How to deal with related party transactions in unlisted firms? – The Economic Times

Clipped from: https://economictimes.indiatimes.com/markets/stocks/news/how-to-deal-with-related-party-transactions-in-unlisted-firms/articleshow/82012942.cmsSynopsis

For larger economic stability, one cannot undermine the importance of sound governance in unlisted public companies for two reasons.

Alby Joseph

In the words of Uday Kotak in the Kotak Committee Report, there are broadly two styles of corporate governance in India: the “Raja” (Monarch) model and the “Custodian” model. In the “Raja” model, promoter interest precedes interests of “praja” i.e. other stakeholders. On the other hand, “Custodian” model works on Gandhian principles where the promoters wear the hat of “trustees” and act in the interest of all stakeholders. What is more commonplace is anybody’s guess, however, the burning question is how to correct the existing inequity that exists between the promoter and stakeholder interest.

One particularly relevant aspect of corporate governance where this question becomes extremely pertinent is related party transactions (RPTs). These are transactions between related parties as defined under the Companies Act, 2013 (CA 2013) such as promoters and their relatives, for instance, and are inevitable in any business ecosystem. They are quite common in India where historically most corporate organizations are family run with informal business relations. Many of the recent corporate controversies in India such as those involving InterGlobe Aviation (Indigo), Jet Airways, IL&FS, DHFL etc. involved alleged misappropriation of funds to related parties such as promoters and directors, or their relatives. While the said allegations are in the domain of listed entities, they provide sound reason to suspect such malpractices could fester abound in the relatively less regulated and less transparent domain of unlisted public companies. A case in point would be the fraudulent RPTs of Firestar International Limited, associated with the Nirav Modi scam.

Misuse of RPTs could shortchange (minority) shareholders and other stakeholders such as creditors. On the other hand, transparent RPTs create synergies and enhance value. Hence, an ideal regulatory framework would encourage value enhancing RPTs while also penalizing fraudulent RPTs. Despite living in the age of unlisted ‘unicorns’, there is not much literature on RPTs by such companies.

Why it matters?
For larger economic stability, one cannot undermine the importance of sound governance in unlisted public companies for two reasons. First, large unlisted public companies have significant public interest in terms of being systemically important. They also have large borrowings from the financial system, including banks, and thus they also have wide public shareholding. Second, without adequate investor protections in unlisted public companies, equity markets fail to develop and banks become the only source of finance. This is because poorly governed unlisted companies won’t be willing or capable of tapping the capital market via listing in the future. This undermines both corporate interests by adversely affecting access to non-debt expansionary capital as well as investor interest by reducing potential for greater transparency, which comes as a result of listing.

RPTs in unlisted companies are solely governed by the CA 2013, while listed companies are additionally governed by the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015. For unlisted companies, the requirement for shareholder approval via ordinary resolution is triggered only when the statutory materiality threshold prescribed under the Companies Rules is crossed. For RPTs such as supply of goods or services, property leasing etc., the threshold is 10% of turnover. Further, with effect from April 1, 2021, the definition of ‘listed company’ has been narrowed to exclude those companies which have only listed their debt securities. Consequently, even a systemically important company like IL&FS Limited which has only its debt securities listed, will now be considered as an unlisted company. Thus, with this amendment, the role of sound governance in unlisted companies becomes even more important.

Recognizing the importance of large unlisted companies, the government recently added Section 129A in the CA, 2013, which requires additional financial disclosures from certain class of unlisted companies.

Even though the government has not yet notified the class of companies which would be covered under this requirement, it clearly recognizes the potential systemic importance of unlisted companies.

Way forward
A legal framework can be said to be only as good as its implementation. World Bank ranks India an impressive 13th out of 190 jurisdictions with regard to protection of minority investors. Despite the high ranking, systematic problems persist, with many corporates following “tick-the-box” approach which merely focuses on the letter, not spirit, of law. In many instances the resolutions provided to shareholders for RPT approval are of poor quality in which shareholders are not provided adequate information so as to make an informed decision. In some cases, RPTs are shielded from shareholders using defenses of ‘ordinary course of business’ and ‘arm’s length’.

To reform the RPT regime, especially for unlisted companies, as a first step, the materiality thresholds for unlisted companies may require being revisited. This is to ensure that such thresholds adequately bring large RPTs within its ambit for the purposes of shareholder approval. As on date, many RPTs of large unlisted companies could possibly escape shareholder scrutiny. To illustrate, an RPT with a value of INR 16,000 Crore by an unlisted entity, such as Reliance Retail Limited, with a publicly disclosed turnover of INR 1,62,936 Crore can possibly escape shareholder scrutiny due to the 10% threshold in the CA 2013, even though in absolute terms it is definitely a high value transaction. Secondly, the selection criteria for independent directors may require being reviewed. Diligent independent directors can potentially weed out fraudulent RPTs, without harming value enhancing RPTs. Valuable guidance may be derived from a recent SEBI consultation paper on Independent Directors which proposed a “dual approval” mechanism for appointment of independent directors, giving more say to minority shareholders in such appointments.

Thirdly, as the Kotak Committee observed, market intelligence gathering and data analytics are potential tools to strengthen law enforcement and deter fraudulent RPTs. Urgent steps need to be taken to that end with adequate resource allocation for such projects. SEBI’s recent decision to call off its proposed data analytics project for lack of funds does not augur well for corporate governance standards in the country.

Most importantly, there is an urgent need to simultaneously improve investor education and promote investor activism. This way, the “praja” can itself become an efficient gate-keeper and keep a check on the “Raja”.

(Alby Joseph is Project Fellow at Vidhi Centre for Legal Policy, Delhi. Views are his own)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s