The Firm

Show Timings:

Friday: 10.30 pm, Saturday: 11.30 am

Sunday: 9:30am & 11.00pm

CNBC TV18
Network18

Cos Act Ep#12: Related Party Transactions

Published on Sun, Jul 20,2014 | 20:47, Updated at Tue, Jul 22 at 19:14Source : CNBC-TV18 |   Watch Video :

If there is one Section in the Companies Act, 2013 that most companies wish did not exist, that is Section 188 – Related Party Transactions! The new law wants minority shareholders to have final approval on related party transactions. But companies say the additional reporting and approval requirements will drown shareholders in reams of transaction details and prevent them from spotting the most important transactions. On the 12th Episode of this special series, we debate 'Related Party Transactions' with Bharat Vasani of the Tata Group, VS Parthasarathy of M&M & Dolphy D'Souza of EY.

Before we begin the discussion, here is an overview of the scope of Section 188. Firstly it applies to all companies- listed or not. It covers a variety of transactions entered into with related parties except transactions in the ordinary course of business and at arm’s length are excluded. All others must obtain audit committee approval and Board approval. They must also be disclosed in the Board’s report to shareholders along with the justification for entering the transaction. Of these, transactions entered into by a company with Rs 10 crore and more of share capital or transactions exceeding certain prescribed size thresholds in the Rules must be approved by shareholders via a special resolution. The related party connected to the transaction cannot vote on the special resolution. The wording is vague here but we will come to that later. So that is the related party regime.

RELATED PARTY TRANSACTIONS
Section 188

  • Applies to all companies
  • Applies to a variety of related party transactions
    *Sale, purchase or supply of goods or materials
    *Selling or leasing of property
    *Availing or rendering of any services
    *Appointment to an office or place of profit

    RELATED PARTY TRANSACTIONS
    Section 188
  • Exclude transactions done in ordinary course of business & at arm’s length
  • All other RPTs need Audit Committee & Board approval
  • All such RPTS need to be disclosed in Board’s Report
  • All such RPTs need shareholder approval via special resolution if
    *company has Rs 10 cr or more in share capital
    or
    *transaction exceeds prescribed size thresholds
  • Related party cannot vote in special resolution

Now let us go back to the beginning, to the definition of Related Party. The definition runs long and wide and includes a director or key managerial personnel (KMP) and his relatives. Relative is separately defined to include two generations and siblings and their spouses – that’s 8 relations in all whether or not they are financially dependent on the director or the KMP. The related party definition also includes companies in which they serve as directors, managers or partners or companies that act on their advice. Of course it includes holding, subsidiary and associate companies and other subsidiaries of its parent. That is a large family of related parties and not devoid of absurdities. For instance, sub-section (v) implies that if an independent director is on the Board of two otherwise unrelated companies, his directorship would make them related. The Ministry has only this week removed that difficulty. After months of confusion another amendment to the Rules clarifies that a director, other than an independent director or a KMP of a holding company or his relative or related parties, implying that an independent director of a holding company can now serve on the Board of a subsidiary company as independent but there is more cleaning up to be done.

RELATED PARTY TRANSACTIONS
Section 2 (76)
Related Party with reference to a company means

  • a director or his relative
  • a key managerial personnel or his relative
  • a firm, in which a director, manager or his relative is a partner

RELATED PARTY TRANSACTIONS
Section 2 (76)
Relative
Father, Mother (includes step-father & step-mother)
Son, Son’s wife (includes step-son)
Daughter, Daughter’s husband
Brother (includes step-brother)
Sister (includes step-sister)

RELATED PARTY TRANSACTIONS
Section 2 (76)

  • a private company in which a director/manager is member/director
  • a public company in which a director/manager is a director or holds along with his relatives, more than 2% of its paid-up share capital
  • any body corporate whose Board/MD/manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager
  • any person on whose advice, directions or instructions a director or manager is accustomed to act
  • any company which is
    a holding/subsidiary/associate company of such company or
    a subsidiary of a holding company to which it is also a subsidiary

