Related Party Transactions: Some perspectives

The Companies Act, 2013 (hereinafter referred to as “the Act”) provides a composite code for regulating transactions with related parties through the insert of provisions under Section 177 and 188 and Rules prescribed under the Companies (Meetings of Board  ) Rules, 2014.To ease the rigmarole associated with obtaining sanctions for such transactions, certain amendments have also been proposed in the Companies (Amendment) Bill,2014 which still awaits approval of Parliament. Listed Companies are required to adhere to the procedure of authorization laid down in the revised Clause 49 of the Listing agreement relating to Corporate Governance .The provisions in the listing agreement have not been aligned entirely with the Act. The resultant   fall-out of this   is that Companies , listed entities in particular, have willy-nilly to comply with  two sets of compliance procedures which is totally undesirable, as it  will lead to unnecessary  duplication besides causing  confusion and add to the retinue of compliances  which have been brought to bear on Companies in the aftermath of the Act and the Rules there under. In this discussion,   we shall deal with the   procedural law, identify  the grey areas  which have given rise  to  myriad sets of compliances, bring out the differences  between the Act and Clause 49 in the matter of compliance  and end with a  fervent plea to the Powers that be  for a seamless integration of the provisions in the Act and the Listing agreement.

Related Party defined-under the Act and the Listing Agreement

Section 2(76) in the Act provides a restrictive “means” definition to the term. To avoid tedium, the definition is not being reproduced. The definition stands further extended by Rules 3 and 4 in the Companies (Specification of Definitions) Rules, 2014. Rule 4 therein  provides the list of relatives in terms of clause(77) to Section 2.An interesting observation from the said list of Relatives is that whereas a “son” is defined to include a step-son, a “daughter” does not include a step-daughter !.Inexplicably a “sister” includes a “step-sister”!!. A clear drafting aberration, if there was one, unless it is a case of male chauvinism!!. Suffice to say, the definition   in Section 2(76) is  extremely comprehensive and encompasses a multitude of relationships. Its tentacles are widespread like that of an octopus.

Any transaction entered into   by a Company with a related party as defined by Section 2(76) comes in for scrutiny under the law. Before we go into the substantive   provisions  , we would also discuss the relevance of AS-18 (Accounting Standard-18  which deals  with related party disclosures)in the context of our discussion. As-18, inter alia, applies to related party relationship as described in Paragraph-3  therein  .The relationships captured in the said paragraph of AS-18 are not in sync with the definition provided by Section 2(76).Where a listed Company is concerned, as clarified by Clause 49(VII) of the Listing Agreement a ” related party” shall not only cover the persons covered by Section 2(76) but also such Entities covered by the applicable Accounting Standards. As AS-18 continues to apply as a mandatory standard,  ,the relationships covered under the Standard have to be also taken into consideration not only by a listed company but also by an unlisted company with the only difference being that for unlisted companies, the process of approvals under the Act will be triggered off only in respect of  transactions with related parties as defined by Section 2(76). As Accounting Standards are mandatory in application under Section 129 of the Act, all companies, listed or otherwise,   will have to adhere to the applicable  Accounting    Standards   . For   the purpose of disclosure in its Financial Statement, an unlisted company will have to report all related party transactions after taking into consideration all related party relationships covered by paragraph 3 of AS-18.  On the other hand, a listed Company will have to identify related party transactions both with reference to the definition  as per Section 2(76) as also AS-18.

Section 188 and Rule 15 of the Companies(Meetings of Board) Rules,2014

Section 188 in the Act applies to every Company ,whether public or private and provides inter alia, that no contract or arrangement shall be entered into with a related party without the approval of the Board through a resolution passed at its Meeting with respect to:

a) sale, purchase or supply of 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;

e) appointment of any agent for purchase  or sale of goods, materials, services or property;

f) such related party’s appointment to any office or place of profit in the company, its subsidiary company or associate company ; and

g) underwriting the subscription of any securities or derivatives thereof, of the company.

