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New Materiality Threshold for RPTs: Nagging questions on shareholder approval

Vinita Nair and Sikha Bansal

Related Party Transactions (RPTs) are perceived as potential tools for unjust enrichment of those in fiduciary capacity. Hence, the stock market regulator has recently revamped RPT norms (most of which are to take effect from 1st April, 2022 though) intending to have a greater scrutiny on RPTs. Among all the measures, one is revision in threshold for ‘materiality’, and second is, ‘prior’ approval of shareholders for all such material RPTs. Materiality is now fixed as a value above – (i) INR 1000 crores, or (ii) 10% of annual consolidated turnover of the listed entity, whichever is lower. For all such contracts which cross the threshold, the listed entity would need to have prior shareholder consent. Additionally, the scope of RPTs now also covers cross-RPTs, that is, transactions of listed entity with related parties of subsidiary, transactions of subsidiary with related parties of listed entity, and transactions of subsidiaries with its own related parties.

Given the above, all companies which have annual consolidated turnover exceeding INR 10000 crores, alongside contracts exceeding INR 1000 crores, are now faced with a quizzical issue: Do the amendments impact only future contracts or even past contracts? The question becomes perplexing as to continuing contracts because of the wide ramifications which can possibly occur if the contract fails to get favour from shareholders (which of course, would be unrelated shareholders). Further, there would be questions, relating to scope of transactions to be included to determine the threshold limit (especially because of expanded scope of RPTs), and the computation and aggregation of values thereof.

We intend to address these nagging questions in our write up below.

Tripling effect: ‘cross-RPTs’, ‘lower materiality threshold’ and ‘prior approval’

SEBI has made amendments to the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘LODR’), vide the SEBI (Listing Obligations and Disclosure Requirements) (Sixth Amendment) Regulations, 2021 (‘amendment’).

The changes, which we are discussing here, are three-fold, as below:

First, SEBI felt that it is prudent to obtain “prior” approval of shareholders for material RPTs; this is on account of the practical difficulties which the listed   entity   may   face   in case the  transaction   is   rejected by the shareholders at a later stage. Further, this would ensure consistency with  the   requirement   of   obtaining   prior   approval   of   the   audit committee for all RPTs as specified in the regulations.

Second, and rather more importantly, as the threshold for determining materiality has changed (many companies would have transactions falling in the the bracket of INR 1000 crores), one is left to think if ongoing RPTs need to be reclassified as material and non-material; and if such classification is required, whether the RPT now classified as material RPT would need ‘prior’ shareholder approval.

The question of retrospective application to ongoing contracts arises because of reg. 23(8), which states, “All existing material related party contracts or arrangements entered into prior to the date of notification of these regulations and which may continue beyond such date shall be placed for approval of the shareholders in the first General Meeting subsequent to notification of these regulations.” Of course, reg. 23(8) has been in place right from the time LODR was notified; however, the expression ‘these regulations’ would refer to LODR as amended from time to time. The regulation, so far, has not been omitted.

Pursuant to the same, if it is concluded that a reclassification is required and consequently, all RPTs categorised as material RPTs have to pass shareholders’ nod before proceeding further, the same may have wide ramifications. The company would have entered into an ‘agreement’; the agreement would require both parties to execute their part of obligations under the agreement. The agreement would also include, as a part of default covenants, damages, etc. for breach of agreement. Hence, failure to have shareholders’ approval may have commercial implications on the company, along with ancillary consequences.

Here, note that there are certain other provisions in LODR which seem connected and may be relevant – one is proviso to reg. 1(2) which says that provisions of reg. 23(4) shall come into force on the date of notification of these regulations, and the other is reg. 23(6) which says that the provisions of this regulation shall be applicable to all prospective transactions. All these provisions, at the first stance, seem to be conflicting and overlapping (however, see below).

