Related Party Transaction Provisions - Case for Comprehensive Review!

The Companies Act, 2013 (“Act”), with an intention to revamp the corporate law in India in line with today’s business practices, has, in reality, surpassed the ground realities of corporate practices in India. In some ways, it has led to various anomalies and interpretational issues, defeating the objective of ‘ease of doing business in India’. 

Though various issues in the Act can be debated at length, in this article, we have briefly discussed the key implementation issues surrounding the related party transaction (‘RPTs’) provisions in the Act which seems to be a major pain point for Indian corporates in their day-to-day business.

RPT’s scope has been significantly widened in the Act, though greater flexibility has been granted to corporates as regards the approval process, with the condition of greater transparency and stringent penalties in case of non-compliance.  Let us see some key implementation issues surrounding the RPTs provisions in the Act.

Deadlock situations:

Section 188 of the Act, dealing with RPTs provision, provides that no member of company shall vote to approve any contract or arrangement, if such member is a related party. This provision was further clarified by MCA ,by specifying that the term ‘related party’in this context would only mean such related party, which is a related party in context of the contract or arrangement, for which resolution is passed by members.  

The intent of the aforesaid provision seems logical, i.e. mitigating conflict of interest that may arise in approval of RPTs contracts. However, in absence of any exemption for RPTs undertaken within privately owned groups (except for transactions with wholly owned subsidiary), in some cases, it has resulted in over-regulation, creating a deadlock in such situations.  

Say, for instance, a promoter owns a trademark which it intends to transfer it to a company whose shares are entirely owned by said promoter (along with its nominee).

Section 188 of the Act exempts the transaction from the requirement of board and shareholders’ approval provided that the said transaction is at arm’s length AND in ordinary course of business. In this case, one can possibly argue that the said transaction may not qualify as a transaction done in “ordinary course of business”. Accordingly, company would need board and shareholders’ approval (applicable in case transaction is above a specified threshold) for undertaking this transaction. Given the promoter would not be able to vote in the said resolution as he is a ‘related party’ in context of contract which is being approved, the resolution of members cannot be passed for approving the contract. This results in a deadlock situation as the company will not be able to obtain necessary approvals under the Act for undertaking the said transaction on account of prohibitions imposed by the provisions of the Act. 

Similar deadlock situations can also arise in case a company is undertaking transactions with another company with similar shareholders (unless, said transaction falls under scope of exempted transactions).

What constitutes ‘ordinary course of business’?

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 wherein 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.

What constitutes an ‘arm’s length basis’?

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 large intra-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. 

Audit committee approval

Under the Act, Audit Committee (‘AC’) approval is required for any RPT irrespective of any threshold, whether such transaction is at arm’s length and in ordinary course of business or not. This means every trivial transaction would need to be placed before AC for approval, reducing the AC’s role to that of an operating manager.

For mitigating the practical difficulties on account of AC approval requirements, the concept of omnibus approvals has been brought in the listing agreement prescribed by SEBI. Further, the government has also proposed an amendment to the Act (which is pending approval) for introducing a similar concept.  Irrespective of the aforesaid procedural relaxation, for one-off transactions, irrespective of any monetary threshold, would need to be placed before the AC for approval.

Further there is no relaxation in the Act for obtaining a post-facto approval of the AC for any RTP, unlike the approvals required from the board or shareholders, for which, there is a prescribed timeframe of three months under the Act.

Compliance with two set of regulations – Clause 49 of the Listing Agreement and Section 188 of the Act

Currently, Indian listed companies have to grapple with two set of regulations for compliance in relation to RPTs i.e. Clause 49 of the Listing agreement (“Clause 49”) and Section 188 of the Act.  Moreover, certain conflicting provisions under these two laws have created more pain points of compliance for Indian companies.  Some of conflicting provisions are highlighted as under:

• Definition of related party: The definition of related party is very wide in Clause 49 as compared to Act, thereby effectively demonstrating that any transaction can be covered in its ambit irrespective of its nature, while the provisions of Act specifies the list of transactions that can be covered under the ambit of RPTs. It is interesting to note that certain transactions which are not deemed as RPT as per MCA clarification say i.e. Scheme of Arrangements under Section 391-394 of Companies Act, 1956 etc, may still get caught under Clause 49. 

• Restriction of voting by shareholders: Clause 49 has prescribed that any related party, irrespective whether it is party to a contract or not (or interested in such contract or not), is barred from voting on material RPT, while Act does not impose such wide restriction i.e. it essentially prohibits a related party, which is interested in a contract or arrangement, from voting on such contract. 

• Transactions with wholly owned subsidiary (‘WOS’): Clause 49 exempts requirement of any approval in case of a transactions with a WOS (whose accounts are consolidated and placed for approval of shareholders), while Act do not provide any such exemption. Instead it prescribes that if shareholders’ approval is required under the applicable provisions of Act, approval should be obtained from shareholders of the holding company. 

Disclosures

Section 188(2) of the Act provides that every contract or arrangement which requires board or shareholders’ approval shall be reported in the Board’s report, along with justification for entering into such contract / arrangement. This would essentially mean that transactions which are either not at arm’s length or not in ordinary course of business would need to be disclosed in board report along with justification. 

However, new format (i.e. Form AOC-2) prescribed for disclosure of RPTs in the board report has expanded the scope by even including the transactions which are at arm’s length. This will make procedural compliance more difficult for companies and result in a potential information overload for stakeholders,thereby making the board report irrelevant to some extent. 

RPTs provisions – do they need a comprehensive review? 

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 the RPTs provisions in the Act. 

It is specifically important that government re-evaluates exempting privately owned companies from the ambit of provisions governing RPTs.  Further, there is a 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.