In a developing market, where businesses are still closely promoter held and concentrated, related party transactions ("RPT(s)") are inevitable. It is but natural that companies in a large business conglomerate deal with their group entities, to create synergies and enhance value. One might say it is even easier to do so within the same group, as each entity is guided by the same business principles, have similar business ethos and understanding of each other's needs, and are capable of being driven as one composite aligned economic unit.
In the Indian context, RPTs are, however, viewed with much wariness, and for good reason, as such transactions often become means of value leakage in favour of the related parties. Therefore, in relation to corporate governance with respect to such transactions, it is important to strike the right balance between regulation and self-governance.
The report of the SEBI working group on related party transactions, submitted on January 22, 2020 (the "WG Report"), takes a re-look at the scope of 'related parties,' and 'related party transactions,' to re-visit the net cast by the existing regulatory regime, during times when business constructs, structures and holdings have evolved and become more complex.
Presently there is a dichotomy in practice when it comes to treatment of preferential allotment of shares to related parties (such as, promoters and members of the promoter group) by listed companies as RPTs. While certain listed companies appear to have not treated such transactions as RPTs (for the purpose of seeking majority of minority shareholders' approval under LODR), there have been others who have treated them as such.
Preferential allotment of securities to related parties and the existing RPT regulatory regime.
An assessment of the issue above requires a closer look at the definition of RPTs under the various laws and standards, which are applied to corporate governance.
The Companies Act, 2013 (the "Companies Act") sets out a list of transactions, which if conducted between related parties, would qualify as RPTs. Amongst others, this list includes contracts or arrangements with respect to: "(a) sale, purchase or supply of any goods or materials; and (b) selling or otherwise disposing of, or buying, property of any kind...". Each of the verbs in this definition imply a transfer. Judicial precedents1 have explained that allotment of shares is appropriation out of the previously unappropriated capital of a capital, of a certain number of shares to a person. Until such allotment, the shares do not exist in the first place, and as such, their allotment (i.e., their creation) should not be construed to be transfer. Further, in line with this thought process, the guidance note on RPTs issued by The Institute of Company Secretaries of India, addressing this specific point has clarified that shares become goods only once allotted. Accordingly, for the purposes of the Companies Act, allotment of shares does not qualify as an RPT.
On the other hand, the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the "LODR") prescribe a broader and more subjective definition of an RPT than the Companies Act. The LODR defines RPT as "a transfer of resources, services or obligations between a listed entity and a related party, regardless of whether a price is charged." Although this definition casts a wider net, it still refers to the act of 'transfer.' Therefore, as mentioned above, even in the context of the LODR, issue and allotment of shares should not be construed as an RPT since issuance of shares should not be construed as a 'transfer' of goods or property in the first instance.
The issue gets somewhat complex when one refers to the third source of definition of an RPT, the accounting standards. The term 'related party transactions' is defined under Accounting Standard 24 (the "Ind-AS 24"), which deals with related party disclosures in financial statements of a company. Although this definition is identical to the one under the LODR, Ind-AS 24 provides certain examples of RPTs, one of which is 'transfers under finance arrangements (including loans and equity contributions in cash or in kind)...' Keeping the usage of the term 'transfer' aside, Ind-AS 24 seems to suggest that financing arrangements between related parties in the form of equity contribution, which should include issue and allotment of shares, would be covered in the definition of RPT. In fact, in the case of many listed companies, issuance of shares to related parties is disclosed as an RPT in their financial statements.
The LODR definition and the Ind-AS definition of RPTs being identical is probably the genesis of the alternate view, i.e., RPTs, for the purpose of LODR, must also include such finance arrangements and equity contributions (such as preferential allotments) as these are alluded to in the illustration of RPTs under Ind-AS 24. The argument that an action such as a preferential allotment, as opposed to a rights issue, provides an unwarranted advantage to the promoters in the form of an opportunity to increase their shareholding in the company at the cost of dilution of the others, can be used to support this view.
However, there is good reason to perhaps not be guided by the illustrative examples provided in the Ind-AS 24 for the purposes of reading and applying the LODR provisions (despite the identical definition), as both have different objectives while dealing with the same issue. While Ind-AS 24 focuses solely on disclosures of all necessary information to users of financial statements, to enable such user to assess risk and opportunities relating to the entity appropriately, the LODR seeks to regulate such transactions by prescribing actions and compliance requirements. Therefore, it is understandable that the scope of a definition in both should have different imports, given the difference in objective. For example, it may be beneficial for an investor to know that an entity has raised funds from its promoters, whereas it may not be required to regulate the same and prescribe an additional layer of approval for the same action, especially when the requirement for one already exists in the procedural course of things. To elaborate further, so long as a preferential issue is approved by the shareholders, and is at an appropriate valuation, there is no reason why an additional loop of procuring a separate approval, with abstinence from voting to approve, should be made necessary.
Conclusion; the WG Report and the much-needed clarity.
The WG Report that has revisited the existing RPT regulatory regime, to recommend necessary updates to the regime, appears to subscribe to the view above (i.e., for the purpose of LODR, issuance of shares should not constitute an RPT). While the WG Report states that the scope of RPTs should be broadened to include transactions, which are undertaken, whether directly or indirectly, with the intention of benefitting related parties (arguably, a preferential allotment to the promoter group), it also states that corporate actions that are subject to detailed procedure laid down by SEBI in its other regulations, such as preferential allotment, should be excluded from such scope.
This clarity is a welcome step, and is a recommendation that SEBI should consider implementing. It will settle the dust on the practice and process to be followed on issue and allotment of securities to related parties.
1 Khoday Distilleries Ltd. v. Commissioner of Income Tax and Ors. ((2009)1SCC256), and Sri Gopal Jalan & Company v. Calcutta Stock Exchange Association Ltd. (AIR1964SC250)