Introduction:
Members of the professional fraternity are aware that the Companies Act 2013(hereinafter referred to as “The Act”) is being notified for implementation in a phased manner-not surprisingly though, considering its overwhelming slant and dependence on sub-ordinate Legislation in the form of Rules. As we write these lines, only 98 out of the 470 Sections in the Act have been notified either in full or in part on September 12, 2013 in the Official Gazette. Understandably those provisions which are inextricably linked to the need for sub-ordinate legislation have been held back for implementation on a prospective date. The MCA have also come out in four tranches with a clutch of draft Rules which will complement the substantive law. The draft Rules have been debated across various platforms and the responses received from the stakeholders, will be considered by the MCA before the Rules are finalized.
Given the above background, we have therefore the unenviable specter of both the new Act as also the Act of 1956 co-existing concurrently. Corporate Professionals have therefore to willy-nilly consult both the Acts while dealing with various issues – an entirely undesirable situation which is somewhat analogous to consulting two sets of the Hindu Almanac ! – Surely not the best environment to tackle the intricacies of Corporate Law!!. As they say, one cannot always have the best of both worlds and in the given scenario, one has to accept the ground realities and move along stoically.
“Related Party” Defined
Be that as it may, we shall focus on the subject of our discussion which is the procedural law proposed in the Act to regulate Related Party transactions. Section 2(76) of the Act provides a “means” and restrictive definition to the term “Related Party”. This definition has been notified in the Official Gazette with effect from September 12, 2013. It is pertinent to note that there was no definition to the above term in the 1956 Act. Accounting Standard-18(AS-18) issued by The Institute of Chartered Accountants of India which has mandatory application under the aegis of Section 211(3C) of the 1956 Act sets out the various types of related party relationships and transactions between a reporting enterprise and its related parties which will fall within the ambit of disclosure. In this exposition we shall not try to identify the areas of difference between the definition given by Section 2(76) of the Act and AS-18.We shall confine only to our observation that the tentacles of Section 2(76) are far wider than what is contemplated for coverage under AS-18.
Procedure for Authorization –Section-177
Section 177 of the Act which has not yet been notified which corresponds to Section 292A of the 1956 Act speaks about the manner of functioning of the Audit Committee. Sub-section (4) stipulates that the Audit committee shall act in accordance with the terms of reference to be provided in writing by the Board. The terms of reference of the Committee, shall, inter alia, include “approval or any subsequent modification of transactions of the Company with related parties” (Emphasis supplied). It is submitted that the drafting of this clause leaves much to be desired and the same is grammatically incorrect. The clause ought to have been redrafted on the following lines to convey the meaning it seeks to provide –“approval of transactions of the company with related parties or any subsequent modifications thereto”. (Emphasis supplied)
From the above, it follows that the Audit Committee is expected to approve all transactions of the Company or any modifications of such contracts with related parties regardless of the value involved. By contrast Section 292A of the 1956 Act does not provide for a similar requirement. Under clause 49 of the Listing Agreement relating to Corporate Governance the Audit Committee is, inter alia, mandatorily expected to review the related party transactions as defined by the Committee submitted by the Management. Both under Section 292A and clause 49, the role carved out for the Audit committee is by and large only recommendatory in nature. As and when Section 177 is notified it will be the responsibility of the Committee to approve all contracts with related parties as also any modifications thereto.
Requirements under Section 188 of the Act
Section 188 speaks about the Board’s responsibilities where it comes to granting approval to related party transactions. Draft Rules underlying the above provision have been brought out by Ministry of Corporate Affairs (MCA) under Chapter XII. Neither the above section nor the draft rules have yet been notified.
The section contemplates that except with the consent of the Board obtained by a resolution at a duly convened Meeting and subject to such conditions as may be prescribed, a company cannot enter into any contract or arrangement with a Related Party with respect to:
a) Sale, purchase or supply of any goods or materials;
b) Selling or otherwise disposing of, or buying, property of any kind;
c) Leasing of property of any kind;
d) Availing or rendering of any services;
e) Appointment of any agent for purchase or sale of goods, materials, services or property;
f) Such related party’s appointment to any office or place of profit in the company, its subsidiary company or associate company; and
g) Underwriting the subscription of any securities or derivatives thereof, of the company.
From the above, it can be inferred that the approval to related party transactions cannot be obtained from the Board through circulation nor can the power to approve such transactions be delegated by the Board to a Committee of the Board.
The first proviso to the above section sets out that a company having the prescribed size of Share Capital or seeking to approve related party transactions for a value exceeding the prescribed sum shall not enter into contracts with related parties except with the prior approval of the Shareholders by Special Resolution.
