New Theory of Relativity for Corporate India

Introduction
One of the definitions of relativity is the quality or state of being relative. Albert Einstein has made relativity famous by his Theory of Relativity (E= mc2)which is now a fundamental principle of Physics.

However, Corporate India is now grappling with a new Theory of Relativity – the one propounded by the Ministry of Corporate Affairs (via the Companies Act, 2013)and the SEBI (via the Listing Agreement), i.e., the Related Party conundrum!

A host of new regulations have revolutionised the concept of related party transactions. While the intention of these new regulations is very clear, i.e., safeguarding minority interest, some of the original provisions were rather harsh and may have lead to stifling the normal business operations. Accordingly, the provisions of the Companies Act, 2013 were diluted to some extent. Recently (on 15th September, 2014), SEBI also amended the original provisions of Clause 49 of the Listing Agreement. Let us, through this Article, look at these new provisions under the Companies Act as well as the Listing Agreement.

New Theory
We may rephrase Einstein’s famous theory as follows for Corporate India’s related party transactions:

R = S.2(76) + S.188 + Cl. 49 + S.40A(2)(a) + AS 18

Where the Variables of this Equation are:

R = Related Party Transactions;

Section 2(76) and S.188 of the Companies Act, 2013, both of which are effective from 1st April, 2014 for all companies;

Clause 49 of the Listing Agreement, which is effective from 1st October, 2014 for listed companies;

Section 40A(2)(a) of the Income-tax Act, 1961 and

AS 18 = Accounting Standard 18 issued by the ICAI

Let us look at these variables in detail.

Who is a Related Party?
The compliances for related party transactions (“RPTs”) are to be done under two laws – section 188 of the Companies Act, 2013 and Cl. 49 of the Listing Agreement. In effect, for listed companies, the higher (stricter) of the two laws would apply. The definition of a related party in relation to a listed company u/s. 2(76) of the Companies Act, 2013 and Clause 49 of the Listing Agreement is given in Table-1.

* U nder the Companies Act, a relative for an individual means his HUF, spouse, parents, children, siblings and spouses of children. Stepfather, step-mother, step-son, step-brother and step-sister are also relatives. However, a stepdaughter is not a relative. Further, unlike the earlier list u/s. 6 of the Companies Act, 1956, several relatives have been omitted from the definition, these include, grandparents, grand children, spouse of grand children, spouses of siblings.

Under the earlier provisions of Clause 49 of the Listing Agreement (prior to the amendment carried out on 15th September, 2014), several other entities were considered to be a related party. However, all those entities have now been replaced with one single statement – Related Parties under an Accounting Standard. A person who is not a related party under the Companies Act but is covered under an Accounting Standard would now be so even under Clause 49. Thus, listed companies have to consider the definition under the Companies Act and also the definition under the applicable Accounting Standards.

What is a RPT?
Now that we have considered who is a related party, let us also understand what constitutes a Related Party Transaction (RPT) for a listed company. Clause 49 defines the same in a very wide manner to mean a transfer of resources, services or obligations between a company and a related party, regardless of whether a price is charged. Hence, even a free service would be a related party transaction. Further, a RPT includes a single transaction or a group of transactions in a contract.

Section 188 on the other hand gives a specified list of contracts or arrangements with a related party which constitute a related party transaction. Hence, the scope of section 188 is much narrower and would only apply to the transactions specified therein. While what constitutes a contract is easy to understand, what constitutes an arrangement could be a moot point? Further, the Rules treat certain RPTs as prescribed RPTs for which a special resolution of the shareholders is required. Both these lists are given in Table-2.

Turnover. Using a consolidated turnover is a good move for Holding Companies which have little or no operations of their own.

What compliances are required?
The compliances required for RPTs under both the laws are illustrated below.

(A) If the RPT is in the Ordinary Course of Business and on an arms’ length pricing, the compliances are given in Table-3.

