Related party transactions (“RPTs”)[1] potentially represent an inherent conflict of interest between the interests of listed entities on the one hand and ‘related parties’ on the other. Since Indian listed entities are significantly promoter driven or closely held, SEBI has been constantly reforming the regulatory framework governing RPTs to mitigate the possibility of abuse.
The principles governing RPTs by listed entities are covered in the SEBI (Listing Obligations and Disclosure Requirements) Regulations (“LODR Regulations”) under the following:
- Regulation 4 outlines the principles governing disclosures and obligations of listed entities, highlighting the importance of transparency;
- Regulation 23 mandates disclosure of RPTs and prescribes thresholds for obtaining audit committee and shareholders’ approval for material RPTs; and
- Regulation 27 and 30 mandate disclosure of RPTs.
In recent years, SEBI has focused on strengthening the regulatory framework pertaining to RPTs by listed entities. Such reforms can be traced back to the Report of the SEBI Working Group on RPTs, dated January 27, 2020 (“Working Group Report”), wherein SEBI observed that companies were complying with the erstwhile letter of the law while violating it in spirit and therefore, the need to expand the scope of the law. This led to significant amendments to the scope of the RPTs to inter alia include transactions with unrelated parties with the “purpose and effect” of benefitting a related party.[2]
In addition to expanding the legislative framework, recent enforcement orders in Linde India Limited (“LIL”)[3] and Reliance Home Finance Limited (“RHFL”)[4], detailed below, indicate that SEBI is moving inexorably toward a stricter enforcement of the LODR Regulations and is considering the purpose and effect of transactions executed by listed companies/ subsidiaries to determine compliance with the RPT framework.
In this article, we deal with the evolving regulatory stance, the impact it could have on listed companies and some compliance guardrails.
Bad Borrowers – SEBI’s Order in re RHFL (“RHFL Order”)
In a voluminous order dated August 22, 2024, wherein SEBI picked and isolated a variety of breaches entity by entity, SEBI penalised 27 companies on the grounds that significant monies were transferred by RHFL, a non-banking financial company (“NBFC”).
The corporate loans were given to borrowers with weak financials and non-existent profit/ cash flows, circumventing the customary due diligence and loan approval related processes.
SEBI alleged that these diversions were the result of an elaborate scheme orchestrated by the promoters, in collusion with KMPs of RHFL, to transfer funds to entities connected to the promoters. Key observations from the order are as follows:
- It was contended by RHFL that the loans were provided in the ordinary course of business in its capacity as an NBFC, at arms’ length basis and therefore, did not constitute an RPT.
- SEBI held that the transactions in this case were a part of a coordinated design to benefit connected entities at the expense of public shareholders, without making the requisite disclosures, given that:
- RHFL had been granting loans to ‘potentially indirectly linked entities’ and while there is no provision in law which provides for this term, SEBI held that the connection between the entities (including the onward borrowers) was established due to various factors such as common directorships, common addresses, common e-mail addresses, etc.
- the borrowers of RHFL and onward borrowers had ‘box-structured shareholding’, i.e., there was cross-holding among each other and the shareholding was intertwined in a manner that it was difficult to ascertain the ultimate beneficial owners of the companies.
- It was contended that SEBI did not have the jurisdiction to act against RHFL as it was regulated by the National Housing Bank/ the Reserve Bank of India. However, SEBI held that it had jurisdiction on the ground that RHFL was a listed entity and was empowered to penalise the borrower/ related unlisted entities because they had played a role in defrauding public investors.
- Based on the above, SEBI concluded that the entities had violated the provisions of the SEBI (Prohibition of Fraudulent and Unfair Trade Practices Relating to Securities Markets) Regulations, 2003, by manipulating investors and the market. The concealment of siphoning of funds by RHFL, on account of inadequate disclosures, was viewed as misleading investors and therefore a violation of the LODR Regulations and principles relating to adequate disclosures.
Allocate and Perish: SEBI’s Order in re Linde (“Linde Order”)
The order dated July 24, 2024, was in relation to certain agreements between LIL (listed) and Praxair India Private Limited (unlisted) (“PIPL”), entered into following a global merger between Linde AG and Praxair Inc, including for commercial transactions and a JV/ shareholders’ agreement setting out business allocation. Investors complained that the transactions were RPTs, not in the interest of public shareholders. Key observations from the order are:
- LIL contended that shareholder approval was not required for commercial transactions because materiality threshold of 10% of the turnover of the listed company under Regulation 23 of the LODR Regulations was not met, as only transactions executed under a ‘common contract’ are considered while determining the 10% threshold. SEBI disagreed and held that the LODR Regulations establish a clear rule of aggregating the value of RPTs undertaken with a particular related party while assessing materiality, regardless of the same being under different contracts. In concluding so, SEBI relied on settled law as well as the position taken by the independent directors of LIL in other companies in which they were directors.
- LIL contended that product allocation and geographical allocation of business is not a transfer of assets or resources of LIL and therefore did not constitute an RPT under the LODR Regulations. SEBI took the principle-based view that:
- allocation of future business opportunities is synonymous with transfer of business/ assets and therefore needs to be subjected to the same scrutiny as traditional RPTs;
- related parties have a higher degree of influence, which could be used to divert assets of the company/ not be at arm’s length, and therefore, higher decisional and disclosure thresholds are prescribed;
- the allocation was agreed to by the board without obtaining a valuation report. Further, no material was placed before the board to determine any gain or loss from the business allocation and only synergy at the holding company level was considered when agreeing to the business allocation;
- such allocation of business has a financial impact, poses a risk to future growth prospects and may not be in the best interests of the public shareholders, if requisite approvals are not taken.