It may be noted that the Board’s approval will be imperative for transactions of the genre stated above, irrespective of the value of  the transaction  with a related party. The approval has to be obtained through a resolution passed by the Board at its Meeting at which some of the Directors may be  present through the facility of video conferencing. It is not necessary that all the directors must be present physically at the Meeting to authorize the transaction.  The approval of the Board cannot  be through a circular  resolution  and it should not also  be post facto. We would hasten to add that although sub-section (3) under Section 188 provides for a process of ratification by the Board /shareholders within a period of three months from the date of the Contract or Arrangement, in keeping with the spirit of good governance which the Section seeks to uphold ,   it is essential that the approvals are obtained prior to the entering into of the contract  or arrangement.

One important observation we wish to make at this juncture is that in as much as Section 188 is a specific provision, the need for seeking approval of either the Board or the shareholders, as the case may be is triggered off only if the contract or Arrangement belongs to the genre covered by sub-section (1), a portion of which has been reproduced above. We would reiterate that if the contract is not covered by sub-section (1) ibid it does not come within the ambit of Section 188 at all.

Need for shareholders’ approval under Section 188

Where the value of the contract or Arrangement proposed to be entered into with a related party exceeds the prescribed financial thresholds, it will be necessary to seek the approval of the shareholders by special resolution. The financial thresholds have been laid down by Rule 15(3) of the Companies (Meetings of Board) Rules, 2014 ( hereinafter ”the said Rules”).For the sake of brevity  , the thresholds prescribed by the above Rule are not being reproduced. The Section provides for the approval to be obtained through a special resolution and as stated by the second proviso to Section 188 , no member of the company shall be entitled to vote on the special resolution if he happens to be a related party to   the subject contract or arrangement.

Where the transaction is with a wholly owned Subsidiary, as stated in Rule 15(2) of the said Rules, adequate compliance would be ensured if the approval of the shareholders of the Holding company alone is obtained.

Amendments proposed by the Companies (Amendment )Bill,2014

In keeping with the avowed objective of the Central Govt. to ease the process of doing business in the Country, certain amendments have been proposed to Section 188 in the Act, which whence approved, will go a long way in reducing the rigmarole associated with seeking authorizations for related party transactions. The requirement of seeking approval through special resolution where the prescribed thresholds have been breached is proposed to be substituted by an ordinary resolution. In addition, transactions as between a Holding Company and its wholly owned Subsidiary, whose Accounts are consolidated with that of the Holding Company and placed before the General Meeting are proposed to be kept out of the ambit of authorization under Section 188.

There is a logical basis to the proposed changes, considering  the fact that firstly as between a Holding Company and its wholly owned Subsidiary(WOS), that there should be a conflict of interest would be paradoxical, given that the WOS is only an extended arm of the Holding Company, created either for risk dispersion or for  other legal considerations. Secondly, in the case of closely held companies, it would be difficult to obtain the approval of members by special resolution, given the preponderance of the promoters’ equity and the fact that the promoter group would be barred from the voting process   if it happens to be a related party to the contract or arrangement.

The proposed amendments have not yet been approved by parliament and as such Corporate India will have to live with the existing law on the subject. It would have been appropriate if the amendments had gone through before the close of the current year. Hopefully in the immediate future, the proposed amendments will see the light of the day, leading to the much needed dilution of the  law on the subject.

 Litmus  Test for applicability of Section 188

Section 188 of the Act   comes into play only if both the following conditions are not satisfied:

a) The transaction is not in the ordinary course of business.

b) The transaction is not at arms’ length.

Both the aforesaid conditions  have to be satisfied to ensure that the transaction is spared the rigors of procedure under Section 188.It would not do any good if only one of the above conditions is satisfied.

Meaning of “ordinary course of business”

The   above term has not been defined in the Act. The expression   has been given different meanings and hues. According to Black’s   law Dictionary, it refers to the “normal routine in managing a trade or business’. It refers to the regular or customary condition or course of doing things, as something   which is done with regularity and repetitively. It covers the usual   ransaction ,customs and practices of a certain business and of a certain firm.

Although the term is incapable of being defined with any degree of exactitude, the principles laid down by the courts while considering the scope of the term would be useful in analyzing the meaning of the term for the purposes of Section 188(1).In Matrix Logistics Limited vs. Commissioner of Income Tax(122 ITD 228) it was held that carrying on any activity contained in the objects clause of the Memorandum would constitute the business of the company even if it is not its principal or main business.

