This article is written by Upasana Sarkar, a student at Jogesh Chandra Chaudhuri Law College. This article provides an extensive analysis of Section 188 of the Companies Act, 2013. This article deals with related party transactions that take place between related parties.

This article has been published by Sneha Mahawar.​​ 

Table of Contents

Introduction

A company, while doing its business, enters into a number of transactions in its day-to-day life for business purposes. These transactions can be between unknown or related parties. In both cases, when a transaction takes place for any business reason, some legal obligations come into force. Section 188 of the Companies Act, 2013, deals with the transactions that take place between related parties. This was introduced to create transparency and accountability between the parties to the transaction. This is applicable to both public and private limited companies. It is necessary to contemplate all the aspects before a party decides to enter into a related party transaction. 

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Reasons for introducing Section 188 of the Companies Act, 2013

Section 188 of the Companies Act, 2013, was introduced to ascertain the accurate financial position of the company and to increase the level of transparency when a transaction takes place. This also gives a huge amount of responsibility to the board of directors to review, approve, explain, and recommend the parties related to a transaction, as well as shareholders to seek their approval. This also encourages disclosure, accountability, communication, and proper monitoring while any transaction takes place between the related parties. This also discourages fund diversion that takes place in the name of related party transactions for any kind of extra benefit or profit for the company without any traces. 

What does the term ‘related party’ mean

Section 2(1)(zb) of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirement) Regulations, 2015, deals with ‘related party’ which means those relatives that are defined under sub-section (76) of Section 2 of the Companies Act, 2013. 

According to Section 2(76) of the Companies Act, 2013, the term ‘related party’ means-

  • A person who is a director or his/her relative;
  • A person who is key managerial personnel or his/her relative;
  • A firm where a director, manager, or his/her relatives are related to each other as partners;
  • A private company where a director, manager, or his/her relatives are considered members or directors;
  • A public company where a director or manager is considered a director and holds together with his/her relatives in excess of two percent of its paid-up share capital;
  • A body corporate whose board of directors, managing director, or manager are habituated to acting in compliance with the advice, direction, or instructions of a director or manager;
  • Any person whose advice, direction, or instructions are habitually adhered to while doing any act by a director or manager;
  • A company or a body corporate-
    1. which is said to be a holding, subsidiary, or associate of that company, or
    2. which is regarded as a subsidiary of a holding company to which it is also a subsidiary, or
    3. which is known as an investing company or the venturer of the company;
  • A person who is a director of the company, excluding the independent director or key managerial personnel of the holding company or his/her relatives in relation to the company;
  • Such other persons as may be prescribed.

Definition of ‘relatives’ under the Companies Act

Section 2(77) of the Companies Act, 2013, defines the word ‘relative’ as anyone who is related to another, in case they are members of the Hindu Undivided Family (HUF), or in case they are husband and wife, or if a person is related to another in the manner as may be prescribed in Rule 4 of the Companies (Specification of Definitions Details) Rules, 2014. A person is deemed to be the relative of another person, if he or she is related to the other person in the following ways, namely- 

  • Father or stepfather.
  • Mother or stepmother.
  • Son or stepson.
  • Son’s wife.
  • Daughter.
  • Daughter’s husband.
  • Brother or stepbrother.
  • Sister or step-sister.

Meaning of the term ‘transaction’ with the related party under Section 188(1) of the Companies Act, 2013 

A ‘transaction’ that is covered by Section 188(1) of the Companies Act, 2013, read with Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014, means those transactions which are associated with-

  • Purchasing, selling, or supplying of any particular goods or materials– Where the transaction value is more than 10% of the annual turnover or 100 crore rupees, the threshold will be that amount, whichever is less.
  • Buying or selling any kind of property or disposing of it- Where the transaction value is more than 10% of net worth or 100 crore rupees, the threshold will be that amount, whichever is less.
  • Any kind of property that can be given on a lease- Where the transaction value is more than 10% of net worth, or 10% of annual turnover, or 100 crore rupees, the threshold will be that amount, whichever is less.
  • Availing or rendering any kind of service- Where the transaction value is more than 10% of annual turnover or 50 crore rupees, the threshold will be that amount, whichever is less.
  • The purchasing or selling of any goods, materials, property, or services through the agent.
  • Appointment or placement of related party to any registered office or place of profit in a company, its associate or subsidiary- The remuneration shall be more than Two lakh fifty thousand rupees to fall under this Section.
  • Underwriting the subscription of any kind of securities or derivatives of a firm or company- The transaction value is more than 1% of net worth of the company. 

