Related party transactions are a persistent area of compliance difficulty for Indian companies, particularly group companies where transactions between entities in the same group are routine. The Companies Act, 2013 imposes significant procedural requirements on related party transactions, and failure to comply can result in the transaction being voidable, along with penalties and personal liability for directors.
Who Is a Related Party
Section 2(76) of the Companies Act defines a related party broadly. The definition includes a director or key managerial personnel of the company and their relatives, a firm in which a director, manager, or their relative is a partner, a private company in which a director or manager is a member or director, and a public company in which a director or manager holds more than 2% of the paid-up share capital.
For holding and subsidiary relationships, the parent company, subsidiary, associate company, and any company that is a subsidiary of a holding company that also holds the company as a subsidiary are all related parties. In practice, in a corporate group with multiple tiers of entities, virtually all inter-company transactions will be related party transactions.
Section 188: The Core Requirement
Section 188 of the Companies Act requires that certain specified categories of contracts or arrangements with related parties can only be entered into with the consent of the Board of Directors at a meeting (not by circular resolution) and, in certain cases, with the approval of the members by ordinary resolution.
The specified categories include sale, purchase, or supply of 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, related party appointment to an office of profit, and underwriting subscriptions of securities or derivatives of the company.
The Audit Committee under Section 177 must approve related party transactions before the Board considers them. A company that takes related party transactions directly to the Board, bypassing the Audit Committee, is not in compliance with the Act even if the Board subsequently approves the transaction.
When Shareholder Approval Is Required
Shareholder approval by ordinary resolution is required where the related party transaction exceeds the thresholds prescribed by Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014. The thresholds are set by reference to the higher of the specified absolute amount or a percentage of turnover or net worth.
For sale, purchase, or supply of goods, shareholder approval is required where the transaction value exceeds Rs. 100 crore or 10% of the company's annual turnover. For transactions relating to property, the threshold is Rs. 100 crore or 10% of net worth. For services, the threshold is Rs. 50 crore or 10% of turnover.
In the shareholder vote, the related party concerned cannot vote on the resolution approving the transaction in which they are interested. This restriction is important in group company structures where the related party may hold a significant percentage of the company's shares.
The Arm's Length Exception
Transactions that are in the ordinary course of business and on arm's length terms are exempted from the Section 188 approval requirements. This is an important exemption for group companies, but it must be applied carefully. The burden of establishing that a transaction is at arm's length rests on the company. Internal pricing policies and transfer pricing documentation can help establish the arm's length character of inter-company transactions.
Even where the arm's length exemption applies, best practice is to ensure that the Audit Committee is still informed of material related party transactions, so that the committee can fulfil its oversight function under Section 177.
Consequences of Non-Compliance
A related party transaction entered into without the required Board or shareholder approval is voidable at the option of the Board. The company can ratify the transaction within three months, but if it does not, the directors responsible for entering into the contract without approval are liable to indemnify the company against any loss suffered.
Penalties under Section 188(5) can be imposed on the company and every officer in default. For listed companies, SEBI's related party transaction regulations impose additional and more stringent requirements, with higher thresholds and more detailed disclosure obligations.
Disclaimer: This article is for informational purposes only and does not constitute legal advice. It does not create a lawyer-client relationship. For advice specific to your situation, please consult a qualified legal professional. LawCite Advocates is a law firm registered in India.