By Jayant M. Thakur
Chartered Accountant
BACKGROUND AND CURRENT STATUS OF
REGULATION OF RELATED PARTY TRANSACTIONS
Related party transactions are
transactions by a company with parties that are related to it or to certain
persons having some control over the company. Such transactions present a
classic case of conflict of interest where persons in control of the company
are in a position to approve such transactions where they have interest or
benefit. Related party transactions can thus be termed as a kind of corporate
nepotism. The objective of regulation is to ensure that there is oversight over
such transactions by independent persons, or that they are approved by other stakeholders,
or both. There are requirements also for extensive disclosures.
Thus, the Companies Act, 2013 (‘the
Act’) and the Rules made under it contain elaborate provisions for regulation
of related party transactions. SEBI, too, aims at regulating such transactions
independently through the SEBI LODR Regulations (‘the Regulations’). Since both
these sets of laws govern companies, there is obviously some concern about
conflicting provisions and even duplication / overlap which could result in
excessive compliance needs. Although attempts have been made to harmonise the
two sets of provisions, differences
still remain.
SEBI has recently undertaken an exercise
to review the provisions and a report has been released containing
recommendations for change. After receiving feedback and consultation, SEBI
will notify the final changes.
SCHEME OF PROVISIONS
While this article concerns itself with
the proposed changes in the SEBI LODR Regulations, it is worth reviewing
briefly the scheme of provisions both under the Act and the Regulations.
To begin with, there is the definition
of a ‘related party’. Several persons and entities are listed specifically or
descriptively as related parties. These include relatives and also various
parties with which specified persons in management have control or association.
The Regulations, too, provide a definition which takes the definition under the
Act as the starting point and adds the definition under the relevant accounting
standard.
Then there is the definition of related
party transactions. The Act provides a list of transactions which, if
with a related party, would be subject to regulation. The Regulations, however,
provide a generic descriptive definition and thus are wider in nature.
Next, we have the manner of regulation.
This is in two forms. The first is the manner of approval required. This is
broadly at two levels. All related party transactions require approval of the
Audit Committee and generally the Board. Certain transactions also require the
approval of shareholders. Where approval of shareholders is required, related
parties cannot vote to approve such transactions. Secondly, there are
requirements for disclosures of such transactions which are extensive and also
supplement the disclosures required under the applicable accounting standard.
CONCERNS
The provisions have seen repeated
reviews and changes over the short period since they have been in existence.
SEBI had set up a committee under the Chairmanship of Mr. Ramesh Srinivasan, MD
& CEO of Kotak Mahindra Capital Company Limited, which submitted its report
on 27th January, 2020. SEBI has invited feedback on this by 26th
February, 2020 after which one may expect SEBI to implement the changes by
suitably amending the Regulations.
The Committee has reviewed nearly every
major area of the provisions including the definitions of related party and
transactions, the threshold limits, the manner of approval, disclosures, etc.
Amendments, major and minor, have been suggested. The report, apart from giving
a detailed background and reasoning for proposing the changes, also gives the
exact language of the amendments. There are several advantages of these. One
will be able to know the exact language of the proposed amendments in course of
time. Concerns over ambiguities, difficulties, etc. can thus be pointed out
well in advance. Importantly, it will be easier for SEBI to notify the
amendments quickly.
Let us see in the following paragraphs
some of the important amendments proposed.
DEFINITION OF RELATED PARTY TO NOW
INCLUDE ALL PROMOTERS
Unlike many countries in the West, India
has a very large proportion of its companies promoted and controlled by family
groups. They hold a significant percentage of the total share capital, often
nearly half. Needless to add, generally they control the company for all
practical purposes on most matters.
At present, the Regulations define a
related party in two parts. One is the definition under the Act / or applicable
accounting standard, which itself is broad and includes many entities with
which directors / others may be associated. The second part consists of any
promoter who holds 20% or more of the share capital of the company.
However, there is an important lacuna
here. Even these wide definitions may still not include many entities connected
with the promoters. It is proposed that all promoters and members of the
promoter group would be now treated as related parties. Further, any entity
that directly / indirectly, along with relatives, holds 20% or more of the
share capital would also be treated as a related party.
Interestingly, to be considered as a
related party, the promoter will now not have to hold any shares.
Further, the person holding 20% or more may be a total outsider not connected
with the management at all.
There could be difficulties for the
company to compile a comprehensive list of these newly-covered entities. The
list of promoters, of course, should be readily available. However, identifying
persons who hold 20% or more may present some difficulties. Fortunately, a good
starting point would be the disclosures received from persons holding 5% or
more of the shares under the SEBI Takeover Regulations. However, the
definitions under the two laws are different in detail and hence it may still
be difficult for the company to prepare an accurate list of related parties
covered by these amendments.
