Sun Pharma: What investors should ask of its board
The whistle-blower allegations have raised governance concerns at Sun Pharma. Given its current structure, and the new SEBI-accepted Kotak Committee recommendations, the company will be required to make changes to its processes and its board. Investors are better placed in proactively raising their concerns with the board, to ensure that the new governance structures at Sun Pharma are robust, not just in their compliance but also in their intent.
Sun Pharmaceutical Industries Limited’s (Sun Pharma) board’s silence on the accusations of the whistle-blower letter has allowed the promoters to give themselves a clean chit. The argument of no wrong-doing does not carry enough credibility if it comes from those accused. That is not to say that the whistle-blower letter is correct – but only that the board should have stepped in to set in place a formal external investigation, much like Infosys and (eventually) ICICI Bank.
With SEBI having accepted some of Kotak Committee’s recommendations, Sun Pharma will be required to change course. As the company rethinks its governance structures, investors are better placed in proactively voicing their opinions on the following issues:
1. Clean the holding structure and curb transactions with the promoter group
Sun Pharma is held by the promoter through a series of holding companies. There are 25 shareholders holding promoter equity; a large proportion of promoter equity is held by 18 private limited companies and trusts, the ultimate beneficiaries of which are unknown. Shareholders must engage with the promoters and the company to simplify the holding structure and ensure that there is clarity of ownership.
One of the concerns raised by the whistle-blower letter and subsequently by investors relate to the transactions with Aditya Medisales, which is distributor of the company’s products in the domestic market. The company also has transactions with other entities controlled by promoters and KMPs. Shareholders must insist on putting a stop to these transactions. Other companies have followed this policy – Tata Consultancy Services Limited (TCS), for example, has a policy of not giving any loan / advance / guarantee directly or indirectly to directors, their relatives and any body corporate in which they or their relatives are interested.
2. Strengthen the audit framework across the group
One of the concerns raised by investors is the quality of audit in subsidiaries – more importantly, the choice of auditors. Sun Pharma, on 31 March 2018, had 94 subsidiaries, of which 12 were domestic subsidiaries, and 73 of them were wholly-owned (100%). While Sun Pharma’s auditors in FY18 were SRBC& Co LLP, the auditors of subsidiaries are varied. Investors must engage with the company to ensure commonality between Sun Pharma’s auditors and its domestic subsidiaries. In line with Kotak Committee’s recommendations,shareholders must ask the company to ensure that its audit firm provides oversight over the audit of foreign subsidiaries, or has one of its network firms audit the foreign subsidiaries. Although having the primary auditors provide oversight on subsidiary audits is not part of the regulatory construct in India, given the concerns being raised, investors must push for this measure in Sun Pharma.
3. Reduce promoter dependence in the board and board committees
The current board composition is skewed in favour of management (promoters hold executive capacity). Four of the eight-member board comprises executive directors, two of which are promoters. The Chairperson is a non-executive non-independent director. Of the three remaining independent directors, two were recently appointed - at the 2018 AGM.
Promoters effectively control all board committees other than the audit committee and the nomination and remuneration committee: the two promoters form 2/3rd of all the other board committee (two of the three-member committees). Management presence continues in the audit committee by virtue of having an executive director as its member. Only the nomination and remuneration committee is devoid of executive presence.
Shareholders must insist on reducing the management control of the board and the board committees. This can be done through board expansion and the appointment of more independent directors. Board expansion and board committee independence is even more critical in light of the new regulation that requires disclosure (in the company’s Corporate Governance Report) of instances where the board does not accept the recommendation of a board committee.
4. Formation of the group governance unit or the Governance Committee
SEBI has also accepted the Kotak Committee’s recommendation of a group governance unit or a governance committee – at this stage, it requires voluntary adoption by companies. The governance committee is required to provide stronger oversight over the functioning of subsidiaries. While SEBI is yet to publish its guidance on the matter, companies will need to craft a governance policy, which will provide the framework for such oversight.
Investors need to encourage Sun Pharma to create a governance committee that comprises independent directors in majority. Investors must understand how it proposes to articulate its governance policy. They must bring their perspectives to the board upfront - this will possibly help the board in thinking through some of these new requirements.
5. Improvement in board efficacy
Board evaluation has been mandated under Indian regulations, but disclosures are limited to the process being followed. SEBI has accepted Kotak Committee’s recommendations that companies must begin disclosing the outcome of the board evaluation and the steps it proposes to take following the conclusion of the evaluation exercise. These disclosures are voluntary and companies are expected to adopt these once SEBI issues its guidance.
Investors must engage with Sun Pharma to understand the outcome of its last board evaluation process and encourage the company to make relevant disclosures with respect to the steps it has taken to improve board efficacy. Further, shareholders must understand the efficacy of the board appointment criteria, considering the company’s recent appointment of an independent director with a checkered past.
Other regulatory changes (under the Kotak Committee recommendations) will likely be helpful in addressing some of the practical concerns that Sun Pharma’s investors have with respect to related party transactions and equity issuances. From 31 March 2019, investors will be able to review the nature and extent of related party transactions on a bi-annual basis, as regulations require listed companies to make these disclosures within 30 days of announcing half-year results. Further, the next corporate governance report will also carry disclosures on annual use of issue proceeds of preferential issues and qualified institutional placement, until the proceeds are fully utilized.
One cannot deny that Dilip Shanghvi delivered well on shareholder returns, up until Sun Pharma acquired Ranbaxy. It is still the same promoters and largely the same business. However, the requirements of corporate governance have changed significantly. Increased engagement with investors will perhaps help the company navigate the new requirements and gain back its market aura.