A related party is a person who is related to the company. If one party has the ability to control the other party or exercise significant influence over the other party, directly or indirectly, in making financial and/or operating decisions, those two parties are related to each other. For example, all group entities are related to each other.
Except in the UK, the US and Australia, company groups and concentrated ownership are normal around the world. India is no exception.
Under such conditions, related party transactions (RPTs) are mainly with the controlling shareholders and/or with members of a company group. One of the important themes in corporate governance regulations is to protect minority shareholders from abusive RPTs. RPTs become abusive when they are used as an instrument for self-enriching by the controlling shareholder. Although regulators and minority shareholders view RPTs with scepticism, regulators do not ban RPTs because those are economically beneficial to group companies. A satisfactory solution to the problem of abusive RPTs is still elusive. Different jurisdictions have responded to the issue differently. In most jurisdictions the board of directors and independent directors have been made responsible to protect minority shareholders from abusive RPTs.
In some jurisdictions, some involvement of shareholders is also introduced.
Companies Act 2013 and Securities and Exchange Board of India (Sebi) corporate governance code (clause 49 of the listing agreement), which will be implemented from October 1, 2014, have incorporated certain new provisions to introduce some of the
practices that are available in other jurisdictions. Three important components of regulations that govern RPTs are definition of related party, approval of related party transactions by the board or audit committee and in some cases, by shareholders and disclosure of RPTs. Sebi code of corporate governance (clause 49 of the listing agreement), section 188 of the Companies Act 2013 and accounting standard 18 (AS 18) deal with RPTs. AS 18 requires disclosure of RPTs.
Both Sebi code and section 188 of the Companies Act 2013 specify the individuals and other entities, which are considered related parties. The definitions are quite broad. AS 18 also identifies related parties for the purpose of disclosure of RPTs in financial statements.
Sebi code, which is applicable to listed companies, requires audit committee to approve all RPTs. The Companies Act 2013 stipulates that Board's approval is required for RPTs that are not entered in the ordinary course of business or on an arm's length basis. It makes the audit committee responsible for approving RPTs.
Sebi code requires every listed company to formulate a policy on dealing with RPTs and to disclose the same on its website and also in the annual report. It is advisable that companies that are not covered by the Sebi code should also develop a policy dealing with RPTs to make the job of the audit committee little less onerous.
Formulation of the policy is tricky. While the duty of loyalty of the Board is towards shareholders of the company, in reality, decisions related to RPTs are taken from the group perspective. In some jurisdictions, regulators take this reality into consideration while evaluating the policy dealing with RPTs. RPTs that are beneficial to the group might have a negative impact on a particular entity for a short-term but in the long-term, RPTs benefit all the group entities unless they are used for self-enriching, for example, for tunneling. Therefore, the primary task of independent directors and the audit committee is to protect minority shareholders from those RPTs that are vehicles for perpetrating fraud on them. They should evaluate RPTs based on the group RPT policy and keeping in view the long-term benefits to the company. A particular company's policy should align with the group policy.
The policy should be discussed with large shareholders before finalisation. Indep-endent directors should shed scepticism and examine each RPT with an open mind.
However, at this point, there are two significant uncertainties. First, it is difficult to guess how the regulators and judiciary will interpret the 'duty of loyalty'.
Second, it is difficult to assess whether the disclosure of a transparent group policy dealing with RPTs will enhance scepticism and how it will impact share prices of group companies. These make the task of independent directors onerous.
Although the Sebi code and the Companies Act define material RPTs differently, both require that all material RPTs shall require approval of the shareholders through special resolution and the related parties shall abstain from voting on such resolutions. This practice prevails in some other jurisdictions.
However, the problem with this practice is that sceptical minority shareholders might block a non-abusive RPT without fully appreciating the group policy.
In the new regime, the controlling shareholder has to build a strong relationship of trust with minority shareholders. It is also important that proxy advisory firms take a rational view of RPT policy of different business groups. Scepticism at this point can only be counterproductive.
Institute of Corporate Affairs; Advisor (Advanced Studies), Institute of Cost Accountants of India; Chairman, Riverside Management Academy
Private Limited. Email: firstname.lastname@example.org