Related Party Transactions and Corporate Governance in India

Introduction

In furtherance of India’s first step to protect the small investor’s interest and build confidence in the business and commerce of the country, the Confederation of Indian Industry (CII) presented the “Desirable Corporate Governance: A Code”[1]. Subsequently, the Kumar Mangalam Birla Committee[2] was appointed by SEBI, which included CII’s Code, and in 2000 a significant step was taken to further corporate governance in India with the introduction of Clause 49[3]. Constituting both mandatory as well as non-mandatory provisions, this clause provides the specific ingredients, ranging from independent directors to regular disclosures, to facilitate utmost transparency in the corporate houses. While those provisions that can firstly, be defined under strict and clear terms, and secondly, do not require statutory amendments are “mandatory”, whereas those which the company may, or may not, implement and might also need legislative changes are termed are “non-mandatory”. Distinct from both the Commonwealth as well as the US model, India has taken up the hybrid version of the principle-based and the rule-based models, giving expansive and comprehensive directions on corporate governance.[4]

After the clause underwent its 2004 Amendment, on the basis of the suggestions made by the Narayana Murthy’s Committee, the listed companies are to necessarily provide all disclosures in a quarterly report, signed by the Chief Executive Officer (CEO), to the Stock Exchange Board, at the end of the quarter extending till a maximum of 15 days. The Annual Report of these Companies must have an allocated corporate governance section, along with compliance certificates of it from either its auditors or company secretaries. The main motive behind “corporate governance” or “good governance” is to make the corporate structure tighter and the interests of the investors safer. Hence, these reports and certificates are sent to all the shareholders, annually. In addition, the stock exchange, through a monitoring cell, also checks if Clause 49 requirements are being fulfilled, or not. Within 60 days, the Cell also submits to SEBI a consolidation of the quarterly reports it receives.[5]

Then, the 2009 Voluntary Guidelines[6] were brought in by the Ministry of Corporate Affairs, which were recommendatory in nature. Some of its most effective suggestions were the rotation-based appointment of auditors, disclosures during related-party transactions, and strengthening the whistleblowing policy. Because these guidelines were not mandatory, a large number of companies did not implement them. Hence, to bring a significant betterment to the corporate governance scenario, the Companies Act of 2013[7], with its series of provisions made corporate governance a mandate to be followed by the non-listed companies as well.

Related party transactions

The Indian Accounting Standards (AS-18), while defining the term “related parties” lays down that “parties are considered to be related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial and/or operating decisions”[8]. Transactions, including single or multiple business undertakings, between such affiliated parties are “related-party transactions” (RPTs). This connection is not limited to parent-subsidiary relations but also includes the company’s workforce, both the employees and the management, and the majority stakeholders; it extends to familial ties. Abusive RPTs are a problematic concern for most nations, including India. It is the influence/control that one party can show over the other, either through direct or indirect means, that makes deals of this nature dangerous to both the regulating authorities as well as the investors. The confidence of the public breaks and the economic growth of such companies, in the equity market, are hampered.[9]

To regulate the self-dealings various regulatory measures in the form of disclosures, approvals and bans have been brought into force by the Companies Act of 2013[10], the AS-18[11] and Clause 49[12]. Additionally, both legislative and regulatory directions have been provided by the Organisation for Economic Cooperation and Development (OECD) for the supervision and prevention of abusive RPTs[13].

The Companies Act also incorporated the concept of related parties, it includes[14]:

(i) directors of the company;

(ii) key managerial Personnel;

(iii) immediate relatives of the above; and

(iv) related companies.

Section 188 of the Act regulates the RPTs by the way of disclosures that are to be ratified by not only the Board Members but also by the other shareholders. These disclosures in the Board Report must include valid reasoning, supporting the transactions. The Companies (Meetings of Board and its Powers) Rules, 2014[15], later amended in 2019[16], lays down under Rule 15(3)[17], the attached threshold limit of the RPTs. In case this transaction amount supersedes this limit, the sanction of the shareholders is required. This sanction is in the form of a special resolution which is passed in the Company’s General Meeting and is given only when the material details, including the names of the parties related, the nature of such relationship, the details of the contract, are disclosed.

