[The following post is contributed by Vinod Kothari and Shampita Das of Vinod Kothari & Co. They can be contacted at firstname.lastname@example.org and email@example.com respectively]
The Ministry of Corporate Affairs (MCA) drives what corporate India will do, or will not do, or will do with rudders and rigours, under the new Companies Act 2013. It was the 30th of the Circulars issued under the new law on 17 July 2014, only a few months after the new law has partly been brought into force. As the rigidities and absurdities of the law come to the fore, the MCA continues to come out with circulars to moderate and tone down the law, but often, the language is ambiguous, leaving corporate India looking for yet more clarifications to the clarifications. Sadly enough, if the classic rule of interpretation has been that the Parliament knew what it wanted to write, now the clue is – the MCA knew what the Parliament wanted to write.
MCA’s General Circular No 30/2014 sought to give clarity to the majority of the minority rule pertaining to related party transactions (RPTs) incorporated in section 188 of the Act. While the circular might have wanted to say that only such related party as is involved in the contract or transaction in question will be denied the right to vote in the meeting, it says so in such misty language. Sadly enough, now is the AGM season in the country – most companies have either obtained or are in the process of obtaining general meeting approvals for RPTs.
The Majority of minority rule in RPTs
Now-a-days abusive RPTs have become a common term used to signify the tactics adopted by majority shareholders, who in turn are related to the company, to divert the funds of the company. Thus, what rightfully should be used for enhancing the wealth of the shareholders gets diverted to benefit a handful of shareholders controlling majority of the decisions of the company.
To curb such abusive RPTs, the concept of the “majority of the minority” rule was introduced. Under this principle, RPTs would be deemed to be approved if a majority of the outstanding disinterested shareholders i.e. shareholders of the company who are not related party to the company, accent to such transaction. This principle is applied to ensure that the related party shareholders of the company are not misusing their position to benefit themselves at the cost of the minority shareholders.
Countries around the would have framed their policies in a restrictive manner so as to curb such abusive RPTs. Some precedents that are followed around the world are provided below:
Clause 314 of NYSE Listed Company Manual considers the Audit Committee as an appropriate forum to review the related party transaction. The Exchange also reviews proxy statements and other SEC filings, disclosing RPTs and where such situations continue year after year, the Exchange after evaluation also determines whether such RPTs should be permitted to continue.
Under Regulation S-K of U.S. Securities Law, Item 404 requires public companies to disclose transaction involving amount of more than USD 1,20,000/- in which the related person is or has had direct or indirect material interest.
Financial Reporting Standard-8 require companies to make adequate disclosures in their financial statements to draw attention to the possibility that the reported financial position and results may have been affected by the existence of related parties and by material transactions with them. Further, under the Companies Act, 2006, members’ approval is required for any transaction with the director or if the director is connected in such transaction.
Rule 14A of Listing Rules of the exchange in Hong Kong requires companies to take prior approval of shareholders in case of connected transactions. Any connected person with material interest shall not be permitted to vote at the meeting on the resolution approving the transaction. The manual further requires that the Independent Board Committee of the company should appoint a financial adviser to advise the company’s shareholders about whether the terms of the connected party transactions are fair and reasonable and in the interest of the company and the shareholders as a whole.
The Singapore Exchange Listing Manual requires only disinterested shareholders to vote on any transaction involving interested person. “Interested Person” has been defined to mean a director, CEO or controlling shareholder and an associate of any of these.
The Bursa Malaysia Listing Requirements lay down provisions similar to Hong Kong. Rule 10.08 requires disclosure in case of a related party transaction to the Exchange where the value of the consideration is less than RM 2,50,000 or is a recurrent related party transaction, where the percentage ratio is 0.25% or more. Where any one of the percentage ratios of a related party is 25% or more the company must appoint a Principal Adviser to ensure that such transaction is carried out on fair and reasonable terms and conditions and not to the detriment of the minority shareholders. The stated Requirement debar any interested director from taking part in board deliberations and abstain from voting on such related party transactions. Further, any interested director or major shareholder must ensure that connected persons abstain from voting on such related party resolutions in the general meeting.
