INTRODUCTION
Trade and commerce often include relationships between linked parties. Businesses, for instance, often operate different facets of their value chain via subsidiaries, joint ventures, or connected organisations, and purchase interests in other companies for trading or investing purposes. Related Party Transactions have been more popular in recent years, with the Adani Group facing charges of engaging into related party transactions without required disclosures, with the SEBI probing several Adani offshore operations for alleged rule breaches. There have also been earlier incidents, such as the Satyam Scam and the Eron scam, that have compelled regulatory authorities to enact more strict regulations and guidelines in order to prevent such transactions and protect minority owners in the firm. This article discusses the laws and many regulations that regulate RPTs in India, as well as the legislation that other nations follow. We also discuss the flaws in our existing legal system and some viable solutions to enhance such laws in India based on our knowledge.
WHAT ARE RELATED PARTY TRANSACTIONS?
Before getting into what a related party transaction is, it is important to explain the word related party.
What is Related Party?
A person or organisation that is related to the reporting authority is referred to as a related party. The term “person” also refers to a legal person, which might include a local authority, a company, an individual, or a firm. Moreover, it covers organisations formed outside of India.
Related Party as per Companies Act 2013
“According to section 2(76) of the Company’s act, 2013 related party with reference to company means:
1. A director or his relative, a key managerial personnel or his relative, a firm in which a director, manager, or his relative is a member or I a director or his relative, a key managerial personnel or his relative, a firm in which a director, manager, or his relative is a member or director;
2. A private company in which a director or manager or his relative is a member or director;
- A public company in which a director or manager is a director and owns more than 2% of its paid-up capital with his relatives;
1. Any body corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager.
2. Any person on whose advice, directions or instructions a director or manager is accustomed to act provided that nothing in sub-clauses (vi) and(vii) shall apply to the advice, directions or instructions given in a professional capacity.
3. Any body corporate which is-
4. a holding, subsidiary or an associate company of such company;
5. a subsidiary of a holding company to which it is also a subsidiary; or,
6. an investing company or the venture of a company means a body corporate”[1]
Related Party Transactions are commercial transactions between related parties. Companies regularly leverage their existing resources and enter into agreements with pre-existing networks. Most such transactions are commercially and operationally sound, as long as the interests of the directors / managers and the firms are substantially aligned. Sometimes the only choice is to work with the related firm.
Following transactions between a firm and its related party is described as a related party transaction.
- “Sale, purchase or supply of any materials or goods
- Availing or rendering of any service
- Selling or buying property of any kind
- Leasing of the property of any kind
- Appointment of an agent for the sale or purchase of goods, materials, service or property
- Related party’s appointment to the place of profit or office in the company, associate and subsidiary
- Firm underwriting the subscription of any securities or derivatives of the company”
Corporate Laws in India regarding Related Party Transaction
Section 188 of Companies Act 2013– It mandates a company to take approval of Board and its members , in certain conditions before entering in any transaction or agreement with related party.
This section is applicable to both public and private companies.
In this section there are conditions mentioned in which, in addition to approval of Board, prior approval of Members by means of special resolution is also required before entering in any related party transaction:
- “Paid-up share capital of company is equal or exceeds Rs. 1 Crore.
- The value of transaction individually or collectively with previous related party transactions during a financial year, exceeds5% of annual turnover or 20% of net worth of the company
- The transaction relates to appointment to any office or place of profit in company, its subsidiary company or associate company at a monthly remuneration exceeding Rs. 1 Lakh.
- The transaction relates to remuneration for underwriting the subscription of any securities or derivatives thereof of the company exceeding Rs. 10 Lakh.
- No member of the company shall vote on such special resolution to approve any contract which may be entered into by company, if such member is related party.
- In case of wholly owned subsidiary, the special resolution passed by the holding companies shall be sufficient for the purpose of entering into transaction with wholly owned subsidiary and holding company.”[2]
Exemption of Section 188
It should be emphasised that transactions entered into by a firm in the normal course of business on an arm’s length basis would not be subject to the aforementioned constraints. When two related parties act as though they are unimportant and have no conflict of interest, the transaction is said to be at arm’s length. In this situation, it is crucial to emphasise that the onus of proof rests with the parties agreeing that the aforementioned transactions were carried out at arm’s length.
Accounting Standard 24[3]– According to Indian Accounting Standard 24, a parent company must declare all commercial interactions with subsidiaries, joint ventures, and other connected parties. As a result, a party associated to the reporting entity is referred to as a related party.
The goals of this standard are to emphasise the likelihood that a company’s commercial interactions with related parties may influence its financial statements and net income or loss, as well as to declare any outstanding balances, including commitments to related parties.
SEBI Regulation regarding Related Party Transaction and its approval and disclosure
The board of directors of the listed entity must establish a policy on the materiality of related party transactions and how to handle them that is properly authorised by the board in accordance with the 23rd SEBI Regulation (LODR). The board of directors must also review and revise this policy at least once every three years.
A transaction with a linked party, on the other hand, is deemed significant if the transaction(s) to be entered into during a fiscal year surpass Rs 1,000 crore or 10% of the listed entity’s yearly combined revenue as per the most recently reviewed financial statements, whichever is less.