Concerns regarding abusive RPTs in India

Despite the extensive rules and regulations that India has laid down to prevent abusive RPTs, the country has failed to strike a balance between enough compliances to safeguard the small investors’ interests and facilitate “ease of doing business” by reducing the compliance burden of the companies. Dissatisfied with the current scenario, SEBI established the Working Group (WG) Committee to relook into the RPT regulations, and then provide feasible suggestions. The WG discovered that to evade the strict related laws, companies had started to enter into RPTs through their subsidiaries. For instance, Assam Co. India Ltd. (ACIL) while investing over 24 crores INR in Mexia Resources Ltd. failed to submit the requisite certificates and its proper accounts. The disclosure of investment in the compulsorily convertible preference shares was only done in Duncan Macneill Power India Ltd. which was a subsidiary of ACIL. This consequently resulted in misleading the investors by showing forged financial standing of the company.[18]

Another way in which RPTs have been operating with malice is via the usage of the funds of the shareholders in investing into promoter groups. Usually, the new projects of these Groups are funded with this money, sometimes through quasi-debt, rather than using it for comparatively safer and ethical investment purposes. In Financial Year (FY) 2017-2018, a massive loan of 6100 crore INR was taken by an Infra company, but it was repaid, in full, before the year’s end. Hence, this RPT was not disclosed in the closing balance sheet.

Despite the compulsion to disclose the substantial details of the RPTs, they are generally clubbed under vague and broad headings such as “Associates” or “Joint Ventures” and “Key Managerial Personnel’s Controlled Entities”. Furthermore, explanations related to these dubious transactions are not provided, reducing the trust and confidence of the smaller shareholders. Since enough information is not disclosed to them, through the annual report, these investors remain uninformed about the investments of the company. Due to the lack of comparable options, it becomes difficult to decide whether to approve such RPTs or not. The Audit Committees also contribute to this evasion of compliance. Usually, the risks of the RPTs are not disclosed, mainly because of ill-framed statements, thus, misleading the voting results. The main reason remains that there is no fixed format that has been provided for reporting such transactions.

Case studies

(i) Apollo Tyres: In 2018, two instances of abusive RPTs were brought to light. Firstly, the small investors (56% institutional and 49% retail shareholders) gunned down the special resolution for the reappointment of Neeraj Kanwar (MD) for 5 years and the fixation of his salary. Estimation of his salary would be a 25% increase from his current salary of 68.4 crores INR. Then, the Board was also compelled to curtail the promoter, Onkar Singh Kanwar’s compensation at 7.5% of profit before tax. Additionally, the salaries drawn by both were reduced by 30%; together, they were drawing 13% of the company’s net profits as remuneration.[19]

(ii) Eveready Industries: In FY 2020, the statutory auditor of Eveready Industries, Price Waterhouse & Co., resigned for the reason of “Basis of Disclaimer of Opinion”. The auditor disclosed that the company had provided inter-corporate deposits worth 230.8 crore INR and corporate guarantees estimated at 283.1 crore INR, along with a credit of 62 crore INR to another company of which neither were the details of the deed extended for disclosure nor were any claims made for the refund of the advanced amount. Not enough evidence to account for was given to the audit committee; thus, they were also unable to estimate the real financial standing of the company and its future impact. Evidence of RPTs was also discovered when the “notes to accounts” of the audited reports showed that the default in repayment of several loans had been guaranteed by the promoter directors.[20]

Suggestions

To strengthen the measures of corporate governance, there is a dire need for strict implementation of the rules for the maintenance of good governance. Some suggestions regarding the same are:

(i) The Board is responsible for identifying and approving the RPTs. However, there arise circumstances where the Board indulges in hasty approval, without due diligence. Additionally, “ordinary transactions” which are at an “arm’s length basis” do not require any approvals. It becomes extremely difficult to distinguish between such transactions with the related ones. It is necessary to establish checks and approvals, by the Audit Committee, for all transactions. As the Audit Committee is an independent wing, it is likely to secure the interests of the investors.

