MCA examines relationship between credit period and commission: minority shareholders of Searle getting a raw deal-II

Conversely, in the matter under consideration, the distributor, ie IBL, has a cushy deal at both ends. Not only is the supplier, ie SEARLE, paying commission to IBL at the very high levels of 10-12% but also SEARLE is allowing the longest credit period of 120 days to IBL.
This is quite untenable, particularly when one considers SEARLE's operational relationship with IBL until July 2005. Despite having appointed IBL as the sole distributor of its products, the distribution agreement in vogue until July 2005 stipulated a somewhat unique arrangement, namely, that SEARLE's stock of finished goods were kept on consignment with IBL instead transferring this inventory by way of sale to IBL.
The risk remained fully with SEARLE and all costs related to the goods and their storage as well as movement from one place to another being borne by SEARLE. It is only when IBL actually effected a sale that the ownership of the goods sold got transferred from SEARLE to IBL and then immediately from IBL to the buyer with invoices being raised from SEARLE to IBL and from IBL to the buyer.
Thereafter, while IBL had 75 days or 120 days to make the payment to SEARLE, the payment terms agreed between IBL and the buyer varied from immediate payment to a few days credit (not likely to have exceeded 40 days which is apparently the maximum prevalent in the trade).
Through this arrangement, IBL clearly benefited from the float arising as a consequence of the cash inflow from buyers who had bought on cash payment/shorter credit basis and the payments passed on to SEARLE for which IBL had the much longer credit period of 75 days or 120 days. If, on the odd occasion, this period was exceeded, IBL was expected to pay mark-up to SEARLE on the outstanding balance at the stipulated rate, which seldom, if ever, occurred.
Interestingly, this arrangement also provided for the reverse ie for IBL to charge SEARLE mark-up at the same rate whenever IBL, purportedly on the instructions of SEARLE, was obliged to extend credit to an institutional buyer beyond whatever was the agreed credit period ie 75 days or 120 days.
Thus, effectively, in such cases, the mark-up paid by SEARLE to IBL served to precisely compensate IBL for the mark-up paid by it to SEARLE. We are, therefore, surprised to note an anomaly in IBL's submission of March 27, 2007 to the effect that "mark-up @ 11% is charged on credit sales to government institutions" whereas "IBL is liable to pay mark-up to Searle Pakistan @ 7.5% per annum" - this not only compensates IBL but also earns for it a handsome financial spread!
We find that, in comparison with distribution agreements concluded by other premium pharmaceutical companies, the distribution arrangements of SEARLE with IBL that were extant until June, 2005, were actually quite extraordinary inasmuch as:
-- As distinguished from the usual seller/buyer relationship pharmaceutical companies have with their distributors, IBL was, in the first instance, a consignee of SEARLE. However, the conclusion of a sale meant that title to the goods sold passed seamlessly from SEARLE to IBL to the ultimate buyer. Till the sale occurred, SEARLE effectively retained title, and as owner, all costs related to the goods sold were to SEARLE's account. IBL - unlike other distributors in the industry - took no risk as a buyer till the goods were actually sold at which point it intermediated, back-to-back, between SEARLE and the ultimate buyer.
-- The credit period of 120 days allowed by SEARLE to IBL was in fact three times more than what is ordinarily the upper limit (ie 40 days). The fact that this takes effect not from the date of delivery to IBL but from the date of sale to the ultimate buyer further compounds the enormous financial benefit passed on to IBL at the cost of SEARLE.
-- The 10% commission/discount allowed to IBL for pharmaceutical products is above the range of 4 1/2 - 9% ordinarily seen in the trade. Rates of commission/discount exceeding this range accompanied by a credit period of 75 days or 120 days are inconceivable. Based on the observed practice in the trade, it is actually unconscionable that such a high level of commission/discount subsisted alongside the most generous credit terms.
-- Despite the fact that the distribution agreement of July 01, 2000 does not make any provision for payment of mark-up by SEARLE to IBL on outstandings with institutional sub-distributors (primarily Government institutions) in respect of sales made on credit terms purportedly agreed by SEARLE, it has been averred (in the replies of SEARLE and IBL to the Authority's Show Cause Notice) that the expenses reimbursed by SEARLE to IBL include such mark-up costs. Since the agreement of July 01, 2000, envisages back-to-back sales from SEARLE to IBL and then from IBL to the buyer, and further stipulates that sales to institutional buyers would be on "credit terms agreed by SEARLE", there should not be any question of mark-up costs incurred by IBL to be reimbursed by SEARLE. The only exception would be default on payment by the buyer but this has not been indicated.
