Related party contracts under the Companies Act: approval, arm's length and audit

The starting point is the definition in section 2(76), which lists nine categories of related party in relation to a company. The first two are a director or his relative, and a key managerial personnel or his relative. The third is a firm in which a director, manager or relative is a partner. The fourth is a private company in which a director or manager, or his relative, is a member or director. The fifth is a public company in which a director or manager is a director and holds, along with his relatives, more than two per cent. of its paid-up share capital. The eighth limb carries the group structure into the definition, covering a holding, subsidiary or associate company and the investing company or venturer, and the ninth is a catch-all for persons who may be prescribed. A relative is defined in section 2(77) to include a member of a Hindu Undivided Family, a husband and wife, and any other person related in the prescribed manner.

Section 188(1) opens with a prohibition and then a list. No company shall enter into a contract or arrangement with a related party with respect to seven matters. Paragraph (a) is the sale, purchase or supply of any goods or materials. Paragraph (b) is selling or otherwise disposing of, or buying, property of any kind. Paragraph (c) is the leasing of property of any kind. Paragraph (d) is availing or rendering of any services. Paragraph (e) is the appointment of any agent for the purchase or sale of goods, materials, services or property. Paragraph (f) is the appointment of a related party to any office or place of profit in the company, its subsidiary company or its associate company, and paragraph (g) is the underwriting of the subscription of any securities or derivatives of the company.

The Explanation defines an office or place of profit by reference to what the holder actually receives. Where the office is held by a director, the test is whether the director receives anything by way of remuneration over and above the entitlement as a director, by way of salary, fee, commission, perquisites, rent-free accommodation or otherwise. Where the office is held by an individual who is not a director, or by a firm, private company or other body corporate, the test is whether that holder receives remuneration, salary, fee, commission, perquisites, rent-free accommodation or otherwise. The two limbs of the definition that catch arrangements a board has not thought about as related party dealings are the sixth and the seventh, covering a body corporate whose board, managing director or manager acts on the directions of a director or manager, and a person on whose advice a director or manager acts, with advice given in a professional capacity saved by the Explanation.

The ordinary course arm and the arm's length arm are separate, and a transaction has to clear both. The Explanation defines an arm's length transaction as a transaction between two related parties conducted as if they were unrelated, so that there is no conflict of interest. The second half of that definition is the part that matters. It is not enough that the price can be explained by reference to market data. The company has to be able to show that there was no conflict of interest to be managed, which usually means producing the comparables, the process followed and the reasons the terms were set where they were.

The Explanation's definition of office or place of profit sits in the same section and is used the same way. It is a functional test on the remuneration received, so a director who takes a second office without extra pay, or a firm that is appointed on ordinary commercial terms without the appointment being the source of income, may fall outside it. The company that cannot answer the question from documents should ask it before the appointment is made rather than after.

Two further provisos to section 188(1) narrow the shareholder approval requirement. Where ninety per cent. or more of the members, in number, are relatives of promoters or are related parties, the rule that a related party member cannot vote on the resolution does not apply, so the resolution can be passed by the interested members themselves. And the requirement of passing the resolution does not apply to transactions between a holding company and its wholly owned subsidiary whose accounts are consolidated with the holding company and placed before the shareholders at the general meeting for approval. The carve-out is conditional on the consolidation and the placement, and a group that treats it as automatic is relying on a proviso it has not satisfied.

Section 177(1) requires the board of every listed public company, and such other classes of companies as may be prescribed, to constitute an audit committee. Section 177(2) fixes the shape of it: a minimum of three directors with independent directors forming a majority, and a majority of the members including the chairperson must be persons able to read and understand the financial statement. Section 177(4) lists the terms of reference the board must set in writing, and clause (iv) of that list is the approval or any subsequent modification of transactions of the company with related parties.

Two provisos to clause (iv) shape how the approval is taken. The first lets the audit committee make an omnibus approval for related party transactions proposed to be entered into, subject to such conditions as may be prescribed, which is the mechanism behind a standing authority for a class of transactions. The second provides that where a transaction other than one referred to in section 188 is not approved by the audit committee, the committee makes its recommendations to the board, so the board decides on the record rather than by inaction.

