Sec 188 of CA13-Analysis and Ambiguities

Note on related party transactions under the Companies Act, 2013 (the “Act”) and the Companies (Meetings of Board and its Powers) Rules, 2014 (the “Rules”)

Index

I. Introduction.

Section 188 of the Act - related party transactions- combines erstwhile Sections 314 and 297 of the Companies Act, 1956 which dealt with holding of office or place of profit and contracts in which directors are interested respectively.

While the Companies Act, 1956 required approval of Central Government for related party transaction by certain companies, Companies Act, 2013 calls for larger disclosures with members’ approval.

II. Applicability of the Section 188.

Section 188 is applicable to all types of companies.

III. Definition/meaning of ‘Related Party’.

A. As per Section 2(76) of the Act:-

“related party”, with reference to a company, means—

(i) a director or his relative;

(ii) a key managerial personnel or his relative;

(iii) a firm, in which a director, manager or his relative is a partner;

(iv) a private company in which a director or manager is a member or director;

(v) a public company in which a director or manager is a director or holds along with his relatives, more than two per cent. of its paid-up share capital;

(vi) any body corporate whose Board of Directors, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager;

(vii) any person on whose advice, directions or instructions a director or manager is accustomed to act:

Provided that nothing in sub-clauses (vi) and (vii) shall apply to the advice, directions or instructions given in a professional capacity;

(viii) any company which is—

(A) a holding, subsidiary or an associate company of such company; or

(B) a subsidiary of a holding company to which it is also a subsidiary;

(ix) such other person as may be prescribed;

B. As per the sub-rule 2(1)(e):-

“Related party” means a director or key managerial personnel of the holding company or his relative with reference to a company, shall be deemed to be a related party.

C. Bifurcation of related parties into individuals and non-individuals:

Term ‘relative’ is defined u/s 2(77), ‘Key Managerial Personnel’ u/s 2(51), ‘Private Company’ u/s 2(68) and ‘Public Company’ u/s 2(71), ‘Holding Company’ u/s 2(46) and ‘Subsidiary Company’ u/s 2(87) of the Act.

IV. Main section of the Act, corresponding rule and analysis.

A. Section 188-Related Party Transactions-reads as follows:-

188. (1) 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:

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:

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 basis.

Explanation.— In this sub-section,—

(a) the expression “office or place of profit” means any office or place—

(i) where such office or place is held by a director, if the director holding it receives from the company anything by way of remuneration over and above the remuneration to which he is entitled as director, by way of salary, fee, commission, perquisites, any rent-free accommodation, or otherwise;

(ii) where such office or place is held by an individual other than a director or by any firm, private company or other body corporate, if the individual, firm, private company or body corporate holding it receives from the company anything by way of remuneration, salary, fee, commission, perquisites, any rent-free accommodation, or otherwise;

(b) the expression “arm’s length transaction” means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.

(2) Every contract or arrangement entered into under sub-section (1) shall be referred to in the Board’s report to the shareholders along with the justification for entering into such contract or arrangement.

(3) Where any contract or arrangement is entered into by a director or any other employee, without obtaining the consent of the Board or approval by a special resolution in the general meeting under sub-section (1) and if it is not ratified by the Board or, as the case may be, by the shareholders at a meeting within three months from the date on which such contract or arrangement was entered into, such contract or arrangement shall be voidable at the option of the Board and if the contract or arrangement is with a related party to any director, or is authorised by any other director, the directors concerned shall indemnify the company against any loss incurred by it.

(4) Without prejudice to anything contained in sub-section (3), it shall be open to the company to proceed against a director or any other employee who had entered into such contract or arrangement in contravention of the provisions of this section for recovery of any loss sustained by it as a result of such contract or arrangement.

(5) Any director or any other employee of a company, who had entered into or authorised the contract or arrangement in violation of the provisions of this section shall,—

(i) in case of listed company, be punishable with imprisonment for a term which may extend to one year or with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees, or with both; and

(ii) in case of any other company, be punishable with fine which shall not be less than twenty-five thousand rupees but which may extend to five lakh rupees.

B. Sub rule 15 - Contract or arrangement with a related party –reads as follows:-

A company shall enter into any contract or arrangement with a related party subject to the following conditions, namely:-

(1) The agenda of the Board meeting at which the resolution is proposed to be moved shall disclose-

(a) the name of the related party and nature of relationship;

(b) the nature, duration of the contract and particulars of the contract or arrangement;

(c) the material terms of the contract or arrangement including the value, if any;

(d) any advance paid or received for the contract or arrangement, if any;

(e) the manner of determining the pricing and other commercial terms, both included as part of contract and not considered as part of the contract;

(f) whether all factors relevant to the contract have been considered, if not, the details of factors not considered with the rationale for not considering those factors; and

(g) any other information relevant or important for the Board to take a decision on the proposed transaction.

