Indian Accounting Standards and 'control' quagmire

Niren Patel & Aravind Venugopal

The Indian Accounting Standards (IND AS) are in the process of being introduced to replace Indian GAAP. Different dates have been prescribed for companies to start preparing their financial statements in accordance with IND AS. Listed companies having net worth above Rs 500 crores and their holding, subsidiary, joint venture, and associate companies, and other companies having net worth above Rs 5,000 crores and their holding, subsidiary, joint venture and associate companies are implementing IND AS for reporting period starting April, 2016.

IND AS aligns Indian financial audit and accounting regime with International Financial Reporting Standards, the global financial reporting standards. IND AS will bring India closer to the global economy that she strives to be a part of. While provisions of IND AS are progressive and in tune with global best practices, reconciling ‘control’ as provided under IND AS with those contained in other Indian laws such as the Foreign Exchange Management Act, 1999 (FEMA), Companies Act, 2013 (Companies Act) and SEBI Takeover Code (Takeover Code) may prove to be challenging.

Indian exchange control laws

FEMA, Companies Act and Takeover Code define control as including “the right to appoint a majority of directors or to control the management or policy decisions, including by virtue of their shareholding or management rights or shareholders’ agreements or voting agreements.” Foreign entities are not permitted to acquire control over companies engaged in certain restricted sectors (insurance, terrestrial broadcasting, up-linking of news channels, print media, multi brand retail, single brand retail, brownfield pharma, etc.)

This definition of control is subjective. Ambiguity exists as to whether negative control (i.e. ability to block certain decisions due to veto rights or extent of shareholding) constitutes ‘control’. Veto rights are an integral part of M&A transactions and are essential for protecting the interests of minority shareholders. In the absence of such rights, majority shareholders will have the unfettered ability to take decisions which may not be in the interest of the company or the minority shareholders.

SEBI’s interpretation

SEBI had previously interpreted a similar definition of control under the old takeover code as including negative control. However, Securities Appellate Tribunal (SAT) took a contrary view and held that negative control does not constitute ‘control’. In doing so, SAT unequivocally held that only contractual rights that enable investors to dictate the course of action to be adopted constitutes ‘control’ and that veto rights are reactive in nature and do not confer control.

While SEBI appealed SAT’s decision before the Supreme Court, change in factual circumstances rendered the question of law involved infructuous. However, while disposing off the case, Supreme Court held that SAT’s decision should not operate as a precedent. Under the new takeover regulations adopted by SEBI in 2011, the definition remains largely the same.

Given the ambiguity, SEBI released a discussion paper inviting public comments on two options which would make the control definition more objective. The first of these options proposes to exempt grant of protective veto rights aimed at protecting investment or preventing dilution (as opposed to participatory rights) from the acquisition of control, as long as such rights do not result in control over day to day decision making or policy making.

Grant of rights in decisions involving significant changes to current business or that apply in exceptional circumstances were also proposed to be treated as a protective right. The proposal also contains a non-exhaustive, illustrative list of protective rights which may be granted to an acquirer with at least 10% investment. The second proposal was to link control to enjoyment of 25% or more of voting rights, or ability to appoint majority of non-independent directors on the board. Further, in a recent decision, SEBI acknowledged the position that protective rights do not result in the acquisition of control.

IND AS 110

An entity having control over another is required to present a consolidated financial statement under IND AS 110 (consolidated financial statements). For this purpose, an investor is said to have control over a company if the investor is exposed to variable returns from its involvement in the investee and can affect those returns through its power over the investee. An investor has ‘power’ over a company when it has the current ability to ‘direct’ relevant activities. In our view, veto rights do not confer the ability to direct activities as they only confer the right to react to (i.e. approve or reject) a proposal.

IND AS 110 also provides that protective rights do not confer control. In order to determine the protective nature of a right, IND AS 110 requires an evaluation to check whether rights granted relate to fundamental changes to the activities of an investee or apply only in exceptional circumstances. Not all rights that apply in exceptional circumstances are protective. Rights that prevent another party from having power over an investee are not considered as being protective. IND AS 110 provides an illustrative list of protective rights. Significantly, this list includes the right of investor holding non-controlling interest to approve capital expenditure greater than that required in the ordinary course of business, or to approve issuance of equity or debt instruments.

IND AS 111

IND AS 111 defines joint control as the contractual sharing of control, which exists only when decisions concerning activities that significantly affect the returns of the venture require unanimous consent.

