UNDERSTANDING RELATED PARTY TRANSACTIONS UNDER COMPANIES ACT
“Law cannot stand
still, it must change with the changing social
concepts and values.”
- Yeshwant Vishnu Chandrachud, Former
Chief Justice of India
INTRODUCTION
Law is
promulgated to serve as a yardstick, govern the balance of power and
responsibility, address the needs and to augment the vision of the investors
with the principles and activities of a company. The Supreme Court of India in
the case of “Chiranjit Lal Chowdhuri vs. Union of India & Ors. (1950)” remarked
that “It must be presumed that a
legislation understands and correctly appreciates the need of its own people,
that its laws are directed to the problems that are manifested by experience.” While
the law shields the owners whose wealth is used in the process of business, the
accountability and transparency from the management has always been lens.
The
inherent value of any company lies in the best of the ability to which the real
owners of the business are able to leverage the agents who preside over the
regular affairs of the company. The duty of the agents is embodied as to cater,
promote, protect and do any such activity in the best interest of the
shareholders of the company whose investment in the legally recognised
structure is being used. The Hyderabad bench of the Income Tax Appellate
Tribunal in the case of “National Mineral Development Corporation
Limited vs. DCIT, Circle-16(1) (2017)” contemplated that “Investors are becoming more concerned to
invest in companies that act with good corporate governance and social
responsibility.” Increasingly, a company's performance as a responsible business
is key to its financial and stock market standing, helping to protect it from
instability and share price volatility.
INTERPRETATION OF RELATED
PARTY TRANSACTION
In
today’s extremely competitive environment, companies endeavor to ensure their
standing in the market and to expand their customer base. In order to envisage
business survival and continuity, a company has to undertake certain
transactions on a recurring basis or on the basis of needs. These transactions
may be of two different kinds. Firstly, these transactions may be undertaken with
an individual or entity who as on the date of entering such transactions is
affiliated / associated to the company in certain capacity or such individual
or entity has a nexus with the company. Secondly, these transactions may be
also undertaken with an individual who is totally unknown to the company as on
the date of such transaction.
Those
transactions which are undertaken with the individuals or entities who have
some affiliation or are associated with the company in some capacity are
reckoned as “Related Party Transactions
(RPT)”. These individuals or entities with whom the transactions are done
with are known as ‘related parties’. The Securities Appellate Tribunal in the
case of “J.M.Financial Asset Reconstruction Co. Ltd vs. SEBI (2019)” contemplated
that “The regulator has defined the
concept of related party transaction with respect to Section 188 of the
Companies Act, 2013 as ‘transaction of a specific company with a related
party.’” Simply to put forth, related party transactions imply transfer of
resources for consideration between a company and an individual or entity
recognised as ‘related party’ under law.
POSITION IN THE STATUTE
There
are sharp differences observed between the two statues which are instilled for
the governance of the companies domiciled in India. The Companies Act, 1956 did
not comprehend the concept of related party i.e. in other words, the erstwhile
law did not contain salient distinction on who was a related party and who was
not. The erstwhile act also did not distinctively outline the rationale behind
related party transactions and suffered from lucidity. The Bombay High Court in
the case of “Ramaben A. Thanawala vs. Jyoti Ltd. and Ors. (1956)” while
remarking on the construction of the Companies Act, 1956 held that “It seems to us unfortunate that a law which
is intended to help in the development of companies in our country and also to put
down abuses which were noticed in the working of companies and especially in
the institution of the managing agency which is peculiar to our country, should
have been couched in clear and more precise language.”
However,
Companies Act, 2013 specifically defines related party and comprehensively
enlists provisions pertaining to related party transactions. Section 2(76) of
the Companies Act, 2013 enlist the definition of related party and Section 188
of the Companies Act, 2013 signify the provision pertaining to related party
transactions.
