The nitty-gritty of shareholders’ approval for material RPTs

– A guide for practical implementation under the revised LODR framework

– Team Vinod Kothari and Company; corplaw@vinodkothari.com

Regulation 23(4) of the Listing Regulations require all material related party transactions (‘Material RPTs’) to be approved by the shareholders of the listed entity. With the commencement of the LODR (Sixth Amendment) Regulations, 2021 (‘6^th Amendment Regulations’), the term ‘prior’ has been inserted before the term ‘approval’ thereby requiring prior approval of shareholders for Material RPTs.

With the provisions coming into effect from 1^st April, 2022, several questions need our special attention given the concept of prior approval. Some of them includes –

Detailed discussion on materiality thresholds of RPTs for obtaining shareholders’ approval has been dealt with in our article and can be read here. Further, you may refer to the detailed FAQs on amended LODR framework as amended by the 6^th Amendment Regulations. In this article, we try to focus on the nitty-gritties around obtaining shareholders’ approval for material RPTs.

Periodicity of shareholders’ approval

While the shareholders’ approval is required to be taken prior to entering into a material RPT, the primary question lies as to the periodicity and validity of shareholders’ approval. Looking at the material thresholds given under the explanation to Regulation 23(1), it is beyond doubt that the approvals are required on an annual basis, since the transactions are aggregated on an annual basis for all the transactions entered during the financial year. Further, the basis for determining materiality is the annual consolidated turnover of the listed entity as per the last audited financial statements.

A related question arises on the approval by shareholders in case of material RPTs in the nature of multi-year contracts. In such cases, while the contract may involve series of transactions which continues in subsequent years in addition to the year in which it has been entered, the same contract is to be placed before the shareholders if the contractual value for the said FY exceeds the threshold with all the necessary details. Whether such executory contracts, being already approved by the shareholders in the year of execution, are required to be subsequently approved by the shareholders on the basis of materiality as per the consolidated turnover of preceding financial year? In our view, the answer should be in negative. Considering that a contract has already been approved by the shareholders, the same need not be placed before the shareholders in the subsequent years of its tenure, even if the same is material in any of those financial years. If a converse view is taken, it will lead to repetition of the information before the shareholders and does not serve any fruitful purpose. Therefore, it may be concluded that the shareholder’s approval for multi-year contracts are valid throughout even if the approval is taken in the first year when it being executed becomes material.

Here, it has to be noted that shareholders’ approval for a contract/ transaction will be required only if the same exceeds the materiality threshold on a yearly basis. In case a contract is not material for the year in which the contract is executed, but becomes material in subsequent years of execution on basis of consolidated turnover of relevant preceding financial year, approval for the same should be obtained in such financial year in which it becomes material.

Extent and adequacy of information to be placed before the shareholders

The next question that requires consideration is the extent of information that is required to be placed before the shareholders in order to enable them to take a reasoned decision for approving/disapproving the proposed RPT. SEBI Circular issued on 22nd November, 2021 (‘SEBI Circular’) provides guidance on the disclosures required to be made and we have briefly discussed on the same in our article which can be read here.

However, it has to be noted that all the information pertaining to the proposed RPT are not available with the company at the time of seeking shareholder’s approval. This is so because calling a shareholders’ meeting is a time-taking process and there might be time gaps between approval of an RPT and actual execution of the same, and some information may not be specified well in advance. Therefore, a more reasonable approach towards obtaining shareholders’ approval may be to specify such  quantum of information, as far as may be possible for the company to provide at the time of obtaining approval which is expected to be adequate to aid the shareholders in taking their decision.

The information pertaining to an RPT shall broadly include the following –

1. Name of the parties to the transaction/ contract
2. Nature of transaction/ contract
3. Amount involved
4. Terms of the transaction/ contract
5. Duration/ span of the transaction/ contract

Below we consider some examples to check the obstacles that may arise on providing such disclosures at the time of practical implementation by a company, and the probable way-out for the same without breach of the provisions and intent of law.

