Hassle Free Ride for 'Related Party Transactions' in Companies (Amendment) Bill, 2014

​Published in Taxmann's 'Corporate Professionals Today' Vol. 32
February 1-15, 2015 Issue

Authors: 

DELEP GOSWAMI, FCS, ADVOCATE, SUPREME COURT, NEW DELHI
                                                                AND
ANIRRUD GOSWAMI, ADVOCATE, GOSWAMI&GOSWAMI, ADVOCATES
                AND LEGAL CONSULTANTS, NEW DELHI.
                                                ================
 
When the Companies Act, 1956 (“the Old Act”) got replaced after 57 years by the Companies Act, 2013 (“the Act”), with emphasis on corporate transparency, accountability, corporate social spending, self-governance and less regulatory control, the trade and industry and the three main professional Institutes drew lot of comfort because it allowed liberty and freedom for the corporate sector to take their own decisions without the necessity to seek approval from the Central Government for most of the corporate decisions. 

The Act was notified on 29th August, 2013 and the Central Government soon brought into force 283 sections, out of the 470 sections, of the new Act and also notified corresponding 22 sets of Rules necessary for the working of those notified sections.  However, during the course of implementation of the enforced provisions of the Act and the corresponding Rules, many teething problems cropped up and clarity was needed in proper interpretation of the provisions of the Act and the Rules. The Central Government was alive to the needs of the corporate sector and wherever needed, clarifications were issued and the Central Government even amended the relevant Rules wherever required.  Estimates suggest that in India there are nearly nine lakhs companies registered as purely private limited companies, which are not subsidiaries of public limited companies.  Most of the purely private limited companies do not resort to borrowing of funds from the public sector banks and financial institutions and even do not have public shareholdings, and those companies earlier enjoyed several exemptions from the requirement of stricter compliances with the provisions of the old Act.  However, in the new Act  those exemptions stood more or less withdrawn and has therefore created newer challenges for the promoters/management of those private limited companies.  It is also reported that as a result of stricter provisions of the new Act, the rate of registration of new companies has come down in India after April, 2014.  The purely private companies continue to argue against the excessive regulatory controls over them and hope that the Government will favourably accede to their pleas and relaxations might be accorded to them.  

As is well known, for ensuring good corporate governance, many new provisions were incorporated in the Act and many existing provisions were altered making them more stricter and stringent.  Stiff punishments of imprisonment and/or fine were stipulated for non-compliance of those provisions by the corporate sector.  The Act also elaborated and defined  the duties, responsibilities and liabilities of the Company Directors.  To ensure adherence to good corporate governance practice, the Act stipulated mandatory appointment of “Key Managerial Personnel” (“KMP”) in certain specified companies. To dilute the control of the promoters and company management in corporate decision making processes, the law has now made it mandatory for appointment of “Independent Directors”  in certain specified companies, and elaborate duties  and responsibilities of such independent directors were prescribed in the Act itself and even these independent directors are required to follow a detailed code of conduct, which forms part of the Act itself. 

To prevent corporate frauds, for the first time, well defined provisions were incorporated in the Act with detailed procedure for their investigation, and for speedy trial of those cases  the Act envisaged for the first time, setting up of   Special Courts.  To unearth frauds/suspected frauds, the Auditors of the companies have a mandate to report to the Central Government and to the Audit Committee of the Board the incidence of actual or suspected corporate frauds which they might come across during the course of their audit of company accounts and documents.  Since a large number of gullible investors were duped and lost their savings/earnings in the “fixed deposit” schemes of companies, in the Act stricter and elaborate provisions have been prescribed for compliance by companies obtaining public deposits and stringent punishments have been earmarked for the defaulters.    

To curb the malpractice and misuse associated with the companies entering into contracts and arrangements with relatives of directors and the KMP, as well as with companies in which the company promoters/key managerial personnel are interested, the new Act incorporated elaborate stricter provisions. Collectively they were referred to as “Related Party Transactions” (RPTs) and mainly section 188 of the Act and the corresponding Companies (Meetings of Board and its Powers) Rules, 2014 (“CMBP Rules”) were enacted and it also covered, inter-alia, stricter provisions with regard to giving of loans and guarantees to directors; and also restrictions were imposed on certain transactions between holding and subsidiary company.  The provisions of the Act and the said CMBP Rules also prescribed conditions for the Board of Directors of companies to report to the shareholders the details of the terms and conditions of RPTs and their justification. Additionally,  specific law was enacted in sub-section (1) if section 184 of the Act restricting investment through not more than 2 layers of investment companies.  

