Introduction:
- The “purpose and effect” concept is not unique to our jurisdiction; it was previously embedded in the legislation of other jurisdictions as well, such as the UK. In 2022, this concept was incorporated into the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. This was a step towards to bring the use of complex structures by entering into transactions with unrelated parties, for purposefully benefiting a related party, under the purview of RPT provisions. The phrase ‘purpose and effect’ is used as a negative connotation.
- The regulatory intent behind incorporating the ‘Purpose and effect’ phrase could be analyzed upon referring to the following documents:
a)Report of SEBI Working Group on RPT
b)SEBI Board Note titled as ‘Review of Regulatory Provisions for dealing with Related Party Transaction’
Extracts from SEBI Working Group Report:
“I. Need for Review of RPT Regulatory Framework
Based on the above recommendations and inputs, the current framework of RPTs has evolved. However, as the corporate eco-system evolves, the area of corporate governance including that of Related Party Transactions requires periodic review.
While taking note of some of the recent issues in relation to RPTs, the Working Group observed that one commonality in major corporate wrongdoings was that they were allegedly carried out by persons with the ability to influence the decisions of the company. Shell or apparently unrelated companies, controlled directly or indirectly, by such persons were purportedly used to siphon off large sums of money through the use of certain innovative structures, thereby circumventing the regulatory framework of RPT.
Working Group deliberations and recommendations
The Working Group observed that recently, certain innovative structures have been used to avoid classification of transactions as RPTs and thus avoid the associated regulatory compliance and disclosure requirements. Some such instances are mentioned below:
(i) use of complex structures; (ii) transactions undertaken by a listed entity with seemingly unrelated parties, however intended to benefit related parties; and (iii) instances of loans being given to an unrelated party which in turn gives such loan to a related party.
Accordingly, the Working Group examined the definition of RPTs from the perspective of strengthening it and recommended broadening the definition of RPTs to include transactions which are undertaken, whether directly or indirectly, with the intention of benefitting related parties.
The Working Group deliberated on the present regulatory framework governing transactions of subsidiaries of a listed entity and recommended that prior approval of the audit committee of the listed entity should be mandatory for transactions carried out between:
i.the listed entity or any of its subsidiaries on the one hand and a related party of the listed entity or any of its subsidiaries on the other hand; or
ii.the listed entity or any of its subsidiaries on the one hand and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries.”
Extracts from SEBI Board note:
“Current RPT framework may be insufficient to cover transactions which can be done through subsidiaries or by the listed entity with the related parties of subsidiaries to move the assets out of the consolidated entity without having to follow norms applicable to RPTs. Accordingly, it is proposed to expand the scope of definition of RPTs by including transactions of the listed entity or any of its subsidiaries on one hand and related parties of the listed entity or any of its subsidiaries on the other hand.
It is also desirable to include transactions with unrelated parties, the purpose and effect of which is, to benefit the related parties of the listed entity or any of its subsidiaries. It is important to consider substance of the relationship and not merely legal form as a part of good governance practice”
Emphasis supplied……
Purpose & Effect Test:
- The ‘purpose and effect’ test applies to transactions between the listed entity / its subsidiary and an unrelated party, particularly where there is an intention to benefit the related party.
- A literal interpretation of this test could lead to an absurd outcome, where any transaction that ultimately benefits a related party, even if conducted in the normal course of business, might be covered. However, when read in conjunction with the SEBI working group report and the SEBI Board note, it appears the “purpose and effect” test is designed to address situations where innovative structures are employed to bypass Related Party Transaction compliances and disclosure requirements.
- Therefore, when applying this test in practice, it’s important to consider the underlying context of this provision, which implies the presence of both purpose and effect. Similar to what we say in Hindi, presence of आग और धुआँ…..
Basis the purposive interpretation, it can be concluded that even transactions with unrelated parties that have the purpose & effect of benefiting a related party are deemed Related Party Transactions and such transactions must be placed before the Audit Committee for approval.
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