Related Party Transactions (RPT) are an integral part of the corporate world today. In the early stages of corporate history, RPTs were illegal and could not even be approved or ratified by unanimous shareholder resolutions. Due to practical difficulties faced by companies, at the beginning of the 20th century RPTs were permitted initially with the Boards approval, later with Boards approval and disclosure to shareholders in annual accounts, and finally with shareholders’ approval and disclosures in annual accounts.
RPTs are in the spotlight due to their propensity to be misused by the promoters/executive management in signing personally favourable deals with the company. Given this concern, the Board, especially independent directors, and corporate professionals who are entrusted with upholding good corporate governance have an ethical role to perform, which goes beyond the law. This article seeks to provide these custodians of governance five questions they should answer before approving RPTs.
- Is the RPT a transaction undertaken in the normal course of business?
The primary concern regarding RPTs is in the fairness of contracts to ensure that the related party does not gain at the cost of the other shareholders who are not in the decision making role. The commercial fairness of RPTs in the normal course of business is easy to judge as the related party is treated on par with unrelated parties. Typical examples are consumer products or consumer durables sold to related party at the published price list and volume discounts that are available to other buyers. Likewise, in purchase or employment contracts, multiple vendors or employees would provide benchmark for the price /salary paid.
- If the RPT is not in normal course of business, are there other comparable transactions in the company or in the industry to benchmark?
While transactions related to sales, purchase and employee contracts can be considered as in the normal course of business, purchase, lease and rental of capital goods, and borrowings from or lending to related party pose a challenge in deciding if the terms are fair and the related party is not getting an undue benefit due to their position. In these cases, identifying comparable transactions in the company or the industry between unrelated parties can provide the best benchmark, which need to be documented as the proof of due diligence and exercise of mind in approving the RPT.
- If the RPT is neither in the normal course of business, nor are there comparable transactions in the company or industry to be used as benchmark, is the transaction fairly priced?
If the transaction is neither in the normal course of business nor has a comparable benchmark, the onus on the decision makers is to assess the profitability of the transaction and ensure that unreasonable profits do not accrue to the related party. Further, in providing their approval for RPT, this assessment of profitability needs to be documented for future reference.
- Are RPTs used as an exception in the conduct of business or are RPTs used as the first resort?
A critical factor in approving the RPT is the frequency with which they occur in the company, especially when they fall in the category examined in Question 3 above. Higher the frequency of RPTs, more stringent would be the norms used for fairness with the benefit of doubt given to the company. As in justice, good corporate governance is not just to be ensured, but it also must be seen to be in place.
- Are adequate disclosures made to the shareholders of the company for them to judge the fairness of the transaction?
Despite the care governance custodians exercise, fairness is only an opinion, not a fact. So the ultimate judge of fairness are shareholders, who are the ultimate owners of the company. Hence the custodians of governance must ensure that adequate information is provided to the shareholders to judge for themselves.