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Compliance or Control: Unpacking the Audit Committee’s Role in Subsidiary Transactions - MMJC
Introduction:
As per clause (b) of second proviso to sub-regulation (2) of regulation 23 of Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements), Regulations 2015 [‘SEBI LODR’], “related party transaction to which the subsidiary of a listed entity is a party but the listed entity is not a party, shall require prior approval of the audit committee of the listed entity if the value of such transaction whether entered into individually or taken together with previous transactions during a financial year exceeds ten per cent of the annual consolidated turnover, as per the last audited financial statements of the listed entity”. This provision gives authority to the audit committee of listed entity to give prior approval to related party transactions entered into by subsidiary of listed entity. This situation gives rise to a question that, does this authority given to audit committee of listed holding company undermine the role of audit committee and board of subsidiary? Also, it raises question as to whose approval shall be taken first viz. audit committee and board of director approval of subsidiary company or audit committee of listed entity?
Background:
Clause (b) of second proviso to sub-regulation (2) of regulation 23 was inserted vide SEBI LODR (sixth amendment) regulations, 2021 with effect from April 1, 2022. Before the notification of the said amendment, SEBI had released a report titled, “Report of the Working Group on Related Party Transactions” under the chairmanship of Mr. Ramesh Shrinivasan, MD & CEO, Kotak Mahindra Capital Company Ltd.
Working group members raised concerns regarding the control of the listed entity on related party transactions of its subsidiary highlighting that the listed entity might transfer the resources to its subsidiaries to unlisted subsidiaries and then the unlisted subsidiaries might transfer the same outside the consolidated group by circumventing the legal requirement of obtaining shareholder approval. Considering the above, the Working Group felt the need to strengthen the laws for regulation and oversight of RPTs undertaken by a subsidiary with the related parties of the listed entity or its subsidiaries. Accordingly, a provision was inserted in SEBI LODR whereby listed companies were mandated to give prior approval of audit committee of listed company for related party transactions proposed to be undertaken by unlisted subsidiary.
Do these provisions lead to undermining the authority of audit committee and board of directors of unlisted subsidiary?
Before dwelling into this question, we will glance through various provisions of SEBI LODR wherein board of directors of listed company are expected to review documents / information from subsidiary company. Audit committee of listed entity shall review the financial statements, particularly the investments made by the unlisted subsidiary. Further management of the unlisted subsidiary shall periodically bring to the notice of the board of directors of the listed entity, a statement of all significant transactions and arrangements entered into by the unlisted subsidiary. Minutes of the meetings of the board of directors of the unlisted subsidiary shall be placed at the meeting of the board of directors of the listed entity[1]. Audit committee is also empowered to review utilisation of loans and / or advances from / investments by the holding company in the subsidiary company exceeding Rs 100 crores or 10% of asset size of the subsidiary whichever is lower.[2] On perusal of above provisions it is seen that role of board of directors and audit committee is to review and take note of certain information relating to unlisted subsidiary companies but when it comes to material related party transactions the role is not to review but to give prior approval.
The purpose of bringing material related party transactions of unlisted subsidiary before the audit committee of listed entity was to ensure that subsidiary companies are not used as conduits for transfer of assets out of the consolidated group. While highlighting the importance of related party transactions at subsidiary level for listed companies the Working Group on Related Party Transactions noted that, “In light of the above, the Working Group felt the need to strengthen the laws for regulation and oversight of RPTs undertaken by a subsidiary with the related parties of the listed entity or its subsidiaries. It is of significance that the need to regulate the consolidated entity as a whole was also recognised specifically in the report of the Kotak committee on corporate governance dated October 5, 2017 in the following terms– “The Committee notes that several listed entities in India operate through a network of entities– where some companies have over 200 subsidiaries, step-down subsidiaries, associates, and joint ventures. While investors hold direct equity only in the listed holding company, they have valued the entire business structure at the time of investment. Therefore, it is important for boards to ensure that good governance trickles down to the entire structure.”[3]. So, even if investor has bought shares of listed company but the value of shares of listed company includes the value of subsidiary as well.
The audit committee and board of directors of unlisted subsidiary would be reviewing the transaction at subsidiary level but audit committee of listed entity need to review the proposed related party transaction at group level. Audit committee of listed entity shall ensure that the related party transactions being entered at subsidiary level are genuine business transactions entered into the best interest of shareholders. The purpose of reviewing related party transactions by two levels of committees and board of directors being different it cannot be said that powers of board and audit committee of unlisted subsidiaries are usurped.
Whose approval shall be taken first viz. audit committee and board of director approval of subsidiary company or audit committee of listed entity?
Unlisted subsidiary companies have to take approval of audit committee, if any and board of directors of the company for approval of related party transactions. This compliance is applicable even before the amendment to SEBI LODR mandating prior approval of audit committee of listed company for material related party transactions was made effective. Management of unlisted subsidiary being with the board of directors of unlisted subsidiary approval of board of directors and audit committee is necessary of unlisted subsidiary is necessary before placing the transactions before audit committee of listed entity. Further as Companies act 2013 mandates approval of audit committee and board of directors for related party transactions, approval of same in case of unlisted subsidiary needs to be taken first in case of related party transactions that are required to be brought before audit committee of listed entity. Recommendations or observations, if any of the audit committee or board of directors of unlisted subsidiary shall be highlighted to the audit committee of listed entity when the matter is placed before them for approval.
Audit Committee of listed company to review or reassess?
SEBI vide its circular dt: November 22, 2021[4], has stated that audit committees of listed entities should review the status of long-term (more than one year) or recurring RPTs on an annual basis. Purpose of having this provision is to mandated audit committees to review the nature of related party transaction, need for such related party transactions, need for having such transactions with related parties, time limit for which these transactions are continued and terms at which these transactions are being continued. While approving the material related party transactions at subsidiary level, the audit committee is required to assess various macro parameters with respect to related party transactions being entered at group level. For example, if the subsidiary is taking maximum amount of its raw material from one of its group companies despite having other options, then audit committee should raise a question that the subsidiary and the other group entity are largely dependent on each other and if operations of any one entity are stopped, then the other shall also be adversely affected. The listed holding company being answerable for all its subsidiaries, it should ensure that the independence and wellbeing of all group entities should be safeguarded. As the audit committee and board of directors would have reviewed the minor part of related party transactions the role of audit committee of listed entity is to view related party transactions from a broader perspective.
Conclusion:
Further as per regulation 4(2)(f)(i)(2)(ii)(6) of SEBI LODR it is responsibility of board of directors to prevent abuse of related party transactions[5]. Further it is responsibility of board of directors to monitor governance practices in the listed entity[6]. With these responsibilities it is necessary that contents of the documents reviewed by the board of directors and list of documents brought before them are comprehensive. SEBI’s initiative with respect to scrutiny of material related party transactions would surely have far reaching positive impact.
This article is published in Taxmann. The link to the same is as follows: –
This article is written by Ms Rutuja Umadikar – Research Associate – rutujaumadikar@mmjc.in
[1] Reg 24(2) of SEBI LODR
[2] Schedule II, Part C, Para B, Point 21.
[3] https://www.sebi.gov.in/reports-and-statistics/reports/jan-2020/report-of-the-working-group-on-related-party-transactions_45805.html – Page 19
[4] https://www.sebi.gov.in/legal/circulars/nov-2021/disclosure-obligations-of-listed-entities-in-relation-to-related-party-transactions_54113.html
[5] Monitoring and managing potential conflicts of interest of management, members of the board of directors and shareholders, including misuse of corporate assets and abuse in related party transactions.
[6] Reg 4(2)(f) (2(ii) of SEBI LODR