Ingredients for Crafting a Model Policy On Dealing With Related Party Transactions

Introduction

Related Party Transactions (RPTs) have been a contentious
issue since the advent of Companies. Separation of ownership and control
combined with diffused ownership in companies provides a fertile ground for the
unscrupulous elements to unjustly enrich themselves. More than 200 years ago,
Lord Cranworth in the landmark case of York Building Company vs. McKenzie
highlighted the reason for RPTs invoking distrust. In 1795, he noted

‘No man can serve two masters.
He that is entrusted with the interest of others, cannot be allowed to make the
business an object of interest to himself; because from the frailty of nature,
one who has the power, will be too readily seized with the inclination to use
the opportunity for serving his own interest at the expense of those for whom
he is entrusted.’

A critical strand in the history of corporate law is the
evolution of regulations dealing with RPT, for mal-governance often manifests
itself through RPTs. Despite its role in hampering good governance, RPTs are
not banned anywhere in the world, as this ‘cure’ is more harmful than the
‘disease’ itself.

Given the interdependence, a key element of good governance
is evidenced in the way in which RPTs are regulated. While legal compliance is
the minimum expected of any corporate citizen, good governance practices go
beyond the minimum and set higher standards to inspire shareholders’ and
stakeholders’ confidence in building a profitable and sustainable business.

Regulating RPTs has three critical parts, namely Formulating
a Policy for Dealing with RPTs, Implementing the Policy that is formulated, and
Disclosure of RPTs to their shareholders. This article attempts to provide
insights into crafting a model ‘Policy on Dealing with Related Party
Transactions’ by drawing on the history of regulating RPTs, analysing the
Indian statutes and learning from the practices of the Nifty 50 companies.

A Brief History of Regulating RPTs

One of the earliest recorded RPT disputes involves the East
India Company and Robert Clive. Following the Battle of Plassey, Robert Clive
privately negotiated for himself an annual income of £30,000 for installing Mir
Jaffar as the Nawab of Bengal. In 1765, Laurence Sulivan, the Chairman of East
India Company, who wanted to weed out corruption in the company, initiated the
move to cancel this annual payment as unjustified, resulting in a fight for the
control of East India Company. As it looks, this does not seem to be the first
disputed RPT as joint stock companies were in existence from the 16th century.
However, fighting for the control of the company seemed to be the only method
available to shareholders for redressing their grievances. As RPTs became
avenues for fraud, regulators had to move in to regulate them. Even in events
as recent as 2004, when the US-SEC initiated proceedings against Parmalat of
Italy on what it called ‘the largest financial fraud in history’, RPTs had a
role, revealing a close nexus between frauds and RPTs  

After 1844 AD, when companies could be registered under
specific laws, RPT regulations has evolved rapidly. A major factor prodding on
this evolution is the conflicting economic theories that viewed RPTs from
different perspective. While the Conflict of Interest Theory viewed it
negatively, the Efficient Transaction Theory viewed RPTs positively. Their
difference was in what they viewed as primary to the transaction. In the
Conflict Theory, relationship between Directors and Shareholders in creating
shareholder value was considered of paramount importance, however in the
Efficient Transaction Theory, the business and the business outcome was placed
in the centre stage.

Between the two extremes, corporate law has evolved to
regulate RPTs rather than ban them altogether. Occasionally, on the backdrop of
a large corporate scandal, given the damage they have inflicted on business
confidence, proposals to ban RPTs are mooted and debated at length. However, in
almost all cases, with the passage of time these proposals get diluted as the
ease of doing business assumes importance, resulting in higher disclosures and
more stringent approval processes mandated to prevent misuse of RPTs.

Table 1: Evolution of Regulations for Dealing with Related
Party Transactions

RPT Regulations in India

The Companies Act, 2013 regulates RPTs for all companies in India. Further
listed entities are also required to comply with the SEBI’s (Listing
Obligations and Disclosure Requirements) Regulations, 2015. Taken together, the
two regulations provide a comprehensive framework for dealing with RPTs.

The Companies Act, 2013 that defines a related party, which in addition
to relatives of Directors & Key Managerial Personnel and body corporates
controlled by them and their companies has a distinct category in clause (vii)
of section 2 (76). This clause includes ‘any person on whose advice, directions
or instructions a director or manager is accustomed to act’. Explanatory
statement to this clause specifically excludes professionals who advice the
directors or managers. Given this exclusion, the persons covered by this clause
can be colloquially categorized as ‘friends, philosophers and guides’. In
practice, this clause may come into effect in financial transactions with
former promoters, Chairman and Chief Executives who acting as unofficial
advisors and mentors could be wielding soft-power over the current decision
makers.

