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Related Party Transaction Regime: A Perplexity for Private Companies.

Related Party Transaction regime governed by Section 188 read with Section 2(76) of the Indian Companies Act, 2013 and Rule 15 of the -

Companies Meetings of Board and its Powers) Rules, 2014 has proved fatal to the survival and autonomy of private companies, which even after being a group concern are forced to comply with drawn out, protracted and cumbersome legislative mandates. The inaccurate drafting of Section 188 coupled with the rapidly changing legislative provision by continuous notifications, amendments and clarifications have further exacerbated the state of affairs write Sarvesh Khatnani and Shruti Sethi.

I. INTRODUCTION TO THE RELATED PARTY TRANSACTION REGIME IN INDIA AND THE PERPLEXITY CAUSED.

After its notification on 26th March, 2014, Section 188 of the Companies Act, 2013 which deals with Related Party Transactions has become undoubtedly, one of the most debated provisions in the Corporate Governance Regime due to its application on private companies, which were earlier exempted from its scope under Section 300 . Due to the confusion and ambiguity presented by this Section various Rules like the Companies (Meetings of Board and its Powers) Rules, 2014 and Companies (Specification of definition details) Rules, 2014, Amendment via notification , Orders and Clarifications have been issued by the Ministry in just a time span of 5 months in order to clarify the scope of this Section. However, it has not been able to achieve the same and has in turn become a sword hanging on the private companies.

Such an emphasis on Corporate Governance in the field of Related Party Transaction in the 2013 Act had its inception in the various scams that India faced in the recent past in the light of which this Act was framed, like the Satyam and the Sahara Scam, which were both public companies dealing with public money. The stringent

1. Ministry of Corporate Affairs, Notification, 26th March, 2014 available at http://www.mca.gov.in/Ministry/pdf/CompaniesActNotification27March2014.PDF last seen on 6/09/2014.

2. S. 188, Companies Act, 2013 [hereinafter "the 2013 Act"].

3. S. 300, Companies Act, 1956 [hereinafter "the 1956 Act"].

4. Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Rules, 2014, F. No. 1/32/2013-CL-V, March 31, 2014.

5. Ministry of Corporate Affairs, Companies (Specification of definition details) Rules, 2014, F No. 01/13/2013 (Part-I) CL-V, March 27, 2014.

6. Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Second Amendment Rules F. No. 1/32/2013-CL-V-Part, 2014, August 14, 2014; Ministry of Corporate Affairs, Companies (Specification of definition details) Amendment Rules, 2014, F. No. 01/13/2013 (Part-1) CL-V, July 17, 2014; Ministry of Corporate Affairs, Draft notification for public comments on Companies Act, 2013 F No 1/1 /2014-CL.V, June 24, 2014; Notification no. F. No. 01/13/2013 (Part-I)-CL-V, July 17, 2014.

7. Ministry of Corporate Affairs, Companies (Removal of Difficulties) Sixth Order, 2014 F. No. 2/14/2014-CL.V, July 24, 2014; Order F. No. 2/5/2014-CL.V, July 9, 2014.

8. Ministry of Corporate Affairs, General Circular No. 30/2014, July 17, 2014.

application of this Corporate Governance Principle on private companies, which are mostly a group concern, seems to be absurd.

This stringent control is evident from the proviso to Section 188 which empowers the minority shareholders and disallows an interested member, who is a related party, to attend and vote in meeting for such transactions. This proviso seems to be based on a valid rationale, theoretically; however its practical implementation in the case of private company has raised various issues. The intention of the lawmakers while bringing private companies within the ambit of Section 188 was to increase the level of corporate governance in public as well private companies by way of appropriate disclosures and to safeguard minority interest in the case of Related Party Transaction by empowering the shareholders. However, it has to be considered that private companies represent a different set of relationship in terms of ownership, risk and reward as compared to public companies. Since private companies, do not access capital markets, they require less rigorous protection for their shareholders. This means that private companies do not require stringent statutory Corporate Governance but need ample scope to regulate themselves which has not been provided by the 2013 Act.

II. THE AMOUNT OF CORPORATE GOVERNANCE REQUIRED IN PRIVATE COMPANIES.

Governance has its latin root in the word ‘gubernare’ which means to steer. ‘He that governs sits quietly at the stern and scarce is seen to stir’ is a quotation which should be kept in mind here. It implies that governance (i.e. Corporate Governance) need not and should not be heavy-handed.