- Based on the above, SEBI directed NSE to appoint a valuer to undertake a valuation exercise for LIL (including for business foregone); and LIL to disclose the board’s observations on the valuation report and management comments. SEBI stated that culpability of the directors/ management should be determined post receipt of the valuation report.
Takeaways
The common theme across the 2021 Amendments and the recent orders is that SEBI is adopting a more principle-based approach towards RPTs.
In the RHFL order, SEBI viewed various factors such as circumvention of due diligence measures, involvement of linked/ connected entities, lack of disclosures, etc., as pointing towards a coordinated design to defraud investors. In the Linde Order, it was noted by SEBI that when the shareholder’s rejected the RPT, the company sought legal opinions supporting the view that shareholders’ approval shall not be required and went ahead with the RPT without shareholder nod. It could be argued that the specific facts of the aforementioned cases were egregious and therefore, warranted high thresholds.
While the parties in these cases are likely to appeal to SAT, as Linde already has[5], to make the case that these orders indicate SEBI’s regulatory overreach, a prudent board would be wise to test all RPTs, even those in regular circumstances, against the highest threshold prescribed by the regulator. To this end, set out below are some of the takeaways and the guardrails that companies must adopt in considering and approving RPTs.
Higher regulatory scrutiny
- In the Working Group Report, SEBI had observed that companies are using innovative structures to circumvent regulatory requirements and that there is a need to consider the substance of the relationship and not merely the legal form.
- SEBI has adopted the same principle in examining innovative structures and imposing strictures and penalties for non-compliance in its recent enforcement orders.
- Non-disclosure/ inadequate disclosure of transactions with connected entities shall be perceived as market manipulation, as it affects shareholders’ decision to invest or stay invested.
- SEBI can proceed against unlisted entities if the interests of public shareholders are affected.
Compliance/ disclosures in relation to RPTs
- Listed entities should consider the financial impact of obligations while assessing whether RPT related compliance is required. Independent valuation should be undertaken for such assessment.
- Relinquishment of rights or opportunities in favour of related parties (such as the right to carry on a business and allocation of a revenue generating vertical) could also be considered an RPT depending on facts and circumstances. Agreements which include negative covenants on the listed entity would require careful assessment from an RPT compliance perspective.
Need for principle based internal processes and policies governing RPTs
- The board/ management is expected to not only ensure, but also be able to establish that every decision pertaining to RPTs has been taken with great care and prudence, after assessing whether public shareholders will be impacted adversely.
- Listed entities should put in place internal governance frameworks for transactions undertaken with related parties and even with other connected entities, irrespective of it being in the ordinary course of business.
- The policies created should ensure that they take into account not only those RPTs that strictly fall within the definition of RPT under the regulatory framework, but also those transactions that are similar to RPTs in principle or consequence.
- Such processes will enable the board/ management to establish compliance with RPT principles and strike a balance between shareholder interest and the business judgment rule, i.e. the principle that boards/ management of a company are insulated from liability if they acted in good faith and on an informed basis in the best interest of the company.
The adage ‘When all you have is a hammer, everything looks like a nail’ seems applicable here. It is highlighted by the SEBI employing its wide powers to raise the bar on governance surrounding RPTs, and also its scrutiny of RPTs in general. As a result, these strict thresholds may become the lowest common denominator for compliance. While care should be taken to ensure that the same does not result in an overly cautious approach, the board/ management of listed companies will continue to have the tall order of balancing the interest of the company and the public shareholders.
For further information, please contact:
Ramgovind Kuruppath, Cyril Amarchand Mangaldas
ramgovind.kuruppath@cyrilshroff.com
[1] Regulation 2(1)(zc) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations: “related party transaction” means a transaction involving a transfer of resources, services or obligations between:
- a listed entity or any of its subsidiaries on one hand and a related party of the listed entity or any of its subsidiaries on the other hand; or
- 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, with effect from April 1, 2023;
regardless of whether a price is charged and a “transaction” with a related party shall be construed to include a single transaction or a group of transactions in a contract.
[2] SEBI (Listing Obligations and Disclosure Requirements) (Sixth Amendment) Regulations, 2021, (Notification No. SEBI/ LAD-NRO/GN/2021/55) (w.e.f. 01.04.2022) (“2021 Amendments”).
[3] SEBI | Order in the matter of Linde India Ltd.
[4] SEBI | Final Order in the matter of Reliance Home Finance Limited
[5] Based on publicly available sources, the main appeal before the SAT has been listed for hearing on October 15, 2014. In the interim, Linde India had sought a stay on the valuation exercise, citing UPSI concerns and arguing that if the main appeal is allowed, the valuation exercise would be rendered futile. However, in this regard, the SAT has dismissed its application for a stay on the valuation exercise and Linde Inda has now moved the Supreme Court appealing against the SAT order. The publication of the official SAT order dismissing the stay/ extension on the valuation is awaited. Sources: <Linde India seeks SAT relief on valuation exercise ordered by Sebi | News on Markets – Business Standard (business-standard.com)> and <Linde India moves SC against SAT order in related-party transactions case | Mint (livemint.com)>