The third proviso to clause (iv) deals with the transaction entered into without approval. Where a transaction, other than a transaction referred to in section 188, involving any amount not exceeding one crore rupees is entered into by a director or officer without the approval of the audit committee and is not ratified by the audit committee within three months from the date of the transaction, the transaction is voidable at the option of the audit committee. Where the transaction is with the related party of a director or is authorised by any other director, the director concerned must indemnify the company against any loss incurred by it. Section 177(6) gives the committee the authority to investigate into any matter within its terms of reference or referred to it by the board, with the power to take professional advice from external sources.

The first proviso to section 188(1) is the shareholder approval rule. Where the company has a paid-up share capital of not less than the prescribed amount, or where the transaction exceeds the prescribed sums, no contract or arrangement may be entered into except with the prior approval of the company by a resolution. The proviso to section 188(1) that follows it removes the related party member from the vote: no member of the company shall vote on the resolution to approve any contract or arrangement if that member is a related party. The excluded member is not counted in the denominator either, which is why a special resolution under the articles can be carried by the disinterested shareholders alone.

The second proviso sits on the other side. The Board has to approve the transaction by a resolution at a meeting of the board, and it may attach such conditions as may be prescribed. A transaction that is approved by written circulation, or by a resolution taken without the interested director's participation, has not been approved in the way the section requires. This is the practical point where many private company transactions fail, because the board paper is signed without the interest being recorded.

A related party transaction is not a special resolution under the general meeting rules in the ordinary sense. The requirement is a resolution with the interested member excluded, and the section says so in terms. A general meeting cannot cure a failure to exclude the related party member, and it cannot cure a failure to take the prior approval before the contract was entered into, because the proviso requires the approval to come first.

Section 184 is the disclosure obligation that runs alongside section 188. Section 184(1) requires every director to disclose his concern or interest at the first meeting of the board in which he participates as a director, at the first meeting of the board in every financial year, and whenever there is any change in the disclosures already made. Section 184(2) applies where a director is in any way, directly or indirectly, concerned or interested in a contract or arrangement with a body corporate in which the director, or the director in association with any other director, holds more than two per cent. shareholding or is a promoter, manager or chief executive officer, or with a firm or other entity in which the director is a partner, owner or member. The director must disclose the nature of his concern or interest at the meeting of the board in which the contract is discussed and must not participate in that meeting.

The consequence of a failure is stated. Under section 184(3), a contract or arrangement entered into without the disclosure under sub-section (2), or with the participation of a director who is concerned or interested, is voidable at the option of the company. Under section 184(4) a director who contravenes sub-section (1) or sub-section (2) is liable to a penalty of one lakh rupees.

Section 189 requires the company to keep one or more registers giving separately the particulars of all contracts or arrangements to which section 184(2) or section 188 applies. The register is placed before the next meeting of the board and signed by all the directors present at that meeting. Every director or key managerial personnel must, within thirty days of appointment or of relinquishing office, disclose to the company the particulars specified in section 184(1). The register is kept at the registered office, is open for inspection during business hours, and must be produced at the commencement of every annual general meeting and remain open during it. Section 189(5) excludes a contract for the sale, purchase or supply of goods, materials or services where the value or cost does not exceed five lakh rupees in the aggregate in any year, and a contract by a banking company for the collection of bills in the ordinary course of its business. Section 189(6) puts a penalty of twenty-five thousand rupees on a director who fails to comply. The auditor's own reporting duty is separate: section 143(3)(f) requires the audit report to state whether the observations or comments of the auditors on financial transactions or matters that have any adverse effect on the functioning of the company.

Section 188(3) sets out what happens next, and the answer is that the contract is not automatically void. Where a contract or arrangement is entered into by a director or any other employee without the consent of the board or the approval by a resolution in general meeting, and it is not ratified by the board or, as the case may be, by the shareholders at a meeting within three months from the date on which the contract or arrangement was entered into, the contract or arrangement is voidable at the option of the board or of the shareholders. Where the contract is with a related party of any director, or is authorised by any other director, the directors concerned must indemnify the company against any loss incurred by it.

