Introduction
In recent years, Related Party Transaction has been one of the frequently highlighted subjects discussed in the corporate world of India, but there are still recurring failures of governance that have caused misuse by the power of promoters. Related Party Transaction specifically refers to a business deal between a person or people which are closely related with owners or management. Though Related Party Transaction is not illegal in nature, but it still holds high risks of causing conflict of interest and diversion of companies assets, as it can lack fairness. Therefore procedures are mandatory if not followed it may serve promoters and directors to enter self-serving contracts which leads to causing costs to minor shareholders.
The government recognized these risks and introduced strict disclosures, approvals and compliance mechanism in The Company Act, 2013. The Act helps to ensure transparency, helps maintaining accountability and ensure smooth corporate governance of India.
Meaning
In the Company Act, 2013 Section 188 deals with Related Party Transaction which are generally any contracts or agreement entered into by a company with a related party for specified business activities.
Broadly it covers transactions between:
A company and a person or entities connected with its directors, key managerial personnel or promoters.
Examples of related party transactions
- Purchasing and selling products
- Paying a promoter-controlled entity excessive compensations
- Leasing a directors relatives office space
If not regulated properly it may lead to misuse of managerial authority, financial tunneling, loss to creditors and shareholders.
Who is “ Related Party” ? Section 2 (76)
In the Company Act, 2013 Section 2 (76) provides a comprehensive list of who qualifies as a related party which includes :
“related party”, with reference to a company, means—
(i)a director or his relative;
(ii)a key managerial personnel or his relative;
(iii)a firm, in which a director, manager or his relative is a partner;
(iv)a private company in which a director or manager [or his relative;Ins.by S.O.1894 (E),dated 24th July, 2014] is a member or director;
(v)a public company in which a director or manager is a director [and holds; Subs. by S.O. 1820 (E), dated 9th July, 2014 for “or holds”] along with his relatives, more than two per cent. of its paid-up share capital;
(vi)any 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;
(vii)any person on whose advice, directions or instructions a director or manager is accustomed to act:
Provided that nothing in sub-clauses (vi) and (vii) shall apply to the advice, directions or instructions given in a professional capacity;
[[(viii) any body corporate which is—
(A)a holding, subsidiary or an associate company of such company;
(B)a subsidiary of a holding company to which it is also a subsidiary; or
(C)an investing company or the venture of the company.
Explanation.—For the purpose of this clause, “the investing company or the venture of a company” means a body corporate whose investment in the company would result in the company becoming an associate company of the body corporate;Subs. by Act 1 of 2018, s. 2, for sub-clause (viii) (w.e.f. 9-2-2018)]]
(ix)such other person as may be prescribed;
Types of Transactions
Related Party Transactions is taking practical forms in daily functioning of a company. One common subject is purchase and sales of goods, where a company buys raw material or product from another person/ entity connected to company’s promoters, for illustration a manufacturing company which source inputs from firm owned by promoter. Another forms involve sale or purchase of property, property leasing, Companies can also provide services to related entities for illustration subsidiary company supplies management or IT services to their parent company
Related Party Transactions also includes appointment of an office or place of profit, where a person or the entity is connected to the management like Directors relative appointed as an advisor or consultant with major payout.
Lastly, underwriting securities by related parties- where shares or debentures of affiliated entities back to the company’s which is permissible but with strict scrutiny. Such transactions need transparency to authenticate that they are free from conflict of interest and justifiable.
Approval Requirements for Related Party Transactions
In the Company Act, 2013 Related Party Transaction are topic to layers of approvals to ensure transparency, fairness and protection of shareholders interest.
Every transaction related to parties must primarily approved by the Board of Directors by a formal resolution. To block conflicts of interest, any affiliated member of Board is prohibited from taking part in the decision or voting. The independent member plays a crucial role to ensure fairness.
In some cases, share-holders approval can become mandatory by special resolution. When the value of Related Party transaction crosses the thresholds which is described under Rule 15 of the Companies ( Meetings of Boards and Its Powers ) Rules, 2014, the company have to get approval from the shareholder. Significantly, parties which are related are not allowed to vote in resolutions relating to transactions which helps to ensure decisions are taken independently and the interest of minority shareholder are protected.