Another test for determining the question whether the activity is in the ordinary course is to see whether the transaction serves a business purpose. For deciding this question, it is necessary to consider whether the purpose must result in income or profit as held in Commissioner of Sales Tax Vs.Hindoostan Spinning and Weaving Company Ltd.(15 STC 69(Bom) . It is also necessary to determine, as the Bombay HC held in   Herbertsons Ltd. Vs. Commissioner of Income Tax (87TTJ 840).

The above repository of judicial pronouncements and the analysis of the expression as provided by the legal lexicons provide us an idea as to what constitutes an activity which is “in the ordinary course of business”.

 Meaning of “Arm’s length transaction”

As per Clause (b) in the Explanation under Section 188( 1) the expression  refers to a transaction between two related parties that is conducted as if they were unrelated so that there is no conflict of interest. As the expression suggests, in an arms’ length relationship there is avoidance of intimacy or proximity between the parties. As per Black’s legal lexicon, parties are said to deal at “arm’s length” when they are not related or not on close terms   and who are  presumed to have roughly equal bargaining power.

In an arm’s length relationship neither party is controlled by the other. The onus of proving that the transaction has been concluded on an arm’s length basis lies with the company .The company must be able to prove that the transaction is purely on commercial terms and that there are no extra-commercial considerations. To establish the above, the company should build enough documentary evidence and support. One way of discharging the onus would be to award contracts through the process of tendering particularly for big ticket items. Another mechanism would be to rely on independent, third party certifications and valuations.

We can summarize that where it comes to complying with the provisions of Section 188  ,it must be demonstrated  that the contract or Arrangement is not one which is in the ordinary course of business and secondly it is not on arm’s length basis. Finally, the transaction should be of the genre contemplated by Section 188(1) as enumerated above.

Significance of Section 177 (4)(iv)of the Act

In case of those Companies which are under obligation to set up an Audit Committee, the Committee too has a role to play in the matter of authorization of related party transactions. Sub-section (4) to Section 177 provides that every Audit Committee with the terms of reference specified  in writing by the Board which shall ,inter alia, include:

Clause (iv) which reads as under:

“approval or any subsequent modification of transactions of the company with related parties”

From a plain   reading of the above clause, it is clear that the brief of the Audit Committee runs deeper than that of the Board. Whereas, Section 188(1) directs the Board to grant authorization for contracts or Arrangements with related parties with respect to specific types of transactions   as stated therein, Section 177   empowers the Audit Committee to grant approval to every transaction as also any modifications in the terms thereof entered into with a related party. Another conspicuous feature in Section 177 which makes it a more potent weapon as compared to Section 188 is that the Committee’s approval would be called for   even in respect of transactions which are entered into in the ordinary course of business and are on arm’s length basis. The fact that the Section does not carry a monetary threshold as in Section 188 where it comes to seeking approval of the members makes it much more arduous and irksome to comply. The Question that has often been asked is whether the approval of the Audit committee   as contemplated in Section 177 should be prior to the transaction being consummated. Our view on this is an emphatic yes .Grant of post-facto approval   by the Committee would be analogous to bolting the stable door after the horse has run away!

In our view there is a clear dichotomy in the law, given the divergence between Sections 177 and 188. Any  Committee of the Board is a sub-set of the Board and therefore intended to be  subservient to the Board. Considering this, it is somewhat ironic that the Audit committee should be clothed with such unbridled powers. The role of the Audit Committee is invariably recommendatory as may be evident from a cursory reading of Section 177(4).It is therefore hard to comprehend that the Committee should be provided with so much    arsenal under the law as to relegate in a sense the importance of the Board. It may well be the case of, to use a metaphor, the tail wagging the dog instead of the other way round!

