Demystifying Corporate Governance issues in PE-Promoter's Compensation Agreements

October 24,2016
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Kaushik Mukherjee (Partner, BMR Legal)
Narayan Kedia (Managing Associate)
Saswat Mohanty, (Associate)

 

 

 

 

 

 

The Securities and Exchange Board of India (SEBI) issued a consultative paper on October 4, 2016 inviting comments from the public for regulating potential unfair practices which may arise as a result of ‘side deals’ between private equity investors and employees (including promoters, directors and key managerial personnel) of the target company. The basis of rewarding employees of the company pursuant to compensation agreements or reward agreements is one of the key steps for investors to ensure that the company performs at its optimal potential, which in-turn provides for profitable exits for investors. Under these compensation agreements, employees are provided certain payments at the time of exit that are linked to profits of the target being above a certain threshold. The benefits of such compensation agreements are two-fold -- it incentivizes the employees to look to maximize profits, as well as aids in employee retention. 

SEBI has proposed to make such prospective side deals or compensation agreements entered between private equity investors and the employees of listed companies subject to approval of board and shareholders of the company to ensure fair transparency and disclosure to the public and to avoid any unfair practices. Further, it also requires that existing compensation agreements (that were entered into prior to coming into force of this proposed law) be retrospectively approved in the general meeting of the company for it to be valid.

The measures proposed to be undertaken by SEBI is to ensure effective and good corporate governance. SEBI’s concern stems from the fact that such sharing of profits with the employees on achievement of certain thresholds may compel employees to indulge in unfair practices that maximize profits at the expense of good governance. However, please note that it is a fiduciary duty of the officers of a company including promoters, directors, senior managerial personnel and employees to follow adequate systems and processes to ensure proper growth and functioning of a company in compliance with the corporate governance norms for the benefit of its shareholders.The applicable laws, and rules, regulations and guidelines prescribed by various regulatory authorities in India provides for adequate checks and procedures to ensure that the corporate governance norms are adhered to and the interest of a member of a company is not imperiled for the personal benefit of an employee of a company. The Companies Act, 2013 codifies the fiduciary duties of directors, and breach of such duties is punishable with fine of not less than INR 100,000, which may extend to INR 500,000. Additionally, it also provides that a director shall not achieve or attempt to achieve any undue gain or advantage either to himself or to his relatives, partners, or associates and if such director is found guilty of making any undue gain, he shall be liable to pay an amount equal to that gain to the company.

On September 2, 2015, SEBI notified the SEBI Listing Regulations, aligning various clauses of the listing agreements with the provisions of the Companies Act, 2013, which, amongst others, included event based and information disclosure of material events and stricter governance requirements for board of directors. These included amendments to certain voluntary guidelines provided in the erstwhile listing requirements that were mere recommendatory in nature, making it now mandatory for listed entities to comply with these requirements such as board/shareholders approvals for material related party transactions, amongst others. Further, the SEBI LODR Regulations provide principle-based guidelines imposing a collective duty on the board of directors for ensuring good corporate governance by making it mandatory for the board of directors to, amongst others, disclose any matter that directly affects the company; conduct itself so as to meet expectations of operational transparency while maintaining confidentiality; monitor the effectiveness of governance practices; align managerial remuneration with long term interests of the company and the shareholders; ensure transparent nomination; monitor and manage conflict of interest; and ensure integrity of accounting and financial reporting systems.

The concept of corporate governance hinges on total transparency, integrity and accountability of the management and the board of directors. The importance of corporate governance lies in its contribution both to business prosperity and to accountability.

SEBI has proposed to introduce safeguards in SEBI LODR Regulations to ensure such corporate governance norms are adequately adhered to by the employees of a company while entering into private arrangements with regard to compensation or profit sharing. In contrast to the view proposed by SEBI, scrutiny by board and/or shareholders of the company of the compensation agreement in itself may not be a good enough measure to prevent employees of a company from engaging in unfair practices and such proposal may also act as a deterrent for investors infusing funds in a company. In the private equity ownership model, compensation is the glue that binds the interests of senior management employees of the target company to the financial objectives of the private equity owners. In a typical private equity deal, management will be asked to deliver on performance targets with an expectation that they will share, in a meaningful way, in the corresponding growth in the value of the company. Generally, the incentives in form of profit sharing or performance bonus payable to such employees are subject to pre-agreed milestones to be achieved by the company during the course of the private equity investment. Since compensation lies at the heart of the private equity investment process and is the key to effective retention of management and the alignment of interests essential to drive a successful exit, the measures proposed by SEBI may not be viewed as favorable for growth of private equity investments in the Indian economy.

Moreover, the additional measure proposed by SEBI to avoid any instance of unfair method adopted by employees to garner benefits will not curb such practices in totality. The approach suggested by SEBI seems to be more disclosure oriented by making investors cognizant of such agreements than actually prescribing methods for preventing employee frauds and checks on governance. The one time approval and disclosure on the platform of stock exchanges may not be a good enough check to curb any unfair practices which may occur subsequent to such side deals. Therefore, the whole intent of having a pre-approval of board/ shareholders may be irrelevant in the context of preventing professionals from engaging in unfair practices in the governance of a company. 

The consultative paper seeks to legitimize side deals amongst private equity and employees of a company, thereby leaving no doubt regarding the enforceability of such agreements in the future. This is a positive step for PE funds and employees as the legal standing and validity of such agreements shall no longer be questioned. However, the thought process behind the idea of including a requirement of board and shareholder approval in connection with such agreements is not clear. If it is aimed at preventing employees from indulging in unfair governance practices, it is unclear as to how effective a pre-approval of such agreements shall be in that regard. 

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