Thirdly, as regards expanded scope of RPTs to cover cross-RPTs, it might be possible that threshold limits get crossed because of cross-RPTs not considered earlier. While it is likely that the listed entity may have an existing approval in place for the transactions undertaken with its own related parties, but there is a rare probability of an approval being in place for cross-RPTs (considering the cases where there are no overlaps between the related parties of the listed entity and those of the subsidiary). Further, there would be ‘aggregation’ issues for such cross-RPTs, as we discuss further.

Understanding ‘transaction’ vs. ‘contract’ and implications under RPT framework

One would note that regs. 23(1), 23(4), and 23(6), all use the expression ‘transaction/s’; however, reg. 23(8) uses the word “contracts or arrangements’. What could be the relevance of such different usages? Essentially, ‘transaction’ and ‘contract’ are not one and the same. There may be a single transaction or a series of transactions pursuant to a contract or arrangement. As per the definition of RPT in LODR, a “transaction” with a related party shall be construed to include a single transaction or a group of transactions in a contract. Therefore, the term ‘contract’ is wider or an umbrella term within which there can be a single transaction or even a series of transactions resulting in transfer of resources, service or obligation by a listed entity. For instance, A sells goods to B at a certain price – this is a transaction; and this can as well be a contract. In another example, A agrees to supply goods to B over a period of 3 years at a predetermined price. This is a contract, which can have multiple transactions (multiple supplies of goods to B).

Hence, reading the provisions of LODR, one can have the following conclusions –

  • It needs to be seen if the contract, and the RPT pursuant to such contract, is a secluded transaction, that is to say, the contract results in a single transaction. There is obviously no difficulty in this case. However, where the contract imbibes a series of transactions, the question will be, what are the transactions taking place during FY 22-23 (or subsequent years) pursuant to the said contract.
  • The transaction may be prospective, or may have already taken place. In view of the prospective applicability by way of reg. 23(6), the provisions will be applicable to prospective transactions only. However, it may be tricky to identify the core transaction, and the consequential flow of resources or reciprocal performance due to such a transaction. For example, if goods have been sold during FY 2021-22, for which payment is made in FY 22-23, the transaction was one of sale of goods, and the payment is merely a reciprocal performance. Similarly, if a loan has been given in earlier years, and the same is partly repaid or interest is serviced during FY 22-23, it cannot be argued that the repayment of the loan or the servicing of interest are “transactions” happening in FY 22-23. In this context, it may be noted that, while the meaning of RPT is borrowed from IndAS 24 and may include items like dividend, interest, etc., however, approval requirement under LODR is to be assessed basis the principles above as it is a core part of transaction, unlike ‘disclosures’ which is a consequential part of the transaction.

Therefore, if there is a contract, transactions under which run beyond the effective date, such contracts need to be taken before shareholders with respect to transactions yet to be initiated. In that case, acts already performed under transactions previously concluded under the same contract should not be hampered. However, transactions which are pending execution shall only begin once shareholder approval is received.

Thus, in the context of effective date for the present amendment to take over, there can be various scenarios, and the treatment would accordingly depend as noted below –

  Scenarios Possible implication under present amendment (assuming the transactions/contracts attain materiality limits)
Case 1 The entity enters into single transactions, where one transaction is equivalent to a contract This is a simplistic case. No implication under present amendment if transaction is done and completed. However, the company would need shareholder approval to undertake fresh transactions.
Case 2 The entity has entered into a contract for multiple transactions, and has completed all such transactions

 

This is a simple scenario too – past transactions in a past contract. The contract stands ‘executed’. No transaction remains to be fulfilled. Hence, no impact under present amendment.
Case 3 The entity has entered into a contract for multiple transactions, and has completed only some transactions, while some transactions are yet to be executed This is a case of executory contract. As a part of the transactions contemplated under the contract remains to be fulfilled, the contract might need to be placed before shareholders.

If the contract fails before shareholders, the ‘to-be executed’ transactions may need to be aborted (with possible commercial implications, as discussed above).

