New Materiality Threshold for RPTs: Nagging Questions on Shareholder Approval

[Vinita Nair and Sikha Bansal are Partners at Vinod Kothari & Company, Practicing Company Secretaries]

Related party transactions (RPTs) are perceived as potential tools for unjust enrichment of those in a fiduciary capacity. Hence, SEBI has recently revamped RPT norms (most of which are to take effect from 1 April 2022) intending to impose a greater scrutiny on RPTs.

With the above, all companies which have annual consolidated turnover exceeding INR 10000 crores, alongside contracts exceeding INR 1000 crores, are now faced with a quizzical issue: Do the amendments impact only future contracts or even past contracts? The question becomes perplexing as to continuing contracts because of the wide ramifications which can possibly occur if the contract fails to get favour from shareholders (which of course, would be unrelated shareholders). Further, there would be questions relating to the scope of transactions to be included to determine the threshold limit (especially because of expanded scope of RPTs), and the computation and aggregation of values thereof, among other issues. We intend to detail and address these nagging questions in our post.

Tripling effect: ‘cross-RPTs’, ‘lower materiality threshold’ and ‘prior approval’

The changes, which we discuss here, are three-fold:

  • First, the law now requires “prior” approval of shareholders for material RPTs.
  • Second, the threshold for determining materiality has changed (many companies would have transactions falling in the bracket of INR 1000 crores). Materiality is now fixed as a value above – (i) INR 1000 crores, or (ii) 10% of annual consolidated turnover of the listed entity, whichever is lower.
  • Third, RPTs now include cross-RPTs as well, that is, transactions by listed entity with related parties of a subsidiary, transaction by a subsidiary with related parties of the listed entity, and transactions by a subsidiary with its own related parties.

The combined effect of these changes is that one is left to imagine if ongoing RPTs (including cross-RPTs which may not have been taken to shareholders earlier) need to be reclassified as material and non-material; and if such classification is required, whether the RPT now classified as material RPT would need ‘prior’ shareholder approval.

The question of retrospective application to ongoing contracts arises because of regulation 23(8) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (the “LODR Regulations”), which states: “All existing material related party contracts or arrangements entered into prior to the date of notification of these regulations and which may continue beyond such date shall be placed for approval of the shareholders in the first General Meeting subsequent to notification of these regulations.” [emphasis added] Of course, regulation 23(8) has been in place right from the time the LODR Regulations were notified; however, the expression ‘these regulations’ would refer to the LODR Regulations as amended from time to time. The regulation, so far, has not been omitted.

Pursuant to the same, if it is concluded that a reclassification is required and, consequently, all RPTs categorised as material RPTs have to pass shareholders’ nod before proceeding further, the same may have wide ramifications. The company would have entered into an ‘agreement’; the agreement would require both parties to execute their part of obligations under the agreement. The agreement would also include, as a part of default covenants, damages or other consequences for breach of the agreement. Hence, failure to obtain shareholders’ approval may have commercial implications on the company, along with ancillary consequences.

Understanding ‘transaction’ vs. ‘contract’ and implications under RPT framework

Regulations 23(1), 23(4), and 23(6) of the LODR Regulations all use the expression ‘transaction/s’; however, regulation 23(8) uses the words “contracts or arrangements’. What could be the relevance of such different usages? Essentially, ‘transaction’ and ‘contract’ are not one and the same. There may be a single transaction or a series of transactions pursuant to a contract or arrangement. According to the definition of RPT in the LODR Regulations, a “transaction” with a related party shall be construed to include a single transaction or a group of transactions in a contract. Therefore, the term ‘contract’ is wider or an umbrella term within which there can be a single transaction or even a series of transactions resulting in transfer of resources, services, or obligations by a listed entity. For instance, A sells goods to B at a certain price – this is a transaction; and this can as well be a contract. In another example, A agrees to supply goods to B over a period of three years at a predetermined price. This is a contract, which can have multiple transactions (multiple supplies of goods to B). 

Hence, reading the provisions of the LODR Regulations, one can reasonably arrive at the following conclusions:

  • It needs to be seen if the contract, and the RPT pursuant to such contract, is a secluded transaction, that is to say, the contract results in a single transaction. There is obviously no difficulty in this case. However, where the contract encapsulates a series of transactions, the question will arises as to what the transactions taking place during a financial year (FY) pursuant to the said contract are.
  • The transaction may be prospective, or may have already taken place. In view of the prospective applicability by way of regulation 23(6), the provisions will be applicable only to transactions moving forward.

