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09 Jan 2017

Regulation Of Compensation / Profit Sharing Agreements: A Corporate Governance Perspective

The Securities and Exchange Board of India (“SEBI”), the regulator of securities market in India, had during its meeting held on September 23, 2016, expressed concerns over compensation agreements and profit sharing agreements such as side agreements / reward agreements executed between private equity (“PE”) firms and top personnel and key managerial personnel (KMP) of listed entities. As per SEBI, when such agreements are executed without any prior approval of the shareholders, it could lead to unfair practices.

Accordingly, on October 04, 2016 SEBI issued a consultation paper in which it noted that under compensation agreements, PE firms inter alia share with KMP / other top management of listed companies a certain portion of the gains at the time of selling the shares subject to the company achieving certain performance criteria and the employee continuing with the company for a certain period.

With the intent to make such arrangements transparent and in the interest of the other shareholders of listed companies, in its consultative paper SEBI proposed amendments to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“Regulations”), which is a regulatory framework for continuous disclosures and other obligations related to listed entities, which inter alia, include corporate governance, related party disclosures, etc.

Proposal:

A new sub-regulation (6) was proposed to be added to Regulation 26 (which pertains to obligations with respect to directors and senior management). As per the proposal: (a) approval of SEBI as well as shareholders of the listed entity by way of ordinary resolution prior to the execution of an agreement is required with regard to compensation or profit sharing by an employee, including key managerial personnel, director or promoter of a listed entity; and (b) agreements executed prior to the date of notification and which continue post such date need to be informed to the stock exchanges for public dissemination and approval has to be obtained from shareholders by way of an ordinary resolution in the forthcoming general meeting. In case where approval from shareholders is not received, all such agreements shall be discontinued.

SEBI had called for suggestions from the public and on the basis of the suggestions received, it approved the proposal to amend the Regulations at its meeting dated November 23, 2016.

 Amendments:

The following amendments have been approved by SEBI:

  1. i) No employee including key managerial personnel, director or promoter of a listed entity shall enter into any agreement for himself or on behalf of any other person, with any shareholder or any other third party with regard to compensation or profit sharing unless prior approval has been obtained from the Board as well as public shareholders.
  2. ii) All such agreements entered during the past three years from the date of notification shall be informed for public dissemination to the stock exchanges including those which may not be currently valid.

iii) Existing agreements entered into prior to the date of notification and which may continue to be valid beyond such date shall be informed to the stock exchanges and approval shall be obtained from public shareholders by way of an ordinary resolution in the forthcoming general meeting. The term ‘public’ shall carry the same meaning as defined under Rule 2 of Securities Contracts (Regulation) Rules, 1957.

  1. iv) Interested persons involved in the transactions shall abstain from voting on the said resolution.

Analysis:

At the time of making investment, it is common for PEs to enter into agreements with KMP and other members of top management seen as crucial for the company’s growth to retain them for at least a certain period of time after the investment. It is usually in the form of compensation agreements, profit sharing arrangements, reward arrangements etc., that may require them to perform certain activities for the purpose of achieving certain targeted results. Such private agreements between PEs and shareholders / KMP etc. such as profit sharing agreements for sharing of profits between the parties at the time of exit of the investor, might have the effect of forcing shareholders / KMP to consider their own interests and interest of the investor before the interests of the company.

It is therefore pertinent that prior to execution of these agreements, the other shareholders of the Company and SEBI get to know what these agreements are, the arrangements contemplated therein including whether it might have any adverse impact on the growth of the company or whether it is against the interests of the other shareholders of the company. Therefore, the amendments approved by SEBI rightly seem to be in the direction of corporate governance.

 As per the amendment, interested persons involved in the transactions are required to abstain from voting on shareholders’ resolutions. However, there is no restriction on voting by relatives of such interested persons or by other persons who derive benefit through any arrangement with the interested persons, whether documented or otherwise. It is suggested that a self-certification be sought from those who are voting in such transactions that they are not in any manner deriving any benefit from the transaction. Even if self-certification is not sought in writing, with inclusion of a provision that ‘persons deriving benefit through any arrangement with interested person(s), whether documented or not, shall abstain from voting’, it will be implied that those who participate in voting have self-certified that they are not ‘interested parties’ to the transaction and do not derive any benefit.

Another point of concern relates to subsequent changes to the terms of the agreement. This does not seem to have been expressly covered in the amendment. It appears to be a one-time approval without requiring further amendments to be approved by SEBI / shareholder. Though for the purpose of interpretation, the term ‘any’ used in the proposed amendment may be construed to include all agreements including subsequent changes, however, in order to avoid any disputes on this matter, it is suggested to expressly provide for the same in the amendment. Not addressing this issue might be detrimental to the interest of the company.

There has always a concern over the enforceability of private arrangements between shareholders amongst themselves or with top management. With the proposed amendment, it appears that SEBI intends to make such arrangements transparent while at the same time seeking to minimise any adverse impact on the company and/or other shareholders of the company. It is with this intention that SEBI has not only included agreements executed by key managerial personnel but also directors and promoters of a listed company.

Overall, this is a welcome move by SEBI to improve corporate governance. But as with all regulations, the effectiveness will lie in anticipating and plugging possible loopholes and in driving compliance.

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