In this blog post, Vikram Bhalla, a student pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, analyses the relationship between corporate governance and royalty payments.
What Is Corporate Governance:
Corporate Governance is one of the most important, spoken and regulated word in the Companies act in India and world over. It starts immediately as soon as a new enterprise is born. Whether it is Private Ltd Company, Listed or unlisted Public Company, LLP or even a simple partnership or proprietorship concern, Corporate Governance is spoken a lot about.
In fact, Corporate Governance is a measure of the good business practices followed by an enterprise and a measure of certain ethical practises. Issues like safeguarding of the shareholders’ value (including minority shareholders), protecting the rights of the Investors, Investors return on equity invested, distributing profit with shareholders and key stakeholders and ensuring that the powers and influence of the enterprise are used in a fair manner. It also includes best business practices with regards to the consumers and public at large and a positive societal influence. In almost all the genres of the Investors have desired for very effective Corporate Governance rules and regulations. Governments have also tried to keep the rules effective to as much as possible without adversely impacting the business sentiments of the country.
As is a fair knowledge, the enterprises are formed and promoted with the intention of earning profits. This is supported by the desire of their promoters to increase the market share, increase in the product variants and by offering the quality products to the consumers and also keeping its market position and reputation intact. In order to do so, every enterprise requires to invest huge amount of funds at every stage of its business. This fulfilment of fund requirement can either be by the way of investors investing heavily into this enterprise or on the back of the funding from financial institutions. For this the promoters will have to vouch for the best corporate standards. Even the business structures like Incorporating the Private Limited Company or Public Limited Company or Limited Liability Partnership is decided at this stage of business formation. These mentioned business structures arms the potential investor with a fair level of knowledge and understanding regarding the scope of the business and also shareholders rights, as mentioned in their Memorandum of Association and Articles of Association.
But once the market standing and good reputation of this enterprise is established, the promoters in all possibility would like to exploit its position to generate the maximum gains for them. It has also been seen that the promoters like to keep the majority shareholding and rights vested with them and their family. In case of listed companies, it is more required in order to thwart any possible merger, acquisition or transfer of the management control. The promoters have various options available with them to increase their shareholding. Some most talked about options available with the promoters are issuing of preferential warrants or buy back of the shares. The other reason for doing so is that with this the promoters can keep a major chunk of the dividend with them and the family and thereby increasing their personal gains.
How can the Promoters of the Enterprises Increase their Individual Profit:
Enterprise promoters can increase its profits by making use of the related party transactions like payment of the Intellectual property right fees to its Joint venture, Associate Company, Subsidiary or Subsidiary of its Holding company to which this enterprise is a subsidiary. With this way, they can pass on the maximum benefit to itself rather than to the other shareholders.
This becomes more critical at a stage where the Indian listed company which is the subsidiary, joint venture or associate company of any MNC operating in India. In all possibility, the promoters who are not of Indian origin are also not the Directors of the company. Now, since these MNCs in India are working for the maximisation of their gains including their personal gains.
What are the options available with these promoters of the India Listed MNC arms when the Board of Directors have to function with regards to the India Company Laws?
These MNCs can ask the board to formulate in the AOA to pay the IPR fee as RPT for the helping this Indian arm of the company to start their India operations and to enable this Indian arm to exploit their international brand value, goodwill, high quality, product positioning etc in order to achieve the revenues and profits. To do this, the Indian subsidiary uses the IPRs of the parent company. IPRs can be or any sort like, Licensing, franchising, technology transfer, proprietary know how, trade secrets & Confidential information. So a formal agreement related to the use of the IPRs are signed between the parent company and Indian Company (which as per the Indian law is a separate entity).
This above mentioned is true for the wholly Indian Company as well.
Indian laws were very strict with regards to the transfer of funds from Indian subsidiary to the parent company abroad. But during the reforms of foreign exchange introduced in December 2009, resulted in huge spike of funds transfer to the parent company abroad in the name of the IPR fees was observed. This resulted in the issue of flouting of certain corporate governance standards.
How can the Corporate Governance standards be flouted?
With the increased pay out in the form of the IPR fees, lesser amount of dividend will get reported to Shareholders. IPR fees can be calculated in various ways. Some of the most used type of calculating is either based on (i) either total revenues or (ii) on per unit cost of goods sold.
If the agreement with the other associated company states that the IPR fee will based on the revenue calculation then dividend payout gets affected and also reserves and surplus added to the net worth also gets reduced. And if the IPR fee is based on per unit cost of goods sold, then the EBITDA and Net profit gets reduced substantially. This results in lesser amount of taxes including the corporate tax (which is 40% for MNCs and 30% for Indian Company) and income tax.
Both the above things will also have an adverse effect on the shareholders sentiments and rights of the investors and minority shareholders. This further casts its reflection of poor performance of the enterprise on the share value of this listed Indian subsidiary.
It is easier for the promoters to affect the huge pay-outs out of India as they can influence the Board of Directors to vote in the favour of this pay-outs. Also, these payments can be classified as Related party transactions as the current corporate governance requires the auditors to file some standard disclosures which are not the adequate information for the potential investors and the minority shareholders to decide what they can do in future with regards to the IRR on their investments.
What are the ways in which these corporate Governance principles and rules and regulations be made more effective in protecting the shareholders value and investors rights?
Government can make it mandatory for these firms to appoint the Independent auditors or Audit committees. Also the Independent shareholders can be given more rights and powers. It can make the principle of entrenchment, wherein the minority shareholders can appoint their directors that can vote for the resolution and this vote is the most important one. Also, Investors and minority shareholders can demand to have modifications in the AOA wherein RPT cannot be passed without the consent of all the shareholders or at least 90% of members in favour of this resolution. Regulator can make it mandatory for IPR fees to be transferred only after paying in the all the required taxes and Dividends. Following additions can be further suggested to govern the Royalty payments like:
- Notice of the meeting with clear explanation of the agenda to be discussed
- Increasing the Quorum of the meeting and making it mandatory for the Independent Directors and Directors appointed by the minority shareholders.
- Proxies be allowed to speak.
- Voting by Polls
- Abstaining members who has Interest in RPT to vote and influence.
It has been observed that sometimes the Royalty payments have been misused to evade the taxes and dividend pay-outs to the shareholders. Though the promoters being the majority shareholders also get affected by the way of reduced dividend pay-outs but the RPT by the ways of IPR fees more than compensate them. As dividend only gets paid on the number of the shares held by the promoters and that too after the Board approval regarding the retained earnings. So, IPR fee or RPT can be used by the promoter to maximize their individual returns from the business at the expense of minority shareholders and other investors and stake holders. Unless such checks and balances are introduced, the shareholders other than the promoters and the investors are subject to considerable financial and market risks.