ALP = Arms’ Length Pricing basis, i.e., an RPT conducted as if it were between unrelated parties so that there is no conflict of interest. To demonstrate that the RPT is on an ALP, the Company may consider comparable uncontrolled prices or such other available illustrations which would demonstrate that the transaction has been carried out on an arms’ length price. The concept of ALP is relevant only qua the Companies Act since Cl. 49 makes no distinction between an RPT at ALP or otherwise.

* What is an ordinary course of business has not been defined and would have to be ascertained on a case-by-case basis. The Memorandum of Association, Financial Statements, Board Minutes, history of past transactions, etc., could be some of the indicators of what is ordinary for a company. For instance, purchase of shares of the promoter’s private company would not be in the ordinary course of business even though it may be on an arms’ length pricing.

* The twin conditions or ALP and ordinary course of business need to be satisfied for a company to get out of the provisions of section 188(1) of the Act. Compliance with any one is not enough.

(B) If the RPT is not in the Ordinary Course of Business and/or not on an arms’ length pricing, the compliances are given in Table-4.

The  rules  earlier  prescribed  that  a  company  having  a paid-up capital of rs. 10 crore or more shall not enter into any RPT which is not on an ALP and not in the ordinary course of business without a special resolution. thus, for such companies the requirement of checking whether the RPT was a prescribed RPT was not relevant. However, by virtue of an amendment dated 14th august 2014, the MCA has removed this clause. Hence, as the law stands currently, the threshold requirement of Rs.10 crore of capital stands removed to determine whether an RPT requires a special resolution.

Thus,  the  standards  prescribed  under  Clause  49  are more stringent than those u/s. 188. While section188 provides a gateway in the form of ordinary course of business which is at an arms’ length price, there is no such gateway under Clause 49.

How is the Voting for RPTS to be carried out?

We have seen that shareholders’ approval is required either  under  the  Companies  act  or  under  the  listing agreement  or  both.  This  gives  rise  to  several  issues, some of which are enumerated below.

All for One and One for All?

Section188 provides that no member of the company shall vote on any special resolution, to approve any RPT which may be entered into by the company, if such member is a related party.

A question which arises is that in a transaction between two related parties would all other related parties also be disentitled from voting or would only the ones affected by the transaction be disentitled? for instance, would a director who is a shareholder be disentitled merely because he is a director even though he has no special interest in a transaction? Thus, does the Three Musketeers’ slogan apply – all related parties would be clubbed together even if they have no interest in the transaction?

The MCA issued a clarification in this respect that related party has to be construed with reference to/in the context of the contract or arrangement for which the special resolution  is  being  passed.  this  is  a  very  important clarification that was eagerly awaited. The impact of the same may be illustrated as follows:

Illustration 1
a holding company is entering into a transaction with its substantially owned subsidiary, which is now treated as a related party. the managing director and other directors of the holding company are also treated as related parties u/s. 2(76) of the act. however, if they are shareholders they can vote on this transaction since they are not related parties in the context of the contract being considered.

Illustration 2
A company proposes to enter into a contract with the MD’s wife. here, the md would have to abstain from voting as a shareholder since he is a related party in the context of the contract being considered. however, other directors of the holding company can vote on this transaction if they are shareholders.

To add more spice to the flavour, SEBI has come out with an interesting amendment. It states that for RPTs all entities falling under the definition of related parties shall abstain from voting, irrespective of whether the entity is a party to the   particular transaction or not. this sets at naught the exemption given by the mCa! a classic case of “What the Left Hand Giveth, the Right Hand Taketh  Away.”  thus,  under  the  illustration-1  explained above, the directors of the holding company would have to abstain from voting even though they are not related to the transaction in question. A very strange and harsh requirement.

Father-Son Transactions
In the case of an RPT with a wholly owned subsidiary, the MCA has clarified that special resolution passed by the holding company would suffice under the Act for entering into transactions between the wholly owned subsidiary and the holding company.

Taking a cue from the MCA, the SEBI has also issued a relaxation. neither prior approval of the audit Committee nor shareholders’ special resolution is required for a transaction between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval. however, this exemption is only for a 100% subsidiary.

