Open Access Research Article
ABUSIVE RELATED PARTY TRANSACTIONS: SAFEGUARDING THE INTERESTS OF SHAREHOLDERS THROUGH STRENGTHENED CORPORATE GOVERNANCE
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Article Details
ABUSIVE RELATED PARTY
TRANSACTIONS: SAFEGUARDING THE INTERESTS OF SHAREHOLDERS THROUGH STRENGTHENED
CORPORATE GOVERNANCE
AUTHORED BY - DIVYAM KANDHARI
The
directors or the key managerial personnel have a fiduciary relationship towards
their company and are supposed to take decisions that benefit the company
rather than to pursue their own individual needs and interests. The directors
must prioritize the company’s interest by avoiding any conflict of interest
that may arise in the due course of the functioning of the company and take all
decisions in good faith, trust and with loyalty towards the company. The
position of power of the top level should not be used by them to their personal
advantage like entering into business with a company where the MD is their
relative. Section 2(76) of the companies act defines related party as a
director or any key managerial personnel or their relative or if they or their
relatives hold position in any other company to be a related party.[1]
Section 188 of the Companies Act 2013 defines related party transactions
(hereinafter referred to as RPT) as; except with the permission of the board, a
company cannot enter into business with a related party to sell, purchase,
supply goods or services or to carry out any other business like lease or
underwriting subscription or any sort of business directly or indirectly.
Furthermore these members must not vote or be involved in any decision making
if the board gives approval to get in business with a related party.[2]
Related party transactions are those transactions wherein companies indulge in
business with other companies where they have pre-existing professional and
personal network. These transactions usually become quite detrimental to the
interests of the company and the shareholders since they tend to cater to the
individual interests of a person who enters into such transactions rather than
catering to the interests of the company.[3]
Abusive RPTs are a significant concern
for many nations, including India. Such deals can be dangerous to both
regulatory authorities and investors because they involve one party exerting
influence or control over the other, whether through direct or indirect means.
When these transactions occur, public confidence can erode, and the economic
growth of companies involved in equity markets can suffer.[4]
And so to prevent these transactions, several provisions in the Companies Act,
AS 18, SEBI LODR and similar provisions have been adopted by the government.
Despite the extensive rules and regulations laid down, the efforts to prevent
abusive RPTs has failed and in this paper we are going to look at how RPTs are
misused.
The misuse
of RPTs creates a conflict of interest between the majority shareholders or
promoter group and minority investors. If the company generates profits, the
majority shareholders or promoters are required to share them with minority
investors. However, if the promoter group can divert resources to themselves or
another firm within the group where they have a larger stake, they can capture
a greater portion of the company's profits. Self-dealing transactions are one
of the most common methods used to divert resources, wherein value is shifted
from one firm within the promoter group to another.[5]
While
it is compulsory to reveal the significant facts of the RPT, these transactions
are usually clubbed under a vague and broad head like “Associates” or “Joint
Ventures” and “Key Managerial Personnel’s Controlled Entities”. In 2020, PWC, the statutory auditor of Eveready Industries, resigned due
to a "Basis of Disclaimer of Opinion." According to the auditor,
the company had extended inter-corporate deposits totalling 230.8 crore INR,
provided corporate guarantees amounting to an estimated 283.1 crore INR, and
extended a credit of 62 crore INR to another company. However, the details of the deed were not disclosed, and no claims
were made for the refund of the advanced amount. The audit committee did not
receive enough evidence to account for these actions, which made it impossible
to estimate the company's true financial standing and its future impact.
