SEBI’s amendments to the regulatory architecture for related party transactions (“RPTs”) under the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”) came into force from April 1, 2022 (“RPT Regulations”), bringing about a paradigm shift in the RPT approval and disclosure requirements applicable to listed companies in India.
The foundational principle of the RPT regulatory architecture is to avoid conflict of interest, and this is succinctly captured in the definition of arm’s length transaction under Section 188 of the Companies Act, 2013 (“Act”). The definition highlights that it is a ‘transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest’.
With almost 70% of Indian listed entities being owned/controlled by the promoters, SEBI has a tough task at hand in arresting the alarming and steady rise in cases of abusive RPTs where resources were diverted from the listed entity to promoter group entities. SEBI has obviously amended the LODR, basis the lowest common denominator, with the objective of safeguarding minority interest which is an important role of SEBI as articulated in the preamble to the SEBI Act, 1992.
In this blog, the authors examine whether the RPT Regulations cast the regulatory net rather too wide, whereby the audit committees are forced to examine a very large number of routine and legitimate transactions carried out in the ordinary course of business between the listed companies and their subsidiaries/associate companies. In this process, the audit committees lose out on precious time that would otherwise be devoted to careful and detailed examination of abusive RPTs.
The authors believe that it is unwise to assume that all RPTs are not in the interest of the company. In fact, many RPTs are legitimate business transactions and are completely defendable as they create synergy and economies of scale for the listed company. They do not harm the interest of minority shareholders. So why should the audit committees or the shareholders waste their time and resources in examining those transactions? Here, the authors have given some suggestions for SEBI’s consideration in order to bring in a more balanced RPT regime.
Definitions of ‘related party’ and ‘RPTs’ expanded, Materiality Threshold for Shareholders’ Approval Lowered
Along with covering promoters/promoter group entities, the definition of ‘related party’ under Regulation 2(1)(zb) now includes any person/entity holding equity shares of 20% or more in the listed entity, either directly or on a beneficial interest basis as per Section 89 of the Act, at any time, during the immediate preceding financial year.
A pure shareholding-based threshold without any filters will disenfranchise even financial investors such as the LIC and private equity (“PE”) investors from voting to approve a material RPT. The use of the words “at any time” implies that crossing the threshold for even a single day during the preceding financial year will disenfranchise the shareholder. Moreover, even the Government of India’s (“GoI”) shareholding is not exempt, and if GoI holds equity shares above the prescribed threshold, it may also stand disenfranchised.
The possibility of disenfranchisement doubles up once the 20% threshold is reduced to 10% w.e.f. April 1, 2023. The SEBI working group report (“WG Report”) recommended the 20% threshold based on the test for “significant influence” under the Act and Accounting Standard Ind AS 28, and while the 20% threshold may still arguably have a legal rationale, the 10% test has no such legal basis.
Further, the ‘related party’ definition also includes related parties as defined under the applicable accounting standards. Using the accounting standard definition under Ind AS 24 for determining regulatory approvals is a fundamental flaw in the legal architecture, as the accounting standard definition is purely for disclosure purposes.
By expanding the definition of ‘RPT’ under Regulation 2(1)(zc) to cover subsidiary-level transactions, legitimate business transactions undertaken in the ordinary course of business and at an arm’s length basis amongst the holding/subsidiary/associate companies in a large business conglomerate, that has many such entities for legitimate business reasons, will require prior audit committee approval.
Such routine intra-group operational transactions should not be subject to undue hurdles, and the regulator’s focus should be on capturing abusive RPTs, where the listed entity’s resources are diverted to promoter owned/controlled entities at a value that is less than fair market value (“FMV”), such as (i) a real estate transaction below FMV or (ii) loans/corporate guarantee to promoter entities at unreasonable commercial terms.
As the audit committee now has many more RPTs to examine, there may be situations where the audit committee is unable to devote sufficient time to scrutinise abusive RPTs, which get camouflaged in the large volume of routine transactions placed before the audit committee for approval.
The problem is exacerbated by the fact that four audit committee meetings in a financial year are consumed in approving the quarterly financial results, leaving very less time for detailed deliberations on RPTs. There is also no regulatory guidance for the audit committee in determining the ‘arm’s length pricing’ for an RPT.
SEBI has exempted certain corporate actions by the listed entity, which are uniformly applicable/offered to all shareholders, from the RPT definition. This covers rights issue, buyback, dividend, etc. However, the use of the words “by the listed entity” has resulted in confusion as to whether corporate actions by the subsidiaries of the listed entity are also carved out.
