Regulatory Context
The definition of ‘Related Party Transaction’ (“RPT”) under Regulation 2(1)(zc) of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”), inter alia provides that with effect from April 1, 2023, a transaction involving transfer of resources, services or obligations between “a listed entity or any of its subsidiaries on one hand, and any other person or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or any of its subsidiaries,” will also be regarded as an RPT (referred to below as the “Purpose and Effect Test”).
The Purpose and Effect Test brings about a fundamental shift in the existing regulatory regime, as it covers transactions with independent third parties i.e., the counterparty to the transaction need not be a related party of the listed entity or any of its subsidiaries.
This provision appears to be inspired by the UK Premium Listing Rules, with identical wording[1]. However, unlike the UK Premium Listing Rules, the Purpose and Effect Test under Regulation 2(1)(zc) does not contain any exemption for RPTs entered into, in the ordinary course of business.
Regulatory Intent for Introduction of the Purpose and Effect Test
The regulatory intent behind incorporating the Purpose and Effect Test becomes clear by referring to: (i) the Report of the SEBI Working Group on Related Party Transactions, dated January 27, 2020 (“SEBI WG Report”); and (ii) the SEBI Board Note titled ‘Review of Regulatory Provisions dealing with Related Party Transactions’ (“SEBI Board Note”).
SEBI WG Report
The SEBI WG Report noted that in recent corporate scandals, shell companies/ unrelated companies were used to siphon off funds from listed entities. Further, it was noted that in the recent past, innovative structures were being used to avoid categorisation of transactions as RPTs, and transactions were being entered into with seemingly unrelated parties, with the clear objective of benefitting a related party.
In this regard, the SEBI WG Report states:
“While taking note of some of the recent issues in relation to RPTs, the Working Group observed that one commonality in major corporate wrongdoings was that they were allegedly carried out by persons with the ability to influence the decisions of the company. Shell or apparently unrelated companies, controlled directly or indirectly by such persons, were purportedly used to siphon off large sums of money through the use of certain innovative structures, thereby circumventing the regulatory framework of RPT”.[2] (emphasis supplied)
“The Working Group observed that recently, certain innovative structures have been used to avoid classification of transactions as RPTs and thus avoid the associated regulatory compliance and disclosure requirements. Some such instances are mentioned below:
- use of complex structures.
- transactions undertaken by a listed entity with seemingly unrelated parties, however, intended to benefit related parties; and
- instances of loans being given to an unrelated party, which in turn gives such loan to a related party.
Accordingly, the Working Group examined the definition of RPTs from the perspective of strengthening it and recommended broadening the definition of RPTs to include transactions which are undertaken, whether directly or indirectly, with the intention of benefitting related parties. This concept is also captured in the legislation of other jurisdictions, such as the U.K”.[3] (emphasis supplied)
SEBI Board Note
With regard to the introduction of the Purpose and Effect Test, the SEBI Board Note states:
“It is also desirable to include transactions with unrelated parties, the purpose and effect of which is to benefit the related parties of the listed entity or any of its subsidiaries. It is important to consider substance of the relationship and not merely legal form as a part of good governance practice”. (Emphasis supplied)
Purpose and Effect Test – Applying the Principle of ‘Purposive Interpretation’
It can be argued that the Purpose and Effect Test under Regulation 2(1)(zc) of the LODR Regulations should be interpreted keeping in mind the mischief that was sought to be remedied, and the defect that was sought to be cured – where transactions with seemingly unrelated parties (unrelated party introduced as a subterfuge) that would ultimately benefit a related party, were escaping regulatory scrutiny. A literal reading of the Purpose and Effect Test could potentially result in an absurdity, where any and every transaction that ends up benefitting a related party would get covered, even if such a transaction is in the normal course of business operations and creates synergies and economies of scale for the listed entity.
As is evident from the SEBI WG Report and the SEBI Board Note, the Purpose and Effect Test is intended to cure the mischief where innovative structures are used to bypass RPT-related disclosures, and this test is not intended to cover genuine commercial transactions that do not cause any disproportionate economic benefit to a related party and are not detrimental to the interests of the minority shareholders of the listed entity.
Bright Line Tests
Based on a reading of the SEBI WG Report and the SEBI Board Note, it is quite evident that the Purpose and Effect Test was introduced as an anti-abuse provision in the backdrop of recent corporate scandals, where innovative structures were used to avoid categorising a transaction as an ‘RPT’, resulting in the siphoning off of funds from the listed entity. This context behind its enactment should be kept in mind, while applying the test in practice. The objective is to cover transactions with seemingly unrelated parties, that are structured in a manner that is intended to benefit a related party of the listed entity or a related party of any of the subsidiaries of the listed entity.
