Disclosure of Interest & Related Party Transactions – Some Intricate Issues

Shri. U.K. Chaudhary, Senior Advocate and Ms. Manisha Chaudhary, Managing Partner (June 24, 2014)

The Companies Act, 2013 (the “Act”) at first glance manifests sweeping changes in the corporate governance system of our country and highlights the intention of the government to change from the control based or regulatory regime to a disclosure based and transparent regime. The Act, amongst other things, focuses on good corporate governance practices, amongst other things, by:
1. Increasing the roles and responsibilities of the Board of Directors and Independent Directors,
2. Protecting shareholders interest, and give them inter alia special rights to sue
3. Enhancing the disclosures and transparency,
4. Increasing accountability of company’s management and auditors,
5. Encouraging Corporate Social Responsibility (CSR) etc.

The expanded vistas of the disclosure of interest by an interested director which assumes immense importance under the Act is a tool through which board members recognise their fiduciary duty to the shareholders and the company and operate in an accountable and transparent manner so that there is no conflict of interest of a director with his duty considering his fiduciary role vis-a-vis the company. The Act, amongst other things, focuses on good corporate governance practices by bringing in a disclosure-based regime and built in deterrence through self-regulation. The Act significantly changes the way in which Companies shall be governed.

Section 184 (which is almost similar to its corresponding Section 299 of the Companies Act 1956) relates to newly appointed directors having to disclose their concern or interest in any company, body corporate, firm, association of individuals at the very first meeting of the Board of Directors in which he participates and thereafter by all directors at the first meeting of the Board of Directors in every financial year or at the first meeting following any change in disclosures already made. Further the section also provides for specific disclosures, which have to be made by directors with regards to their direct or indirect concerns or interests (within certain parameters as provided for in the section itself) in respect of contracts or arrangements or any proposed contracts or arrangements being discussed at any board meeting. This section also contains penal clauses in case of any defaults on the part of the Directors.

The section’s overall scope is very wide as the disclosure of concern or interest by directors is not only a responsibility, but also a duty imposed on the Board of Directors of the company. “Disclosure of interest” is an important information for the Board, the Company and other shareholders, which has to be duly recorded by the Board of Directors under Rule 8 (5) of Companies (Meetings of the Board and its Powers) Rules, 2014 under Chapter 12 of the Act and to further enable the Board to pass the requisite resolutions at the meetings of the Board. At the same time, Rule 9 (1) and (2) of Companies (Meetings of the Board and its Powers) Rules, 2014 under Chapter 12 of the Act renders the same to be a duty of each Director to duly disclose such concern or interest.

Some clarifications however, are necessary to further elucidate a situation and dispel doubts wherein a contract or arrangement is entered into by a company, without a disclosure of concern or interest by director who is not present at the meeting, or with participation by a director who is interested but not aware of any such interest in any way, directly or indirectly, in the contract of arrangement. In such circumstances, it is possible to take a view that such an interested director may make the disclosure at the first available opportunity, as and when such director becomes aware of the same and the company may then take a decision, as to whether to continue with the contract or arrangement or to declare it void, under its option of contract being voidable.

Sub-Section (2) of Section 184 emphasizes on the situation wherein if any director holds more that 2% shares in any body corporate, and any other entity in which he is interested directly or indirectly or in which he is a promoter or manager or Chief Executive Officer, individually or together with other directors is bound to make such disclosures as mentioned above. However, as per Rule 16 (1) (a) of Companies (Meetings of the Board and its Powers) Rules, 2014 under Chapter 12 of the Act, if a director himself or together with any other director holds less than two Percent of the paid-up share capital, then such a disclosure shall not be required to be entered in the register, wherein every company shall maintain a record of the interest of the Director in any Body Corporate or other entities.

Section 184, nevertheless, has emerged as more stringent than its corresponding Section under the Companies Act, 1956, as it makes any director who contravenes the provisions to be liable for a punishment of an imprisonment for a term that may extend to 1 year or a fine between Rs. 50,000 to Rs. 1,00,000 to be paid or both.

The basic objective of Section 184 is to enhance transparency in the companies with the disclosures made in the very beginning of the year or time of appointment by their directors and thereafter as required under the Act. This section does not limit the powers of the directors, or creates obstruction in their interests in any contracts or arrangements or proposed contracts or arrangements, but, for the sake of transparency and fairness, conditions them to make disclosures in the first meeting and thereafter, if required. Section 184 not only supports the directors to have interests in other contracts or arrangements, but also has some strict provisions, which hover over the directors thereby compelling them to do the right thing and follow the best practices. If any director does not disclose the interest in the first meeting, the contract/ arrangement shall be voidable at the option of the company and the director would also be subject to punishment of imprisonment and fine. Thus under this Section, the onus of discharge of responsibility lies on the Director and not on the Company.

Another important aspect is that Section 184 in its normal course of action may in relation to a director’s direct and indirect interest be read with Section 188 of the Act, which refers to related party transactions.

The term ‘Related party’ determining this section, as per Section 2 (76) of Companies Act, 2013 includes the primary entities like director or his relative, a key managerial personnel or his relative, a firm wherein director, manager or his relative is a partner, a private company in which a director or manager is a member or director, and likewise others as set out in the section. A related-party transaction can also play a beneficial role by saving transaction costs and improving the operating efficiency of a company on one hand, but on the other hand it could be seriously misused against the interest of the company and to the detriment of public shareholders and other stakeholders, also.

