Proxy advisories raise 8 concerns regarding royalty payments to related parties in SEBI study

The performance of royalty-paying companies is not at higher pedestal compared to their peers, especially those who are not paying royalty, pointed out proxy advisories, in the SEBI study.

Royalty payments are meant to translate into growth in sales or improvement in margins. But, in reality, royalty payments to related parties (RPs) had little correlation to profits or revenues over the years, said proxy advisory firms, in a SEBI study released on Thursday.

Royalty payment generally refers to consideration paid by a company for technology transfer agreements or collaborations entered into with another company, or towards the use of trademarks/ brand names of the other company. In India, listed companies make royalty payments to their holding companies or fellow subsidiaries.

The Securities and Exchange Board of India (SEBI) published the results of a study it had done on listed companies making royalty payments to its RPs. The SEBI study analysed data of ten years, between FY14 and FY23, of 233 listed companies across sectors in India.

The study captures the concern raised by proxy advisory committees on the lack of transparency around royalty payments.

Here are the eight points the proxy advisories raised:

1.Royalty is a legitimate expense and the parent company or the concerned RP needs to be compensated for the development of the brand and technical know-how. The payment towards such brand and/or know-how, however, needs to translate into commensurate growth in sales or result in improved margins. In reality, royalty payments had little correlation to profits or revenue over the years.

2.The performance of royalty-paying companies is not at higher pedestal compared to their peers, especially those who are not paying royalty. This raises the question “In what manner is the royalty justifiable, when performance of the company is not much different from non-royalty paying peers?”, and in case of a proposed step-up in royalty rates, “On what grounds is the proposed hike in royalty justified?”

3.Companies often make significant payments towards brand usage, despite the royalty-paying companies themselves spending significantly on advertisement, brand promotion and creating/ adding value to the parent brand.

4.Cash outflows to RPs take many forms, other than royalty or brand payments. These are usually termed as ‘Management fees’, ’Technology License fees’, ‘Expenditure on information technology, engineering, management and other services.’ Such payments do not fall within the ambit of royalty from regulatory perspective and quantum of such payments can be uncomfortably large.

5.Poor disclosure levels continue to remain a governance concern. It is expected that requiring shareholder approval will oblige companies to explain the basis of charging royalty and be more considered in their decision-making. In practice, companies paying royalty do not provide adequate justification or rationale for royalty payments, and details of benefits derived in return for the royalty paid. However, most of these payments go off the radar since the prescribed regulatory threshold is too high to filter out such payments for shareholder scrutiny.

6.In case of MNCs, shareholders of the Indian subsidiary have little information on the rates of royalty being charged from fellow subsidiaries in other geographies, in order to have a meaningful comparison with royalty paid by the Indian subsidiary and to ascertain the fairness of such royalty payment.

7.Currently, shareholder approval for royalty is required if payment to an RP exceeds the threshold of 5% of consolidated turnover. Some royalty-paying companies pay less than 5% to more than one RP without requiring shareholder approval, while the cumulative payment to all RPs together is much in excess of the regulatory threshold.

8. Companies often take recourse to independent fairness opinions to justify the payment of royalty and to fix the royalty rates. It is observed that such fairness opinions from different agencies vary significantly in terms of valuation. This suggests a high degree of subjectivity surrounding the valuation, casting doubts on the fairness of royalty rates arrived upon.