RELATED PARTY TRANSACTIONS
Section 2 (76)
BEFORE
(v) a public company in which a director or manager is a director or holds along with his relatives, more than 2%. of its paid-up share capital

AFTER REMOVAL OF DIFFICULTY ORDER
(v) a public company in which a director or manager is a director and holds along with his relatives, more than 2% of its paid-up share capital

RELATED PARTY TRANSACTIONS
Section 2 (76)
EARLIER RULES

  • a director or key managerial personnel of the holding company or his relative

AFTER AMENDMENT

  • a director (other than an independent director) or key managerial personnel of the holding company or his relative

Vasani: There is a very serious lacuna which they should have plugged which is not plugged which is the previous sub-clause- it is sub-clause(iv) - dealing with private companies. World over, the abusive RPTs happen when private companies are controlled by director’s relatives. In that clause, they missed out relative. In all other clauses, the word relative is there. In private companies, the word relative is missed out. So effectively director’s wife can control 100 percent of a private company and can have an interior designing contract for the entire office and still not be covered by Section 2 sub-section (76). So in my opinion, that is a very serious lacuna, which they should plug.

Doshi: On the issue of definition, there are a couple of things that are undefined as of now. For instance, those transactions that are at arm’s length and in the ordinary course of business would not come under the scope of 188 but these two concepts are undefined or poorly defined or loosely defined; there are different interpretations out there?

D’Souza: I think the important aspect of this is the ordinary course. If a technology company is buying a real estate company, then there is certainly something wrong and that is not in the ordinary course and that is where the shareholders come in for an approval process. That is perfectly fair. As far as arm’s length is concerned, it is a very judgmental concept and it would be based on facts and circumstances of each case. The Income Tax Transfer Pricing legislation would provide some persuasive evidence of what is at arm’s length and what is not at arm’s length. To just give you an example, let us say, there is a hotel that is providing a better discount to the related parties. That would still be treated as arm’s length because it has got a huge corporate customer and for that reason, it is giving a discount. So I think it would be based on facts and circumstances of each case and it would essentially be judgmental. Having said that, there would be some disputes and we cannot rule that out. For example, if under your Transfer Pricing legislation, you have agreed your transfer pricing should be based on safe harbour rules and you say, look my margin is 29 percent, would that be acceptable under Companies Act or not. I think the bottomline is- are you depriving minority shareholders of some value? If you are not, if you have got that fact right then I don’t think that is a problem.

Vasani: The objectives of the two statutes - the tax statute which is a fiscal statute and Section 188, which is a minority protection provisions are different. It would be hazardous for the Board or a committee to entirely rely on this transfer pricing methods to determine whether a particular transaction is at arm’s length.

Doshi: So you need guidance from the ministry on what they mean by these two concepts?

Vasani: According to me, apart from the guidance, because guidance can never be comprehensive, the Board and the Audit Committee need to exercise independent judgment to come to a view. You cannot go on taking three quotations every time otherwise you are bureaucratising the Boards and the Audit Committees. So you need to take a judgment call and you need to take an independent view that in our opinion, this transaction is at arm’s length. For example we have situation where there are 100 percent subsidiaries and that is also not carved out and the Board has to take a call whether this transaction is in ordinary course and arm’s length.

Parthasarathy: I just wanted to go back once. I’ve got all my 60 companies together and have strength to explain what is the difference between the last Act and this. The last Act is only talking about Association of Directors that means their relatives, the company in which they are interested.

There are three layers, the director, the company itself and the KMPs. So the multiplication is not just three fold, maybe 27 fold because of the association and clause 49…(Interrupted by Anchor)

Doshi: I haven’t even brought Securities and Exchange Board of India (SEBI) into the mix as yet but nonetheless.

Parthasarathy: Because it adds to the definition- it says an associate-associate is related. So if I have a joint venture partner at one end in trucks and a joint venture partner maybe in IT services both will become related.

