By Jayant M. Thakur
Chartered Accountant
Related parties
and transactions with them are a concern of many laws – the Companies Act,
2013, the SEBI Regulations, the Income-tax Act and so on. The core concern is
that when parties are ‘related’, there is a conflict of interest between such
related parties who are involved in taking a decision regarding these
transactions and the interests of other parties who have no say or even
knowledge about it. For example, a firm owned by the daughter of the MD of a
listed company is sought to be given a contract of services. There is obviously
concern whether the terms would be fair, whether such services were indeed
needed by the company, etc. In a sense, thus, transactions with related parties
are a form of corporate nepotism. However, the definition of related parties,
as we will see a little later, is not narrow to include merely relatives of
controlling / deciding person/s. It includes subsidiaries, parent companies,
group entities of a certain type, etc. Business realities require that certain
activities are carried on by the same group in different entities, and even
otherwise transactions between groups or related entities are inevitable. Yet,
concerns would remain about the conflict of interest and whether the
arrangement is on commercial arm’s length terms.
The Companies
Act, 2013 (the Act) and the SEBI (Listing Obligations and Disclosure
Requirements) Regulations, 2015 (the LODR Regulations) both deal with matters
relating to related parties and transactions with them. There is a detailed
accounting standard, too, dealing with this. Generally, these provide for
certain safeguards. There are requirements of approval of shareholders beyond a
particular threshold of materiality, with related parties generally barred from
voting thereon. The Audit Committee also has to approve all related party
transactions. Besides, there are requirements of disclosure of related parties
and transactions with them in the accounts. All of this serves at least two
purposes. Firstly, parties whose interests could potentially be affected would
get a say. Secondly, there is disclosure irrespective of whether such approval
was required. Hence, readers can review the nature and extent of such transactions.
Considering these varied safeguards and considering that parties may
still try to avoid them, an understanding of the provisions relating to such
transactions is important. A recent decision of the Securities Appellate
Tribunal (SAT) provides such an opportunity. Essentially, it held inter alia
that a public charitable trust whose managing trustee was father / father-in-law of the promoter directors of a listed company was
not a related party. Thus, although there were significant transactions with such
trust, the relevant provisions of law governing related parties would not
apply. The decision of SAT is in the matter of Treehouse Education and
Accessories Limited vs. SEBI [(2019) 112 taxmann.com 349 (SAT), order dated 7th
November, 2019].
BACKGROUND
The facts of
the case are complicated and may even appear to be sordid, involving alleged
criminal acts. The background of what had transpired, as narrated by the
decision of SAT discussed here, an earlier decision of SAT and two orders of
SEBI, is as follows.
Treehouse
Education and Accessories Limited, a listed company (the Company) is engaged in
the business of education that it carries out through its own schools,
franchisees and along with certain public charitable trusts. It develops the
course and curriculum for the purpose. The franchisees and the trusts had
certain commercial arrangements with the company. It appears that there were
proposals and negotiations to merge the company with a company of the Zee group
for which an exchange ratio was also determined. For certain reasons, details
of which are not relevant here, there were disputes to such an extent that the
matter went to the police and the courts and the share exchange ratio was
revised substantially downwards.
The company
suffered very large losses which had allegedly questionable issues. There were
media reports about the company as per the SEBI orders which led to SEBI
initiating a preliminary inquiry.
Soon
thereafter, after making certain preliminary allegations, SEBI passed an
interim order debarring the company and its directors from accessing the
capital markets and ordered a forensic audit into its affairs. The order of
SEBI was appealed against to SAT which asked SEBI to pass a final order within
a specified time after giving due opportunity to the parties to present their
case. SEBI did so and passed a confirmatory order on 16th November,
2018 imposing the same directions as did the interim order. This order was
appealed again and SAT passed the order which is now discussed here.
Two issues of
contention arose. One was whether SEBI was entitled to initiate such
investigations and pass such harsh orders on the facts (more so when they were
admittedly initiated on the basis of media reports). The second issue, and
which is the subject of more detailed discussion here, is whether the company
and the public charitable trust whose managing trustee is a relative of the
promoter directors, can be said to be related parties? And thus, whether the
provisions of disclosure, approval, etc. under the relevant provisions apply to
transactions with them.
Whether
transactions with public charitable trust where relative of promoter directors
is a managing trustee are related party transactions?
Owing to, as
the company explained to SEBI, certain peculiar circumstances / laws relating
to educational institutions / schools, the company had to enter into a tie-up
arrangement with public charitable educational trusts to run certain schools.
The company would provide its name and backing and curriculum, etc. More
importantly, it would provide funds (returnable over certain years, with
interest for a part of this time) that can be used to set up the schools.