9. S. 188(1) Second Proviso, Companies Act, 2013.

10. Jamshed J. Irani, Report on Companies Law, May 31, 2005 at 11 available at http://www.primedirectors.com/pdf/JJ%20Irani%20Report-MCA.pdf last seen on 6/09/2014.

11. Adrian Cadbury, Corporate Governance and Chairmanship: A personal view 1(Indian Ed., 2003).

12. Gee Publishing Ltd. (1992), Report of the Committee on the Financial Aspects of Corporate Governance (ISBN 0 852589158).

13. Supra 11.

Corporate Governance has been defined by the Cadbury Report (U.K.) as "a system by which businesses are directed and controlled." The definition in the preamble of the OECD Principles is also all encompassing and states "Corporate governance . . . involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined."

It has to be remembered that Private Companies are inherently different from public companies and require a lighter regulatory overhang. Private companies should be provided a certain relaxations on account of their nature. While good Corporate Governance is important for success of private companies, the obligation for dissemination of information of corporate process should be so structured that such enterprises do not lose the flexibilities in conduct of their business.

It has to be remembered that statutory and self-regulation have their part to play in corporate governance, especially for private concerns. Striking a balance between them is equally important as the voluntary approach (self regulation) can promote compliance, not just with the letter of law, but with the intention behind it, thus setting a higher standard. Unlike Section 188, Good Corporate Governance is not just a matter of prescribing particular corporate framework and complying with a number of hard and fast rules. The law should enable a private company to take any decision it is otherwise empowered to take by providing elasticity in law which complements

14. Adrian Cadbury, Report of the Committee on the financial aspects of Corporate Governance, December 1, 1992, available at http://business.gov.in/outerwin.php?id=http://www.ecgi.org/codes/documents/cadbury.pdf, last seen on 6/09/ 2014.

15. See Report of SEBI Committee on Corporate Governance 3 (February 8, 2003) available at http://www.sebi.gov.in/commreport/corpgov.pdf , last seen on 6/09/ 2014.

16. See Jamshed J. Irani, Report on Companies Law, May 31, 2005 at 11 available at http://www.primedirectors.com/pdf/JJ%20Irani%20Report-MCA.pdf last seen on 6/09/ 2014.

17. Supra 11.

18. Hampel Committee, Gee Publishing Ltd. (1998), Final report: committee on Corporate Governance, January (ISBN I 860890342), para. I.II.

their flexible nature.

III. POSITION UNDER THE COMPANIES ACT, 1956 (SECTIONS 297, 299, 300) vis-a-vis THE COMPANIES ACT, 2013 (SECTION 188).

The position under the 1956 Act with respect to Related Party Transactions is very different from that under the 2013 Act. The 2013 Act in Section 188 explicitly provides provisions for governing "Related Party Transactions." This Section is a counterpart of Section 297, 299 and 300 of the 1956 Act which did not expressly use the term "Related Party Transaction" as unlike Section 188 of 2013 Act.

Section 300 of the Companies Act, 1956 detailed the position of the private companies in the cases of Related Party Transactions by stating that "No director of a company shall, as a director, take part in the discussion of, or vote on, any contract or arrangement entered into, or to be entered into, by or on behalf of the company, if he is in any way, whether directly or indirectly, concerned or interested in the contract or arrangement; nor shall his presence count for the purpose of forming a quorum at the time of any such discussion or vote; and if he does vote shall be void. However, this is not applicable to a private company which is neither a subsidiary nor a holding company of a public company."

However Section 188(1), of the 2013 Act provides no exemption to private companies regarding Related Party Transactions as was given under the 1956 Act. This implies that private companies have to follow lengthy procedures for approving simple transactions.

The 2013 Act widens the scope of transactions covered under "Related Party Transactions" by increasing the scope of the definition of Related Party provided under Section 2(76) which now also includes a Key Managerial Person and his relative, a public company in which a director or manager is a director and holds along with his relatives more than 2% of its paid up share capital, anybody corporate

19. Ministry of Corporate Affairs, Order F. No. 2/5/2014-CL.V, July 9, 2014.

of which a director or manager of a company is a shadow director, any shadow director of a company (i.e. any person on whose advice, directions or instructions a director or manager of the company is accustomed to act) etc. This has extended the scope of Section 188 immensely which now covers almost all the transactions which a company enters into for the fulfillment of its purpose of formation. This leads to unnecessary and cumbersome compliance processes for Private entities.

