In India, statistics indicate that about 85% of the total enterprises are family-controlled businesses which contribute to over 50% of the total employment1 . The discourse on corporate governance of related party transactions ("RPT") in India has largely evolved around (i) the history of family-run businesses by promoter groups who exercise control over the decision-making process; and (ii) the ensuing corporate scandals that the country has witnessed in the past decades owing to inadequate regulatory checks on RPTs which are undertaken for the sole interest of related parties and not the company itself2 .
Unlike transactions with third parties, the distinguishing factor of an RPT is the special relationship between the parties transacting, which if misused, can lead to serious consequences. Such consequences may include reduction in returns to unrelated shareholders, tarnished reputation with regards to corporate governance of an entity, adverse effects on stakeholders' expectations in the equity market and the overall economic growth of the country3 . On the other hand, benefits of RPTs are well-known to aid growth and self-sustenance of businesses by allowing risk sharing, transferring income flows from one affiliate to another, and achieving more effective asset utilization from a strategic standpoint.4
The Indian regulatory regime has been constantly adapting itself to address the corporate governance issues that have arisen from misuse of RPTs by Indian companies. The Government, from time to time, has attempted to increase transparency and accountability of companies to its stakeholders. New provisions governing RPTs were brought in through the Companies Act, 2013 and the rules framed thereunder (the, "Companies Act"), that stipulate shareholders' approval for certain RPTs which are not in the ordinary course of business and at arm's length basis. Similarly, the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the, "Listing Regulations") require the shareholders' approval for material RPTs.
However, it has become public knowledge that certain innovative complex structures have been employed by companies for undertaking RPTs with the intent to escape the regulatory ambit requiring disclosures with respect to such transactions. As a prime example, whistleblower allegations were made against Sun Pharma and its wholly owned subsidiary Sun Pharmaceutical Laboratories for diverting funds through its related party in India (i.e., its wholesale distributor)5 . Consequently, the value of shares of Sun Pharma plummeted by 12% on the day of the whistleblower complaint.6 The Securities and Exchange Board of India (the, "SEBI") particularly observed that Sun Pharma had not obtained prior approval of the audit committee and the shareholders for undertaking RPTs with its wholesale distributor, and disclosures of such transactions were not made in the financials of the company until financial year 2017-18. It was alleged that the managing director of the company had acted in collusion with a related party to manipulate the transactions of the company.7 In February 2021, Sun Pharma settled the pending dispute with SEBI by agreeing to pay a cumulative penalty of INR 2.92 Crores.8
2. PROPOSED CHANGES IN THE REGULATORY REGIME
On January 22, 2020, SEBI issued a report of the working group on RPTs (the, "WG Report") that proposed a combination of substantive and procedural changes to the review process of RPTs under the Listing Regulations. Subsequently, SEBI issued a notification on November 09, 2021, to effectuate the sixth amendment to the Listing Regulations (the, "Sixth Amendment") incorporating changes suggested by the WG Report to be put in effect from April 2022 and from April 2023.
The rationale of the proposed changes suggested in the WG Report is to tackle structures consisting of shell or apparently unrelated companies that have been used to siphon off large sums of money by circumventing the existing regulatory framework of RPTs.9 Recently, the bankruptcy of Cox & Kings, a two and a half centuries old travel agency, and the allegations of fraudulent RPTs with its overseas subsidiaries10 has confirmed the use of innovative structures used by companies to divert funds. The Economic Offences Wing, Mumbai, in its investigation report found that between 2013 and 2019, at least INR 5,000 Crores had been transferred from the travel firm to companies where the company's promoter has "direct interest". 11
The changes introduced in the Sixth Amendment inter-alia include the expansion of the definition of 'related party', revision of materiality thresholds of RPTs, and inclusion of transactions between unlisted subsidiaries and any related party of the listed entity. Such changes are discussed in further detail in the following sections.
3. INTERPLAY BETWEEN THE COMPANIES ACT AND THE LISTING REGULATIONS
This article explores the interplay between the two different avenues under which RPTs in India are regulated, i.e., the Companies Act and the Listing Regulations from the perspective of certain identified aspects including coverage of transactions under the RPT ambit, approval process and disclosure requirements. While the Listing Regulations apply to listed companies, the relevant provisions of the Companies Act are applicable on all companies whether listed or unlisted, albeit with certain differences that are discussed in detail below.
