RESPONSE PAPER- 03

[RELATED PARTY TRANSACTIONS]

NAME: Yashvi Shah

ROLL NO: AU1813041

SUBMITTED ON: 22nd April 2020

SUBMITTED TO: Prof. Nimit Thaker

SECTION: 1
Meaning and Concept of Related Party Transactions

Related Party transactions refers to the transactions between a company and its related entities
which may be subsidiaries, associates, joint ventures, substantial shareholders, executive
directors and their relatives, or entities owned or controlled by its executives, directors and their
families. When the related party transaction occurs, it occurs between two entities who are
already in a special relationship prior to the transaction. A related party transaction could be a
business deal, any financial arrangement or a series of financial contracts. Indian Accounting
Standards (AS-18) considers parties to be related to each other “if one party has the ability to
control or significantly influence the other in making financial and/ or operating decisions in a
particular period”. The definition by Accounting Standards can be explained as Mr. M Shah is
dealing in detergent manufacturing. To further extend his scope of business he is in a need of a
larger factory. He therefore approaches his son, Mr. S Shah who is engaged in the property
business. So, in this case Mr. S was already in relation with Mr. M and he further engages in the
decision which is linked with the company’s financials. So, this becomes a related party
transaction.

Further, if we say a related party transaction can be considered valid if the transaction takes place
at arm’s length price. This means that the two parties which are involved in the transaction can
be related but are indulged in the transaction for commercial purpose of the company and not for
earning any undue gains.
Regulatory Framework and Legal requirement for Related Party transactions

The regulations related to Related Party Transactions are found in The Accounting Standard 18
(Ind AS 18) and LODR Guidelines.

● The regulations laid by Accounting Standards are:

It does not mandate any specific format for reporting Related Party Transaction. It does
describe the provision for aggregating these transactions. Only those related party
transactions pass are exempted from aggregation which pass the materiality test (the
transaction should be in excess of 10% of the monetary values of the total number of
transactions of such nature. The disclosure requirement under AS are: a) The name of the
related party should be; b) The relationship which the parties have with each other; c)
The nature of transaction which the parties are going to have; d) The monetary value of
the transaction; e) any other items which the Related Party has specifically mentioned; f)
The outstanding amount, if any.

● The regulations laid by LODR Guidelines are:

The LODR Guidelines proposes that the related party transactions with the name of the
related parties and their statement should be presented before the Audit Committee. The
Audit Committee may approve the transaction if it is between 2 entities and is carried on
at an arm's length price. The approval from the Audit Committee is required only if the
transaction goes beyond the limit specified in the Articles of Association. The Audit
Committee checks if the approval done by the Board of directors was within Omnibus
approvals or not.

The approval from shareholders is also necessary if the value of the transaction goes beyond
certain limits.
The law also states that the interested director should not be present in the meeting when this
topic is discussed. And if he is present, he should not participate in the decision making. The
Company Secretary may request the Independent director to not attend the meeting. The
interested director is not considered as a part of quorum (which says that either 1/3rd or half
whichever is higher number of directors should be present to discuss the same). And also at least
2 Independent directors should be present in the meeting when the RPTs are discussed. If not,
then the meeting will be considered as invalid.

Risks associated with Related Party Transactions

Related party transactions are not always beneficial to investors as each and every RPT are not
carried on at arm's length price. Though RPT may not be illegal but the facts that get covered
under this transaction are difficult to identify. Companies often indulge in RPTs to manage their
earnings or to or to transfer the assets of listed companies to other affiliated firms. So, since the
shareholders do not know the facts that are covered under these transactions, they have a huge
risk in estimation of earnings.

Adverse RPT reduces transparency in reporting, decreases the value of the firm, and stunts the
growth of the capital markets ultimately.

The RPT may lead to conflict of interest to the interested directors as the same director has to
play two roles which are divergent in nature. The shareholders may think that the director for
which he/she is appointed is not performing that task with independence and therefore may have
some personal interest in the transaction.

The Related party transaction may result in undue favor to the interested director and the related
party as the rate at which the transaction is decided with the related party may be higher than
what rate it is available in the market and therefore, the company may resort to spending more
money and this marginal difference has to be bared by the shareholders.
Improvements which can be done in the legal requirements of Related Party Transactions

The Accounting Standards can provide additional guidelines for reporting of RPTs. The time
intervals at which the disclosures are to be made for RPTs are also equally necessary and
important. In the current legal structure the approval of RPT is done by the Board of Directors
and the Audit committee. The information regarding the RPT reaches the shareholders at the end
of the year through the annual reports or else if the transaction goes beyond certain limits then
the shareholders are informed. Companies should be asked to file major RPTs with stock
exchange at greater frequency which can be quarterly, monthly or for certain instances and the
same should be communicated to the shareholders. Though approval from shareholders is a
difficult task but the information regarding the same could be communicated.

From the legal regulations we can say that the audit process has an important bearing on the
RPTs. Therefore the Board of Directors and Audit Committee must play a proactive role in
related party agreements. They must put in place a policy for entering into RPTs and for the
periodic monitoring of all material RPTs. The Auditors may not reveal all the information
regarding RPT but can communicate RPT which are related to the investors. But a problem can
occur that the company may not pass essential information to the Auditors. So, in this case the
Audit Committee norms can be improved.

The Law can also increase the number of Independent directors on the board as that would limit
the Related Party Transactions. The reason behind this is the Independent directors are not
having any financial interest with the company. So, they may restrict the directors from having
any undue gains.

Along with the Independent directors the statutory auditors who are already well known may not
let the companies hide such details as they don't wish to spoil their image.
Reviewing Related Party Transactions

Not all Related Party transactions are harmful either to the investors or to the company. When
such transactions are carried at arm’s length price is carried upon for mutual interest of
stakeholders then it may result in a decrease in overall cost of the company in the long run. And
this may result in smoothening of the purchasing process to the company and that time could be
devoted to other important matters.

The other benefit which the company enjoys while indulging in related party transactions is that
the party shares its true views with the company and may not offer the company fraudulent
goods or services which may happen in case of 3rd party transactions.

The other benefit is that the company may wish to raise capital for its operations but may not get
loans from banks. So, in this case related party transactions emerge as a better source of
providing capital.

The ill effects which the RPTs may put up may not be able to differentiate the distinction
between within the limits and undue gain. So, if the transactions are carried on for earning undue
gains then this may lead to loss in interest and trust of shareholders and in this case the question
arises on the corporate governance of the company.
Conclusion

In India, more number of Related Party transactions are seen where the shareholding pattern is
concentrated and therefore the shareholders do not have much saying in the decision making.
The concentration of shareholding is due to family owned businesses where majority of the
shareholding is among the promoter group. So, in order to reduce such frauds, the regulations
can be tightened and the role of auditors can be increased.

REFERENCES

http://www.mca.gov.in/MinistryV2/related+party+transactions.html

https://taxguru.in/company-law/guide-related-party-transaction.html