RELATED PARTY – FROM
STATUTORY STANDPOINT
It
is imperative to understand the position and persona behind the cloth of the
term reckoned as ‘related party’. Section 2(76) outlines who related parties
are with respect to a company. The Bangalore Bench of Income Tax Appellate
Tribunal in the case of “DCIT vs. M/s. EMC Software and Services
(India) Private Limited (2019)” postulated that “Related Party" is defined u/s.2 (76) of the Companies Act,
2013, as under:
"Related party",
with reference to a company, means-
(i) A director or his
relative; (ii) A key managerial
personnel or his relative; (iii) A
firm, in which a director, manager or his relative is a partner; (iv) A private company in which a
director or manager or his relative is a member or Director; (v) A public company in which a director
or manager is a director and holds along with his relatives, more than two per
cent of its paid-up share capital; (vi)
Any body corporate whose board of directors, managing director or manager is
accustomed to act in accordance with the advice, directions or instructions of
a director or manager ; (vii) Any
person on whose advice, directions or instructions a director or manager is
accustomed to act; (viii) Any body
corporate which is-
(A) A holding,
subsidiary or an associate company of such company; or
(B) A subsidiary of a
holding company to which it is also a subsidiary;
(ix) As per Rule 3 of The
Companies (Specification of Definitions Details) Rules, 2014 a director or key
managerial personnel or his relative of holding company shall be deemed to be a
related party to a company.
Section 2(77) of the
Companies Act, 2013 defines ‘relative’:
"Relative",
with reference to any person, means any one who is related to another, if—
(i) They are members of
a Hindu Undivided Family; (ii) They
are husband and wife; or (iii) As
per Rule 4 of The Companies (Specification of Definitions Details) Rules, 2014,
A person shall be deemed to be the relative of another, if he or she is related
to another in the following manner, namely:-
(a) Father including
step father; (b) Mother including
step mother; (c) Son including step
son; (d) Son’s wife; (e) Daughter; (f) Daughter’s husband; (g)
Brother including step brother; (h)
Sister including step sister.
INTERPRETATION OF THE POSITION OF RELATED PARTY
It
is of importance to understand that specific transactions as enshrined under
the Companies Act, 2013 with any individual or entity would not amount to
related party transaction. There should be sufficient nexus proved by the
virtue of the position of such individuals or entities to the company with
which they would transact. In other words, the position of related party is to
be determined if the individual or entity is able to influence business
transactions by the virtue of his/her position as enlisted under Section 2(76)
of the Companies Act, 2013. The critical aspect to observe is the capacity of
the person in connection to the company. Business relationship by the virtue of
positions as stated under Section 2(76) of the Companies Act, 2013 is the most
essential ingredient to determine whether a transaction is related party
transaction or not. The Bombay High Court in the case of “Ralliwolf Ltd. vs. Union of
India (1992)” opined that “Related
person means a person who is associated with the company that they have
interest, directly or indirectly, in the business of each other and includes a
holding company, a subsidiary company, a relative of such person.” It
becomes imperative to chalk out the interest of the individual or entity with
the company with whom transactions are proposed.
THE
SPECIFIED TRANSACTIONS
It
is imperative to understand that all transactions with related parties need not
be related party transactions but whereas all related party transactions are
necessarily transactions with related parties as specified by the legislation.
Section 188 of the Companies Act, 2013 enlist certain transactions that would
construed as transaction with related party. Section 188 places emphasis on the
words ‘contract or arrangement’ in relation to transactions with related
parties. It must be observed that these words are used inter-changeably and not
together. The contract denotes contractual relationship where the company is a
party to the obligation to be performed against the act of a related party. The
word contract is of much wider interpretation than an arrangement. The Calcutta
High Court in the case of “Anath Bandhu Deb vs. Dominion of India (1955)”
coined the definition of contract as “Section 2(h)
of Contract Act, describes an agreement not enforceable by law to be void
and an agreement enforceable by law to be contract.” The
statutory books have recognised that a contract is necessarily enforceable by
law. But whereas, the concept of arrangement has a different interpretation. The
Pune bench of Income Tax Appellate Tribunal in the case of “ACIT vs. Persistent Systems Pvt.
