Unravelling SEBI’s Amendments: Corporate Governance and Ethical Challenges in REITs and InvITs
[Vaibhav is a student at Gujarat National Law University.]
Real estate investment trusts (REITs) and infrastructure investment trusts (InvITs) have recently come under significant regulatory scrutiny by the Securities and Exchange Board of India (SEBI). On 17 August 2023, the regulator introduced the SEBI (REITs) (Second Amendment) Regulations 2023 and the SEBI (InvITs) (Second Amendment) Regulations 2023 (collectively, Amendments).
By virtue of the Amendments, Regulations 4(2)(g) and 4(2)(h) of REITs and InvITs regulations, respectively, provide the right to eligible unitholder(s) to nominate one unitholder nominee director on the board of directors of investment managers (IM) of the REITs / InvITs. SEBI recently notified the procedure for this in 2 similarly worded circulars dated 11 September 2023, for REITs and InvITs.
The amendments have come against SEBI’s consultation paper dated 16 May 2023, which discussed corporate governance concerns which the suggested amendments may pose in REITs / InvITs. In light of the Amendments, the author analyzes the extent to which SEBI has addressed governance concerns raised previously. Further, the author points out the ethical dilemma the unitholder nominee director may face in relation to the corporate governance of REITs / InvITs.
The Backdrop of the Amendments
The Amendments aim to enhance the corporate governance of REITs / InvITs, and these measures reflect the regulator’s goal of making REITs / InvITs an attractive option for investors to earn stable income through passive ownership of real estate and infrastructure projects.
In pursuit of the same objective, the consultation paper proposed 2 alternative mechanisms to provide representation to unitholder(s) in IM, namely Option A and Option B. In the Amendments, SEBI chose to proceed with Option A and rejected Option B, which alternately discussed the nomination of the unitholder(s) representatives in the unitholder(s) council constituted by the IM.
SEBI’s consultation paper in Option A suggested that each unitholder who holds at least 10% of the total unitholding may be eligible to nominate one director to the IM for every 10% of the units owned. SEBI noted that the REITs / InvITs regulations mandate that at least half of IM must consist of independent directors. This provision potentially opens the door to a significantly large IM. In an extreme scenario where every unitholder exercises their right to nominate a director, assuming each holds 10% of total unitholding, IM could reach a large number of 20, with 20 independent directors and 20 nominee directors.
This issue related to a larger IM carries the tangible risk of compromising the board’s effectiveness, potentially leading to excessive bureaucracy and causing delays in the decision-making process. The real estate and infrastructure project market is inherently sensitive to external factors such as government policy changes, interest rate fluctuations, and other variables. In such a dynamic environment, the ability to make timely and effective decisions becomes paramount for the effective governance of REITs / InvITs.
SEBI’s job was to implement the suggestions in the consultation paper only after effectively addressing these concerns. This required deliberations to introduce modifications in Option A, keeping in view a large IM. The investigation of the extent to which the Amendments have addressed the governance issues are in order.
The Amendments: Addressing Corporate Governance Concerns?
The Amendments have defined unitholder(s) with a minimum of 10% of the total unitholding, either individually or collectively, as eligible unitholder(s), who can appoint a maximum of one unitholder nominee director, regardless of whether an entity holds a higher proportion of shares than the prescribed threshold. It is essential to note that this marks a modification from the suggested provision in Option A wherein the unitholder(s) were allowed to appoint one unitholder nominee director for every 10% of units held in REIT / InviT, but does this modification address the possibility of a large IM?
Let us consider an extreme situation of 10 eligible unitholders(s), each having 10% unitholding and all intending to appoint one unitholder nominee director due to the mandate that half of the directors must be independent directors under the REIT / InvIT regulations. Here, the size of the IM could again reach 20, with 10 independent directors and 10 unitholder nominee directors. Therefore, the anterior concern related to a large IM posing difficulties in the corporate governance of REITs / InvITs still remains unaddressed.
However, the implications of this modification in REITs / InvITs are not negligible. In Option A (as discussed in the consultation paper), unitholder(s) were allowed to nominate one unitholder nominee director for every 10% of the units held. In light of the mentioned provision, SEBI highlighted a concerning situation where institutional investors, given their capacity to hold a large percentage of units in REITs / InvITs, may appoint multiple unitholder nominee directors, consolidating significant power in the hands of a few institutional investors in the functions performed by the IM.
