Guest Post: MCA Circular on Related Party Transactions

[The following post is
contributed by Vinod Kothari and Shampita Das of Vinod Kothari & Co.
They can be contacted at vinod@vinodkothari.com
and shampita@vinodkothari.com
respectively]
The
Ministry of Corporate Affairs (MCA) drives what corporate India will do, or
will not do, or will do with rudders and rigours, under the new Companies Act
2013. It was the 30th of the Circulars issued under the new law on
17 July 2014, only a few months after the new law has partly been brought into
force. As the rigidities and absurdities of the law come to the fore, the MCA
continues to come out with circulars to moderate and tone down the law, but
often, the language is ambiguous, leaving corporate India looking for yet more
clarifications to the clarifications. Sadly enough, if the classic rule of
interpretation has been that the Parliament knew what it wanted to write, now
the clue is – the MCA knew what the Parliament wanted to write.
MCA’s
General Circular No 30/2014 sought to give clarity to the majority of the
minority rule pertaining to related party transactions (RPTs) incorporated in
section 188 of the Act. While the circular might have wanted to say that only
such related party as is involved in the contract or transaction in question
will be denied the right to vote in the meeting, it says so in such misty
language. Sadly enough, now is the AGM season in the country – most companies
have either obtained or are in the process of obtaining general meeting
approvals for RPTs.

The Majority of minority rule in RPTs
Now-a-days
abusive RPTs have become a common term used to signify the tactics adopted by
majority shareholders, who in turn are related to the company, to divert the
funds of the company. Thus, what rightfully should be used for enhancing the
wealth of the shareholders gets diverted to benefit a handful of shareholders
controlling majority of the decisions of the company.

To curb
such abusive RPTs, the concept of the “majority of the minority” rule was
introduced. Under this principle, RPTs would be deemed to be approved if a majority
of the outstanding disinterested shareholders i.e. shareholders of the company
who are not related party to the company, accent to such transaction. This
principle is applied to ensure that the related party shareholders of the company
are not misusing their position to benefit themselves at the cost of the minority
shareholders.
Countries
around the would have framed their policies in a restrictive manner so as to
curb such abusive RPTs. Some precedents that are followed around the world are provided
below:
United
States
Clause
314 of NYSE Listed Company Manual considers the Audit Committee as an
appropriate forum to review the related party transaction. The Exchange also
reviews proxy statements and other SEC filings, disclosing RPTs and where such
situations continue year after year, the Exchange after evaluation also
determines whether such RPTs should be permitted to continue.
Under
Regulation S-K of U.S. Securities Law, Item 404 requires public companies to
disclose transaction involving amount of more than USD 1,20,000/- in which the
related person is or has had direct or indirect material interest.
United Kingdom
Financial
Reporting Standard-8 require companies to make adequate disclosures in their
financial statements to draw attention to the possibility that the reported
financial position and results may have been affected by the existence of
related parties and by material transactions with them. Further, under the
Companies Act, 2006, members’ approval is required for any transaction with the
director or if the director is connected in such transaction.
Hong Kong
Rule
14A of Listing Rules of the exchange in Hong Kong requires companies to take
prior approval of shareholders in case of connected transactions. Any connected
person with material interest shall not be permitted to vote at the meeting on
the resolution approving the transaction. The manual further requires that the
Independent Board Committee of the company should appoint a financial adviser
to advise the company’s shareholders about whether the terms of the connected
party transactions are fair and reasonable and in the interest of the company
and the shareholders as a whole.
Singapore
The
Singapore Exchange Listing Manual requires only disinterested shareholders to
vote on any transaction involving interested person. “Interested Person” has
been defined to mean a director, CEO or controlling shareholder and an
associate of any of these.
Malaysia
The
Bursa Malaysia Listing Requirements lay down provisions similar to Hong Kong.
Rule 10.08 requires disclosure in case of a related party transaction to the
Exchange where the value of the consideration is less than RM 2,50,000 or is a
recurrent related party transaction, where the percentage ratio is 0.25% or
more. Where any one of the percentage ratios 
of a related party is 25% or more the company must appoint a Principal
Adviser to ensure that such transaction is carried out on fair and reasonable
terms and conditions and not to the detriment of the minority shareholders. The
stated Requirement debar any interested director from taking part in board
deliberations and abstain from voting on such related party transactions.
Further, any interested director or major shareholder must ensure that
connected persons abstain from voting on such related party resolutions in the
general meeting.
Australia
Section
208 read with section 224 of the Corporations Act, 2001 of the Commonwealth of
Australia provides that at a voting at general meetings on related party transactions,
related parties of the public company to whom the resolution would permit a
financial benefit must refrain from voting on such resolutions. However the
Australian Securities & Investment Commission (ASIC) has the power to make
a declaration for the purposes of section 224, allowing a related party or an
associate of a related party to vote, if they are satisfied that it will not
cause unfair prejudice to the interests of any member of the company.