‘Related party transaction’ under SEBI (Listing Obligations and Disclosure Requirement) Regulations, 2015

According to Regulation 2(1)(zc) of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirement) Regulations, 2015, ‘related party transaction’ means any kind of transfer of resources, services, or obligations that takes place between the entities that are listed and a related party, irrespective of whether a price is charged or transaction with a related party. This shall be deemed to include a single transaction or a group of transactions for which a contract is made. It can be presumed that this Section shall not be applied where the units are issued by mutual funds that are listed on an acknowledged stock exchange.

Approvals for related party transactions 

Certain approvals are needed for the transactions between the related parties. Any kind of transaction under Section 188 cannot take place without prior ratification by members of the company,i.e., the directors, shareholders, and audit committee, which is done by passing a resolution as provided in Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014.

Approval of the board of directors 

  • In the event a company decides to enter into a related party transaction, prior approval of the board of directors is required.
  • Though prior approval of the board of directors is not needed when a company enters into a transaction in the ordinary course of business at arm’s length. 

Approval of the shareholders 

  • Shareholder approval is required in the case of a related party transaction that does not take place in the normal course of business or is not at arm’s length price and the amount of the transaction is in excess of the materiality threshold. The approval is given only after passing a resolution.
  • The approval of the shareholders is also needed in the case of listed companies if a related party transaction exceeds the materiality threshold under listing regulations.

Approval of the audit committee

  • The role of the Securities and Exchange Board of India (SEBI) is also important. According to Regulation 18 of the SEBI (Listing Obligations and Disclosure Requirement) Regulations Act, 2015, all the companies that are listed shall form an audit committee, which will have at least three members as directors.
  • The audit committee shall have at least two-thirds independent members.
  • The audit committee members shall be financially literate which means that they should be capable enough to read and understand the basic financial statements, i.e., balance sheet, profit, and loss account and likewise, and at least one of them shall have knowledge or expertise in the field of related financial management or accounts.
  • Prior approval of the audit committee is necessary for the listed companies in the following cases-
    • Where a related party to the transaction is a subsidiary of a listed company, but the listed company itself is not a party to such a transaction, and the value of the transaction is in excess of ten percent of the annual consolidated turnover, according to the last audited financial statements.
    • Where a related party to the transaction is a subsidiary of a listed company but not the listed company itself and the value of such transactions, whether entered into individually or taken together during a fiscal year, is in excess of ten percent of annual standalone turnover, will come into force from 1st April, 2013.

Omnibus approval

The audit committee in case of repetitive transactions gives consolidated or standing approval which is termed as omnibus approval.

  1. With the board’s approval, the audit committee frames the criteria for the omnibus approval that shall include-
  • The maximum gross transaction value in a year.
  • The maximum value for a transaction.
  • The manner of the transaction and the extent of disclosure to be made for the transaction.
  • The transaction should be reviewed at periodic intervals.
  • The transaction does not fall under omnibus approval.
  1. While starting the criteria, the following should be mentioned-
    • Repetitiousness of the transaction that has been made in the past or will be made in the future.
    • The reasons for the requirement of omnibus approval shall be taken into consideration.
  2. The omnibus approvals are valid for one fiscal year only.
  3. The omnibus approvals cannot be given for selling or disposing of undertakings.

Exemptions from approval

  • Related party transactions do not require the approval of the board of directors and prior approval of the shareholders if the transaction is done in the ordinary course of business.
  • Related party transactions do not need the approval of the board of directors or prior approval of the shareholders if they are carried out on the basis of arm’s length.
  • Related party transactions do not require prior approval of the shareholders and audit committee if the transaction is done by listed companies or any kind of transaction takes place between its wholly owned subsidiary company, whose accounts are consolidated and retained so that they can be approved in the general meeting.
  • Related-party transactions are not applicable to private companies or IFSC-registered public companies.
  • Related party transactions are not carried out if more than ninety percent of the members are relatives of the related parties or promoters. 
  • Translations are not allowed in cases where the related parties are government companies or the ministry in charge has given its approval to the government companies.

Meaning of the expression ‘ordinary course of business’

The expression ‘ordinary course of business’ is not precisely defined in the Companies Act, 2013, or under any rules. It normally defines those business practises, customs, and transactions that take place on a daily basis without any hidden aspects. The Institute of Chartered Accountants of India (ICAI) has excluded some of the transactions that will not fall under the expression “ordinary course of business.” They are as follows-

  • Complex entity transactions, which include corporate restructurings or acquisitions.
  • Transactions that take place between foreign companies where the corporate laws are lagging behind.
  • In the absence of consideration, the leasing of business premises or facilitation of service by a company to another company.
  • Sales transactions at a very huge discount or return.
  • Transactions that have arrangements for a circular or repurchase.
  • The terms of contract transactions can be changed before the expiry.

