Related Party Transactions India: Section 188 of the Companies Act, 2013

Introduction

In the normal course of business, a company may enter into transactions with people or entities that are closely connected to it, such as its directors, their relatives, holding companies, subsidiaries, associate companies, or businesses in which the directors have an interest. Such transactions are known as related party transactions. They can include buying or selling goods, providing or receiving services, renting property, appointing a person to a position in the company, or entering other business arrangements. These transactions are not prohibited and are often necessary for conducting business efficiently.

However, because the parties involved are connected to the company, there is a possibility that decisions may be influenced in favour of the related party rather than in the best interest of the company. To prevent misuse and ensure fairness, transparency, and accountability, the Companies Act, 2013 has prescribed certain rules for dealing with related party transactions India.

Section 188 of the Companies Act, 2013 specifies the types of transactions that are covered, the approvals that may be required from the Board of Directors or shareholders, and the disclosures that need to be made. These provisions help ensure that related party transactions India are carried out fairly and in the best interests of the company and its stakeholders.

Who Qualifies as a Related Party Under Section 188 of the Companies Act?

Under Section 2(76) of the Companies Act 2013, a related party includes directors and their relatives, Key Managerial Personnel, firms and companies in which directors or managers have an interest, group companies including holding, subsidiary and associate companies, and any person whose instructions the company’s director or manager generally follows.

Related Parties as Defined Under Section 2(76)

The following categories of persons and entities are defined as related parties for the purpose of related party transactions India:

1. A Director or his relative
2. A Key Managerial Personnel (KMP) or his relative
3. A Firm in which a director, manager, or his relative is a partner
4. A Private Company in which a director, manager, or his relative is a member or director
5. A Public Company in which a director or manager is a director and, along with relatives, holds more than 2% of the share capital
6. A Company whose Board follows the instructions of the company’s director or manager
7. A Person whose instructions the company’s director or manager generally follows
8. Group Companies including:
   • Holding, Subsidiary, or Associate Company
   • Fellow Subsidiary
   • Investing Company or Venturer
9. Any other prescribed person

Who Is a Relative Under the Companies Act 2013?

Section 2(77) of the Companies Act 2013 defines “relatives” as

1. Members of the same Hindu Undivided Family (HUF)
2. Husband and Wife
3. A person is considered a relative of another person if he or she is:
   • Father (including stepfather)
   • Mother (including stepmother)
   • Son (including stepson)
   • Son’s wife
   • Daughter
   • Daughter’s husband
   • Brother (including stepbrother)
   • Sister (including stepsister)

What Types of Transactions Are Covered Under Related Party Transactions India?

Section 188 Companies Act covers seven categories of related party transactions India: sale or purchase of goods, disposal or purchase of property, leasing of property, availing or rendering of services, appointment of an agent, appointment to an office or place of profit, and underwriting of securities. Board approval is mandatory before entering any of these transactions.

The law says that a company shall not enter into certain contracts or arrangements with a related party without the prior consent of the Board of Directors. Section 188 does not prohibit a company from entering into transactions with related parties. However, to ensure transparency and prevent conflicts of interest, it requires the company to obtain the necessary approvals before entering into the following specified contracts or arrangements:

1. Sale, purchase, or supply of goods or materials
2. Sale, disposal, or purchase of property of any kind
3. Leasing of property of any kind
4. Availing or rendering of services
5. Appointment of an agent for purchase or sale of goods, materials, services, or property
6. Appointment of a related party to any office or place of profit in the company, its subsidiary, or associate company
7. Underwriting the subscription of any securities or derivatives of the company

Further, the law also requires approval from the shareholders in certain cases. If the value of a related party transaction crosses the limits prescribed under Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014, the company must obtain prior approval of its shareholders by passing an Ordinary Resolution.

In simple terms, while smaller related party transactions can generally be approved by the Board of Directors, larger transactions having a significant financial impact on the company must also be placed before the shareholders for their approval. This ensures greater transparency and provides shareholders with an opportunity to review and approve important transactions involving related parties.

What Are the Shareholder Approval Thresholds for Related Party Transactions India?

Under Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014, shareholder approval by Ordinary Resolution is required for related party transactions India that exceed the prescribed thresholds based on the company’s turnover or net worth as per the previous year’s audited financial statements.