Majority of minority rule under Section 188
Taking
cue from various jurisdictions from around the world, the Companies Act, 2013
also provided for approval of RPTs through the majority of the minority rule. However
the language of the section was such that, instead of disallowing the concerned
or interested related party(s) to the resolution to vote, it implied that no
related party of the company would vote on resolutions approving such RPTs. The
second proviso to Section 188 has
been reproduced below:
Provided
further that no member of the company shall vote on such special resolution, to
approve any contract or arrangement which may be entered into by the company,
if such member is a related party;”
The
phrase “such member is a related party” indicated that only members who were
not related to the company could vote on such resolution while all related
parties would refrain from voting in the general meeting, creating confusion on
various grounds.
For
instance, if 70% of the shareholding of a company was held by related parties,
then only the remaining 30% could have voted on a RPT resolution. Now, if out
of the 30% shareholding, 20% was held by single shareholder, the company would
be at the mercy of such a shareholder for passing of the resolution. Even if
the remaining 10% shareholders vote for the resolution, the resolution would
still fail for want of a special majority. This would not give a true sense of
the opinion of the shareholders.

Circular of 17 July
The
MCA’s clarification Circular, in MCA’s usual way, tries to clear out the fog from the apparent construction of the
meaning abovementioned second proviso
to Section 188 of the Act.
The Circular
states: “Thus, the term ‘related party’ in the above context refers only to
such related party as may be a related party in the context of the contract or
arrangement for which the said special resolution is being passed.”
It
would be hard to know the meaning of “related party in the context of the
contract or arrangement”. There is nothing called “related party to a
contract”. Sec 2 (76) defines related party with reference to a company – the
concept of related party to a particular contract is nowhere envisaged by the
law. In addition, the concept of “related parties” anyways intertwines all
entities which are related to the company. If A is related to company X, and B
is related to company X, A and B automatically have a common economic interest
– that is, Company X. The company is the cluster of common interests of all
related parties.
The
intent of the Circular seems clear, but not the language, confounded by such
expressions as “such related party as may be a related party”. “Such related
party as may be a related party” sums up into nothing. Also, no one can easily
figure out what is “related party……in context of the contract”. For example,
there is a contract with X’s subsidiary, can X’s holding company take a stance
that the holding company  is not a
“related party” in context of the contract? Was it not much easy to write what
the writer might have meant – “the related party with whom the contract or
arrangement is proposed”, etc?

Clause 49(VII) of the Listing Agreement
Now
coming to the provision of the Listing Agreement in this regard. Para VII (E) to
Clause 49 of the Listing Agreement provides that ‘All material Related Party Transactions shall require approval of the
shareholders through special resolution and the related parties shall abstain from voting on such resolutions.’
The language
of the Listing Agreement is a bit clearer than its counterpart. It provides
that ‘the related parties’ shall not
vote on RPT resolutions giving an implication that only the related party(ies)
to such resolutions shall not vote on the matter.

Majority of minority rule diluted
Taking
the advantage of the Circular, companies may completely dilute the majority of
the minority rule by contracting with such related parties as have minimal
shareholding in the company.
Let us
understand this by way of an example: 70% of the shareholding of a company X is
held by 3 related parties to X, viz.
A, B and C in the proportion of 50%, 10% and 10%, respectively.  Further X ltd. frequently enters into
transactions with A. In light of the Circular, apart from A, all the other
shareholders of the company i.e. rest 50% can vote on such RPTs. Since the 20%
shareholding of B and C would not be sufficient to pass the resolution, X ltd.
may resort to diluting the shareholding of A to B and C so that X ltd. has the certainty
of requisite majority to pass such RPTs without depending on the votes of the minority
shareholders.

Conclusion
If the
idea was to moderate the law, it would have been much simpler to think of an
amendment. Several leading commentators are strongly advocating for a rewrite
of the law including Mr. Omkar Goswami who is noted economist of the country.
He correctly points out that the piece-meal ratifications and clarifications as
brought out by the MCA will not serve the purpose of fostering a positive
corporate environment. The law is flawed on numerous grounds to correct it by
these numerous modifications and clarifications. Moreover the MCA cannot keep
up with the role the Parliament and make amendments and modifications in the
law of the law on its whims and fancies.

– Vinod
Kothari & Shampita Das

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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