Section 208 read with section 224 of the Corporations Act, 2001 of the Commonwealth of Australia provides that at a voting at general meetings on related party transactions, related parties of the public company to whom the resolution would permit a financial benefit must refrain from voting on such resolutions. However the Australian Securities & Investment Commission (ASIC) has the power to make a declaration for the purposes of section 224, allowing a related party or an associate of a related party to vote, if they are satisfied that it will not cause unfair prejudice to the interests of any member of the company.
Majority of minority rule under Section 188
Taking cue from various jurisdictions from around the world, the Companies Act, 2013 also provided for approval of RPTs through the majority of the minority rule. However the language of the section was such that, instead of disallowing the concerned or interested related party(s) to the resolution to vote, it implied that no related party of the company would vote on resolutions approving such RPTs. The second proviso to Section 188 has been reproduced below:
Provided further that no member of the company shall vote on such special resolution, to approve any contract or arrangement which may be entered into by the company, if such member is a related party;”
The phrase “such member is a related party” indicated that only members who were not related to the company could vote on such resolution while all related parties would refrain from voting in the general meeting, creating confusion on various grounds.
For instance, if 70% of the shareholding of a company was held by related parties, then only the remaining 30% could have voted on a RPT resolution. Now, if out of the 30% shareholding, 20% was held by single shareholder, the company would be at the mercy of such a shareholder for passing of the resolution. Even if the remaining 10% shareholders vote for the resolution, the resolution would still fail for want of a special majority. This would not give a true sense of the opinion of the shareholders.
Circular of 17 July
The MCA’s clarification Circular, in MCA’s usual way, tries to clear out the fog from the apparent construction of the meaning abovementioned second proviso to Section 188 of the Act.
The Circular states: “Thus, the term 'related party' in the above context refers only to such related party as may be a related party in the context of the contract or arrangement for which the said special resolution is being passed.”
It would be hard to know the meaning of “related party in the context of the contract or arrangement”. There is nothing called “related party to a contract”. Sec 2 (76) defines related party with reference to a company – the concept of related party to a particular contract is nowhere envisaged by the law. In addition, the concept of “related parties” anyways intertwines all entities which are related to the company. If A is related to company X, and B is related to company X, A and B automatically have a common economic interest – that is, Company X. The company is the cluster of common interests of all related parties.
The intent of the Circular seems clear, but not the language, confounded by such expressions as “such related party as may be a related party”. “Such related party as may be a related party” sums up into nothing. Also, no one can easily figure out what is “related party……in context of the contract”. For example, there is a contract with X’s subsidiary, can X’s holding company take a stance that the holding company is not a “related party” in context of the contract? Was it not much easy to write what the writer might have meant – “the related party with whom the contract or arrangement is proposed”, etc?
Clause 49(VII) of the Listing Agreement
Now coming to the provision of the Listing Agreement in this regard. Para VII (E) to Clause 49 of the Listing Agreement provides that ‘All material Related Party Transactions shall require approval of the shareholders through special resolution and the related parties shall abstain from voting on such resolutions.’
The language of the Listing Agreement is a bit clearer than its counterpart. It provides that ‘the related parties’ shall not vote on RPT resolutions giving an implication that only the related party(ies) to such resolutions shall not vote on the matter.
Majority of minority rule diluted
Taking the advantage of the Circular, companies may completely dilute the majority of the minority rule by contracting with such related parties as have minimal shareholding in the company.
Let us understand this by way of an example: 70% of the shareholding of a company X is held by 3 related parties to X, viz. A, B and C in the proportion of 50%, 10% and 10%, respectively. Further X ltd. frequently enters into transactions with A. In light of the Circular, apart from A, all the other shareholders of the company i.e. rest 50% can vote on such RPTs. Since the 20% shareholding of B and C would not be sufficient to pass the resolution, X ltd. may resort to diluting the shareholding of A to B and C so that X ltd. has the certainty of requisite majority to pass such RPTs without depending on the votes of the minority shareholders.
If the idea was to moderate the law, it would have been much simpler to think of an amendment. Several leading commentators are strongly advocating for a rewrite of the law including Mr. Omkar Goswami who is noted economist of the country. He correctly points out that the piece-meal ratifications and clarifications as brought out by the MCA will not serve the purpose of fostering a positive corporate environment. The law is flawed on numerous grounds to correct it by these numerous modifications and clarifications. Moreover the MCA cannot keep up with the role the Parliament and make amendments and modifications in the law of the law on its whims and fancies.