In SEBI’s board meeting, the regulator mentioned that in the context of REITs / InvITs, assets are often acquired from sponsors (related parties), and these funds can use leverage, and the decisions made by IM can significantly impact long-term returns for minority unitholder(s). To ensure fairness, it is crucial that all unitholders, not just those with large holdings, have a say in these decisions. This inclusive approach promotes transparency and safeguards the interests of all investors.
In order to promote this inclusive approach, the Amendments allowed the eligible unitholder(s), irrespective of their percentage of unitholding, to appoint a maximum of one unitholder nominee director. Therefore, an institutional investor with 50% of total unitholding can nominate only one unitholder(s) nominee director. As per Option A, such an institutional investor was conferred the power to appoint 5 unitholder(s) nominee directors. This provision dilutes the exponential power conferred to institutional investors by Option A and directs representation toward minority unitholders in REITs / InvITs, providing them an equal opportunity to have representation in IM.
SEBI has done a commendable job when it comes to increasing the confidence of minority unitholder(s) looking towards REITs / InvITs as a powerful tool for investment. However, SEBI still has not been able to address the concern of a significantly large IM in an extreme scenario. Further, the Amendments have sparked the dual responsibility dilemma for unitholder nominee director, as discussed in the rest of the post.
Dual Responsibility Dilemma of the Unitholder Nominee Director
The term ‘nominee director’ inherently implies a dual responsibility – serving both as a representative and as a director. The nominee director bears the responsibility of ensuring compliance with both sets of duties. This dual role frequently places the nominee director in a dilemma, where they must make decisions that may prioritize either the company’s interests or those of their nominator.
In Tata Consultancy v. Cyrus Investments, the Supreme Court, addressing the dilemma of the nominee director, held that “while a nominee director is entitled to take care of the interests of the nominator, he is duty bound to act in the best interests of the company and not fetter his discretion.” This clearly brings to light the dual responsibility dilemma where the nominee director is always obligated to balance the interests of its nominator and the company's interests.
Further, with this dual responsibility dilemma also comes the issue of confidentiality. In the case of Harkness v. Commonwealth Bank of Australia Ltd [(1993) 32 NSWLR 543], it was established that the nominee director’s confidentiality duty precedes the duty owed to their nominator. It has been historically argued that the nominee director cannot share confidential information with the nominator. Still, as recognized in the Report of the Kotak Committee on Corporate Governance, given the nominator’s position, the information communication under the shadow can be assumed to be a strong possibility, raising the significant concern pertaining to confidentiality in corporate governance.
In summary, as evident from the discussed jurisprudence, the unitholder(s) nominee director may face a similar dual responsibility dilemma, requiring them to balance the interests of their nominating eligible unitholder(s) with those of the REITs / InvITs. The Supreme Court’s ruling emphasizes the company’s best interests, and confidentiality duties often prioritize not sharing information with the nominator. This complexity remains a challenge in corporate governance, underscoring the need to carefully navigate these responsibilities in the governance of REITs / InvITs.
The introduction of the right for eligible unitholders to nominate one unitholder nominee director in the IM of REITs / InvITs is a significant step towards increasing transparency and representation in these investment vehicles. However, it also brings about a set of governance dilemmas that must be carefully considered.
While the amendments partially address the concern of concentration in IM representation by institutional investors, they do not fully mitigate the risk of excessive bureaucracy and decision-making delays due to a potentially large IM in an extreme scenario. Furthermore, the dual responsibility dilemma for unitholder nominee directors adds complexity to the governance framework as balancing the interests of the company and its nominator requires careful consideration and adherence to ethical standards.
In conclusion, while SEBI’s amendments are a positive step towards improving corporate governance in REITs / InvITs, they bring forth a new set of challenges and ethical dilemmas. It is essential for eligible unitholders and unitholder nominee directors to approach their roles with the utmost responsibility, transparency, and a commitment to upholding the interests of all stakeholders. SEBI’s efforts to strike a balance between representation and governance should be acknowledged, and further refinement of these regulations may be required in the future to address the governance concerns congruously.