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Related-Party Transactions: New Framework from April 2022

The regime for RPTs has undergone an overhaul from 1 April 2022. The new regime is widening its ambit to enhance transparency, accountability and to protect minority shareholders in large corporates.

Related-Party Transactions or RPTs are deals or arrangements that are carried out by two parties connected with a pre-existing business relationship or some common interest. Such deals are often sought after, since many parties are comfortable with familiarity and tend to strike deals with those having a similar or common interest.

Though such deals and transactions are frequent and completely legal, they often create convoluted conflicts of interest that, in turn, may lead to illegalities. Thus, public companies are mandated to disclose such transactions and deals, as and when they are struck. If unchecked, such transactions often lead to fraud, money laundering, and eventually, financial ruin for those involved.
 

Background to the new framework


In November 2019, before the onset of the COVID-19 pandemic, the Securities & Exchange Board of India (SEBI) constituted a working SEBI panel to review and recommend changes pertaining to RPTs in India. Number of changes were put forth by the panel to overhaul the corporate governance of RPTs and to ensure that a wider range of transactions are covered under the RPT regime. These recommendations included additions/changes to ‘related party’ and ‘related party transaction’ definitions under the SEBI (Listing Obligations & Disclosure Requirements) Regulations, 2015 (hereinafter the ‘LODR’).
 

Why must one disclose RPTs?


Disclosures of RPTs are required, firstly, because it is mandated by statutes to maintain financial statements. It is a legal obligation and responsibility to disclose all possible transactions, whether RPTs or not. If RPTs are not disclosed, the presumption in financial statements is that the transactions(s) are on an ‘arm’s length basis’, i.e. the transaction occurs between two unrelated parties, unaffected by any relationship. Any RPT brings about a change and influence on the operating results of the enterprise. A mere existence of a relation, without any transactions, can explain why a transaction is the way it is and explains its nature.
 

What are the legal compliances for RPTs?


With respect to RPTs, Section 2(76) of The Companies Act 2013 defines ‘related party’ with reference to any company entering in such transaction. Section 2(77) further defines the term ‘relative’ in reference to any person who may be related to any other such person. For example, members of a Hindu Undivided Family (HUF), spousal relation, or any other such relation as may be prescribed by the statute under this provision.

Section 2(76) and 2(77) are read in tandem with Section 188 of the Act to govern RPTs in India. The section provides a series of exceptions for the corporate governance and procedural aspects of RPTs. The Companies Act, in general, stipulates that shareholders’ approval be sought for any transactions ‘not in the ordinary course of business’ and at arm’s length basis. The Securities and Exchange Board of India (Listing Obligations & Disclosure Requirements Regulations, 2015 [SEBI (LODR)], Regulation 23, governs RPTs and their procedural working, in addition with The Companies Act, 2013.  This regulation gives powers to the audit committee, with 23(2) stating that no RPTs can proceed without prior approval of the audit committee, whether in ordinary course of business or not, and regardless of arm’s length basis. 23(3) lays down conditions for the audit committee to consider before passing an order for the execution of the RPT. Along with the consent of the audit committee, 23(4) demands approval of shareholders via resolution (minus the related party votes) for a RPT to go through.

Additionally, the Accounting Standards (AS) of the Institute of Chartered Accountants of India (ICAI) also plays a hand in the corporate governance in India. In this regard, AS 18 requires for the disclosure of related-party transactions and transactions between a reporting enterprise and its related parties. This standard is applicable to the financial statements of reporting enterprises and the consolidated financial statement of the holding company. AS 18 defines ‘related party’ as one party having the ability to: (i) control the other party and (ii) exercising influence over another party in terms of financials and/or operating decisions. Control may be exerted through excess of 50% voting power, control over composition of board of directors, or directing financial aid or operating policies on behalf of the enterprise.

Under the Companies Act 2013, a ‘related party’ is exempted from voting on shareholders’ resolution if the transaction involves any such member/company who is a related party. However, in cases where 90% of such members are relatives or promoters or related parties to the transaction, such exclusion from voting is not applicable. Under SEBI (LODR), all related parties are excluded from voting rights at the shareholder approval stage, irrespective of the nature or involvement of a related party to the transaction.
 

Why have the changes been proposed?


Given the roles of promoter-driven and closely held companies in the country, the risk of exploitation and circumvention of applicable regulations via RPTs, and the consequential financial loss of value in a listed entity, is widespread. Shareholders and promoters tend to use RPTs for personal gain. Interlinks in shareholding, operations and management have immense potential for misuse by those in control. This is harmful for the public shareholding and the overall financial security of the country. The recent scam of IL&FS had RPTs at its core and highlighted the current framework’s inability to catch wrongdoers in time; the case had huge misuse of subsidiaries and faults in transfer of assets.

An increase in the scope of RPTs was required to ensure that listed companies are deterred from using innovative new structures to classify transactions as RPTs and avoid associated regulations, compliances and disclosure requirements. The panel proposed widening the definition of ‘related parties’ to keep a check on unrelated parties who are present in transaction only as ‘dummies’ or for namesake. In such cases, it is imperative that the corporate veil is lifted and the actual beneficiaries from the transaction are traced to the shareholders, promoters, executives, etc. This nexus may be direct or indirect, past or present, but it is the duty of any company to scrutinize and disclose it as far as possible.
 