One trust, to which large amounts were provided as security deposit, had
a managing trustee who was the father / father-in-law of the promoter director
couple. Owing to losses by the said trust, security deposits of large amounts
had effectively eroded and hence potentially huge losses were faced. The
question thus arose whether the law relating to related party transactions was
violated. For this purpose the moot question was whether the company and the
trust were related parties as understood in law.
The relevant
provisions for this purpose are contained in the Act and the LODR Regulations.
Section 2(76) of the Act defines the term ‘related party’ exhaustively. On a
plain and literal reading of the definition, it appears that a public
charitable trust would not be covered under the said definition. However, since
the company is a listed company, the provisions of the LODR Regulations would
also be applicable. Hence, if a party with whom the company transacts is a
related party under those Regulations, then the relevant requirements contained
therein would also have to be complied with.
Regulation
2(1)(zb) defines related party as follows (emphasis supplied):
‘”related
party” means a related party as defined under sub-section (76) of section
2 of the Companies Act, 2013 or under the applicable accounting standards:…’
Thus, it
includes, first, a related party as defined under the Act that we have seen
does not include a public charitable trust. However, the definition is wider
and has a second leg and includes a person defined as a related party under the
applicable accounting standards. If we apply the Indian Accounting Standards
(Ind AS 24), the definition therein is fairly wide and indeed worded
differently. It includes categories of persons not included in the definition
under the Act. Thus, for example, it includes entities that are controlled by
the persons who control the company or the ‘close relatives’ of such persons.
There are other categories, too. The relevant question would be whether on the
facts of the case a public charitable trust whose managing trustee is the
father / father-in-law of the director couple said to be in control of the
company is a related party. This would have been an interesting analysis.
Here is a case
where a company has commercial relations with a public charitable trust whose
objective is understood to be public welfare. There is a relative of the
promoter director who is stated to be the managing trustee.
SEBI had in its
interim as well as confirmatory orders made a preliminary allegation that the
said trust was a related party, the transactions with whom were carried out
without complying with the relevant provisions of law. And on this and other
grounds, ordered debarment of the parties and a forensic audit of the affairs
of the company. The appellants challenged this order and asserted that the
trust was not a related party.
SAT observed as
follows while holding that the trust was not a related party (emphasis
supplied):
‘18. Similarly,
we are unable to agree with the contentions of SEBI that a trustee of a public
charitable trust is a related party going by the correct reading of the
definition in the Companies Act as well as in the LODR Regulations, unless
there is evidence to show that those Trusts have been set up or (are) operating
for the benefit of the appellant(s). Moreover, there is nothing on
record to show that Mr. Giridharilal, the trustee, has personally benefited in
any manner not only by virtue of being a trustee or in general by any other
means.’
Making this
legal and factual conclusion, the SAT overturned the order of SEBI insofar as
it debarred the appellants.
Interestingly,
neither SEBI nor SAT made any detailed analysis of the definition of related
party under the Act or under the Regulations. SAT merely says that on a
‘correct reading of the definition’ under the Act / Regulations, a trustee of a
public charitable trust is not a related party. It did not explain what this
reading was and how was it correct. Curiously, it places its own additional
condition about the trust being set up or operating for the benefit of the
appellants.
However, it is
respectfully submitted that such a condition is not part of the law relating to
related party transactions.
It is submitted
that the Order of SAT needs reconsideration. The definitions of related party
would need to be analysed, the facts of the case examined in more detail and
only the conditions specified in the law applied. It appears that the second
leg of the definition in the LODR Regulations was not even examined.
Reliance on media
reports by SEBI in making adverse orders against parties
Another
observation SAT made is that SEBI initiated the examination based on media
reports which resulted in passing of adverse orders against the appellants that
remained in place for a very significant time. It is submitted that taking
hasty action relying on media reports is a dangerous way of reacting. Media,
particularly social media, have a tendency to quickly build outrage which a
patient regulator may consider letting pass, focusing instead on the surer
method of meticulous examination. It was particularly noted by SAT that the
appellants have suffered debarment for quite a long period and the
investigation and even the forensic audit has not yet been completed.
CONCLUSION
The SAT order
is only with reference to the interim / confirmatory order. SEBI is yet to
investigate fully and also yet to receive the forensic report ordered.
Thereafter, it may make formal charges, if any, and pass a final order. This
may happen in the near future. It would be interesting to see how SEBI deals
with the issue of related party in the context of these facts since in the
earlier orders it had made preliminary allegations only. More interesting would
be to see how SEBI deals with the reasoning and ruling of SAT on related
parties, which I submit requires reconsideration.