SEBI’s new Clause 49 adds another layer of complexity for listed companies. It expands the definition of related party to include those in control, joint control or having significant influence. It also includes entities related to a company if they are members of the same group, if one entity is an associate or joint venture of the other and if both entities are joint ventures of the same third party.

RELATED PARTY TRANSACTIONS
SEBI NEW CLAUSE 49

Related Party includes
Those in control, joint control, having significant influence

Entities related to a company if they are members of the same group; if one entity is an associate or joint venture of the other; and if both entities are joint ventures of the same third party.

Clause 49 also says all material related party transactions need shareholder approval via a special resolution. Material is defined as transactions exceeding 5 percent of annual turnover or 25 percent of net worth. There are no exemptions or transactions in the ordinary course of business and at arm’s length.

RELATED PARTY TRANSACTIONS
SEBI NEW CLAUSE 49

All ‘material’ transactions need shareholder approval via special resolution
Material: Transaction exceeding 5% of annual turnover or 25% of networth

No exemption for transactions in the ordinary course of business or at arm’s length

Parthasarathy: I was joking just before I started this session by saying like we say all Indians are brothers and sisters. Everybody under the new Companies Act with clause 49 are relatives, everybody.

D’Souza: The problem with the SEBI requirements is practically all transactions are covered because they are talking about resources; not even assets. So they maybe resources which are not yet assets but they are still covered under SEBI regulations.

Doshi: They also cover transactions that are done free of charge, right?

D’Souza: But that would be under Companies Act also because free of charge would mean that the transaction is not at arm’s length. So the SEBI requirements are very onerous in the sense that there is no arm’s length and ordinary course exemption and therefore any transaction that is greater than 5 percent of turnover or 20 percent of net worth would be covered. So your normal royalty payments in certain cases would have to go to shareholders’ approval where only minorities vote. That is really fundamentally a big issue in my mind.

Doshi: But shouldn’t normal royalty payments go to minority for approval? For instance and let me give you the example and where I am coming from. We have seen a large number of companies in this country, either subsidiaries of MNCs or now even subsidiaries in large Indian groups, pay their parent company or sometimes even their promoter’s company a royalty whether it is for the brand or for the technology etc. And in some cases the amount of that royalty has been fairly high and divergent from industry standards. Shouldn’t minority get an opportunity to vote on this even though we haven’t yet started talking about the approval systems? So I am saying why should these transactions not be covered?

D’Souza: Unless they are abusive, but if they are not abusive and you have a whole process of approval, the management approves it, the Board approves it, the Audit Committee approves it- then I don’t think, if you have gone through all these processes, and they have come to a view that this is not really abusive, then put that to shareholders. And if it is really abusive and all these entities have approved it then obviously there would be noise from proxy advisory firms and the company would be compelled to do otherwise but I don’t think in all those cases which royalty payments are at arm’s length you need to have shareholders’ approval.

Doshi: The kinds of transactions that are covered, thanks to section 188 and the kinds of transactions that get covered, thanks to SEBI, clause 49.

Vasani: We can discuss for three consecutive shows only on that topic but to be very brief the Section 188 itself is very wide. In fact it encompasses several transactions which are separately regulated by Companies Act itself. For example, old transactions dealing with corporate restructuring; mergers, demergers, hiving off are all covered by 188. Now they are also subject to a separate discipline under the current Companies Act - Sections 391 to 394 and going forward when the new sections are notified 231 to 234, there is a very separate process prescribed but 188 is silent and it is today unclear whether you have to comply with the discipline of both the Court approval, the notice to Competition Commission - all the process under those sections as well as under the companies act.

Doshi: As well as under 188?

Vasani: As well as under Section 188 of the Companies Act. Similarly guarantees- holding company gives a guarantee to the subsidiary. It is a very routine commercial transaction, day in and day out it happens, you cover only under Section 186 or you need to also subject it to the discipline since holding subsidiary are related parties, to the discipline of Section 188.