Three points follow. The ratification period is three months from the date the contract was entered into, so a company that discovers a missed approval late cannot rely on it. The remedy is voidability at the option of the company, which means the company may affirm the contract and keep the benefit of it, so the exposure is not automatic. And the indemnity is in addition to the voidability, so a director who cannot show the board approval cannot escape the loss by arguing that the company chose to affirm.

Section 188(4) is separate from the voidability. Without prejudice to anything in sub-section (3), it is open to the company to proceed against a director or any other employee who entered into the contract in contravention of the section for recovery of any loss sustained as a result of it. Section 188(5) then attaches a personal penalty: a director or employee who entered into or authorised the contract in violation of the section is liable to a penalty of twenty-five lakh rupees in the case of a listed company and to a penalty of five lakh rupees in the case of any other company.

Three sections sit alongside section 188 and are frequently confused with it. Section 185 deals with loans to directors. Section 185(1) prohibits a company from advancing any loan, including a loan represented by a book debt, or giving any guarantee or providing any security in connection with any loan taken by a director of the company or of its holding company, or any partner or relative of such a director, or by a firm in which any such director or relative is a partner. Section 185(2) allows a loan, guarantee or security to a person in whom a director is interested, subject to a special resolution and to the money being used for the borrowing company's principal business activities.

Section 186 deals with the company's loans and investments more generally, and is a limit rather than a prohibition. A company may not directly or indirectly give any loan to any person or body corporate, give any guarantee or provide security in connection with a loan, or acquire the securities of any body corporate, exceeding sixty per cent. of its paid-up share capital, free reserves and securities premium account, or one hundred per cent. of its free reserves and securities premium account, whichever is more. Section 186(3) requires a special resolution before the limits are exceeded, and section 186(4) requires the particulars of the loans, investments, guarantees and security to be disclosed to the members in the financial statement. Section 187 requires investments to be held in the company's own name, with the exceptions for a nominee holding the shares of a subsidiary, a bank deposit, a security for the repayment of a loan, and a depository holding.

A structure that clears section 188 can still fail under section 185 or section 186, and the reason is that the three sections test different things. Section 188 asks whether the counterparty is connected to the board. Section 185 asks whether the money is going to a director or a person in whom a director is interested. Section 186 asks how much of the company's balance sheet is committed. A loan to a related party can clear the shareholder approval requirement under section 188 and still require a special resolution under section 186, and a deposit that is not a loan can escape section 185 while remaining inside section 186.

Group restructurings often put a related party transaction inside a scheme of compromise or arrangement, and the two processes then run together. Section 230(3) governs the notice where a meeting is proposed to be called in pursuance of an order of the Tribunal. The notice must be accompanied by a statement disclosing the details of the compromise or arrangement, a copy of the valuation report if there is one, and an explanation of their effect on creditors, key managerial personnel, promoters and non-promoter members, and the debenture holders. The notice must also explain the effect of the compromise or arrangement on any material interests of the directors of the company or the debenture trustees.

The same notice has to be placed on the website of the company, and in the case of a listed company the documents go to the Securities and Exchange Board and to the stock exchanges for placing on their websites, and must be published in newspapers in the prescribed manner. Where the notice is issued by advertisement, it has to indicate the time within which copies of the compromise or arrangement can be obtained free of charge from the registered office.

Section 231 then gives the Tribunal the machinery to implement what it has sanctioned. Where the Tribunal makes an order under section 230 sanctioning a compromise or arrangement, it must have power to supervise the implementation and may, at the time of making the order or at any time thereafter, give directions in regard to any matter or make such modifications in the compromise or arrangement as it considers necessary for its proper implementation. Where a valuation is required, section 247 requires it to be made by a person with the prescribed qualifications and experience, registered as a valuer, and appointed by the audit committee or in its absence by the board. The valuer must make an impartial, true and fair valuation, exercise due diligence, and not undertake the valuation of assets in which he has a direct or indirect interest during the three years before his appointment or the three years after the valuation.