The first section of this paper introduces the concept of upside-sharing arrangements and presents an empirical review of corporate disclosures made by certain listed and to-be-listed companies in India, woven around the regulation notified and informal guidance issued by the Securities and Exchange Board of India, requiring public shareholder approval for upside-sharing arrangements.

The second section highlights that current policy and regulation in this area do not directly speak to the issues faced by founders who do not have sufficient funds to finance their companies' growth, particularly in the early stages, without a financial investor, and financial investors who are happy to incentivize founders and key employees with a profit-sharing arrangement on their exit.

In this paper, we argue that the benefits of corporate disclosures are understood, but not a sufficient economic justification for mandating public shareholder approvals for such structures. In conclusion, given the differential benefits and costs for different stakeholders in India, our insight and recommendation is that policymakers may consider a disclosure-based, rather than approval-based, approach. In the meanwhile, Indian companies and market players should inform themselves of the compliance requirements entailed in upside-sharing structures.

Section I: Introduction

Upside-sharing arrangements entered into by promoters or senior management of a listed entity came under the microscope in India when it was reported that Ajay Bijli, Managing Director and Chairman of Indian multiplex operator, PVR Limited ("PVR"), an Indian-listed company, had entered into an incentive fee agreement with a private equity investor in PVR, to share profits at the time of its exit in the future. These agreements that were not disclosed to the shareholders or the stock exchanges, based on the logic that payments that may be made in the future would not be made from PVR's books, hence no disclosure was required.

The Securities and Exchange Board of India ("SEBI") issued a show-cause notice to PVR in November 2016, pointing out violation of corporate governance and disclosure-related norms, as well as the code of conduct for board members, on account of non-disclosure of material price-sensitive events and information. In PVR's case, while the incentive fee structure was not subject to and did not violate limits on managerial remuneration payable by the company itself under the Companies Act, 2013, this ushered in a new regulatory development in the realm of corporate disclosure.

What are upside-sharing arrangements?

Upside-sharing arrangements, also called earn-out structures or incentive fee arrangements, are typically entered into between an investor and promoters or founders or key employees of a company, with the understanding that if the investor makes a profit on its investment at the time of its exit, a certain portion of such profit will be shared with those individuals. These agreements are often linked to the internal rate of return ("IRR") the investor makes at the time of exit, or other performance criteria, and may be either cash-settled or equity-settled. Upside-sharing arrangements are devised to incentivize and retain employees over a period of time, while giving investors in an IPO or M&A-bound company a measure of control regarding the terms of an exit.

The upside-sharing arrangement may form part of an employee stock option plan adopted by the company, or a shareholders' agreement or employment agreement where the company itself is also a party. More typically, as the company is not a party to the agreement, the compensation is not charged to or recoverable from the company itself, or other shareholders. Moreover, such a transaction is not reported within the ambit of related party transactions between the company and its controlling shareholders or management.

Why regulate upside-sharing arrangements?

In their best avatar, upside-sharing structures represent a symbiosis between founders and key employees who have the background and motivation to run a successful business venture, and the private equity investors who have the means to remunerate those founders and key employees who have earned them good returns.

The policy argument against upside-sharing agreements is rooted in the possible conflict of interest between promoters and management team, vis-à-vis the company and its other shareholders. It is possible that upside-sharing arrangements may encourage promoters or management to act on a short-term basis and in their personal interest, rather in the longer-term larger interest of the company and the public shareholders.

SEBI had already, in October 2016, even before the PVR incentive fee controversy was reported in the media, issued a consultation paper on corporate governance issues in compensation agreements. SEBI observed that upside-sharing arrangements are "not unusual", but "give rise to concerns" and "potentially lead to unfair practices", so it was felt that such agreements are "not desirable" and are hence "necessary to regulate". While SEBI did not espouse the more stringent view that "there is no place at all for such side agreements in case of listed companies", it presented the view that "before key managerial personnel, directors and promoters of listed entities enter into such reward agreements, it would be mandated that such agreements undergo thorough scrutiny of the boards and shareholders who may vote on the resolution approving such agreements".

SEBI notification in January 2017

Following a SEBI Board Meeting on November 23, 2016 (interestingly, the day after SEBI issued the show-cause notice to PVR), SEBI notified an amendment to the Securities and Exchange Board of India (Listing Obligation and Disclosure Requirements) Regulations (the "SEBI Listing Regulations") in January 2017, to regulate upside-sharing arrangements.

