Why The Related Party Transaction Regime Should Be Expanded
Articles / By Luke K Jose
A. Introduction
The Related Party transaction (RPT) can be defined as any transaction that is a single or series of financial contracts, deal or arrangement between any two parties related to each other through any particular relationship.[1] Three main legal frameworks govern the Related party transactions in Indian, The Companies Act 2013 (CA2013), The SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR) and the Indian Accounting Standard 24 (IND-AS 24). §2 (76) of CA2013 defines who is a related party.[2] The LODR and the IND-AS 24 also define the various transactions which come under the purview of related party transactions and who all are related parties. The legal framework relating to Related party transactions have come under immense scrutiny due to the various corporate frauds related to such transactions.[3] Further, the related party transactions must have exceptional attention in a country like India where many companies are family-controlled.
The related party transaction in India was always regulated. With the enactment of CA2013 and the LODR, the framework of the RPTs in India have changed to approval, review and disclosure from review and disclosure. The regime related to RPTs needs a change considering that people have been influenced over a company have been misusing their power through circular transactions, continuous intra-group lending, provision of inadequate information to audit committee/ shareholders.[4] Over the years, various committees set up by the central government and other government bodies had recommended a change in the law relating to RPTs. Further, several people have been able to dodge the regulation related to RPTs through various complex corporate structures and transactions.[5] The author believes that there is a need to change the current legal regime related to RPTs.
In this paper, the author will analyse whether there is a need for a change in the law relating to RPTs. The first part of the papers analyses the current legal regime regulating the RPTs. In the next part, the author identifies the problems relating to the current legal regime and discusses the possible solutions to this problem by analysing the various recommendations made by committees set up by the central government or other government bodies and the legal regime RPTs in other jurisdictions. In this paper, the author will specifically consider the report of the working group set up by SEBI on Related Party Transactions. The working paper is against the government’s current direction in which the government eased some regulations regarding the RPTs.[6] The SEBI working committee report is recommending to tighten the definition of related party transaction.
B. The Current Legal Regime Relating To RPTs
As mentioned earlier the RPTs in India are governed by § 2(76) & 188 of CA2013 read with Rule 6A, 15 and 16 of Companies (Meeting of Board and its Power) Rules, 2014 and Regulation 23 of the LODR and the Indian Accounting Standard 24 (IND-AS 24).[7] The LODR defines RPTs as a transfer of resources, obligations or services between the listed entity and a related party without regarding whether a price was charged for such transaction or not.[8] Further, the transaction with a related party includes both a single transaction or a group of transactions in a contract.[9] Further, § 188 of the CA2013 lays down the various transactions under the purview of related party transactions.[10] The §2(76) lays down the people and entities who can be considered a related party with respect to the company.[11]Further, the LODR deems any person who belongs to the promoter or promoter group and holds twenty per cent or more of the shareholding in such listed entity as a related party.[12]
Further, a relative means any person related to each other by being part of a Hindu Undivided Family or a spouse or any other relationship as prescribed.[13] The provisions of section 188 apply to all public and private companies except those who are explicitly exempted. The companies mentioned under §2(76) (viii) are exempted from the provisions of §188.[14]
The §188 of CA2013 deals with the various transactions that can be considered as RPTs and require the board of directors’ approval. [15] It states that a company shall not engage the RPTs mentioned in it without the Board of Directors’ prior approval given by a resolution at a board meeting and subject to such conditions as may be prescribed.[16] The LODR requires the approval of the Audit Committee for all the RPTs.[17] Further, Regulation 23(3) lays down several conditions subject to which the Audit Committee can grant omnibus approval for all the RPTs to be entered by the listed entity.[18] Regulation 23(4) states that the shareholders must approve all the material RPTs through a resolution.[19] The material transactions are defined as the transactions which are entered individually or considered together with the previous transactions in a financial year and exceed 10 per cent of the annual consolidated turnover of a listed entity as the last audited financial statements of that entity.[20]
Further, a transaction with a related party concerning payments for the brand usage or royalty shall be considered as a material transaction if such transactions whether entered individually or considered together with the previous transactions in a financial year and exceeds 5 per cent of the annual consolidated turnover of a listed entity as the last audited financial statements of that entity.[21] The related parties of the company must abstain from voting on such resolution regardless of whether the entity is a related party to such a particular transaction or not.[22] Further, the sub regulations 23(2), (3) and (4) does not apply to a transaction between two government companies and the one entered between a holding company and its wholly-owned subsidiary whose accounts are consolidated with such holding company and placed before the general meeting of the shareholders for approval.[23]