Ltd. (2019)” opined that “The
term arrangement means any agreement or understanding between the parties
concerned.” A much wider interpretation for arrangement was found in the
case of “K.V. Kuppa Raju and Ors. vs. Government Of India and Ors. (1999)” where
the Karnataka High Court remarked that “Arrangement
means any scheme, trust, grant, understanding, covenant, agreement,
disposition, transaction and includes all steps by which it is carried into
effect.” Thus it is pertinent to note that contracts are legally binding by
law but whereas arrangements need not be necessarily be enforceable by law as
they also arise out of mutual understanding.
Section
188(1) enlist the following transactions with related parties that would come
under the cloud of related party transactions:
(a)
sale, purchase or supply of any goods or materials;
(b) selling or otherwise disposing of, or buying, property of any kind;
(c) leasing of property of any kind;
(d) availing or rendering of any services;
(e) appointment of any agent for purchase or sale of goods, materials, services or property;
(f) such related party's appointment to any office or place of profit in the company, its subsidiary company or associate company; and
(b) selling or otherwise disposing of, or buying, property of any kind;
(c) leasing of property of any kind;
(d) availing or rendering of any services;
(e) appointment of any agent for purchase or sale of goods, materials, services or property;
(f) such related party's appointment to any office or place of profit in the company, its subsidiary company or associate company; and
(g) Underwriting the
subscription of any securities or derivatives thereof, of the company.
These
transactions are directly attributable to related party transactions if entered
with related parties. There are though some transactions that would not be
directly attribute to be related party transaction that is to say there are not
forming part of list under Section 188 but are governed through some other
sections. These are also related party transactions but not directly
attributable under Section 188. One such instance could be perhaps loans to
entities to which directors are interested in under Section 185 of the
Companies Act, 2013. Interested entities are to be interpreted as to the
private companies in which the director of the company is a director or a
member.
APPROVAL MECHANISM
The
provisions of Section 188 mandate that the approval of board of directors shall
be required only in cases where the transactions as listed above are not in
arm’s length basis and not in ordinary course of business. If a transaction
does contain the above-mentioned two ingredients i.e. being at arm’s length and
performed in ordinary course of business, then the approval from the board of
directors is voluntary in nature. Rule 15 of the Companies (Meeting of Board
and its Power), Rules 2014 stipulates certain thresholds, wherein when the
value of transactions as mentioned under Section 188(1) exceed the thresholds
as mentioned under Rule 15 then those transactions would necessitate
shareholder’s approval in form of a special resolution.
Practically,
it is slightly difficult to determine the difference between a transaction
undertaken at ordinary course of business and a transaction which would be
undertaken on requirement basis. Reliance could be placed in the case of “Peddi
Virayya vs. Doppalapudi Subba Rao and Anr. (1957)” where the Andhra
High Court held that “The expression
"in the ordinary course of business" is susceptible of
one meaning viz., that there should be a series of transactions as
distinguished from one transaction.” It could be perhaps interpreted that to
constitute a related party transaction to be in ordinary course of business,
such transactions should be recurring in nature and should be taken in
cognizance with the objects as enshrined in the Memorandum of Association.
Coming to the second ingredient of “Arm’s length price”, the rationale behind
granting relief from approval is to make companies look and prove that the
transactions with related party stand on equal footing with an individual or
entity who is not a related party with the company. In simple term, Arm’s
length price could be termed as the consideration that would be paid with
respect to a transaction to a related party as if the same would be paid to an
unrelated party if the transaction is undertaken with such unrelated party. In
other sense, arm’s length price could be termed as the fair price paid. This
was reiterated by the Punjab-Haryana High Court in the case of “M/s.
Coca Cola India Inc. vs. Assistant Commissioner of Income Tax (2008)” where
the court stated that “Arm's length price
is nothing but a fair price which would have been normal price.”