All these measures were intended to curb corporate malpractices/mismanagement and to ensure good corporate governance norms by companies.  Though the relevant provisions of the Act and the Rules were found to be too complex and complicated and very difficult to follow, yet, gradually the companies and the professionals associated with companies in their implementation started complying with them.  However, simultaneously, the Industry bodies and the Professional Institutes started representing to the Government to remove some of the bottlenecks in RPTs to facilitate ease in doing business.    

In order to address the issues and concerns raised by the stakeholders including the Professional Institutes and with a view to enabling “ease in doing business”, in the Winter Session of the Parliament, the Government introduced a new Bill viz. The Companies (Amendment) Bill, 2014 (“the Amendment Bill”) proposing 14 amendments to the new Act and on 17th December, 2014, the said Amendment Bill was passed by the Lok Sabha and now awaits its passing from the Rajya Sabha. 

In this article, an attempt has been made to elaborate only the proposed changes which dilute the restrictions on “related party transactions”(“RPTs”) as well as liberalises the transactions between the holding and subsidiary companies. Before we analyse the impact of the changes being brought out by the Amendment Bill, it would be necessary to look at some of the important provisions of the new Act which have a direct bearing on the RPTs.  One such provision is who is a “related party”.   Section 2(76) of the new Act defines that with reference to a company  ‘related party’ means :-

1. A director or his relative;
2. A  “Key Managerial Personnel” (“KMP”) or his relative;
3. A firm, in which  director, manager or his relative is a partner;
4. A private company in which a director or manager is member or director;
5. A public company in which a director or manager is a director or holds along with his relatives, more than 2 (two) percent of its paid up share capital;
6. Any body corporate whose BOD, Managing Director or Manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager;
7. 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;
8. Any company which is – (A) a holding, subsidiary or an associate company of such company; or (B) a subsidiary of a holding company to which it is also a subsidiary;
9. Such other person as may be prescribed.

Further, section 2(77) of the new Act defines “relative” with reference to any person and it means anyone who is related to another if –

1. They are members of a Hindu Undivided Family;
2. They are husband and wife; or  
3. One person is related to the other in such manner as may be prescribed.

Rule 4 of the Companies (Specification of Definitions Details) Rules, 2014 provides that a person shall be deemed to be the relative of another, if he or she is related to another in the following manner, namely – (i) Father (including step-father); (2) Mother (including step-mother); (3) Son (including step-son); Son’s wife; (5) Daughter; (6) Daughter’s husband; (7) Brother (including step-brother); and (8) Sister (including step-sister).
Section 2 (51) of the new Act defines “KMP”, in relation to a Company means –

1. The Chief Executive Officer (CEO) or the Managing Director (‘MD’) or the Manager;
2. The Company Secretary;
3. The Whole Time Director;
4. The Chief Financial Officer;
5. Such other officer as may be prescribed.

 
To restrict related party transactions (RPTs), sub-section (1) of section 188 of the Act stipulates that  “except with the consent of the Board of Directors  given by a resolution at a Board meeting and subject to such conditions as may be prescribed, no Company shall enter into any contract or arrangement with a Related Party with respect to –

1. Sale, purchase or supply of any goods or materials;
2. Selling or otherwise disposing off, buying  property of any kind;
3. Leasing of property of any kind;
4. Availing or rendering of any services;
5. Appointment of any agent for purchase or sale of goods, materials, services or property;
6. Such Related Party’s appointment to any office or place of profit in the Company, its subsidiary Company or associate Company; and
7. Underwriting the subscription of any securities or derivates thereof of the Company”.

However, the first two provisos to sub-section (1) of Section 188 of the Act stipulates that RPTs can be entered into by passing “special resolution” by non-related party shareholders of the company.  Passing of “special resolution” (75% majority) by non-related shareholders was envisaged so that ostensibly under the garb of entering into contracts or arrangements in respect of the aforesaid areas mentioned in sub-section (1) of Section 188 of the Act, it would be rather difficult for promoters/company’s management to favour their own relatives or group companies and divert company’s funds thereby to the related parties.  in this way a tough call for promoter/interested-parties dominated companies.

