Out with it

Mohan R Lavi | Updated on July 31, 2014 Published on July 31, 2014

Companies cannot hide related party deals

The new companies Act is so replete with words such as arrest, imprisonment, fraud and penalty that many joke it was composed by the CBI! So lengthy and complex is the new law that even an offender will be caught unawares by the clause he is breaching. That said, the impact of the new Act is already being felt.

Take the recent disclosures on related party transactions. The rigorous disclosure requirements of Section 188 of the new Act has brought to light something that was hidden in the balance sheet of Cairn India — a ₹7,500 crore loan it had given to a unnamed related party.

At the next opportunity, shareholders are bound to ask tough questions about the rationale behind the deal — the loan earns an interest of 3.5 per cent a year while even an investment in the dullest fixed deposit scheme in India could return more than double the interest.

Related parties

Section 188 of the Act says any contract or arrangement with a related party would need the approval of the board of directors. For certain companies or transactions, it takes a special resolution.

‘Related party’ has been defined in Section 2(76) and is wide enough to cover anyone even remotely related to the company or any of its key management personnel. The board of directors are supposed to justify the transaction in their report and provide details of it.

If the board’s approval or the special resolution has not been obtained, the board can call the contract null and void. And if any directors are involved, they must pay for the loss.

Penalty and imprisonment clauses are an integral part of Section 188. The section was a bit generally worded and clarifications were sought on when and how the special resolution would be needed. Later, the Ministry of Corporate Affairs (MCA) came out with a general circular, which is even more liberally worded.

It clarified that related party referred to in the second proviso had to be construed with reference only to the contract or arrangement for which the said special resolution was being passed.

Alibaba and MCX

It is stated that when the International Accounting Standards Board (IASB) sold the concept of International Financial Reporting Standards (IFRS) to China, they fell for it hook, line and sinker but were very uneasy about the extensive related party disclosures that were needed.

The recent IPO document filed by Chinese e-tail giant Alibaba proves that China thrives on related party transactions.

In India, the post-mortem audit of the MCX revealed that the exchange entered into agreements with related trading parties, paid about ₹709 crore to erstwhile promoter Financial Technologies India and group firms without following a proper documentation process and that there were gaps in the way MCX processed related party transactions.

The audit firm expressed doubts whether these agreements were conducted on an arm’s length basis. MCX also entered into related-party transactions with other FT group companies for various ancillary services.

In an economy such as India, there are bound to be a number of related party transactions due to the fact that many businesses are family-owned and trust forms an integral part of other businesses.

The Indian corporate sector has to get its act right on entering into properly documented related party transactions and justifying them. If not, the Companies Act is waiting with Section 188 and the Income Tax Department with its Section 92BA on domestic transfer pricing. The mantra is clear “When in doubt, just disclose it”.

The writer is a chartered accountant

Published on July 31, 2014
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