Relinquishment of source of profit in favour of an RP: also an RPT

Mahak Agarwal | corplaw@vinodkothari.com

The broad spectrum of the definition of Related Party Transactions (RPTs) under the Listing Regulation, continues to be an error prone area in terms of compliance. A recent SEBI ruling has further strengthens this aspect where the phrase ‘transfer of resources, services or obligations’ has been explained in an extremely new dimension with a commendable insight from the authorities which again shows that the regulators can no more be restricted by the imaginary boundaries placed by the corporates when it comes tightening the loose ends of corporate governance.

This article delves into the basis which the Regulators considered for concluding a mutual understanding and agreement between related parties to be an RPT notwithstanding the  contention of the company. The essential question of law involved in this case was whether the allocation of certain products and geographic areas between RPs constitutes an RPT. The article contains our analysis of SEBI’s order in the matter affirming the said stand.

Understanding the phrase “Transfer of resources, services or obligations”

The definition provided for  RPTs under Regulation 2(1)(zc) of the SEBI LODR Regulation has an extensive broad phrase which reads transactions involving transfer of resources, services or obligations between RPs. Based on the above definition, two elements become prominent in the said definition, first the element of ‘transfer’ and the other being ‘of resources’ / ‘of services’ / ‘of obligations’.

Transfer in simple terms means to convey from one to another. Further, if we discuss it in the context of ‘resources’, the same would refer to  transfer of the assets of the company which may be in the form of tangible or intangible assets. In fact assets can also mean to include rights of the company whether in present or future.

Given the aforesaid explanation, if we refer to the SEBI ruling,  it is pertinent to note that the transfer need not necessarily involve a direct exchange of assets or services between the RPs at present.

Implied transfer  – a case of entering into transaction

The instant question at hand involves the allocation of business- both from the perspective of a business vertical  and also a geographical split, between two related parties. Here, let us understand that when there is an allocation of business between two RPs such that one is placed in a more beneficial position than  the other, who gets into a relatively disadvantageous position, there comes into existence a benefit to the RP who gets the more profitable business. This is to say that between the two parties, one gets a promising business opportunity and the other- consequent loss of future revenues and benefits that would otherwise accrue to it. In other words, it has been held that where one party relinquishes the rights to carry on a future business and the consequent opportunities of growth and earnings and cash flows associated with those business rights/ opportunities, in favour of its RP and opts to choose the business vertical that is less profitable, the same should be  considered equivalent and synonymous to the transfer of business/ resources/ assets since the same involves giving up of future opportunities and benefits in favour of an RP.

A similar stand has also been taken under Para 7 of IndAS 24 (Related Party Disclosures) which states as under:

“The profit or loss and financial position of an entity may be affected by a related party relationship even if related party transactions do not occur. The mere existence of the relationship may be sufficient to affect the transactions of the entity with other parties. For example, a subsidiary may terminate relations with a trading partner on acquisition by the parent of a fellow subsidiary engaged in the same activity as the former trading partner. Alternatively, one party may refrain from acting because of the significant influence of another—for example, a subsidiary may be instructed by its parent not to engage in research and development.”

From the above, it is further understood that there need not be a specific exchange of assets or services between RPs to constitute an RPT. Where the act of doing or refraining from doing a certain act by one RP benefits the other RP, the same would also constitute as an RPT.

Transfer: both in the present and in the future

The SEBI ruling throws light on yet another important point; i.e.,to constitute an RPT, the transfer of resources, services or obligations is not confined to the present. Such transfer may also be in the form of access to promising opportunities, higher profits and higher revenue streams in the future. Considering the instant case, the business allocation cum split of future business rather than being a current transaction effectively alters how business opportunities are allocated among related parties for the future course of action. Such arrangements can lead to a redistribution of corporate business and opportunities that would otherwise have benefitted the party. This poses a potential prospect to one party and potential risk to the future growth prospects of another. Accordingly, a business allocation, comprising no transfer of assets or services at present but promising future growth prospects to an RP would also constitute an RPT.

Requirement of valuation report

The decision of determining the allocation of a business vertical or geographical location, as in this case, should ideally be based on a valuation report which would help in determining the gain or loss accruing to each of the parties to whom business is being allocated. This is to say that compliance with RPT provisions should not be limited to mere identification of RPs but also determining what benefit is being rendered and what opportunity is being lost.

The need for a valuation report becomes all the more essential in cases such as the one under question at present, to determine the RPT approval authorities. It helps to determine whether the decision allocating such business required approval of just the Audit Committee or whether shareholder approval was also required. In most cases (including the case at hand), abusive related party transactions where a counterparty is benefited to the detriment of the listed company itself would raise concerns amidst the shareholders, especially in situations where the same is not backed by supporting documents. Therefore, a valuation report becomes indispensable to ensure that the Board does not overreach its authority and ensures that shareholder’s interests are safeguarded.

Further, given the nature of abusive RPTs, OECD^[1] provides for a list of questions that a shareholder can put forward:

• Why is the asset being traded?
• In many cases, assets are traded for reasons of ‘diversification’ of the listed entity; – why the listed company is ‘diversifying’ into an asset that is – by coincidence – owned by a parent company;
• Why now is the best time to undertake this transaction; 
• If the market is depressed – is the best time to sell an asset to a related party. Waiting for six months might potentially see the company obtain a higher valuation for the entity

On several occasions, the timing of the transaction becomes crucial for the analysts in case of  abusive RPTs because related parties may have incurred losses on a separate entity or business venture, and may be keen to ‘inject’ assets into that entity to prevent a breach of debt covenants. It may be that on a personal level he/she has incurred losses associated with the stock market and needs funding. In any of these cases, the alignment of interests may be absent.

Concluding remarks

The instant ruling of SEBI is a testament of the intricate scrutiny undertaken by regulators in various areas of corporate governance with the aim to restore proper engagement and oversight by the Board and shareholders over significant corporate decisions.

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^[1] Guide on Fighting Abusive Related Party Transactions, OECD 2009

Also refer to our resource center on RPT here