Background
The concept of “material subsidiary” under the SEBI Listing Obligations and Disclosure Requirements Regulations, 2015 (“SEBI LODR”) is an important group governance requirement for listed entities. A practical issue arises where:
- the subsidiaries have negative net worth or
- where the consolidated net worth of the listed entity and its subsidiaries itself is negative.
In such cases, the question is whether the subsidiary can still be identified as a material subsidiary and whether the turnover test can be applied independently?
Relevant provision under SEBI LODR
Regulation 16(1)(c) of SEBI LODR defines “material subsidiary” to mean a subsidiary whose turnover OR net worth exceeds 10% of the consolidated turnover or net worth respectively, of the listed entity and its subsidiaries in the immediately preceding accounting year.
The definition therefore contains two independent parameters:
- Turnover test; OR
- Net worth test.
The use of the word “OR” is significant. It indicates that a subsidiary may qualify as a material subsidiary if it satisfies either the turnover test or the net worth test.
Further, Regulation 16(1)(c) also requires the listed entity to formulate a policy for determining material subsidiary. Therefore, the regulation gives a statutory threshold but also expects the listed entity to have a documented policy for identification of material subsidiary in case thresholds are not relevant to identify material subsidiary. The following four questions consequently arise.
Q1. If the net worth figure is negative as specified under regulation 16(1)(c ) of SEBI LODR, what shall be the criteria for determination of material subsidiary?
Where the networth of the subsidiary is negative but net worth of consolidated entity is positive then, the negative net worth of the subsidiary is not comparable with a positive consolidated net worth. The net-worth test would, therefore, not be satisfied. In this case, the turnover test must be applied and ascertained whether subsidiary would be considered as material subsidiary or not? However, a subsidiary with a substantial negative net worth may create greater risk for the listed entity than a subsidiary with a positive net worth.
Now looking at a situation where the consolidated net worth of the listed entity and its subsidiaries is negative or zero. In this situation ten per cent of a negative consolidated net worth would itself be negative. A mechanical comparison may consequently produce anomalous results for example, a subsidiary with a small positive net worth may technically “exceed” the negative threshold, while a subsidiary having a substantial negative net worth may not.
In order to tackle such situations, the material-subsidiary policy may, therefore, adopt a stricter criterion based on the absolute value of negative net worth, accumulated losses, guarantees, funding exposure or similar factors. Such an additional test would expand governance oversight rather than dilute the LODR threshold.
Q2. Can the listed entity follow only one of the two parameters?
No. The word “OR” makes turnover / net worth alternative and independently sufficient tests. It does not give the listed entity an option to select whichever parameter it prefers. Accordingly, both materiality criteria needs to be checked with turnover and net worth respectively. It may happen that in a particular situation one of the criteria for determining materiality is not relevant. In such scenario that criteria may not be relevant and hence policy for determining materiality of subsidiaries would come into play.
Where one parameter becomes arithmetically distorted because the denominator is zero or negative, the other parameter continues to operate independently, but the difficulty concerning the affected parameter must be addressed through a reasoned and documented process that may be provided under the policy for determining of material subsidiary
Q3. Why is a policy required for determination of material subsidiary when SEBI LODR already prescribe the criteria expressly for determination of material subsidiary?
Reg. 30(4) of SEBI LODR prescribes criteria for determination of materiality for the purpose of disclosure of events or information to stock exchange. It provides for three criteria for determination of materiality for the purpose of disclosure of events or information as per Sch III, Para B of SEBI LODR viz. 2% of net worth, 2% of turnover or 5% avg of absolute value of profit after tax for last three financial years. In addition to this reg. 30(4) provides for determination of other criteria for determination of material events or information that may form part of the policy on determination of materiality. Further Reg 23(1) of SEBI LODR provides for framing of policy on determination of material related party transactions. Reg. 23 provides that transactions with related party would be material once they cross threshold specified under Sch XIII of LODR.
It can be seen that when it comes to determination of materiality, SEBI has in LODR not only prescribed the threshold for determining materiality but has empowered the listed entity to frame policy.
It is seen that when it comes to assessment of materiality, SEBI has provided for framing policy for determination of materiality in addition to prescribing threshold for ascertainment of materiality, in order to ensure that the determination of materiality is always holistic in nature. Policy for determining materiality of subsidiary or otherwise is always prescribed in order to further the purpose of identification of material subsidiary.
Hence the policy requirement is not redundant but has to be applied for where the identification of subsidiary as material subsidiary only on the basis of turnover or net worth would not be correct in the context of the compliances that are made applicable to material subsidiary under LODR.
The policy for determination of material subsidiary may address matters such as:
- the financial statements and accounting figures to be used;
- treatment of foreign, step-down and newly acquired subsidiaries;
- treatment of negative or zero net worth;
- responsibility for preparing and verifying the calculations;
- monitoring of subsidiaries approaching the threshold;
- treatment of mergers, demergers or changes in the group structure;
- cover subsidiaries having significant borrowings, guarantees or funding exposure;
- identify strategically or operationally critical subsidiaries; or
- additional qualitative or quantitative criteria requiring enhanced oversight.
Q4. What is the role of the board in identifying and overseeing material subsidiaries?
Its role is to ensure that the criteria for determination of material subsidiary is applied across all subsidiaries uniformly and check whether it is relevant to determine subsidiary as per the criteria laid down in SEBI LODR.
Where it is not relevant to identify material subsidiary as per the criteria laid down in SEBI LODR then ensuring that the policy for determination of material subsidiary has all the relevant criteria for same.
The board cannot override the statutory formula merely because it considers a subsidiary to be immaterial.
The board should ensure that:
- The policy for identification of material subsidiary is appropriately framed, approved and periodically reviewed and identification of material subsidiary is done accordingly;
The board’s oversight is not confined only to material subsidiaries. Regulations 24(2), 24(3) and 24(4) refer to unlisted subsidiaries, rather than only unlisted material subsidiaries. Consequently, the audit committee must review the financial statements and investments of unlisted subsidiaries, while their board minutes and significant transactions must be brought before the board of the listed entity.
Conclusion
A holistic assessment of materiality does not permit the listed entity to depart from the statutory thresholds. It requires the company to apply both prescribed parameters, recognize the limitations of a purely arithmetic exercise and supplement the statutory tests with stricter and consistently applied policy criteria. The policy may expand the universe of subsidiaries receiving enhanced oversight, but it cannot narrow the scope prescribed by the LODR Regulations. The board must ultimately ensure that the identification process is annual, reasoned, documented and aligned with the governance consequences flowing from Regulations 24, 24A, identification of designated persons under Reg. 9 of PIT and 30. It is advisable for the listed entity to initiate tracking for material subsidiary classification as soon as a subsidiary’s turnover or net worth attains 8% to 9% of the consolidated turnover or net worth of the listed entity.
The article is written by
Vallabh Joshi – Associate Director
This article is published on taxguru link below.