Many frauds or allegations of fraud, particularly in listed companies, tend to have at their core a complex network of related party transactions. In India, related party norms are laid down in the Companies Act, 2013 ("Companies Act") and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 ("LODR Regulations"). The irony remains in how often such transactions do fully comply and fairly pass by the various corporate governance norms and are yet fraudulent. Often, it is only when there are several defaults of large loans (typically and naturally, unsecured and to related parties) that allegations of a potential "fraud" surface. Restating at the cost of repetition, it does more often than not turn out, even for such companies, that technical compliances under the Companies Act and LODR Regulations have been complied with.
This then invites the uncomfortable question of how, at a policy-meets-practical level, can governance be more meaningful to address a situation where companies- and transactions- which 'check all boxes' from a compliance standpoint still operate to effectuate a fraud.
Spectrum of RPT compliances
We have set out below the spectrum of compliances required in related party transactions ("RPT"). These rise, as will intuitively seem fair, from minimal for private companies to maximum for listed companies. The RPT compliances are set out below according to the nature of entities:
A. Public unlisted companies
Prior consent from the board of directors is required for all companies entering into RPTs (except when the transaction is in the ordinary course of business and on an arm's length basis). Apart from a board resolution, an ordinary shareholders' resolution approving the RPT is also required for- (i) larger companies which cross the prescribed threshold in terms of paid-up capital; and (ii) for any company irrespective of size, material transactions with related companies i.e. deals which exceed a prescribed threshold. Both thresholds are laid down in Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014 of the Companies Act).
Significantly, shareholders who qualify as "related parties" (i.e. if they are a party to the particular transaction) cannot vote on such shareholder resolutions [MCA General Circular No. 30/2014-Clarifications on matters relating to Related Party Transactions]. However, the voting restriction does not apply to companies where 90% or more members, in number, are relatives of the promoters or are related parties (the Companies (Amendment) Act, 2017).
Further, the audit committee is required to approve the RPT if the company's paid-up share capital, turnover or aggregate borrowings or deposits exceed prescribed amounts.
B. Private companies
The requirements listed in A. above also apply to private companies. However, certain categories of private companies have been specifically exempted by virtue of a Ministry of Corporate Affairs notification dated June 5, 2015 ("Notification"): holding, subsidiary or associate companies of private companies no longer qualify as "related parties" vis-à-vis the company and are therefore exempted from the purview of compliances under S. 188 (i.e. board and shareholder resolutions). This is not a sweeping exemption for all private companies. For example, a transaction between two seemingly unaffiliated private companies with common directors or managers will attract all compliances applicable to RPTs.
Notably, in RPTs involving public companies, related parties are not permitted to vote on the shareholders' resolution, but for private companies, there is no such restriction.
C. Listed companies
Listed companies are governed by the LODR Regulations in addition to the Companies Act. Apart from the obligations in A. above, which apply by force of the Companies Act, 2013 to all public companies, there is the additional requirement of (i) enhanced housekeeping (such as approval by the audit committees for all RPTs); and (ii) an obligation to seek shareholders' approval by ordinary resolution for deemed "material" RPTs. In a key difference of position with unlisted public companies, for listed companies, related parties are not allowed to vote to approve such a resolution, irrespective of whether they are a party to the particular transaction or not. However, they can vote to reject such a resolution.
A transaction with a related party is deemed to be "material" if individually, or taken together with previous transactions during a financial year, it exceeds ten percent of the annual consolidated turnover of the listed company as per the last audited financial statements.
Definition of a 'related party': Listed v. unlisted companies
A related party is defined in the Companies Act inclusively and includes:
Additionally, as per the LODR Regulations, this also includes 'related parties' as defined under the relevant accounting standards and any person or entity belonging to the promoter or promoter group of a listed company and holding 20% or more of shareholding in the listed company. This means that the pool of RPTs are significantly larger for listed companies due to a more expansive definition of 'related parties'. For example: a party can be a related party by definition but not a party to the particular RPT and yet be barred from voting on it in the shareholders' meeting.
On a close read, it appears that the corporate governance standards applicable to larger unlisted public companies are fairly similar to those for listed companies. One significant difference between listed and unlisted companies is that an RPT which qualifies as on "arm's length" basis is exempted from all the checks and balances under the Companies Act for the latter. For listed companies, there is no comfort in the arm's length defence and RPTs still require approval by an ordinary shareholders' resolution for "material" RPTs.
RPTs for all companies are easy to track in the public domain given the Companies Act filing obligations to the Registrar of Companies on board and shareholder resolutions, annual reports, and adhering to other financial reporting standards. For listed companies, any material transaction requires reporting to the stock exchanges which then publish the disclosures. There are a suite of management disincentives, including jail term, penalties and for listed companies, also a prohibition or suspension on trading.
The irony or inadequacy remains as a broader governance concern: a company can, for an extended period, continue to comply with the letter of the law and the network of contracts may actually be unraveled as a potential fraud situation only in retrospect when, over time, the play of facts indicate a marked number of major defaults