1.     Amount involved in the transaction/ contract

Let us assume the case of issuance or subscription of bonds by a listed company. It may happen that a listed company, from time to time, issues short-term bonds to its group companies or promoters or directors etc. for meeting temporary funding requirements. The amount of funds raised by the company may not be presumed in advance and therefore, disclosure of the same will not be possible.

Consider the case of an even more floating arrangement, such as that of investment in securities through a stock broker, who is a related party or the maintenance of a savings or current account with a related party. The value of the transaction in each of these cases cannot be presumed, and therefore, the specific disclosure of the said information in such a scenario may become difficult.

Possible way to address the issue

A probable solution in such a scenario may be to disclose the estimated maximum amount of transactions to be entered into with the related parties, and the basis for reaching such estimates.

2.     Terms of the contract/ transaction

We again take the example of the loans proposed to be given by the holding company to its subsidiary. The time of granting such loans is not fixed at the time of taking shareholders’ approval. Considering that all transactions are required to be done on an arm’s length basis, the terms of the contract cannot be reasonably determined well in advance since the same will depend on the market conditions at the time of actual transaction taking place.

For example, at the time of granting loans, the relevant terms relating to the tenure of loans, rate of interest, prepayment penalty etc. has to be determined on the basis of the prevailing market rates at that point of time. Therefore, disclosure of the same cannot be possibly made before the shareholders at the time of obtaining approval for the same.

Possible way to address the issue

The shareholders resolution may specify that the terms and conditions of the proposed contract will be determined on an arm’s length basis, at the time of actual execution of the transaction. The responsibility of the shareholders is limited to the approval of an RPT on the basis of information placed. The judgement call as to verification of the arm’s length terms has to be made by the Audit Committee and the shareholders place reliance on the same. The shareholders’ approval for entering into a material RPT does not absolve the Audit Committee from examining the reasonableness and viability of the transaction, as to satisfaction of arm’s length basis.

3.     Duration/ span of the contract

Another information to be disclosed is with respect to the duration/ span for which a contract continues. Any RPT should not be approved for an infinite period, but a maximum duration/ span of the contract should be indicated in the statement seeking shareholders’ approval.

Carve-outs to shareholders’ approval

Having discussed the practicalities involved in obtaining shareholder’s approval, another matter that requires our attention is the possibility of a generic shareholders’ approval providing carve-outs from obtaining shareholders’ approval for each material RPT. By a generic approval, we mean approval sought from shareholders for proposed RPTs without specifying most or all of the information referred above. For example, a bank obtains approval from shareholders for providing banking services to one or more of its related parties on such terms and conditions as suitable on an arm’s length basis, in the ordinary course of business, for any amount as approved by the Audit Committee, irrespective of the same being in excess of the materiality thresholds under Regulation 23 of the Listing Regulations.

Note that the above resolution does not contain any of the details, such as, the name of the parties, amount involved, detailed terms, or the tenure of the contract. Even the nature of the contract is very generic and the specific services included under the broad term ‘banking services’ is not mentioned. More than an approval, the resolution seems to be an enabling resolution giving powers to the Audit Committee to approve any transaction with any related parties, subject to the same being in ordinary course of business of the bank, being banking services and on an arm’s length basis. It is imperative to note here that such sort of approvals are not Material RPTs in itself but an approval for carving out exclusions from the RPT approval process.

While one may doubt the admissibility of such resolutions, it has to be kept in mind that in the given case, a specific shareholders’ resolution specifying all the requisite information would not have been tenable. Similar justifications exist for an NBFC in the business of lending providing personal loans to its related parties at terms approved by the Audit Committee on an arm’s length basis. In our view, such carve-outs are admissible only when the RPT is in ordinary course of business at an arm’s length basis, otherwise entered into with the general public as well.