Meaning of the expression ‘arm’s length transaction’

The expression ‘arm’s length transaction’ means any transaction where two or more unrelated parties agree to do business and act independently and in their own interests so that no conflict of interest takes place. For example, if a purchaser buys a house from a stranger, each person offers what they want. But they are not bound by any obligation, and they are not related to each other. They can make a deal that serves them equally without being related to each other.

Section 188 cannot be applied if the transaction is done in the ordinary course of business and is at arm’s length. If a transaction takes place at arm’s length, then no resolution is needed. The burden of establishing whether the transaction is at arm’s length or not is upon the company. It is the company’s responsibility to properly set up and maintain appropriate and suitable information and documentation regarding price and terms of supply. 

Disclosures that are necessary for related party transactions 

The transactions that are proposed to be carried out between the parties with the approval of the board by passing the resolution shall be as follows:

Disclosure to be made in the board’s report for the related party transaction under Section 188(2) of the Companies Act, 2013

  • The contracts that are entered into by a company for related party transactions shall be mentioned in the board’s report to the shareholders, together with the reason for entering into such agreements or contracts.
  • Those related party transactions that are not at arm’s length on price and material-related party transactions that are at arm’s length must have their particulars reported. It shall be reported in AOC-2.

Disclosure to be made in the register of contracts or arrangements for related party transactions 

  • It is the responsibility of all the companies to record the details of the transactions that take place between the related parties.
  • It should be registered on Form MBP-4.

Disclosure to be made to the stock exchange for listed companies for related party transactions 

  • It is necessary for a listed company to disclose the information of the related party transactions on a consolidated basis in a prescribed format to the stock exchanges and on the company’s website.
  • Previously, it was required to be done within thirty days and from 1st April, 2022, within fifteen days and from 1st April, 2013, together with the release of financial statements from the date of publication of the standalone and consolidated financial statements for six months.

Disclosure to be made in the annual report in the annual meeting for the listed companies under Section 188(3) of the Companies Act, 2013

  • The name of the related party, the director, or other key managerial personnel who are involved in the related party transactions.
  • The kind of relationship and nature, material terms, value of the transaction, and particulars of the arrangement or contract.
  • Any details or relevant information that is important for the members to take a decision by passing a resolution in the meeting.
  • It is required to be disclosed in the corporate governance section of an annual report.

Disclosure to be made in the board meeting

According to Rule 15 of the Companies (Meeting of the Board and its Powers) Rules, 2014, the resolution to be passed for the agenda at the board meeting shall include the following particulars:

  • The name of the related party and the nature of their relationship with each other.
  • The nature, particulars, as well as duration of the contract.
  • The material terms of the arrangement or contract along with its value.
  • Whether any advance is paid or received for the arrangement or contract.
  • The mode of determining pricing and other commercial terms.
  • Any details or relevant information that is important for the members to take a decision by passing a resolution in the meeting.

Disclosure required to be done to the audit committee

  • It is not necessary to make any kind of disclosure for the related party transactions.
  • But Section 177(6) of the Companies Act, 2013, states that the audit committee shall have full access to all the details and particulars present in the company’s records. They can also obtain professional advice from external sources to ensure proper and fair decision-making.

Disclosure required to be made by the interested directors

Any director who is interested in the related party transactions, directly or indirectly, in the contract that has already been entered into or will be entered into, should disclose the nature of the deal at the board’s meeting where such an arrangement or contract is discussed.

Points that are related to annual actions for related party transactions 

  • To obtain disclosure of interest regarding any change made at the board meeting by directors or key managerial personnel on their appointment.
  • To acquire a list of related parties from subsidiaries of listed companies.
  • It is the responsibility of the listed companies to frame a policy on related party transactions that shall include the processes to identify, review, and approve related party transactions.
  • The policy on related party transactions must be monitored and updated routinely.
  • The policy on related party transactions should be disclosed on the website of company.

Voidable contracts

  1. When a director or any other employee enters into an arrangement or contract without the approval of the board or by passing a resolution in the general meeting, and the board or the shareholders at the meeting have also not ratified it within three months from the date of such arrangement or contract, it shall be voidable at the option of the board or the shareholders as the case may be.
  2. When the arrangement or contract is with a party that is related to any director or is authorized by any other director, it is his responsibility to indemnify the company against any loss that it incurs. 
  3. The company has the discretionary power to proceed against a director or any other employee who has entered into an arrangement or contract that is contrary to the provisions of this Section. If, because of an arrangement or contract, the company faces any loss, then it can be recovered from that person.