3.1. Definition of 'Related Party'
|Who is a 'Related Party'?||Companies Act||Listing Regulations|
|Section 2(76) of the Companies Act prescribes 9 distinct categories of related parties including: (i) a director or his relative; (ii) a key managerial person 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 or holds along with his relatives, more than 2% of its paid-up share capital; (vi) any body corporate whose director/ manager acts 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) a director (who is not an independent director) or key managerial personnel of the holding company or his relative with reference to a company; or (ix) any company which is a holding, subsidiary or an associate company; or a subsidiary of the same holding company; or an investing company/venturer12, of the company.||
Under Regulation 2(zb) of the Listing Regulations, any person is a related party of a listed entity if it is: (i) a related party under the Companies Act or the applicable accounting standards; or (ii) any promoter or member of the promoter group of the listed entity irrespective of its shareholding; or (iii) any person holding 10%13 or more of the listed entity's equity shareholding whether directly or as a beneficial owner under the Companies Act.
As per Indian Accounting Standard – 24 (the, "Ind AS-24") the following categories are included within the definition of a 'related party':
Analysis: The definition under the Listing Regulations is all-encompassing, as it covers the categories of related parties under the Companies Act and the applicable Accounting Standard14 , making the regulatory ambit of 'related party' wider than any other legislation.
While the new definition of 'related party' under the Listing Regulations explicitly includes a promoter or members of a promoter group of a listed entity, the Companies Act only makes a reference to "any person on whose advice, directions or instructions a director or manager is accustomed to act". The rationale for inclusion of promoter under the purview of related parties was two-fold: (i) the exercise of control over a listed entity may not depend on shareholding; and (ii) there was a need to capture the classic/traditional Indian family-oriented business models that are structured as intrinsically linked group entities that operate as a single group unit with the promoters having the ability to exercise control over the entire group.
With the inclusion of a 'promoter or members of a promoter group' in the definition of a related party under the Listing Regulations, the WG Report has cured an inadequacy in the earlier definition by ensuring that transactions between the listed entity and its promoters comply with the disclosure requirements of the regulatory framework. However, from a practical perspective, this inclusion may pose administrative and governance challenges for the day-to-day business of a listed entity by making it onerous to track and identify all the transactions undertaken by promoters or members of a promoter group of a listed entity and seeking approval of the audit committee for undertaking such transactions.
It is also worthwhile to note that a shareholder holding more than 20% of the listed entity's shares who is a related party under the Listing Regulations, may not be considered a related party under the Companies Act unless: (i) such shareholder is a director or a manager of the listed entity; or (ii) a director or manager of the listed entity is accustomed to act on the advice, directions or instructions of such shareholder.
3.2. Definition of 'Related Party Transaction'
|What is an RPT?||Companies Act||Listing Regulations|
Any contract or arrangement with a related party with respect to:
will qualify as an RPT in accordance with Section 188 of the Companies Act. An exclusion under this definition is given to RPTs undertaken at an arm's length basis by a company in its ordinary course of business.
A transaction involving a transfer of resources, services or obligations between:
regardless of whether a price is charged, will qualify as an RPT in accordance with Regulation 2(zc) of the Listing Regulations.
Certain exclusions are given to corporate actions which by their nature treat shareholders equally, such as payment of dividend, buy-back, rights and bonus issue of securities and preferential allotment which is already regulated by SEBI.
Analysis: The definition of an RPT under the Listing Regulations has a wider import than the Companies Act definition, especially due to the inclusion of transactions that directly or indirectly benefit the listed entity. This concept has been introduced to combat the use of complex structures to transfer resources out of the listed entities to seemingly unrelated parties which are intended to benefit the listed entity or its related parties16 .
The Asian Roundtable Guide on RPTs suggests that 'the legal definition of "related parties" should refer to control and be broad enough to capture relevant transactions that present a risk of potential abuse. It should be sufficiently harmonised with respect to different bodies of law such as company law, listing rules and accounting standards in each jurisdiction to avoid misunderstanding and an excessive regulatory burden, thereby underpinning better implementation and enforcement'17 .
However, the harmonisation of the frameworks governing RPTs in India is yet to be achieved. For instance, transactions in the ordinary course of business and at an arm's length basis will not be required to comply with the Companies Act provisions, but there is no such exclusion under the Listing Regulations. This is discussed in further detail in the following section on approval requirements.
It may be reasonable to expect that in the near future, the framework of RPTs under the Companies Act may be harmonised with that under the Listing Regulations since the former does not adequately capture transactions that are undertaken with seemingly unrelated parties.
3.3. Approval Mechanism and Materiality Threshold of RPTs
|Approval Mechanism & Thresholds||Companies Act||Listing Regulations|
Approval process for RPTs under the Companies Act (except for transactions with wholly owned subsidiaries)18 is as follows:
All RPTs and subsequent material modifications (materiality of modification to be determined basis the materiality policy of the listed entity) thereto require the Audit Committee's approval, with certain exceptions for RPTs involving listed or wholly owned subsidiaries of the listed entity.
All 'material' RPTs require approval of the shareholders, irrespective of whether the transactions entered into by the company are in the ordinary course of business and/or on an arm's length basis.
