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Why rules for related party transactions should be more rational

27 June, 2016

There’s not even an ounce of doubt on the rationale of regulations surrounding Related Party Transactions (RPTs). The Indian corporate sector has been marred by continuing and colossal corporate frauds, and imposition of strict penal action was indeed the need of the hour. 

The concept of RPT, being a highly litigious area indeed, called for scrupulous regulation. But the best of intentions can sometimes unknowingly prove self-defeating and consequently adverse for the listed companies. Let’s see how.

At the outset, let’s zero in on the essence of RPTs. They are essentially business dealings or arrangements between two parties linked by a special relationship prior to the deal. In India, RPTs are primarily governed by Section 188 of the Companies Act, 2013 read with Companies (Meetings of the Board and its Powers) Rules, 2014 and Regulation 23 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (Listing Regulations).

Section 188 has three significant portions. First, it describes RPTs. Second, it requires an approval by the Board, unless the RPTs are in ordinary course and at an arm’s-length basis, and it also requires an approval from shareholders by way of an ordinary resolution, where the transaction exceeds the prescribed thresholds (See Rule 15), to the exclusion of a vote by an interested related party. Third, it requires a disclosure of RPTs in the Board’s report. Further, Section 177 mandates approval to all RPTs by the audit committee of the company, (omnibus approval also permitted).

On the other hand, Regulation 23 also has three significant portions. First, it requires formulation of a policy on ‘material’ RPTs (‘material’ as explained under the Listing Regulations). Second, it requires prior approval of the audit committee (omnibus approval also permitted) for all RPTs. Third, it requires the prior approval of shareholders on all material RPTs to the exclusion of all related parties, irrespective of whether they are interested in the particular transaction or not. Other than Regulation 23, Regulation 46 requires the RPT policy to be disclosed on the website of the company, while Regulation 53 requires RPTs to be disclosed in the annual report.

On the face of it, the laws appear to be (or at least are expected to be) working in tandem to deal with RPTs. However, read through the law and one can find serious anomalies.

One of the major anomalies is with regards to the voting rights of related parties. While Section 188 initially prohibited all the related parties from voting on the approval of RPTs, the Ministry of Corporate Affairs later clarified and prohibited only those related parties who factually are related to the transaction from voting on the approval of RPTs.  Despite this, Regulation 23 (4) and (7) of the Listing Regulations prohibits all related parties from voting on the approval of all RPTs, irrespective of whether the related party is interested in that particular transaction or not. This is serious. 

Now what scope does it leave for the promoter who is deemed to be a ‘related party’ under both the laws? In listed companies, he/she simply cannot vote on such resolutions. One mustn’t overlook the fact that RPTs are an effective corporate tool to structure business operations or achieve economies of scale or otherwise, particularly transactions between subsidiary and holding companies. That’s precisely why depriving promoters (simply because they are related parties) of the crucial right to vote or from participating in such critical decision-making may, in some cases, defeat the competitive edge of the said companies. This is clearly unwarranted.

And this is not all. There are many more anomalies that are equally glaring.

The definition of related party u/s 2(76) of the Companies Act 2013 includes a director, key managerial personnel, entities having common directors and so on. However, Regulation 2 (zb) of the Listing Regulations defines related party to mean the same as defined under section 2(76) of the Companies Act 2013 or under the applicable accounting standards. What does that imply? That the scope of definition under the Listing Regulations thus includes the meaning assigned to it under AS 18 / IND AS 24, which amplifies the scope of RPTs.

The more serious anomaly is that there’s no uniformity in the manner in which both laws explain Related Party Transactions. While Section 188 enumerates a list of transactions like sale, purchase, rendering of services and so on, Regulation 2 (zc) of the Listing Regulations defines RPT as ‘a transfer of resources, services or obligations between a listed entity and a related party, regardless of whether a price is charged and a transaction with a related party shall be construed to include a single transaction or a group of transactions in a contract’. 

While the amplification may be justified, the same has to be absolutely clear enough for compliance. And somehow these gaps never seem to be addressed through the ‘n’ number of clarifications and notifications issued almost on a daily basis, bringing a risk of non-compliance on the heads of compliance departments and other key managerial personnel. More importantly, in a given case any critical RPTs may just not get approved by vested interests which may be in minority.

Even a cursory glance at the applicable laws makes the anomalies clear and evident. What the lawmakers must bear in mind is the fact that there’s a big difference between regulation and strangulation. Mandating contradictory legal provisions applicable to RPTs is clearly unwarranted. More than unwarranted, it’s unfair to create an environment of confusion over conflicting laws and thus these laws should be immediately realigned, if not outrightly abolished. 

Nitin Potdar is the M&A Partner at law firm J. Sagar Associates. Views are personal.

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Why rules for related party transactions should be more rational

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