Now, the 2013 Act mandates the private companies to take approval from the board before entering into any Related Party Transaction and during such an approval any interested director is not allowed to be present during discussions in the meeting on the subject matter of the resolution relating to such contract or arrangement. Further, if such transactions exceed the prescribed threshold they also need to take approval from the uninterested members of the company. Such a provision gives rise to a situation of difficulty. To explain this let us assume that there is a private company with two directors and one of whom is interested, they would not be able to pass such resolution for want of quorum. It is not practical to appoint a director (outside person) just for the sake of approving a resolution. This will make the transaction impracticable.

The concept of Arm’s length has also been introduced in the 2013 Act which is still undefined and is causing uncertainty for companies. To understand this one has to

20. Rule 15, Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Rules, 2014, F. No. 1/32/2013-CL-V, March 31, 2014; Amendment to Rule 15; Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Second Amendment Rules F. No. 1/32/2013-CL-V-Part, 2014, August 14, 2014

21. Ibid.

22. Amendment to Rule 15; Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Second Amendment Rules F. No. 1/32/2013-CL-V-Part, 2014, August 14, 2014.

23. Supra 9.

24. S. 174(3), Companies Act, 2013.

25. S. 188(1) Explanation b, Companies Act, 2013; It states (b) the expression "arm’s length transaction" means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.

look into Income Tax Act, 1961 as opposed to the 2013 Act. Here, it has to be kept in mind that the intention of the two Acts are different as on one hand we have Income Tax Act which is a fiscal statute and on the other hand the Companies Act, 2013 the intention of which is to safe guard the interest of the minority shareholders of a company. Such an impracticable stringent control has also been accompanied with a penalty which was not provided in the previous Act.

IV. THE UNCERTAINTY CAUSED BY THE PROVISION FOR RELATED PARTY TRANSACTIONS UNDER SECTION 188 FOR PRIVATE COMPANIES.

As has been previously stated, Section 188 is has been accompanied by various Rules, Amendment notification , Orders and Clarifications which when read together has lead to a lot of confusion and uncertainty in the current Related Party Transaction Regime for private companies. This coupled with the inaccurate wordings of Section 188 has resulted in innumerable implementation problems. Some of these issues with their illustrations have been described below:

A. Transactions between a private company and its subsidiary (excluding wholly owned subsidiaries).

One of such problems, arising out of the absence of the bifurcation of Section 188’s implementation on Private and Public companies, can be seen in the case of subsidiary of private companies. A transaction between a subsidiary and a holding company is treated to be Related Party Transaction. Therefore, any transaction

26. S. 92 F, Income Tax Act, 1961; "arm’s length price" means a price which is applied or proposed to be applied in a transaction between person other than associated enterprises in uncontrolled conditions.

27. S. 188(5) (ii), Companies Act, 2013; (ii) in case of any other company (other than public company, i.e. private company), be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees.

28. Supra 4,5.

29. Supra 6.

30. Supra 7.

31. Supra 8.

32. S. 2(76), Companies Act, 2013.

between the holding and subsidiary, if it exceeds the prescribed threshold, requires member’s approval. This leads to a problem for the subsidiaries as holding company (which might also hold 99% of shares) will not be allowed to vote in a meeting regarding the transaction. This will in turn lead to the failure of the objective for which the subsidiary was created. Further, the rules notified in this regard reduce the ambiguity in relation to wholly owned subsidiaries but they are still silent on the issue of subsidiaries which are not wholly owned.

B. Presence of Directors in a Board Meeting.

Directors play a key role in the management of the company and they are an integral part of it. This implies that they should be aware of the whereabouts of the company which becomes impossible if they are not allowed to attend the meetings of the Board if are a Related Party. In other words, an uncertainty caused by Rule 15(2) is that the directors are not allowed to be present during the discussion on the Related Party Transaction. Such a stringent rule was not present in the 1956 Act which in Section 300 allowed the directors to be present in the meeting but prevented them from participating in the discussions. Also, their presence does not count for the purpose of forming quorum for the meeting. Having said so, one can come up with an argument that presence of the director might influence decision of the board. However, such an argument fails in most cases of private companies, which are mainly private concerns.