(2) Where any director is interested in any contract or arrangement with a related party, such director shall not be present at the meeting during discussions on the subject matter of the resolution relating to such contract or arrangement-

(3) For the purposes of first proviso to sub-section (1) of section 188, except with the prior approval of the company by a special resolution-

(i) a company having a paid-up share capital of ten crore rupees or more shall not enter into a contract or arrangement with any related party; or

(ii) a company shall not enter into a transaction or transactions, where the transaction or transactions to be entered into -

(a) as contracts or arrangements with respect to clauses (a) to (e) of sub-section (1)  of section 188 with criteria, as mentioned below -

(i) sale, purchase or supply of any goods or materials directly or through appointment of agents exceeding twenty five percent. of the annual turnover as mentioned in clause (a) and clause (e) respectively of sub-section (1) of section 188;

(ii) selling or otherwise disposing of, or buying, property of any kind directly or through appointment of agents exceeding ten percent. of net worth as mentioned in clause (b) and clause (e) respectively of sub-section (1) of section 188;

(iii) leasing of property of any kind exceeding ten percent. of the net worth or exceeding ten percent. of turnover as mentioned in clause (c) of sub-section (1) of section 188;

(iv) availing or rendering of any services directly or through appointment of agents exceeding ten percent. of the net worth as mentioned in clause (d) and clause (e) of sub-section (1) of section 188;

(b) appointment to any office or place of profit in the company, its subsidiary company or associate company at a monthly remuneration exceeding two and half lakh rupees as mentioned in clause (f) of sub-section (1) of section 188; or

(c) remuneration for underwriting the subscription of any securities or derivatives thereof of the company exceeding one percent. of the net worth as mentioned in clause (g) of sub-section (1) of section 188.

Explanation-

(1) The Turnover or Net Worth referred in the above sub-rules shall be on the basis of the Audited Financial Statement of the preceding Financial year.

(2) In case of wholly owned subsidiary, the special resolution passed by the holding company shall be sufficient for the purpose of entering into the transactions between wholly owned subsidiary and holding company.

(3) The explanatory statement to be annexed to the notice of a general meeting convened pursuant to section 101 shall contain the following particulars namely:-

(a) name of the related party;

(b) name of the director or key managerial personnel who is related, if any;

(c) nature of relationship;

(d) nature, material terms, monetary value and particulars of the contract or arrangement;

(e) any other information relevant or important for the members to take a decision on the proposed resolution.

C. Analysis of Sec. 188 and corresponding Rules:-

Section 188(1) which mentions about consent to be obtained in the Board Meeting or by way of a special resolution in General Meeting does not apply if the transaction to be entered into by the Company is in its ordinary course of business other than transactions which are not on an arm’s length basis.

This means, if the transaction is in ordinary course of business and on arm’s length basis, then the consent by way of Board Resolution or Special Resolution is not needed.

If the transaction is not in ordinary course of business of the Company, then consent by way of Board resolution or Special resolution shall be obtained, even if the transaction may be on arm’s length basis.

If the transaction is in ordinary course of business of the Company but not on arm’s length basis, then also consent by way of Board resolution or Special resolution shall be obtained.

Ordinary course of business- meaning-

The Act has not defined the term “ordinary course of business”. In general terms, it may be said that the intention of lawmakers is to avoid Board Meeting to be conducted for approving every such transaction at every frequent instance if transaction is Company’s ordinary course of business. E.g. If a Company’s ordinary business is to buy and sale a property and it is about to enter into such a transaction with related party on arm’s length basis, it need not obtain Board’s or members’ approval. But suppose Company’s business is providing legal services and it intends to sell its property to related party, then Board’s or members’ approval must be obtained. Intention of lawmakers can be perceived with the help of provisions of Sec. 186 wherein restriction on or conditions for providing loans by Companies are not applicable to a Banking Company, the very main business of which is to grant loans, among other businesses. This indicates that ordinary course of business is to be construed as a business activity which is the main activity or one of the main activities of the business operations of the Company.

Arm’s length basis – meaning-

As per the Act, “arm’s length transaction” means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.

Definition suggests that the interest among the related parties should not influence the transaction.

