Key Takeaways
- There seems to be an overlap between regular RPT approvals and omnibus approval route creating ambiguity on what type of approvals must be procured for long term related party contracts?
- Listed companies often enter into long term contracts with their subsidiaries, affiliates or related parties – must they seek majority of minority approval for such contracts only once, or must that approval be refreshed each year?
- Omnibus, or blanket approval, appears designed for transactions that may not necessarily be contained in a ‘contract’; arguably, so long as all transactions are within the confines of a ‘contract’ a one-time approval should be sufficient
Key Takeaways
- There seems to be an overlap between regular RPT approvals and omnibus approval route creating ambiguity on what type of approvals must be procured for long term related party contracts?
- Listed companies often enter into long term contracts with their subsidiaries, affiliates or related parties – must they seek majority of minority approval for such contracts only once, or must that approval be refreshed each year?
- Omnibus, or blanket approval, appears designed for transactions that may not necessarily be contained in a ‘contract’; arguably, so long as all transactions are within the confines of a ‘contract’ a one-time approval should be sufficient
Understanding related party approvals
The underlying premise of regulating related party transactions is to ensure a level playing field, in other words – that these transactions are priced at the same terms as a transaction with an unrelated party. The law recognises the commercial importance or necessity of related party transactions and therefore instead of an outright ban on such transactions has settled on an approach of putting in place checks and balances, exercised by unrelated stakeholders in a company (the public shareholders and the audit committee), against “sweetheart deals”.
The level of scrutiny an RPT is subjected to depends on the value of such transaction. Lower threshold matters are only scrutinised by the audit committee (which has a majority of independent directors) and minority shareholders weigh in on only on meatier transactions.
The typical process for an approval can be simplified to be – (a) the management of a company negotiates a contract, and then (b) the audit committee weighs in to evaluate the transaction. The intent is that this is the first level of check, where this special board sub-committee looks into whether the contract is in the interest of the company as a whole. If it passes this hurdle, then the contract may be executed by the company. In some cases, the value of the transaction is sufficiently large that the regulations have provided for an additional layer of check exercised by the shareholders themselves (only the non-involved or public shareholders). At this stage, for the company to be granted the power to enter into the contract, it must be approved by a majority of votes cast by public shareholders, often referred to as ‘majority of minority approval’.
This process seems clear enough. However, the ambiguity seeps in, when we explore the type of audit or shareholder approvals, since there are effectively two types, (a) a regular approval; and (b) an “omnibus approval”. The answer to this seemingly innocuous question has wide ranging consequences. We have explored these below.
The type of related party approval
Take a long-term contract, between say, M&T Realty and M&T Constructions to collaborate on a real estate development. These are two companies have the same controlling shareholder and therefore are related parties – with the transaction between them being an RPT.
This single contract is essentially an amalgam of a series of discrete transactions – from the transaction that requires the architect plan to be approved and building permits to be obtained, to plumbing or electrical works sections. The contract is scheduled to take 10 years to complete and at the current annual revenue figures of the parties, account for more than 30% of each party’s revenue. It is therefore one of those transactions that are substantial enough to require shareholders to weigh in – known as a a “material” RPT.
Looking at this from the vantage point of being a board member of M&T Realty and a part of its audit committee – the question when it comes up for approval in the audit committee is whether the approval to be granted is (a) a regular RPT approval; or (b) an omnibus approval.
What are omnibus approvals? When are they relevant?
The critical element in being able to answer this is to first understand the very reason for existence of omnibus approval. For this, we turn first to the operation of an “omnibus” approval, where the most critical element is the duration of the approval. Unlike a normal approval which is once per RPT, an omnibus approval is a “decaying approval” – in that it needs to be refreshed every single year.
Details to be disclosed for an omnibus approval versus a one-time approval are as follows:
On a closer look, it seems that both one time and omnibus approvals substantively require the same set of details, i.e., the maximum value of transactions, the tenure and the overall price. Given the choice to pick between an approval that is required to be refreshed every year, or one which can be obtained at once for the duration of an RPT – any dealmaker would prefer the latter since the approach provides stability throughout the duration of the contract and does not leave the transaction exposed to a continuing risk of being shut down by shareholders.
However, in so far as the approval is a choice – it is dictated by the very nature of the RPT. This hinges on a simple fact – is there an underlying contract whose approval is being sought? If the answer to that is yes, then the normal approval route is to be used. If there is an underlying contract that captures all these transactions, then the audit committee considers it under the normal route. If however, the management approaches the board without a contract but rather the details of the transaction to be entered into, then the board can grant it an “omnibus approval” which can be understood as a “go ahead but come back soon” approach.
This decaying approval ensures that once a contract has actually been entered into within the overarching limits it will be subject to further scrutiny. This rationale is also backed up by provisions of the SEBI LODR where the audit committee is required to periodically review the transactions entered pursuant to the overarching “omnibus” approval.
Conclusion: The spirit of the regulations
As we had referenced above, the regulators seem to only want to place RPTs on a level field and not necessarily proscribe RPTs. Subjecting RPTs to a yearly approval, where the facts of the contract have not been materially altered, amounts to providing shareholders with a free do-over every year which would both be commercially untenable and otherwise serve no practical purpose.
Therefore, by laying out that boards and shareholders can give decaying approval for transactions that are repetitive but not contained within a contract, the regulator must have recognized the inherent investor protection requirement and provided for such decaying approvals. The mischief sought to be contained here is the possibly of a sweetheart deal becoming binding upon the company without the board or the shareholders being able to weigh in – which is a possibility when the contract does not yet exist. By identifying that there may be commercial reasons why such contract may not be available or feasible to be presented in time and balancing it against protection of investors – the regulators seem to have settled on this rather balanced approach. After all, investors cannot be expected to bind themselves potentially forever when they do not have sight on what it is they are actually signing up for.