C. Ambiguity in the approval mechanism in the Meeting in case of 2 members.

Section 149 (1) states that every company shall have a Board of Directors consisting of individuals as directors and shall have (a) a minimum number of two directors in the case of a private company. This implies that the criteria for incorporation of a private company is that it should have atleast 2 members. Further, Section 188 (1)

33. S. 188(1) First Proviso, Companies Act, 2013.

34. Supra 20.

35. Supra 4.

36. S. 149. (1), Companies Act, 2013.

second proviso states that no member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party. This proviso raises a situation of difficulty in case of private companies which have 2 members, both of whom are interested which leads to an impossible to dodge, impractical difficulty.

D. Difficulty in attaining quorum.

Section 174(3) provides that "where at any time the number of interested directors exceed or is equal to two-third of the total strength of the Board of Directors, the number of directors who are not interested directors and present at the meeting, being not less than 2 shall be the quorum during such meeting." This raises an issue in the case of private companies where there are only 2 directors, both or any one of whom is an interested party. Then according to the Rule 15(2) they will not be allowed to attend the meeting. This will stand in the way of formation of quorum for the passing of the approval by the Board.

V. COMPARISON OF THE RELATED PARTY TRANSACTION REGIME IN INDIAN WITH THAT IN OTHER COUNTRIES WITH RESPECT TO PRIVATE COMPANIES.

In order to understand whether the provisions implemented by the 2013 Act are viable we should look at other countries and their perspective regarding incorporation of private companies in the area of Related Party Transactions. These have been underlined below:

i) United Kingdom

In UK Section 201 read with Section 202 and 203 of UK Companies Act, 2006 clarifies the applicability of Related Party Transaction in case of public and private

37. S. 174(3), Companies Act, 2013.

38. Rule 15(2), Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Rules, 2014, F. No. 1/32/2013-CL-V, March 31, 2014.

companies. Section 203 mandates members’ approval during Credit Transactions. However, Section 201 is only applicable to public companies and companies associate with public companies. Under this "Credit Transaction" means "(1) a transaction under which one party ("the creditor")—

(a) Supplies any goods or sells any land under a hire-purchase agreement or a conditional sale agreement,
(b) Leases or hires any land or goods in return for periodical payments,
(c) Otherwise disposes of land or supplies goods or services on the understanding that payment (whether in a lump sum or instalments or by way of periodical payments or otherwise) is to be deferred.

This is similar to the transactions mentioned in Section 188(1) except that it fully exempts private companies unlike Companies Act, 2013.

ii) Australia

Section 207 in Chapter 2E of the Corporation Act, 2001 which deals with the Related Party Transactions in Australia, while stating the purpose states "the rules in this Chapter are designed to protect the interests of a public company’s members as a whole, by requiring member approval for giving financial benefits to related parties that could endanger those interests."

According to the chapter "Related Party" includes controlling entities, directors and their spouses, relatives of directors and spouses, entities controlled by other related parties. An entity is a related party of a public company at a particular time if the entity was a related party of the public company at any time within the previous 6 months and if the entity believes or has reasonable grounds to believe that it is likely

39. S. 203, United Kingdom Companies Act, 2006.

40. S. 201(1), United Kingdom Companies Act, 2006.

41. S. 188(1), Companies Act, 2013.

42. S. 207, Australia Corporation Act, 2001.

to become a related party of the public company. Financial benefit are such as giving or providing the related party finance or property; buying an asset from or selling an asset to the related party; leasing an asset from or to the related party; supplying services to or receiving services from the related party; issuing securities or granting an option to the related party; taking up or releasing an obligation of the related party.

The provisions laid down under this chapter are only applicable to public companies and not private companies and for the protection of its member. The rationale behind this seems to be that private companies do not need the same level of stringent legislative control as is required by private companies.

iii) Hong Kong

In Hong Kong Related Party Transactions are governed by Section 503 of New Companies Ordinance, 2014 which says that "Specified company" means (a) a public company; or (b) a private company or company limited by guarantee that is a subsidiary of a public company. It further mandates that "(1) without the prescribed approval of its members, a specified company must not-

(a) Enter into a credit transaction as creditor for-
(i) A director of the company; or
(ii) An entity connected with such a director; or
(b) Give a guarantee or provide security in connection with a credit transaction entered into by any person as creditor for such a director or an entity connected with such a director."