Further, §188(1) do not apply to transactions that in the ordinary course of business and at an arm’s length.[24] Arm’s length transaction has defined any transaction conducted by related parties as if they were unrelated, and there is no conflict of interest.[25] Further, the law does not provide any method to determine whether a transaction is an arm’s length transaction apart from the generic definition. Further, even the LODR does not define the term arm’s length basis. The inadequacy of the terms in this proviso has led companies terming RPTs as transactions in the ordinary course of business at arm’s length basis to avoid going for the aboard shareholders’ approval[26]
Rule 15 of the Companies (Meeting of Board and its Powers) Rules, 2014 deals with requirements for the approval of Board and Ordinary resolution by the companies for RPTs.[27] Rule 15 (1) lays down the disclosure that is to be made in the agenda of a Board meeting in which the resolution for the approval of the RPTs is to be proposed.[28] Further, any director who has an interest in any transaction with a related party shall not be present at the meeting when the subject matter of the resolution relating to such transaction is being discussed.[29] Rule 15 (3) of the Companies (Meeting of Board and its Powers) Rules, 2014 lays down specific criteria of transactions for which the company cannot enter into without the prior approval by the passing of an ordinary resolution.[30] A member who is a related party cannot vote in a resolution for the approval of an RPT. However, it is provided that this rule does not apply to companies where more than ninety per cent of the member are either related parties or relative of the promoters.[31]Further, it also lays down the particulars to be included explanatory statement annexed to General meeting notice pursuant to §101.[32]
C. The Problems With The Current Legal Regime
The legal regime related to RPTs is one of the most strictly regulated in India. However, the current framework of the RPTs is inadequate to prevent several types of corporate wrongdoings. The working group on Related Party Transactions constituted by SEBI noted that the people in control of the companies have continued to do several corporate scams circumventing the regulatory framework on RPTs.[33]They have continued to do so using shell companies directly or indirectly controlled by them which transferred the money using several innovative structures.[34] Further, several other companies escaped the requirement under the RPT legal framework by getting approval for continuous lending to its group companies.[35] One such example of corporate entities using RPT to do malpractice is that of Jet airways. Jet Airways entered into RPTs with several shell companies floated to create fake transactions to transfer funds into various tax-havens.[36]
One of the significant changes the author feels can be made to the current legal framework in the definition of the terms related party. The author believes that the term related party must also include persons within the promoter group of a listed entity and holding less than 20 per cent of the shareholding of such listed entity. The working group had observed it on the related party transactions that even person within the promoter group and with less than 20 per cent of the shareholding can significantly influence the working of a company.[37] Further, several Indian Companies’ structure is such that they constitute various group entities linked together intrinsically and work as one single economic unit. These group entities engage in various transactions such as corporate loan and cross collateralisation. It was observed that such transactions between the group entities raise concern relating to RPTs.[38] Moreover, the promoters and the promoter group who influence such group and exercise control on such promoter group entities must come under the definition of the related party.
Further, there are instances in which a person who is not a promoter holds a significant amount of shareholding in a listed entity. They can also exercise influence and control over the transactions of a company. A person with a substantial shareholding in a listed entity is deemed to be a related party in the UK.[39] A substantial shareholder is defined as any person who is entitled to exercise or control 10 per cent or more of the voting rights in a company.[40] Further, they also consider any person exercising significant influence over a company as a related party.
Furthermore, the IND-AS 24 also considers the person with significant influence over an entity to a related party with respect to that entity.[41] Therefore, the author believes that a person with a significant shareholding can influence the decisions and exercise control over an entity. Hence, the persons which such significant influence must be considered as a related party. The CA2013 defines ‘significant influence as to control at least 20 per cent of the voting power or participation or control in the business decisions. The Working group on RPTs also identified 20 per cent as the threshold for exercising significant influence. The author believes that the percentage of shareholding above which a person is considered a related party can be lowered since the more advanced jurisdictions such as the UK consider a person with 10 per cent or more shareholding to be a related party. However, as there is a need to maintain uniformity in the law therefore one 20 per cent control of the shareholding can be deemed to be the threshold for considering a person as a related party.