Additionally, for all the listed company approval of Audit Committee is compulsory. The Audit Committee has to inspect the justification of the transaction assessing whether is it entered in an Arm’s length basis, and can calculate its necessity and its commerce. The additional layer of inspection to strengthen corporate governance and reduce the risk of misuse of Related Party Transactions.
Arm’s length transactions and Ordinary Course of Business
An Arm’s length transaction is referred to a business deal where parties act independently and voluntarily for self-interest. Arm’s length transaction happens when all parties act in self-interest and they are not under influence of any other party. They make sure that there is no collusion between seller and the buyer. In interest of fairness both parties get equal access to information related to the deal.
An Arm’s length transaction are most commonly applied to commercial dealings and real estate because such transaction can impact the immediate parties which are involved and also some others such as stakeholders, includes lenders, tax authorities and the broader market.
When an property is sold between two parties which are not related to each other – the price which is agreed by the parties is close to the fair market value (FMV). This is because it is assumed that both parties have equal bargaining power and access to information about the property. The buyer aims to minimize price whereas seller tries to maximize it. As in result the negotiated price typically shows true economic value of the property. The amount of finance bank is willing to avail.
Reason for these widely shows, arm’s length pricing is important to maintain transparency and markets integrity.
Reporting, Disclosure and Record-Keeping Requirements
Companies should ensure transparency in related party transactions by complying with various statutory disclosure requirements. In the section of 134 of the Company Act, 2013 it is stated that details of Related Party Transaction must be disclosed in Board’s report to enable shareholder to assist managerial decisions.
Schedule III of the Company Act, 2013 makes mandatory disclosure in financial statement, which helps in ensuring such transactions are reflected in company’s accounts. Further in Section 189 it is required to companies to maintain a register for contracts and agreements in which director are interested, which provides internal records.
In the case for listed companies, all disclosures are compulsory by SEBI (LODR) Regulations, which imposes strict reporting standards and transparency. Together, the disclosure mechanism allow regulators and shareholders to effective scrutinize related party transactions and ensure sound corporate governance
Penalties for Non-Compliance
If a company or entity violates section 188 of the Company Act, 2013 which attracts legal consequences for both the individual and also the company which are involved. Any related party transaction which is entered without procedures or approvals then it may be voidable at the option of the company. Directors or Promoters involved in such transactions are subject to disqualifications from office, monetary penalties and recovery from any undue advantages gained by the transactions. For illustration if a director unlawfully leases office property to his own firm at lower rate, the company has right to cancel the contract and also can recover loss suffered due to such misuse of authority
Conclusion
Related Party Transactions has significant corporate governing challenges, specifically when sufficient safeguards are not present. Major concerns include promoters dominance, conflict of interests and diversion of funds through associated companies. Several Indian corporate scandals shows misuse of related party transactions which undermine transparency and erode investors confidence, highlight the need of strict governance control.
To effectively manage Related Party Transaction, company should allow strong governance related best practices.Which includes strengthening the role of independent audit committee, implementing a formal related party transaction policy, and ensures that all such transactions are conducted on an arm’s length basis.Regular annual reviews and maintenance of transparent documentations to further help in minimizing risks and ensuring regulatory compliance.
Related party transactions play an important role in corporate operations but pose serious governance risks if unchecked. The Companies Act, 2013, through Section 188, creates a steady framework that permits legitimate business transactions while enforcing transparency and accountability.
About Author
Samiksha Chinchole a final-year BA LL.B. student at Dr. D Y Patil Law college Pune, is an aspiring legal writer, having a keen interest in Corporate Law, Contract Drafting, and Legal Compliance. Samiksha is passionate about legal research and explores contemporary legal developments through writing, with a focus on practical and evolving regulatory frameworks.
References
1. Registration Arena, Related Party Transaction https://registrationarena.com/blog/related-party-transactions/
2. Kannakkpillai Related Party Transaction under companies act https://www.kanakkupillai.com/learn/related-party-transactions/
3. AUBSP section 188- Related party Transactions https://www.aubsp.com/section-188-related-party-transactions/