A Critical Analysis of Veto and Reserved Rights under the Indian Accounting Standard 110
Brief: AS 110 defines “control” as the authority to guide an investee’s pertinent actions and affect returns. Although they frequently appear in shareholder or joint venture agreements but veto, affirmative, and reserved rights do not always imply control. Protective rights, which protect interests, and participatory rights, which have an impact on important decisions, are the two main differences. Control may only be achieved through participative rights that give an investor the ability to guide pertinent operations. In order to evaluate control under AS 110, one must consider not only the legal structure of these rights but also their content.
Introduction
The concept of “control” is central to determining whether an entity should consolidate another under Accounting Standard (AS) 110 Consolidated Financial Statements. In contrast to conventional methods that just consider ownership percentage, AS 110 uses a more comprehensive, content-driven paradigm. It focuses on whether an investor is currently able to influence an investee’s pertinent activities in a way that impacts the investor’s returns. Rights like veto rights, affirmative rights, and reserved matters frequently become controversial in this situation. Not all these rights grant control, even though they could offer influence. Differentiating between participatory rights, which may equate to control under AS 110, and protective rights, which only serve to defend an investor’s interests requires a sophisticated understanding. Making this distinction is essential to guaranteeing accurate financial reporting, especially in complex shareholder arrangements, joint ventures, and private equity structures.
Control under Accounting Standards 110
Indian Accounting Standard 110(Ind AS110) is primarily for the purpose of Consolidation of Financial Statements wherein an entity i.e. Holding Company which control one or more other entities is required to submit the Consolidated Financial statements. [2]A similar requirement has been bestowed upon the Holding Company under Section 129(3) of the Companies Act, 2013.[3] However, a distinguishing feature between them is that under Ind AS110 consolidated is only required when the entity exercise “Control” over the other entity. Consolidated Financial statements are required to disclose the true and fair view of the company as a single entity.
The Control as defined under the Ind AS 110 is when:
‘The investor is exposed, or has rights, to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee.’[4]
Consequently, the control model under Ind AS 110 is based on three necessary elements and for the purpose of consolidation all three elements should be present:[5]
1.1 Power over the Investee;
1.2 Exposure, or rights, to variable returns from its involvement with the investee; and
1.3 the ability to use its power over the investee to affect the amount of the investor’s returns[6]
a. Power Over the Investee
An Investor is considered to have power over an investee when he has existing power which allows him to direct the relevant activities. Relevant activities are those which can significantly affect the investee’s returns such as determining the financial policies, funding structures, selling and purchasing of goods and services etc. [7]It is irrelevant whether the investor exercises his ability immediately or not, mere presence of the ability to direct relevant activities will be considered as sufficient. This power arises from existing rights which gives him the ability to direct the relevant activities. But for the purpose of control only substantive rights are considered and not protective rights.
Protective Rights are those which protect the interest of investors without giving any control over the relevant activities of the investee. It is exercisable when the activities of an investee are leading to fundamental changes. Such as, veto on winding up, issuance of new shares, altering the article of association etc. Similarly, the right to veto the budget would be considered a protective or substantive right would be depending upon the shareholding agreement between the shareholders and thus effectively differs from case-to-case basis.
b. Exposure to Variable Returns
The second element refers to the potential benefit that the investor will receive from or affected by the performance of the investee through the returns that are not fixed but are subject to vary based on the investee’s failure, success or performance such as dividends, tax benefit, future liquidity etc. Though it does not require that all the investors must be exposed to variable returns.
For Example: If ‘A’ company is holding a 60 % equity in another company ‘B’ and is dependent upon its performance for returns such as profits, dividends etc., then Company ‘A’ would be exposed to Variable returns would be considered as a company influencing the Company ‘B’.
c. the ability to use its power over the investee to affect the amount of the investor’s returns
The third element requires that an investor has the ability to use its power to affect the ability of the investor’s variable returns. This element ensures that the investor has practical ability to exercise the control in a manner to direct the activities of the investee so that it can generate returns for itself. This element is based on principal-agent relationships.
Shrouded Inconsistencies in the Judicial Interpretation of Control.