Materiality Threshold: RPT(s) entered into individually or taken together with previous transactions in a financial year is 'material' if it exceeds:
** Only those members of the audit committee, who are independent directors, shall approve the RPTs.
Analysis: A clear difference in the threshold requirements under the two legislations is the basis of a transaction being at arm's length basis and done in the ordinary course of business of a company. While such a transaction does not need an approval from the board of directors or the shareholders' of a company under the Companies Act, it would require approval of the shareholders' of a listed entity under the Listing regulations if it is a 'material' RPT.
Further, while the Companies Act had been amended in 2019 to remove the numerical threshold of INR 100 crores with respect to determining the materiality of certain RPTs, the Sixth Amendment has introduced the numerical threshold of INR 1,000 crores (in addition to 10% of annual consolidated turnover) to determine the materiality of an RPT that requires the shareholders' approval. It was noted in the WG Report that the 10% threshold was too high, and many RPTs did not cross this threshold and therefore were not required to comply with regulatory and disclosure requirements. While the regulators have adapted to the growth of Indian businesses, the need for increased transparency was felt for high value transactions irrespective of the net worth of the company.
The centrality of autonomy of audit committees is intrinsic to improved corporate governance, as is evident in the approval mechanism under both the Companies Act and the Listing Regulations which require every RPT to be laid before the audit committee. Both the legislations mandate that independent directors of the company shall form the majority of the members of the audit committee, thereby creating more accountability for actions undertaken by the controlling shareholders of a company that may be detrimental to the other stakeholders.
3.4. Right to Vote for Approval of RPTs
|Voting Rights||Companies Act||Listing Regulations|
Related party of a company is excluded from voting on the shareholders' resolution if the transaction involves such member/ company who is the related party.19 However, such exclusion from voting is not applicable to a company in which 90% or more members are relatives of promoters or are related parties.20
All related parties of a listed entity are excluded from voting on any material RPTs (and on subsequent material modifications) at the stage of shareholders' approval, irrespective of whether a particular entity is a related party involved in the particular transaction.21
Analysis: While the Companies Act excludes only interested related parties from voting on the resolution for approval of the RPT in which such related party is interested (subject to the exception highlighted above), the Listing Regulations exclude any related party of the listed entity from voting on a resolution for approval of any material RPT (and any subsequent material modifications thereto) involving the listed entity. Consequently, a promoter who is a related party in terms of the Listing Regulations cannot vote on any shareholders' resolution for the approval of a material RPT (irrespective of whether such promoter is interested in such RPT). However, a promoter can vote on such a resolution under the Companies Act if such a promoter is not interested in the transaction.
4. BALANCING COMPLIANCES
Owing to the widened ambit of RPTs and the consequent increased burden of compliances on entities, restoration of balance from a regulatory standpoint had to be achieved, therefore, certain exceptions to the approval mechanism of RPTs were introduced under the Listing Regulations and the Companies Act.
As per the Listing Regulations, certain transactions do not require prior approval of the listed entity's shareholders and audit committee, including:
- RPT between listed entity and its wholly owned subsidiary whose accounts are consolidated with the listed entity and placed in a general meeting22;
- RPT to which listed subsidiary is a party but the listed entity is not a party (provided that the listed subsidiary is required to comply with the disclosure requirements under the Listing Regulations)23;
- RPT to which unlisted subsidiary of a listed subsidiary is a party but the listed entity is not a party (approval of audit committee and shareholders of the listed subsidiary would suffice)24; and
- RPT between two wholly owned subsidiaries of listed entity whose accounts are consolidated with such holding company and placed in general meeting25 .
With an aim to review and strengthen the regulatory norms pertaining to RPTs undertaken by listed entities in India, the amendments to the Listing Regulations are a welcome step towards strengthening corporate governance. The regulatory changes would enhance transparency in the interest of minority shareholders further providing stronger safeguards for their interests in large companies. By importing a wider meaning to 'related party' and RPTs, SEBI has increased the ambit of its radar to keep an eye over many persons/ entities and transactions of the listed entities as well as their unlisted subsidiaries. As a result, listed entities along with their subsidiaries will have to be more transparent in their dealings with parties that may be considered related parties. However, what remains to be seen is the change in the current regulatory framework for unlisted companies, which the legislature may bring in order to harmonize the framework under the Listing Regulations and the Companies Act.
Although changes in the regulatory regime harbor faith of investors at large, the amended provisions have increased the compliance burden of listed entities, especially their audit committees and independent directors who need to comply with the new approval mechanism and additional disclosure requirements.
While theoretically most of the recommendations of the WG Report have been adopted by SEBI, the real effect of the recommendations will emanate from April 1, 2022, which will be the litmus test to check whether such recommendations of the WG Report are a positive step towards good corporate governance.