In India, regulations related to Related Party Transactions (“RPTs”) are found in the erstwhile Companies Act, 1956, the Companies Act, 2013, the Indian Accounting Standard 18, the Auditors Report Order, and Clause 49 of the Listing Agreement. The Income Tax Act 1961 also contains provisions related to transfer pricing issues on such transactions. Recent changes in Income Tax (domestic transfer pricing), Companies Act, 2013 and Clause 49 are significant steps by regulators towards addressing risks arising from RPTs, that have until now been somewhat inadequately addressed and concern from adverse related party transactions are not particularly redressed. There are some more important issues which also need clarification, particularly in case of companies with captive consumption of raw material and unfinished products in integrated manufacturing complex, controlled by various companies/ firms by the same set of shareholders and directors where raw material and semi-finished goods are transferred and used on daily basis for manufacture of final products or for exports. The central government may thus make some rules for mitigating such difficulties. It may be appreciated that such arrangement or transactions are done on daily basis and in such cases it is not possible to obtain Board or shareholders approval in each case separately.

Changes introduced through Clause 49 and Companies Act, 2013 are an attempt to improve the corporate governance framework in India and respond well to the global practices in this regard. These changes have expanded definition of related party; coverage of type of such transactions; have brought in the concept of approval of audit committee or board of directors or the shareholders for all related party transactions. Implementation effectiveness would be result of application of these new regulations by various stakeholders.

The new regime for RPTs seems complex because the definition of ‘related party’ has changed significantly. The scope of transactions has been significantly enhanced and proposes to cover sale, purchase, and leasing of any property of any kind (including immovable property).

There is tremendous emphasis on the approval process for related party transactions. The mandatory code of conduct for independent directors stipulates that they should pay sufficient attention and ensure that adequate deliberations are held before approving RPTs, and assure themselves that the same are in the interest of the company.

Section 188 provides for the matters that require the consent of Board of Directors of company or prior approval in case of special resolution, which is defined under Section 114 of the Act. It also mentions that the agenda of the Board meeting at which the resolution is proposed to be moved shall disclose the name of the related party and nature of relationship; the particulars and material terms of the contract or arrangement, any advance paid or received for the contract or arrangement, if any, etc. It also mentions that the interested directors cannot participate in case of special resolutions under this section. In this regard, some difficulty will arise in cases, where same set of directions and shareholders “control” the related parties (i.e. companies/ firms). It will be difficult, rather impossible to pass Board or shareholders resolution in such related companies, unless some extra measures are taken, such as appointing more uninterested directors and shareholders for requisite quorum. However, the flexibility of this section is depicted as it also includes that nothing would apply to any transactions entered into by the company in its ordinary course of business other than transactions, which are not on arm’s length basis. ‘Arm’s length transaction’ herein means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest. Another feature depicting flexibility of this Section is that the limit is further marked in Rule 15 (3) of Companies (Meeting of the Board and its Powers) Rules 2014 under Chapter 12 of the Act, contracting the paid-up share capital to Rs. 10 Crores. Even though the objective is to make the Act’s approach to be sizeable, the line is drawn herewith, as the section seeks to provide that every such contract or arrangement shall be referred to in the Board’s report to the shareholders along with the justification. The Arms length transaction, thus are intricate, as such transactions may require some evidence that is tangible in order to prove the bonafide in case of dispute, particularly in class action suit or petition complaining oppression and mismanagement and the same may be true for transaction in ordinary course of business of company.

The liberal character of the section is exhibited by doing away with the approval needed by the Central Government for related party transactions. Under the Act, a company is now allowed to proceed against a director or any other employee for recovery of any loss sustained by it as a result of a contract/ arrangement entered into by such person in contravention of the its provisions and therefore, the extensive reporting of related party transactions to the regulators and shareholders will entail transparency in the process. Non-executive and independent directors are entitled to immunity from prosecution only when they can demonstrate evidence of due diligence. Companies will have to gear up to face greater scrutiny and questioning by independent directors. The management would have to design a format and structure for recording discussions in Board meetings, which will help in asking the right questions and provide evidence of due diligence as well. This may even lead to class action suit, in case of any dereliction of duty.

A new concept of ‘interested member’ has been introduced in this section. If an interested member is covered under the definition of ‘related party’, he/ she cannot vote. This is to check misuse of shareholding power by controlling shareholders, and to prevent stifling of the minority by the majority. Since major transactions have to be approved by shareholders through special resolution, denial of voting rights to interested members would sometime mean approval by majority consisting of the minority shareholders. It may however, be noted that even after passing of necessary resolution, as above, legal actions, such as class action suit or petition for oppression and mismanagement cannot be ruled out completely. Further under Rule 15 (2) of the Companies (Meeting of the Board and its Powers) Rules 2014 under Chapter 12 of the Act, in case of wholly owned subsidiaries, resolution passed by the parent company shall be sufficient thereby recognising the corporate democracy of majority rule as applicable to such a subsidiary.

Similar to section 184, this section also puts out itself to be profound, but at the same time restrains the directors from entering into any contract or arrangement not in compliance with the provisions of the section, making it voidable at the option of the Board in case the approving authority does not ratify it. The strictness also bounds the directors under this section by penalising them for entering into or authorising and contract or agreement in violation of the provisions in case of listed or unlisted company.

Therefore, the Act, vide Sections 184 and 188 has made elaborate provisions to control such related party transactions and ensure that related party transactions are not used as a tool to divert resources and funds of the company for personal benefit of directors or controlling shareholders.


This article was first published on icsi.edu.





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