India: Law On Related Party Transactions– Need For Reform?

INTRODUCTION

In recent months, the topic of 'related party transactions' (RPTs) has been the subject of intense media interest and discussions.

This article proposes to analyze the provisions in the Companies Act, 2013 ("the 2013 Act") pertaining to RPTs in brief and explore whether the law, as it stands, requires further modifications to adequately address the concerns voiced from within the industry and without.

WHAT ARE RELATED PARTY TRANSACTIONS (RPTs)?

In layman's language, RPT means an act of a company of entering into a contract or arrangement with a 'related party' on favourable or more advantageous commercial terms as compared to an 'unrelated party'.

WHO IS A 'RELATED PARTY'?

Section 2(76) of the 2013 Act (as amended by the Companies (Amendment) Act, 2017) enumerates the various categories of 'related party' with reference to a company[1]. Further, Section 2(77) of the 2013 Act sets out the meaning of the term 'relative', with reference to a person[2]. Additionally, the Companies (Specification of definitions details) Rules, 2014, framed by the Central Government, provides a list of more relatives in terms of Clause (77) of Section 2, including father (includes step-father), mother (includes step mother), son, son's wife, daughter, daughter's husband, brother (includes step brother) and sister (includes step sister).

THE PRE- 2013 ERA

The precursor to the 2013 Act, the Companies Act, 1956 ("the 1956 Act"), dealt with RPTs under Section 297. The said Section provided that

a) Companies having a paid-up share capital of above rupees one crore were not allowed to enter into RPTs except with the previous approval of the Central Government.

b) In other cases, RPTs were not permitted except with the prior approval of the Board of Directors.

c) The requirement of Board approval was only exempted where

  1. the purchase of goods and materials from the company, or the sale of goods, and materials to the company, by any director, relative, firm, partner or private company for cash was done at prevailing market prices; or
  1. any such contract or contracts was for sale, purchase or supply of any goods, materials and services in which either the company or the director, relative etc., regularly trades or does business. This was qualified by a Proviso which effectively stated that the exemption will not apply where the contract or contracts related to goods and materials the value of which, or services the cost of which, exceeded rupees five thousand in the aggregate in any year (with a further exemption that in circumstances of urgent necessity, such contracts could be entered into and consent of the Board could then be obtained within three months); or
  1. any such transaction, in case of a banking or insurance company, was in the ordinary course of business of such company with any director, relative, firm, partner etc.

THE DR. JAMSHED J. IRANI COMMITTEE REPORT

Section 188 of the 2013 Act, titled 'Related party transactions', was enacted pursuant to the recommendations of the Expert Committee Report on Company Law, 2005 constituted under the Chairmanship of Dr. Jamshed J. Irani. The Committee recommended that having a 'Shareholder Approval and Disclosure-based regime' was more appropriate for approval of RPTs rather than a 'Government Approval-based regime' as prevailed previously. The Committee further suggested that in addition to the disclosure requirements in respect of RPTs, certain transactions between a company and director or persons connected with director, in respect of sale, purchase of goods, materials or services, should take place only with the approval of the Board of Directors. It was further recommended that beyond a certain threshold limit, the approval of shareholders, by a special resolution, should be mandated.

THE PRESENT RPT REGIME

Section 188 of the 2013 Act expressly bars any RPTs on the matters contained therein, except with the approval of the Board of Directors and in certain cases with the approval of the company by a resolution. The approval of the Board is required for a wide array of items such as (a) selling, purchasing or supplying 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 etc. It further stipulates that every contract or arrangement entered into under sub-section (1) of Section 188 shall be referred to in the Board's report to the shareholders along with justification for entering into such contract. The Section further provides penalties/ punishments for a director or employee who acts in contravention of the said provisions.

However, the fourth Proviso to Section 188(1) whittles down the rigor of the above rule by providing that nothing in the said sub-section would apply to any transaction entered into by the company in its 'ordinary course of business' other than transactions which are not on 'an arm's length' basis. Explanation (b) to Section 188(1) defines the expression 'arm's length transaction' to mean a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.

PROCEDURE TO BE FOLLOWED FOR ENTERING INTO AN RPT

The procedure to be followed by a company for entering into an RPT is detailed in Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014 ("2014 Rules"). The said Rule inter-alia stipulates that a company shall enter into any contract or arrangement with a related party subject to the condition that a detailed agenda of the Board meeting at which the resolution is proposed to be moved, discloses material details.

Further, sub-Rule (3) prescribes certain threshold limits above which the prior approval of the company would be required by way of a resolution.

ISSUES, CONCERNS AND NEED FOR REFORM

In the authors' view, recent news reports on controversies surrounding RPTs unerringly point to the need for reform of the present legal regime, especially in relation to the following aspects:

  1. The fourth Proviso to Section 188 leaves it open to the company to not seek Board approval, if in its wisdom, the transaction is done in the 'ordinary course of business' and is on an 'arms length basis'. The question is, if not the Board, then who will make the determination that a particular transaction between two related parties is being conducted as if they were unrelated, such that there is no conflict of interest, and further, whether the law needs to be amended to ensure that the company's or Board's discretion (as the case may be) is properly exercised and not to the detriment of other shareholders?
  1. The definition of 'arms length transaction'[3], being somewhat loosely worded at present, is problematic as it does not lay down any objective and mandatory guidelines which should be followed prior to a value judgment on whether a particular transaction is at arms-length or not.
  1. While the legislature has taken great pains to define the term 'relative', in the authors' view, the said definition may need to be tweaked to cover potential delinquent conduct such as formation of proxy companies or firms by officers/employees of a company through other employees, distant relatives, personal staff etc. with a view to enter into RPTs with them.
  1. It also needs to be considered whether passing of a special resolution by the Board (and by shareholders in prescribed situations) should be mandated for certain specified categories of RPTs , so as to obviate any dispute or objection by minority shareholders (or their nominee directors) at a later stage.

CONCLUSION

To conclude, it is imperative that the Central Government engages with the industry bodies and representatives to bring suitable legislative changes with alacrity, so as to ensure greater probity in corporate governance and protection of shareholders' interests.

Mr. Ajit Warrier is a Partner at Shardul Amarchand Mangaldas & Co. He specialises in the Dispute Resolution and Litigation Practice. Mr. Aditya Nayyar and Mr. Devansh Agarwal are a former Principal Associate - Designate and an Associate respectively of the Firm.

[1] Related party, with reference to a company, means—

(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 is a director and holds along with his relatives, more than two per cent. of its paid-up share capital;

(vi) 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;

(vii) 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;

(viii) any body corporate which is--

(A) a holding, subsidiary or an associate company of such company;

(B) a subsidiary of a holding company to which it is also a subsidiary; or

(C) an investing company or the venturer of the company;

Explanation.-- For the purpose of this clause, "the investing company or the venturer of a company" means a body corporate whose investment in the company would result in the company becoming an associate company of the body corporate.

(ix) such other person as may be prescribed

[2] Relative, with reference to any person, means anyone who is related to another, if--

(i) they are members of a Hindu Undivided Family;

(ii) they are husband and wife; or

(iii) one person is related to the other in such manner as may be prescribed.

[3] 'arms 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances. Further, the views in this article are the personal views of the author(s).

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