However, it would be pertinent to note that
perhaps the concept of arm’s length under Income Tax Act is not the appropriate
meaning to be taken in conscience with the provisions of the Companies Act,
2013 as the object of the statutes are different. Thus if a related party
transaction is at arm’s length basis and in the ordinary course of business,
then the approval for such transaction is not mandatory but the power is
delegated to the company on voluntary basis. The Madras High Court in the case
of “Unknown
vs. The Registrar of Companies (2017)” opined that “Accordingly, as per the proviso of Section 188(1) of CA 2013, the
section would not apply to arm's length transactions in the ordinary course of
business.”
IMPLICATION OF RELATED PARTY
TRANSACTIONS
The
most important part of any concept is its potential implication. Related party
transactions are to be critically observed. In the absence of the approval
mechanism, it is highly possible that related party transactions can prove
detrimental to the interest of the shareholders and the company. It is very
important to maintain the control over related party transactions at a
transaction level than to look at related party transactions as a disclosure
obligation. The Bangalore Bench of Income tax Appellate Tribunal in the case of
“DCIT
vs. M/s. Radisys India Private Ltd. (2017)” has come out to opine a
different interpretation with respect to related party transaction as “the term related party transaction is of
wider importance and it is working on transaction level instead of managing
control level under the Companies Act, 2013.” Related party
transactions are not barred by the law but confides a legal obligation to
undertake such transactions in the best interest of the owners and the company.
There is an obvious impact on the market position of the company on the advent
of related party transactions. Related party transactions if not handled in the
right way can prove dangerous to the health of the company.
Over
the period of time, the veil of corporate persona had pave way for the agents
to mismanage entities and inflate numerical figures that the investors rely
upon for measuring the performance of the entity as a whole. This affects the
investors who are the prime stakeholders. The Supreme Court of India in the
case of “Delhi Cloth and General Mills, Etc. vs. Union of India (1983)” postulated
that “the shareholders' rights are
equally and necessarily affected if the rights of the company are
affected.” The board of directors are duty bound to administer the affairs
of a company in a proper way that would channelize and align the business
objectives with shareholder’s interest. The Calcutta High Court in the case of “ITC
Limited vs. JP Morgan Mutual Fund India Private Limited (2018)” held
that “Board of Directors are under a duty
of care to protect the investments of the investors and exercise due care and
skill in managing such investments.” Therefore the individuals dealing with
the affairs of the company shall make use of the owner’s wealth in an optimum
way that would curtail all possible foreseeable business losses.
But
the question always arises, whether personal pursuits could be placed over
business objectives. India has seen series of cases which had served as
catalyst to the regulators to impose more stringent norms and to make the
agents more accountable and transparent to the owners. Onus is placed on the
conduct of the individuals occupying positions in the management which prompts
these individuals to dress up the documents presented to the shareholders in
order for personal pursuits. It is very evident in the case of “V.S.
Ramaswamy Iyer and Anr. vs. Brahmayya & Co., Official (1965)” where
the Madras High Court contemplated the position of Directors as "One must have regard to
the position of directors of a company. It is said they are
not trustees. Answering that objection in general, we should say they are
trustees and nothing else. They have interests of their own, but they are
trustees of the money which may be collected by subscriptions, and of all the
property that may be acquired ; they have the direction and management of that
property, and at the same time they have incurred direct obligation to the
persons who have so entrusted them with their money."
Though
several decades have passed by, the autonomy of shareholders by the virtue of
their investment into a corporate structure has been put through
interpretations and the law has firmly recognised that the owners possess an
inherent right in the business management by the virtue of their holding. The
Delhi bench of Income Tax Appellate Tribunal in the case of “H.K.
Mittal vs. Assistant Commissioner of Income Tax (1994)” held that “A shareholder so registered and
so recognised by a company, obtains a valuable right which he can exercise,
because, he becomes one of the several owners of the company. The various
powers which a shareholder can exercise for the company or against
the company are bundled rights that accompany the shares registered in his
favour.” Shareholders should ensure that the deployment of their funds are
being utilised in the right manner to ensure optimum results to the other
co-owners. The Company Law Board in the case of “Central Government vs. Sterling
Holiday Resorts (India) Limited (2005)” stated that “It shall be borne in mind that for carrying
out the objects to safeguard the interests of the Company, it must be ensured
that the shareholders are given a reasonable return.”