Despite the aforementioned, if the transactions to be entered into individually or in combination with prior transactions during a fiscal year exceed 5% of the listed entity’s annual consolidated turnover as reported in the most recent audited financial statements, a transaction involving payments to a related party for brand usage or royalty shall be considered. The audit committee of the listed business should have the authority to pre-approve any related party transactions and any material amendments thereto.
Provided, however, that only audit committee members who are independent directors may approve related party transactions.
INTERNATIONAL PRACTICES RELATING TO DISCLOSURE OF RELATED PARTY TRANSACTIONS
The legal framework for related party transaction disclosure is comprised of general common law requirements, corporate laws, and quasi-legislative obligations such as exchange regulations and accounting standards. Even among nations with the same common law background and preceding laws, corporate regulation varies widely. The primary distinction between common law disclosure obligations and corporate statute disclosure requirements is that the latter are frequently more explicit and involve criminal or penal repercussions. The common law principles and corporate legislation provisions primarily benefit present shareholders. They either provide a legal recourse if the company is injured as a consequence of the transaction or apply criminal penalties as a deterrent to unreported / unapproved or outright banned activities.
Laws under United States
For disclosing related party transactions in the US, refer to FASB Statement No. 57, “Related Party Disclosures,” from the Financial Accounting Standard Board. According to FASB Statement No. 57, financial statements must disclose major related party transactions like compensation agreements, expenditure allowances, and other analogous items in the normal course of business.
FASB Statement No. 57 states “that transactions between related parties cannot be regarded as arm’s length if the conditions for competitive, free-market transfers do not exist” . Unless such statements can be substantiated, representations concerning transactions with related parties may not imply that the related party transactions were conducted under circumstances comparable to those in arm’s-length transactions.
According to Section 307 “Related Party Transactions” of the NY Stock Exchange’s (NYSE) Company Manual, related party transactions should be better disclosed in the company’s annual report, proxy statements, and other corporate filings. It is crucial to remember that certain connected party transactions need shareholder approval under Exchange regulations. As a consequence, any discussion of the items addressed in Section 307 should occur concurrently with any consideration of NYSE Listed Company Manual Section 312.00 “Shareholder Approval Policy.”
Laws under United Kingdom
The Financial Reporting Standards, FRS 8 “Related Party Transactions,” which provides instructions on disclosing related party transactions, were developed in the UK by the Accounting Standards Board (ASB). FRS 8’s goal is to inform linked parties of their presence as well as the kind and scope of any interactions with them. It is crucial to remember that FRS 8 only aims to oversee transaction disclosure—not implementation. FRS 8 strives to identify parties tied together by control or influence since it is in these instances that one party may engage in a transaction under terms and conditions that are not in its best interests.
Chapter 11 of the UK Listing Authority’s Listing Rules governs transactions between related parties. If there is any uncertainty as to whether a transaction comes within the scope of the Chapter, a business wishing to participate in a related party transaction must contact the UK Listing Authority and publish a circular to its shareholders with the relevant transaction information.
Laws in Singapore
The exchanges in Hong Kong and Singapore operate on very similar principles. The Singapore Exchange defines “interested person” and “transaction” similarly to Hong Kong, with rather wide definitions, and then requires disclosure or disclosure and independent shareholder approval.
According to SAS 21, “related party relationships” also include people with significant influence over the reporting firm, as well as their immediate family members, as well as linked companies and related enterprises as defined by the Companies Act. To effectively safeguard shareholders’ interests, the Listing Manual requires the issuer to get shareholder approval for related-party transactions aggregating more than 5% of the issuer’s audited net tangible assets, either individually or collectively.
CONCERNS ABOUT ABUSIVE RPTS IN INDIA AND POTENTIAL SOLUTIONS
The related party transactions at various occasions has been used to benefit the company itself and to maximise the shareholder’s value. Nonetheless, the most of the time, the company engages in business with related parties to control their own earnings and sometimes to syphon off assets to other related businesses. It is logical to presume that the significant shareholders who have the majority of the voting rights execute such transactions.
The phrase “regular course of business,” which the corporation has used to explain transactions by saying they are in the ordinary course of business, is not defined in the statute. As a result, the first concern is raised. There have been several court rulings to clarify the meaning of the word, but there is still some uncertainty as to what would fall within the scope of usual course. The Hon’ble High Court held in the matter of Seksaria Biswan Sugar Factory v. Commissioner of Income Tax that the amount borrowed by the corporation from a third party was not done in the regular course of business. The Court concluded that just because an activity is included in the Memorandum of Association does not mean it must take place during normal business course.
Another way in which RPTs have behaved cruelly is by investing shareholder funds in promoter organisations. These Organizations’ new projects are often funded using this money, sometimes via quasi-debt, rather than for comparable safer and ethical investment aims. The company use the shareholder funds by investing in the other promoter company and not disclose it properly in the financial statements of the company, which might be abusive use of shareholder’s fund.