Here the definition of "Specified Company" as provided in Section 503 specifically excludes private companies from the ambit of Related Party Transactions. This is similar to the approach of the 1956 Act where under Section 300 private companies

43. S. 228 Chapter 2E, Corporations Act 2001.

44. S. 229(3) Chapter 2E, Corporations Act 2001.

45. S. 491(1), New Companies Ordinance, 2014 (Hong Kong).

were excluded from the control that was applicable on the public companies.

VI. SUGGESTIONS

The private companies are mainly referred as closely held companies consisting mostly of family members or relatives or close friends and run through the contribution given by them. In such kind of closely held setup public money is rarely involved and therefore, the question of public interest hardly arises. The need for their proper and smooth functioning was the reason for their exemption under Section 300 of the 1956 Act as contrary to public companies. Considering this difference in the composition of private companies, that is, common shareholding and directorship they were treated as a separate class of companies under Related Party Transactions. However, the 2013 Act for the purpose of the same does not differentiate between the public and the private companies and treats them as a homogeneous group which is fundamentally flawed.

It is a general practice, all around the globe, that private companies are treated as a separate class of companies and are exempted from the clutches of Related Party Transactions. The same can be substantiated by seeing the practice of countries like UK, Australia and Hong Kong.

Due to the flexibility expected out of private companies they should not be made to comply with such stringent provisions of Related Party Transaction which are applicable to public companies under Section 188 of the 2013 Act. We are of the belief that Companies Act, 1956 provided for certain relaxations to private companies on account of this nature which should have been continued and amplified and not altered by the 2013 Act. While good Corporate Governance is important for success of private companies in conduct of their business the need to maintain the flexibility for their day to day operation is equally important. Law should enable a private company to take any decision without following the unnecessary, cumbersome and drawn out formalities which the public companies are bound to follow.

It has to be remembered that Corporate Governance is not about control but about openness, integrity and accountability. What the 2013 Act should have done is that it should have laid down a common framework – i.e. the "form," in order to ensure standards for private companies. The "substance" of the Section 188 will ultimately determine the credibility and integrity of the Related Party Transaction regime.

The Majority of the minority rule, which is an exceptional shareholder consent rule, provided by Section 188 is basically for the governance of very large companies such as those listed on stock exchanges. The Law makers by importing this corporate governance norm in the realm of private companies are making their smooth functioning complex and unfeasible.

The Ministry of Corporate Affairs has taken note of this situation after innumerable representation made to them regarding the same through the daft notification for public comments on Companies Act, 2013 notified on June 24, 2014. The same has been presented before the Parliament in which private companies have been exempted from the application of Section 188(1). It is utmost importance that this draft, exempting the private companies, should be approved by the Parliament as soon as possible so that this situation of chaos and confusion can be resolved.

CONCLUSION:

Private companies have a completely different setup as compare to public companies

46. Supra 15, at 1.

47. Ibid.

48. Vinod Kothari, Ten Monsters in Companies Act, 2013- Part 2, Indian CorpLaw Blog, http://indiacorplaw.blogspot.in/2014/02/ten-monsters-in-companies-act-2013-part_26.html, last seen on 6/09/ 2014.

49. Ministry of Corporate Affairs, Draft notification for public comments on Companies Act, 2013 F No 1/1 /2014-CL.V, June 24, 2014.

50. Ministry of Corporate Affairs, Companies (Meetings of Board and its Powers) Rules, 2014, F. No. 1/32/2013-CL-V, March 31, 2014.

and therefore, they require a certain leeway when it comes to stringent statutory organization. After all, it has to be considered that they entail personal investment and not public wealth. However, the working of Section 188 of the 2013 Act has negated this requisite of flexibility by daunting a legislative framework which puts tough sanctions on private companies. This coupled with the statutory imprecision and regular notifications, rules and regulations in the last five months has deteriorated the situation further.

The execution of lengthy and cumbersome procedures to be followed by the private companies in order to permit simple dealings has had the effect of causing disorder and chaos. This is apparent from the response to the daft notification for public comments on Companies Act, 2013 notified on June 24, 2014. Keeping this in mind a draft on the same has been presented before the Parliament which exempts private companies from the application of Section 188(1). This draft should be passed as soon as possible to curb the menace that this provision has caused because if this is not done at the earliest then one can be assured that this situation will not get better but worsen by the day.

SARVESH KHATNANI and SHRUTI SETHI are fourth year law students at Hidayatullah National Law University, Raipur. They can be reached at sarvesh.hnlu@gmail.com and shruti.hnlu@gmail.com respectively.