Case Study on Related Party Transactions

This article is a case study on section 188 i.e. entering into contracts or arrangements with a related party with respect to:

Case Study:

Parties for which the case is to be discussed:

a. ABC Pvt Ltd, a Company incorporated under Companies Act, 1956; 

- Director: Mr. A and Ms. B

- Member: Mr. A and Ms. B

b. XYZ Pvt Ltd, a Company incorporated under Companies Act, 1956 and a sister concern of ABC Pvt Ltd;

- Director: Mr. A and Ms. B

- Member: Mr. A and Ms. B

Since the director and members in all the two companies are same and the directors and shareholders of the company are “Related Parties” as per section 2 (76) of the companies act, 2013 thus section 188 of the Companies Act, 2013 attracts to all the companies which is described hereunder:

Section 188:  Except with the consent of the Board of Directors given by a resolution at a meeting of the Board and subject to such conditions as may be prescribed, no company shall enter into any contract or arrangement with a related party with respect to— 

a) sale, purchase or supply of any goods or materials;

b) selling or otherwise disposing of, or buying, property of any kind;

c) leasing of property of any kind;

d) availing or rendering of any services;

e) appointment of any agent for purchase or sale of goods, materials, services or property;

f) such related party's appointment to any office or place of profit in the company its subsidiary company or associate company; and

g) underwriting the subscription of any securities or derivatives thereof, of the company.

Provided that no contract or arrangement, in the case of a company having a paid-up share capital of not less than such amount, or transactions not exceeding such sums, as may be prescribed, shall be entered into except with the prior approval of the company by a special resolution: (Described as per MCA Notification dated 14th August 2014)

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. (*see note 1)

Provided also that nothing in this sub-section shall apply to any transactions entered into  by the company in its ordinary course of business other than transactions which are not on an arm’s length price. 

Definition of Ordinary Course of business:

Companies Act, 2013 does not define the term “ordinary course of business”.

“Ordinary course of business” covers the usual transactions, customs and practices of a certain business and of a certain firm. This term is used particularly to judge the validity of certain transactions. (*see note 2)

- Activities that is necessary, normal, and incidental to the business. These are common practices and customs of commercial transactions. An example is a contractor works with a financial institution to secure a loan to continue a project.

*(Note 1) Clarification had been given by MCA vide General Circular No. 30/2014 regarding this clause and it has clarified that ‘related party' referred to in the second proviso has to be construed with reference only to the contract or arrangement for which the said special resolution is being passed. 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.

*(Note 2) The Division Bench of Allahabad High court in the case of Kishori Lal Vs. CIT MANU/UP/0904/2014, while dealing with the issue of giving loan as permitted as a part of Ancillary Object and not as a Main Objects, has held under:-

In holding that the advance was not in the ordinary course of business, the sole consideration which weighed with the Tribunal was that the main object of the two companies was not to engage in money-lending business, though the ancillary object was to invest and deal with the funds of the company not immediately required, in such investments or securities and in such manner as shall from time to time be considered necessary for the benefit of the company.

The Tribunal was of the view that the two companies were not involved in the business of money-lending. Consequently, the Tribunal came to the conclusion that since the main object of the two companies was not money lending but the companies were permitted to invest their surplus funds for the time being, this could not be regarded as being in the ordinary course of the business.

Findings of Hon’ble High Court

Moreover, where the advance or loan was made in the ordinary course of the business of the company, the fact that the lending of surplus funds is not part of the main object but is at the same time permissible as an ancillary object would not detract from the loan or advance being made in the ordinary course of its business.

Conclusion: Objects ancillary and incidental to the main object of the company also falls under the category of Ordinary Course of business.

Problem discussed is hereunder:

Let’s say the provision of section 188 (1) (c) is attracted in the case of ABC Pvt Ltd and XYZ Pvt Ltd which can be further explained as per the below explanation:

XYZ Pvt Ltd has given a property on lease to ABC Pvt Ltd.

XYZ Pvt Ltd has taken a property on lease from ABC Pvt ltd.

Matter Raised: As the directors and shareholders are interested in both the companies and hence related parties as per section 2 (76), to enter into any transaction company needs to pass Board Resolution or Special Resolution as may be applicable to the company where none of the director or shareholder is interested.

Hence there is a requirement of appointing Directors/ Shareholders who shall be unrelated to the companies and hence shall be eligible to pass the board resolution/ special resolution.

Opinion 1: Since for the approval of Related Party Transactions, Board resolution or Special Resolution is required to be passed with unrelated directors or shareholders respectively and as the case may be depending upon the value of transactions and taking MCA Notification dated 14th August, 2014 into consideration which defines the nature of resolution to be passed depending upon the nature of transaction, we may appoint independent directors or unrelated additional directors and members differently in both the companies and thus related party transaction could be approved by taking such director’s or shareholder’s approval in the said Board Meeting or General Meeting.

Opinion 2:  Generally companies have leasing of property in their ancillary course of business  which could be explained hereunder:

As explained in note 2 that ancillary course of business is covered under the definition of ordinary course of business.