April 26, 2023

What is Related Party Transaction - Policy & Companies Act

It is customary for organisations to conduct business with their personal and professional networks. These close associates may be substantial shareholders, subsidiaries or minority-owned businesses. A related-party transaction is a deal or preparation between two parties with a previous business connection or a mutual interest.

Companies commonly form profitable partnerships with people they know or share a common interest. Though related-party transactions are legal in and of themselves, they can create conflicts of interest or other illegal conditions. Companies that are freely traded are required to declare these transactions.

Who is a related party?

The term "related parties" refer to the companies or individuals that the company is affiliated with for a commercial transaction.

According to the Indian Accounting Standards (AS-18), two entities are considered connected "where one party can control or significantly influence the other in making financial or operating decisions in a specific reporting period."

The Companies Act, 2013 of India, defines related parties as:

Directors or key management personnel of the organisation or their family
- Any partnership, corporation or other groups of individuals in which a director, manager or family is a partner or director.
- Any legal entity whose Board of Directors, managing director, or management is used to acting on a director's or manager's advice, directives or instructions.
- Any company that is:
- a) A corporation's holding, subsidiary, or associate company
- b) A subsidiary of a holding company that is also a subsidiary of the corporation
- Any person who is not an employee of the company but has a material financial transaction or arrangement with the company, or its promoters, directors, or manager, totalling ten per cent or more of the company's or such person's gross turnover or total income or fifty crore rupees, whichever is less, in the previous financial year.

The definition of connected parties under the Companies Act is comprehensive and includes a wide range of entities and individuals. Businesses must identify and disclose all related party transactions to ensure transparency and accountability.

Meaning of related party transaction

Any business transaction, arrangement, or relationship involving two parties with a pre-existing connection, association or mutual interest is referred to as a related party transaction. These parties could include family members, relatives, individuals or companies with joint directors, or entities with significant influence or control over each other.

Examples of related party transactions:

A company buying goods or services from a supplier owned by a relative of one of the company's directors. Here are some examples of related party transactions:
- A company leases the property from a related party, such as a director or shareholder.
- A company provides a loan to a related party, such as a director or an affiliated company.
- A company enters into a joint venture or partnership with a related party, such as a subsidiary or a company in which a director has an interest.
- A company hires a consultant or service provider who is also a relative of one of the company's directors.
- A company sells assets to a related party, such as a subsidiary or a company in which a director has an interest.
- A company provides guarantees or collateral for loans taken by a related party, such as a subsidiary or an affiliated company.

Which regulation covers related parties?

SEBI Clause 49 also contains a few regulatory requirements for linked-party transactions. According to this definition, a transaction involving related parties involves the transfer of resources, services or obligations.

In comparison to the 2013 Companies Act, its scope is broader. It includes members of the directors' or primary managerial personnel's immediate families and any private company.

Over which the directors' or critical managerial personnel's relatives have significant control or influence.

Every material-related party transaction requires shareholder approval via a special resolution, and all related parties are prohibited from casting votes on such solutions.

Related-Party trade example

One example of a related party transaction in real life is Amazon's purchase of Whole Foods Market. Amazon, a multinational technology company, acquired Entire Foods Marketplace, a hypermarket chain that focuses on natural and organic foods. John Mackey, the CEO of Whole Foods, owned approximately 1.3 million company shares, making him one of the largest individual shareholders.

The acquisition was valued at $13.7 billion, and Amazon agreed to pay $42 per share for Whole Foods' outstanding common stock. As part of the transaction, Whole Foods agreed to pay Amazon a $13.7 million termination fee if it entered into another agreement to be acquired by a third party.

The purchase of Whole Foods by Amazon was considered a related party transaction. John Mackey, the CEO of Whole Foods, was a significant shareholder and stood to benefit financially from the acquisition.

However, the transaction was approved by the board of directors and met the legal and regulatory requirements for related party transactions. The acquisition enabled Amazon to expand its presence in the retail industry and leverage Whole Foods' expertise in the grocery business.

In an example from India, Adani Enterprises was accused in a report by US-based research firm Hidenberg Research of engaging in related party deals through a series of asset transfers to a private Singapore-based company controlled by Vinod Adani, Dubai-based older brother of Adani Group chairman Gautam Adani.

Conclusion

In conclusion, related party transactions are an essential aspect of business operations that involve two parties with pre-existing relationships conducting transactions with each other. While such transactions can provide advantages, such as improved efficiency and reduced costs, they also risk conflicts of interest and potential violations of laws and regulations.

As such, businesses must maintain transparency and implement appropriate safeguards to mitigate these risks. Understanding related party transactions and their potential impact on a business are essential for stakeholders, including investors, auditors, and regulators, to certify that the transactions are conducted ethically and in compliance with relevant laws and guidelines.

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