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

(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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