By only enumerating select corporate actions that are exempted, an ambiguity has been created over other corporate actions that are strictly regulated under the Act and LODR will now require prior shareholders’ approval. For instance, only acceptance of fixed deposits by banks/NBFCs has been exempted, which has prompted some listed banks to obtain shareholders’ approval for acceptance of current account deposits above INR 1000 crore, from a related party.
Further, given the enlarged definition of RPT, it is unclear whether a scheme of arrangement between two unlisted subsidiaries of the listed entity, that is exempt under the July 17, 2014 MCA circular, will now require prior approval of the majority of minority shareholders of the listed entity, under Regulation 23(4).
INR 1000 crore materiality limit
While the earlier limit of 10% of annual consolidated turnover to determine materiality of RPT was rather too liberal and most RPTs escaped scrutiny by the shareholders, the new absolute monetary limit of INR 1000 crore is devoid of any logic and is susceptible to a constitutional challenge under Articles 14 and 19(1)(g) of the Indian Constitution on the ground of manifest arbitrariness, as all listed companies are treated alike, irrespective of the value of their consolidated turnover, scale of operations, and nature of business.
Moreover, as Regulation 23 does not exempt RPTs undertaken in the ordinary course of business and at arm’s length basis, the revised threshold has resulted in situations where prior shareholders’ approval is required even for routine operational transactions between the listed entity and its group companies in any large business conglomerate.
Transactions between two overseas subsidiaries of the listed entity
One interesting issue that arises is in situations where the audit committee of the Indian listed entity rejects a transaction proposed between two foreign subsidiaries. It may be perfectly legal for the Boards of such foreign subsidiaries to ignore rejection by the audit committee of the listed entity in India and undertake the transaction, if permissible under the respective local laws of their incorporation, and the Board of each foreign subsidiaries believes that the transaction is in the subsidiary’s best interest.
In the Vodafone judgment, the Supreme Court noted that “the legal position of any company incorporated abroad is that its powers, functions and responsibilities are governed by the law of its incorporation” – which suggests that for a foreign subsidiary, the law of incorporation attains primacy over Indian law.
More Stringent Regulations Applicable from April 1, 2023
Along with the 10% shareholding test, two other far-reaching changes are applicable w.e.f. April 1, 2023:
(a) Purpose and effect test
The ‘purpose and effect test’ covers transactions where the counter party is not a related party of the listed entity or of its subsidiaries. While this ‘catch-all’ provision is borrowed from the UK Premium Listing Rules, no carve-outs have been provided, and there is no regulatory guidance on how to apply this test in practice.
Applying this test will be very challenging for compliance officers and audit committee members, who will be required to examine virtually all commercial transactions to ensure that the purpose and effect of none of these transactions is to benefit a related party of a listed entity, or its subsidiaries. This may potentially make the RPT Regulations unworkable for large listed companies, and the regulator seems to have adopted the Hindu Vedic philosophy of Vasudeva Kutumbakam which means the entire universe is one family!
(b) 10% of annual standalone turnover of subsidiary
The existing threshold of 10% of annual consolidated turnover of the listed entity, for subsidiary-level transactions requiring audit committee approval reduces to 10% of annual standalone turnover of the respective subsidiary. For a subsidiary having a standalone turnover of INR 1 crore, even a transaction worth INR 10 lakh will require prior approval of the audit committee of the listed entity, and this exacerbates the concern where review of legitimate business transactions would result in situations where due to a large number of RPTs to be examined, the abusive RPTs may escape the audit committee’s attention.
Concluding Thoughts and Recommendation
Many RPTs are in the interest of all stakeholders and are in the best economic interest of the listed companies as also of the Indian economy. SEBI should undertake a comprehensive review of its RPT Regulations, preferably by an expert committee with adequate representation from the industry and all other stakeholders. After wider stakeholder consultation, it should revise the RPT Regulations to ensure that the focus of the new regulations is to create the right balance between protecting minority shareholders’ interest and not creating too many obstacles for listed companies, in carrying out its legitimate business activities.
Following seven suggestions are made for SEBI’s consideration:
- The definition of ‘related party’ under Regulation 2(1)(zb) should omit reference to the accounting standard, which is for disclosure purposes. It should also omit 10% shareholding as the threshold for treating the shareholder as a related party. The GoI is always subject to the discipline of Article 14 of the Constitution and cannot act arbitrarily. Hence, the GoI should not be treated as related party wherever it is a shareholder.
