On 28-9-2021, Securities and Exchange Board of India (SEBI) in its Board meeting approved changes in the related party transaction (RPT) framework under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR). The changes were based on the recommendations of the Working Group, constituted in November 2019, to review the policy space pertaining to related-party transactions.
The approved changes in the form of Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements)(Sixth Amendment) Regulations, 2021 were notified on 6-11-2021. Major modifications under this amendment include the widening of the definition of “related party”, revision of materiality threshold, and the requirement of “prior” approval of shareholders for material related-party transactions. These modifications have been made in an attempt to provide greater scrutiny of RPTs, taking into account the abuse of the relevant provisions, thus considering the interests of the shareholders.
This article seeks to analyse certain aspects of the aforementioned amendment and highlight the ambiguities therein. It then moves on to deal with threefold modifications in the provisions dealing with material related-party transactions and point out the issues pertaining to shareholders’ approval for existing contracts/arrangements. While taking note of the legislative intent, it also aims to provide possible interpretation of the provisions where such issues lie. Finally, it concludes with the possible steps to clarify the ambiguities that have arisen and have put companies in a confused state.
Major modifications and their analysis
Definition of “related party”
The definition of a related p(RP) has been significantly changed by this amendment. It has been broadened to include any person or entity who is part of the promoter group of the listed entity as well as any person or entity holding equity shares of 20% or more either directly or as a beneficial interest under Section 89 of the Companies Act, 2013 (the Act). Due to this, all the promoter groups which hold control in interlinked groups will come under the scrutiny of LODR. Further, as a result of including persons with 20% or more shares in the definition of “related party”, LODR will cover every individual holding a decision-making power and significant shareholding.
Definition of “related-party transaction”
While the erstwhile definition included only a transaction between a listed entity and its related party, now it also includes transactions between a listed entity or its subsidiary and related parties of the listed entity or its subsidiary.
(i) Cross RPTs
As mentioned above, now that RPTs will also include transactions between a subsidiary and its related parties, it is likely that the threshold of INR 1000 crores or 10% of annual consolidated turnover of the listed entity, for seeking shareholders’ approval will reach sooner than usual. As per Section 2(87) of the Companies Act, 2013, a “subsidiary” company will also include subsidiaries that are based abroad. If a foreign subsidiary enters into a transaction with another company, the Audit Committee and the shareholders of the parent Indian company will have a deciding factor in the success of that transaction. This will create a conflict of laws and jurisdictional issues.
This amendment could also be challenged on the ground that it violates the principle of separate legal existence. Further, the foreign subsidiaries will be governed by the laws of their place of incorporation. Therefore, there is no clarity as to how the implementation of these provisions be interpreted. To avoid all the hassle, a possible solution could be to grant certain exemptions and provide detailed guidance specifically in relation to foreign subsidiaries.
(ii) “Purpose and effect” clause
An important aspect of the amendment is that it will also include the transactions between a listed entity or its subsidiary with an unrelated party which has the “purpose and effect” of causing a benefit to the related party. This provision will come into effect from 1-4-2023.
This provision has been borrowed from the UK (Para 11.1.5 of Financial Conduct Authority Handbook). It would be interesting to see how the “purpose and effect” is going to be interpreted. Since the word “and” has been used, both purpose and effect have to be read together while determining the impact of a transaction. In a situation where a transaction has not been entered into intentionally for the benefit of a related party, it will not be considered an RPT just because it is indirectly benefiting a related party. While the effect can be seen explicitly, it would be a difficult task to determine the purpose as it might not be evident. It will have to be determined on the basis of facts and circumstances.
The authors believe that this provision would be very beneficial in keeping a check on fraudulent and camouflaged transactions. The provision brings into effect the “smoke test” propounded by the Supreme Court of India in Phoenix ARC (P) Ltd. v. Spade Financial Services Ltd. to detect collusive or sham transactions which create an illusion of transfer of money when in reality the transaction has been entered into with an ulterior motive.
It will prevent the companies from bypassing approval processes by entering into transactions with unrelated parties. However, the regulatory authorities should contemplate and provide guidance on the investigation to determine the “purpose and effect”. This will prevent the companies from exploiting the loopholes and will also give them a clear understanding of the provision.
(iii) Exclusions in the definition
Until now, the companies have been forming separate RPT policy and made certain exclusions in line with the LODR and the Act. However, this Amendment has brought in certain exclusions in the definition of RPT itself. These exclusions include the issue of specified securities on a preferential basis, certain corporate actions like payment of dividends, etc., and lastly, acceptance of deposits by banks, etc. With this amendment, it can be concluded that the companies will not be in a position to make any further exclusions apart from what is mentioned in the provision.