1 E.K. Satheesh, K.P. Muraleedharan A.C Fernando, 'Corporate Governance, Principles, Policies and Practices', pg.516 (3rd ed. 2017)
2 ICSCI Guidance Note on Related Party Transactions, pf.7 of 100, available online at https://www.icsi.edu/media/webmodules/Guidance_Note_on_RPTs_4-4-2019.pdf, last accessed on February 12, 2022
3 Padmini Srinivasan, 'An Analysis of Related Party Transactions in India', IIM-Bangalore, Working Paper No. 402, 2013, pg.3
5 Shrimi Choudhary, 'SEBI Probe Finds Violation of Listing and Disclosure Norms by Sun Pharma', available online at https://www.business-standard.com/article/companies/sebi-probe-finds-violation-of-listing-and-disclosure-norms-by-sun-pharma-120022101264_1.html, last accessed on February 07, 2022
6 Jayshree P. Upadhyay, Ashwin Ramarathinam, Sun Pharma Shares Plunge Over 12% on Whistleblower Complaint, available online at https://www.livemint.com/Money/qXOKBGC82bg2QD8i19IPIK/Sun-Pharma-shares-slump-to-sixyear-low-on-report-of-fresh-a.html, last accessed on February 07, 2022
7 Jayshree P. Upadhyay, 'Sun Pharma Shares Fall 7.5% After Whistle-blower Email to SEBI', available online at https://www.livemint.com/Companies/SxFvCwnKfzUyEOl4tnv1FI/Sun-Pharma-shares-crash-after-whistleblower-email-to-Sebi.html; Our Bureau, 'Sun Pharma, Dilip Singhvi Settle Funds Diversion Case with SEBI', available online at https://www.thehindubusinessline.com/markets/stock-markets/sun-pharma-dilip-singhvi-settle-funds-diversion-case-with-sebi/article33813045.ece, last accessed on February 07, 2022
8 Samie Modak, 'Sun Pharma, 7 Executives Settle Dispute with SEBI Pay Rs. 2.92 Cr.', available online at https://www.business-standard.com/article/companies/sun-pharma-7-executives-settle-dispute-with-sebi-pay-rs-2-92-cr-121021101380_1.html#:~:text=Budget%202022,Sun%20Pharma%2C%207%20executives%20settle%20dispute,Sebi %3B%20pay%20Rs%202.92%20cr&text=Sun%20Pharma%20has%20agreed%20to,lakh%20and%20Rs%2037.4%20l akh, last accessed on February 07, 2022
9 Report of the Working Group on Related Party Transactions issued on January 27, 2020, pg. 8, available online at https://www.sebi.gov.in/reports-and-statistics/reports/jan-2020/report-of-the-working-group-on-related-party-transactions_45805.html, last accessed on February 10, 2022
10 Khushboo Narayan, 'Cox & Kings Set Up 15 Fake Companies to Dress Up Books, Divert Funds', available online at https://indianexpress.com/article/business/companies/economic-offences-wing-cox-kings-set-up-15-fake-cos-to-dress-up-books-divert-funds-7730663/; Paranjoy Guha Thakurta, Sourodipto Sanyal and Jyotindra, 'Who Led Cox & Kings Into a Deep Pit?', available online at https://www.theleaflet.in/who-led-cox-kings-into-a-deep-pit/, last accessed on February 06, 2022
12 As per Section 2(76) of the Companies Act, "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.
13 Presently, this threshold is 20% of the total shareholding, however, it will further be revised to 10% of the total shareholding from April 01, 2023.
14 There are two parallel accounting standards in India for making RPT disclosures, i.e., Accounting Standard -18 and Ind AS-24. However, we note that in practice, most companies incorporated in India adopt the Indian accounting standards and accordingly, we have provided the definition of 'related party' under Ind AS-24.
15 This inclusion in the definition will be made effective from April 01, 2023.
16 See footnote 9.
17 OECD (2012), 'Related Party Transactions and Minority Shareholder Rights', OECD Publishing, available online at http://dx.doi.org/10.1787/9789264168008-en, last accessed on January 29, 2022.
18 As per Section 188 of the Companies Act, passing of a board resolution is not required for transactions entered into between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval.
19 See 2nd proviso to Section 188(1) of the Companies Act.
20 See 3rd proviso to Section 188(1) of the Companies Act.
21 See Regulation 23(4) of the Listing Regulations.
22 See Regulation 23(5)(b) of the Listing Regulations.
23 See Regulation 23(2)(d) and 1st proviso to Regulation 23(4) of the Listing Regulations.
24 See Explanation to Regulation 23(2)(d) and Explanation to Regulation 23(4) of the Listing Regulations.
25 See Regulation 23(5)(c) of the Listing Regulations.
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