TRANSACTIONS BETWEEN RELATED PARTIES OF
PARENT AND SUBSIDIARIES
Currently, transactions between the
company and its related parties are covered and to some extent between the
company and its subsidiaries. The concern is that certain sets of transactions
may get left out.
It is now proposed that transactions
between subsidiaries of the company and a related party either of the company
or its subsidiaries will be deemed to be related party transactions. Thus, the
following would now be related party transactions:
(i) Between the company and its related party;
(ii) Between the company and any related party
of any of its subsidiaries;
(iii) Between the subsidiaries of the company
and any related party of the company; and
(iv) Between the subsidiaries of the company
and any related party of any of its subsidiaries.
TRANSACTIONS WHOSE PURPOSE IS TO BENEFIT
RELATED PARTIES
It is now proposed to
cover transactions with any parties, ‘the purpose and effect of which is to
benefit a related party of the listed entity or any of its subsidiaries’.
The intention
obviously is to cover those transactions ostensibly carried out with a
non-related party but the intention and also the effect is to benefit related
parties. In a sense, the intention seems to be to cover indirect transactions.
The requirement is that not just the actual effect, but even the purpose
of the transaction has to be benefit to a related party. Arguably, a
transaction with an unintentional benefit to a related party ought not to be
covered. However, this aspect may need clarification.
No guidance is given
as to how to determine or even detect such transactions. It is very likely that
the management or person who is the related party would know about the benefit
and thus the onus would be on such person to inform the company.
It is also not clear
whether the benefit should be for the entire amount of the transaction or part
of it. For example, a contract may be given to a non-related party X, who may
sub-contract a part of the contract to a related party. If other conditions are
met, it would appear that such a contract should also get covered.
MATERIAL MODIFICATIONS LATER TO RELATED
PARTY TRANSACTIONS
Related party
transactions may be approved and transactions initiated but later they may
undergo modifications. At present, unless the modification is in the form of
entering into a de novo transaction, the modification may not get
covered. To ensure that material modifications also get covered, it is provided
that they require approval in the same manner as original transactions. It is
not clear what does the word ‘material’ mean. As this term is not defined, one
will have to adopt alternative definitions and interpretations of this term.
In case where the
transaction is by a subsidiary with a related party, the modification will
require approval only if certain specified thresholds are exceeded.
PRIOR APPROVAL OF SHAREHOLDERS
Certain material
transactions with related parties that are above the specified thresholds
require approval of shareholders at present. It is proposed that such approvals
should be taken prior to undertaking such transactions. This requirement
will also extend to material modifications to such transactions.
MODIFICATION IN CRITERION FOR DETERMINING
MATERIAL RELATED PARTY TRANSACTIONS
Transactions above a
certain threshold are deemed to be material. It is now provided that the
threshold shall be the lowest of the following:
(a) Rs.
1,000 crores;
(b) 5%
of consolidated revenues;
(c) 5%
of consolidated total assets;
(d) 5%
of consolidated net worth (if positive).
This will
particularly affect very large companies for whom, as per the present
thresholds, even Rs. 1,000 crores of transactions were not ‘material’.
REVIEW REQUIREMENTS BY AUDIT COMMITTEE
AND DISCLOSURES TO SHAREHOLDERS
The Audit Committee
will now be required to mandatorily review certain aspects of the related party
transactions that are placed before it for approval. This, on the one hand,
provides guidance to the Audit Committee as to what specific factors to take
into account. On the other hand, it places responsibility on the Audit
Committee to go into these details.
It is also proposed
that the notice to shareholders for approval of material related party
transactions should give specific items of information. This again increases
transparency and enables the shareholders to take an informed decision on the
transactions. Interestingly, whether or not the Audit Committee approval was
unanimous has to be stated.
CONCLUSION
There are other
amendments proposed, too. And there are some other aspects of the amendments
apart from those discussed above. The final amendments as notified would be
worth going into in detail taking into account all the amendments.
As mentioned earlier,
SEBI has given some time for feedback on the proposed amendments. Considering
the past track record of SEBI, it is likely that the amendments may be notified
soon thereafter. It will have to be seen whether the amendments are put into
place immediately or phased out and also whether they are made applicable to
all companies or only to some.
The
responsibility of the company, and particularly of the Audit Committee, will
only increase after such amendments. Related party transactions are a source of
concern and even wrongdoings such as siphoning off profits / assets of
companies. The amended provisions may result in increased accountability by all
parties concerned.
For the Board
generally and for the Independent Directors / Audit Committee in particular, it
is not easy to determine whether all related party transactions are covered.
Ideally, the primary onus should be on the management / promoters and
particularly those persons with respect to whom the related party connection
exists with a counter party. If they fail to disclose their interest and
connection, it is possible that others may not even come to know. However, this
is not readily accepted in law and the Board / Independent Directors / Audit
Committee and even the Auditors will have to exercise diligence and care as
expected respectively from them. Their responsibility, and hence liability,
will only increase.
