New Delhi: Over the past month, IndiGo has undergone major turbulence in its governance, with one promoter, Rakesh Gangwal, accusing another, Rahul Bhatia, of indulging in ‘questionable’ related party transactions.
Gangwal and Bhatia together hold 75 per cent of the market-leading airline’s shares.
In his defence, Bhatia claimed that all transactions between IndiGo and his InterGlobe Enterprises (IGE) have been conducted on an ‘arm’s-length’ basis. This was later affirmed by an independent forensic review by Ernst & Young (EY).
This is not the first time that a dispute over related party transactions has surfaced in India. Several significant corporate frauds in the country, including the Satyam scam, have their roots in related party transactions or similar arrangements.
ThePrint takes a look at what these transactions mean and the circumstances under which these transactions should raise eyebrows.
What is a related party?
The Companies Act, 2013, defines a related party to mean a director or a key managerial person, or their relatives, or a private company in which the partner, director/manager or their relatives are partners.
The definition also includes a private company or a public company in which a director or manager is a director, and holds, along with relatives, more than 2 per cent of the paid-up share capital. Holding companies, subsidiaries and associate companies as well as others that can influence the company are also part of the list.
Transactions may include sale or purchase, supply of any material or goods, sale/purchase/ lease of any property, or appointment of the party to any office in the company.
The idea essentially is to flag any transaction where the parties are not acting in their own self-interests and may be subject to any pressure or influence from the related party. Such transactions run the risk of the related party being favoured with terms that hold the potential of inadvertently harming the company’s shareholders.
For instance, if a company places a huge raw materials order with another company owned by a relative of one of the directors, it is a related party transaction. When the company pays an amount higher than the market rate for these goods, the transaction naturally harms the shareholders of the company.
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Need for approvals
The laws that govern these transactions include the Companies Act, 2013, the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015, and the Indian Accounting Standard (Ind AS) 24 — Related party disclosures, 2015.
The concept was not defined under the Companies Act, 1956, but it did impose restrictions on certain transactions with parties like the director of the company or his relative, a firm in which the director of his relative is a partner, etc.
The 2013 Act, however, focused on disclosure norms rather than on a regulatory framework. It requires every company to get an approval from its board of directors as well as the audit committee for any related party transaction.
During the meeting convened for taking this decision, the director who has an ‘interest’ in the transaction should not be present, as per rule 15 of the Companies (meeting of board and its powers) Rules, 2014. Details of such transactions need to be disclosed in the board’s report.
In certain cases, such as one where the transaction value exceeds specified limits — say, 10 per cent of net worth or annual turnover, or Rs 100 crore — a special resolution needs to be passed by a majority of the shareholders in addition to the approval of the board of directors.
The ‘arm’s length’ standard
Every related party transaction need not be flagged. Transactions which are conducted in the “ordinary course of business” at “arm’s length” and not “material” only need audit committee approval, not approval from the board of directors and shareholders.
According to the explanation under Section 188 of the Companies Act, 2013, an “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”.
In order to determine if the transaction is at ‘arm’s length’, the entire transaction needs to be seen as a whole. The mere fact of the company charging the same price to a related party and an unrelated party might not be enough for it to qualify as an ‘arm’s length’ transaction.
For instance, if the credit period granted to an unrelated party is a month while to a related party is say, six months, the transaction would not qualify. If a property is leased out to a related party at the market rate but without any deposit, as would have been the case with an unrelated party, the transaction would not be an ‘arm’s length’ deal.
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Consequences of non-compliance
Any agreement pertaining to a related party transaction without adherence to the norms is ‘voidable’ at the option of the board, if it is not ratified by the board or the shareholders within three months.
The provisions also require the director who is related to a party in an unauthorised related party transaction to indemnify the company against any losses incurred.
The Act provides penalties for the director or any employee violating the provisions pertaining to related party transactions. For a listed company, they can face punishment of one year’s imprisonment or a fine ranging from Rs 25,000 to Rs 5 lakh, or both.
For other companies, a fine ranging between Rs 25,000 and Rs 5 lakh can be imposed.