Think Tank

Related Party Transactions: Decoding the Regulatory Regime

In November 2021, SEBI notified several important changes to the regulatory regime around related party transactions (RPTs). These include: broadening the definition of ‘related party’ to include entities belonging to the promoter group; expanding the list of RPTs that require approval from the Audit Committee; and tweaking the materiality thresholds. At a recent session of the India CFO Forum, Bharat Vasani, Partner – General Corporate, Media and Entertainment at Cyril Amarchand Mangaldas, provided a bird’s-eye view of these amendments and their implications for businesses.

The MCA has been relaxing the RPT rules for unlisted companies whereas SEBI has been tightening them for listed ones

Current Regulatory Framework

In India, related party transactions are regulated by two entities: the Ministry of Corporate Affairs (MCA) for unlisted companies and SEBI for listed companies. Specifically, the former are required to follow the Companies Act, 2013 on issues around RPTs, whereas the latter are governed by SEBI’s LODR (Listing Obligations and Disclosure Requirements) regulations of 2015. The MCA, in line with its mantra of improving the ease of doing business, has been relaxing rules for unlisted companies, while SEBI has been doing the opposite for listed ones.

SEBI has been most prolific about amending regulations as soon as it discovers any ‘malignant’ RPTs. The agency’s view is that, since there is public money involved in listed companies, tighter scrutiny is justified. Accordingly, it has made a series of important changes in the recent past.

Inclusion of promoters within the definition of related party

The definition of related party now includes the promoter group A broader definition of RPTs

Recent Amendments

Section 2(76) of the Companies Act, which defines ‘related party,’ has a vital loophole: it omits the promoter group from this definition. SEBI has now proposed to plug this loophole for listed companies by including promoter/promoter group within the definition. Additionally, the definition of ‘related party’ will be broadened to any person/entity holding equity shares amounting to (i) 20% or more from April 1, 2022 or; (ii) 10% or more from April 1, 2023. The implementation of such low percentages will impose a significant compliance burden on a large number of companies with several subsidiaries and a high frequency of transactions.

Transactions between two subsidiaries will now be regarded as RPTs

Regulation 2(1)(zc) of the LODR has been amended to cover any transactions that are undertaken between two subsidiaries of a listed entity, whether incorporated in India or abroad. Transactions between two subsidiaries will be considered to be RPTs and will be subject to the listed entity’s approval. This poses barriers to transactions between a parent company and subsidiaries that are listed in a different country with different regulations.

Approval of the Audit Committee is required for transactions undertaken between two or more subsidiaries

Audit Committee approval for transactions

Perhaps the most contentious of the recent amendments is a requirement to obtain approval from the Audit Committee of the listed entity, for transactions undertaken between two or more of its subsidiaries. Moreover, starting from January 1, 2022, only IndependentDirectorson the Audit Committee can approve of RPTs. This goes against the cardinal responsibility of the Board to collectively approve transactions. It is also unclear whether most IDs actually possess the ability to express dissent on transactions which they find questionable.

Common materiality thresholds have been set but it is unclear if Brand usage and royalty payments are part of the total

Materiality thresholds

SEBI has also revised the materiality threshold for obtaining shareholder approval, to cover transactions exceeding Rs 1,000 crores, or 10% of the annual consolidated turnover of the listed entity, whichever is lower. It is a matter of concern that SEBI has set a common, Rs 1,000 crore limit, irrespective of the size of the company. Further, it has not specified whether payments for brand usage and royalty payments fall within the 10% limit. Additionally, while the Companies Act has definitions for manufacturing, trading and service companies, it has no definition for investment companies with no turnover. For investment companies and CICs, therefore, a net-worth-based materiality threshold may be more appropriate. However, SEBI has so far not incorporated such criteria within its regulations.

The compliance burden on most listed companies is set to rise

Conclusion

SEBI’s recent amendments bring a paradigm shift to the RPT regime but also create new governance-related challenges. The regulator has, in effect, increased the compliance burden for many listed companies by broadening the definition of RPTs and by introducing new materiality thresholds. This will increase the workload for Audit Committees and specifically for its Independent Directors, who will have to scrutinise a much larger volume of RPTs.

THINK TANK