Is Sebi study on royalties a wakeup call on governance?

The markets regulator’s study into royalty payments by listed companies has sparked a fresh debate on governance and financial propriety, raising crucial questions about the principles guiding such payments, particularly when related parties are involved.

In the study, Sebi revealed a concerning trend among listed companies in India: royalty payments to related parties often exceed reasonable thresholds, raising questions about governance and accountability. The study, which analysed 233 companies over the decade from FY14-FY23, highlighted that one in four royalty payments exceeded 20% of net profit. Even more striking, loss-making entities collectively paid ₹1,355 crore in royalties during this period, with some companies consistently incurring losses while making royalty payments. These findings spotlight the complex interplay between financial prudence and governance in corporate India.

The issue does not lie in the legitimacy of royalty payments—an essential business expense—but in the patterns Sebi has identified. Over the 10-year period, 79 companies consistently paid royalties to related parties. Of these,18 companies’ royalty payments grew at a compound annual growth rate (CAGR) of 14.6%, outpacing both turnover (6.5% CAGR) and net profits (6% CAGR). Proxy advisory firms have flagged these discrepancies, noting that royalty payments often lack a correlation with revenues or profits and fail to deliver commensurate performance advantages compared to peers.

For instance, in May 2024, 57.18% shareholders of Nestle voted against a motion that would have entailed Nestle India's royalty payment to Nestle S.A. rise to 5.25% of net sales over a period of five years, from 4.5%. The ordinary resolution stated that the royalty payment will increase by 0.15% each year and had sought shareholder approval for the next five-year period beginning July 1, 2024. “What additional services is the parent company providing? If Nestlé is just going to launch new brands, then the revenue will automatically increase, and they can collect 4.5% of the higher revenue. Why increase it across the board to 5.5%?” questions Shriram Subramanian, founder of the Bengaluru-based InGovern Research Services, a proxy advisory and governance firm. For example, if the revenue increases by ₹100 crores due to new brands, Nestle would have still got 4.5% of that extra ₹100 crores. “Why charge 5.25% on all revenues — including what they were already earning from older brands like Maggi?” points out Subramanian.

According to Aniket S. Talati, partner Talati & Talati LLP and former President of The Institute of Chartered Accountants of India, the principle underlying royalty payments is clear: they are tied to revenues, not profits. “Royalty payments are what companies pay for the right to sell or use intellectual property. Whether it’s a patent, a brand name, or proprietary know-how, these rights fuel the company’s operations. Naturally, such payments are based on revenue—the activity generated using the intellectual property—not profitability, which can fluctuate due to other factors.”

This perspective is supported by accounting standards AS 9 and Ind AS 18, which emphasize the accrual and disclosure of royalty payments but do not prescribe their commercial terms. “The standards tell you how to record and disclose payments,” Aniket explains. “For instance, they mandate transparency about related-party transactions. But whether royalties are tied to revenue or profit is not something the standards dictate.”

The governance slip

Sebi’s findings, however, bring to light a deeper governance issue. Companies have been found seeking approval for perpetual royalty arrangements — contrary to corporate governance principles — and providing insufficient justification for royalty payments. In the case of multinational corporations, minority shareholders are often left in the dark about how royalty rates in India compare to those charged in other geographies. “The real question,” Aniket notes, “is whether these payments are at arm’s length. If a company weren’t dealing with a related party, would it have negotiated a better rate?”

This governance lapse extends to poor disclosures. SEBI’s study found that companies rarely provide adequate details on the rationale for royalty payments, or the benefits derived from them. Aniket highlighted the implications: “Transparency is key. If a company is paying royalties while incurring losses, the board must clearly explain why this is strategically necessary. Maybe it’s a long-term play, where today’s payments set the stage for future growth. But without transparency, minority shareholders have every reason to question the arrangement.”

Sebi’s concerns may also relate to tax planning - payments routed through jurisdictions with lower tax rates raise red flags about profit shifting. Aniket acknowledged this issue, saying, “If I set up a company in Mauritius or Switzerland and pay royalties at 10% tax rate instead of India’s 30%, that’s profit shifting. The Income Tax Act has transfer pricing rules to address such scenarios, requiring related-party transactions to be at arm’s length.”

Despite these concerns, Aniket argued that the solution does not lie in regulatory micromanagement of commercial terms. “SEBI can enforce governance frameworks, but it can’t dictate royalty rates. That’s the board’s responsibility. Regulators can set rules for transparency and fairness, but they shouldn’t interfere with the business’s strategic decisions.”

Sebi’s study also noted a significant issue with valuation subjectivity. Independent fairness opinions on royalty payments varied widely, suggesting inconsistencies in how royalty rates are assessed. This only compounds the lack of clarity for shareholders, especially when combined with opaque disclosures and perpetuity clauses.

Ultimately, SEBI’s findings underscore the need for stronger board oversight and better governance practices. “Good governance isn’t about regulators stepping in, but it’s about boards stepping up. They need to ensure that decisions around royalties—and all related-party transactions—are made transparently and in the best interests of the company,” says Aniket.

Who will bell the cat?

The debate over royalties is a reminder that while regulators can enforce accountability, the ultimate responsibility for ethical and strategic decision-making lies with companies themselves.

“The good thing here is that shareholders have the right to vote on such proposals, and it’s only the majority of minority shareholders that decides. This wasn’t always the case in the past,” says Subramanian.

Boards must play a proactive role in ensuring that royalty payments are fair, justified, and transparent. This begins with evaluating whether these payments reflect arm’s length pricing, a principle that ensures related-party transactions are comparable to those negotiated with third parties. Strategic justifications for royalty payments, particularly in loss-making scenarios, must also be scrutinised, with boards assessing whether such expenses align with long-term growth objectives.

Transparency is equally critical. Boards should mandate detailed disclosures that explain the rationale for royalty rates, the benefits derived, and comparisons with industry norms. By providing clear and comprehensive information, boards can build trust with minority shareholders and address concerns about potential misuse of funds. Moreover, robust approval processes, involving both audit committees and the board, are essential to ensure every royalty payment is carefully vetted for its commercial rationale and fairness.

“When companies propose an increase in royalty payments, there must be a clear justification. They can’t just impose it on shareholders. They must engage with shareholders,” feels Subramanian.

In doing so, boards can create a governance framework that not only complies with regulatory expectations but also upholds the company’s fiduciary responsibilities to all shareholders.

Sebi’s study serves as both a wake-up call and an opportunity to redefine the governance of royalties in India Inc.