Section 186: Loans/Guarantees/Acquisition of shares exceeding certain thresholds require special resolution approval

Section 186 restrictions combined with RPT provisions make loans/guarantees to subsidiaries difficult

D’Souza: On guarantees I have a different point of view because 186 applies to people who provide guarantees, not to the recipients of guarantees whereas 188 would apply to both and if the guarantee is not at arm’s length then it should certainly be covered. Also with regards to legislation, what we have seen in the past, when there is company law and when there is SEBI law, what we do is- let us say company law says you need to have three independent directors and SEBI requires four independent directors then you take the higher limit and have four independent directors on your Board. So also with this provision of 186, 188 it should go through a higher requirement of 188, particularly when the transaction is not at arm’s length.

Vasani: Take another example. Trade mark license agreement- very common for most companies- the word used is lease and not license but it is providing a trademark. Is it also a service, whether it comes under a different clause which is sub clause (d) of section 188? Then effectively the whole trademark license agreement will be covered under 188 and will be subject to the discipline of majority of minority and these are transactions where Audit Committee may take a view that we are not in a position to decide whether it is arm’s length or not and many of the times these trademark license valuations are very technical subjects. So they would say I would like to have an accounting firm opinion.

Doshi: Only those which are not in the ordinary course of business and not at arm’s length will require majority of minority approval?

Parthasarathy: Absolutely; that is correct as per Companies Act. So now the question is what is the list of such transactions, because who is going to judge till the definition comes that what is arm’s length; everything is in the grey area.

Doshi: You are going to put it into the list?

Parthasarathy: The Audit committee will say we will take it to the shareholders.

Doshi: So how long will the list be and let’s say the parent company - in you group which is Mahindra and Mahindra (M&M)- give me how many pages will that be for shareholders?

Parasarathhy: Let me come to the first one but it will be maybe in say 20 pages.

Doshi: 20 pages of single line transaction listing?

Parthasarathy: It will be that kind of a list which will go to the shareholders and then we will say that listen I don’t know whether it’s arm’s length or not. Let me give you an example and this is a very simple example. I have a Enterprise Resource Planning (ERP) platform say Systems, Applications and Products in data processing (SAP) platform which I am doing for the head office - anyway Mahindra and Mahindra limited (M&M) does this. So I am now providing a little service for the next company which comes up which is a related company and say I am going to charge him on marginal cost- now is it arm’s length or not? I am saying I am going out to the shareholders and anyway declare to them and let them approve it. Now these kinds of transactions which normally they have never dreamed of taking it would now be part of the scrutiny. Your point about do the shareholders actually need to look at some of the big transactions- yes, but if they get buried in the 20 pages who is gaining.

Vasani: What I felt is that perhaps you can bring some discipline into it by saying that there is nothing in section 177 which mandates that needs to be approved by Audit Committee, that the Board can prescribe certain materiality thresholds. There is nothing which can say you do it, there is nothing which says you can’t do it.

Doshi: You cannot do it either?

Vasani: Perhaps it may be prudent for the Board to prescribe certain materiality threshold under Section 177 so that not very trivial transactions go to the Audit Committee; otherwise you are reducing the Audit Committee’s role to that of an operating manager.

D’Souza: India is a country where is a lot of concentrated ownership. Organisation for Economic Co-operation and Development (OECD) has done a study and they have found that on an average 57 percent of the shares are held by promoters and with a lot of web of companies. So the possibility of abuse has increased many folds. So I agree with the principles in Section 188 where Board has to approve and shareholders have to approve but there are a lot of things in the drafting- whether it is in respect of the definition, materiality, transaction- that has to be substantially changed.

Doshi: The drafting bit seems to imply that no related party can vote on that transaction; not just the related party connected to that transaction which has been put to vote.  That’s something that needs to get cleaned up.

Parthasarathy:  The concept between an interested related party and uninterested is an important distinction to make.

D’Souza: Our view really is that it’s not related party of the company but the related party who is in conflict with that transaction should not vote.

Doshi: The second thing is the legal concept of depriving a shareholder the ability to vote on this? I am sure you are going to say that is also going to get challenged?

