Related Party Transactions
A related party transaction can be called a transfer of goods, resources, services, or business between a reporting entity and a related party, whether or not a payment is made. If an entity had related party transactions during the periods covered by the financial statements, Indian Accounting Standard 24 requires it to disclose the nature of the related party relationship as well as information about those transactions and outstanding balances, including commitments that users need to understand the potential effect of the relationship on the financial statements. IAS 24 mandates any institution to divulge key management personnel compensation in aggregate and by category, in the manner defined by the IAS.
To understand related party transactions, we must first understand the concept of Related Party.
- RELATED PARTY
Related parties are companies or persons with whom the company has a commercial transaction. As to the Indian Accounting Standards (AS-18), parties are deemed related: “if one party can control or significantly influence the other in making financial and/or operating decisions in a particular reporting period.”
Section 2(76) of The Companies Act, 2013 defines the term “related party” as
A director, his relative, any key managerial personnel or his relative, a firm, in which a director, manager or his relative is a partner, a private company in which a director or manager is a member or director, a public company in which a director or manager is a director or holds along with his relatives, more than two per cent. of its paid-up share capital, any body-corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager or any person on whose advice, directions or instructions a director or manager is accustomed to act or any company which is a holding, subsidiary or an associate company of such company; or a subsidiary of a holding company to which it is also a subsidiary or such other person as may be prescribed.
This does not apply to expert or professional recommendations, directives, or instructions.
Related Party has also been defined under Regulation 2(zb) of Listing Obligations and Disclosure Requirements, Section 2(84) of The GST Act, Section 2(41) of the Income Tax Act, 1961, Rule 2(2) of the Customs Valuation Rules, 2007, Accounting Standard-18 and Accounting Standard 24.
Section 2(76) talks about the related party as a director or his relative. Relative is defined under section 2(77) as any person who is related to another through being
- A member of the Hindu undivided family
- A husband and wife
- One related to the other in such a manner as may be prescribed.
The Companies (Specification of Definition Details) Rules, 2014 gives the list of the relatives to be included under Sub-clause 3:
- Father (Including Step-Father)
- Mother (including Step-Mother)
- Son (including Step-Son)
- Son’s wife
- Daughter (including Step-Daughter)
- Daughter’s husband
- Brother (including Step-Brother)
- Sister (including Step-Sister)
1.2 Key Managerial Personnel
Key management professionals are individuals with the authority and responsibility for planning, directing, and supervising the reporting enterprise’s activities.
A body corporate can be a public corporation, a private company, a small or large company, or, a one-person company, an LLP, or a foreign firm. So, if any body-corporate is accustomed to acting on the advice of any director or management, that director or manager, together with their firm, will be a connected party.
1.4 Accustomed To Act
Section 2(76), sub-clause (vi) and (vii) talk about ‘Accustomed to act’. It covers a series of acts done by a person or corporate and does not take single or two acts in its ambit. It can be understood as there may be reasonable grounds to believe that any person (here, Board of Directors, managing director or manager) will act in a particular manner (in accordance with the advice, directions or instructions of a director or manager).
- RELATED PARTY TRANSACTIONS
A Related Party Transaction is defined as a transaction or arrangement made between two parties or entities who are linked by a prior business relationship or a common interest. Whether or whether a fee is charged, it is a transfer of resources, services, or responsibilities between a reporting company and a linked party. The most prevalent categories of linked parties include business affiliates, shareholder groupings, subsidiaries, and minority-owned enterprises. Related-party transactions include sales, leases, service agreements, and loan arrangements. The approach to the phenomena of RPT has been progressive and has aimed to idealize the twin notions of Transparency and Compliance by primarily advocating for self-regulation, e-governance, and investigative and penalizing laws.
Related party transactions usually have the inherent potential for conflicts of interest, and therefore regulatory agencies closely scrutinize them. These types of transactions are not always unlawful. However, they can muddy the business environment by creating conflicts of interest by favoring close associates of the hiring company. If related-party transactions are misused, it can lead to fraud and financial catastrophe for all parties involved. These agreements limit market competitiveness as well.
Sections 134, 177, 184, 188, and 189 of the Companies Act of 2013, together with Rule 15 of the Companies (Meetings of Board and Its Powers) Rules, 2014, address Related Party Transactions. Section 188 is an amalgamation of Sections 294, 294A, 294AA, 297 & 314 of the 1956 Act and beyond.
