India’s regulators are recognising that appropriate checks and balances in relation to related party transactions are crucial for good governance, and are improving safeguards and disclosures pertaining to them
Related party transactions (RPTs) has been an area that has received considerable attention in India and across the globe. Significant corporate frauds have happened connected to RPTs or similar arrangements, such as the Satyam scandal, Enron fiasco and WorldCom débâcle, to name a few. In India, RPTs assume even more significance due to the nature of Indian business houses, which are primarily promoter-led and consist of family business structures. Discussion on RPTs also brings to light corporate governance issues, such as the duties of directors to act in good faith and in a fair and transparent manner individually, which runs in parallel with the authority vested upon them to regulate the affairs of the company in a collective manner. Directors have an obligation to ensure that while acting for the company, there is no conflict between their duty to act in the best interests of the company and their own personal interests. Directors must not use an asset of the company, or any information pertaining to the company, for their personal gain.
The legal regime related to RPTs has constantly evolved with recommendations from various government committees, starting from the Bhabha Committee Report (1952) and JJ Irani Committee Report (2005) to the Companies Law Committee Report (2016). The recommendations made by the Companies Law Committee have been largely reflected in the Companies Amendment Act, 2017 (CA 2017). It is an opportune time to discuss some grey areas and issues that regularly arise in relation to the RPT regime and analyse the implications of CA 2017 to this regime. The JJ Irani Committee had deliberated whether transactions in which directors or their relatives are interested or arrangements that can be broadly classified as RPTs are to be regulated through a government approval process or through a Board-cum-shareholder approval process. After examining at length international best practices, the Irani Committee felt that RPTs should be governed by a mere Board/shareholder approval process. This is reflected in the Companies Act 2013 (CA 2013), which prescribes that Board approval would be required for transactions that are not in the ordinary course of business; or for transactions that are in the ordinary course of business, but not at arm’s length. The phrase “ordinary course of business” is not specifically defined under CA 2013. The Companies Law Committee had received suggestions to clarify the definition of this term. In its report, it observed that the definition of this term would vary on a case-to-case basis and would be difficult to define it in a precise manner. It was rather stated that it had to be understood as per general commercial parlance and accounting guidance available in relation to it. Therefore, transactions in the ordinary course of business may constitute those that are undertaken as part of customary business practices of the company.
The Allahabad High Court has observed that for a transaction to be construed to have occurred in the regular course/usual course of business, there must be “an element of continuity and habit for it to constitute the exercise of a profession and business.” The frequency of transactions over a period of time should not be the only criterion and it cannot be restricted to the core business activities of a company alone. Support services that do not form part of the main core activity of a business, but are nevertheless necessary and ancillary for running the core business, can also be considered as transactions that happen during the ordinary course of business. Given the above and the lack of any specific guidance, the determination of a transaction being in the ordinary course of business would depend upon the examination and scrutiny of facts of each case and with the nature of business and market practice in relation to it. The Companies Law Committee has also recommended that the Institute of Chartered Accountants of India (ICAI) should come out with a detailed guidance in relation to this. Currently, the ICAI has only provided some examples and guidance in relation to transactions that should not be considered as falling within the ambit of ordinary course of business activity of a company.
The phrase “arm’s length transaction” has been currently defined in a very broad manner, under CA 2013, to mean “a transaction between two related parties that is conducted as if they are unrelated, so that there is no conflict of interest.” The transfer pricing provisions under the Income-tax Act, 1961, define arm’s length price as “a price that is applied or is proposed to be applied to transactions in uncontrolled conditions between persons other than associated enterprises, in uncontrolled conditions.” The Income-tax Act also provides certain modes for determination of arm’s length pricing, such as comparable uncontrolled pricing method, resale pricing method, cost plus method, profit split method and transactional net margin method. Given the fact that CA 2013 does not specifically provide any method for determination of arm’s length, the methods provided under the Income-tax Act may be resorted to by the parties.
Under the Companies Act, 1956, loans made to or security provided or guarantee given in connection with loan given to the director of the lending company or specified parties required prior approval from the central government. CA 2013 altered this position. Section 185 of CA 2013 provided an almost blanket restriction by imposing a total prohibition on companies providing loans, guarantee or security to the director or any other person in whom the director is interested. This proved to be an impediment and affected the ability of companies to access funds. Faced with significant criticism, the ministry of corporate affairs exempted the applicability of this provision to private companies subject to compliance of certain conditions, such as there being no investment in the company from any other body corporate, no borrowing from any banks, financial institutions or any body corporate greater than twice its paid up share capital or `50 crore, whichever is lower, and there is no default in repayment of such borrowings subsisting at the time of making such transactions under Section 185.
CA 2017 seeks to liberalise the regime and should facilitate business interests. It merely restricts and prohibits lending only to certain individuals and firms. Further, the prohibition on lending to companies and body corporates (in which any such director is interested) has been removed subject to fulfilment of certain conditions, such as a special resolution being passed by the shareholders in a general meeting and the loans being utilised by the borrowing company for its principal business activities. The Listing Obligations and Disclosure Requirements formulated by Sebi mandate listed entities to formulate a policy on materiality of RPTs and on dealing with RPTs. The Kotak Committee reviewed the provision in relation to materiality policy and observed that the regulations currently do not spell any threshold limits for determining materiality and, therefore, enforcement in such cases becomes difficult. It has been recommended that clear threshold limits, as considered appropriate by the Board of Directors, should be disclosed in the materiality policy. Further, such threshold limits are required to be regularly reviewed and updated once every three years.
Globally also, in many jurisdictions, the Board is considered responsible for making decisions and approvals pertaining to RPTs and sometimes a shareholder approval is brought in to complement such a framework. As seen from above, India’s regulators are mindful and are recognising that appropriate checks and balances in relation to RPTs are crucial for good governance and are improving safeguards and disclosures pertaining to them.
Bharat Anand and Satish Padhi
Anand is partner and Padhi is associate, Khaitan and Co.
Views are personal