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Perspective

Good intent, complex detail
While the new law regarding related-party transactions is a welcome step, implementing it will be a challenge

Sai Venkateshwaran

The Companies Act 2013 and the Revised Clause 49 of the Listing Agreement are the latest set of changes introduced by Indian lawmakers and regulators to protect investor interests from the risks of related-party transactions (RPTs). With these changes, the universe of related parties and RPTs has been significantly widened and by introducing a self-governance model, all RPTs now require the prior approval of the audit committee.

Further, as a step to empower minority shareholders, transactions that are not at arm’s length or not in the ordinary course of business or are material (Sebi has defined material as higher than 5% of turnover or 20% of net worth) are required to be put to shareholders’ vote, where a super majority of the minority shareholders have to vote in favour. Therefore, in a 75% promoter-owned company, three-fourths of the 25% minority shareholders will have to vote in favour of the transaction. Sebi requirements are more stringent than those under the Act, covering transactions for which no price is charged and certain previously contracted long-term arrangements. With the new requirements under the Act being effective from April 1, all stakeholders in the corporate ecosystem are grappling with the changed environment and what it means for them. 

Roadblocks

Companies are stumped by the procedural nightmare of collating a list of their related parties and keeping that list updated at all times. The relationships to be monitored extend several levels beyond those immediately connected to the company, such as relatives (including parents, siblings, children and their spouses) of directors or key managerial personnel, firms or companies where such relatives are interested or relatives of directors of a holding company, including those outside India. Getting an audit committee pre-approval for all RPTs is also proving to be impractical when RPTs are undertaken frequently, and this could potentially hamper the day-to-day business operations.

The other nightmare is assessing each transaction — is it at arm’s length and is it in the ordinary course of business? Considering that several stakeholders, including the audit committee, auditors, etc., will be relying on this assessment, there is an increased focus on the adequacy of documentary evidence supporting these assessments. An added complexity in many of these transactions is that some of these are also covered under the tax transfer pricing regulations, where these RPTs are tested for being at arm’s length.

Therefore, companies need to make sure that the stands taken by them for tax and company law purposes are in sync, although the legislative intent behind both these laws are very different — tax looks at making sure that the profit of the Indian entity is not understated, whereas company law looks at the reasonableness to all parties. For some conglomerates and MNCs, this determination is quite challenging when they deal with proprietary materials — say, purchase of specialised raw materials from the parent company, for which there are no comparables or when they decide to use shared services within the group at higher rates, due to commercial and other considerations such as confidentiality or of data privacy. 

Lastly, as companies gear up to put out RPTs to shareholders for their approval, there is a tough balancing act to follow — disclosing enough to ensure that shareholders understand the rationale for the transaction and its pricing but at the same time not disclosing too much, which may give out commercially sensitive information. 

By the rulebook

The onus of approval of RPTs has shifted from management to the audit committee, which is composed largely of independent directors, who have a duty to protect the interests of minority shareholders in particular. Apart from the onus of approval, that of judging whether a transaction is at arm’s length or in the ordinary course of business also rests on the audit committee.

To discharge these responsibilities, the audit committee members have to spend considerable time understanding the basis of each transaction and its pricing and reasonableness, etc. — this involves getting into an almost executive role in the company. The key question that comes to mind is whether one is expecting too much of the independent directors and audit committee and will they be able to do justice to this? Or should they be made responsible only for approving transactions that are out of the ordinary, that is, those that are not at arm’s length or are not in the ordinary course of business? 

Under the new rules, the board of directors gets involved in approving only those transactions that are not in the ordinary course of business or at arm’s length; all others do not need board approval. Therefore, if the audit committee approves the transaction and concludes that they are at arm’s length and in the ordinary course of business, then the MD, CEO and other directors don’t need to approve or be party to the approval of such transactions. One wonders if the intent was to swing the needle to this extent, shifting all responsibility to the independent directors and the audit committee. Perhaps, it would have been ideal to have the MD/CEO/promoter directors take the primary responsibility for the approval of RPTs, with only non-routine transactions being referred to the audit committee; the additional anti-abuse mechanism being with significant penal provisions if minority interests are not balanced or protected by the MD/CEO/promoter directors. 

The new rules also swing shareholder democracy to another level — from a point where controlling or promoter shareholders could pass whatever resolution they wanted to a point where only minority or non-controlling shareholders can vote on RPTs. With this, there is a significant power shift. However, with great power comes great responsibility and minority shareholders need to act more responsibly and in the long-term interests of the company, rather than satiating their short-term self-interest. This is a double-edged sword and any misuse of this power could lead to holding the majority to ransom — greenmailing, for instance — and holding up genuine business transactions. 

Not all clear

There are several areas where the law isn’t entirely clear, leading to implementation challenges. For instance, would a five-year supply arrangement entered into in 2012 and approved under the 1956 Act get grandfathered or does it need to be approved afresh? Or should this arrangement be continuously assessed for being at arm’s length? What happens if the supply terms cease to be at arm’s length in the third year? Also, would shareholder approvals be required for this arrangement or are they required for each purchase order under that arrangement, as each such order constitutes a contract under law? 

Some of the requirements are also impractical — for instance, in a joint-venture company, where all the shareholders are related parties, none of them can vote on such RPTs. The question then remains about the validity of such transactions, in case they can’t get the shareholders’ approval in the manner prescribed under the Companies Act. 

Clause 49 also has some grey areas — it seems to imply that in assessing whether transactions are material, a company has to aggregate all transactions undertaken during the year. For instance, a loan of ₹100 crore, sales of ₹50 crore and purchases of ₹25 crore with the same related party would all need to be aggregated to determine whether the ₹175-crore transaction value is material; this does not seem to make much logical sense, as one is adding apples and oranges.

Similarly, the materiality thresholds seem to apply at a standalone level and not at a consolidated group level, as a result of which transactions that may be immaterial from the group’s perspective may still be referred to shareholders. There also seem to be some loopholes: if an RPT is being undertaken at an unlisted subsidiary level — say, a subsidiary derives all of its sales from transactions with a related party, even if those sales are material to the group as a whole — it may not need to be referred to the listed parent company’s shareholders for approval, which clearly isn’t the intent of the legislation.

Now, as the new government and the MCA set out to review the implementation of the Companies Act and make requisite changes, the following key areas need to be addressed:

Rationalise the list of related parties: The definition of relatives should include only financially dependent relatives, rather than all relationships currently listed. Further, when including directors and key managerial personnel of foreign holding companies, these should restricted to just one level above the Indian company.

Pre-approval of transactions: Audit committee pre-approvals should be made mandatory only for transactions that are not in the ordinary course of business or not at arm’s length, the assessment of which should be the responsibility of the management along with the MD, CEO and directors of the company. 

Shareholder approvals: Only those transactions that also meet the materiality criteria should be referred to shareholders, rather than every single non-routine transaction. In addition, only interested related parties should be precluded from voting at the shareholders’ meeting. 

While the intent of these regulatory changes are welcome in the interests of investor protection, the current rules appear a little excessive and difficult to implement. If some level of practicality is brought in, it is bound to ease conducting business while still helping raise the bar on governance.  

All views expressed are the author's alone and do not necessarily represent the opinions of KPMG

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