Vasani: The cardinal principle of company is that shareholder is not acting as a fiduciary for someone else; unlike directors. So shareholder is entitled to act selflessly in his own economic interest; now you are reversing that cardinal principle. I do realize that several countries in the world have done it, but I have studied all of them and I have found that all countries have done it only for publicly listed companies. We have gone further to even cover it to unlisted companies. The private companies now, there is a proposal to carve them out under the proposed notification; they are going to issue it. Can you just take away right of a majority to vote on a transaction; it is a one part. Second, the larger issue they have raised is - they have said for listed companies, if you are prosecuted, you can go to jail plus fine.  Unlisted companies you go and just pay the fine. The issue I have is that without looking at the gravity of the offense - unlisted company could have done a transaction which is extremely malignant but without looking at the nature of the offense, they have prescribed two different level of punishment- that is also subject to judicial scrutiny under Article 14 that whether it meets the test of reasonable classification- all those issues will come up and thirdly the issue will come up of double jeopardy - whether SEBI prosecuting you for the same offense and Ministry of Corporate Affairs prosecuting for the same offense - whether it violate the constitutional rule guaranteed by Article 20 that you cannot be punish for the same offense twice. So there are multiple issues on which this can be challenged.

RELATED PARTY TRANSACTIONS
Section 188 (5)
Violations of provisions punishable
Listed company: Imprisonment for up to 1 year  and/or  Penalty up to Rs 5 lakh
Unlisted company: Penalty of up to Rs 5 lakh

Section 188 is accompanied by many implementation problems. For instance in the case of a wholly owned subsidiary, in a transaction with the parent company, how would the wholly owned subsidiary get shareholder approval since the parent can’t vote. Thankfully the Rules have fixed that by saying the special resolution passed by the holding company is sufficient but what if the parent is a foreign company. Can Indian law prevail on it to pass a special resolution?

RELATED PARTY TRANSACTIONS
Section 188 Implementation
WoS – Parent transaction
WoS Special resolution: Parent can’t vote as it is a ‘Related Party’

RELATED PARTY TRANSACTIONS
Section 188 Rules
In case of wholly owned subsidiary, the special resolution passed by the holding company shall be sufficient for the purpose of entering into the transactions between wholly owned subsidiary and holding company.

What if parent is a foreign company?

D’Souza: As far as a foreign company is concerned, you can’t apply Indian legislation to foreign shareholders and they are not going to pass any resolution for an Indian subsidiary. So the related party transaction rule should only apply to the subsidiary and if it has got only one shareholder, then the provision is infructuous and you say that it does not apply but again like many things, the Act would have to be amended for some of these difficulties and some of these problems because the Act otherwise is not clear and the Rules have further complicated these whole issues.

Parthasarathy: Let me give you one example. I have an associate and the gratuity trust of this associate is now a related party. Just look at what we will have to do. Just take an implementation issue. I can’t appoint a director till my accountant goes through all the related parties and says this is the prior approval that has to be taken before he is even appointed. So these are the kind of issues it is going to throw up, each one.

D’Souza: The problem with the Clause 49 definition is they have picked up the IFRS definition which essentially relates to disclosure requirements. They are saying that if you pay something to your provident fund, you have to disclose. Now they have used that definition also for approvals. And therefore if you pay to your provident fund greater than 5 percent of your turnover or 20 percent of net worth which could be a very rare instance but you will need shareholders’ approval and that is where the problem is.

Vasani: One of the company; I wouldn’t name it there are 1,700 parties we have to examine.

Doshi: 1,700?

Vasani: Yeah. So the question today I have is that you create a regime where you have to monitor so many transactions. Now they have to be appointed to go to the audit committee for prior approval and one way to take a view that there is no threshold applicable. Imagine the plight of the audit committee members and I am telling you some of the audit committee members have confided in me that they are finding it too tough to handle it because of the fact that everything comes, fortunately not in a group like ours, but there could be unscrupulous promoters. Now the transaction requires approval by the audit committee; not by the board. So some of the difficult transactions they are going to pass it onto the audit committee for approving it and then they say we have not done it, it is the audit committee which has approved the transaction.

