Section: 188 Related Party Translation

Introduction

Section 188 of Companies Act, 2013, part of chapter XII that deals with meetings and powers of boards, primarily lays down the provision with respect to related party transactions. The Indian Government is becoming stringent in respect of transactions by corporations with related parties because several scandals in the U.S. and other parts of the world have brought the misuse of this type of transactions at the forefront as a means to manage earnings as well as divert resources from their companies. The large-scale accounting frauds in Enron, Lehman Brothers, Satyam in India etc. are glaring examples of the same. Proper RPTs regulations will strengthen the corporate governance practices in India. Indian Regulators are closely following corporate governance development around the world. This section along with other sections of the act, 2013 and the other regulations strengthen the corporate governance regime in India. This analysis will discuss this section in-depth as well as give a comprehensive understanding of this section.

Purpose of Section 188

This is a very important section of the act, 2013 laying down the requirement of related party transactions, the conditions and disclosures that need to be adhered to by any company. The provision lay down following:

• Any transaction entered with a related party will be called as related party transactions, however the same thing has been said quite technically in sections 188, 189 and Schedule III of the Companies Act, 2013 read with Rules that supplement this section. Following list of transactions will be called Related Party Transactions (“RPTs”) as per this section in brief (a) sale, purchase or supply of any goods, material or services (b) selling or otherwise disposing of or buying property (c) leasing of property (d) availing or rendering of any service (e) appointment of agent for purchase or sale of goods, material, services or property (f) such related party’s appointment to any office or place of profit in the company, its subsidiary companies and associate companies (g) underwriting the subscription of any shares in, or debentures of, the company.
• This section prohibits related party transactions except subject to board resolution/shareholder’s resolution, as given in the following (a) Board approval: Board approval is needed when in order to enter related party transactions. The section provides that except with the consent of the board of directors of the concerned company, no company shall enter into any contract or arrangement with related party (b) Prior Shareholder’s approval: Transaction with related parties covered within the scope of section 188 of the Act, which are either not in the ordinary course of business or not on ‘arm’s length basis and exceeds the threshold prescribed under rule 15(3) of Companies (Meetings of Board and its Powers) Rules, 2014 requires prior approval of the shareholders through resolution.
• No member of the company who is a related party under this section has the right to vote on such a resolution to approve any related party transaction, if such member is a related party to such transaction under this section. The Ministry has clarified vide Clarification dated 17th July, 2014, that this restriction only applies to such related parties which may be related in the context of the RPT for which the resolution is being passed in the concerned meeting. As a result of this provision other entities that fall in the parameters of related parties under the act but are not directly involved in the transaction can vote on such resolution.
• The requirement related to restriction on voting by relatives in the general meeting will not apply to a company in which 90% or more members in numbers are relatives of promoters or related parties as added by Companies (Amendment) act, 2017, to make the business world more flexible.
• In the following cases shareholder’s approval is not required (i) where transactions is made in the ordinary course of business and on arm’s length basis (ii) where transactions is made between holding company and its wholly owned subsidiaries whose accounts are consolidated with such holding company and placed before the shareholders at the general meeting for approval.
• The phrase ‘ordinary course of business’ is not defined under the act, 2013 or rules. It seems that ordinary course of business will cover the usual transactions in which the company regularly deals, and the company repeatedly enters into such transactions for the purpose of its business or the transaction is necessary, normal and incidental to business. The onus to prove that the particular transaction is on arm’s length basis is on the company.
• In a board’s report to shareholders, every related party transaction must be refereed and mentioned, along with justification for entering into such transactions. This disclosure under the Act of 1956 was not required.
• Where any contract or arrangement is entered into by a director or any other employee, without obtaining the consent of the board/ approval by a resolution and the same is not ratified by the board/shareholders within three months then such contract or arrangement would be voidable at the option of the Board or as the case may be, of the shareholders. If the contract or arrangement is with a related party to any director, or is authorized by any other director, the directors concerned have to indemnify the company against any loss that company incurs.
• Thus, the act, 2013 provides that non-ratification of transactions shall be voidable at the option of the board or shareholders. This amendment aims at bringing clarity since currently though ratification is allowed both by board and shareholders, but transaction was only voidable at the option of the board. Further it would be open to the company to proceed against a director or any other employee who had entered into such a contract or arrangement in contravention of the provisions of this section for recovery of any loss sustained by it as a result of such contract or arrangement.
• Any violation of section 188 can lead to disqualification for appointment as a director under section 164 of the act, 2013.
• Any director or other employee of a company, who had entered into the contract or arrangement in violation of the provisions of this section will be (i) in case of listed company, be punishable with imprisonment for a term that can be extended to one year or with fine which that would not be less than twenty-five thousand rupees but can be extended to five lakh rupees, or with both (ii) in case of any other company, be punishable with fine which shall not be less than twenty-five thousand rupees but can be extended to five lakh rupees.

For the definition of related party, reference may be made to section 2(76) of the Companies Act, 2013. Following parties are categorized as related party under the act, 2013: (1) director or his relative (2) key managerial personnel or his relative (3) A firm, in which a director, manager or his relative is a partner (4) A private company in which a director or manager is a member or director (5) A public company in which a director or manager is a director or holds along with his relatives, more than two percent of its paid-up share capital (6) Anybody corporate whose Board of directors, managing director or manager  is accustomed to act in accordance with the advice, directions or instructions of a director or manager (7) Any person on whose advice, directions or instructions a director or manager  is accustomed to act (8) Any company which is (a) A holding, subsidiary or an associate company of such company or (b) A subsidiary of a holding company to which it is also a subsidiary.