As per Rule 12.14(1) of the Draft Rules on the above, circulated by MCA under chapter XII, the thresholds for applicability of the first proviso are as under:
(i) The company has a paid up share capital exceeding Rs. 1 Crore or more ; or
It is pertinent to note that Section 2(64)of the Act which has been notified defines “paid up share Capital” or “Share capital paid up” to mean ,inter alia, such aggregate amount of money credited as paid-up as is equivalent to the amount received as paid up in respect of shares issued. It follows from the above that in as much as the definition does not distinguish between different species of capital, the term “paid up capital” would be inclusive of both equity and preference capital.
(ii) If the above threshold is not met, where the transaction value either individually or taken together with previous transactions during a Financial year exceeds 5% of the Annual Turnover or 20% of the Net Worth of the Company, whichever is higher. This threshold shall apply to transactions of the nature set out in (a) to (e) above.
The term”Net worth” shall carry the meaning given to it by Section 2(57).This definition has legal force since it has been notified. From a plain reading it is clear that the term “Net Worth” shall include both paid up Equity and Preference Capital, apart from Reserves which are created out of profits and the securities Premium Account.
Where the transaction relates to appointment of any related party to an office or place of profit in the company, its subsidiary company or associate company at a monthly remuneration exceeding Rs. 1 Lac, prior approval by Special Resolution would be necessary.
If the transaction is by way of remuneration for underwriting the subscription of any securities of the company and the remuneration exceeds Rs 10 lacs prior approval of shareholders by special resolution will be necessary.
For contracts involving Holding Company and its Wholly Owned Subsidiary, it would be adequate if the Special Resolution for approval is obtained from the shareholders of the Holding Company only.
Exception:
The procedure prescribed above shall not apply in respect of transactions entered into by the company
(i) In its ordinary course of business
(ii) other than transactions which are not on an arms’ length basis.
The above exception applies only if both the conditions above apply.
What constitutes “ordinary course of business” has not been defined by the Act. The term will have to be therefore, given the meaning applied to it in general parlance and in decided judicial precedents. As per the Legal Lexicon, “‘ordinary course of business’ has been defined to mean the ‘usual course and routine of business’.
The expression ‘arms’ length basis’ has been defined in the explanation to section 188 to mean “a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest”.
Board’s Report to include details of Related Party Transactions:
In addition, Section 188(2) provides that every related party transaction shall be referred to in the Board’s Report to the shareholders circulated with the Accounts along with the justification for entering into such contracts or arrangements.
Contents of Explanatory Statement under Section 102 of the Act:
Where the approval of the shareholders is required to be taken by special resolution, an Explanatory Statement should be annexed to the notice of the General Meeting under section 102 of the Act which will contain the following details:
(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.
Consequences of such contracts entered into without approval by Board / Shareholders:
Although subsection (1) to section 188 of the Act speaks about the need for obtaining previous approval of the Board or Shareholders, sub section (3), however, provides for ratification of such contracts either by the Board or by the Shareholders. Ratification can be obtained from the Board or the Shareholders within 3 months from the date of such contract. If no ratification is obtained within the above period, the contract shall be voidable at the option of the Board. Further, if the contract is with a Party which is related to any director or is authorised by any other director, the directors shall be liable to indemnify the company against any loss incurred.
Authority to Company to proceed against Director or Employee:
The section authorises the company to proceed against any director or any other employee who has entered into such contract in violation of the provisions for the recovery of any loss sustained.
Penalties for contravention- A clear case of over-legislation
a) In case of a listed company, imprisonment for a term which may extend to one year or fine which may extend to Rs. 5 lacs or both imposable on any director or employee who has entered into the contract in contravention of the section.
b) In case of any other company, fine which may extend up to Rs. 5 Lacs.
It may also be noted that in terms of Section 167(1) (c) and (d) a Director is liable to vacate his office if he acts in contravention of the provisions of Section 184 relating to contracts in which he is directly or indirectly interested or when he fails to disclose his interest in contracts in which he is directly or indirectly interested.
Yet another deterrent in the law is to be found in terms of Section 164(1) (g) which provides that a Director shall be disqualified from acting as one in case he has been convicted of any offence dealing with related party transactions u/s 188 at any time during the last preceding five years. This provision obviously has retrospective force as it would encompass aberrations committed by the Director in the last preceding five years.
An interesting duty that is being cast upon the independent Directors where it comes to related party transactions is to be found in Schedule IV of the Act which lays down the code for Independent directors. One of the duties of the Independent directors is quote “ to pay sufficient attention and ensure that adequate deliberations are held before approving related party transactions and assure themselves that the same are in the interest of the company” unquote.
