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Royalty payments to group companies needs stronger regulation to balance shareholder interests

Royalties are necessary but the present regulatory regime rely heavily on independent directors who aren’t sufficiently empowered to protect outside shareholders

January 27, 2023 / 05:59 PM IST
Royalty payments are a category of what are known in law as related party transactions. (Representative image)

Royalty payments are a category of what are known in law as related party transactions. (Representative image)

Royalty payments to the holding or group company for use of the latter’s intellectual property rights are again in the limelight. While multinational companies are seen typically paying such royalty to their foreign group entity, domestic companies too make such payments.

When royalty rates are changed – particularly if upwards – there is a level of unease amongst shareholders and even at a political level as to whether MNCs are enriching themselves at the cost of the shareholders/nation. Shareholders resist for obvious reasons – higher payment of royalty decreases net profits and hence eventually their dividends and wealth.

The question which then arises is what are the legal safeguards to ensure that there is due process and oversight, for transparency and particularly against self-benefit.

Why Legal Safeguards?

Royalty payments are a category of what are known in law as related party transactions. Essentially, they are transactions with related parties and are defined very broadly. The regulation of related party transactions is to ensure that those in control do not make such transactions that unduly favour themselves.

Managing Directors, for example, should not enter into a transaction with a firm in which their spouse has a partnership interest, except after following due process. The reason is obvious. But for checks and balances, there may be temptation to benefit oneself at the cost of the company/public shareholders.

This concern is even more in companies which have controlling promoters, whether based abroad as in case of MNCs or Indian. Such promoters may be able to get such transactions easily approved at the Board and, if required, even at the shareholders level.

How Regulation Evolved

The law has evolved over a period to progressively higher levels of protection. Initially, the law tackled such transactions in three ways:

* One was a benign way by which directors who were ‘interested’ in certain transactions needed to recuse themselves from both the discussions and the voting.

* The second was the other extreme – a total ban on certain transactions.

* Then there were certain transactions that fell between these two where such transactions were permitted with certain limits and requiring approvals. Even approval of central government was required in certain cases.

More recently, the shift has been almost wholly to eliminate any need for approval of central government and instead, the law provides for a multi-layer process. The matter remains complex though because of overlapping/conflicting requirements under the Companies Act, 2013, and under SEBI Regulations.

But essentially, the requirements are these:

* All related party transactions require approval of the Audit Committee.

* If the transactions are ‘material’, as defined, then the approval of the shareholders is required.

There are two important further riders:

* Even for the approval by the Audit Committee, only independent directors have a say.

* Further, in the approval by shareholders, all related parties are prohibited from voting for the resolution.

Audit Committee’s Weakness

Material transactions are those transactions which exceed 10 percent of the annual turnover or Rs. 1,000 crore whichever is lower. In respect of royalties, however, the limit is 5 percent. The direct implication is that the approval of the shareholders – where only non-related parties could vote – is not required for royalties under such a limit. The reality is that, even at 5 percent, the threshold for requirement of approval is pretty high considering that this is applied with regard to the turnover. A company with, say, 10,000 crores could pay up to Rs. 500 crores as royalty without such shareholder approval.

The onus then falls on the independent directors in the Audit Committee to approve such royalties. In principle, this may still sound good. After all, the representatives of the promoters, of the holding company, of management, etc. do not have any say. The Audit Committee would generally consist of financially literate persons, often highly qualified and experienced. However, in reality, there are several limitations to this whole process, indeed to the very basis of corporate governance in India.

Independent directors are meant to be independent of the promoters/company, but effectively the latter do have a strong say in their appointment. It is not as if such directors are appointed exclusively by outside shareholders. They are neither well paid nor they usually have adequate time. Further, there are no detailed criteria, not even broad guidelines, provided in law on how the independent directors should approach such transactions. The only effective requirement is they will need to have – and also demonstrate that they have – exercised diligence. Thus, there is considerable leeway and discretion inherent in the process.

Royalties With Shareholder Approval

It is also interesting to compare the requirements of certain other transactions with management. For example, in case of managerial remuneration, the limits are specified with reference to net profits and if such limits are exceeded, approval of shareholders may be required. Compare this to royalty, where the limit is specified with reference to annual turnover. Thus, even if the company is in a loss, considerable royalty can be paid without approval of shareholders.

So where does that leave the public shareholders? Is the only attitude for them to take is of cynicism – that this is an unavoidable risk in investing in MNCs and some other Indian groups that one has to live with? And that they should be merely satisfied that at least such transactions have to be transparently disclosed in accounts? While this is an extreme view to take, the law does need some major tinkering.

Payment of royalties, particularly for well-established trademarks, patents, etc., is surely a must since such well established products almost always sell themselves with good profits. A Lux soap, a Gillette blade and an iPhone are good examples. Further, buying goods and services within the group has several advantages of efficiencies, confidentiality, etc. That said, if such companies take monies from the public and desire benefits of listing, there also needs to be greater accountability and due process.

Approval of such outside shareholders needs to be taken at much lower thresholds than presently provided. Of course, there is the argument that the holding company/promoters have as much stake in the company as shareholders as the outsiders. Excluding them altogether from having a say sounds unfair. But that is also the reason why approval of outside shareholders for material related-party transactions is at a lower majority level and not by a special resolution.

Related party transactions are a necessary part of corporate structures and not a necessary evil. What is needed is well thought out safeguards in law where the issues of conflict of interest and say of outside shareholders needs to be managed. The present law certainly needs a rethink.

Jayant Thakur is a chartered accountant. Views are personal and do not represent the stand of this publication.

Jayant Thakur is a chartered accountant.
first published: Jan 27, 2023 05:59 pm