1 The SEBI LODR allows less details to be disclosed in an omnibus approval only if all the transactions stay below the limit of INR 1 cr, but that benefit is for more day-to-day transactions, and less relevant for PE/ M&A dealmaking.
2 As per SEBI Circular No. SEBI/HO/CFD/CMD1/CIR/P/2021/662 dated 22 Nov. 2021.
Understanding related party approvals
The underlying premise of regulating related party transactions is to ensure a level playing field, in other words – that these transactions are priced at the same terms as a transaction with an unrelated party. The law recognises the commercial importance or necessity of related party transactions and therefore instead of an outright ban on such transactions has settled on an approach of putting in place checks and balances, exercised by unrelated stakeholders in a company (the public shareholders and the audit committee), against “sweetheart deals”.
The level of scrutiny an RPT is subjected to depends on the value of such transaction. Lower threshold matters are only scrutinised by the audit committee (which has a majority of independent directors) and minority shareholders weigh in on only on meatier transactions.
The typical process for an approval can be simplified to be – (a) the management of a company negotiates a contract, and then (b) the audit committee weighs in to evaluate the transaction. The intent is that this is the first level of check, where this special board sub-committee looks into whether the contract is in the interest of the company as a whole. If it passes this hurdle, then the contract may be executed by the company. In some cases, the value of the transaction is sufficiently large that the regulations have provided for an additional layer of check exercised by the shareholders themselves (only the non-involved or public shareholders). At this stage, for the company to be granted the power to enter into the contract, it must be approved by a majority of votes cast by public shareholders, often referred to as ‘majority of minority approval’.
This process seems clear enough. However, the ambiguity seeps in, when we explore the type of audit or shareholder approvals, since there are effectively two types, (a) a regular approval; and (b) an “omnibus approval”. The answer to this seemingly innocuous question has wide ranging consequences. We have explored these below.
The type of related party approval
Take a long-term contract, between say, M&T Realty and M&T Constructions to collaborate on a real estate development. These are two companies have the same controlling shareholder and therefore are related parties – with the transaction between them being an RPT.
This single contract is essentially an amalgam of a series of discrete transactions – from the transaction that requires the architect plan to be approved and building permits to be obtained, to plumbing or electrical works sections. The contract is scheduled to take 10 years to complete and at the current annual revenue figures of the parties, account for more than 30% of each party’s revenue. It is therefore one of those transactions that are substantial enough to require shareholders to weigh in – known as a a “material” RPT.
Looking at this from the vantage point of being a board member of M&T Realty and a part of its audit committee – the question when it comes up for approval in the audit committee is whether the approval to be granted is (a) a regular RPT approval; or (b) an omnibus approval.
What are omnibus approvals? When are they relevant?
The critical element in being able to answer this is to first understand the very reason for existence of omnibus approval. For this, we turn first to the operation of an “omnibus” approval, where the most critical element is the duration of the approval. Unlike a normal approval which is once per RPT, an omnibus approval is a “decaying approval” – in that it needs to be refreshed every single year.
Details to be disclosed for an omnibus approval versus a one-time approval are as follows:
On a closer look, it seems that both one time and omnibus approvals substantively require the same set of details, i.e., the maximum value of transactions, the tenure and the overall price. Given the choice to pick between an approval that is required to be refreshed every year, or one which can be obtained at once for the duration of an RPT – any dealmaker would prefer the latter since the approach provides stability throughout the duration of the contract and does not leave the transaction exposed to a continuing risk of being shut down by shareholders.
However, in so far as the approval is a choice – it is dictated by the very nature of the RPT. This hinges on a simple fact – is there an underlying contract whose approval is being sought? If the answer to that is yes, then the normal approval route is to be used. If there is an underlying contract that captures all these transactions, then the audit committee considers it under the normal route. If however, the management approaches the board without a contract but rather the details of the transaction to be entered into, then the board can grant it an “omnibus approval” which can be understood as a “go ahead but come back soon” approach.
This decaying approval ensures that once a contract has actually been entered into within the overarching limits it will be subject to further scrutiny. This rationale is also backed up by provisions of the SEBI LODR where the audit committee is required to periodically review the transactions entered pursuant to the overarching “omnibus” approval.
Conclusion: The spirit of the regulations
As we had referenced above, the regulators seem to only want to place RPTs on a level field and not necessarily proscribe RPTs. Subjecting RPTs to a yearly approval, where the facts of the contract have not been materially altered, amounts to providing shareholders with a free do-over every year which would both be commercially untenable and otherwise serve no practical purpose.
Therefore, by laying out that boards and shareholders can give decaying approval for transactions that are repetitive but not contained within a contract, the regulator must have recognized the inherent investor protection requirement and provided for such decaying approvals. The mischief sought to be contained here is the possibly of a sweetheart deal becoming binding upon the company without the board or the shareholders being able to weigh in – which is a possibility when the contract does not yet exist. By identifying that there may be commercial reasons why such contract may not be available or feasible to be presented in time and balancing it against protection of investors – the regulators seem to have settled on this rather balanced approach. After all, investors cannot be expected to bind themselves potentially forever when they do not have sight on what it is they are actually signing up for.
1 The SEBI LODR allows less details to be disclosed in an omnibus approval only if all the transactions stay below the limit of INR 1 cr, but that benefit is for more day-to-day transactions, and less relevant for PE/ M&A dealmaking.
2 As per SEBI Circular No. SEBI/HO/CFD/CMD1/CIR/P/2021/662 dated 22 Nov. 2021.
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