SEBI recently revised the materiality threshold for obtaining shareholder approval for related party transactions (“RPTs”) under Regulation 23(1) of the SEBI (LODR) Regulations, 2015 (“LODR”) to cover RPTs exceeding INR 1000 crore or 10% of a listed entity’s annual consolidated turnover (as per the most recently audited financial statements), whichever is lower. The revised materiality threshold went into effect on April 1, 2022, and this change is significant because there was no absolute numerical threshold for RPTs that required shareholder approval prior to April 1, 2022. This also begs the question of whether an absolute numerical threshold of INR 1000 crore could be construed as a violation of Article 14 of the Indian Constitution.
The authors intend to delve deeper into this constitutional issue and examine some of the arguments that can be made from both sides of the debate in this post.
Problems posed by the revised materiality threshold
The following example illustrates the unintended consequences of an absolute numerical threshold of INR 1000 crore. Consider the following scenario: Company A has a consolidated annual revenue of INR 10,000 crore. The INR 1000 crore materiality threshold represents 10% of Company A’s consolidated revenue. Company B, on the other hand, has a consolidated annual turnover of INR 2,00,000 crore, and the materiality threshold of INR 1000 crore represents only 0.5 per cent of its consolidated turnover. This begs the question of whether it is constitutionally permissible to subject a relatively minor transaction of Company B to the same shareholder approval requirement as Company A.
It is also worth noting that SEBI has made significant changes to the definitions of “related party” and “RPTs” under LODR. The amended definition of related party’ now includes any shareholder holding 20% or more equity shares in a listed entity, in addition to persons/entities belonging to the promoter/promoter group. This would then include even a financial investor with a 20% equity stake.
The definition of ‘RPT’ has been expanded to include, among other things, a “transfer of resources, services, or obligations” between the “listed entity or any of its subsidiaries on the one hand and a related party of the listed entity or any of its subsidiaries on the other.” Even a transaction between two unlisted subsidiaries of a listed entity will be considered an RPT under the revised definition.
Significantly, SEBI has amended Regulation 23(4) of the LODR to specify that an RPT requires “prior approval” of the shareholders, and that ex post facto approval or ratification of the shareholders is not permitted. Furthermore, according to Regulation 23(4), no related party shall vote to approve the shareholder resolution for an RPT, whether or not it is a related party to the specific transaction.
As a result, every material RPT would require the approval of the majority of the minority shareholders of the listed entity, as the LODR prohibits the holding company, promoters, and any shareholder with a stake of 20% or more from voting to approve a material RPT.
This may have unintended consequences, such as RPTs entered into as part of a listed entity’s interconnected business operations being halted until prior shareholder approval is obtained at the upcoming AGM. For example, a routine RPT entered into between the listed holding company and its subsidiary for raw material supply, component sourcing, and so on may be stalled, posing business continuity risks.
Could it be argued that the requirement of obtaining prior shareholder approval – which poses significant business continuity risks and subjects two companies with the significantly different consolidated turnover to the same requirement of obtaining prior approval of the majority of the minority shareholders’ – suffers from the vice of over-inclusion and thus violates Article 14?
Is the revised materiality threshold of INR 1000 crore arbitrary?
SEBI is the securities market regulator and a statutory authority established by the SEBI Act, 1992 (“SEBI Act”) and the Securities Contracts (Regulation) Act, 1956 (“SCRA”). There is no doubt that SEBI is a ‘State’ within the meaning of Article 12 of the Constitution, and that it is subject to the discipline of Article 14 in exercising its powers and functions under the SEBI Act and the SCRA, including the power to frame regulations.
Thus, if the revised materiality threshold of INR 1000 crore framed by SEBI in the exercise of its power to frame/amend regulations violate Article 14 of the equality code requires substantive equality as well as formal equality. In EP Royappa v State of Tamil Nadu, the Supreme Court held that the arbitrariness of state action is sufficient to constitute a violation of Article 14.
In Khoday Distilleries Ltd. v. the State of Karnataka, it was determined that Article 14 protects against arbitrary action and that delegated legislation can be overturned under Article 14 if it is ‘manifestly arbitrary.’ Furthermore, the Supreme Court has ruled that a piece of subordinate legislation does not have the same level of immunity as a statute passed by the legislature. The equality code enshrined in Article 14, is open to constitutional challenge.
It was held in Sharma Transport v. Govt. of Andhra Pradesh that delegated legislation can be shown to be manifestly arbitrary if it is established that the delegated legislation is framed capriciously, without an adequate determining principle, or is done without sound reason or judgement.
