Jurisdiction - India
Reports and Analysis
India – Related Part Transactions: Regulatory Developments And Persisting Concerns.

16 October, 2014

 

 

The regulation of related party transactions (“RPTs”) is a significant aspect of corporate governance. The governance framework has undergone a transformation from the limited framework under the Companies Act, 1956 (“1956 Act”), which mandated disclosures and approvals for contracts in which the directors were interested, to the strict disclosure and transparency requirements under the Equity Listing Agreement (“Listing Agreement”) and the Companies Act, 2013 (“2013 Act”), both of which seek to regulate connected transactions involving controlling shareholders and related entities. This becomes important as most Indian companies are closely held unlike foreign companies with diversified ownership.


Evolution Of The Regulatory Framework On RPTs


Section 297 of the 1956 Act required the approval of the board of directors for any contract or arrangement in which directors or their relatives were interested. The approval of the Central Government was required to be obtained in case of a company with a paid-up share capital of INR 1 crore or more. Further, the 1956 Act imposed a duty on directors to disclose their interest in a particular transaction to the board, and disallowed a director from voting during any resolution relating to any business in which such director was interested.
Further, the Accounting Standard – 18 (“AS 18”) issued by the Institute of Chartered Accountants of India (“ICAI”) required companies to disclose RPTs (transactions between parties where one party exercises significant influence/control over the other party) in their financial statements. Recently, in a move aimed at converging the Indian accounting standards with the International Financial Reporting Standards, the ICAI has published the Indian Accounting Standards 24, which prescribe a wider definition of RPTs and more specific disclosure requirements.


In view of the felt need for identifying and regulating RPTs (which sometimes serve as a conduit used by the controlling shareholders to funnel moneys out of the company) and protecting shareholder interest while maximizing shareholder value, the J.J. Irani Committee Report (2005) and the Parliamentary Standing Committee on Finance on the Companies Bill (2009) made certain recommendations in relation to transparency and disclosure requirements for RPTs. Principal recommendations were the need to put in place enhanced disclosure requirements and a prior shareholders approval (unlike the Central Government approval requirement under the 1956 Act) for certain specified transactions.


With reference to a company, the 2013 Act has defined a ‘related party’ under Section 2(76) to include, inter alia, a director or key managerial personnel or its relative, a holding, subsidiary or associate company and any person on whose advice, directions or instructions a director or manager of the company is accustomed to act. Further, Section 188 has widened the class of transactions considered as ‘related party transactions’ to include those related to the sale, disposal and leasing of property and appointment to a place of profit in the company or in a subsidiary or associate of the company.


Each of such specified RPTs, that are not entered into by the company in its ordinary course of business and on an ‘arm’s length basis’, are required to be approved by the board of directors of the company, with prior approval of the shareholders through a special resolution being required in case of the classes of transactions as per the prescribed thresholds. The thresholds for triggering the special resolution requirement under Section 188 have been laid out under the Companies (Meetings of Board and its Powers) Rules, 2014 (“Meetings of Board Rules”), which came into force from April 1, 2014.


Further, the Meetings of Board Rules provide for a comprehensive set of disclosure requirements, and mandate that the agenda of the board meeting at which a resolution for a RPT is tabled shall, inter alia, disclose:

 

  • the details of the related party;
  • the nature and particulars of the contract or arrangement; and
  • the manner of price determination.

The Meetings of Board Rules also provide that any director interested in such contract or arrangement shall not be present at the meeting during any discussions on the subject matter. Further, in the case of a transaction between a holding company and its wholly owned subsidiary, a special resolution passed by the holding company shall be sufficient for entering into the transaction.