- The definition of RPT under Regulation 2(1)(zc) should carve out a larger list of legitimate business transactions, undertaken in the normal course of business activities of listed entities, particularly when they are subject to the discipline of other provisions of the Act and LODR, like the schemes of arrangements for mergers/demergers/corporate restructuring etc, which have a specific regulatory regime under Section 230 to 232 of the Act.
- RPTs between two foreign subsidiaries of the Indian listed holding company should be specifically carved-out, because SEBI in any case has no jurisdiction over such foreign subsidiaries.
- Materiality threshold under Regulation 23(1) should not have an absolute monetary limit of INR 1000 crore. SEBI could consider a lower threshold of 5% of annual consolidated turnover or 5% of net assets in case of investment companies.
- The provision of the ‘purpose and effect test’ to be introduced from April 1, 2023, where the counter party is not a related party, can be safely omitted.
- SEBI could mandate statutory auditor’s certification confirming that the related party transactions above a certain value are examined by the auditors by using the most appropriate of one of the five methods of valuation for the determination of arm’s length price prescribed under Section 92C of the Income Tax Act, 1961. The auditor’s report under the CARO, 2020 should also confirm the compliance by the company of the RPT provisions of the LODR. Presently, it only provides for compliance with Sections 177 and 188 of the Act.
- In the explanatory statement of the AGM/EGM/postal ballot notice for approval of a material RPT, the Boards of companies should declare, if convinced, that the transactions are negotiated on an arm’s length basis, and that their terms and conditions are not prejudicial to the minority shareholders, and they believe that the proposed transaction is in the best interest of the company and all its stakeholders.
Implementation of these changes would enable the audit committee and the minority shareholders to focus only on the abusive RPTs, where the promoter group has a conflict of interest or derives disproportionate economic benefit and the commercial terms of the transaction are not in the best interest of all stakeholders. Otherwise, we will continue to miss the wood for the trees and disproportionate compliance burden on the listed entities will discourage many companies from going public. It could also discourage top professionals from joining corporate boards as independent directors.
 The amendments were notified by SEBI on November 9, 2021, vide the SEBI (Listing Obligations and Disclosure Requirements) (Sixth Amendment) Regulations, 2021.
 For a general analysis of the amendments notified by SEBI on November 9, 2021, interested readers may refer to our earlier blog titled “Decoding SEBI’s latest amendments to the RPT regime”, available at – https://corporate.cyrilamarchandblogs.com/2021/11/decoding-sebis-latest-amendments-to-the-rpt-regime/
 SEBI WG Report, at Pg. 11. For a detailed analysis of the recommendations of the SEBI WG Report, interested readers may refer to the following two earlier blogs:
 Accounting Standard Ind AS 24 deals with Related Party Disclosures.
 For a detailed analysis of the ever-expanding responsibilities of the audit committee, interested readers may refer to our earlier blog on this subject, available at – https://corporate.cyrilamarchandblogs.com/2022/06/regulatory-overload-on-audit-committees-is-there-a-need-to-have-a-fresh-look-at-its-role/
 MCA General Circular No. 30/2014, dated July 17, 2014.
 As per Regulation 23(4), all material related party transactions and subsequent material modifications as defined by the audit committee under sub-regulation (2) shall require prior approval of the shareholders through resolution and no related party shall vote to approve such resolutions whether the entity is a related party to the particular transaction or not.
 As per the proviso to Regulation 23(1), a transaction with a related party shall be considered material, if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year, exceeds INR 1000 crore or 10% of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity, whichever is lower.
 For a detailed analysis of the constitutional implications of the INR 1000 crore limit, interested readers may refer to our earlier blog titled – “Revised threshold of Rs. 1000 Crore for ‘material’ RPTs under LODR – Does it pass the Article 14 test?” Available at https://corporate.cyrilamarchandblogs.com/2022/04/revised-threshold-of-rs-1000-crore-for-material-rpts-under-lodr-does-it-pass-the-article-14-test/
 Vodafone International Holdings B.V. v. Union of India, (2012) 6 SCC 613.
 Under Regulation 2(1)(zc), with effect from April 1, 2023, a transaction involving a transfer of resources, services or obligations between a listed entity or any of its subsidiaries on one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries, will be covered under the definition of RPT.
 Under Regulation 23(2), with effect from April 1, 2023, an RPT to which the subsidiary of a listed entity is a party but the listed entity is not a party, shall require prior approval of the audit committee of the listed entity if the value of such transaction whether entered into individually or taken together with previous transactions during a financial year, exceeds 10% of the annual standalone turnover, as per the last audited financial statements of the subsidiary.