As per Transfer Pricing under the Income Tax Act, 1961, “Arm’s Length Price” means a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

While Income Tax Act mentions about ‘Arm’s Length Price’, the Companies Act, 2013 broadens the scope by defining ‘arm’s length transaction’. This means that apart from price, other aspects of the transactions like product quality, credit period, delivery period etc. shall also to be considered while deciding whether the transaction is an ‘arm’s length transaction’ or not.

In a situation where comparables are not available, determination of ‘arm’s length transaction’ may be difficult.

- Wherever the consent by way of Board Resolution is to be obtained, it shall be obtained only at the Board Meeting. Consent cannot be obtained by way of Circular resolution.

- As per the rule, interested director shall not be present at the Board meeting during the discussions on the subject matter of the resolution. This means, mere abstaining himself from voting on this particular matter is not sufficient. Interested director should not be present at the meeting at all when the discussion is on.

Interested member shall not vote in General Meeting.

These provisions are very ambiguous and a clarification is needed.

Consider a situation where a private company having two directors on Board who are the only members of the company and one of them is interested in a transaction to be entered into with a related party, he should not be present at the meeting for particular item of business. In this situation, how would the item be transacted in Board Meeting in presence of only one director? Further, the same business can not be transacted by calling a General Meeting also as an interested member shall not vote in General Meeting. Further, there may be a situation where both directors may also be interested. Are they both supposed not to be present in Board Meeting?

MCA should bring out a clarification on this point.

V. Other sections of the Act having reference to the related party.

A. 164(1)(g):

A person shall not be eligible for appointment as a director of a company, if he has been convicted of the offence dealing with related party transactions under section 188 at any time during the last preceding five years.

B. 177(1) and Sub-rule 6 prescribes that every listed company, and public company with a paid up capital of ten crore rupees or more or having turnover of one hundred crore rupees or more or having in aggregate, outstanding loans or borrowings or debentures or deposits exceeding fifty crore rupees or more shall constitute Audit Committee.

177(4)(iv) prescribes that Audit Committee shall approve or subsequently modify transactions of the Company with related parties. Sub-sec. (6) gives Audit Committee right to investigate into any such related matter.

At present, for listed companies, clause 49 of the Listing Agreement mandates that audit committee should review the annual financial statements before submission to the Board for approval with respect to disclosure of related party transactions and review the statement of significant related party transactions too. But as per the Act, a company needs approval of the audit committee on all related party transactions and subsequent modifications thereto. This is irrespective of whether they are in the ordinary course of business and at arm's length or they are below prescribed thresholds.

C. 184 and 189 vis a vis 188

Sec. 184(1) mentions about disclosure of interest to be made by a director.

Sec. 184(2) reads as-

Every director of a company who is in any way, whether directly or indirectly, concerned or interested in a contract or arrangement or proposed contract or arrangement entered into or to be entered into—

(a) with a body corporate in which such director or such director in association with    any other director, holds more than two per cent. shareholding of that body corporate, or is a promoter, manager, Chief Executive Officer of that body corporate;    or

(b) with a firm or other entity in which, such director is a partner, owner or member,           as the case may be,

shall disclose the nature of his concern or interest at the meeting of the Board in which the contract or arrangement is discussed and shall not participate in such meeting:

It may be noted that entities covered under 184(2)(a) and (b) are related parties as per the definition of Related Party.

Sec. 189 mentions about Register of contracts or arrangements in which directors are interested. Sub-sec(1)&(2) read as-

189(1) Every company shall keep one or more registers giving separately the particulars of all contracts or arrangements to which sub-section (2) of section 184 or section 188 applies, in such manner and containing such particulars as may be prescribed and after entering the particulars, such register or registers shall be placed before the next meeting of the Board and signed by all the directors present at the meeting.

(2) Every director or key managerial personnel shall, within a period of thirty days of his appointment, or relinquishment of his office, as the case may be, disclose to the company the particulars specified in section 184(1) relating to his concern or interest in the other associations which are required to be included in the register under that sub-section or such other information relating to himself as may be prescribed.

Sec. 189 further prescribes provisions for keeping the abovementioned Register and its production at AGM.

Sub-sec. 5 reads as-

(5) Nothing contained in sub-section (1) shall apply to any contract or arrangement—

(a) for the sale, purchase or supply of any goods, materials or services if the value of         such goods and materials or the cost of such services does not exceed five lakh     rupees in the aggregate in any year; or

(b) by a banking company for the collection of bills in the ordinary course of its         business.

Penalty is prescribed for non-compliance with the section.

D.Schedule IV: Code for Independent Directors

As per the code, independent directors are entrusted with a duty to pay sufficient attention and ensure that adequate deliberations are held before approving related party transactions and assure themselves that the same are in the interest of the company.

CS Varadvinayak V. Khambete.