Further Analysis on Compensation Agreements

[The following guest post is contributed by Rohit Sharma, who is a Research Associate at Vinod Kothari & Co.Two earlier posts on this topic are available hereand here.]Introduction The Securities and Exchange Board of India (SEBI) drew attention to the issue of compensation arrangements that take place between the private equity investors (PE) and the promoters, directors and key managerial person (KMP) (the ‘management’) of listed entities (investee companies), and certain disclosure issues arising from these arrangements. SEBI felt that such agreements are not desirable and shall not be entered into in case of listed companies. There is a need to scrutinise such agreements between the management and the PE as these agreements hamper the principle of transparency and disclosure in the governance of listed entities. Therefore, SEBI has come out with a consultative paper with a proposal to mandate disclosure of all such agreements between the private equity and the management. What is a Compensation Agreement? A compensation agreement is an agreement between the PE and the management of the listed entities whereby the PE agrees to share an agreed proportion of the profits above a certain threshold limit made by them at the time of selling the shares, and which are also dependent on the fact that the company attains a performance criteria. These rewards are a proportion of the profit earned by such PE through the management’s extra effort that enables the PE earn such high returns. Hence, such an agreement can also be termed as a reward agreement. The management of the company will therefore be willing to enter into such agreements, as they will be incentivised to enhance the value of the shares. SEBI felt that as these agreements between the PE and the management of the listed entities will lead to aggressive measures being taken by the management of the company, it may lead to a downfall in overall shareholder value. The management may give preference to their personal interest over the shareholders’ interest as a whole. Such compensation agreements carry both advantages and disadvantages. The advantage is that the management will strive to enhance the performance of the company in return for the extra incentive provided by the PE. Also, the shareholders will benefit if the PE benefits from the same, as the share price will rise. However, this extra effort from the management could be for a short period (the time period could be until the PE holds the shares of the company); after the PE exits, the extra incentive that of the management will also disappear. Also, this may lead to unfair practice as the management is obtaining a distorted incentive, which may lead them to act in their own interests before that of the company and the shareholders. SEBI’s Paper In this background, SEBI issued a Consultative Paper on Corporate Governance Issues in Compensation Agreements, which highlighted the aforesaid issue and proposed to curb the same by advising that the management of the listed companies should enter into compensation arrangements only after obtaining the prior approval of the board of directors and also the shareholders (by passing an ordinary resolution). SEBI proposes to add the following sub-regulation (6) to Regulation 26 (pertaining to obligations with respect to directors and senior management) to the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 (the ‘LODR Regulations’): “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”. What SEBI was referring to can be explained with an example: PE firms make a pact with a promoter to transfer 20% of the profit earned beyond a 30% internal rate of return on the sale of shares. The 20% incentive to the promoters is given by the PE as a reward for handling the day-to-day business in such a way that the share price has grown enough to help investor enjoy such returns. Also, SEBI denounced that such practice has to be regulated as because such arrangements are not considered prudent, to which SEBI stated: It is felt that such agreements are not desirable and hence it is necessary to regulate such practices. One view is that there is no place at all for such side agreements in case of listed companies. Another view is that the focus may be on the principle of disclosure and transparency in governance of listed entities. The exit of certain investors from PVR Limited could be a case that bought SEBI’s attention towards these types of arrangements. An ‘Incentive Fee Structure’ was signed between the MD and CEO of PVR, which was not disclosed to the shareholders or the stock exchanges based on the consideration that any such payments to the MD will not be made from the books of PVR. The MD was to receive additional 20% of the amount received by the investors in excess of 30% return on their investments. Also, the compensation limits of the promoters as described in the Companies Act, 2013 (which imposes a limitation of 11% of the net profits of the company or the limits specified in Schedule V of the Act depending on the profitability of the company) is not breached as the act uses the language “remuneration payable by a public company”. Conclusion An argument can be made for not regulating such a compensation arrangement because the company itself is not involved in this arrangement. It is between the PE being the shareholder and the management who could themselves be holding proportionate number of shares. Neither is the company made liable for any payments nor is there any financial outflow from the company in any manner in respect of these arrangements. Hence, they do not fall within the purview of a related party transaction as regulated by section 188 of the Companies Act, 2013 and regulation 23 of the LODR Regulations. But, this is not a viable option because although there is no financial outflow from the company, the incentive generated by the management through this agreement gives rise to governance issues which could financially affect the shareholders of the company. Therefore, a disclosure for the same arrangement is necessary for the shareholders to have full information regarding the nature of the arrangement. This new provision, if inserted, will in some ways be disconcerting to the management of the listed entities, as their side agreement with the PE may be taken away even if they try to improve or enhance the company’s performance. These rewards shall lead to aggressive measures being adopted by the management leading to huge risks being taken by the management which in return can erode overall shareholder value. However, these agreements are not illegal and they merely create a reward arrangement for the management of the investee company. SEBI’s proposal for obtaining an ordinary resolution by such management before entering into such agreements with the PE is appropriate and would help in ensuring full disclosure and transparency for the benefit of the shareholders.- Rohit Sharma

Source: Corporate

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