-- The distribution agreement of July 01, 2000 uniquely provides that the "cost of freight and Octroi up to the ultimate customer (ie, customers of IBL) will be borne by SEARLE". This type of blanket and sweeping transfer of liability on account of transportation of goods to the supplier is most unusual and rare. It is usual for distribution agreements to provide that the supplier bears the cost of transportation of the goods up to the relevant significant location of the distributor. Beyond this, the cost of any further movement of the goods is borne by the distributor albeit there are instances where the supplier also, to some extent, bears this burden - however, any such arrangement rationally influences the rate of commission paid to the distributor.
-- IBL has charged SEARLE warehouse rent for "stock storages". There does not exist any provision for this in either the distribution agreement July 1, 2000 or in that of July 01, 2005. Nor have we come across any distribution agreement for pharmaceutical products (or for consumer products) that specifies that the distributor can charge the supplier for storage of the products being marketed since, barring rare exceptions, this is clearly an accepted and necessary part of the package of services that constitute the function of distribution. Both the distribution agreements executed between SEARLE and IBL appoint IBL the "exclusive Distributor" and use the same language to require "IBL" to distribute all products being "marketed" and to "purchase all products exclusively direct from SEARLE". The distribution agreements fully bind both parties - SEARLE is obliged to sell all its products only through IBL, and IBL must sell all SEARLE's products without exception. The question of any inventory of SEARLE being held by IBL merely for storage is inconceivable. The Authority has not been provided any reason as to why, as alleged by IBL in their letter of March 27, 2007, "Searle Pakistan is storing their stocks, which is not sold to IBL for distribution at our National Warehouse Karachi and other regional warehouses ...............". This simply does not make any sense. It is noteworthy that the thin veil of a consignor-consignee relationship stipulated in the agreement of July 01, 2000 does not provide any room for charging storage costs to the consignor (ie SEARLE) when the consignee (ie., IBL) has taken on the exclusive responsibility to distribute all the consignor's products. A consignment arrangement - particularly one between non-armslength parties - must not serve to militate against normal business practice and common sense.
-- Despite the fact that there is nothing in either the agreement of July 01, 2000 or in the subsequent agreement executed after five years of experience on July 01, 2005, with regard to reimbursement of expenses (including vehicle hiring charges) incurred by IBL on account of SEARLE, yet such reimbursements appear endemic in this relationship. While one can readily appreciate that being two separate corporate entities, SEARLE must reimburse IBL for any expense incurred by IBL for SEARLE and vice versa, such reimbursements must be based on the application of strict criteria and tests to indisputably establish the veracity of the reimbursement claimed, particularly in view of the associated status of the two undertakings and the potential for abuse. It is clear that ordinary, "in due course" audit procedures applied by external auditors may not suffice. In fact, if the reimbursements are an on-going occurrence that are a part of the business relationship (which appears to have been urged in this case) carefully devised procedures with in-built, independent checks are called for. We have been provided no evidence of this. We have been essentially advised that field staff of SEARLE working in 80 stations across the country often utilise IBL's telephone/fax facilities and vehicles - and SEARLE is then required to reimburse these expenses. This seems loose and open-ended. Neither SEARLE nor IBL have been able to provide information regarding any criteria or process put in place to verify or justify the reimbursibility of the expenses in question. In a group situation, there could also be fundamental conceptual issues related to reimbursibility eg if the work of SEARLE's field staff, for the most part, directly or indirectly, facilitates the sale and distribution of its products this would represent a service to IBL, and in view of this, IBL would not be entitled to claim re-imbursement. On the contrary, it may well be fit and proper for IBL to pay SEARLE for the time spent by SEARLE's staff in assisting or facilitating IBL discharge its contractual obligations to distribute SEARLE's products under the distribution agreements.
We find that the distribution agreement executed on July 01, 2005, made three material changes, as follows:
-- Firstly, the consignment basis has been replaced by the more usual seller/buyer relationship. SEARLE now bears the cost of transportation up to "the delivery point" of IBL - at this stage the title and all risk of damage or loss pass on to IBL;
-- Secondly, the 120 day credit period starts from the date the goods are delivered and not from the date the goods are eventually sold to the ultimate customer. This is much more in line with normal business practice albeit the 120 day credit period together with the 10% commission/discount allowed on pharmaceutical products constitutes an exceedingly generous package for IBL.