(ii) A criterion needs to be laid down, elaborating the definition of “arm’s length”, under Section 188 of the Act[21]. Specific parameters need to be incorporated to ascertain “unrelated transactions”.

(iii) As per Regulation 23 of the Listing Regulations, “material” RPTs are only those which exceed 10% of the annual consolidated turnover, as per the last financial statement, of the listed companies. Similarly, the four categorised thresholds of the MCA are also considerably high[22]. For several RPTs get excluded out of the ambit of approval from the Board, there is a need to reduce this threshold limit to keep a stricter check.

(iv) As mentioned above, there exists a need for a fixed reporting format, reporting the RPTs. This would ensure that all the details are disclosed. Disclosures must also be made as to why certain high valued transactions could not be done with unrelated entities. A fair opinion from an independent financial advisor must also be taken before the approval, and the same must also be included in the annual report.

(v) The interests of the casual investors will be safeguarded with the establishment of proxy advisory firms that would duly monitor transactions, keeping the shareholders informed.

(vi) One of the most significant amendments to Clause 49 was the introduction of the Whistleblower Policy in 2003[23]. The objective of it is to report any improper practice to the Audit Committee by the Personnel. However, there is no statutory provision for unrelated third party acting as a whistleblower. Moreover, the Act does not allow for absolute anonymity; a “competent authority” assures identity confidentiality but whistleblowers are not trustful of this, and hence, abstain from reporting. Those involved in the illegal activities are not protected or granted immunity from prosecution if they choose to disclose. Unless leniency is showed, instances of whistleblowing would remain low. Proper guidance and counselling must be made readily available to the complainants to make the process easier for them. Wrong or misleading information results in imprisonment and fines; this makes the potential whistleblower vary. A proper definition of “victimisation” should be incorporated, along with the acts that amount to it.

(vii) Despite the strict rules, the implementation of corporate governance has not been up to the mark in India. It is the enforcement that must be bettered considerably before amending the laws.

Conclusion

India has made considerable efforts to protect shareholders, however, there still exists a considerable gap between the statutes and their implementation. Steps need to be taken to uplift the state of corporate governance, especially, with regards to abusive RPTs. Since these transactions are not only at the discretion of the Board but are also such entities that are sometimes related to the top management, special efforts are taken to conceal information and evade disclosures. Stringent measures must be taken to create a balance between needed RPTs and safeguarding the interests of innocent shareholders.

*3rd year student, BBA LLB (Hons.), Kirit P. Mehta School of Law, NMIMS, Mumbai.

**4th year student, BLS LLB, Rizvi Law College, Mumbai.

[1]Confederation of Indian Industry, Desirable Corporate Governance: A Code (April 1998). <http://iias.in/downloads/Corporate_governance_CII_1997.pdf>.

[2] Kumar Mangalam Birla Committee Report on Corporate Governance (2000).

[3]Equity Listing Agreement of SEBI, 2000, Cl. 49.

[4]Equity Listing Agreement of SEBI, 2000, Cl. 49.

[5] Aryan Sinha, Significance of Corporate Governance in the Present Context, 432 IJLMH, 434 (2021), <https://www.ijlmh.com/wp-content/uploads/Significance-of-Corporate-Governance-in-the-Present-Context.pdf>.

[6] MCA, Corporate Governance Voluntary Guidelines, 2009 (14-12-2009 to 21-12-2009).

[7]The Companies Act, 2013.

[8]Accounting Standard (AS 18), Definitions (10.1), Related Party Disclosures.

[9] Padmini Srinivasan, An Analysis of Related-Party Transactions in India, 1 IIMB 3 (2013), <https://www.iimb.ac.in/sites/default/files/2018-07/WP_No._402_0.pdf>.

[10]The Companies Act, 2013.