In a joint arrangement, no single party controls the arrangement on its own. If an investor can prevent others from controlling the arrangement, then such investor is considered as having joint control. However, if the requirement for unanimous consent relates only to decisions that give an investor ‘protective rights’ and not to decisions about activities that significantly affect the investee’s returns, then such rights do not constitute control. In this regard, AS 111 must be read with AS 110 to understand the meaning of the expression protective rights. Such a construct is problematic as veto rights (including those that are considered as minority protection rights) typically have the ability to significantly affect the investee’s returns.

IND AS 28

IND AS 28 prescribes accounting principles for treatment of investments in associate and joint venture concerns. While joint ventures are determined as per the requirements of IND AS 111, associates are described as entities in which the investor has significant influence. Significant influence is described as the power to participate in financial and operating policy decisions without control, or joint control over such policies.

In cases where an investor holds more than 20 percent of voting rights, significant influence is presumed unless the contrary can be demonstrated. Conversely, holding less than 20 percent of voting rights results in a presumption regarding absence of significant influence, unless the contrary can be demonstrated. Significant influence is usually evidenced by board representation, participation in policy making, material transactions between investor and entity, interchange of managerial personnel and flow of essential technical information. Existence and effect of potential voting rights that are currently exercisable or convertible are considered while assessing the existence of significant influence.

In examining whether potential voting rights contribute to significant influence, all facts and circumstances that affect such rights, except the intentions of management and the financial ability to exercise or convert those potential rights are to be considered. The Companies Act while defining the term associate companies has also defined the term ‘significant influence’ to mean control over 20 percent of total capital or business decisions under an agreement. The treatment of significant influence under Companies Act and IND AS 28 appear to be congruous. In our view, the existence of veto rights may result in significant influence for the purposes of IND AS 28 and Companies Act, given the investor’s ability to participate in policy formulation.

The quagmire

The conceptualisation of control under IND AS differs from the treatment under Indian exchange control laws and SEBI. Certain regulators have clarified that mere existence of veto rights does not constitute control and that veto rights will result in control only if such rights result in control over day to day operations. RBI, DIPP and FIPB have not provided any guidance on how control has to be interpreted in the context of exchange control laws.

In entities engaged in sectors where foreign investment by non-residents is permitted without acquisition of control, application of IND AS is likely to be problematic. In such restricted sectors, typically, investments are made as joint ventures between Indian and foreign shareholders, with the Indian shareholder retaining ‘control’ as defined under exchange control laws and relevant sectoral regulations. Typically, such investments require prior approval from the government, which is granted after a detailed evaluation of the investment proposal. Such investments conform to the definition of control under Indian exchange control laws and other sectoral regulations.

If the Indian partner has to prepare its financial statements under IND AS, it may likely have to account for such an investment as joint venture as it may find it difficult to argue that it has sole control over the venture, given the strict requirements of IND AS. The implication of such treatment for the joint venture is significant. An argument can be made on this basis that the foreign partner exercises joint control and that the joint venture is therefore in violation of applicable Indian exchange control laws, although regulators responsible for clearing foreign investment proposals have concluded that control is absent in those facts and circumstances.

Accordingly, introduction of IND AS has only further complicated the control question and deepened the existing quagmire. Existing Indian laws defining control are subjective without being adequately prescriptive about the circumstances in which veto rights would result in negative control. While IND AS is generally prescriptive on what constitutes a ‘protective right’, compliance with IND AS may result in companies engaged in sectors where foreign investment is permitted only without the acquisition of control being disclosed as being under foreign control or joint foreign control given the overall complexity on this issue.

SEBI had taken a view that the existence of control for the purposes of Competition Act, 2002 does not in itself indicate the existence of control for the purposes of Takeover Code. It distinguished various aspects of the two definitions to arrive at this conclusion. Similarly, the existence of control under IND AS should not automatically result in the conclusion that control under Indian exchange control laws exist and an independent evaluation in this regard will need to be made. However, the way that other regulators would view this contradiction remains to be seen.

Considering the above, it is imperative that Indian exchange control laws be modified to clarify that the existence of control for financial reporting purposes does not automatically result in the assumption that control exists for the purposes of Indian exchange control laws.

Authors are Niren Patel, Partner & Aravind Venugopal, Principal Associate; Khaitan & Co, Mumbai