Changes in RPTs governance


Following are the significant changes proposed by the panel on RPTs:

Widening the ambit of ‘related parties’


The biggest change proposed by the panel is widening the definition of ‘related party’ under SEBI (LODR). It is suggested that all persons who act as promoter(s) of a listed company be considered as ‘related parties’ of such listed entity, regardless of their shareholding percentage. As per the existing regulation, a promoter is held as a related party only if they possess 20% or more stake in such listed entity. The recommendation goes beyond shareholding capacity and understands that promoters may wield significant control and influence over the decision making of a listed entity. Additionally, any non-promoter, who has a shareholding of 20% or more of the total equity shareholding, whether directly or indirectly, and including holdings with their relatives, will be considered as related parties. 20% or more shareholding is seen as wielding ‘significant influence’ over the operations of the listed entity. This would be applicable from 1 April 2023.
 

Widening the range of transactions regulated by RPT norms


The panel has further proposed that any transactions undertaken by subsidiaries of a listed entity, whether directly or indirectly, with the intention and knowledge of it benefitting related parties, must be brought under the regulatory ambit applicable to RPTs. Any transaction between a listed entity or its subsidiary and a related party or its subsidiary must be included within the definition. This is a change from the current scenario wherein RPTs included only transactions between a listed entity and its related party. The current regime mandates no approval by a listed entity for any transaction involving a subsidiary of a listed company, or by a related party of a subsidiary.
 

Material Related Party Transaction changes


Material Related Party transactions are defined as transactions with related parties where those entering into the transaction, individually or in combination, exceeds 10% of Annual Consolidated Turnover with previous transactions (Regulation 23, LODR). The proposed change is to consider transaction as materially related if the consideration exceeds 1,000 Cr or 5% of the annual total revenue/net worth. Such a transaction, however, needs to be approved by the shareholders. With this change, the burden of compliance on shareholders increases as they will be under intense scrutiny in case of any mishap/default.
 

Audit Committee


The current regulation, Regulation 18 of LODR, mandates that listed entities provide information to the audit committee. However, it is completely silent on the type/kind of information that needs to be provided. The panel, consequently, has listed out a new format that specifies the nature of the information that must be provided to the audit committee when seeking approval for RPTs. Besides this recommendation, it is further suggested that parties involved in the transaction disclose the precise time within which the transaction would be completed.  It is believed that this information will help avoid any concealment of information by parties undertaking the transaction. Independent company directors will be on the committee.
 

Shareholder Approval


Pursuant to the amendments proposed, RPTs will now require approval of shareholders, including modifications suggested by the audit committee, on transactions with a value equivalent to the lower of: (i) INR 1,000 Cr and (ii) 10% of the consolidated annual turnover of the listed entity, with effect from 1 April 2022. However, such approval is not sought if the subsidiary of the listed entity is a listed entity itself under SEBI LODR. Due to high turnovers, several high value RPTs went unchecked without shareholder approval in the absence of a numerical threshold.
 

Other Disclosures


Listed entities now must disclose details of loans, deposits and inter-corporate deposits with a description on the purpose on the funds and its ultimate beneficiary to the audit committee and shareholders at the time of considering RPT. A justification on how the RPT serves the interests of the listed entity must also be provided.
 

Potential Impact of Changes

  • Expanding the ambit of related parties to include Promoters: Many businesses in India are structured in a manner in which they operate as a single economic unit, with Promoters exercising a large influence over the entire group. Widening of the definition, to unequivocally include Promoters, may have a huge impact on most business as Promoters act at the forefront of transactions. Further, by determining related party via shareholding percentages and including relatives under this umbrella ensures that the panel has aligned its policies with foreign jurisdictions such as the United Kingdom, Italy and Korea, in which shareholding above a certain limit is deemed to be a related party as it is assumed that they wield enough influence in corporate matters of the company.
  • RPTs to go through additional vetting stage: By keeping shareholder boards and audit committees in the loop, RPTs will go through an additional vetting stage before being passed. The centrality of the audit committees is an essential feature of the proposed corporate governance of RPTs. This is evident because the Companies Act and the SEBI (LODR) mandate that directors of companies form majority of the members in audit committees, thereby improving accountability for actions controlled by shareholders that may be detrimental to others.
  • Burdensome procedural compliance: There will be an increase of burden for companies to unambiguously disclose the purpose and effect on transactions, and then to analyse if a transaction falls under the RPT ambit or is beneficial for the related party. This would make procedural compliance more burdensome and cumbersome for shareholding boards, audit committees, and the companies, in general. This is because identification of such transactions requires time and resources, especially if the listed company has multiple subsidiaries.
 

Conclusion


The proposed amendments are a step towards strengthening regulatory norms pertaining to RPTs in India. It is believed that it will enhance corporate governance and help reduce financial ruin of listed entities, especially when traced back to RPTs. The changes would enhance transparency and accountability and would work in favour of minority stakeholders by safeguarding their interests in larger corporates.
By widening the ambit of ‘related  party’ and RPTs, SEBI is ensuring that they have eyes on multiple people involved in related party transactions, especially influential Promoters. Subsidiaries and listed entities now have to be more transparent and disclosure of information is key to ensure regulatory compliance. However, unlisted companies still do not fall under this regime and it remains to be seen how the legislature governs them in order to streamline them with the Companies Act and the SEBI (LODR).

Nonetheless, these changes will bring about a compliance burden and cost, especially on directors who will sit on audit committees to review RPTs. What may further harm efficiency is the lack of a description of ‘tests’ that audit committees can use to determine the nature of transactions. However, once the mechanism is in full flight (post April 2022 and April 2023), answers to certain procedural and substantive questions will flow.
 

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