Related Party Transactions-Issues with respect to Corporate Laws
While the Companies Act, 1956 warranted approval of Corporate Governance for related party transaction by large cap companies, Companies Act, 2013 calls for larger disclosures with members' approval. The new regime for related party transactions seems complex because the definition of 'Related Party' has changed significantly. Holding Company, Subsidiary Company, Associate Company and fellow subsidiary company have been included which will have significant impact on transactions between group companies. The scope of transactions has been significantly enhanced and proposes to cover sale, purchase, leasing of any property of any kind (including immovable property).
By a general definition of 'Related Party Transactions', it means any transaction, deal or arrangement between two or more parties who have a special relationship before the transaction or deal. As per Section 2 (76), Related Party Transaction to mean:
(a) Director or a key managerial personnel or their relatives or;
(b) A firm, private company in which partner, director/manager or his relative is a partner or;
(c) A private company or a public company in which director or manager is a director and holds alongwith his relatives, more than 2% of its paid-up share capital.
The Companies Act, 2013 and the Rules made there under as well as the SEBI's Listing Regulations provides for exhaustive provisions relating to RPTs.
i. Approval for RPTs : Herein Companies Act allowed related parties to vote on a RPT while SEBI's Listing Regulations require such parties to abstain from voting. It is required that the SEBI's Listing Regulations may be amended to allow related parties to cast a negative vote, as such voting cannot be considered to be in conflict of interest.
ii. Change in Related Party : Considering the definition of 'Related Parties' under SEBI's Listing Regulations, it is observed that certain promoters/promoter group entities are not being categorized as 'related parties'. The transactions with such parties are not getting categorized as RPTs under SEBI's Listing Regulations. It is suggested to expand the definition of 'related party', i.e. all promoters/promoter group entities that hold 20% or above in a listed Co. to be considered "related parties" for the purposes of Listing Regulations. Also, as per the Kotak's Committee recommendations disclosures of transactions with promoters/promoter group entities holding 10% or more shareholding be made annually and on half yearly basis (even if not classified as 'related parties').However, it is to be viewed that merely holding 20% in a company should not amount to a party being a 'related party'. There ought to be some amount of influence in the company.
iii. Disclosure of RPTs & strict penalties for such non-disclosures : In order to strengthen transparency and disclosures on RPTs, half yearly disclosure of RPTs on a consolidated basis should be introduced in the disclosure format required for RPTs in the annual accounts (as per Accounting Standards) to ensure better disclosure practice. Further, although the Companies Act provides for strict penalties for non-contravention of provisions for RPTs, it is suggested strict penalties may be imposed by SEBI for overall non-compliance of RPT provisions including the inadequate disclosure as well.
iv. Materiality Policy: Pursuant to the extant provisions of SEBI's Listing Regulations, listed entities are under obligation to formulate a Policy on materiality of RPTs and on dealing with RPTs. Some listed companies have prepared Materiality Policy on RPTs as one-page document and have also given necessary references to SEBI's Listing Regulations, Companies Act, 2013 and Accounting Standard, as applicable. Based on this practice, and taking into consideration the constant changes in business and economic environment along with significant changes in the applicable law, recommending monetary threshold limits for approval and review and updation of Materiality Policy atleast once in three years is apt.
v. Royalty and Brand Payments to Related Parties: Presently, there are no specific provisions in SEBI's Listing Regulations for the payments made pertaining to brand and royalty to related parties. It is suggested that payments made by listed entities with respect to brand susage/royalty amounting to more than 5% of consolidated turnover of the listed entity may require prior approval from the shareholders on a "majority of minority" basis to have a significant impact on the listed Indian companies which are joint venture/associate/subsidiaries of foreign holding company. Pursuant to the Kotak Committee's recommendation, the shareholders' approval is required for payments relating to brands usage/royalty in excess of 5% of consolidated turnover of listed entity. Such approval will be required even if the transaction is in the ordinary course of business and on arm's length basis (important conditions under Cos. Act, 2013). One of the interesting recommendations is w.r.t. the voting which will be on "majority of minority" basis. Therefore, Kotak Panel recommends that the related parties or the recipient parties are abstained from voting such resolution. This provision will be having an impact on the foreign exchange inflows and outflows. At the same time, approval under the Companies Act, 2013 will be required when the prescribed thresholds (under the Rules) are breached.
vi. The Act does not provide any definition of 'ordinary course of business' nor does it provide any guidance in determining nature of transactions that would normally fall under 'ordinary course of business'. Based on judicial precedents under other laws, it can be inferred that ordinary course of business would include usual transactions or as per customs and practices of a business and of the company. ICAI has provided some guidance through Standard on Auditing (SA) 550 where in some examples of transactions falling outside ordinary course of business are specified. In many cases, it may be apparent that a transaction is in 'ordinary course of business' or not, however in some cases, the assessment of whether a transaction is in ordinary course of business or not may be highly subjective, judgmental and will vary from case-to-case basis. In practice, it is understood that many of the companies are adopting a position that transaction covered in main objects (or incidental to main objects) in their constitution documents, would qualify as a transaction undertaken in ordinary course of business. Also, historical practice with a pattern of frequency, and common commercial practice for businesses are considered key factors by such companies for assessing whether the transaction is undertaken in ordinary course of business or not.
vii. An 'arm's length transaction' has been defined under Act as a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest. This definition seems to be very subjective, as it does not provide any specific guidance. Further, the Act does not even prescribe any methodologies or approaches to be used for determining whether a RPT has been entered into an arm's length basis or not. One may refer to rules for registered valuers (which are yet to be notified) for some guidance, wherein, valuation methodologies are prescribed for registered valuers. Also, guidance may be drawn from methodologies and practices adopted under other statutes i.e. Income Tax Act, 1961 ("IT. Act"). It should be noted that such guidance, if drawn, is not conclusive and would have only persuasive value, at best. However, solely relying or testing arm's length basis for all RPTs based on guidance available from one statute, say, for example, transfer pricing guidelines under IT Act, may also not be advisable since the objective of the statutes may be different. As far as the transfer pricing guidelines under IT Act are concerned, it intends to prevent revenue leakage while provisions of the Act intend to protect minority shareholders' interest. The companies (especially those which have largeintra-group dealings) should form a policy with detailed guidelines for determining arm's length price, clearly specifying the methodologies and approval matrix for regular transactions as well as extraordinary transactions.
To achieve the objective of ease of doing business in India and address the key implementation issues, there is a pressing need to undertake a comprehensive review of RPTs provisions in the Act. Further, there is an urgent need to bring more clarity and guidance on the various subjective terms used in RPTs provisions and to resolve conflicts between different set of regulations. This will help address key implementation issues to a large extent and also reduce the scope of misuse.