However, it may be tricky to identify the core transaction, and the consequential flow of resources or reciprocal performance due to such a transaction. For example, if goods have been sold during FY 2021-22, for which payment is made in FY 22-23, the transaction was one of sale of goods, and the payment is merely a reciprocal performance. Similarly, if a loan has been given in earlier years, and the same is partly repaid or interest is serviced during FY 22-23, it cannot be argued that the repayment of the loan or the servicing of interest are “transactions” occurring in FY 22-23. In this context, it may be noted that while the meaning of RPT is borrowed from IndAS 24 and may include items like dividend and interest, the approval requirement under the LODR Regulations is to be assessed on the basis of the principles above as it is a core part of transaction, unlike ‘disclosures’ which are a consequential part of the transaction.

Therefore, if there is a contract, transactions under which run beyond the effective date, such contracts need to be taken before shareholders with respect to transactions yet to be initiated. In that case, acts already performed under transactions previously concluded under the same contract should not be hampered. However, transactions which are pending execution shall only begin once shareholder approval is received. In our detailed article on this topic, we tabulate certain scenarios (examples) and possible implications under present amendment.

Hence, regulation 23(8) cannot be read dehors regulation 23(6). On a harmonised reading, it can be deduced that where there are no prospective transactions, there is no question of applying regulation 23(8) and, consequently, regulation 23(4) is not attracted.  However, shareholder approval for ‘existing contracts/arrangements’ which are continuing shall be required for prospective ‘transactions’ under those contracts.

An interpretation that the amendment applies only to prospective contracts but not to existing contracts will provide leeway to errant entities or controlling shareholders to have their way well before the amendment takes effect. Also, to say that prospective transactions under past contracts and those under future contracts should be treated differently will lead to anomalies and discrimination, and would thus be incorrect. Therefore, the scope of RPTs to be considered for shareholders’ approval should be for all prospective transactions (including under continuing contracts) after the effective date.

Aggregation of transactions for determining material RPTs

According to the proviso to regulation 23(1), a ‘transaction’ has to be adjudged as ‘material’ or ‘immaterial’ in relation to ‘a related party’. Hence, all transactions which either the listed entity or the subsidiary(ies) enter into with ‘a related party’ (that is, a particular related party) shall be aggregated to see if the value of the transactions is breaching the threshold limit. The intent is to regulate ‘the consolidated entity as a whole’, where a ‘network of entities’ may be used as conduit to benefit related parties (see discussions in pages 19-20 of Working Group Report on Related Party Transactions).

Note that the aggregation shall exclude transactions entered into by a listed subsidiary with a related party, where the listed entity is not a party. Further, the coverage does not include associate companies. Similarly, transactions by holding company will not be included.

Another important aspect is determination of values. As discussed earlier, for example, in case of a subsisting loan, payments of interest or even repayment of loan, being reciprocal to the entire transaction of loan, should not be counted for the purpose of material thresholds. However, in case of incremental loans or renewal of loan or extending fresh loans, the entire amount will be required to be considered.

Closing Remarks

Besides the above, there would several other possible questions. For example, by what time should the entity go to its shareholders for taking approvals? Regulation 23(8) of the LODR Regulations, when the regulations was notified, allowed placing material contracts for shareholder approval in the first general meeting subsequent to notification of LODR. In our view, the intent remains in effect that a reasonable time should be made available. Also, SEBI now requires an array of information to be specifically placed before the audit committee and the shareholders. Hence, all the ongoing contracts which are taken to the shareholders pursuant to the amendments shall be accompanied by the required information. The aspects have been covered in our detailed article.

Another interesting question to explore is – say, shareholders approve material transactions up to a limit – whether the board will now have to take fresh approval for even the slightest of upward revisions in the value of such transactions, or whether the board can possibly undertake fresh transactions until reaching the materiality limit? The question is intriguing and may have both possibilities.

Given that there is still some time left for amendments to take effect, it is possible that the regulator comes up with further clarifications or literature on the amendments.

Vinita Nair & Sikha Bansal

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