For example, say A has agreed to deliver 5 lots of products to B over a period of 1 year. While 3 lots have been delivered and paid; 2 lots are pending (neither delivery nor payment has taken place). In such a case, the shareholder approval would be required for the pending 2 lots.

Case 4 The entity has entered into a contract for multiple transactions, and all transactions thereunder are just partly fulfilled.

 

The contract too, is continuing. But this is a case where each transaction may have been partly fulfilled. For example, A might have delivered goods, but is yet to receive payments from B in tranches, or vice-versa. In such a case the transaction has been initiated, and should not come under shareholders’ radar.
Case 5 The entity has entered into a contract for multiple transactions (say 10 sale transactions), out of which –

–        3 are complete as to delivery and payment

–        2 have been delivered on credit sale basis, payment is awaited

–        in 5 sale transactions, goods are yet to be delivered

Going by the interpretation and logic applied –

–        3 transactions are fulfilled, shall not need any approval

–        2 transactions have been initiated already, and thus the transactions are not ‘prospective’

–        remaining 5 transactions are prospective in nature, and thus would need shareholder approval.

Understandably, the examples above are basic ones; in reality, contracts may be quite complicated and each contract has to be read with all its dimensions to understand the implications with respect to the present amendments.

Hence, reg. 23(8) cannot be read dehors reg. 23(6). On a harmonised reading, it can be deduced that, where there are no prospective transactions, there is no question of applying reg. 23(8) and consequently, reg. 23(4) is not attracted.  However, shareholder approval for ‘existing contracts/arrangements’ which are continuing shall be required for prospective ‘transactions’ under those contracts.

An interpretation that the amendment applies only to prospective contracts but not to existing contracts will provide leeway to errant entities/controlling shareholders to have their way well before the amendment takes effect. Also, to say that prospective transactions under past contracts and those under future contracts should be treated differently, will lead to anomalies and discrimination, and would thus be incorrect. Therefore, the scope of RPTs to be considered for shareholder’s approval should be for all prospective transactions (including under continuing contracts) after the effective date.

There is another dimension to the issue, that is, aggregation, as discussed below.

Aggregation of transactions for determining material RPTs

As is clear from the language of the proviso to reg. 23(1), a ‘transaction’ has to be adjudged as ‘material’ or ‘immaterial’ in relation to ‘a related party’. Now, the revised definition of RPT includes cross-RPTs, that is, transactions by the listed entity and the subsidiary with – (i) their own related parties, and also, (ii) each other’s related parties[1]. Hence, all transactions which either the listed entity or the subsidiary(ies) enter with ‘a related party’ (that is, a particular related party) shall be aggregated to see if the value of the transactions is breaching the threshold limit. The intent is to regulate ‘the consolidated entity as a whole’, where a ‘network of entities’ may be used as conduit to benefit related parties[2]. Hence, irrespective of whether the transaction is undertaken by the listed entity or the subsidiary, if the counterparty is the same related party, aggregation has to happen. Otherwise, the easiest way to avoid materiality threshold will be to route the RPTs through various subsidiaries to ensure that the threshold is not breached. Note that, the aggregation shall exclude transactions entered into by a listed subsidiary with a related party, where the listed entity is not a party – as in that case, such transaction will have to be separately assessed under reg. 23 for the listed subsidiary. As proviso to reg. 23(4) also says, such transactions by listed subsidiary shall not require approval of shareholders of listed entity.

Also note that the coverage does not include associate companies. However, an interesting question is – whether any transaction entered into by the holding company of a listed entity with a related party (of its own or of the listed entity) needs to be considered? Assuming that the holding is an unlisted entity, there is no provision for aggregation of transactions at the holding level. On the other hand, if both holding and subsidiary are listed entities, question of aggregation does not arise (as explained above).

Another crucial question pertains to the manner of computing amounts for determining materiality. The answer depends on the type of transaction. For example, in case of a subsisting loan, payments of interest or even repayment of loan being reciprocal to the entire transaction of loan, should not be counted for the purpose of material thresholds. However, in case of incremental loans or renewal of loan or extending fresh loans, the entire amount will be required to be considered.