Basis the principles of purposive interpretation and keeping in mind the context of incorporating the Purpose and Effect Test as an anti-abuse provision, in our view, an Audit Committee could consider adopting the following bright-line tests while evaluating whether a transaction with a third-party would get covered under the Purpose and Effect Test:
- The Purpose and Effect Test per se aims to regulate potentially abusive transactions, that:
- could potentially result in disproportionate economic benefit or disproportionate pecuniary gain to a related party, thereby resulting in a detriment to the interests of the minority shareholders of the listed entity; or
- are undertaken on terms and conditions that could potentially impinge the interests of the minority shareholders, and other key stakeholders of a listed entity.
- In this regard, the following indicative factors will have to be considered:
- Lack of economic/ commercial substance in a transaction: The following indicative aspects may be considered for determining whether there is a lack of economic/ commercial substance in a transaction:
- The arrangement/ transaction involves round-trip financing i.e., there is only an inter-se transfer of funds among the parties to the arrangement.
- The arrangement/ transaction involves an accommodating party.
- The arrangement/ transaction has elements that can effectively offset or cancel each other.
- The transaction is conducted through one or more persons and conceals the value, location, source, ownership or control of funds involved in such transaction.
- Transactions with a third-party entity that lacks commercial substance (i.e., is a shell entity), or lacks technical competence and expertise to undertake transactions of a similar nature.
- Transactions involving unusual commercial terms (i.e., deviation from standard market terms for similar transactions) and/ or pricing that is not on an arm’s length basis.
- Transactions that create rights or obligations that are not ordinarily created between persons dealing at arm’s length.
- Transactions that result, directly or indirectly, in circumvention/ misuse/ abuse of the RPT provisions of the LODR Regulations.
- Transactions that are entered, or carried out, by means, or in a manner, not ordinarily employed for bona fide purposes.
- Transactions having irrelevant legs.
- Transactions having circular arrangements.
- Transactions involving a third-party entity for temporary parking of funds, which are ultimately disbursed to a related party of the listed entity.
Transactions that are in the nature of collective bargaining
It is a common practice for large, listed companies to undertake ‘collective bargaining’ with independent third parties, to ensure that the group companies get access to raw materials, components, service contracts, etc., at a competitive cost.
This would not in any way be abusive, unjustified, or detrimental to the interests of the minority shareholders, as a listed entity is expected to protect the legitimate commercial interests of its group companies to create value for the business group/ conglomerate. This can be contrasted with a situation where the listed entity grants a loan to a seemingly unrelated party, who in turn disburses a loan to a related party of the listed entity – thereby resulting in potential disproportionate economic benefit that is detrimental to the interests of the minority shareholders.
Extending the Purpose and Effect Test to transactions that are in the nature of ‘collective bargaining’ would result in an absurdity, as such transactions are not in any way detrimental to the interests of minority shareholders, and in fact, create value for the corporate group and all its stakeholders.
Given that transactions that are in the nature of ‘collective bargaining’ (a) further the interest of the corporate group as a whole; and (b) do not cause any disproportionate economic benefit to a related party in a manner that would be detrimental to the interests of the minority shareholders of the listed entity, a view may be taken that such transactions with independent third parties may not fall within the ambit of the Purpose and Effect Test under Regulation 2(1)(zc) of the LODR Regulations.
Concluding Thoughts:
The Supreme Court has been very deferential to SEBI as an expert regulator of the securities market, as is evident from some of its recent judgments including in the cases of Prakash Gupta and Vishal Tiwari.[4] It is, therefore, unlikely that the Supreme Court will material depart from the interpretation adopted by SEBI on the purpose and effect test, if the matter ever reached the Court.
In the absence of any regulatory guidance from SEBI on the scope of the new test introduced in the regulatory architecture for RPTs, Corporates and Audit Committees are finding it challenging to establish a robust internal process for complying with the new requirement. In fact, many Audit Committees are essentially going with the certification provided by the management to the effect that this provision has been complied with and none of the transactions violate the Purpose and Effect Test. Unless there is a regulatory guidance or a judicial pronouncement from the Supreme Court on this subject, there is every likelihood that this provision may be glossed over by many Audit Committees. As suggested by the Sodhi Committee in its 2003 Report on the Insider Trading Regulations, there should be an interpretative guidance note provided below each regulation so that the Regulator’s intent becomes clear to all stakeholders.
[1] Chapter 11 of the UK Premium Listing Rules inter alia provides that “related party transaction” means ….. (3) any other similar transaction or arrangement (other than a transaction in the ordinary course of business) between a listed company and any other person the purpose and effect of which is to benefit a related party”. [Rule 11.1.5]
[2] Page 8, SEBI WG Report.
[3] Page 13, SEBI WG Report.
[4] Vishal Tiwari vs Union of India & Ors. 2024 INSC 3. Para 16 says “ In a consistent line of precedents, this Court has been mindful of the public interest that guide the function of SEBI and has refrained from substituting its own wisdom over the actions of SEBI.
