A Comparative Analysis: Section 188 of Companies Act, 2013 & AS-18

Introduction:

A company undertakes a variety of transactions with various parties, including related parties, as part of its business. The term “related party” is defined under Section 2(76) of the Companies Act, 2013. The conditions for obtaining board or member’s approval in a general meeting are outlined in Section 188 of the Companies Act, 2013. The Accounting Standard-18 (hereinafter referred to as AS-18) provides the requirements for disclosing related party transactions (hereinafter referred to as RPT). In this article, the authors have provided a brief discussion on the provisions of Section 188 of the Companies Act, 2013 and AS-18 as a comparative analysis.

Significance of Related Party Transaction (RPT):

RPTs are advantageous to companies in the following ways:

a) Due to the pre-existing relationship, the parties’ degree of trust and confidence regarding the transactions is enhanced.

b) The related parties’ direct or indirect interest in the company guarantees that the transactions are carried out efficiently.

c) It results in fruitful negotiations over the terms and conditions of the contract or agreement, which lowers costs.

What constitutes a related party?

The term related party is defined under Section 2(76) of the Companies Act, 2013 and AS-18 as follows:

Particulars	Section 2(76) of the Companies Act, 2013	AS-18
Related party	The term related party as per Section 2(76) of the Companies Act, 2013 includes: (i) a director or his relative; (ii) a key managerial personnel or his relative; (iii) a firm in which a director, manager, or his relative is a partner; (iv) a private company in which a director or manager or his relative is a member or director; (v) a public company in which a director or manager holds, along with his relatives, more than two percent of its paid-up share capital; (vi) anybody 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; (vii) any person on whose advice, directions, or instructions a director or manager is accustomed to act: (viii) any company that is— (A) a holding, subsidiary, or associate company of such a company; or (B) a subsidiary of a holding company to which it is also a subsidiary; (C) an investing company or the venturer of the company;”	AS-18 deals with two terms, one being “related party” and the other being “related party relationship. As per paragraph 10.1 of AS-18, parties are considered to be related if, at any time during the reporting period, one party has the ability to control the other party or exercise significant influence over the other party in making financial and/or operating decisions. Only the related-party relationships outlined below are covered by this standard. As per paragraph 3 of AS-18, the related party relationships are: (a) enterprises that directly, or indirectly through one or more intermediaries, control, are controlled by, or are under common control with the reporting enterprise (this includes holding companies, subsidiaries, and fellow subsidiaries); (b) associates and joint ventures of the reporting enterprise and the investing party or venture in respect of which the reporting enterprise is an associate or a joint venture; (c) individuals owning, directly or indirectly, an interest in the voting power of the reporting enterprise that gives them control or significant influence over the enterprise, and relatives of any such individual; (d) key management personnel and relatives of such personnel; and (e) enterprises over which any person described in (c) or (d) is able to exercise significant influence. This includes enterprises owned by directors or major shareholders of the reporting enterprise and enterprises that have a member of key management in common with the reporting enterprise.
Exception to the term-related party	The advice, instructions, or directions given in a professional capacity are not covered by subclauses (vi) or (vii) of Section 2(76) of the Companies Act, 2013.	The following are deemed not to be related parties: a) two companies having common directors except for the cases mentioned earlier, i.e., in paragraphs 3(d) or (e) of AS-18. But if they are able to affect the policies of both companies, then they will be considered related parties. b) a company transacting a significant volume of business merely by virtue of the resulting economic dependence with a single customer, supplier, franchiser, distributor, or general agent. c) i) providers of finance ii) trade unions iii) public utilities iv) government departments and government agencies, including government-sponsored bodies, in the course of their normal dealings.
Deemed-related party	As per Rule 3 of the Companies (Specification of Definitions Details) Rules, 2014, a director other than an independent director or key managerial personnel of the holding company or his relative with reference to a company shall be deemed to be a related party.	There is no such provision.

What constitutes Related Party Transaction (RPT)?

Now that we are familiar with the definition of a related party, let’s examine the covered transactions. The following are the general categories:

SECTION 188 (1) OF THE COMPANIES ACT, 2013

AS-18

The sub-section (1) of section 188 of the Companies Act, 2013 provides the related party transactions as follows: (a) sale, purchase, or supply of any goods or materials; (b) selling or otherwise disposing of, or buying, property of any kind; (c) leasing of property of any kind; (d) availing or rendering of any services; (e) the appointment of any agent for the purchase or sale of goods, materials, services, or property; (f) such related party’s appointment to any office or place of profit in the company, its subsidiary company, or associate company; and (g) underwriting the subscription of any securities or derivatives thereof to the company:

Here are some instances, as per paragraph 24 of AS-18, of related party transactions about which a reporting company may provide information: (a) purchases or sales of goods (finished or unfinished); (b) purchases or sales of fixed assets; (c) rendering or receiving services; (d) agency arrangements; (e) leasing or hire purchase arrangements; (f) transfer of research and development; (g) license agreements; (h) finance (including loans and equity contributions in cash or in kind); (i) guarantees and collaterals; and (j) management contracts, including for the deputation of employees.