In line with the globally established practice of regulating RPTs and
not banning them, the Companies Act, 2013 too regulates RPTs through section
177 and section 188. Section 188 requires the Board of Directors to approve all
RPTs in both public and private companies. Contrary to the popular
perception, all provisions regulating RPTs specified in the Companies Act, 2013
apply to both the public and the private limited companies equally. The
only concession provided to the private company is vide a notification issued
on June 5, 2015, where the related party in a RPT is permitted to vote on their
transactions in both the Board and Shareholder meetings.

The Act for approving RPTs uses the lens of ‘Ordinary Course of
Business’ and ‘At arm’s length’ basis. As these two terms are not defined in
the Act or by SEBI, a working definition is attempted here. A transaction in
the ordinary course of business would have many other comparable transactions
with multiple unrelated parties thereby making RPTs comparable. Likewise, a
transaction at arm’s length is one in which all the economic benefits and
rewards are embedded in the transaction itself and thereby stand the test of
market place.

Given its comparability and market based pricing, a transaction that is
in the ordinary course of business and at arm’s length basis requires only the
audit committee’s prior approval (section 177). Extending this principle
further, the Audit committee can provide a blanket approval for repetitive
transactions that have a valid reason necessitating prior approval.

Where a transaction does not meet either one of the two
criteria-ordinary course of business or at arm’s length basis, approval of the
Board of Directors is required in a duly conveyed meeting. Hence, this approval
cannot be given by them passing a Circular Resolution. Further, where the
transaction size exceeds defined threshold levels, approval of the Shareholders
is required either in a physical meeting or through the postal ballot.  Rule 15 of the Company (Meeting of the Board
and its Powers) Rules 2014 details these thresholds, which is quite elaborate,
capturing different types of transactions like sales and purchase of goods,
availing or rendering services, buying, selling or leasing of property, with
specific absolute and relative limits for each one of them.

The provisions of the Companies Act, 2013 as detailed above are quite
technical and require considerable analysis to identify the approval process
required. Good governance requires transparency and clarity. Probably taking
this cue, Regulation 23 of the SEBI’s LODR Regulation 2015 provides for the
formulation of a Policy on Materiality of RPTs and on dealing with RPTs to help
decision makers interpret the law and provide operational guidelines for
implementing it. Further, Regulation 46 requires this policy to be displayed on
the Company’s website inviting public scrutiny. Considering its availability,
we have reviewed all the policies that were displayed in the month of May 2017
by Nifty 50 companies to arrive a model policy. 

Lessons from the Practices of Nifty 50 Companies in Drafting
their Policy for Dealing with RPTs

Our review of the Policies on dealing with RPTs of the Nifty 50
companies revealed five critical clauses that define the quality of their policy,
namely:

1.  Objective of the policy,

2.  Basis for giving Omnibus Approvals,

3.  Effect of RPTs not approved,

4.  Criteria for Granting Approvals to RPTs, and

5.  Disclosures required of RPTs.

For each of these clauses, we have picked out one of the exemplary
extracts from the Nifty 50 companies as possible role model for adoption.

I.       Objective of
the Policy

To effectively deal with RPTs, the policy objectives need to be clearly
articulated as illustrated in the example given by highlighting it in bold. 

Reliance Industries Limited.

“Reliance Industries Limited (the “Company” or “RIL”) recognises that
related party transactions can present potential or actual conflicts of
interest and may raise questions about whether such transactions are consistent
with the Company’s and its stakeholders’ best interests.”

II.      Omnibus
Approval

The clarity and specificity of conditions attached to granting omnibus
approval and its subsequent reporting should be unambiguous of what is expected
from the Audit Committee and the management team of the company as seen in the
example given here.

Bosch Ltd.

“In the case  of frequent /
regular / repetitive transactions which are in the normal course of business
of the Company, the Audit Committee may grant standing pre-approval / omnibus
approval. While granting the approval, the Audit Committee shall satisfy
itself of the need for the omnibus approval and that the same is in the
interest of the Company. The omnibus approval shall specify the following:

a.  Name of the related
party.

b.  Nature of the
transaction.

c.  Period of the
transaction.

d.  Maximum amount of the
transactions that can be entered into.

e.  Indicative base price
/ current contracted price and formula for variation in price, if any.

f.   Such other
conditions as the Audit Committee may deem fit.