Past Life Benefit?
The MCA has also clarified that related party contracts entered into by companies, after making necessary compliances u/s. 297 of the Companies act, 1956, which contracts came into effect before the commencement of section 188 of the Act, will not require fresh approval u/s. 188 of the act till the expiry of the term of original contract. However, if a modification in such contract is made on or after 1st April 2014, then the requirements u/s. 188 will have to be complied with.

Blanket Exemption?
Further, section 188 does not apply to transactions arising out of compromises, amalgamations, arrangements, etc., dealt with under specific provisions of the Companies Act, 1956 or Companies act, 2013. Clause 49 does not carry a similar exemption.

Before or After?
Should the consent of the Board be obtained prior to     or after entering into the RPT? For prescribed RPTs, shareholders’ resolution is required to be passed prior  to the transaction but in other cases, no such express provision is made. Further, the section 188 provides that in case of a contract or arrangement entered into by a director or any employee without approval of the Board/Company, such contract may be ratified by post-facto consent within 3 months.

The   provisions   of   Clause   49   are   applicable   to   all prospective RPTs entered into after 1st October 2014. All existing material related party contracts or arrangements as on the date of this circular which are likely to continue beyond 31st march, 2015 must be placed for approval of the shareholders in the first General Meeting subsequent to 1st october, 2014. However, a company may choose to get such contracts approved by the shareholders even before 1st october, 2014. In case of a listed company, the shareholders’ resolution would also require an e-voting facility.   The   amended   Clause   49   permits   the  audit Committee to grant an omnibus approval for RPTs subject to certain conditions.

Consequences     of Non-Compliance The Act provides that any RPT which is not in compliance with section 188 may be  voidable  at  the  option  of  the Board.  The  director  or the employee concerned who authorised such contract or arrangement with the related party will be liable to indemnify the company for any loss incurred by it. Further, the company can proceed against such  director or employee for recovery of any loss it sustains due to such RPT.

The   punishment   for   non-compliance   of   section   188 on a director/employee in case of a listed company is imprisonment for a term of up to 1 year and/or fine of Rs. 25,000 to rs. 5 lakh. in case of an unlisted company the punishment is a fine of Rs. 25,000 to Rs. 5 lakh. Further, a person who has been convicted of an offence u/s.   188 at any time during the last 5 years is not eligible for appointment as a director of a company. the  punishment  for  non-compliance  with  the  listing Agreement has been laid down under the Securities Contract (regulation) act, 1956 and can extend up to a term of a maximum of 10 years and/or a fine of up to a maximum of Rs. 25 crore.

Reporting and Accounting requirements
Disclosures about RPTs are to be given under 3 Regulations – Section 188, Clause 49 and AS 18:

The  Standard  on  Auditing  (SA)  550  Revised-  related Parties lays down the auditor’s responsibilities with respect to related party relationships and transactions while auditing financial statements.

Specified Domestic Transactions
How can there be any major development in india without the income-tax act having its share of the pie? the last piece of this jigsaw puzzle is s. 40a(2)(a)of the income-tax act which has introduced the concept of Specified Domestic Transactions. Any payments made by an assessee to related parties as specified under the income-tax act which are excessive or unreasonable may be disallowed to the extent of such excess. Further, certain related party transactions need to comply with the prescribed documentation, reporting and audit requirements in a manner similar to international transactions under the Transfer Pricing Regime. A  recent  delhi  tribunal  decision  in  the  case  of  Jai Surgicals Ltd vs. ACIT, reported at 534(2014) 46-A, BCAJ has held that payments made to a related party without obtaining approval under the erstwhile section 297 of the Companies act, 1956 cannot be treated as an offence or being prohibited by law. hence, such payment would not be disallowed u/s. 37(1) of the income-tax act.

Conclusion
SEBI has clearly thrown down the gauntlet to listed companies to carry out related party transactions both in letter and in spirit of the law. A plethora of regulations would force companies to have a relook at such transactions and ensure better minority protection. However, while we welcome better governance, let us not lose sight of the difference  between  governance  and  regulation.  these regulations  should  not  end  up  leading  to  more  law, but no order!!