What are the approvals required under Section 188 of Companies Act, 2013?

PARTICULARS	COMPLIANCES
Board Resolution	The approval of the board by way of a board resolution is mandatory for all the RPTs as mentioned under Section 188 of the Companies Act, 2013.
Special Resolution at the General Meeting	According to Rule 15(3) of the Companies (Meetings of the Board and its Powers), it is required to take a special resolution of the members at the General Meeting in the following cases: i) Sale, purchase, or supply of any goods or material, directly or through the appointment of an agent—10% or more of the turnover of the company. ii) Selling or otherwise disposing of or buying property of any kind, directly or through the appointment of an agent—10% or more of the net worth of the company. iii) Leasing of property of any kind—10% or more of the turnover of the company. iv) Availing or rendering of any services, directly or through the appointment of an agent—10% or more of the turnover of the company. (The aforementioned limits are explicitly stated here and will be applicable to any transactions made during a financial year, whether they are done individually or in conjunction with prior transactions.). v) The appointment to any office or place of profit in the company, its subsidiary company, or associate company at a monthly remuneration exceeding Rs. 2,50,000. vi) The remuneration for underwriting the subscription of any securities or derivatives thereof of the company exceeding 1% of the net worth
The resolution of the holding company is sufficient.	As per Rule 15 of the Companies (Meetings of the Board and its Powers), in cases of transactions between a holding company and its wholly owned subsidiary, a resolution passed by the holding company shall be sufficient.
Restriction to vote	For approving any contract or arrangement where a member is a related party to it, he shall be restricted from voting in this regard. Provided that the restriction to vote shall not apply where 90% or more members in the number are relatives of promoters or are related parties. Judicial Pronouncement on Restrictions to Voting: Securities and Exchange Board of India vs. R.T. Agro Private Limited & Ors. In this case, the related parties abstained from voting in the AGM on the resolution approving the RPT. Further, an EGM was conducted to rescind the resolution, and the members who were related parties voted. The Supreme Court held that the bar for voting under Section 188 of the Companies Act, 2013 is only applicable when the contract or arrangement has been entered, i.e., when the resolution is passed and the members are allowed to vote on the agenda items rescinding the resolution.

Which transactions are not considered RPT as per sub-section (1) of Section 188 of  Companies Act, 2013?

Any transactions that are entered into in its ordinary course of business and are at arm’s length shall not be considered RPT’s as per sub-section (1) of Section 188 of the Companies Act, 2013.

What is an ordinary course of business?

The term ordinary course of business is not defined in the Act. The term “in the ordinary course of business” typically refers to “a regular or customary condition or course of things; as things usually happen” and is used to describe a portion of conducting regular business. The meaning of the term is decided as per the facts and circumstances of the case.

Who decides what constitutes an ordinary course of business in a transaction with a related party?

There is no rigid rule that states who decides what constitutes an ordinary course of business. The memorandum of the company may be referred to in this regard, but this will not be a conclusive test. The company may also frame a policy on RPT and decide on what constitutes an ordinary course of business. Further, the audit committee may also decide whether a transaction constitutes an ordinary course of business or not. Where the company does not have an audit committee, the board may decide in this regard.

In the case of M/s Bharti Televentures Ltd. v. Addl./Jt. Commissioner of Income Tax

It was held that memorandum and articles of association are not conclusive in determining the ordinary course of business. The activity is to be carried out in a continuous, normal, and organized manner.

What is at arm’s length?

As per the explanation to sub-section (1) of Section 188 of the Companies Act, 2013, the expression “arm’s length transaction” means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.

In the case of Public Prosecutor v. T. P. Khaitan (1957), under Section 188 of the Companies Act, 2013, the term “interest” was understood to indicate personal interest. The definition is not limited to financial interests alone; it can also refer to interests resulting from a personal or fiduciary connection. The related party may have direct or indirect interests.

The concept of the arms length basis considers the entire bunch of terms and conditions of the transaction and not just the price. For illustration, the credit period provided to the parties to the transaction is also a crucial point to be checked. If the credit period provided to the related party is longer than the credit period provided to an unrelated party for the same transaction, then it is not at arm’s length.

In the case of Iljin Automatic Private Limited v. Asst. Commissioner of Income Tax, the Court held that “the determination of ‘arm’s length price’ seeks an answer to the question: What would have been the price if the transactions were between two unrelated parties, similarly placed as the related parties in so far as the nature of the product and terms and conditions of the transactions are concerned?”