A transaction involving the sale, purchase, or supply of products; buying, selling, or disposing of any property; Leasing any property; Utilizing or delivering any service; Appointment of agent for the acquisition or sale of commodities, services, or property; An associated party’s placement in any office or profit-generating location occupied by the corporation, its subsidiary company, or associate entity, underwriting the subscription of any of the company’s securities or derivatives thereof, are all such kinds of transactions that are prohibited by Section 188 as a contract or arrangement between related parties unless prior approval has been taken by the Board of Directors for the same. It provides that a related party shall not vote on such a resolution to approve any contract or arrangement with the company.
However, this rule has its exceptions:
- If the firm is a government agency and the contract is with another government agency, the federal government, a state government, or a combination of the three.
- If a contract is made with a non-listed government firm and it is approved by a ministry or department of the Central or State government.
It means that any agreement that has been entered between government companies or departments shall not be considered a Related Party Transaction.
- Ordinary Course of Business
Related party transactions, as per section 188, provide flexibility to a company in case of transactions in the ordinary course of business and on an arm’s length basis. The ordinary course of business is not specifically defined under the Act. It covers the usual/ ordinary transactions, customs and practices of a business entity. ICAI has included a few examples of transactions that are to be considered outside the entity’s ordinary course of business-
- Complex equity transactions e.g. corporate restructuring or acquisitions,
- Transactions with offshore entities,
- Sales transactions with unusually high discounts/ returns
- Transactions under contracts.
- Arm’s length transaction
Arm’s length transaction as defined under the section talks about a transaction between two related parties that is conducted as if they are unrelated so that there is no conflict of interest. This definition is subjective and requires the company to consider what would be an arm’s length transaction or otherwise.
Section 188 aims at self-regulation and leaves contracts or arrangements with related parties to the decision of the board and shareholders, their decision & justification of transaction would not be subject to further enquiry if found to be reasonable.
- Interested Shareholders
The Act calls for the “interested shareholder”, i.e., the shareholder who is a related party, to not vote on the resolution for ratifying the related party transaction due to the reason of partiality of such shareholder. It, however, fails to acknowledge such a situation where the majority of shareholders of any business are a related party to a transaction or where both the directors of any joint venture are related parties preventing the resolution from being passed.
- Office or Place of Profit
The term “office or place of profit” has been defined as an office or place held by a director if the director receives anything from the company in addition to the remuneration to which he is entitled as a director in the form of salary, fee, commission, perquisites, and rent-free accommodation or otherwise, or an office or place held by an individual other than a director or by any firm, private company, or other body corporate if the individual, firm, private company, or other body corporate.
- APPROVAL PROCESS
The prior consent of the Board of Directors must be acquired by a resolution at a Board meeting unless the transaction involves an exempted category.
Every contract or agreement entered into according to section 188(1) must be recommended to boards and reported to board members together with an explanation for entering into the contract or agreement. The Board resolution cannot be adopted by a circular resolution, i.e., the resolution can only be adopted by those physically present at the meeting.
- Any Director with a financial stake in the transaction shall not be present during the discussion at the Board Meeting.
- The agenda for the board meeting must include specific information on the related party and the proposed transaction, as required by the rules.
- If a director or other employee enters into a contract without board permission or general meeting approval, the contract must be confirmed by the board or the shareholders within three months of the date of the contract; otherwise, the board has the discretion to annul the contract.
- Audit Committee
Audit Committee permission is required for all transactions with related parties under section 177, and this approval is not limited to RPT transactions under section 188. Any transaction that occurs in the normal course of business and at arm’s length prices still requires audit committee clearance. The Audit Committee can only ratify transactions up to ₹ 1,00,00,000. The audit committee consists of at least three board members. Independent directors should constitute the majority of the audit committee. If a transaction is not permitted by the audit committee within three months, the transaction is null and void, and the director is accountable for the loss.
- Omnibus Approval
The term “Omnibus Approval” refers to a consolidated/standing approval granted by the Committee for recurring transactions.
After obtaining board approval, the Audit Committee can set the criteria for omnibus approval, which must include, the maximum value of all transactions in a given year, maximum value per transaction, scope and method of disclosures that should be made, examining such transactions at regular times and transactions not covered by the omnibus authorization.
