Related party transactions: Know when they are risky

Published: October 28, 2019 12:08:12 AM

In corporate structures, no separation of ownership and control exists, so RPTs can be tainted with conflicts of interest that could short-change investors.

The dominant control structure makes it easy for RPTs to take place. (Illustration: Shyam Kumar Prasad)The dominant control structure makes it easy for RPTs to take place. (Illustration: Shyam Kumar Prasad)

By P Saravanan, Bipin Kumar Dixit & Narendra N Kushwaha

A transaction is considered as a related-party transaction when a deal is entered into by at least two entities, where one has control over the other or where the parties come under the same control of another. In Asia, there is a prevalence of related party transactions (RPTs) and generally, these affect the interests of shareholders, especially minority shareholders.

Let us see how investors can identify and stay away from such companies while selecting shares for their portfolio.

Ownership of a typical Indian conglomerate is either concentrated in a single group or a family or is state-owned. In family-controlled firms, senior management and board positions, including chairman and chief executive, are often filled by family members. The dominant control structure makes it easy for RPTs to take place.

RPTs are legitimate
Investors should understand that RPTs are legitimate activities and serve practical purposes. These are recognised in companies and tax laws, these have their own standards for accounting treatment and checks and balances have been built to make sure they are conducted within these boundaries. These transactions above a certain threshold limit should have prior consent of shareholders and be subject to disclosure to ensure that they are conducted under terms that would not expropriate wealth from minority shareholders.

Where the problem arises
In corporate structures, no separation of ownership and control exists, so RPTs can be tainted with conflicts of interest that could short-change investors. For instance, a listed company might deposit its surplus cash to its unlisted subsidiary for a relatively longer period, denying itself and its minority shareholders the opportunity to generate higher returns through strategic investments.

Or, it could buy assets from an unlisted affiliate at an inflated price, a clear form of channelling the fortunes of a public entity into the private interests of the same controlling shareholder. Empirical evidence states that RPTs is a common tool for controlling shareholders to expropriate wealth from minority investors.

Types of transactions
Related activities may include transactions such as leasing of property, sharing of assets and resources, sales, purchases, transfers of realty and personal property, group procurement to take advantage of economies of scale, shared-services received or provided on accounting, management, engineering, legal services, transfers of research and development, license agreements, intercompany borrowing and lending, providing bank guarantees or collateral, inter-company billings based on allocations, treasury management techniques, etc.

All RPTs are not bad
RPTs are good in many ways. For instance, for a contract manufacturing firm, connected transactions are key element. These companies consider it as a strategic and cost advantage because they are able to control their inventory and processes without the risk of surprises from unpredictable external suppliers. RPTs require prior audit committee approval and it should be disclosed in board’s report along with justification for such transactions. Companies document and disclose their policy of dealing with RPTs in their website and annual report.

The line between what is legitimate and abusive can be crossed easily. Investors should read RPTs carefully and avoid companies which are indulging in such transactions with an intention to expropriate wealth from minority shareholders.

P Saravanan and Bipin Kumar Dixit are faculty members and Narendra N Kushwaha is a doctoral candidate in finance & accounting, IIM Tiruchirappalli

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