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Aarati Krishnan

INDIA boasts of a legal framework that actively discourages a company's top management from entering into transactions with the company they manage. But the related party disclosures by major Indian companies in the maiden year after such reporting became mandatory, show that the incidence of such transactions is quite high. Companies have sidestepped the legal framework to engage in a web of transactions with group companies and entities controlled by the management.

Before Enron and a host of other American corporations were exposed in a series of accounting scandals, the words "related party transactions" may not have held much meaning for lay investors. But they certainly carry a wealth of meaning now. Enron used complicated financial transactions with a host of special-purpose entities to boost their operational performance and, in the process, shielded from public gaze some of their questionable forays into the derivatives markets.

Indian companies have largely refrained from direct transactions with the top management. Unlike the instances that have surfaced in the US, companies have not doled out large zero-interest loans to their CEOs, entered into contracts with construction companies owned by their CEO or paid for the CEO's private jet. This is not because Indian CEOs are more virtuous than their counterparts elsewhere, but because of a fairly stringent legal framework (see below).

Instead, related party transactions have taken a different form. Transactions have been routed through entities indirectly controlled by the promoter group/management. Detailed below, are the common related party transactions thrown up by the disclosures of 50 major Indian companies in their 2000-01 and 2001-02 annual reports.

Largesse to `associates'

The law prohibits loans by a company to its director, relatives of a director or to partnerships or private limited companies in which the director is a member. However, related party disclosures reveal that companies have been quite liberal with loans to subsidiary companies, joint ventures and "associates" (entities over which the company or its directors have significant influence).

In 2001-02, Reliance Industries extended loans of Rs 14,000 crore to associated companies (Rs 12,833 crore was paid back before the year end, but the size of the transaction is still significant). Indeed, there is nothing wrong with such arrangements if such loans were made on terms that would be applied to disinterested third parties. But in the absence of specific disclosures on this, it is difficult to judge whether they have been executed strictly on an arm's-length basis.

Business with group entities

Quite a few companies, it would seem, like to keep their business within the family. It appears to be common practice for MNCs to source a significant portion of their raw material requirements from companies under the control of the same parent. In 2001-02, Gillette India sourced 44 per cent (Rs 97 crore) of its input requirements (both raw materials and traded products) from its US parent and its fellow subsidiaries.

P&G Hygiene, Syngenta India and Novartis also sourced a key portion of their input requirements either from their parents or sibling subsidiaries. Quite a few of them (Nestle India, Gillette India and P&G) also derive a significant portion of their revenues from sales of finished products to their parent or other group companies.

There could be both positive and negative spin-offs to such dependence on group companies.

On the positive side, if the sourcing arrangement is due to centralised procurement of inputs by a parent, this could well result in input cost savings for its Indian arm. Similarly, a sales arrangement with a parent or other group companies could provide an assured market or a stable source of revenues to the Indian company.

However, on the flip side, such transactions allow the parent/group companies to wield considerable influence over the revenues and profitability of a listed company.

In the absence of disclosures about the price and other terms at which such sale/purchase transactions are executed, it is difficult to judge whether the terms are unduly favourable to the group companies.

Reimbursement of expenses

Quite a few related party transactions have taken the form of "expenses" reimbursed to group companies or enterprises controlled by the top management. In 2001-02, ICICI Bank paid around Rs 80 crore to affiliates such as ICICI Brokerage Services, ICICI (subsequently merged), ICICI Personal Finance Services and ICICI Capital Services for various services provided.

The services ranged from leasing of premises and deputation of employees to expenses for corporate advertising, installation of ATMs and call centre services. The above are some instances of related party transactions that appear to create a conflict of interests between the company and its promoters or top management.

A broader purpose

In quite a few instances, the disclosures also provide an additional insight into a company's operations.

Dr. Reddy's Labs conducts some of its research through the Dr. Reddy's Research Foundation, a private company over which the promoters "exercise significant influence." The Foundation is funded by contributions from Dr. Reddy's Labs. In 2001-02, Dr. Reddy's Labs contributed Rs 44 crore to the Foundation.

Companies in skill-intensive businesses such as software, banking and pharmaceuticals probably have to go that extra mile to retain employees. By March 2002, Infosys had loans of Rs 2.08 crore outstanding from its employees. The company extends home, vehicle and personal loans to its employees at interest rates of 0-4 per cent.

In 2001, Nestle India paid Rs 55 crore in "general licence fees" to fellow subsidiaries of its parent.

Clearly, there are more reasons than one to skim through the section in the company's annual report which details related party disclosures. Even if the disclosures contain no startling revelations about the misdemeanours of the top management, they can still leave you with a better understanding of the company's operations.

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