While outlining the requirements, the recurrent nature of the transactions (in the past or future) and justification for the requirement for omnibus approval must be evaluated. The validity term for omnibus approvals shall not exceed one fiscal year. No omnibus permission shall be granted for transactions involving the sale or disposal of an undertaking.
- Not Pre-approved Transactions
If the contract or arrangement is not pre-approved by the company’s Board of Directors or shareholders, it must be ratified by the Board or shareholders within three months of the date the contract or arrangement was entered into. If it is not ratified, the contract or arrangement is voidable at the discretion of the Board or, in the case of a shareholder vote, at the discretion of the shareholders, and if the contract or arrangement is with a related party to any director or is authorised by any other director, such directors shall indemnify the company against loss. The company may also take legal action against such a director or directors to recover any losses incurred as a result of such contract or arrangement.
- MAINTENANCE OF REGISTRY
Section 177 of the Act provides that every firm must maintain a registry of contracts or agreements in which directors have a financial interest, using Form MBP-4 for
- Disclosure of Interest by Directors.
- Keeping track of Related Party Transactions
This register is presented during board meetings and is signed by all directors present. Every director is required to reveal his stake in the company and other entities within 30 days of his appointment, and this information is recorded in the register. The register must be kept at the registered office of the firm and should be accessible during business hours. It must be given at each AGM.
A register is not necessary if the value of items sold or purchased throughout the year is less than 5 lakh, by a financial institution for bill collection in the usual course of business and in the case of Section 8 corporations if the transaction amount does not exceed one lakh rupees.
Section 188 of the Act, sub-section (5), provides for penalties for violating the section’s provisions. In the case of a publicly traded company, any director or other employee who entered into or authorized the contract or arrangement in violation of Section 188 of the 2013 Act is punishable by imprisonment for up to one year or a fine of not less than Rs. 25000/- but not less than Rs. 500,000/-. In the case of any other company, the violation is punishable by a fine of not less than Rs. 25000/- but not less than Rs. 500,000/-.
- COMPANIES (MEETINGS OF BOARD AND ITS POWERS) RULES, 2014
Section 188 of the Act shall be read with Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014 which talks about conditions subject to which a company shall enter into any contract or arrangement with a related party, inter alia, listing the details to be disclosed while moving the agenda for passing the resolution in the board meeting.
A Form AOC-2 is to be submitted under rule 8(2) of Companies (Accounts) Rules, 2014 which requires the Board’s Report issued to shareholders under section 134 of the 2013 Act to furnish particulars of contracts or arrangements with related parties referred to in section 188(1) of the 2013 Act.
- NEED FOR RELATED PARTY DISCLOSURES
- Influence of the relationship between the reporting entity and related party on the transaction
- Related party transactions have an effect on unrelated party transactions.
- Better corporate governance
- Aids stakeholders in making knowledgeable decisions
- The entity’s financial situation and performance are accurate and honest.
Several precedents have been established over the years to clarify the law on Related Party Transactions.
In the case of Yashovardhan Saboo Groz-Beckert Saboo Ltd., the Company Law Board held that The provisions enacted in the Companies Act, 1956 are founded on the principle that a director is precluded from dealing on behalf of the company as himself and from entering into engagements in which he has a personal interest conflicting or which possibly may conflict with the interest of those with whom he is bound by fiduciary duty. A director occupies a fiduciary position concerning a company and he must act bona fide in the interests of the company. If a director makes a contract with the company and does not disclose his interest, he will be committing a breach of trust.
In the case of Globe Motors Ltd. v Mehta Teja Singh & Co., the Division Bench of Delhi High Court observed: “A resume of the law clearly shows that the Companies Act does not forbid a contract being entered into by the company with a firm in which one of the directors is a partner. Disclosure of interest and not voting on the resolution by the interested director are only formal aspects of the compliance with the statutory provision. The basic question is as to the conduct of directors and whether it satisfies the test considering their fiduciary relationship to the company.”
In conclusion, corporate governance is becoming increasingly important in the business world. And any irregularities could undermine stakeholders’ trust, as their money is at stake. As a result, investors should review the Related Party Transactions regularly. And it is up to corporations to uphold the standards of good corporate governance and ethics.