Regarding the definition of RPT, it was noted by the working group on RPTs that the companies use several complex structures and transactions to escape from the disclosure and compliance requirement. It was noted that there were several instances in which the companies transacted with unrelated parties to benefit related parties eventually.[42] Such transaction defeats the purpose of having a strictly regulated RPT regime. Further, the definition of RPT in the UK also considers this matter. According to UK Listing rules, the definition of RPT includes a transaction between any listed entity and another party entered into to benefit a related party.[43] The author thinks that we must also expand RPT’s definition to include their transactions entered into by the listed entity with unrelated party intending to benefit a related party. Such an expansion of the definition will help to bring many transactions entered into by the corporates for escaping the various compliance and disclosure requirements of RPT under the scanner.
Furthermore, one of the glaring omission in §188 of the CA2013 is that giving loans to promoter or promoter-related companies that have not been considered an RPT according to the section. There have been several instances where companies gave loans to unrelated entities, which gave loans to related entities. One such case is DHFL, which used the public money to give loans to various entities directly or indirectly related to its promoters.[44] The author feels that §188 must include the financial transactions to related parties as RPTs.
One other area of concern relating to the RPT regime is the transaction done through subsidiary level. The transactions done by an unlisted subsidiary does not require any prior approval of shareholder/ Board or the audit committee unless they involve the sale leasing or disposal of 20 per cent or more of the assets of a material subsidiary. It was noted committee set up the SEBI that the current RPT regime does not consider the transaction entered into by an unlisted subsidiary of a listed entity and the related parties of that entity.[45]Further, the Kotak Committee report also noted that there is a lack of monitoring of the transactions entered into by the subsidiaries of the listed entity. It stated that several listed entities in Indian operate through a network of subsidiaries, and there is a need for stricter governance of those subsidiaries.[46] Therefore, the author opines in favour of the Working committee report, which recommended that the RPT regime be expanded to include the transactions between a listed entity or its subsidiaries on the one hand and a related parties of the listed entity of its subsidiaries on the other hand. Moreover, as discussed in the previous paragraphs, one must also consider the transactions with unrelated parties to benefit a related party. Therefore, the definition of RPT must also include the transaction entered into by a listed entity or its subsidiaries on the one hand and an unrelated party on the other hand to benefit a related party of a listed entity or any of its subsidiaries.
One other recommendation made by the working group is on reducing the materiality threshold required for shareholder approval. According to LODR, the transactions which are entered individually or considered together with the previous transactions in a financial year and exceed 10 per cent of the annual consolidated turnover of a listed entity as the last audited financial statements of that entity are considered to be material transactions.[47] The working group stated that 10 per cent of the consolidated turnover is high and suggested reducing the criteria. The working group also looked at international parallels in reducing the threshold. A similar provision of the percentage limits is in the UK, where transactions above 5 per cent threshold require shareholder approval.[48] Therefore, considering the above aspects, the working group suggested that the threshold for shareholder approval be reduced to 5 % of the annual total revenue or total assets or net worth of a listed entity on a consolidated basis or Rs 1000 crore lower.
The author feels that while reducing percentage limits is a welcome change, re-introducing the absolute numbers is a problem. A percentage limit is sensible as the materiality of a transaction is related to its sized. However, for a huge company, the absolute numbers may be minuscule. Hence, the absolute numbers limit may prove to be cumbersome for huge companies. Therefore, the materiality threshold should ideally must only contain a percentage limit.
D. Conclusion
The author feels that the RPT regime in India needs much change. The author believes that the definition of RPT and the related party must be expanded. As mentioned in the previous sections, there are several loopholes in the current legal framework. There are several instances where the corporate entities have utilised the loopholes in the legal framework and abused the RPTs.[49] The Legal regime related to RPTs always needs a periodic review and necessary changes. The various corporate scandals using RPTs indicates that it requires a change. Expanding the scope of RPTs will help bring several types of transaction used to circumvent the various regulatory requirements relating to the RPTs under the purview of the RPT regime.
After a careful analysis of the recommendations by working group of RPTs, the author believes that several of those recommendations are much-needed changes to tighten the legal regime related to RPTs. A stricter regime relating to RPTs is required for preventing most of the scandals done by various corporate entities using RPTs. Further, it is high time to bring several transactions which are currently not under the definition of RPT, under the purview of RPTs. Further, the term related party’s expansion to include persons within the promoter group and significant shareholders is also necessary. Furthermore, apart from expanding the term related party, the approval mechanism for RPTs must also be made stricter. Finally, even while tightening the regime relating to RPTs, it must not be made too cumbersome to affect the ease of doing business negatively.
[1] Pratip KAR, Related Party Transactions and Effective Governance How it works in practice in India, Background Document Asia Roundtable on Corporate Governance, 25-26 October, 2010, New Delhi, India.