Pre-approved transactions beyond the scope of aggregation

Having obtained shareholders’ approval for material RPTs to be entered into with a related party, whether transaction of any value in excess of what has been approved, entered into with the same related party during the same financial year for which a material RPT has already been approved, will require approval of shareholders? Let us understand the same by way of an example.

Suppose X Ltd, a listed company, purchases coal from its associate company, B Ltd. On the basis of the production capacity of the company, X Ltd obtains an approval from the shareholders for purchase of coal upto a value of Rs. 1500 crores in the FY 2022-23 from B Ltd, its associate company, at prevailing market prices. Now, during the year 2022-23, B Ltd offers debentures of a value of Rs 50 lacs to X Ltd. In the instant case, the value of transaction involving subscription of debentures by X Ltd does not exceed materiality threshold, however, aggregating the same with the material RPT of Rs 1500 crores, the same becomes material.

Therefore, whether it can be said that entering into a material RPT with a related party, disqualifies a listed company from entering into a transaction of any value without obtaining prior approval of shareholders for the same, or whether one may take a view that pre-approved transactions are not required to be aggregated again for the purpose of determining materiality, and therefore RPTs of an immaterial value may be entered into with the approval of the Audit Committee, instead of placing the same before shareholders for their approval?

If one goes by the first alternative, it would mean that for parties with which a company has entered into a material RPT, no transaction can be undertaken without the approval of shareholders. On the contrary, considering that the material RPTs have already been pre-approved by the shareholders, one may safely take a view that approval of the shareholders need not be taken for the transaction entered into with the same related party in excess of the value or other than the nature of transactions for which approval has been taken by the shareholders. Transactions upto the materiality limits, excluding the pre-approved transactions may be taken care of by the Audit Committee instead of placing the same before shareholders, since the same falls within the authority of the committee.

Ratification of material RPTs without shareholders’ approval

A company cannot be expected to anticipate all the transactions/ contracts to be entered into with its related parties in advance. Therefore, there may be a possibility of any transaction having entered into with a related party by a listed company, resulting in exceeding the materiality thresholds, thereby, causing a violation of Regulation 23(4) of the Listing Regulations. In such circumstances, does the RPTs become void or can the same be ratified by the shareholders so as to keep the validity of the contracts intact?

The issue itself is not simple – there are several angles to the ratification principles. If the interests of shareholders is in question, the shareholders may ratify the breach of duty of the directors. However, if there is a question of creditors’ interest too, for example, funds borrowed from creditors have been hived off into an RPT, there is no question of ratification by shareholders. In a New Zealand ruling in Nicholson v Permakraft (NZ) Ltd [1985] 1 NZLR 242, it was held that the concurrence by the shareholders prevents any complaint by them, but compounds rather than excuses the breach as against creditors. Similarly, if there is question involving public policy, there can be no ratification.

In case of Material RPTs, the power to approve lies with the shareholders, who are not related parties to the company. While we discuss the power of ratification by shareholders, it has to be noted that the act, in itself, is not beyond the authority of the company. It is merely because of the apprehension of conflict of interest that the transaction required shareholders’ approval. Therefore, the shareholders had the authority, but the directors did not have the authority. If the shareholders, who had the original authority to approve the transaction, after due consideration of the relevant facts, decide to approve it, the approval dates back to the date on which the original act was done. This is backed by the age-old maxim: Omnis ratihabitio retrorahitur et mandato priori aequiparatur.  Section 196 of the Contract Act also incorporates the principle of ratification of the acts of an agent by the principal; in the context, the directors may be regarded as the agents of the company.

Therefore, if there is a ratification by shareholders, the legality of the contract is not disrupted; the contract may continue. Ratification of such RPTs cannot undo the violation of Reg 23(4) but avoid a continuing non-violation on the part of the company.

Our resource center on RPTs can be accessed here – https://vinodkothari.com/article-corner-on-related-party-transactions/