Related Party Transactions Under the Companies Act, 2013: The Governance Gap India Cannot Afford to Ignore

Introduction

In the field of Indian corporate law, related party transactions (“RPTs”) are in a grey area. On the other hand, group corporate structures, such as holding companies, subsidiaries and associate companies, inevitably involve internal transactions with other members of the group, for operational efficiency and sharing of resources. However, at the same time, RPTs are the most potent tool in creating the diversion of corporate funds from minority shareholders to controlling promoters.

Though there was much pressure brought with the amendments in the 2015 LODR and 2013 Companies Act, the framework still has three major structural weaknesses: under-inclusive definitions, lack of audit committee scrutiny, and no post-transaction accountability.

The Statutory Framework

This requires the board's endorsement and in cases subject to the prescribed thresholds, secondary shareholders for RPTs involving “related parties”, as defined by Section 2(76) [3] of the Act, which includes holding companies, subsidiary companies, associate companies, the directors and KMPs, their relatives and any other company in which they have a prescribed interest.

Under the new definition of material relating to listed company transaction ( Regulation 2(1)(zb)), any transaction with a material related party is defined as that of the listed company whose turnover in an annual consolidated financial statements is greater than ten percent of the listed company’s annual consolidated financial statements.

The Definitional Gap: Substance Over Form

While the 2021 amendments extended the definition, a promoter’s job is not necessarily limited to those types of entities; some promoter groups, regardless of whether they are holding companies, limited liability partnerships or private trusts, can frequently engage in transactions through entities that do not fit the formal definition of a promoter, and still have the same business effect.

The remarks made in the case of Tata Consultancy Services Ltd. v. Cyrus Investments Pvt. Ltd[5] are relevant. In responding to oppression and mismanagement under the Act, the Court stated that the Act does not require any formal legal relationship in order to find there to be a “related party character” where a de facto control or beneficial interest has been established. This judicial reasoning, based upon the substance over form idea, is unmatched with a corresponding amendment to section 2(76) that leaves the gap between substantively and formally.

That the principle of statuary substance over form is taken in the context of tax avoidance (as in the context of RPT) is reform which Parliament has hitherto refrained from enacting and the current structure desperately needs.

Understanding and evaluating the gap between design and practice for Audit Committee oversight.

The audit committee may also give general or “omnibus” approval for recurring RPTs with conditions in respect of types of counterparty, nature of RPT, the maximum amount of RPT involved as well as the length of time for the approval.

This mechanism in its theoretical rape is undermined by India's corporate governance reality. Most companies in India are promoter-controlled and the definitions of independent directors and those influenced by the promoter are more of a sentimental expression. The independent directors’ dissent rates on approvals of these RPTs are invariably minimum in promoter controlled companies based on institutional proxy advisory data. Near zero dissent rates among the independent directors on RPT approvals has been consistently reported in promoter controlled companies in institutional proxy advisory data.

The omnibus approval mechanism is a bigger issue to note. Though it was introduced to speed up regular exchanges, it also creates the clout of permitting types of RPTs to go forward without having to be reviewed individually. This is but a classic example of the systemic risk that can arise due to weak oversight of audit committees, as can be seen in the case of the Brightcom Group Limited (Brightcom) which was the subject of an enforcement action by SEBI in 2023 for the obstruction and manipulation of the true nature of related party transactions through inflated RPTs with promoter related entities and failure to report the related party character.

The Majority-of-Minority Voting Standard

The most important change in the governance introduced by the amendments to the LODR in 2021 is the new “majority-of-minority” voting on material RPTs; under this requirement, a promoter is not able to use its majority shareholding to get its own way on material RPTs because approval of the transaction will require a majority of all shareholders except related parties' approval.

However, this mechanism is only effective if the institutional shareholders have an active engagement with the institutions, an area where India has seen only passive engagement in the past. While the March 2023 circulars from SEBI mandating public disclosure of the voting records and reasons for voting in mutual funds are welcome, the quality of engagement (voting record disclosure) is still superficial and the majority-of-minority standard is likely to turn into a formality.

Conclusion and Recommendations

There are three structural reforms that are needed. In the first place, the Act should include in its definition of “related parties” a substance-over-forms test, which would encompass de facto related party relationships irrespective of their formal nature. Secondly, SEBI should mandate audit committee (AC) chairmen of the firms which have multiple material violations where they have committed to the RPT to personally certify the nature of the transaction for each approved transaction made by them as arm's length. Third, the intent of Section 245 of the Act, which grants authority for class action suits but has never been invoked, should be realized by reducing the standing standard by way of procedural rules so that institutional shareholders may recover the benefits obtained incorrectly through RPTs.

In the corporate world, related party transactions simply cannot be avoided. This is a regulatory question then would there be adequate enough legal structures that would make sure that the law is going to be used for the companies benefit and not the promoters? At present, there is no evidence that it is.

Author: Bijendra Shandilya, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.

ENDNOTES

1. Vikramaditya Khanna & Shaun J. Mathew, Governance and the Challenges of Related Party Transactions in India, 3 Indian Law Review 123, 126 (2019).

2. SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, No. SEBI/LAD-NRO/GN/2015-16/013 (India).

3. Companies Act, No. 18 of 2013, § 188, India Code (2013).

4. SEBI (Listing Obligations and Disclosure Requirements) (Second Amendment) Regulations, 2021, Reg. 2(1)(zb).

5. Tata Consultancy Services Ltd. v. Cyrus Investments Pvt. Ltd., (2021) 9 SCC 1 (India).

6. SEBI LODR Regulations, 2015, Reg. 23(2).

7. Institutional Investor Advisory Services India, Proxy Season Review 2023, at 47 (IIAS, 2023).

8. SEBI, Adjudication Order in the matter of Brightcom Group Ltd., Order No. Order/KM/2023-24/19784 (Jan. 10, 2023).

9. SEBI LODR (Second Amendment) Regulations, 2021, Reg. 23(4).

10. SEBI Circular No. SEBI/HO/IMD/IMD-PoD-1/P/CIR/2023/31 (Mar. 8, 2023).