A further set of compliance requirements for listed companies are provided for under Clause 49 of the Listing Agreement which require a review of RPTs by the audit committee along with an internal control mechanism. Further, the Securities and Exchange Board of India (“SEBI”) required senior management to make disclosures regarding all material transactions in which they had an interest or which resulted in a conflict of interest. Note here that Clause 49 has been recently amended to further strengthen the provisions relating to RPTs by, inter alia, prescribing:

 

  • a wider definition of related parties in comparison to the 2013 Act; and
  • the formulation of a policy on materiality of RPTs by companies subject to a minimum threshold.

Further, unlike the 2013 Act, the amended Clause 49 does not provide any exclusion to transactions entered into in the ‘ordinary course of business’ and on an ‘arm’s length basis.’


Recent Clarifications And Circulars


Any company with a paid-up share capital of INR 10 crore or more was required to enter into a RPT only with the prior special resolution of shareholders, irrespective of the materiality of the transaction. Further, there was lack of clarity on the validity of subsisting contracts and arrangements under the 1956 Act and on the extent of voting restrictions under Section 188.


The aforesaid have been addressed by the Ministry of Corporate Affairs (“MCA”) by way of a circular dated July 17, 2014 and an amendment to the Meetings of Board Rules dated August 14, 2014.


(i) Applicability Of Thresholds: In terms of the amended Meetings of Board Rules, a special resolution is required in case of contracts or arrangements qualifying under the following categories:

 

Sale, purchase or supply of any goods or material Lower of 10% of the turnover of the company or INR 100 crore
Sale, purchase or disposal of property Lower of 10% of the net worth of the company or INR 100 crore
Leasing of property Lower of 10% of the net worth or turnover of the company or INR 100 crore
Availing or rendering of services Lower of 10% of the turnover of the company or INR 50 crores
Appointment to any office of profit in the company, its subsidiary or associate company Remuneration exceeding INR 2.5 lakhs per month
Underwriting of the subscription of any securities or derivatives thereof of the company Remuneration exceeding 1% of the net worth of the company

 

The amendment dated August 14, 2014 has excluded the prior threshold based on the paid up share capital of a company. Thus, now the compliance thresholds are purely transaction specific, allowing shareholders of larger companies to focus on significant transactions.


(ii) Corporate Restructuring: Transactions arising out of compromises, arrangements and amalgamations under specific provisions of the 1956 Act or the 2013 Act would not attract the requirements of Section 188. Such transactions are in either case subject to specific approvals from the shareholders and the courts.


(iii) Validation Of Prior Contracts: Any contracts entered into by companies in accordance with Section 297 of the 1956 Act, and which had come into effect prior to the commencement of Section 188, would not require a fresh approval under the new provision until the expiry of the original term of such contracts. A clarification on the point was necessary due to the ambiguity in the wording of the grandfathering provision under Section 465 of the 2013 Act. However, any modifications to such contracts made or on after April 1, 2014 would fall within the purview of Section 188.


This clarification will have a limited impact on listed companies, since the amended Clause 49 provides that any existing material related party contracts or arrangements entered into under and in accordance with Section 297 of the 1956 Act, and which are likely to continue beyond March 31, 2015, would require shareholders’ approval under Section 188 in the first general meeting subsequent to October 1, 2014. Hence, such contracts or arrangements entered into by listed companies would still require shareholders’ approval under the Listing Agreement.


(iv) Voting In Relation To Interested Contracts – Section 188 has provided for abstention by ‘related parties’ on resolutions where RPTs were being approved. A literal interpretation of the provision would result in any shareholder who is a related party to the company being required to abstain from voting on any RPT, irrespective of whether or not such shareholder was a party to the transaction. Unrelated shareholders would be vested with disproportionate rights to block RPTs. This concern was addressed by providing that a ‘related party’ for the purpose of the voting restriction, is to be determined with reference to the contract or arrangement for which the special resolution is being passed.


The MCA’s moves are welcome and address some crucial concerns relating to RPTs under the 2013 Act.

 

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For further information, please contact:

 

Cyril Shroff, Partner, Amarchand & Mangaldas
cyril.shroff@amarchand.com

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