However, IBL is allowed to claim mark-up from SEARLE on outstandings with institutional sub-distributors (mainly Government institutions) that exceed the normal credit period of 120 days. This may have some merit if the sales to these institutions were indeed made on the instructions of SEARLE and in accordance with credit terms agreed by SEARLE as stipulated in the distribution agreement. As indicated earlier, there is really no justification for this on such sales under the previous agreement of July 01, 2000; and
-- Thirdly, the commission/discount allowed for non-pharmaceutical products will vary from 3% to 12%, as negotiated, and not a uniform 12% on all non-pharmaceutical products. This seems more reasonable. The commission/discount on pharmaceutical products was continued at 10%, which, as stated earlier, is perhaps the highest in the industry.
As indicated, the 2005 agreement is, in some ways, an improvement over the earlier agreement -- in structural terms it can be regarded as somewhat closer to the distribution agreements generally executed by leading pharmaceutical undertakings in Pakistan. However, despite this improvement, the specific terms of the 2005 agreement remain fairly onerous for SEARLE and exceptionally beneficial for IBL.
We refer primarily to the 10% commission on pharmaceutical products and the extended 120 day credit period allowed to IBL. Also, as discussed in preceding paras, IBL makes recoveries from SEARLE with respect to a variety of cost items which, for the most part, are not in keeping with normal trade practice. The overall arrangements are skewed in favour of IBL to the detriment of SEARLE and it is impossible to conceive of these arrangements as occurring between two unconnected parties.
As it happens, SEARLE and IBL are associated undertakings, and the IBL Group (ie IBL, its shareholders, and entities fully controlled by IBL and its shareholders) has a controlling equity interest in SEARLE. In 2005, four out of eight directors of SEARLE were also on the board of IBL where they comprised 80% of the IBL board (ie, four out of five directors).
These directors along with Mr Shahid Abdullah, a major, 11.54% shareholder of IBL, who is also on the board of SEARLE, effectively meant that, IBL controlled SEARLE in 2005. With some inconsequential variations, this situation, ie the substantial control of SEARLE by IBL, has prevailed both before and after 2005, possibly since IBL's acquisition of a major equity interest in SEARLE in 1993.
The extension of 120 days payment credit by SEARLE to IBL is a significant deviation from the usual industry practice of securing advance payment from distributors or at most extending a few days credit which hardly ever exceeded 40 days. In its submission of May 04, 2007, SEARLE has admitted that the "industry trend is generally 45 days credit which again is linked with the number of days inventory is required to be held by the distributor".
Despite being given every possible opportunity to do so, neither SEARLE nor IBL has provided any commercial rationale for the 120 days credit or for that matter the 75 days credit previously allowed to IBL.
It is obvious that this excessive and concessionary credit to IBL with costly implications for SEARLE and its shareholders could only occur because of IBL's control over SEARLE. By no means can either the very high commission/discount of 10% allowed to IBL (essentially above the industry range) coupled with the 120 days concessionary credit can be deemed to be a normal commercial arrangement when considered in the light of industry practice as observed by us.
It is clear that the 120 days credit without any justification or redeeming feature whatsoever cannot be regarded as normal trade credit. In fact, instead of provisions to ameliorate the extraordinary 120 days credit, the distribution arrangements contain unique aspects that allow IBL to reap additional benefits that are not in accord with usual industry practice like charging SEARLE for storage of stock, requiring SEARLE to reimburse certain expenses, passing on to SEARLE the costs of carriage and duties until delivery to the ultimate customer etc.
It is somewhat amazing that SEARLE was not able to produce any documentation manifesting appropriate corporate approval of these extra-ordinary distribution terms, whether in the shape of clearance by the Board or a shareholders' resolution. Since the 120 days credit cannot be regarded as normal trade credit, this would appear to fall within the purview of Section 208 of the Companies Ordinance, 1984, requiring a special resolution of the shareholders which was not arranged.
Prima facie, it also seems, in view of the common directorships held, that the loan accommodation provided by SEARLE to IBL comes within the mischief of Section 195 of the Companies Ordinance, 1984, which inter alia prohibits loans to directors as well as entities in which they have a material interest as specified in this Section.
A loan to a private company of which a member or director is also a director of the lending company is not permitted under Section 195. However, we feel, it is not for the Authority to delve into these matters but would prefer to leave it to the Securities & Exchange Commission of Pakistan being the corporate regulator to adopt a considered view in this connection.
We have very carefully considered this case in the light of the various submissions made by both the parties, the extensive deliberations at the hearings, and our own market inquires. The business relationship between SEARLE & IBL is not the outcome of rational interaction between two economic agents on a level playing field.
The content of both distribution agreements and, even more so, the actual dealings of the parties with each other reflect the marked tilt in favour of IBL as compared with most distribution arrangements put in place by major pharmaceutical undertakings in Pakistan. It is self-evident that IBL has been able to use its majority equity interest and control over SEARLE to extract a most favourable arrangement for itself which is way out of line from market practice, and which has greatly disadvantaged the other shareholders of SEARLE.
