By Ajay Tyagi and Rachana Baid
Related party transactions (RPTs) are common business practices followed world over. When entered into for bona fide purposes and with the right intentions, RPTs prove to be value-enhancers for a company, by saving transaction costs and improving operational efficiency.
However, concern arises when such transactions are not in the interest of a company, and are carried out to benefit the other party or to defraud the company. Such abusive RPTs could take various forms, viz., sale at lower prices, purchase at higher prices, giving inter-corporate loans at cheaper rates, excess royalty payment to parent company, etc, resulting in siphoning of funds and assets, and destruction of shareholder value.
Also read: Energy security first
What is even more problematic is that it may not be easily discernible whether a RPT is beneficial or harmful to the company. The complexity comes from the way the businesses are structured and/or the way transactions are executed. The businesses could be inter-related through various corporate structures—the common one being through subsidiaries or cross-holdings. The transactions could be circuitous and convoluted. Abusive RPTs have been at the core of many global corporate scandals.
Given the possible benefits from RPTs, no known jurisdiction in the world imposes outright bans on such transactions. Instead, with a view to contain abusive RPTs, regulators worldwide generally prescribe various approval mechanisms and disclosure requirements.
Coming to the Indian scenario, in addition to the issues relating to complex corporate structures and transaction modes, the concentration of ownership of companies with the promoters/promoter groups exacerbate the problem. The promoters/promoter groups of many companies may have varied interests in them, depending inter alia upon their ownership or controlling rights. This could incentivise them to structure RPTs amongst these companies in their own best interests, which may not necessarily be in the interest of some of the participating companies, thereby expropriating the minority shareholders of those companies.
As per a recent Organisation for Economic Co-operation and Development report Company groups in India, on an average, Indian listed companies have more than tripled the number of subsidiaries for the past 15 years and, as on March 2020, listed companies in the NIFTY 50 index have an average number of approximately 50 subsidiaries/step-down subsidiaries. Further, out of all listed companies, there were 15 listed companies that have more than 100 subsidiaries, including wholly-owned subsidiaries and step-down subsidiaries, while a few of them had more than 200 subsidiaries.
With a view to analysing the promoter-holding concentration in listed companies and their income from RPTs, we took a sample of top 100 listed companies in terms of their average market capitalisation during the six months ending December 31, 2022. Excluding the insurance companies, the remaining 95 companies have an average promoter shareholding of around 52%. Only nine companies have promoter holding below 25%. Thirty-nine companies have promoter holding over 60% percent. Many of these companies are grouped together under the common control of a single shareholder or family. Taking into account hundreds of subsidiaries and associate companies of these companies, it is apparent that the same promoter group effectively controls a significantly large number of companies. There are just too many parties related to each other!
Also read: Sailing into choppy waters
For the financial year ending March 31, 2022, 12 companies out of this sample have reported more than 50% of their total income under RPTs, whereas 34 companies have reported this proportion to be more than 10%. On an average, more than 16% income is reported under RPTs. This shows the importance of RPTs in these companies’ operations.
The legal provisions concerning RPTs are in the Companies Act 2013 and the Sebi (Listing Obligations and Disclosure Requirements) Regulations 2015. The Income Tax Act 1961 also covers some aspects under the transfer-pricing provisions. Ind AS 24 prescribes the accounting standard for disclosing RPTs.
Sebi (LODR) provisions are perhaps most expansive as compared to the ones under any other statute, and, based on experience gained during enforcement, have been amended on several occasions by the market regulator. The amendment in 2021 expanded the definition of related party; increased the scope of RPTs; revamped the approval mechanism and materiality threshold of RPTs- all RPTs need audit committee approval and all material RPTs require shareholder approval; and excluded all related parties from voting on resolutions for approval of RPTs.
Notwithstanding the stringent norms, the RPTs continue to be arguably one of the most serious corporate governance concerns in India. Curbing the abuse of RPTs cannot just be left to the company management—the other stakeholders need to be much more alert and vigilant. Recent developments in the market structure over the last few years give some hope.
First, the gradual increase in the institutional shareholders holding in companies over period is a positive development. The average institutional shareholding in the sample companies is approximately 32% as on March 31, 2022. Many of these institutions are also represented on the companies’ boards. Their increased presence is likely to keep a check on promoters’ misadventures.
Second, the comprehensive stewardship code introduced by Securities and Exchange Board of India (Sebi) for mutual funds and AIFs in the year 2019, followed by a directive in March 2021 to compulsorily vote on board resolutions, is gradually improving these institutions’ involvement in corporate governance. IRDAI and PFRDA have issued similar codes for their regulated entities.
Third, the regulations relating to appointment, removal and role of independent directors; constitution and functioning of audit committees of companies’ boards have been much revamped following the Kotak Committee report of 2017. Independent directors and audit committees have important gatekeeper role to watch the interests of minority shareholders.
Lastly, the Sebi-registered proxy advisers have become quite active in making appropriate voting recommendations on companies’ resolutions including the ones seeking the approval of RPTs.
In conclusion, containing abusive RPTs continues to be challenging, requiring constant vigil from the regulator and other stakeholders.
Writers are respectively, former chairman, Sebi, and professor, NISM