The new Regulation 26(6) requires prior approval from the board of directors and shareholders of the listed company through an ordinary resolution for new upside-sharing agreements between an employee, including a key managerial personnel or director or promoter, and a shareholder or third party, provided that existing upside-sharing agreements would remain valid and enforceable, if disclosed to Indian stock exchanges for public dissemination, approved at the next board meeting and, thereafter, by non-interested public shareholders of the listed company.

Testing the amendment – SEBI informal guidance

What bears testament to the ubiquity of upside-sharing arrangements is the fact that we have accumulated a significant body of regulatory precedent in this matter, within a short period of just over a year and a half since the SEBI show-cause notice was issued to PVR in November 2016.

Accelya Kale informal guidance

The SEBI amendment in January 2017 was possibly first tested by Accelya Kale Solutions Limited in May 2017. As part of a global programme, senior managers of the Accelya group of companies, including Accelya Kale Solutions Limited ("AKSL"), subscribed to securities of offshore unlisted Accelya group companies. In 2014, the global senior managers entered into sale agreements pursuant to which they were to sell those securities in the offshore group companies to Accelya Holding (Luxembourg) S.A. (which held an indirect controlling stake in AKSL). The payment for the sale was in tranches, commencing in 2014 and 2016, with the final tranche to be paid on the occurrence of, and linked to the sale consideration for an exit event, when the ultimate shareholder, private equity fund Chequers Capital XV FPCI exited from its investment in the Accelya group. The principal question was whether the payment of deferred consideration for the third tranche would fall afoul of Regulation 26(6) of the SEBI Listing Regulations.

AKSL set out several reasons why Regulation 26(6) ought not to be attracted. The first was a question of timing. Although the deferred consideration became payable in 2017, the arrangements were entered into in 2014, prior to the amendment to the SEBI Listing Regulations in January 2017. The second related to the criteria for computing profit sharing. The payment of deferred consideration was not linked to the profitability of AKSL, the Indian-listed company. The third pertained to the securities being dealt with as part of the arrangements. In this matter, SEBI opined that since the compensation or profit sharing was linked to the securities of the group as a whole, including unlisted group entities, and not of listed entities, the January 2017 amendment to the SEBI Listing Regulations was inapplicable in this instance.

Mphasis informal guidance

The amendment was next tested in the context of the informal guidance issued by SEBI in May 2017 in the case of Mphasis Limited ("Mphasis"). Hewlett Packard Enterprise ("HPE"), through its wholly owned subsidiaries, the EDS entities, owned a controlling stake in Mphasis, an Indian listed entity. In 2016, the EDS entities sold their entire shareholding in Mphasis to the Blackstone Group. Prior to HPE's exit, HPE had issued incentive letters to certain eligible employees of Mphasis and its wholly owned unlisted subsidiaries, under which HPE agreed to make payments to eligible employees in certain situations, including HPE's exit, retention payment for remaining in employment for one or two years following HPE's exit, and severance payment in case of termination of employment without cause prior to completion of two years from HPE's exit.

While board and shareholders' approval for payments to be made by HPE to eligible employees of Mphasis were being obtained, HPE sought clarification from SEBI on the applicability of the amendment to the SEBI Listing Regulations to the payments to be made by HPE to eligible employees of unlisted subsidiaries of Mphasis.

In its informal guidance, SEBI widened the ambit of the regulation, which explicitly applies only to Indian listed companies, and opined that payments to eligible employees of unlisted subsidiaries of Mphasis would fall under the scope of the regulation. This informal guidance can be distinguished from the informal guidance received by Accelya Kale, as the arrangement in Mphasis related to employees of listed and unlisted entities in connection with the sale of securities of an Indian-listed company.

PNBHFL informal guidance

Next came the informal guidance issued by SEBI in September 2017, in the case of PNB Housing Finance Limited ("PNBHFL"). M/s Destimoney Enterprises Limited, Mauritius ("Del-Mauritius") acquired a non-controlling stake in PNBHFL in 2009, through its subsidiary M/s Destimoney Enterprises Limited ("Del-India"). The principal assets of Del-India were shares of PNBHFL. In 2005, Del-Mauritius's holding in Del-India was acquired by Quality Investments Holdings, Mauritius ("QIH"). In appreciation of the excellent returns received by DEL Mauritius on the sale, DEL Mauritius decided to make ex-gratia payments to senior management of PNBHFL. Having initially put in on hold, Del-Mauritius revived this proposal when PNBHFL listed in November 2016. PNBHFL sought informal guidance from SEBI whether this transaction would require the prior approval of its board and shareholders.