There has been a inconsistent approach by the various tribunals and courts with respect to what amounts to control, judgments follow a hay why approach with no objective test to determine control. The Competition Commission of India(CCI) in the case of Cairnhill CIPEF Ltd. v. Cairnhill CGPE Ltd., 2017 held that even with a share holding of only 10.77 % in the target company the investor was conferred affirmative rights that amounted to control over the management and affairs of the company.[8] But to contrary in the case of Vishva Pradhan Commercial & RRPR Holding Pvt. Ltd. vs. SEBI,2022,[9] the Securities Appellate Tribunal held that negative or protective veto rights, even when bundled with convertible or call options, do not necessarily amount to “control” under SEBI’s Takeover (SAST) Regulation, 2011[10].
Further, CCI had an occasion to deal with the Control under the Ind-AS110 in the matter of Investcorp India Asset Managers Pvt. Ltd.[11] Wherein it passed an order that under Indian Accounting Standard (Ind AS) 110, an investment manager is not required to consolidate the financials of the investee/portfolio companies of the funds managed by it.[12]
The most landmark judgment has been Vodafone International Holdings BV v. Union of India, (2012)[13] wherein the Supreme Court held that meaning of “control that influence over an Indian firm does not simply result from the legal ownership or possession of shares in a foreign company that controls the Indian company. It underlined that control must be actual and real i.e. the capacity to decide on management and policy issues, rather than merely indirect or hypothetical. This interpretation is aligns with AS 110 wherein emphasis has been laid over the substance rather than the form.
Conclusion
Accounting Standard (AS) 110 defines control as more than just ownership or shareholding. It depends on the investor’s capacity to effectively guide the investee’s pertinent actions, which have a big impact on its results. Affirmative rights, reserved topics, and veto rights frequently present interpretive difficulties in this situation. Unless they are substantive and participatory in character, such rights do not always equate to control, even though they might grant a shareholder protective power. Under AS 110, protective rights such as those meant to protect the investor’s interests without affecting the investee’s daily or strategic choices do not grant control. These rights could be regarded as signs of control, nevertheless, if they go beyond business planning, budget approvals, or key management appointments, thereby granting the investor the present capacity to oversee the pertinent operations. Accounting frameworks, courts, and regulators have all stressed that the practical impact and substance of the rights are more important than their appearance. Therefore, it is essential to comprehend the distinction between protective and participatory rights in order to accurately evaluate control under AS 110. The distinction has important ramifications for stakeholder responsibility, governance, transparency, and consolidation decisions in intricate organizational systems.
Reference
[2] Decoding ‘Control’ Under Ind AS 110, Consolidated Financial Statements. THE STANDARD STANCE, Volume 10.https://www.bdo.in/getmedia/933493c6-aafd-42b1-99e3-93a6cadb4db7/The-Standard-Stance_BDO-India_Vol-10.pdf
[3]Companies Act, § 129(3).
[4]Indian Accounting Standard (IND AS) 110 | Companies Act Integrated Ready Reckoner| https://ca2013.com/indian-accounting-standard-ind-110/
[5] Agrawal, V. (2024, September 11). Variable Capital Company: Basic Structure and its Evolving Framework. Thinking Legal. https://thinkinglegal.in/variable-capital-company-basic-structure-and-its-evolving-framework-india
[6] Directorate of Studies, The Institute of Cost Accountants of India. (n.d.). IND AS 110: Consolidated Financial Statements. In INDIAN ACCOUNTING STANDARD (Ind AS) (pp. 1–3). https://icmai.in/upload/Students/Supplementary/Dec2018/Clarification_P17_110.pdf
[7] Supra Note 3
[8] Cairnhill CIPEF Ltd. v. Cairnhill CGPE Ltd, 2017 SCC OnLine CCI 106
[9] 2022 SCC OnLine SAT 1128
[10] Securities and Exchange Board of India (Substantial Acquisition of Shares and Takeovers) Regulations, 2011, F. No. LADNRO/GN/2011-12/24/30181
[11] CCI order in Investcorp India Asset Managers Pvt. Ltd dated 17th December 2021
[12] Supra Note 7
[13](2012) 6 SCC 613
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Author: Shivam Singh | 4th Year Law Student I B.A.LL.B (Hons.) (BALLB/095/22) | Dharmashastra National Law University, Jabalpur