Even though it is necessary to provide the key details of the RPTs, they are frequently categorised as “Associates,” “Joint Ventures,” and “Key Managerial Personnel’s Owned Companies.” Furthermore, no explanations are offered for these questionable transactions, which undermines the smaller shareholders’ faith and confidence. It is difficult to decide whether to accept such RPTs since there aren’t any other options that are comparable. Due to poorly phrased claims that skew vote results, the risks of RPTs are often not disclosed. The main issue is that there isn’t a set standard structure for reporting these transactions.
When the transaction exceeds the predetermined limit, Section 188 of the 2013 Companies Act[4] requires RPT approval. Only transactions of 10% or more of the company’s revenue or net worth now need approval. This barrier is really high. Many companies may take part in RPT if they keep the quantity of their transactions below this cap. That will make it easier for them to commit RPTs without getting permission.
To tackle the some of the issues mentioned above, there is need of some stringent rules and regulations and proper implementation of these rules to protect the minority shareholders interest and maintenance of good corporate governance.
– A significant amount of checks and balances must be carried out by the Audit Committee on “ordinary transactions” that are conducted at “arm’s length.” Without doing sufficient due diligence and properly informing the shareholders, the board should not accept the transaction. This would allow the shareholders to decide whether or not to support the transaction.
– As was already said, RPTs need a common reporting format. This makes sure all information is provided. The reasons why certain high-value deals with unrelated firms were unable to be completed must also be made public.
– India’s implementation of corporate governance has fallen short of expectations despite strict regulations. The enforcement of the law must be much improved before it is changed.
– The establishment of proxy advisory services to monitor transactions and keep shareholders informed would defend the interests of inexperienced investors.
SOME JUDICIAL INTERPRETATIONS IN INDIA
1. The meaning of “interest” under Section 188 was interpreted as “personal interest” in the case of Public Prosecutor v. T. P. Khaitan (1957)[5]. The word encompasses not only financial interests, but also those arising from a fiduciary or personal relationship. The interest of the related party may be direct or indirect.
2. The question in Needle Industries Ltd. v. Needle Industries Newey (India) Holding Ltd. (1982)[6] was whether all transactions with related parties were subject to scrutiny and compliance with Section 188 of this Act. The third provision to sub-section (1) of Section 188, as an exemption clause, gives a solution to this dilemma. It exempts all transactions engaged into by the entity in the ordinary course of business, save those that are not at arm’s length.
3. The phrase “arm’s length transaction” was defined in the case of IndusInd Bank v. Additional Commissioner of Income Tax (2012) as the amount for which assets can be transferred in an arm’s length transaction between a willing and knowing buyer and a willing and knowledgeable seller
CONCLUSION
The Satyam case and other occurrences provide proof that India needs stricter regulation to stop frauds or scam involving “related party transactions,” as shown by the facts mentioned above. The current system raises several issues, including the absence of a definition of the normal course of business, arm’s length transactions, and other issues. It is therefore time to create new laws or amend such laws on this subject because companies like Adani continue to take advantage of these loopholes, and in our opinion, as a result of these wrongdoings, the average investor who puts his hard-earned cash into businesses, loses both his money and faith in the capital market. As a result, the government should introduce new laws on this subject to preserve their faith and encourage them to invest more.
REFERENCES
1. Renu Suresh, Related Party transactions – companies act IndiaFilings (2019), https://www.indiafilings.com/learn/related-party-transactions/ (last visited Mar 2, 2023).
2. Alok Kumar Ghosh, Overview of related party and Related Party transaction TaxGuru (2022), https://taxguru.in/company-law/overview-related-party-related-party-transaction.html (last visited Mar 2, 2023).
3. Galani, Ami, and Nathan Rehn. “Related Party Transactions: Empowering Boards and Minority Shareholders to Prevent Abuses.” National Law School of India Review 22, no. 2 (2010): 29–57. http://www.jstor.org/stable/44283790.
4. Teen, Y. and Prof. Lim (no date) Shareholder rights and the Equitable Treatment of shareholders, Defining and Disclosing Related Party Transactions: A Survey of International Practices. Available at: https://www.oecd.org/corporate/ca/corporategovernanceprinciples/2484893.pdf (Accessed: April 3, 2023).
5. Shambharkar, A.M.B. (2021) Related Party transactions, Lawwallet. Available at: https://lawwallet.in/related-party-transactions/ (Accessed: April 5, 2023).
6. Chaturvedi, Letishiya, and Poorna Dixit. “Related Party Transactions and Corporate Governance in India.” SCC Blog, November 2, 2021. https://www.scconline.com/blog/post/2021/11/02/related-party-transactions/.
7. LegalWindow, Team. “Regulation 23 of SEBI (LODR) Regulations 2015.” Legal Window, July 9, 2022. https://legalwindow.in/regulation-23-of-sebi-lodr-regulations-2015
Notes:-
[1] Companies Act, 2013
[2] Section 188 of Companies Act 2013
[3] Indian accounting standard 24
[4] Sec 188, Companies Act 2013
[5] IR 1957 Mad 4, 1957 CriLJ 69
[6] 1981 AIR 1298, 1981 SCR (3) 698
Author Bio
