The 2019 India AGM season is well underway. Thus far, two notable items have appeared on the radars for investors. First, existing concerns regarding corporate audits have deepened as the ‘Big Four’ firms appear to have gotten themselves into serious trouble with the Reserve Bank of India (“RBI”) and the Ministry of Corporate Affairs (“MCA”). Second, the Securities and Exchange Board of India (“SEBI”) has issued preliminary decisions on the future of differential voting rights shares.
The Big Four in Big Trouble
On June 3, 2019, the RBI released a statement noting that the auditing firm S.R. Batliboi & Co. LLP (“SRBC”), a network firm of Ernst & Young, would not be approved to audit commercial banks for a period of one year due to lapses in statutory audits. The RBI’s decision originated from alleged divergences in the financial year 2015-16 in Axis Bank Limited and Yes Bank Limited’s bad debt, compared to what was reported in their annual reports in 2017 — reportedly totalling around INR 135 billion. Thus far, due to the RBI actions SRBC has been removed as the auditor from HDFC Bank Limited, however that may not be the end of its troubles: SRBC is reportedly awaiting a decision from SEBI on whether the ban will have any impact on the firm’s right audit other publicly-listed companies (SRBC is the auditor for over 150 companies).
Not to be outdone by SRBC, it has been reported that Deloitte affiliate Deloitte Haskins Sells (“DHS”) and KPMG’s affiliate, BSR & Co. (“BSR”) may also face government scrutiny. Both DHS and BSR were auditors of Infrastructure Leasing & Financial Services (“IL&FS”), and in particular its non-banking finance arm – IL&FS Financial Services. The near collapse of IL&FS in October 2018 was averted by the Indian Government taking control of IL&FS after IL&FS began defaulting on its debt. Now both firms face inquires from the Serious Fraud Investigation Office, the MCA and the National Company Law Tribunal. As a result of the IL&FS debacle, the Indian Government is reportedly seeking a five-year ban on both DHS and BSR from serving as the auditor of any listed or unlisted company.
The actions against SRBC, DHS, and BSR come on the heels of a two-year ban against PricewaterhouseCoopers (“PwC”) which went into effect from March 31, 2018. PwC cannot take on new clients until 2020. It would appear there is a problem with auditing when each of the Big Four is each the subject of bans or may face bans. But, what are shareholders to do? As previously discussed, regulations changed in 2018 ended the annual ratification of auditor appointments at AGMs. Instead, shareholders now only ratify the appointment at the start of their term for up to five years or reappointment for the second term as a company’s auditor.
There may be some movement from the Indian Government to impose caps on the number of companies an auditor may audit. Likewise, there may be amendments to the Companies Act, which could result in a further reduction in what services an auditor cannot provide. Another potential source of reform is the newly-created National Financial Report Authority, which will have the power to regulate auditors – and, if need be, determine punishments by way of fines and/or debarment for up to 10 years.
It remains to be seen how companies, and foreign investors, will respond. In other markets where concerns have been raised regarding the audit market, regulatory efforts to encourage competition have been stymied by the perception that only the Big Four firms have the scope and resources to do the job – even when those very firms have been caught out.
Tech Wins Big in DVR Sweepstakes
Earlier in 2019, SEBI released a consultation paper on whether it should allow differential voting rights shares (“DVRs”). As of June 27, 2019, SEBI issued its initial decisions on companies being able to adopt DVRs. For now, the biggest winners would be tech companies as defined by those “intensive in the use of technology, information technology, intellectual property, data analytics, bio-technology or nano-technology to provide products, services or business platforms with substantial value addition.” As for the share structure that may be permitted, at this time, pre-IPO companies would be allowed to have “superior voting rights shares” (“SR shares”) that could have voting strength of 10 votes for each share held.
While the rules will still need to be formally adopted by way of new regulations, the decision by SEBI about DVRs carries some restrictions. Notably:
- SR Shares would be subject to a maximum sunset clause of 10 years following an IPO.
- SR Shares would be locked-in following the IPO to the conversion to ordinary shares. Transfers of SR shares would not be permitted, nor can SR shares be pledged or liened. The holders of SR shares could only be in a company’s promoter group, while overall voting power is not to exceed 74% of a company’s total voting rights.
- Corporate governance: the audit committee must be entirely independent, while other committees would need to be 2/3rd The board would have to be at least half independent.
- Under coat-tail provisions, SR Shares would not have voting power on proposals to appoint a company’s auditor; elect or remove of independent directors; related party transactions involving SR shareholders; amendments to articles or memorandum (except for changes to the SR instrument); utilization of funds for purposes other than business; or passing special resolutions for delisting or share buy-backs.
One notable decision, however, was to not allow existing listed companies the ability to issue fractional rights shares. Were this to happen, listed companies would have been able to issue shares to investors with voting rights that were a fraction of the ordinary equity shares. To be clear, SEBI did not close the door on those share classes – instead, it appears that SEBI wants to review the experiences gained from SR shares before making a final decision on fractional rights shares.
Jeff covers the India market.