Further investigation revealed that the "notes to accounts" of the
audited reports showed that several loans had not been repaid, and the promoter
directors had guaranteed the default. This is a clear case of the abuse of
related party transactions.[6]
Furthermore,
the justifications to these dubious transactions are not provided and this
undermines the faith and confidence of the minor shareholders. These investors are still in the dark
about the company's investments since not enough information is revealed to
them in the annual report. It is challenging to decide whether to authorise
such RPTs because there aren't any similar alternatives. This evasion of
compliance is also facilitated by the Audit Committees. Mostly, the risks of
RPTs are not communicated, primarily due to the ill-framed and vague statements
deliberately made to avoid providing justifications of the dubious
transactions, which then deceives the voting results. The reason for the same
is that there is no prescribed format that has been provided for reporting of
RPTs and thus no proper accountability mechanism is there to keep a check.[7]
Another way in which the RPTs are
misused is when companies enter into RPTs through subsidiaries. According to
section 184 of the Companies Act deals with the disclosure of interests by the
directors. If any director has any interest in another company, he/she must
disclose it to the board.[8] In
order to circumvent this provision, directors use the subsidiaries to
indirectly enter into RPTs. This way the director is not directly into business
with the related party but still fulfils his interest. Many a times the
directors go to an extent of forming a new sham company just for the purpose of
entering into RPTs, wherein the company has no business and the
directors/members are their own family members or people who are under their
direct control. An example of this is; when investing over 24 crores in Mexia
Resources Ltd., Assam Co. India Ltd. (ACIL) neglected to produce the necessary
certificates and its correct accounts. Duncan Macneill Power India Ltd., an
ACIL subsidiary was the only one to disclose investments which was done through
compulsorily convertible preference shares. As a
result, the company's financial standing was forged, which led to investors
being misled.[9]
The Satyam Computer Services scandal has
been well-documented and illustrates some of the dangers associated with
Related Party Transactions (RPTs). On December 16, 2008, Satyam's board of
directors approved the purchase of Maytas Properties and Maytas Infrastructure
for $1.3 billion and $300 million, respectively. These two entities were linked
to B. Ramalinga Raju, Satyam's founder, chairman, and CEO. Due to concerns
about the valuation of the companies, the timing and method of payment, as well
as objections raised by independent directors, investors began to scrutinize
Satyam more closely, resulting in the cancellation of the proposed acquisition
deals. Following the revelation of a $1 billion accounting fraud by
Satyam's former chairman and CEO Raju on January 7, 2009, four independent
directors resigned. Although abusive related party transactions were not
necessarily the main cause of the fraud, the terms and conditions of these
transactions brought Satyam into the spotlight and ultimately led to the
discovery of the accounting fraud. The existence of an abusive RPT may not
always be the direct cause of such fraud, but it can draw attention to the
company's financial records, aiding regulators and investors in identifying
other inappropriate activities.[10]
Now talking about some of the suggestions which must take place, the Board is accountable for recognizing and sanctioning RPTs, but there are situations where the Board hastily approves such transactions without conducting the necessary due diligence. Furthermore, "ordinary transactions" conducted at an "arm's length basis" do not require approval, making it challenging to differentiate between related and unrelated transactions. To ensure the interests of investors, all transactions should be reviewed and approved by the independent Audit Committee. To ascertain "unrelated transactions", it is essential to establish criteria that define the term "arm's length" and include specific parameters under Section 188 of the Act. One proposed solution is to expand the definition of 'RPT' in Regulation 2(1)(zc) to cover transactions at the subsidiary level, in order to ensure proper oversight. However, legitimate business transactions between holding, subsidiary, and associate companies within a large business conglomerate that are conducted at arm's length and in the normal course of business should still require approval from the audit committee. The definition of RPT under Regulation 2(1)(zc) should also include a more comprehensive list of legitimate business transactions that are part of the normal course of business activities of listed entities. This list should include transactions subject to other provisions of the Act and LODR, such as schemes of arrangements for mergers, demergers, and corporate restructuring that have specific regulatory