Additionally, Rule 15(3) of the aforesaid un-amended CMBP Rules prescribed certain pre-conditions for entering into RPTs.  As per Rule 15(3)(i) of the un-amended CMBP Rules, no company having a paid up share capital of Rs.10 crores or more could enter into RPTs without following the pre-requisite conditions. Further, Rule 15(3)(ii) prescribed certain limits on the contracts/transactions enumerated in sub-section (1) of Section 188.  However, the Central Government vide Notification dated 14.8.2014, amended the aforesaid Rule 15(3) and now the paid-up share capital clause has been omitted.   This means that the RPTs are applicable to all types of companies, as the paid-up share capital criteria stands deleted.  Certain threshold limits were prescribed in Rule 15(3) of the said CMBP Rules, 2014 but vide notification dated 14.8.2014, the said Rule has been amended.  Now, earlier Rule 15(3) of the CMBP Rules stands substituted by the following rules :

“(3) For the purposes of first proviso to sub-section (1) of section 188, except with the prior approval of the company by a special resolution, a company shall not enter into a transaction or transactions, where the transaction or transactions to be entered into –
(a) as contracts or arrangements with respect to clauses (a) to (e) of sub-section (1) of section 188, with criteria as mentioned below –
(i) sale, purchase or supply of any goods or materials, directly or through appointment of agent, exceeding ten per cent of the turnover of the company or rupees one hundred crore, whichever is lower, as mentioned in clause (a) and clause (e) respectively of sub-section (1) of section 188;
(ii) selling or otherwise disposing of or buying property of any kind, directly or through appointment of agent, exceeding ten per cent of net worth of the company or rupees one hundred crore, whichever is lower, as mentioned in clause (b) and clause (e) respectively of sub-section (1) of section 188;
(iii) Leasing of property of any kind exceeding ten per cent of the net worth of the company or ten percent of turnover of the company or rupees one hundred crore, whichever is lower, as mentioned in clause (c) of sub-section (1) of section 188;
(iv) availing or rendering of any services, directly or through appointment of agent, exceeding ten percent of the turnover of the company or rupees fifty crore , whichever is lower, as mentioned in clause (d) and clause (e) respectively of sub-section (1) of section 188;

                      Explanation:  It is hereby clarified that the limits specified in sub-clauses (i) to (iv) shall apply for transaction or transactions to be entered into either individually or taken together with the previous transactions during a financial year.
(b) is for appointment to any office or place of profit in the company, its subsidiary company or associate company at a monthly remuneration exceeding two and half lakh rupees as mentioned in clause (f) of sub-section (1) of section 188; or
(c) is for remuneration for underwriting the subscription of any securities or derivatives thereof, of the company exceeding one per cent of the net worth as mentioned in clause (g) of sub-section (1) of section 188.

Explanation (1) The turnover or net worth referred in the above sub-rules shall be computed on the basis of the audited financial statement of the preceding financial year.
(2) In case of a wholly owned subsidiary, the special resolution passed by the holding company shall be sufficient for the purpose of entering into the transactions between the wholly owned subsidiary and the holding company.
(3) The explanatory statement to be annexed to the notice of a general meeting convened pursuant to section 101 shall contain the following particulars, namely –
(a) name of the related party;
(b) name of the director or key managerial personnel who is related, if any;
(c) nature of relationship;
(d) nature, material terms, monetary value and particulars of the contract or arrangement;
(e) any other information relevant or important for the members to take a decision on the proposed resolution.”

 Nonetheless, despite the amendment dated 14.8.2014 to the aforesaid CMBP Rules, the companies were still required to get approval through special resolution for RPTs exceeding  the threshold limits.  As is known, to oversee the important corporate functions,  section 177 of the Act, read with Rule 6 of the CMBP Rules, 2014 mandates setting up an “Audit Committee” of the Board of Directors (consisting of a minimum of three directors with Independent Directors forming a majority) in  every listed company and in every public company with a paid-up share capital of ten crore rupees or more;  all public companies having turnover of one hundred crore rupees or more; all public companies having in aggregate, outstanding loans or borrowings or debentures or deposits exceeding fifty crore rupees or more.   Clause (iv) of sub-section (4) of section 177 deals with the power of the Audit Committee with regard to approval/any subsequent modification of RPTs.

