While conducting business it is necessary for a company to enter into transactions. And in the interest of good governance, the company should maintain transparency in those transactions. As opposed to other transactions, transactions with related parties are seen as an area of conflict of interest. This conflict of interest can be justified as corporate frauds such as Satyam Scandal, Enron fiasco and WorldCom scandal were connected to Related Party Transactions.
RPT’s are per se not beneficial to the shareholders or to the company. Transactions involving related parties are not usually at arm’s length basis; i.e. as defined by the companies act 2013 as “a transaction between two related parties that is conducted as if they are unrelated so that there is no conflict of interest.” Most of the times the company enters into the transactions with the related party for managing their personal earnings and sometimes siphoning off the assets to the other affiliated companies. It can be presumed that such transactions are done by the dominant shareholders having the majority of voting rights.
But sometimes RPT’s can be beneficial to the company as it would save transaction costs and also improves efficiency. In some cases the transaction might be unavoidable as not entering into them can go against the principle of maximizing shareholder value.[i] Thus completely prohibiting the related party transaction is not feasible. But restricting them is still a necessity. Thus to regulate these transactions, in order to avoid the replay of the mentioned scandals, legislature developed legal regime through committee reports and amendments. Now, the related part transactions in India are governed under the Companies Act 2013, SEBI (Listing Obligation and Disclosure Requirement) Regulation 2015 and accounting standards.
RPT’s in India and their Regulations
Related party transaction is said to be a transaction between the company and its related entities. These related parties have been mentioned in section 2(76) of the act. It includes director or his relative, Key managerial personnel or his relative, subsidiaries, associate company, joint ventures, substantial shareholders and advisors of the company.
The legislators by the way Companies Act 2013 and SEBI (LODR) put restrictions on these transactions. The Act mandates the approval of the board if the transaction is covered under section 188(1). The thresholds of the transactions have also been provided under the Act. Under the company’s rules, the shareholders’ approval has been made mandatory if the transactions are above the threshold limit. The listing regulations have placed a stricter control on the listed companies, that all transactions would mandatorily need the approval of the audit committee. Relaxation for the companies has also been provided if the transaction is in the ordinary course of the business and at arm’s length. In that case, the approval of the audit committee would suffice.
The Act has also made a requirement of the disclosure of the related party in the director’s report necessary. Further, the accounting standards have necessitated the disclosure of amount also. This fact would ensure complete transparency in the transactions.
The act of 2013, as opposed to that of 1956, has provided for the penalty in case of non-compliance with the provisions of the act. In the case of a listed company, the director or concerned employee of the company would be punishable with imprisonment for a term which may extend to one year or with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees, or with both. While in the case of any other company the concerned person would be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees.[ii]
Issues that may arise
The related party transactions do not apply in some situations. One of them is corporate restructuring. Although till now there has not been a situation where it complained, there may be possibility that some malafide RPT’s can be done as corporate restructuring is done in situations of financial jeopardy. Apart from corporate restructuring, squeeze-outs are also exempted from the provisions of RPT. Squeeze out of minority shareholders is buying them off by the majority shareholder who owns at least 90% of the equity shareholding. [iii]
The act does not define the phrase ‘ordinary course of business’. This has led to abuse of related party transactions by the companies as they use this lacuna in their favor by construing it accordingly. There were some judicial pronouncements to clear the meaning of the phrase, but still, there is confusion as to what would come under the ambit of ordinary course. In the case of M/s Bharti Televentures Ltd v. Addl.Jt. Commissioner of Income Tax[iv], the court held that the charter documents of the company cannot be conclusive documents for deciding what is the ordinary course of business. The frequency of the activity should be seen. The activity should be continuous and it should be carried out in a normal course of business. Also in the case of Seksaria Biswan Sugar Factory v. Commissioner of Income Tax[v], the Hon’ble High Court decided that the amount lent by the company to a third party will not be in the ordinary course of business. The Court observed that just because an activity is included in the Memorandum of Association, the activity does not become an activity in the ordinary course of business of the company.
These two judgments do not help to improve the situation. There is still no clarity as to what would come under the ambit of the ordinary course of business.
The provisions related to RPT’s have been amended many times and the possible loopholes were covered. But there are certain improvements can be made to meet the objectives in a more convenient way. The most important step that the company can take at the time of incorporation is to mention the ordinary course of business in the charter documents so as avoid the malafide operations later on. Further, the companies could keep a check on the transactions that are occurring at arm’s length basis so as to eliminate the possibility of malafide RPT’s.
Also to enhance shareholder activism, the ability to take action can be granted to minority shareholder and to become more active in the process of monitoring these transactions. There can be a stricter control of SEBI on RPT’s so as to strengthen enforcement. Further RPT provisions could also be applied in the situations of corporate restructuring and squeeze out.
Further, the increase in shareholder activism is necessary. As the disclosure is a mandatory requirement of approval, it is necessary that there should be some shareholders who can raise their voice if they find something amiss.
As most of the biggest corporate frauds have had a connection to RPT’s they are a tightrope for both corporate governance and regulation. They have become a ground for suspicion. Also as most of the companies in India are promoter-led RPT’s are usually assumed to be malafide. Thus the legislators intend to regulate transactions if not completely ban it.
After Capitoline data, it can safely be said that India has seen a decline of RPT’s over the past year. According to the annual profit and loss statements made public by S&P BSE 100 companies, RPTs accounted for 11.5% of net sales in FY19—down from 15.4% in FY18. The reason given by the experts is that now the company has to face a stricter regime than it did with the 1956 Act. So it can be assumed that the stringencies put by the act and the market regulator SEBI has the potential to achieve the objectives. [vi]
This can be a successful step for having good governance and controlling fraud. Even if this is an outcome of enhanced scrutiny of stricter regulations or rise in awareness, there is a need for having provisions that do not allow disregard of all RPT’s, including those which are good for the company and are bonafide.[vii] The presumption that all these transactions are for managing personal earnings should not be there while considering the transaction. There needs to be an open mind that it could also be the other way round.
Endnotes[i] Rohan Abraham, IndiGo crisis: Understanding related party transactions, (Jul 25, 2019) available at https://economictimes.indiatimes.com/news/et-explains/indigo-crisis-understanding-related-party-transactions/articleshow/70383085.cms?from=mdr [ii] The Companies act 2013 [iii] Vikramaditya Khanna, (2015) Related Party Transactions, available at: https://www.nseindia.com/research/content/res_QB8.pdf [iv] [ITA 1395/2006, ITA 1656/2010] [v] AIR 1950 Bom 200 [vi] Related party transactions falling could be a sign of improving corporate governance (July 24, 2019) available at: https://www.financialexpress.com/opinion/related-party-transactions-falling-could-be-a-sign-of-improving-corporate-governance-in-the-country/1654241/[vii]Anand Kalyanaraman, All you wanted to know about related party transactions, (July 16, 2019) https://www.thehindubusinessline.com/opinion/columns/slate/all-you-wanted-to-know-about/article28447195.ece#
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