[2] The Companies Act, 2013 §2 (76).
[3] Munmi Phukon, Expanding the web of control over related party transactions: SEBI’s recent proposal to tighten RPT regime, 30th January, 2020, available at: http://vinodkothari.com/2020/01/expanding-the-web-of-control-over-related-party-transactions/ (last accessed 5 February 2021)
[4] Id.
[5] Akhilesh Bhargava, The Curse of the Related Party Transactions, July 17, 2019, available at https://hwnews.in/business-finance/curse-related-party-transactions/106481 (Last visited February 6, 2021).
[6] Payaswini Upadhyay, Related-Party Transactions: Mischief Via Subsidiaries Must Be Fixed, Says SEBI’s Working Group, February 11, 2020, available at: https://www.bloombergquint.com/law-and-policy/related-party-transactions-mischief-via-subsidiaries-must-be-fixed-says-sebis-working-group (Last visited February 6 , 2021)
[7] Indian Accounting Standard 24, ¶9.
[8] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 2 (zc).
[9] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 2 (zc).
[10] The Companies Act, 2013, §188(1).
[11] The Companies Act, 2013, §2(76).
[12] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 2 (zb).
[13] The Companies Act, 2013, §2(77).
[14] Ministry of Corporate Affairs, Exemptions to private companies, REGD. NO. D. L.-33004/99 ( Notified on June 5, 2015)
[15]The Companies Act, 2013, §188.
[16] The Companies Act, 2013, §188(1).
[17] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(2).
[18] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(3).
[19] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(4).
[20] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(1).
[21] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(1).
[22] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(4).
[23] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg.23(5).
[24] The Companies Act, 2013, §188(1).
[25] The Companies Act, 2013, §188(1) Explanation (b).
[26] Bharat Vasani & Esha Himadri, Arm’s Length Pricing -Navigational Tools for the Audit Committee 2 , India Corporate Law, November 10, 2020, available at https://corporate.cyrilamarchandblogs.com/2020/11/arms-length-pricing-navigational-tools-for-the-audit-committee/#more-4148 (Last accessed 11 February, 2021)
[27] The Companies (Meeting of Board and its Powers) Rules, 2014, Rule 15.
[28] The Companies (Meeting of Board and its Powers) Rules, 2014, Rule 15(1).
[29] The Companies (Meeting of Board and its Powers) Rules, 2014, Rule 15(2).
[30] The Companies (Meeting of Board and its Powers) Rules, 2014, Rule 15(3).
[31] The Companies Act, 2013, §188(1).
[32] The Companies (Meeting of Board and its Powers) Rules, 2014, Rule 15(3) Explanation (3).
[33] Ramesh Srinivasan, Report of the Working Group on Related Party Transactions, 8 (January 22, 2020).
[34] Id.
[35] Id.
[36] Rashmi Rajput, Jet formed illegal pacts with related offshore parties, October 15, 2019, available at : https://economictimes.indiatimes.com/industry/transportation/airlines-/-aviation/jet-formed-illegal-pacts-with-relatedoffshore parties /articleshow /71590257.cms?utm_source= contentofinterest &utm_medium=text&utm_ampaign=cppst (last visited on February 6, 2021)
[37] Id, page 10.
[38] Id. Page 11.
[39] UK listing Rules, 11.1.4 (1).
[40] UK listing Rules, 11.1.4 A
[41] Indian Accounting Standard 24, ¶9(a) (ii)
[42] RAMESH SRINIVASAN, Report of the Working Group on Related Party Transactions, 14 (January 22, 2020).
[43] UK listing Rules, 11.1.5 (3).
[44] Aman Kapadia, How DHFL Loan Funds Made Their Way To Kyta – A Wadhawan Company, March 13, 2019, available at: https://www.bloombergquint.com/bq-blue-exclusive/how-dhfl-loan-funds-made-their-way-to-kyta-a-wadhawan-company (Last visited on February 7, 2021)
[45] RAMESH SRINIVASAN, Report of the Working Group on Related Party Transactions, 19 (January 22, 2020).
[46] Uday Kotak, Report of the Committee on Corporate Governance, 45 (October 5, 2017).
[47] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, Reg. 23(1).
[48] RAMESH SRINIVASAN, Report of the Working Group on Related Party Transactions, 26 (January 22, 2020).
[49] Akhilesh Bhargava, The Curse of the Related Party Transactions, July 17, 2019, available at https://hwnews.in/business-finance/curse-related-party-transactions/106481 (Last visited February 6, 2021).