Threefold modification in the provisions dealing with material related-party transactions
Before proceeding further, it is important to note that an RPT as defined under Regulation 2(1)(zc), shall be construed to include a single transaction or a group of transactions in a contract.
Modifications in the provisions dealing with material RPTs are threefold. First, under Regulation 23(4) the requirement of approval of material RPTs from the shareholders has been made “prior” to the entering of such transactions. Second, the threshold of determining the materiality of RPTs has been changed and now stands as a value above: (i) INR 1000 crores; or (ii) 10% of annual consolidated turnover of the listed entity, whichever is lower. Third, the scope of RPTs has been expanded to cover cross-RPTs.
Thus, these modifications when collectively interpreted would mean, related-party transaction/s including cross-RPTs that exceed the materiality threshold will require prior shareholders’ approval.
Issues pertaining to shareholders’ approval for existing contracts/arrangements
In the light of these changes, there are certain issues that arise. Though the modification in the materiality threshold is applicable with effect from 1-4-2022,it has the potential to trigger changes on the part of a company’s compliance requirement prior to the effective date. The provision of compliance requirement of shareholders’ approval [Regulation 23(4)] uses the term “material related party transactions” and not “material related party contracts”. Therefore, there is a possibility of the amendment affecting contract/centered into prior to the effective date of changed materiality threshold if such contract/s have transactions to be carried on or after 1-4-2022.
A company with a turnover of INR 2000 crores for the financial year 2019-2020, enters into a contract worth INR 1500 crores with a related party. When the contract was entered into, the materiality threshold was a value exceeding 10% of the consolidated turnover of the past financial year, hence shareholders’ approval for carrying out this contract was not a requirement. Some transactions under this contract are to be executed after the end of Financial Year (FY) 2020-2021. The question here is,
In the light of the changed materiality threshold, are companies required to reclassify the ongoing RPTs as material and non-material since an ongoing contract (which crosses the changed materiality threshold) may have transactions to be executed on or after FY 2021-2022?
If such a reclassification is required, certain follow-up questions would arise. Apart from shareholders’ approval for material RPTs that will be executed after the end of FY 2021-2022,
Will it be required for continuation of RPTs under a contract/s reclassified as material? and,
Will it be required for ratification of completed RPTs forming part of a contract reclassified as material?
Analysis: Is reclassification of ongoing RPTs required
Regulation 23(6) provides for the application of Regulation 23 to all prospective transactions, therefore, the application of the amended provision would apply to transactions taking place after the end of FY 2021-2022. However, these prospective transactions may be part of contracts or arrangement centered into prior to 1-4-2022.
Before the notification of the amendment i.e. before 6-11-2021, companies entered into contracts or arrangements, keeping in view the10% threshold and not taking into account cross-RPTs. Some of these contracts or arrangements may consist of transactions to be carried on or after 1-4-2022. If these contracts or arrangements cross the revised materiality threshold, the question that arises is:
Is shareholders’ approval under such types of contracts required only for the transactions that will be executed after the end of FY 21 or it is required for all the RPTs aggregated under those contracts?
Through the reading of Regulation 23(6) of the LODR, it is clear that transactions to be executed after the end of FY 2021 (including the ones that are part of ongoing contracts or arrangements) that cross the revised materiality threshold will require prior shareholders’ approval. Therefore, in the absence of reclassification of ongoing contracts considering the changed materiality threshold and the inclusion of cross-RPTs, companies may face ramifications. These ramifications may come in the form of breach of contract if transactions that are to be executed after the end of FY 2021 under such ongoing contracts are denied shareholders’ approval.
The second part of the above-posed question can be further divided into two sub-questions:
(i) Will the RPTs (to be executed before 1-4-2022 under a contract/s reclassified as material require shareholder’s approval for continuation?
(ii) Will the completed RPTs forming part of a contract be reclassified as material, require shareholders’ approval ratifying it?
The answer to these questions depends on the applicability of Regulation 23(8) in light of the present amendment.
Regulation 23(8) states,
23(8). All existing material related party contracts or arrangements entered into prior to the date of notification of these regulations and which may continue beyond such date shall be placed for approval of the shareholders in the first General Meeting subsequent to notification of these regulations.
This regulation has been in place from the date of the notification of the LODR i.e. 2-9-2015. There is an absence of additional words such as, “as amended from time to time”, after “these regulations” or any explanation stating that the date of notification as provided in Regulation 23(8) would change with respect to the date of notification of amendments that may be made in Regulation 23. In such an absence, it appears that the date of notification suggested in the regulation is 2-9-2015 i.e. the date of the publication of the Regulations in the Official Gazette [Regulation 1(2) of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements)Regulations, 2015].