It is well known that well established companies examine the credentials of persons whom they wish to appoint as Independent Directors minutely and only after they are convinced that the stature and credentials of the person concerned is commensurate with the image of the company that they zero down on the appointee. To state expressly in the statute that Independent Directors should pay sufficient attention would be an affront to the reputations of persons of stature. We would submit that the statute should not be reduced to an exercise in pontification !
Critique of Section 188
1) The Section applies to every company including a private company. Compliance particularly by private companies will be rendered difficult.
2) The definition as to what constitutes “Arms’ length transaction” is very vague and open to conflict.
3) Definition of related party: Definition of related party is given in section 2(76) of the Act which, as stated above, has already been notified. The definition is much wider and is not in harmony with AS 18. It follows therefore that the definition under AS 18 will have to be necessarily modified in line with the above section to facilitate seamless integration. In the given present scenario, therefore, if the section is notified and no consequential changes are made to the definition in AS-18, two sets of statements of transactions with related parties will need to be prepared by the Company and placed for Board authorization – (i) As per AS 18 and (ii) As per Section 188.
Further, as per Clause 49 of the listing agreement, there is at present only a requirement of disclosure of related party transactions and this disclosure only is to the Audit committee and not to the Board. Hence, unless Clause 49 is consequentially amended, related party transactions will have to be placed before the Audit committee under Section 177 for approval and u/s 188, referred to the Board for approval.
Conjoint reading of Section 177,188 and the draft Rules underlying Section 188
A conjoint reading of the above provisions reveals the following contradictions/inconsistencies.
Section 177 provides that every related party transaction regardless of its value, whether or not it is struck on arm’s length basis, will have to be approved by the Audit committee. Such approval will be required for every conceivable transaction whereas in Section 188 Board Authority will be required only for transactions outlined in items (a) to (g) in section 188 as stated above.
No authorization shall be required either of the Board or the shareholders if both the following conditions in Section 188 are ensured:
a) The transaction is in the ordinary course of the company’s business.
b) The transaction is on arms’ length basis.
Section 177 does not contemplate either of the above eventualities. The question that comes up for contention is whether the provisions of Section 177 will prevail over Section 188. A pragmatic view that can be taken is that in as much as Section 188 is a specific provision, Section 177 will have to yield place to Section 188 since the former is a general provision dealing in the main with the functioning of the Audit Committee ,.in deference to the settled principles of judicial interpretation:
As both Sections 177 and 188 contemplate approval by the Audit committee as also by the Board, there would be redundancy in procedure which will again give rise to the question as to the approval of which body namely the Audit committee or the Board would carry greater force. The Committee being sub-ordinate to the Board ,it should only play a recommendatory role as at present.
No value bands have been prescribed u/s 177 for approval by the Audit committee. It is only appropriate that value thresholds ought to have been prescribed. As per the provisions of Section 177 the Audit Committee would have to approve every related party transaction. Further it does not have to examine whether the transaction is in the ordinary course of business and whether it has been finalized on arms’ length basis as contemplated u/s188.
Section 188, per se, suggests that approval of the Board or the shareholders would not be necessary if the transaction with the related party is in the ordinary course of the company’s business and is on arm’s length terms.
The first proviso to Section 188 (1) lays down that “no contract or arrangement, in the case of a Company having a paid-up share capital of not less than such amount, or transactions not exceeding such sums ,as may be prescribed, shall be entered into except with the prior approval of the company by a special resolution.”
Pursuant to the above, draft Rules have been prescribed under Chapter XII, the particulars of which have been provided hereinabove. The need for seeking members’ approval by special resolution based on the draft Rules prescribed would arise only when the thresholds laid down in draft rule 12.14 are breached.
We can therefore summarize the legal position that emerges from the conjoint reading of the provisions as under:
i) As per Section 177 every transaction with a related party and any modifications in the terms thereto will have to be approved by the Audit committee.
ii) The Board will have to approve related party transactions at a duly convened Meeting in the following circumstances:
a) If the transaction entered into is not in the ordinary course of the company’s business.
b) the transaction is not struck on arm’s length basis.
iii) The need to obtain Members’ approval by special resolution would arise if the thresholds laid down in the draft rules are exceeded.