It is difficult to imagine a more glaring manifestation of undue concentration of economic power at play and a more obvious situation to which Section 4(b) of the Ordinance applies. As already indicated in preceding paras, we find that the following aspects of the distribution arrangements have the effect of unfairly benefiting the shareholders of IBL to the prejudice of the shareholders of SEARLE and would have to be revised or eliminated as stated against each:
FIRST: the commission of 10% for pharmaceutical products is above the range of 41/2 - 9% for such products and the commission of 12% for non-pharmaceutical products (until July 01, 2005) is perhaps at the very high end for such products.
These rates of commission/discount are particularly unacceptable when considered alongside the lengthy credit period of 75/120 days allowed to IBL. Considering the overall circumstances, while we may be willing to concede these rather high rates of commission/discount, in good conscience, we cannot accept or permit the rather excessive credit periods allowed to IBL which must be reduced to 40 days.
Also, the credit period must commence from the date of delivery to IBL and not - as was the case until July 01, 2005 - from the date of sale to the ultimate buyer. This arises out of the consignment basis in vogue prior to July 01, 2005, which inter alia had the effect of starting the credit period from the date of sale.
Consistent with normal market practice, the consignment basis will have to be deemed retrospectively as inoperative with the necessary consequences that follow from this - instead of placement with IBL on consignment, each delivery of the products to IBL will be deemed sold to IBL with a 40 day credit period.
In this connection, we are of the view, considering the circumstances, that mark-up calculations may be made at the rates stipulated by the parties from time to time since the effect of any reasonable revision of these rates is likely to be marginal;
SECOND: all amounts charged to SEARLE on account of warehousing stock being not in accord with market practice will need to be reversed;
THIRD: instead of bearing the cost of transportation up to the ultimate customer which was the case until July 01, 2005 in terms of the Distribution Agreement of July 01, 2000, adjustments will have to be made to ensure that SEARLE does not, in any instance, bear the cost of transportation beyond IBL's location of sale ie the point from which the products are dispatched to the customer;
FOURTH: payment of mark-up to IBL on account of credit availed by institutional sub-distributors (mainly Government institutions) beyond the credit period allowed to IBL is possible only if incontrovertible evidence exists on record to show that the transaction occurred "on the discretion and approval of SEARLE" as has been specified in both the distribution agreements. Also, the rate of mark-up allowed to IBL must not exceed the rate of mark-up payable by IBL to SEARLE on account of payments received after the credit period allowed to IBL; and
FIFTH: being not in keeping with market practice, it is not possible to allow reimbursement of miscellaneous expenses (such as telephone/fax charges, vehicle hiring charges etc allegedly incurred by SEARLE field staff) unless (i) incontrovertible evidence is on record to unquestionably demonstrate pre-authorisation by SEARLE in each case; and (ii) it can be irrefutably shown that the expense in question was not incurred to assist or facilitate IBL in fulfilling its contractual obligations to SEARLE, whether directly or indirectly.
We are, however, prepared to allow payment of charges on account of group corporate services to the extent of approximately Rs 300,000 out of Rs 1,600,000 for the entire group (ie about 18.75%) specified in the submissions of both SEARLE and IBL dated May 04, 2007, as this appears reasonable.
ORDER In the light of the aforegoing, we direct and order as follows:
(i) the principles and specifications enshrined in para 34 will apply henceforth to all dealings between SEARLE and IBL and will supersede as well as take precedent over any distribution agreement or other understanding between these parties, whether written or verbal.
(ii) SEARLE and IBL will procure that the statutory auditors of SEARLE (or alternatively, a firm of Chartered Accountants approved by the Authority) examine all transactions between these undertakings since July 01, 2000 to date in the light of our observations in para 34 above and determine the net amount due from IBL to SEARLE after adjusting for payments already made. Any clarification needed in this respect will be provided by the Chief (Investigation) of the Authority or such other person as may be designated by the Authority for this purpose. This task must be completed within 90 days of the date of this Order and settlement for the net amount determined as due and payable must be effected to the satisfaction of the Authority within 120 days of the date of this Order; and
(iii) the Registrar of the Authority will make a reference to the Securities & Exchange Commission of Pakistan ("the Commission") drawing their attention to para 33 of this Order to enable the Commission to take cognisance of possible contravention of Sections 195 and 208 of the Companies Ordinance, 1984, and to take such measures as may be deemed appropriate by the Commission.
(Concluded)