It was argued that since the shares of Del-India were transferred from Del-Mauritius to QIH in 2015 (when PNBHFL was unlisted, and prior to the date of the SEBI notification), there was no direct dealing in shares of PNBHFL by Del-Mauritius or by Del-India. SEBI opined that the proposal to make payments was revived when PNBHFL had listed and Regulation 26(6) of the SEBI Listing Regulations was effective. Accordingly, PNBHFL would require approval from its board and shareholders before accepting ex-gratia payments from Del-Mauritius.

A segue to analogous situations under the Takeover Code

Taking a few steps back, a somewhat analogous concept of rewarding promoters and company management under separate agreements with investors existed under the erstwhile (Substantial Acquisition Of Shares And Takeovers) Regulations, 1997 (the "erstwhile Takeover Code"). Under the erstwhile Takeover Code, payments by an acquirer to selling shareholders in the form of non-compete fees over and above the offer price were permitted, to ensure that exiting promoters or founders did not compete with the listed company for a certain period following the acquisition by the investor.

In 2002, the Bhagwati Committee, noting the possibility of misuse of non-compete fees (wherein the acquirer passes on a significant portion of the consideration to the outgoing promoter in the form of non-compete fee and only a token amount is shown as negotiated price for acquisition of shares under the agreement), recommended a limit of 25% of the offer price on such payments, which would be exempted from inclusion in the offer price calculated under the erstwhile Takeover Code.

After protracted analysis by the Achuthan Committee, the present SEBI (Substantial Acquisitions of Shares and Takeover) Regulations, 2011, did away with the exclusion of up to 25% of the acquisition price (in the form of non-compete fees), requiring the acquirer to include the entire amount paid, by way of non-compete fees or in any other manner, in the offer price, for the exit offer made to other shareholders. This was hailed at the time as a rational move, as SEBI did not prohibit such arrangements, it merely simplified the law and curbed the inclination towards malpractice by extinguishing the previous distinction between non-compete fees and acquisition price.

The Takeover Code analogy is not an exact one, as the process of a tender offer involves non-interested shareholders of the company voting on the terms of the exit. This is different from a company where no change in control occurs and no shareholder vote is due, except under a SEBI regulation recently and specifically introduced to regulate profit sharing with "any employee", requiring "public" shareholder approval even where the company itself is not a party and the company and "public" shareholder are arguably not prejudiced. While there is a whole gamut of administrative and judicial precedent on non-compete agreements, shareholder agreements, restraint of trade and contract law in general, where various courts in India have acknowledged the commercial wisdom and independence of parties entering into agreements, unless it is established that the contracting parties had mala fide intentions, it is SEBI's mandate to protect investors in the Indian market and it is difficult to challenge SEBI on the precept that contracts between shareholders should not be subject to shareholder approval or public disclosure if the contracting parties had bona fide intentions.

Circling back to where this analysis began, PVR and its Managing Director and Chairman settled with SEBI for an aggregate sum of Rs. 2.32 million, as reported to the Indian stock exchanges in January 2018, taking over a year to settle since the filing of the consent application, at double the original sum proposed by the applicants.

As is typically the case with SEBI consent orders, no admission of guilt was required or made, and no examination of mala fides was conducted by SEBI. However, media reports and investor reactions suggested that a settlement fee of this nature, seen along with the informal guidance issued to other companies, was akin to ruling that SEBI would penalize profit-sharing or incentive fee arrangements, unless disclosed publicly and made subject to shareholder vote.

Section II: Concerns and Implications

Although SEBI does not prohibit upside-sharing agreements, several concerns arise from the January 2017 amendment, including, firstly, the unfortunate implications of requiring approval from "public" shareholders. From a corporate governance perspective, the conflict of interest motive is understood and it is critical that interested persons be excluded from voting for upside-sharing arrangements. However, the regulations, in their current form, presume that "promoters" will be interested. Such a presumption may not be true at all times, in structures created to incentivize and retain non-promoter employees, such as the Mphasis structure. While it is helpful that the requirement under Regulation 26(6) of the SEBI Listing Regulations is for an ordinary resolution, and not a special resolution, there is a strong argument to be made that the shareholder vote, where required, should be from "non-interested" shareholders only.

As a linked matter, the January 2017 amendment refers to any upside-sharing agreements between any "employee", including a key managerial personnel or director or promoter. While a so-called SEBI-compliant employee stock option plan (namely, one that complies with the requirements of the SEBI (Share Based Employee Benefits) Regulations, 2014) is already subject to approval of shareholders of a company by a special resolution, any other employee benefit or incentive plans, even individual employee contracts, may also trigger shareholder approval requirements under Regulation 26(6) of the SEBI Listing Regulations, even where the beneficiaries are professionals, not promoters, founders or key managerial personnel. It is argued that SEBI could consider altering the definition or perhaps notifying a materiality threshold, or de minimis provision, wherein the ordinary employee, unconnected to promoters or controlling shareholders, may enjoy the benefit of an upside-sharing plan or contract.