Reporting of Related Party transactions in the Board’s Report as per Section 134(3)-Redundancy of Procedure
We have already spoken hereinabove about the need to disclose in the Board’s Report to the members particulars of all related party transactions which fall within the ambit of section 188(1) together with a justification for entering into such transactions. The above requirement is called for in terms of Section 188(2). In spite of the above, it is intriguing to note that Section 134(3) of the Act which lays down the contents of the Board’s Report to the members of the company, reiterates the need for such a disclosure. Clause (h) in Section 134(3) provides that the Report shall contain particulars of contracts or arrangements with related parties referred to in sub-section (1) of Section 188 in the prescribed form. The above is a verbatim repeat of the requirements called for u/s 188(2).Form No.9.5 has been prescribed pursuant to Rule 9.10(2) for disclosing particulars of the contracts/arrangements with related parties referred to in Sub-section(1) of Section 188. A perusal of the form reveals that particulars have to be disclosed both in respect of transactions not at arm’s length basis as also certain contracts which are at arm’s length basis which are in excess of the limits prescribed under the first proviso to Section 188(1) read with Item (a) and (c) of Rule 12.13(1) provided under Chapter XII.
One fails to understand the need to emphasize on the requirement of the same disclosure under the aegis of two provisions of the law unless the Legislature were paranoid about companies ensuring compliance on reporting such transactions , thus justifying the two pronged attack.!!
It is also pertinent to note that Section 134(3) (h) enjoins on the company to report to the Members only on related party transactions which fall within the ambit of subsection (1) of Section 188. The third proviso under subsection (1) of section188 clarifies that the subsection does not apply in respect of transactions which occur in the ordinary course of business and which are finalized on arms’ length basis. Therefore the reporting to the members and the justification thereof would be confined only to those transactions which enter the scope of Section 188(1).
A further dichotomy in the law can be discerned from a combined reading of Section 134(3) and 188(2). Whereas Section 134(3) (h) calls for provision of information in the Board’s Report relating to related parties in the prescribed format, Section 188(2) enjoins upon the Board to provide a justification for entering into such contracts. The prescribed form of disclosure u/s 134(3) does contain a column for provision of justification for contracts which are not arm’s length. That the Board has to also provide a justification for such contracts does not come out so obviously from a plain reading of Section 134(3).
Status Quo on Compliance
In view of the fact that as of now, since Sections 134,177 and 188 of the Act and the Rules underlying await notification, in our view, the status quo on reporting related party transactions will continue as before. The Audit Committee of the Listed Company will have to be provided with details of related party transactions. However the list of related party transactions will have to be compiled both in terms of the definition given to the term by Section 2(76) as also based on the provisions contained in AS-18. Such compilation will be rendered difficult and cumbersome due to the areas of divergence between AS-18 and Section 2(76).
Road Ahead
Going forward, assuming that no changes are made to Section 177,188 and the Rules there under the following scenario could conceivably emerge:
1) The Audit Committee will have to approve every related party transaction regardless of their materiality. Such identification will be based on Section 2 (76).The compilation would be both with reference to the above section and AS-18 unless AS-18 is in the interregnum aligned with Section 2(76).
2) The Board will approve transactions of the genre which fall within the scope of sub section (1) of Section 188 if they are not made in the ordinary course of business and are not struck on arm’s length basis.
3) The Board’s report will have to contain a report on such transactions in line with the format referred to hereinabove.
4) The tests for determining arm’s length basis will by no means be fool proof and in as much one cannot be an arbiter of one’s own actions, companies will have to resort to third party certifications to convince themselves.
5) As an onerous duty has been cast on the Board by the provisions, what with the prescription of stiff penalties, the Board members may adopt the policy of “safety first” and insist that such transactions whether or not they are at arm’s length basis be subjected to Board/Member’s approval.
6) One of the thresholds laid down for necessitating shareholder approval, namely the criteria of paid up share capital of Rs 1 Crore is so low that even marginal companies will be sucked into the vortex of elaborate compliance – The end result could be that the aspect of materiality will be sacrificed at the altar of procedure.
Conclusion
One message that comes out loud and clear from the procedural law laid down for sanctifying related party transactions in the new law is that such transactions will be subjected to Board/Member scrutiny like never before. We have no quarrels on that score. By all means, there should be greater transparency and greater dissemination of information to the minority holders.
What is going to make the compliance exercise more difficult and arduous is the possibility of redundancy in compliances, the conflict between Section 177 and 188 which we have dealt with copiously above, the conflict in the concept of related party as between Section 2(76) and AS-18.Under the new regime, the Company Secretary will have to ensure compliance of a mountain load .His position is going to most unenviable once the new law becomes fully operational. The dichotomy in the law on the subject authorization of related party transactions should not prove to be the proverbial last straw which broke the camel’s back.
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