Especially
in the cases of closely held companies, shareholders who hold majority stake in
the company and are connected to the management should ensure that the voice of
the minority shareholders are taken into consideration to be devoid of any
transaction that would be detrimental to the interest of the company. Again
normal business activities cannot be termed as oppressive against the interest
of the minority shareholders and the company. There must be continuous acts on
the part of the majority shareholders, recurring again and again, showing
that the affairs of the company were being conducted in a manner oppressive or
prejudial to minority shareholders and the company. The Gujarat High Court in
the case of “Mohanlal Ganpatram vs. Shri Sayaji Jubilee Cotton and Jute Mills
Limited (1964)” opined that “Shareholders
must exercise their rights in the best possible way to cater the interest of
the company as a whole. There may be transactions effected by the
directors and the controlling shareholders with a view to giving
preference to the directors and their relatives over the other minority holders
and that is therefore, oppressive to the minority shareholders and
prejudicial to the interests of the company.” In the case of “H.L
Botton Engineering Co. Ltd. vs. T.J. Graham & Sons (1957)” Lord
Denning categorically remarked that “The
Directors and manager represent the directing mind or will of the company. The
state of mind is the mind of the company.” The management position enjoyed
is not limited to directors but also other individuals designated as Managing
Director, Chief Executive Officer, Chief Financial Officer etc. who are in the
position of influence a business transaction to derive the maximum benefit in
order of personal pursuit. So management positions are often stimulated to
misled the investors and enjoy profitability out of business transactions. Thus,
the value of business serves as the window of opportunity for the individuals
occupying positions in the company and also certain shareholders to malign the
interest of the investors and to derive advantages using business opportunities
which are postulated to be enhancing the business value.
Related
parties are able to derive benefits through repetitive transactions with the
company. The position of related parties enables them to influence the pricing
terms and other conditions that would be more stringent if such transaction is
undertaken with a third party. This price manipulation results in eroding the
wealth of the owners and such investment made in the company by the investors gets
ended up in the hands of the related parties. Truth be told, the related party
transactions do not get the notice of the investors until the financial
statements and Board’s report is sent to the shareholders where the company is
obliged to make mandatory disclosure. The blanket of corporate veil entails the
related parties to undertake transactions with the company and accumulate the
wealth of the company in their hands. The essence is that the company through
repetitive transactions paints a portrait that the company is actively
undertaking business activities but the reality is such that those transactions
with related parties are undertaken at a favourable pricing conditions such
that the wealth of the company is taken out and is bestowed in the hands of the
related parties. The end result is such that the wealth of the company gets
depleted and the financial position of the company is window dressed. The true
financial figures do not get to the eyes of the members but a different projection
is made on the basis of the conditions entered for each transaction with the
related parties. In simple, if control, transparency and disclosure over
related party transaction is not maintained, then it could result in mismanagement
of funds or “Siphoning of funds”.
Reliance
could be placed in the case of “Ramesh Kumar Sareen vs. Union of India
(2016)” to understand the term siphoning of funds. The Delhi High Court
in the said case contemplated that “The
term siphoning of funds imply the utilisation of funds for the purposes other
than sanctioned by the owners and transferring thereof to subsidiaries/group
companies or known individuals or routing thereof to other investments, showing
an element of illegally enriching therefrom.” In the due course of
building the value of business, the opportunity is seized by individuals or
entities in influential position to deter from the achieving the business
objectives of the organization.
THE VISION FORWARD
The
National Company Law Appellate Tribunal in the case of “Parag Gupta & Associates vs
B.K. Educational Services Pvt. Ltd. (2017)” postulated that “The law must ensure that all key
stakeholders will participate to collectively assess business viability.”
This statement is of utmost importance. If the control over related party
transactions at the transaction level is maintained then the entity can endure to
prevent cases like the Enron Debacle, the Kingfisher Saga, the Indigo crisis etc.
