Monday, December 31, 2012

Royalty Payments and Corporate Governance

In the past, the corporate governance discourse pertaining to Indian companies has revolved substantially around family owned businesses and government-owned (public sector) companies. Another type of companies that is quite prevalent in the corporate scenario, but usually does not receive specific attention, is Indian listed subsidiaries of multinational companies (MNCs). A significant governance issue in respect of such MNC subsidiaries has now been highlighted due to the unintended consequences of a change in regulation pertaining to foreign investment and foreign exchange.

Earlier, the Government had imposed restrictions (including limits) on the amount of royalties and trademark fees that Indian companies could pay under foreign collaboration agreements. However, in December 2009, these restrictions were removed, and Indian companies were free to make these payments to foreign collaborators without any restrictions or limits. The purpose of this change was to ease such payments from a foreign exchange perspective. The matters that transpired since have sparked off major concerns from the point of view of corporate governance and minority shareholder protection in Indian listed companies that are subsidiaries of MNCs.

The Institutional Investor Advisory Services (IIAS), a proxy advisory firm, has issued a recent report that indicates a spurt in royalty payments by Indian listed MNCs to their parent companies. This has also attracted follow-up discussion and commentary (see Business Standard and Spicy IP). What emerges is that since the liberalization in December 2009, royalty payments have increased substantially despite the lack of commensurate increase in revenues and the faster increase in revenue and margins of local competitors. The net result of these efforts is that what would have otherwise been paid out as dividend pro rata to all shareholders is now being paid out as royalty only to the parent company (controlling shareholder). This operates to the detriment of minority shareholders in such listed companies. The discussion also indicates a lack of transparency in the manner in which such payments are made, which also does not require any specific shareholder approval under current law.

Such royalty payments are a classic case of related party transactions (RPTs) between the company and a controlling shareholder. As we have previously lamented, the regulation of RPTs in India is far from the desirable. Current corporate governance norms only require appropriate disclosure in the financial statements, a responsibility imposed on the auditors and the audit committee. One way of approaching the issue is to consider disclosure as fulfilling an important function because investors can then decide their further course of action depending on the nature of disclosures. However, there are problems with disclosure as the sole option. First, disclosures can sometimes lack meaning if they are not appropriately and accurately made. Second, disclosures tend to acquire an element of standardization over a period of time thereby leaving investors with little information to distinguish among companies that make the royalty payments.

Due to the failure of disclosure as an adequate option, it is necessary to consider other possibilities through amendment to corporate governance norms. Essential among them is the need for a committee of independent directors to specifically consider and approve such royalty payments (or any other material RPTs for that matter) after specifically expressing their views on the impact of such transaction on the interest of minority shareholders. Another option would be to mandate shareholder approval for such royalty payments (or other RPTs), wherein the recipient of the royalty payment (i.e. the parent company) must be required to abstain from voting in view of the conflict of interest.

Unless such checks and balances are introduced, the minority shareholders in such MNC subsidiaries will be exposed to considerable risk that the parent companies will likely treat the Indian listed companies as if they are merely arms of themselves.


coolgal138 said...

How can royalty payments be treated as related party transactions?

V. Umakanth said...

It would be a related-party transaction when royalty payments are made to the parent company, which is usually the case in the instances that gave rise to governance concerns.

coolgal138 said...

How can we bring this royalty payment within the meaning of Sec 188 of Companies Act, 2013? Isn't this just a commercial arrangement?