Related Party Transactions in India: Recent Amendments & Their Implication on Corporate Governance in India

The Ministry of Corporate Affairs, Government of India, has recently notified the Companies (Meetings of Board and its Powers) Second Amendment Rules, 2019 (“Amendment”), through a notification dated November 18, 2019, for amendment of Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2019 (“Rules”), which provides for the conditions governing contractual arrangements by a company governed by the Companies Act, 2013 (“Act”) with a related party.

This article aims to examine the wider implications of the Amendment on corporate governance and protection of minority shareholders in private companies in India, in context of related party transactions.

Related Party Transactions

Section 2(76) of the Act defines a related party to include the following:

• director or key managerial personnel of the company or of the holding company, or their relative;
• a firm, in which a director, manager or his relative is a partner;
• a private company in which a director or manager or his relative is a member or director;
• a public company in which the director or manager is a director and holds along with his relatives, more than 2% (two percent) of its paid-up share capital;
• 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 of another company;
• any person on whose advice, directions or instructions a director or manager of the company is accustomed to act (not including any advice, directions or instructions given in a professional capacity);
• body corporate which is (i) a holding, subsidiary or an associate company of such company; (ii) a subsidiary of a holding company to which it is also a subsidiary; or
• an investing company or the venturer of a company.

A contract or arrangement undertaken by a company with a related party is termed as a related party transaction. The Act permits companies to undertake specified related party transactions such as sale, purchase, supply of goods or services, sale or leasing of any property, availing or rendering of services etc., subject to consent of the board of directors and fulfilment of conditions laid down in Rule 15 of the Rules. However, these conditions do not apply to related party transactions undertaken in ordinary course of business and on an arm’s length basis.

The Amendment

Rule 15(3) of the Rules specifies the maximum thresholds, beyond which any related party transaction undertaken by a company would require shareholders’ approval. The Amendment provides for decreased thresholds in the following manner:  

Nature of Related Party TransactionsEarlier ThresholdsAmended Thresholds Sale, purchase or supply of any goods or material, directly or through appointment of agent. 10% (ten percent) or more of the turnover of the company or INR 100,00,00,000 (Rupees One Hundred Crore), whichever is lower. 10% (ten percent) or more of the turnover of the company. Selling or disposing of or buying property of any kind, directly or an agent. 10% (ten percent) or more of the net worth of the company or INR 100,00,00,000 (Rupees One Hundred Crore), whichever is lower. 10% (ten percent) of net worth of the company. Leasing of any kind of property 10% (ten percent) or more of the turnover of the company or 10% (ten percent) or more of the net worth of the company or INR 100,00,00,000 (Rupees One Hundred Crore), whichever is lower. 10% (ten percent) or more of the turnover of the company. Availing or rendering of any service, directly or through an agent. 10% (ten percent) or more of the turnover of the company or INR 50,00,00,000 (Rupees Fifty Crore), whichever is lower 10% (ten percent) or more of the turnover of the company

Implications on Corporate Governance

The Amendment aims at alignment of thresholds prescribed under the Act for related party transactions with the materiality thresholds under the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”).  Regulation 23 of the LODR provides that all material related party transactions of a listed entity must be approved by shareholders, with material related party transactions being defined as all transactions which, either individually or together with previous transactions during a  financial year, exceed 10% (ten  percent) of the annual consolidated turnover of the listed entity as per its last audited financial statements. An alignment of the thresholds results in similar treatment of related party transactions by private and public companies in India. However, this could have adverse consequences on rights of minority shareholders in private companies, which are less regulated in comparison to listed entities. For example, for companies having turnover of hundreds of crores, the Amendment results in a scenario whereby shareholder approval may not be even required for most related party transactions, as such transactions would not meet the threshold. As such, minority shareholders would not have any control over a company entering into such transactions. In case of intra-group transactions, or transactions impacting a company’s strategic future, concerns arise such as decreased transparency in transactions undertaken, denial of fair corporate opportunities and corporate self-dealing at the cost of minority shareholders[1].

Further, in case of private companies organised as pyramid ownership structures, wherein a chain of companies are ultimately controlled by a single investor exercising control, related party transactions can result in corporate tunnelling. Corporate tunnelling involves an intentional transfer of resources from a lower level firm in the pyramid structure (aka a subsidiary company) to a higher-level firm (aka the controlling shareholders of the parent company) at a substantially lower value, in order to derive economic value. But this results in losses for shareholders of the subsidiary company in the form of low dividend value[2].

Another concern is an increase in propping activity. Propping happens when the parent company transfers its financial resources to its subsidiaries in order to assist them in financial activities[3]. This could be in the form of providing inter-group corporate loans, corporate guarantees, or creating security upon its own assets in order to secure the facilities availed by its subsidiary.

Conclusion

Related party transactions, therefore, possess the potential of abuse by private companies. In such a scenario, apart from protections provided under the Act, minority shareholders may consider negotiating for contractual protections in order to protect their interests. These protections could be in the form of (a) right to nominate directors on a company’s board of directors, (b) right to appoint an observer to the board, (c) veto rights relating to resolutions proposed at directors and shareholders meetings, and (d) information rights. T

he views and opinions expressed in this article belong solely to the author and do not reflect the position of Tatva Legal Hyderabad.

[1] Organisation for Economic Co-operation and Development 2012, Related Party Transactions and Minority Shareholder Rights

[2] Riyanto, Y.E., Toolsema, L.A. 2008, Tunneling and Propping: A Justification for Pyramidal Ownership, Journal of Banking & Finance, 32, 2178-2187

[3] Hamid, Masdiah Abdul Hamid, Ting, Irene Wei Kong, Kweh, Qiang Long 2016, The Relationship between Corporate Governance and Expropriation of Minority Shareholders’ Interests, Procedia Economics and Finance, 35, 99 – 106