Such transactions will be deemed to be pre-approved and may not
require any further approval of the Audit Committee for each specific
transaction. The thresholds and limitations set forth by the Committee would
have to be strictly complied with, and any variation thereto including to
the price, value or material terms of the contract or arrangement shall require
the prior approval of the Audit Committee.

Further, where the need of the related party transaction cannot be
foreseen and all prescribed details (as aforementioned) are not available, the
Audit Committee may grant omnibus approval subject to the value per transaction
not exceeding Rs.1,00,00,000/- (Rupees One Crore only). The details of such
transaction shall be reported at the next meeting of the Audit Committee for
ratification.

Further, the Audit Committee shall, on a quarterly basis, review and
assess such transactions including the limits to ensure that they are in
compliance with this Policy. The omnibus approval shall be valid for a
period of one year and fresh approval shall be obtained after the expiry of one
year.” 

III.     Effect of  RPT
not approved

The options available to the Audit Committee on dealing with a RPT needs
to be explicitly spelt out. This could include seeking the related parties to
pay compensation for loss suffered in addition to examining the reasons for this lapse in reporting and suggesting measures to rectify it.

Tata Motors Ltd., Tata Steel Ltd., Tata Power Ltd.

“In the event the Company becomes aware of a
transaction with a related party that has not been approved in accordance with
this Policy prior to its consummation, the matter shall be reviewed by the
Audit Committee. The Audit Committee shall consider all of the relevant
facts and circumstances regarding the related party transaction, and shall
evaluate all options available to the Company, including ratification, revision
or termination of the related party transaction. The Audit Committee shall also
examine the facts and circumstances pertaining to the failure of reporting such
related party transaction to the Audit Committee under this Policy and failure
of the internal control systems, and shall take any such action it deems
appropriate.

In any case, where the Audit Committee determines not to ratify a
related party transaction that has been commenced without approval, the
Audit Committee, as appropriate, may direct additional actions including, but
not limited to, discontinuation of the transaction or seeking the approval of
the shareholders, payment of compensation for the loss suffered by the related
party etc. In connection with any review/approval of a related party
transaction, the Audit Committee has authority to modify or waive any
procedural requirements of this Policy.”

IV.     Criteria for
approval

The criteria captured for approval here is a brief and succinct summary
of the complex legal provisions.   

Axis Bank

“All Material Related Party Transactions shall
require approval of the shareholders through ordinary resolution and the
Related Parties shall abstain from voting on such resolutions. The approval
policy framework is given below:

–  Audit Committee- All Related Party Transactions

–  Board Approval- All Related Party Transactions referred by
Audit Committee for approval of the Board to be considered and Related Part
Transactions as required by the statute

–  Shareholders’ Approval- Approval by Ordinary Resolution
for:

i.   Material Related
Party Transaction

ii.  Related Party
Transactions not in Ordinary Course of Business or not on Arm’s Length basis
and crosses threshold limit as prescribed under the statute.

Related Party
Transactions will be referred to the Audit Committee for review and prior
approval. Any member of the Committee who has a potential interest in any
Related Party Transaction will recuse himself or herself and abstain from
discussion and voting on the approval of the Related Party Transaction.

In determining whether to approve, ratify, disapprove or reject a
Related Party Transaction, the Audit Committee, shall take into account all the
factors it deems appropriate.

To review a Related Party Transaction, the Audit Committee is provided
with all relevant material information of the Related Party Transaction,
including the terms of the transaction, the business purpose of the
transaction, the benefits to the Bank and to the Related Party, and any
other relevant matters.”

V.      Disclosures

The scope and extent of disclosures of RPTs needs to be captured
comprehensively by including all employees concerned with implementation.

Aurobindo Pharma Ltd.

“The particulars of contracts or arrangement with Related Parties
referred to in section 188(1) shall be disclosed in the Board’s report for the
financial year commencing on or after April 1, 2014 in Form AOC-2
enclosed as Annexure-I and the form shall be signed by the persons who have
signed the Board’s report.

Further the particulars of contracts or arrangement with Related Parties
shall also be entered in the Register of Contracts as per the provisions
of section 189 of the Act and the Rules made there under.

All Material RPTs that are entered into with effect from October 1,
2014, shall be disclosed quarterly along with the compliance report on
corporate governance.

The Company shall disclose this Policy on its website and also a web
link thereto shall be provided in in its annual report. The Policy shall also
be communicated to all operational employees and other concerned persons of
the Company.”

Conclusion