Thirdly, the informal guidance issued by SEBI in the case of Mphasis raised questions impacting listed companies with unlisted subsidiaries in India. Given compliance costs and procedures for unlisted companies and the fact that SEBI informal guidance by its nature is not binding, it may still be argued that the requirement for corporate approvals should be limited to listed companies, or to material subsidiaries of listed companies only.

Fourth, while the SEBI amendment in January 2017 explicitly applies only to listed companies, it could have implications for IPO-bound companies. In the to-be-listed space, the convention that has developed is for IPO-bound companies to make disclosure in their offer documents, such as in the IPO of S. Chand Company and Limited in 2016 (in which disclosure was made in the offer documents, regarding performance-linked incentives for finance and business heads and non-sales staff). Following the SEBI amendment in January 2017, the disclosure requirements for IPO bound companies may include building in the requirement for post-IPO shareholder approval for the upside-sharing arrangements.

The capital markets practice is built around disclosure, flowing from the commercial principle, "caveat emptor" or "let the buyer beware". Even as models of investor protection and securities market regulation continue to evolve in various jurisdictions, one anchoring tenet is that an investor should be able to make an informed investment decision. There is, therefore, an argument to be made that in a listed company where an upside-sharing arrangement already exists, or was not originally entered into with notice to the shareholders, fair disclosure must be made and dissenting shareholders must be given the opportunity to voice dissent.

It is useful to reiterate that SEBI seeks not to restrict upside-sharing arrangements, but to ensure transparency. Companies continue to list or seek listing on the basis of offer documents containing disclosures on upside-sharing, including Security and Intelligence Services (India) Limited, which filed its draft offer document with SEBI in September 2016, but completed its listing in August 2017, as well as MAS Financial Services Limited, CMS Info Systems Limited and TCNS Clothing Co. Limited, which have all been filed after the January 2017 amendment was notified by SEBI.

However, the requirement for a listed or to-be-listed company to make public disclosure and obtain shareholder approval may dissuade some companies, and entails a compliance cost, in terms of convening a general meeting for the passing of an ordinary resolution for approving such arrangements. Experience in India and internationally has shown that stricter disclosure requirements for publicly-traded firms may motivate companies to remain unlisted, or explore avoidance mechanisms such as moving the shareholder arrangements or obligations a level up or overseas, or moving the capital market activity overseas, so that the nature or level of disclosure required is reduced, while achieving an equivalent economic objective.

While 2017 was a bumper year in terms of Indian IPOs and QIPs, equity markets are inherently cyclical. Opportunities to raise capital in overseas equity and debt markets provide alternatives to an Indian IPO, and affect liquidity in the Indian equity market. Increased regulation on upside-sharing may also dampen enthusiasm for PIPE deals (private investment in public enterprises), where secondary transfers occur between significant shareholders and investors through the block window of an Indian stock exchange, or off-market transactions. PIPE deals move quickly, with little or no involvement of the company, and a requirement for shareholder approval may be an impediment.

Section III: Conclusion

It is challenging to design a single regulation and enforcement system that suits all stakeholders. A "one-size fits all" approach may impose significant costs on certain market players, which may be unlisted subsidiaries of listed entities, investors seeking to incentivize entrepreneurial founders or non-promoter professional employees, or unlisted companies struggling to list in India. Experience also suggests that corporate transparency is a joint outcome of market forces and regulatory intervention. Desired effects such as informed investment choices, trading at fair value and robust compliance can be best achieved by finding a balance between stakeholder perspectives.

Returning to core principles, a market is built around trades, motivated by gains. What we trade away in terms of shareholder control on upside-sharing agreements, we may gain in terms of incentivizing private equity players and founders (who have the vision but not the funds) to build strong companies together and take them to market in India.

SEBI could consider either a simpler form of regulation, disclosure-based rather than approval-based, or scaled regulation that better serves the various needs of different types of companies in India. One practical view is that where payments are made out of the resources of an exiting investor, subject to disclosed criteria such as increased share valuation or other parameters of financial or corporate performance of a listed or to-be-listed company and its material subsidiaries, there should be a requirement merely for public or shareholder disclosure, provided that shareholder approval would be necessitated if the earn-out structure compensates promoters, promoter group or persons acting in concert.

Pending policy review, Indian companies and other stakeholders can continue to explore upside-sharing structures subject to appropriate corporate disclosure norms, or to explore alternative capital raising and exit options.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.