That the above provision could   stifle the   functioning of the company Board has come  as a late  realization to the architects of the Legislation as  is evident from the attempt  to soft pedal on it  through making suitable amendments to the Section. The Companies   (Amendment) Bill,2014 proposes to insert a  proviso after clause(iv) under Section 177(4) in terms of which the Audit Committee may make omnibus approval for related party transactions proposed to be entered into by the company subject to such conditions as may be prescribed. Once the above proviso becomes a part of the statute, it will substantially reduce the rigors of Section 177(4)(iv).Until this happens, companies will have to seek the approval of the Audit committee for every related party transactions regardless of the value, notwithstanding that the same is in the ordinary course of business and at arm’s length.

Related party transactions and listed Companies

We have prefaced our discussion by stating at   the outset that the listing agreement with the stock exchanges and the provisions in the Act are not on the same page where it comes to related party transactions. The differences between the two can be enumerated as under:

The definition of a “related party” where it comes to unlisted companies would be restricted to the definition in Section 2(76).For listed companies the definition is wider in that it combines the features of   both  Section 2(76) as also AS-18.

Approval of the Board under Section 188 would be required only on respect of the transactions covered therein .Further the transaction should not be in the ordinary course of business as also not on arm’s length thus triggering off the need for Board approval and in applicable cases, approval of the shareholders. As per clause 49 of the listing agreement , all related party transactions regardless of value have to be approved by the Audit committee. Such approval will be needed even in respect of transactions in the ordinary course of business and at arm’s length.

Where the value of the transaction exceeds 10% of the consolidated turnover of the listed company, as per Clause 49 approval of members shall be obtained by special resolution and all the related parties, whether or not they are a party to the transaction will abstain from the voting process. Rule 15 of the Companies (Meetings of Board) Rules,2014  read in conjunction with Section 188 lays down different monetary thresholds for different types of transactions. Further, although the approval of members has to be obtained as on date only by special resolution , only  the member who is a related party to the transaction will be restrained from voting. The Companies (Amendment) Bill, 2014 seeks to ease the procedure further by providing for an ordinary resolution instead of a special resolution.

Revised Clause 49 which has become effective from October,1,2014,allows the Audit Committee to grant omnibus approval in respect of transactions which are repetitive in nature, subject to the condition that the value of each transaction does not exceed Rs 1 Crore  per transaction. The transaction should be in the interests of the company.The  Act does not have a provision for omnibus approval although the Companies (Amendment)Bill ,2014 does contain  a proposal for such  dispensation. As the Amendment bill is in a state of limbo, unlisted Companies cannot take advantage of the same yet.

As per the listing agreement any transaction between the Holding Company and its wholly owned subsidiary does not have to go through the process of approvals. The Act does not provide for a similar exemption although the Amendment Bill, 2014 does provide for such exemption.

It is imperative that the listing agreement is seamlessly integrate with the Act at the earliest so as to put an end to duplication of  procedures .

Definition of Related party transaction as per listing agreement

The listing agreement contains a very generic definition to a related party transaction. A related party transaction  , as per the listing agreement is a transfer of resources, services, or obligations between a company and a related party regardless of whether a price is charged. Section 188 of the Act only refers to transactions belonging to a specific genre. If the definition in the Listing agreement is construed strictly ,it could bring within the ambit of  shareholders’ approval even an apparently innocuous decision  such as the declaration of dividend by a subsidiary to its Holding Company if the value of the dividend exceeds the threshold prescribed in the listing agreement even if there is no conflict of interest, as between the holding company and the Subsidiary ,given the fact that the rate of dividend would be the same for all the members. Further , as per the definition, a transaction between two related parties where consideration does not flow from both sides would have to be taken cognizance of. It is settled law that, bar certain exceptions, when there is no consideration   flowing from both sides, the transaction becomes legally unenforceable.

Conclusion

The law regulating related party transactions is now almost approaching its first anniversary since its introduction from April, 1, 2014. Corporate India is still struggling to grapple with the welter of procedures   and compliances that the new law has given rise to. Any legislation, to be effective has to be in tune with the ground realities. There are several facets in the present law relating to related parties which assume draconian proportions and these need to be in sync with the economic environment .Otherwise, we may well have a situation where the law is observed more by the letter and not in spirit, a most unenviable prospect in which good governance may well be the proverbial lamb, sacrificed at the altar of procedure.

Ramaswami Kalidas