The prior approval of shareholders by way of an Ordinary Resolution is required where a related party transaction under Section 188 Companies Act exceeds the following limits:

The turnover or net worth shall be calculated based on the audited financial statements for the preceding financial year.

What Are the Exceptions to Section 188 Approval Requirements?

Not every related party transaction India requires approval under Section 188 Companies Act. Three categories of transactions are exempt: transactions in the ordinary course of business conducted at arm’s length, transactions between a holding company and its wholly owned subsidiary whose accounts are consolidated, and transactions between two wholly owned subsidiaries of the same holding company.

1. Transactions in the Ordinary Course of Business at Arm’s Length

The provisions of Section 188 do not apply where a transaction is entered into in the ordinary course of business and on an arm’s length basis. An arm’s length transaction means a transaction conducted as if the parties were unrelated, so that there is no conflict of interest and the terms are fair and commercially reasonable.

2. Transactions Between Holding Company and Wholly Owned Subsidiary

Shareholder approval is not required for related party transactions India entered into between a holding company and its wholly owned subsidiary, provided the accounts of the subsidiary are consolidated with the holding company and placed before the shareholders at the general meeting for approval.

3. Transactions Between Two Wholly Owned Subsidiaries

Shareholder approval is also not required for related party transactions India between two wholly owned subsidiaries of the same holding company, provided their accounts are consolidated with the holding company and presented before the shareholders at the general meeting.

Although certain related party transactions may qualify for exemption from the approval requirements under Section 188, many companies continue to place such transactions before the Board of Directors as a matter of good corporate governance and transparency. Obtaining Board approval helps create a proper record of the transaction, confirms that the terms have been reviewed by the directors, and reduces the risk of future disputes regarding the applicability of exemptions. Accordingly, while not always mandatory, seeking Board approval is often considered a good compliance practice, particularly for significant or recurring related party transactions.

What Happens If Related Party Transactions India Are Entered Without Approval?

Section 188 Companies Act provides that a related party transaction entered without the required Board or shareholder approval must be ratified within three months of the transaction date. If not ratified within this period, the transaction becomes voidable at the option of the Board or shareholders, meaning the company may cancel or set aside the transaction entirely.

Section 188 recognises that in certain situations, a related party transaction may be entered into without obtaining the required approval of the Board of Directors or shareholders. In such cases, the transaction must be placed before the Board or shareholders, as applicable, for ratification within three months from the date on which the transaction was entered into.

Consequences of non-ratification

If the transaction is not ratified within the prescribed period of three months, the transaction becomes voidable at the option of the Board of Directors or the shareholders, as the case may be. This means that the company may choose to cancel or set aside the transaction.

What Are the Penalties for Contravention of Related Party Transaction Rules in India?

Non-compliance with Section 188 Companies Act attracts monetary penalties on the concerned director or employee. The penalty is Rs. 25 lakh for violations in a listed company and Rs. 5 lakh for violations in any other company. These penalties apply regardless of the value of the transaction involved.

The Companies Act, 2013 imposes monetary penalties on directors and employees who enter into or authorise a related party transaction without obtaining the approval required under Section 188. In case of a violation:

• Listed Company: The concerned director or employee is liable to a penalty of Rs. 25 lakh
• Any Other Company: The concerned director or employee is liable to a penalty of Rs. 5 lakh

These penalties are intended to ensure that related party transactions India are undertaken transparently and in the best interests of the company.

Conclusion

Related party transactions India are a normal part of doing business and are often necessary for the efficient operation of a company. However, because these transactions involve people who may have a close connection with the company, there is always a possibility of a conflict of interest.

Section 188 of the Companies Act, 2013 does not prohibit companies from entering into transactions with related parties. Instead, it seeks to ensure that such transactions are carried out in a fair, transparent, and accountable manner. By obtaining the required approvals, maintaining proper documentation, and ensuring that transactions are conducted on reasonable terms, companies can avoid regulatory issues and protect the interests of all stakeholders.

In simple terms, whenever a company proposes to enter into a related party transaction India, it should first check three important things:

• Who is the related party?
• What is the nature of the transaction?
• What approvals are required?

A careful review of these aspects can help the company remain compliant and avoid unnecessary penalties and disputes in the future. Corporate Legit Consulting LLP assists companies in reviewing, structuring, and documenting related party transactions India to ensure full compliance with Section 188 Companies Act and the applicable Rules. Reach out to Corporate Legit for advisory on related party compliance.