SEBI amendments to Related Party Transactions

SEBI amendments to Related Party Transactions

Related Party transactions has been a hot topic for all regulators worldwide. In India, this topic is super-hot because a large part of corporate India is still family owned and influenced by promoters / their family. If one looks at the regulatory landscape, the definition of who is a related party is itself not consistent, probably across various regulations. The Securities and Exchange Board of India (“SEBI”) made some landmark changes to Regulation 23 of the SEBI Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR”) and connected definitions. The objective of these amendments has been to protect the interests of minority shareholders from controlling shareholders/Promoters. Some of these changes are already applicable from 1 April 2022 and some are applicable from 1 April 2023. These will have significant implications on Companies, Audit Committees (“AC”), Board of Directors and Auditors. Let us understand what some of these key changes are:

Expansion of who is deemed to be a Related Party

“Related Party” means a related party as defined under sub-section (76) of section 2 of the Companies Act, 2013 or under the applicable accounting standards. Provided that the following shall be deemed to be related parties:

a) any person or entity forming part of the promoter or promoter group of the listed entity.

b) any person or any entity holding equity shares: (i) of 20% or more; or (ii) of 10% or more, with effect from 1 April 2023; in the listed entity either directly or on a beneficial interest basis as provided under section 89 of the Companies Act, 2013, at any time, during the immediate preceding financial year.

Snapshot of key changes to the deeming provisions are:

a) Prior to 1 April 2022, a person/entity forming part of promoter or promoter group AND holding 20% or more of shareholding was deemed to be a related party.

b) From 1 April 2022, any person/entity forming part of the promoter/promoter group is deemed to be a related party irrespective of shareholding.

c) From 1 April 2022, every other person (meaning other than promoter/promoter group) is deemed to be a related party if he holds 20% or more of equity shareholding/ beneficial interest.

d) From 1 April 2023, every other person is deemed to be a related party if he holds >10% or more of the equity shareholding/beneficial interest.

e) For points c and d above, the shareholding of 20% or 10% is to be evaluated based on previous years’ holding.

Key considerations - Related Party definition

a) Classifying every entity of the Promoter/Promoter Group as a related party could be argued to be a low hanging fruit considering that in many cases it is the Promoter who is in control of decision making irrespective of the shareholding of the entity within the promoter group.

b) Classifying every entity/person having more than 10% equity shareholding in the listed entity as a related party may result in many private equity investors/FIIs/large independent shareholders becoming related parties. If this is an unintended consequence, then SEBI may consider providing certain practical expedients to avoid such unintended consequence. One such instance is Synnex Mauritius Ltd (FII) which holds 24.13% of Redington (India) Limited as on 31 March 2022 (Source: Redington (India) Limited Annual Report 31 March 2022).

c) The issue highlighted in “b” above gets accentuated if one considers the expanded definition of Related Party Transaction (discussed in the later section). So, for example, If Company X and Company Y are related parties, then all subsidiaries of Company X would also be related parties of Company Y. Theoretically if Company X contributions to Gratuity fund, Superannuation etc., is maintained with Company Y, then all the transactions, such as contributions to Gratuity, Superannuation trusts etc., maintained with Company Y would be RPTs.

d) Threshold percentage like 20% or 10% for considering a party as a related party is limited only to stake in the listed entity. If an investor has a stake of >20% or 10% in a subsidiary of a listed entity (assuming it is not related through any other criteria), it will not be a related party but if it holds 20% or 10% in the listed entity, then it is a related party. SEBI may clarify as to whether this needs further amendment/clarification to cover listed entity and group. Identification of parties as related parties is based on 20% or 10% equity shareholding of the previous year. Hence, it is possible that a party was holding 25% stake in equity shares in 2022-23 in the Company and sold off its entire stake in 2022-23, but its transactions in 2023-24 will still be considered as related party transactions and will need to follow the compliance requirements. The perspective of the Working Group of SEBI on Related Party Transactions might be that shareholders who hold significant shareholding could influence decision making. The current regulations did not capture the transactions as Related Party Transactions during their period of shareholding and hence may have been ineffective.

Voting on Related Party Transactions

a) Regulation 23(4) of SEBI LODR regulation states as follows “All material related party, transactions and subsequent material modifications as defined by the audit committee under sub-regulation (2) shall require prior approval of the shareholders through resolution and no related party, shall vote to approve such resolutions whether the entity is a related party to the particular transaction or not”.

b) he common belief is that if a party is a related party, it is not allowed to vote on ANY transaction of another related party. However, that is not true. SEBI LODR has a concept of “vote to approve”, which means that if a party is a related party it cannot vote to approve on ANY other related party transaction whether it is party to that transaction or not. But it can vote to dissent. This is an interesting concept whereby large shareholders, if they are classified as related parties, can still vote to dissent on promoter or any other related party transactions. In a sense, negative voting is allowed but positive voting is not allowed.

Change to the definition of Related Party Transaction

There are certain significant changes which have been made to the definition of Related Party Transaction. They are captured in the two diagrams below.

Diagram 1: Shows the changes applicable from 1 April 2022 (which are already effective)

a) With effect from 1 April 2022, a transaction between Related Party (“RP”) of Holdco (List Co)/subsidiary with List Co or subsidiary is treated as a related party transaction of the Group of List Co and subsidiary.

b) With effect from 1 April 2023, a transaction with a Third Party (“TP”) is treated as Related Party transaction if the purpose and effect of that transaction is to benefit the RP of List Co or its subsidiaries.

Key considerations - Related Party transaction

This is probably the first time that a transaction is treated as a Related Party Transaction if it is beneficial to the other party. Also, determination of a related party transaction is based on the books of account and accounting records which in this case mean the Listco and subsidiary. It would however be extremely difficult for the Board/ Audit Committee/ Auditor to determine whether the onward transaction done by the Third Party benefitted the related party of the Hold co/Sub. Further, determining whether there is “benefit” is very subjective and AC and Board would have tough time to conclude this. Suppose there is a transaction with a third party and an onward transaction with a Related Party of Listco or Sub of Listco and the transaction is at arm’s length, then can one argue that there is no benefit because both legs of the transaction are at arm’s length? The word benefit has an immense significance in the drafting. A clarification from SEBI on what is meant by benefit and what type of transactions would get covered/excluded would help understand the intent of SEBI on introducing this clause.

Regulatory oversight to Related Party transactions is an extremely important part of ensuring robust governance mechanism and hence constant change to the regulations is an extremely necessary step. At the same time, ease of implementation and ensuring that the regulatory changes do not cause unintended inconveniences is also an important aspect of any change. Whilst some of the changes are welcome, few changes, especially those relating to treating 10% equity shareholding as a Related Party and the clause relating to meaning of the word “benefit” in dealings with third party need further clarification.