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Assuming summary toxicity: SEBI’s new norms on related party transactions norms risk being a policy overkill

Research by TARI shows over 51% of the financial fraud between 2012 to 2018—investigated by regulators and resulting in indictment—have used RPTs as the favoured mechanism.

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The changes made by SEBI would make compliance a burden while adding little to the quality of oversight.

By Kaushik Dutta & Souvik Sanyal

Related party transactions (RPTs) often are the route taken by Indian companies for easy access to capital, managing contract delays, mitigating supply constraints, curtailing costs, etc. Yet, RPTs a key concern for regulators as their abuse has contributed corporate frauds. Their mere existence is often considered suspect, contrary to existing research highlighting their beneficial impact in terms of business continuity and competitiveness. A 2022 OECD report says, in 2006, approximately 5.5% of the total income for top 500 listed companies came from RPTs, which rose to 11% in 2019.

Regulatory actions in recent times have highlighted issues such as diversion of funds involving related parties acting as sole distributor, non-disclosure of RPTs, bypassing scrutiny of audit committee, etc. Research by TARI shows over 51% of the financial fraud between 2012 to 2018—investigated by regulators and resulting in indictment—have used RPTs as the favoured mechanism.

Balancing RPT benefits and risks is a challenge. SEBI recently approved key changes with respect to how companies deal with RPTs, plugging key loopholes but has left much to be concerned over the feasibility and use of some of the changes. A key change is including “promoter” within the definition of a related party, and including any person/entity holding equity shares either directly or on a beneficial interest basis, amounting to 20% or more with effect from April this year, and 10% or more from April 2023.

From April 2023 onwards, a transaction between a listed company or any of its subsidiaries on one hand and any other person or entity on the other hand—the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries—will also be an ‘RPT’.  Regulation expects companies to determine if any transaction involving the consolidated group and any other person could or intend to benefit any related party. To determine if such a transaction could potentially benefit a related party at any leg of the transaction can be extremely difficult for the management and for independent directors.

It is normal for financial and other strategic investors to enter into transactions with multiple listed companies or their subsidiaries under normal course of business, with no intention of exercising any control, and considering such investors as related parties will only complicate the compliance at the investee company level. Even government companies, which deal with other government companies will need to be compliant.

Yet another point is that some companies, innovation driven and relying on proprietary know-how, would often prefer working within the group to keep trade secrets. Seeing such transactions with an eye of suspicion can be counterproductive to the competitiveness of firms and also impact efficiencies. The SEBI Working Group on RPTs, in its report in 2020, had highlighted fears of companies using their subsidiaries as a conduit to move assets away from the company.

As part of the revised framework, listed companies’ audit committees would now have to approve transactions undertaken between two or more of its subsidiaries. Further, audit committee approval is required if the value of the transaction with a subsidiary (either individually or taken together with previous transactions during a financial year) exceeds 10% of the annual consolidated turnover of a listed company, as per its last audited financial statements. The requirement shall also apply to transactions undertaken between two or more foreign subsidiaries, in which case oversight by audit committees of the Indian holding company also raises issues of feasibility and legality.

As of March 2020, listed companies in NIFTY 50 index have an average number of approximately 50 subsidiaries/step-down subsidiaries. For large companies, the numbers of subsidiaries are far higher and keeping track of all such transactions would be difficult. On a practical basis, the requirement could adversely impact the workings of audit committees and would reduce efficiencies of board and the company itself.

Another key change is revising the materiality threshold for obtaining shareholder approval to cover transactions that exceed Rs 1,000 crore or 10% of the annual consolidated turnover, whichever is lower. Accordingly, large transactions, even in the ordinary course of business, can be undertaken only pursuant to shareholders’ approval. For instance, in the Nifty 50, during FY21, 47 companies had annual consolidated turnover ranging from Rs 2,000 crore to Rs 5,40,000 crore; for the largest companies, the Rs 1,000 crore threshold does not constitute even 1% of the turnover while, for smaller companies, it will never be breached. A more meaningful way would perhaps be to determine it in relation to a company’s turnover.

Unlike the Companies Act, 2013, SEBI has not chosen to provide any exemption to transactions done in the ordinary course of business and on an arm’s length basis. The changes made by SEBI would make compliance a burden while adding little to the quality of oversight.

SEBI’s recent amendments hold the risk of a policy overkill and could adversely impact the business climate in India. The purpose of a business is to be in business and create value for all its stakeholders. However, if regulations get too stringent for the entire business universe due to infractions by a few, then the ability of those businesses which are fair and just but strive to remain competitive and productive become severely challenged, and that cannot be the purpose of regulations.

The authors are with the Thought Arbitrage Research Institute.

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