To enable ease in doing business by the public companies, the Amendment Bill inserts a new proviso to Section 177(4) which stipulates “provided that the Audit Committee may make omnibus approval for related party transactions proposed to be entered into by the company, subject to such conditions as may be prescribed.”  Thus, the Audit Committee will now be empowered to give omnibus approvals for related party transactions. 

In order to make doing business easier for public companies, apart from liberalising abovementioned Section 177 of the Act, the Amendment Bill  stipulates that in the first proviso to section 188(1) of the Act, instead of  passing of “special resolution” by non-related shareholders in respect of approval of RPTs,  “special resolution” has been substituted with “resolution”.  In other words, the requirement of passing of “special resolution” of non-related shareholders is being diluted for RPTs, and companies will find it rather easy to get ordinary resolutions passed.  Corporate experts and critics fear that while there is no doubt that it will help in “ease in doing business”, yet it would  also adversely impact the financial discipline and adherence to good corporate governance standards by public  companies.

Not only the abovementioned relaxations in the RPTs, in respect of transactions between the holding and subsidiary companies, the Amendment Bill  inserts  a new proviso to sub-section (1) of Section 188 and it reads as “provided also that the requirement of passing the resolution under first proviso shall not be applicable for transactions entered into between a holding company and its wholly owned subsidiary whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval.” This amendment also aims in easing  entering of  transactions between holding and subsidiary company.
Explanation (b) to Section 188(1) of the Act further stipulated that the restrictions shall not apply to any transactions entered into by the Company in its ordinary course of business, other than transactions which are not on arm’s length basis. The expression “arm’s length transaction”  was explained as meaning a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest. In a closely held public company or in a company where the promoters/company management directly or indirectly controls majority voting powers, it would have been rather difficult for the companies to establish and prove that the concerned contract or arrangement was “arm’s length” basis and not between related parties.   
This being the statutory provisions restricting RPTs, it covered virtually all the major and substantial transactions of the company relating to sale, purchase or supply of any goods or materials, disposing off, buying/leasing property of any kind and/or availing of or rendering of any services. However, what the corporate sector found most intriguing and bothersome was the requirement of passing of special resolution of un-related shareholders for approving RPTs.  So, the trade bodies relentlessly represented to the Central Government to liberalise the mandatory requirement of passing of special resolution by un-related shareholders for approving RPTs.  Since, section 188(2) of the Act mandates the Board of Directors of a company to report all RPTs in their report to the shareholders along with adequate justifications and contract/arrangement details, naturally the RPTs could not kept hidden.   Further, section 188 stipulates that company may proceed against a director or against any other employee who has contravened the provisions of this section and may proceed for recovery of any loss sustained by it as a result of such contract or arrangements.  Also, Section 188 (5) provides that any Director or any other employee of the Company who had entered into or authorized the contract or arrangement in violation of the provisions of this section shall  be punishable with imprisonment for a term extendable up to 1(one)  year or with fine which shall not be less than Rs.25,000/- but which may extend to Rs.5,00,000/- or with both; and in case of any other company, be punishable with fine ranging between Rs.25,000/- to Rs.5,00,000/-.  In addition, provisions of section 192 of the Act also prohibited entering of contracts in which directors are interested, without following the due process of law.
Therefore, the Amendment Bill passed by the Lok Sabha on 17th December, 2014 (which is yet to be passed by the Rajya Sabha), liberalises and dilutes the restrictions in entering into of contract or arrangements in which the directors, their relatives, the KMPs are interested.  This will no doubt provide great relief to the companies and will definitely help in “ease in doing business”.  One only hopes that this will not adversely impact the adherence to good corporate governance norms by the companies and will continue to protect the interests of the ordinary shareholders who do not exercise control over the functioning of the companies.  To accelerate the economic growth, India is expecting huge foreign investments and how the Indian companies perform in maintaining transparency and protections of all the stakeholders, is a moot question and one hopes that the Indian corporate sector and the professionals associated with them will not fail in maintaining ethical standards.
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