Manner of shareholder approval

Regulations require clubbing of all transactions to be undertaken with a particular related party for determining material RPT. However, the transactions may be of varied kinds – sale, purchase, loan, etc. Should shareholder approval be obtained separately for each kind of transaction? The regulations do not require separate resolutions. However, there is a possibility, that shareholders may be in favour of one transaction but not for others. Hence, the risk is that in case the shareholders intend to turn down one transaction, they will have to vote against the resolution covering several transactions.

Time available for seeking prior approval for material RPTs

Since, the amended provisions mandate prior approval of material RPTs, it is important to ascertain the time within which the listed entity shall approach shareholders, especially for ongoing transactions.

The requirement to seek approval of shareholders for material RPTs was first inserted under Clause 49 (VII) of the equity listing agreement w.e.f. October 1, 2014.  When LODR superseded the listing agreement, reg. 23 (8) of the LODR provided a timeline for seeking shareholder’s approval and mandated (permitted) placing the same in the first general meeting subsequent to notification of LODR. Hence, companies were saved from the hassle of convening an extraordinary general meeting solely for the purpose of reg. 23(4).

As regards the present amendment, there are three possibilities:

  1. Obtain shareholder’s approval at the first general meeting held after the effective date;
  2. Obtain shareholder’s approval prior to the effective date; or
  3. Obtain shareholder’s approval before the threshold of Rs. 1000 crore or 10% of consolidated turnover is actually crossed.

In the first case, one may argue that provisions of reg. 23(8) were only relevant at the time of commencement of the regulations and will not be relevant in case of commencement of further amendments under the said regulation. However, the intent of the provision, in our view, remains in effect that a reasonable time should be made available post enforcement of a provision to be able to approach the shareholders.

In the second case, it may be argued that material RPTs are required to be determined on the basis of the annual consolidated turnover for the immediately preceding financial year. The immediately preceding financial year prior to the effective date is March 31, 2022 and the annual consolidated turnover as on March 31, 2022 will be available only when the financial statements are audited and approved by the Board. However, if 10% of the existing consolidated turnover as on March 31, 2021 was already above Rs. 1000 crores and it is reasonably expected that the situation will continue; in that case, it will be futile to wait for the audited numbers for consolidated turnover of March 31, 2022.

The third case seems most suitable as the provisions mandate prior approval for material RPTs, therefore, listed entities are free to undertake RPTs until the said threshold is breached. However, given the broad definition of RPT, it is not just sufficient to track the RPTs undertaken by the listed entity itself but also the transactions undertaken by the subsidiaries with that particular related party. This tracking may be difficult at a group level and therefore, it is prudent to avoid seeking approval at the last hour.

Information to be placed before shareholders/audit committee

As per SEBI Circular dated November 22, 2021, an array of information is required to be placed before shareholders, including a summary of information provided by the management of the listed entity to the audit committee. All the ongoing contracts which are taken to the shareholders pursuant to the amendments, shall be accompanied by all such information as mandated in the aforesaid SEBI Circular.

Also, if the transactions were not placed before the audit committee earlier, then the same will be first required to be placed before the audit committee, along with the information prescribed in SEBI Circular and approved only by the independent directors in the audit committee, in terms of requirement under the proviso to reg. 23 (2) effective from January 1, 2022.

For discussion on the information requirements, refer our earlier article on the same.

Closing Remarks

The amendments are to be take effect from April, 2022; as such it is possible that the regulator comes up with further clarifications or literature on the amendments. The discussions above have been made keeping in view the framework as it appears today. Needless to say, RPT framework has been constantly evolving. While the intent of law is to reach out to undesirable transactions, there is a simultaneous compliance burden on the companies, which also percolates at the group level.

[1] Regulation 2(1)(zc)(i) includes 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.

[2] See discussions in pgs. 19-20 of Working Group Report on Related Party Transactions