This is where the role of the Audit committee is extremely crucial. The audit
committee should draw a line between the personal interest of the members and
that off the company. Recognising related party transaction alone would not
amount to the violation of law. There has to be an element of direct benefit
that accrues to a related party which would not have been arisen if the
transaction had been with an unrelated party. This was reiterated by the Jaipur
bench of Income Tax Appellate Tribunal in the case of “Deputy Commissioner of Income
Tax vs. M/s Shri Ramdoot Prasad Sewa Samiti Trust (2020)” where
the court opined that “Only when it is
found that the company has given undue benefit to the related party then it
would amount to violation of law.”
A
post mortem analysis of the impact would make no difference as the value of the
company would have already been eroded. A system of checks and balances ought
to be implemented for related party transactions. Making board approval
mandatory cannot be the solution to this. The Kerala High Court in the case of “Mukkattukara
Catholic Co. Ltd. vs. H.V. Thomas and Ors. (1995)” categorically
remarked that “A director of a company
stands in a fiduciary position towards the company and is bound to protect its
interest. He must not place himself in a position in which his personal
interest conflicts with his duty.” This position is not only limited
to directors but also for the key managerial personnel, CFO, CEO and other
individuals at the management level. This position is not limited to fiduciary
but also extends to accountability and transparency to the owners. This is
pertinent reason for the disclosure of interest of directors in Form MBP-1 to
the Board of directors to signify in the event of any transaction with such
entities, the board should immediately resort to an appropriate measure to curb
any undue benefit to the related party. This however is not the case when a
related party is an individual that too concerning the large volume of trade
which a company undertakes. A company thus has to get a list of related parties
whether be it individual or entities and keep a track of such transactions and
also review the same at every board meeting. Stringent measures are the need
the hour to bring out the true value of business. A report has to be presented
by a delegated authority to the board at every meeting indicating the value,
conditions and impact of related party transactions and also the company should
consider adequate parameters such as pricing and conditions in the market by
other companies before undertaking transactions with related parties.
It
doesn’t end there, shareholders must be given the autonomy to participate full-fledged
in the management of affairs. They must be given the autonomy to ratify the
related party transactions on mandatory basis once in a half year. In such way
the company would effectively involve the inclusiveness of the owners in the
business thereby ensuring reduced mismanagement actions by the agents. The
Mumbai bench of Income Tax Appellate Tribunal in the case of “Rohiniben
Trust vs. Income-Tax Officer (1985)” held that “A share in a company represents the right of participation in the
capital as also other necessary rights in the management which a shareholder enjoys in a limited liability company.” The
regulator on the other hand should invoke the mandatory disclosure of related party
transactions and the list of related parties on a regular intervals. For the
purpose of the same, the Ministry of Corporate Affairs (‘MCA’) should deploy a
form and mandate a form based disclosure by the companies in respect of related
party transactions and list of related parties on a half yearly basis to start
with. Prevention is better than cure, such prevention of inappropriate
practices concerning related party transactions can be curbed at every single
level of hierarchy starting from the shareholders to the directors to the
company as a whole. While the position of listed entities and companies differ
as enshrined under SEBI Regulations and Accounting standards with the
provisions of Companies Act, 2013, it is imperative to deploy certain
additional regulations to curb the intention of undue benefit substantially.
CONCLUDING REMARKS
“If you think compliance is costly, try
non-compliance.” This is an understatement. The sense of
oneness with the company and its benefit should be articulated in every single
individual at the management level and also in every individual. Maintenance of
transparency and also keeping the interest of the company at the forefront can
remove the clouds of uncertainty over business failure and enriching the
credibility of the company. The true business value is not in transaction but
in intention. Related party transactions if not channelized properly could have
dastardly effects. The Bombay High Court in the case of “Snowcem India Ltd. and Ors. vs.
Union Of India (2004)” had rightly pointed out that “Transparency in the functioning of the
company would lead to the protection of the investment of investors and better
corporate governance.”
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Found the article useful. Case laws referred in the Article are relevant and informatory.
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