These tests were also reiterated in the context of plenary legislation in the landmark Supreme Court (“SC”) decision in Shayara Bano v. Union of India, which held that “manifest arbitrariness” is something done by the legislature “capriciously, irrationally, and/or without adequate determining principle.”
SEBI has used the numerical yardstick of INR 1000 crore or 10% of the listed entity’s annual consolidated turnover (as per the last audited financial statements) to differentiate RPTs that require prior shareholder approval from those that do not. SEBI has not undertaken to categorise the listed companies that will be subject to this regime. This is significant because the analysis involved in conducting an Article 14 violation review differs in classification and non-classification cases.
While “non-classification arbitrariness” is tested using the “proportionality” test, which requires that the means be proportional to the object, “classification arbitrariness” is tested using the “rational nexus” test, which requires that the means share a “nexus” with the object. The SEBI Act and the SCRA aim to protect public investors and minority shareholders while also ensuring the purity of listed company administration.
In this context, the critical question to consider is whether the absolute numerical threshold of INR 1000 crore, without taking into account a company’s size and the scale of its consolidated turnover as a benchmark, can be called an “adequate determining principle.” While the goal of establishing an absolute numerical threshold may be valid, can it be argued that the disproportionate impact on large publicly traded companies is what makes it arbitrary?
In defence of the amendment, it can be argued that the INR 1000 crore materiality threshold achieves SEBI’s goal of bringing RPTs above a reasonable threshold within the scope of shareholder approval, and SEBI may rely on market data/surveys or other material that suggests that currently very few RPTs are put before shareholders for approval, or that there is a greater need for regulation beyond the said threshold.
Thus, it could be argued that the revised materiality threshold advances corporate democracy by advancing the rights of minority shareholders, because a greater number of RPTs would be presented to minority shareholders for approval, allowing them to assess whether these transactions are truly in the best interests of the company.
This is especially important because in the State of Tamil Nadu & Anr. v National South Indian River Interlinking Agricultural Association, the Supreme Court argued that, when reviewing Article 14 violations, the emphasis should be on the “effect” of the law rather than the “object” or “objective,” as has traditionally been suggested. The Supreme Court determined that a much more substantive review was required, focusing on the multi-axle operation of equality and non-discrimination.
In this regard, the Preamble to the SEBI Act, 1992, states, inter alia, that the Act’s goal is to “provide for the establishment of a Board to protect the interests of investors in securities…” The Preamble reiterates that SEBI’s primary role is to protect the interests of minority shareholders, and the INR 1000 crore materiality threshold promotes this goal by allowing minority shareholders to scrutinise more RPTs and have a greater say in relation to those transactions of a company where there is a greater potential for a ‘conflict of interest.’
As an expert body established to protect the interests of minority shareholders, courts are likely to give SEBI’s views on issues that fall under its regulatory purview more weight. This approach was followed by the Supreme Court in its recent decision in Prakash Gupta v. SEBI, where it was stated that SEBI’s views must be treated with greater deference as an expert regulatory body for the securities market.
Furthermore, SEBI could argue that the revised materiality threshold is necessary to ensure that all RPTs exceeding a certain value (i.e. INR 1000 crore) are presented to shareholders for approval. As a result, the threshold has been determined based on the value of the RPT rather than solely on the value of the consolidated turnover of the concerned listed entity.
Furthermore, when it comes to business or economic policy, courts are more likely to defer to legislative judgement than when it comes to civil rights. As stated by a Supreme Court Constitution Bench in R. K. Garg v. Union of India, “laws relating to economic activities must be viewed with greater latitude and deference than laws relating to civil rights.”
Furthermore, it was held in Subramanian Swamy v. CBI that legislation does not become unconstitutional simply because there is an alternative view or another effective method that could achieve the objectives of the concerned policy, and that courts cannot substitute their views on what would be the best policy to achieve a specific goal.
Based on the preceding judicial precedents, SEBI could argue that just because there is an alternative viewpoint on what should be an appropriate threshold for classifying material RPTs, the Court cannot substitute its views on SEBI’s legislative judgement as an expert body established to protect investors’ interests.
The road ahead
If the constitutional validity of the revised materiality threshold of INR 1000 crore is challenged in court, there are compelling arguments on both sides of the spectrum.
It will be interesting to see whether the courts will agree to a judicial review of the change brought about by establishing an absolute numerical materiality threshold for RPTs regardless of a listed company’s size and the value of its consolidated turnover, or whether they will defer to SEBI’s judgement as an expert body in a policy matter.