A company enters into many contracts with various parties for purposes like sale, purchase of good, availing or rendering of services or selling or purchasing property. Generally, there is no fundamental issue with such contracts. However, when such contracts are entered into between related parties like directors, key managerial personnel, or their relatives and the company, these contracts are considered as related party transactions (“RPT”).
This playbook will discuss what is a related party transaction, what are the compliances required for entering into a related party transaction, exemption from compliances and effects of non-compliances etc.
This playbook focuses on the Companies Act, 2013 (“Act”) and the Companies (Meetings of Board and its Powers) Rules, 2014 (“Rules”). Listed companies also in parallel have to comply with SEBI regulations: this playbook does not cover those.
For any discussions, please e-mail srishtiojha@veristlaw.com or sudha.muddaiah@veristlaw.com. And remember this is not formal legal advice!
Key Terms
Let's play
1. RPT Test
1.1. It is important to run any potential transaction past the test of an RPT. An RPT is:
Any contract or arrangement with a related party with respect to
sale, purchase or supply of any goods or materials;
selling or otherwise disposing of, or buying, property of any kind;
leasing of property of any kind;
availing or rendering of any services;
appointment of any agent for purchase or sale of goods, materials, services or property;
such related party's appointment to any office or place of profit5 in the company, its subsidiary company or associate company; and
underwriting the subscription of any securities or derivatives thereof, of the company.
2. Compliances
2.1. At the outset, test any potential transaction for: is any party to the transaction a related party? If yes, does the transaction passes the test of RPT? If yes, a Board resolution is mandatory for a company to enter into such RPT.
2.2. Next, is an extraordinary general meeting (“EGM”) also required? This is the checklist to arrive at if EGM is required.[1]
S. No.
| Nature of transaction | Threshold |
Sale, purchase or supply of any goods or materials directly or through appointment of agent | 10% or more of the turnover of the company. | |
2. | Selling or otherwise disposing of, or buying, property of any kind directly or through appointment of agent | 10% or more of net worth of the company. |
3. | Leasing of property of any kind | 10% or more of the turnover of the company |
4. | Availing or rendering of any services, directly or through appointment of agent | 10% or more of the turnover of the company |
5. | For appointment to any office or place of profit in the company, its subsidiary company or associate company | At monthly remuneration exceeding ₹ 2.5 lacs |
6. | For remuneration for underwriting the subscription of any securities or derivatives thereof, of the company | The remuneration exceeding 1% of the net worth of the company |
* the limits set above apply to the transaction(s) entered into either individually or taken together with previous transactions during a financial year.[2]
** the net worth or turnover of company is to be computed basis audited financial statement of the company of the preceding Financial Year.[3]
2.3. Before these meetings – either Board or EGM – some disclosures are required to be made by the company. Below is a table enumerating those:
In case of Board meeting, agenda of the Board meeting should disclose[4]
| a. The name of the related party and nature of relationship; b. The nature, duration of the contract and particulars of the contract or arrangement; c. The material terms of the contract or arrangement including the value, if any; d. Any advance paid or received for the contract or arrangement, if any; e. The manner of determining the pricing and other commercial terms, both included as part of contract and not considered as part of the contract; f. Whether all factors relevant to the contract have been considered, if not, the details of factors not considered with the rationale for not considering those factors; and g. Any other information relevant or important for the Board to take a decision on the proposed transaction. |
In case of general meeting, the explanatory statement to the notice of the general meeting should contain[5]
| 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 arrangements; e. Any other information relevant or important for the members to take a decision on the proposed resolution. |
2.4. Does the RPT involve a director? In case of the Board meeting, if a director is interested in any related party transaction, such director should not be present at the meeting during discussions on the subject matter of the resolution relating to such contract or arrangement.[6]
Does the RPT involve a shareholder? In case of general meeting, a member (i.e., shareholder) should not vote on a resolution to approve any contract or arrangement which may be entered into by company, if he is a related party for such contract or arrangement.[7] However, this restriction shall not apply in case more than 90% of the members of the company are either relatives of promoters or are related parties.[8]
2.5. Every contract or arrangement which is a related party transaction and which has been entered into by the company should be included in the Board’s report to the shareholders along with justification for entering such contract or arrangement.[9]
3. Exemption from compliances
When a related party transaction is entered into by the company in its ordinary course of business and is carried on an arm’s length basis[10], then the company will not be required to undertake any compliances mentioned in this note.[11] A transaction is considered to be entered on arm’s length basis if the transaction between the related parties is conducted as if they were unrelated, so that there is no conflict of interest.
4. Unauthorised related party transactions: correcting the miss
4.1. Retrospective approval: The Board of directors or the general meeting, as the case may be, may approve a related party transaction entered into by a director any other employee without such approval within three months from date of such entering.[12]
4.2 Rescinding the transaction: If an unauthorised related party transaction is not approved retrospectively, such contract or arrangement is voidable at the option of the Board or the shareholders – depending on whose approval was required at the first place.[13]
4.3 Indemnification by Director in certain cases: If the contract or arrangement was with a related party to any director, then the director should indemnify the company against any loss incurred by the company.[14]
4.4 Court process: The company can proceed against the director or employee who has indulged in unauthorised related party transaction for recovery of loss sustained by it as a result of such contract or arrangement.[15]
5. General FAQs
5.1. Is any related party transaction completely prohibited?
Section 188 of the Act aims to regulate the manner in which the related party transactions are to be entered into. It does not impose a blanket prohibition on related party transactions. Therefore, if the compliances required under Section 188 of the Act and the Rules are fulfilled, a company can enter into related party transactions.
5.2. What are the implications on the director or employee violating provisions related to RPT?
Penalty: Any director or employee who has entered into any contract or arrangement in violation of Section 188 is liable to pay to the Registrar a penalty of ₹ 5 Lacs.[16]
Disqualification from future directorship: A person is ineligible for appointment as a director if he has been convicted of the offence dealing with related party transaction under Section 188 of the Act at any time during last preceding five years.[17]
Footnotes:
[1] 1st proviso to Section 188(1) read with Rule 15)(3)(a) of the Companies (Meetings of Board and its Powers) Rules, 2014. [2] Explanation to Rule 15(3)(a) of the Companies (Meetings of Board and its Powers) Rules, 2014. [3] Explanation to Rule 15(3)(b) of the Companies (Meetings of Board and its Powers) Rules, 2014
[4] Section 188(1) read with Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014.
[5] Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014.
[6]Section 188(1) of the Companies Act, 2013 read with Regulation 15(2) of the Companies (Meetings of Board and its Powers) Rules, 2014.
[7] 2nd proviso to Section 188(1) of the Companies Act, 2013. [8] 3rd proviso to Section 188(1) of the Companies Act, 2013.
[9] S. 188(2) of the Companies Act, 2013.
[10] 4th proviso to Section 188(1) of the Companies Act, 2013. [11] 4th proviso to Section 188(1) of the Companies Act, 2013.
[12] Section 188(3) of the Companies Act, 2013. [13] Section 188(3) of the Companies Act, 2013. [14] Section 188(3) of the Companies Act, 2013. [15] Section 188(4) of the Companies Act, 2013.