If the date of notification is taken as 2-9-2015, then, Regulation 23(8) does not become applicable in the light of the present amendment and answer to the above questions i.e. the requirement of shareholders’ approval for completed RPTs and RPTs to be executed before 1-4-2022 under ongoing contracts, is unclear.
Now, if it considered that by “these regulations” as mentioned in Regulation 23(8) is meant these regulations as amended from time to time, then the date of notification will become 9-11-2021 i.e. the date on which Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements)(Sixth Amendment) Regulations, 2021 has been notified in the Official Gazette. However, this amendment is to come into force from 1-4-2022.
If this interpretation is taken, there is confusion as to which date out of the two will be considered for the purpose of Regulation 23(8).
If we analyse the impact of such an interpretation ignoring this confusion, it can be concluded that the companies will have to reclassify the ongoing RPTs and take the approval of shareholders for all the RPTs aggregated under the material related party contracts or arrangements.
Further, in the background of the circular issued by SEBI on 22-11-2021, listed entities have to place an array of information before the Audit Committee and the shareholders, and if ongoing contracts have to comply with Regulation 23(8), they will have to be taken to the shareholders accompanied by information as mandated under the SEBI circular.
Not only this, the amendment has increased the disclosure requirements manifold. The listed entities will have to give in the details of loans, deposits, etc. and the purpose for which this amount will be utilised by the beneficiaries under Regulation 23(9) in a specified format.
Another important aspect of the amendment is that the Audit Committee is also supposed to grant prior approval for “material modification” in a RPT. However, a major problem here is the definition of “material”. This has not been clarified by SEBI. It is the prerogative of the Audit Committee to decide whether a transaction will constitute “material modification”. Leaving this decision solely on the Audit Committee without any guidelines or clarification might create confusion and bring in transactions under scrutiny unnecessarily.
Following the notification of Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements)(Sixth Amendment) Regulations, 2021 which has brought changes in the RPT regime taking note of prevailing loopholes which have been exploited, neglecting the interest of various stakeholders, several questions have arisen, some of which have been discussed in this article.
The broadening of the definition of RPT will have a significant impact in terms of bringing many more transactions under the scanner. It will prevent fraud and help in putting a check on sham transactions. Even though SEBI has included transactions with a third party having the “purpose and effect” of benefiting a related party, the interpretation of “purpose and effect” needs to be clarified in further guidance notes and circulars. Further, by bringing the transactions entered into by subsidiaries and especially foreign subsidiaries under scrutiny, the principles of separate legal entity and autonomy of making independent decisions has been gravely affected.
The major question is the impact of the changed materiality threshold and inclusion of cross-RPTs on ongoing contracts which if reclassified considering these modifications will become material RPTs. The position in this regard as of now is ambiguous. What is clear from the reading of Regulation 23(6) is that the RPTs crossing the revised materiality threshold, to be executed after the end of FY 2021-2022 will require “prior” shareholders’ approval.
However, it is unclear if the RPTs under a contract or an arrangement (which consists of RPTs that will be executed after FY 2021-2022) need reclassification and subsequently require shareholders’ approval for continuation or ratification as the case may be.
Though the intention of the changed RPT framework is better corporate governance and protecting the interests of the minority, however, these changes have put a cumbersome compliance burden on the companies. It might also bring up practical difficulties especially to the big corporate houses with a large number of subsidiaries. Further, due to lack of clarity in certain matters as discussed in this article, these changes can put companies in confusing positions and they might end up unintentionally breaching the amended provisions.
Clarifications on the part of SEBI dealing with issues arising out of the modified Listing Regulations (LODR) will, therefore, be welcomed in order to balance the interests of the companies as well as its stakeholders.
*Fourth year student, BA LLB (Hons.), Hidayatullah National Law University, Raipur, Chhattisgarh.
**Third year law student at Hidayatullah National Law University.
Report of the Working Group on Related Party Transactions, 27-1-2020<https://www.sebi.gov.in/reports-and-statistics/reports/jan-2020/report-of-the-working-group-on-related-party-transactions_45805.html>.
LR 11.1 Related party transactions, <https://www.handbook.fca.org.uk/handbook/LR/11/1.html>.
Disclosure Obligations of Listed Entities in Relation to Related Party Transactions, SEBI/HO/CFD/CMD1/CIR/P/2021/662, 22-11-2021,