclosures and listing obligations for all kinds of securities in tandem with the provisions of the Companies Act, 2013 to ensure shareholder protection and information flow to the stakeholders in the form of mandatory disclosures and approvals.
SEBI periodically proposes changes to various regulations affecting listed securities in order to regulate what are typically called ‘market practices’ which could potentially lead to non-compliance with law. Some instances where SEBI has regulated market practices can be seen in its prohibition of grant of share based employee benefits to promoters / persons belonging to the promoter group. It also regulated payment of non-compete fee to promoters under the Takeover Regulations.
SEBI recently took cognizance of instances where promoters, directors and key managerial personnel (Senior Management) of certain listed entities received rewards from private equity investors by way of sharing of profits upon the company achieving certain financial targets or when there was an increase in the stock price of the company. The understandings regarding such benefits to senior management are generally recorded under private agreements between the private equity investor and the senior management commonly known as compensation agreements. In its Board Meeting held on 23 September 2016, SEBI highlighted the corporate governance issues that emerged from such arrangements and observed that such compensation agreements executed without the prior approval of shareholders could potentially lead to unfair practices thus prompting SEBI to propose an amendment to the Regulations.
On 4 October, 2016, SEBI has issued a Consultative Paper on “Corporate Governance Issues in Compensation Agreements” for public comments. SEBI, under the Consultative Paper has, inter alia proposed that the management of a listed company shall not enter into any such compensation arrangements without the prior approval of the board of directors of the listed company as well as its shareholders (by way of an ordinary resolution). SEBI has proposed that Regulation 26 (which governs the obligations of directors and senior management of listed companies) of the Regulations be amended to insert a new sub-regulation (6) as follows:
“…No employee, including key managerial personnel, director or promoter of a listed entity shall enter into any agreement with any individual shareholder(s) or any other third party with regard to compensation or profit sharing unless prior approval has been obtained from the Board as well as shareholders by way of an ordinary resolution".
"Provided that all such existing agreements entered into prior to the date of notification and which may continue beyond such date shall be informed to the stock exchanges for public dissemination and approval obtained from shareholders by way of an ordinary resolution in the forthcoming general meeting.
Provided further that in case approval from shareholders is not received, all such agreements shall be discontinued..” (Proposed Amendment).
The proviso to the proposed sub-regulation (6) of Regulation 26 (stated above) provides for continuation of any existing compensation agreements, subject to the conditions that the stock exchange be informed and shareholder approval, by way of an ordinary resolution is procured, for such an agreement at the following annual general meeting. The agreement would, however, discontinue if such shareholder approval is not obtained.
Analysis and Conclusion
Commonly referred to as the promoter upside agreements, in these compensation agreements, the private equity investor agrees to share a part of its gains with the senior management subject to certain conditions. These conditions could include the company achieving certain performance targets and the concerned employee continuing to be employed with the company for an agreed period. The Proposed Amendment permits these compensation agreements subject to approvals and proper disclosures. Clearly SEBI has tried to balance commercial interests with regulatory compliance, thereby ensuring shareholder protection.
The concerns raised by SEBI are grounded on legal principles of equity and fair play and directed towards better corporate governance and investor protection. Such agreements could incentivize the management to take decisions which perhaps would otherwise not have been taken per best practices. Illustratively, a director may give short term capital gains precedence over long-term wholesome growth of the company by taking high-risk decisions before the private equity investor exits to secure the benefits under the compensation arrangement leading to possible conflict of interest scenarios. SEBI has proposed an all-inclusive list of persons covered under the definition of the term “Employee” to ensure compliance with the Regulations and the Proposed Amendment at all levels within the company.
From the perspective of a private equity investor, the proposal puts considerable regulatory burden to work out incentivisation of top level employees in listed companies. A workable yet fair solution could be proposed which has been adopted in the past by SEBI where it has mandated board approval with interested parties being disallowed from attending and voting along with disclosures to the stock exchange on the key terms of arrangements without requiring a shareholders’ approval, which in most circumstances could be difficult to procure and would increase management burden and costs. Evidently the proposed amendment would create difficulties for the senior management who have already entered into such arrangements with private equity investors and have achieved the agreed milestones under the compensation agreements but fail to procure shareholder approvals. It may be perhaps possible for SEBI to find a solution to this issue worked into the proposed amendments whilst still ensuring the protection of shareholders from the unfair practices by prescribing maximum disclosures.