requirements. Thirdly, the previous threshold for determining the materiality of RPTs was too lenient, as it allowed most RPTs to go unnoticed by shareholders. The imposition of an absolute monetary limit of INR 1000 crore for related party transactions lacks logical reasoning and could face constitutional challenges under Articles 14 and 19(1)(g) of the Indian Constitution. This is because it is being imposed on all listed companies, regardless of their size and business nature. A more feasible approach could be to use a materiality threshold under Regulation 23(1) that takes into account the company's annual consolidated turnover or net assets. For instance, a lower threshold of 5% of annual consolidated turnover or 5% of net assets could be considered for investment companies. Next, there is a requirement for a standard reporting format for RPTs. To ensure transparency, all details of related party transactions must be disclosed, including reasons why certain high-value transactions could not be completed with unrelated entities. Prior to approval, an independent financial advisor should provide a fair opinion, which should also be included in the annual report. To protect the interests of minority investors, the establishment of proxy advisory firms to monitor transactions and keep shareholders informed is recommended. And lastly, SEBI has granted exemptions to certain corporate actions offered uniformly to all shareholders by the listed entity from the RPT definition. This exemption includes actions such as rights issue, buyback, and dividend. However, the use of the phrase "by the listed entity" has led to uncertainty regarding whether corporate actions undertaken by subsidiaries of the listed entity are also exempted. By listing only specific corporate actions that are exempted, there is confusion over other corporate actions that fall under strict regulation according to the Act. Such actions will now require prior approval from shareholders as per the LODR. This vagueness must be rectified and the definition of RPT must clearly specify these exemptions. The listed entity uncertainty must also be cleared so as to prevent misuse of RPTs by the subsidiaries.[11]
India has made notable strides to safeguard shareholders; however, a significant gap persists between the legal framework and its implementation. It is crucial to take steps to enhance the state of corporate governance, particularly concerning abusive RPTs. These transactions, which are at the discretion of the Board and may involve entities related to top management, can lead to attempts to conceal information and evade disclosures. Thus, strict measures are necessary to balance needed RPTs and protect the interests of innocent shareholders. These measures should prioritize transparency and accountability in corporate actions, effective reporting and disclosure mechanisms, and bolstering the role of independent auditors and regulators. This will ensure that RPTs are conducted ethically and equitably, benefiting both the company and its shareholders.
[1] Companies Act, 2013, Section 2
[3] What is related party transactions -
understand related party regulation, Groww
(2022), https://groww.in/blog/all-about-related-party-transactions (last
visited Apr 7, 2023).
[4] Letishiya Chaturvedi & Poorna Dixit, Related Party transactions and corporate
governance in India SCC Blog
(2021),
https://www.scconline.com/blog/post/2021/11/02/related-party-transactions/
(last visited Apr 7, 2023).
[5] Ami Galani & Nathan Rehn, Related
Party Transactions: Empowering Boards and Minority Shareholders to Prevent
Abuses, 22 National Law School of
India Review 29–57 (2010).
[6] Sharad Dubey, PWC resigns as Statutory Auditor for Eveready BQ Prime (2019),
https://www.bqprime.com/business/pwc-resigns-as-statutory-auditor-for-eveready
(last visited Apr 9, 2023).
[7] Letishiya Chaturvedi
& Poorna Dixit, Related Party
transactions and corporate governance in India SCC Blog (2021),
https://www.scconline.com/blog/post/2021/11/02/related-party-transactions/
(last visited Apr 7, 2023).
[9] Letishiya Chaturvedi & Poorna
Dixit, Related Party transactions and
corporate governance in India SCC
Blog (2021),
https://www.scconline.com/blog/post/2021/11/02/related-party-transactions/
(last visited Apr 7, 2023).
[10] Guide on Fighting Abusive Party
Transactions in Asia, Organization for
Economic Co-operation and Development (2009),
https://www.oecd.org/daf/ca/corporategovernanceprinciples/43626507.pdf (last
visited Apr 7, 2023).
[11] Varun Kannan
& Bharat Vasani, RPT regulations –
some suggestions for SEBI's consideration India Corporate Law (2022),
https://corporate.cyrilamarchandblogs.com/2022/07/rpt-regulations-some-suggestions-for-sebis-consideration/
(last visited Apr 8, 2023).
Article Information
ABUSIVE RELATED PARTY TRANSACTIONS: SAFEGUARDING THE INTERESTS OF SHAREHOLDERS THROUGH STRENGTHENED CORPORATE GOVERNANCE
Authors: DIVYAM KANDHARI
- Journal IJLRA
- ISSN 2582-6433
- Published 2024/01/30
- Issue 7
About Journal
International Journal for Legal Research and Analysis
- Abbreviation IJLRA
- ISSN 2582-6433
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