Doshi: Give me an illustration of what kind of transaction you are saying where the promoter might shirk away from the responsibility of it?

Vasani: Some real estate is sold to a company which is promoter’s company and the transaction comes up before the audit committee and there may be pressures on the audit committee to approve the transaction and eventually if it is approved and they bow down to the pressure, then the problem is that tomorrow if somebody were to challenge the transaction, the promoters who are genuinely interested in the transactions would get away scot-free that I have not approved it, the audit committee has approved it.

D’Souza: This is what the OECD as well said. It says that audit committee should not approve transactions. They should monitor transactions; if required they need to investigate transaction but if you ask them to approve it, you are putting them into the shoes of the management and you are actually stealing their independence from them.

Doshi: What are the possible solutions?  For instance there have been several abusive transactions by promoters in the past and therefore it is a good idea to give shareholders the right to vote down some of these conflicted transactions and therefore the majority of minority process is a good one. It may not apply to everything that’s been discussed here, but how do you retain the good part of this section and do away with all the crazy unliveable implementation issues?

Parthasarathy: Let me take a crack at this.

Doshi: From the Companies Act point of view; SEBI is separate.

Parthasarathy: At least SEBI can subscribe to whatever the companies law has said so that they are aligned. Second is give the financially independence and dependence an important criteria of the definition

Doshi: For relatives?

Parthasarathy: My son in law may not listen to me; yes relative.  

Doshi: So that’s the second request. Would you prefer that instead of the thresholds Companies Act has put in, we follow the SEBI thresholds because there are materiality thresholds and therefore you may change the numbers up and down but at least they make it more useful that only important large transactions have to go through this?

Parthasarathy: If you add ‘and’ instead of ‘or’ in the Companies Act, by and large you will get to the same answer.

Doshi: So Rs 10 crore and more ‘and’ these transactions thresholds.

Parthasarathy: So automatically then it builds the thresholds.

Doshi: But those are very high thresholds.

Parthasarathy: They are not very high thresholds.

Doshi: They are 10-15 percent; I mean the transaction they are 15 percent, 25 percent of turnover - that means only very rare transactions then will come to shareholders for approval; so somewhere in between.

Parthasarathy: I don’t mind, I have not studied which is more or less. What you want the shareholders to know that there is not abuse and that’s a reasonable principle and that would do.

Doshi: What can make more liveable?

D’Souza: Just to add to what he already said one is the audit committee approval, pre-approval.

Doshi: Do away with that?

D’Souza: The audit committees should not be in this business of approving these transactions; that is certainly one thing.

Doshi: Board approval?

D’Souza: Board approval, certainly - they are the management so they should be approving it. I like the principle of majority of minority, particularly when the transaction is not at arm’s length and in ordinary course but the definition of related parties- the parties who should vote, who should not vote, the definition of related party transactions and the whole approval mechanism - those are quite challenging.

Doshi: That’s pretty much everything in the Section? So what you all are suggesting is that maybe somebody in the Ministry should defer the applicability of Section 188 for a year, clean up some of the drafting issues, moderate some of the thresholds, get SEBI to see the same point of view as the MCA and align their Clause 49 requirements on RPTs and only then bring this into form?

Related Party with reference to a company, means -
(iv) a private company in which a director or manager is a member or director

Recent MCA circular clarifies that transactions arising out of Ch 15: Compromises, Arrangements & Amalgamations will not attract Section 188

Recent MCA circular clarifies that only Related Party connected to the transaction cannot vote

Vasani: It’s perfectly legally possible. They can re -notify effective April 1st 2015, instead of 2014 and make the provisions workable.

Doshi: If none of this happens, then what kind of soup are you in?

Parthasarathy: In a hot soup.

 
Twitter


 
Copyright © e-Eighteen.com Ltd. All rights reserved. Reproduction of news articles, photos, videos or any other content in whole or in part in any form or medium without express written permission of moneycontrol.com is prohibited.