Disclosures mandated as per Section 188 of the Companies Act, 2013 and AS-18:

PARTICULARS	SECTION 188 OF THE COMPANIES ACT, 2013	AS-18
Mandatory disclosure is required to be made by the companies.	As per Section 188(2) of the Companies Act, 2013, every contract or arrangement entered into by the company shall be referred to in the board’s report to the shareholders along with the justification for entering into such a contract or arrangement.	Regardless of whether there have been transactions between the related parties, the related party’s name and the nature of their relationship must be stated in the company’s financial statements. If there have been transactions between related parties during the existence of a related party relationship, the reporting enterprise should disclose the following: (i) the name of the transacting related party; (ii) a description of the relationship between the parties; (iii) a description of the nature of transactions; (iv) volume of the transactions, either as an amount or as an appropriate proportion; (v) any other elements of the related-party transactions necessary for an understanding of the financial statements; (vi) the amounts or appropriate proportions of outstanding items pertaining to related parties at the balance sheet date and provisions for doubtful debts due from such parties at that date; and (vii) amounts written off or written back in the period in respect of debts due from or to related parties.
Disclosure is not required in the given cases.	As per MCA General Circular No. 30/2014, dated July 17, 2014, it is clarified that “transactions arising out of compromises, arrangements, and amalgamations dealt with under specific provisions of the Companies Act 2013 will not attract the requirements of Section 188 of the Companies Act, 2013″.	A statute, a regulator, or a similar competent authority governing an enterprise may prohibit the enterprise from disclosing certain information that is confidential. Regarding intra-group transactions, there is no need for disclosure in the consolidated financial statements. No disclosure is required in the financial statements of state-controlled enterprises as regards related party relationships with other state-controlled enterprises and transactions with such enterprises. When a company’s financial statements are inconsistent with the accounting standards mentioned in sub-section (1), the company is required to disclose the deviation from the accounting standards in its financial statements, along with the reasons behind it and its financial effects.
The report from Hindenburg: A blow to the Adani group Pursuant to the Hindenburg’s report, SEBI has carried out investigations on the Adani group companies and submitted the same to the Supreme Court. The substantial part of the investigation includes the failure on the party of the Adani group in disclosing the related party transactions. The company has failed to comply with the provisions of the Companies Act, 2013 and the relevant accounting standards.

Why It is beneficial to disclose RPTs?

• It prevents the unrelated party from being affected by the RPT.
• It enhances the corporate governance of the company.
• It helps the stakeholders make prudent decisions.
• It helps to ascertain the business’s true and fair position and performance.

Implications of failing to secure approvals in accordance with Section 188 of Companies Act, 2013 and AS-18:

If a director or any other employee enters into a contract or arrangement without obtaining approval from the Board or the shareholders through a resolution in the general meeting under sub-section (1) of Section 188 of the Companies Act, 2013, and if it is not ratified by the Board or, in the case of the shareholders, at a meeting within three months of the date on which such a contract or arrangement was entered into, the contract or arrangement shall be voidable at the option of the Board or, as the case may be, of the shareholders and if the contract or arrangement is with a related party of any director, or is authorized by any other director, the directors involved will be responsible for any loss suffered by the company.

As per section 129(5) of the Companies Act, 2013, when a company’s financial statements are inconsistent with the accounting standards mentioned in sub-section (1), the company is required to disclose the deviation from the accounting standards in its financial statements, along with the reasons behind it and any potential financial effects.

Penalty for violation of Section 188 of Companies Act, 2013:

In order to recover any losses incurred by it as a result of the contract or arrangement, the company may take legal action against a director or any other employee who entered into such an arrangement or contract in violation of Section 188 of the Companies Act, 2013.

Any director or employee of a company who violates the terms of this section by entering into or approving a contract or arrangement will be liable to the following penalties:

(i) in the event of a listed company, a penalty of twenty-five lakh rupees; and

(ii) in the case of any other company, be liable to a penalty of five lakh rupees.

The question raised in the case of Needle Industries Ltd. v. Needle Industries Newey (India) Holding Ltd. (1982) was whether it is necessary to scrutinize and comply with Section 188 of the Companies Act, 2013 for every transaction between related parties. This question is answered by the third provision, which is an exemption clause, in sub-section (1) of Section 188 of the Companies Act, 2013. Except for transactions that do not follow an arm’s length agreement, it excludes any transaction that the company enters into during the ordinary course of business.

END NOTES: One aspect of corporate governance is complying with the provisions of RPT. RPT have no negatives and are beneficial to the companies when properly disclosed. Overall, it is beneficial to the organization.

The authors have tried their level best to cover all the relevant aspects related to the topic and in case of any suggestion or improvement; the authors can be reached through mail id: [email protected]

DISCLAIMER: This article is based on the relevant provisions and to the best of my knowledge at the time of preparation of this article and in no event, the author shall be liable for any direct and indirect result from this article and this is only a knowledge sharing initiative provided solely for information, this article is not a piece of professional advice or recommendation.