Keeping it in the family isn’t always bad

A related party transaction is often viewed with an eye of suspicion, as if it is done to encourage nepotism. To some the reason may look obvious, as they believe a related party transaction is always a sham, solely done to siphon off funds to related entities to benefit a few stakeholders in a company.

That may not always be true, as there could be bonafide related party transactions.

For instance, when one entity of a large conglomerate specialises in certain products and services that it can provide to other entities of the group, why should the company approach a third party for those products and services, enriching the third party at the cost of its own group entity?

That makes little commercial sense. In a modern commercial world, it is imperative to accept that large groups and conglomerates execute transactions within the group. It is fine to have a deeper probe into such transactions to unearth any malafide intentions but it is not good to paint all related party transactions with the same brush of suspicion.

It is not a great idea to prohibit related party transactions, instead well-drafted regulations could prevent mischief sought to be achieved by such transactions.

Wide coverage The new Companies Act, 2013 ensures the right balance while laying down provisions with respect to such transactions.

It has widened the scope of definition of a related party, covering people, such as a company’s directors, their relatives, key managerial personnel (KMP) and their relatives, firms in which any director or ‘manager’ or his relative is a partner (like a director of a company also being a partner in a legal firm would make that legal firm a related party), those companies in which the director or relative is a member or a director; the list goes on to include holding company, subsidiary companies (including fellow/sister subsidiaries, associate company.

The wide coverage shows the intention to cover every possible person or entity within the net of related parties.

However, not all transactions done with a related party would qualify as related party transactions.

The new Act in Section 188 lists certain transactions that would fall within the meaning of related party transactions. Transactions other than those listed —although done with a related party — will still fall outside the scope of related party transactions.

For the first time, the concept of debarring the interested shareholder from voting on any related party transaction has been introduced. Further, now not only will the interested director be debarred from voting on related party matters but he will also not be allowed to be present at the meeting of the board where such matter is discussed.

Key changes One major change now is that no approval of the Central government is required for related party transactions. Earlier companies with paid-up capital of Rs 1 crore or more required prior government approval.

The substitute for government approval is shareholders’ approval by way of three-fourth majority. This is a major development and will save substantial time in obtaining government approval with always the risk of approval not being granted.

The board of directors will now have to provide justification in its report for entering into such transactions, for instance, it will need to justify the choice of related party over the unrelated third party. The notice of meeting directors or shareholders, as the case may be, will have to provide for certain disclosures, thereby ensuring that the reasons for entering into related party transactions are better explained.

The audit committee will have to approve the related party transactions and any later modifications thereof.

Specific duties have been cast on independent directors while considering such transactions. They will need to pay sufficient attention and ensure that adequate deliberation is held before such transactions are approved and assure themselves that these are in the interest of the company.

Directors who fail to comply with the conditions of related party transactions face stringent penalties. Now the director concerned could be liable to indemnify the company against any loss incurred by it. Any director convicted of offence dealing with related party transactions at any time during the last five years would be disqualified to be appointed as a director.

The provisions now apply to all kinds of companies — private or public; the existing exemption of transactions between two public limited companies is withdrawn.

Any related party transaction executed in company’s ordinary course of business and at arm’s length basis is completely exempted. This is a good exemption to encourage companies to do transactions between two related parties in the same manner as would be done with an unrelated party.

The provisions of related party transactions are not yet in force. However, as and when they are notified, we can be sure to have well-drafted and thought-of provisions governing related party transactions.

(The author is a partner with J. Sagar Associates. Views are personal).

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