In accordance with accounting standard 18, parties are related if at any time during the reporting period one party has the ability to control the other party or exercise significant influence over the other party in making financial and/or operating decisions.

Private companies exempted from the provisions of second proviso to sub-section (1) of section 188. This implies that if a private company enters any contract or arrangement with a related party requiring prior approval of the company, the related parties are now allowed to vote on such a resolution [1].

Further a company needs approval of the audit committee on all related party transactions and subsequent modifications thereto. This is irrespective of whether they are in the ordinary course of business and consummated at arm’s length price or they are below prescribed thresholds [2].

Since the provisions of section 188(1) are not applicable to transactions made on arm’s length basis, companies are also not required to approve the transaction in the board meeting or pass the ordinary resolution, however the company is required to make entries in the register maintained under format MBP-4, pursuant to section 189(1) read with rule 16(1) of Companies (Meetings of Board and its Powers) Rules, 2014.

Section 188 of the act, 2013 must be read with SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.This regulation provides additional disclosure required for public listed companies.  This regulation focuses on ‘materiality’ of a related party transaction. A transaction under this regulation is considered material if the transaction(s) to be entered into individually or taken together with previous transactions during a financial year exceeds ten percent of the annual consolidated turnover of the listed entity as per the last audited financial statements of the listed entity. Further this section also must be read together with Companies (Meetings of Board and its Powers) Rules, 2014, which provide certain additional requirements and conditions to be followed. This rule provides companies with the power to make omnibus approval of related party transactions for the next one financial year, proving flexibility to the business world. Again, these are very important rules that every company needs to adhere to and follow for a valid transaction.

Situation Before Enactment of Section 188

This section corresponds to section 297 (Board’s sanction to be required for certain contracts in which directors are interested) and section 314 (Director, etc., not to hold office or place of profit) of the 1956 Act (old act). The new act, 2013 does not envisage any approval from the central government for any related party transaction. Instead of the central government, the power to approve the transactions lies with shareholders. Any type of contract, which is not on arm’s length basis, is subject matter of this section. Interested directors, who are shareholders also, cannot participate in passing of special resolutions pertaining to these matters. To remove ambiguity, related parties have been categorically defined under the new act, 2013. Even those directors and KMPs who are not interested but are a party to violation of this section will be covered within the ambit of the penalty clause.

Application of Section 188

This section basically lays down the conditions and disclosures that a company must adhere to with respect to a related party transaction. In India related party transactions are governed by the following legislations (1) Companies Act, 2013 (2) SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (Reg. 23) (3) Accounting Standard 18/IND AS- 115 (4) Income Tax Act and Rules. All of these must be followed by every company, so as to make sure that the act or transaction is not invalidated.

Amendment

This section has been amended in 2015 and 2017, by Companies (Amendment) act, 2015 and 2017 respectively, after its incorporation in the act, 2013. Before the 2015 amended a special resolution was required for approval of a related party transaction, and after it only an ordinary resolution now is sufficient. This is done to give companies some breathing room and make the process more flexible. In 2017, in sub-section (1) a third proviso was added which exempted a company in which ninety percent or more members are relative promoters or related parties from following the requirement of second proviso. Further in sub-section 3, the words “shall be voidable at the option of board or as the case may be shareholder” was substituted, making the scope of the section wider by including shareholders.

Cases at a Glance

• In Section 188(1), the words appearing are “contract or arrangement”. The difficulty arises in understanding the meaning of the word “arrangement”. The Hon’ble Bombay High Court in the case of Bank of India v. Ahmadabad Manufacturing & Calico Printing Co Ltd[3], while interpreting the word “arrangement” as appearing in Section 390 of the Companies Act, 1956, has observed that the word “arrange” has, as one of its meaning, as to come to an agreement or understanding and the word “arrangement” has, as its primary meaning, the action of arranging. As a matter of plain language, it would, therefore, follow that the term “arrangement” means any agreement or understanding between the parties concerned.
• Public Prosecutor v. T.P. Khaitan [4]: In this case the court tries to determine the interpretation of the word “interest” as used under section 188 of the act, 2013. It may not be restricted to financial interest only but may also include interest arising out of fiduciary duties or closeness of relationship. The interest may be direct or indirect. The interest should be an “interest” conflicting with that of his duty as a director.

Concluding Summary

This section lays down conditions and requirements for related party transactions by any company. This section and its compliances and disclosures will be understood best when they are read and complied with various other rules and regulations as mentioned in the above analysis. This is very important section, at least in the coming of age and its proper regulation is to protect and safeguard the interest and rights of the company as well shareholders.

References:

[1] MCA General Circulation no. 30/2014 dated 17th July 2014 (MCA).

[2] Companies Act, 2013, No. 18, Acts of Parliament, § 177 (2013).

[3] India v. Ahmadabad Manufacturing & Calico Printing Co Ltd 1972 (42) CompCas 211 (BOM.).

[4] Public Prosecutor v. T.P. Khaitan (1957) 27 CompCas. 77 (Mad.).