Related Party Transactions and Arm’s Length Transactions in Company Law: Surrounding Ambiguity and Unsettled Dust

[By Suvam Kumar & Harsha Menon ]

The authors are Second and First-year students respectively, of NLU Jodhpur.

Introduction:

With the advent of globalization and boom in India’s economy, as ease of doing business has escalated to a great rank, it is very much imperative to have an efficient regime governing the corporate affairs. Keeping the abovementioned view in mind, the Companies Act, 2013 [“Act”] was enacted to ensure reliability and confidence in the corporate world. One such important concept which requires more importance is related party transactions. In the previous Act of 1956, this concept was not dealt specifically. However, with the increasing challenges in the field of corporate affairs, related party has been specifically dealt under Section 188 of the Act. However, the concept of related party transactions is still shrouded under ambiguity and nebulousness. The authors have tried to highlight the existing paradox and vagueness in the law related to related party transaction with the help of various judicial precedents.

What is related party transactions:

Before understanding related party transactions, we must know who is a related party. A related party means any person who is relative of the director or the key managerial personnel in a company.[i]Section 188 of the Act bars the related party transactions except when such transaction is made after taking consent from the Board of Directors or when the transaction is an arm’s length transaction.[ii]Section 188(1) of the Act specifies seven types of transactions which require prior approval of the Board of Directors.[iii]Among these, the transactions related to the appointment of related party to an office of profit has been always the most contentious and has raised several legal and practical issues with regard to the transparency in the company.

Rationale:

The director of a company has a fiduciary relationship with the company. Hence, it is important to examine whether there exists a conflict between the personal interests and the duty of a director. Hence, it is very much clear that the rationale behind having a provision like Section 188 is to prevent any conflict of interest in the functioning of the company. More often than not, the related party transactions are considered to be influenced by ulterior motives of profiting the persons who are involved in such transactions. Such transactions diminish the transparency and disclosures norms in the company and are against the spirit and objectives of the Companies Act.

Exceptions to the related party transactions:

It is pertinent to note that not all related party transactions are prohibited per se. There are two exceptions to it. Firstly, transactions where prior consent from the Board of Directors have been taken and the procedural requirement has been fulfilled.[iv]Secondly, transactions which are entered on an arm’s length basis.[v]

Arm’s Length Transaction: An Unsolved Ambiguous Concept.

Arm’s length transactions are those which are conducted between two related parties as if they were unrelated, so that there is no conflict of interest.[vi]A very little effort has been put to provide clarity as to what exactly arm’s length transactions mean. There is a serious dearth of the interpretation to the meaning of arm’s length transactions and there seems to be a contradiction in the provisions when they use related party and lack of conflict of interest at the same time. Such casus omissusopens the space for different interpretations.[vii]It can be interpreted as one forming strict procedural requirement given under Section 188. On the other hand, it can also be construed in a more liberal sense, by looking at the intent of the transaction and comparing it with the market conditions rather than stressing on the procedural requirement. However, there is no consistent application of any of abovementioned interpretation. Hence, there is a need of clarity regarding the criterion when a transaction despite being related does not cause conflict of interest. The Courts had met with several occasions to deal with the existing ambiguity but no satisfactory results have come out.

Cases dealing with Arm’s Length Transactions:

One of the very few cases which have tried to give some clarity regarding arm’s length transaction is Madhu Ashok Kapur v. Rana Kapoor.[viii]The Court was dealing with the issue of whether the reappointment of the Managing Director was a related party transaction or whether it was protected under arm’s length transaction. The Court was penchant for liberal interpretation of the arm’s length transaction and emphasized on the fairness of such transactions by comparing them with the market        value of such transaction. The Court held that the appointment was made at an arm’s length basis where it looked at the nature of prerequisites which the Managing Directors are ordinarily entitled to rather than emphasizing on the procedural requirements.[ix]Similar interpretation have been observed by the Apex Court in case of A.K. Roy v. Voltas Ltd.[x]However, there is still some unsettled dust surrounding the interpretations of arm’s length transactions which needs serious review and clarity.

Conclusion:

Considering the serious nature of the related party transactions and its exceptions, any kind of vagueness in its interpretation would lead to serious consequences in the regime of corporate affairs. It is the transparency which gives credibility to any company and boosts the client’s confidence in corporate world. Hence, an objective interpretation of the related party transactions is imperative. At the same time, the Courts have to be very cautious while interpreting the concept of related party transactions and abstain from the mechanical application of the same. As pointed out above, the Courts should be more inclined towards applying arm’s length transaction as a substantive rule rather than looking it as a procedural necessity. The Courts ought to look at the intent of the transactions rather than focusing on the procedural requirement of the transaction. A related party transaction can be related yet protected. For instance, appointment of a person on the basis of related party transaction can be termed as valid if such appointment is fair and objective as per the requirement of the market value of such transactions. Therefore, a transaction should not be declared void merely on the ground of procedural irregularities. Given the fact regarding that lack of settled position of the point of interpretation of arm’s length transactions, mistakes and error are very much possible. Therefore, we are in a dire need of clarity in the interpretation of related party transactions and its exceptions.

[i]Section 2(76), The Companies Act, 2013.

[ii]Section 188, The Companies Act, 2013.

[iii]Id.

[iv]Id.

[v]Id.

[vi]Section 188, The Companies Act, 2013.

[vii]N. Kumar, A Study of Corporate Governance under Companies Act, 2013, 2(6) Asian Journal Of Multidisciplinary Sciences 43 (2014).

[viii]Madhu Ashok Kapur v. Rana Kapoor, 2015 SCC OnLine Bom 5818.

[ix]Id.

[x]A.K. Roy v. Voltas Ltd., AIR 1973 SC 225.

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