Penalties for non-compliance under Section 188(5) of Companies Act, 2013

If a director or an employee of a company enters into a contract that is contrary to or in violation of the provisions of this Section, then he shall be liable to the following punishments-

  • In the matter of a listed company, he shall be punishable with a fine of twenty-five lakh rupees; and
  • In the matter of any other company, he shall be punishable with a fine of five lakh rupees.

This section came into effect on 21st December, 2020.

Judicial pronouncements

  1. In the case of Securities and Exchange Board v. R. T. Agro Private Limited (2022), R. T. Export Limited suggested entering into a transaction for purchasing 40,000 sq. ft. of residential space with one Neelkanth Realtors Pvt. Ltd. This offer was considered a related party transaction, and so it needed the approval of the shareholders of the company. The R. T. Export Limited approved a special resolution, but the related parties, in a formal manner under Section 188, declined to vote on that special resolution. After that, an extraordinary general meeting was held to repeal the resolution where the related parties also voted. SEBI, the appellant, filed a complaint and issued a notice arguing that Regulation 23 of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015, was violated. The Adjudicating Officer awarded a penalty of thirty-five lakh rupees to the respondents for violating Regulation 23. But the Appellate Tribunal has not approved this order and has allowed the respondent to file an appeal against that order. It was held that, as per Section 188 of this Act, the parties have not committed a fault by refusing to vote on the special resolution.
  2. In the case of Public Prosecutor v. T. P. Khaitan (1957), the meaning of the word ‘interest’ under Section 188 was interpreted as personal interest. The meaning is not restricted to financial interest only but may also include those interests arising out of a fiduciary or personal relationship. The interest of the related party may be direct or indirect.
  3. In the case of Needle Industries Ltd. v. Needle Industries Newey (India) Holding Ltd. (1982), the question raised was whether all the transactions with related parties needed scrutiny and compliance with Section 188 of this Act. The third provision to sub-section (1) of Section 188 gives an answer to this question, as it is an exemption clause. It exempts any transaction that is entered into by the entity in the ordinary course of business other than those transactions that are not on the basis of arm’s length.
  4. In the case of IndusInd Bank v. Additional Commissioner of Income Tax (2012), the meaning of ‘arm’s length transaction’ was defined as an amount for which assets can be exchanged between a willing and knowledgeable buyer and a willing and knowledgeable seller in an arm’s length transaction.

Conclusion

The concept of ‘related party transaction’ was introduced in Section 188 of the Companies Act, 2013, which helps us understand the relationship of the related party for business and commercial transactions. All the companies, in their day-to-day affairs, have to enter into transactions for carrying out their businesses. Any transaction that takes place between parties who are either relatives or parties that are closely linked with one another is normally termed a “related party transaction.” When such transactions take place, they may sometimes create disputes or other illegal situations that can have an impact on its financial position. Therefore, to protect the interests of the stakeholders and maintain accountability and transparency in business matters, the legislature amended the old Companies Act and inserted this Section in the new Act. This Section helps to keep better control over the finances of the company by disclosing the related party transactions.

Frequently asked questions (FAQs)

Why are disclosures of related party transactions required?

The disclosures of the related party transactions are needed for the following reasons-

  • So that the relations of the related party do not influence the transaction between the reporting company and related party. 
  • So that the unrelated party is not affected by the related party transaction.
  • For better corporate governance.
  • So that the stakeholders can take appropriate decisions if they are properly informed.
  • To determine the true and fair position and performance of the company.

When does a register not need to be maintained?

A register is not required to be maintained, when-

  • The value of the goods purchased or sold in a particular year is not more than five lakh rupees.
  • The banking company collects bills in the ordinary course of business.
  • The transaction is not more than one lakh rupees under Section 8 of the Companies Act, 2013.

What are the requirements for fresh approvals under Section 188 for past contracts?

The contracts that are entered into by the companies in accordance with Section 297 of the Companies Act, 1956, which has already come into force before the commencement of Section 188 of the Companies Act, 2013, will not need fresh approval under this Section until the original terms of the contracts expire. 

Can any contracts that are entered into under ‘related party transactions’ before April 1, 2014, be governed by the provisions of the Companies Act, 2013?

Any contracts that are entered into by the related parties under ‘related party transactions’ before April 1, 2014, cannot be governed by the provisions of the Companies Act, 2013. It shall be governed by the provisions of the previous Companies Act. The Companies Act of 2013 will not be applicable to any of the related party transactions entered into before that date.

References 

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