Globally RPT is an area of concern. If the board or audit committees do not adequately scrutinize related party transactions, there’s a higher risk for misuse. Complex corporate structures with numerous subsidiaries or affiliates can obscure related party transactions, making them harder to detect and monitor. Sometimes, cultural attitudes towards governance or a lack of rigorous corporate governance can lead to an environment where related party transactions are not critically evaluated for fairness or necessity. Like SEBI, in the U.S., the Public Company Accounting Oversight Board (PCAOB) and the Securities and Exchange Commission (SEC) have stringent rules regarding related party transactions. These transactions must be disclosed in financial statements to ensure transparency. The UK’s Financial Conduct Authority (FCA) and the London Stock Exchange have rules to govern related party transactions, particularly for listed companies.
The Securities and Exchange Board of India (SEBI) has undertaken research on listed firms’ financial practices, including the payment of royalties to Related parties.
SEBI performed the analysis on 233 listed businesses from various industries in India. During the 10-year period from FY 2013-14 to FY 2022-23, these corporations paid royalties to their RPs totalling less than 5% of turnover. During the period under study, there were 1538 occurrences of royalty payments. This includes 185 instances of royalty payments by 63 firms which incurred net losses.
Seventy Nine firms continuously paid royalties to their RPs during the course of the study’s ten-year period, with eleven companies paying royalties in excess of 20% of their net revenues. Royalty payment transactions have generated question on financial sustainability of these organisations, as well as its impact on shareholder value, because hefty royalty payments may create stress on net earnings.
In the case of eighteen firms, the rise in royalty payments surpassed both sales and net profits throughout the period. According to the study, royalties paid by firms have no association with sales or profitability. Companies frequently make considerable amounts of payments for brand usage, while investing much on advertising, brand promotion, and creating/adding value to the parent brand. Cash inflows to RPs (other than royalty or brand payments) are sometimes referred to as ‘Management fees’, ‘Technology licence fees’, etc. Such payments do not fall under the purview of royalties from a regulatory standpoint and the magnitude of such payments can be uncomfortably high.
SEBI’s monitoring of related party transactions is intended to ensure openness and fairness in interactions between firms and their connected entities. RPT transactions and monitoring are essential to prevent the misuse of corporate resources, which might harm the company’s profitability and investor interests.
In addition to SEBI LODR definition of Related Party under Reg 2(zb), RPTs have been defined under various regulations such as Companies Act – Section 2(76), Ind AS on Related Party Disclosures – Para 9 of Ind AS 24. The term “connected person” is also defined under SEBI (Prohibition of Insider Trading) Regulations, 2015 – Reg 2(1)(d).
Presently RPT Disclosure are provided under Schedule III of the Companies Act, Ind AS 24/ AS 18, SEBI LODR – Reg 23(9) etc and approval process for RPTs is also governed by multiple laws and regulations i.e. under Section 188 of the Companies Act , under SEBI LODR – Reg 23(2), 23(3) and 23(4). SEC Regulations and the UK Listing Rules defines the term related persons and provides for disclosure requirements basis materiality thresholds.
Listed entities may face practical difficulties in identification of the related party transactions between their subsidiaries and other parties. Further, the requirement on taking prior approval of shareholders imposes practical challenges for the companies, as they will now need to identify and plan the RPTs during a period and take approval from shareholders before entering such transactions. They need to hold additional meetings (EGMs) to get approvals of shareholders for new transactions, that are essential and fall in the ambit of related parties.
The interpretation of the transactions, “the purpose and effect of which is to benefit a related party” appears too subjective, with possibility of varying interpretations. This leads to lack of uniformity and substantive compliance.
One of the solution can be an option for annual omnibus approval by shareholders, instead of prior approval (similar to the option of omnibus approval available to the Audit Committees) subject to identified governance parameters assessed by the Audit Committees and Board beforehand.
Globally RPT is an area of concern. If the board or audit committees do not adequately scrutinize related party transactions, there’s a higher risk for misuse. Complex corporate structures with numerous subsidiaries or affiliates can obscure related party transactions, making them harder to detect and monitor. Sometimes, cultural attitudes towards governance or a lack of rigorous corporate governance can lead to an environment where related party transactions are not critically evaluated for fairness or necessity. Like SEBI, in the U.S., the Public Company Accounting Oversight Board (PCAOB) and the Securities and Exchange Commission (SEC) have stringent rules regarding related party transactions. These transactions must be disclosed in financial statements to ensure transparency. The UK’s Financial Conduct Authority (FCA) and the London Stock Exchange have rules to govern related party transactions, particularly for listed companies.
SEBI’s concerns are legitimate in a way as in the past by misusing related party transactions, companies have attempted to circumvent debt covenants, tax laws, or other financial regulations. It has been used as a conduit for fraudulent activities like embezzlement or asset misappropriation. Directors or executives might engage in transactions that benefit themselves or their affiliates more than the company or its shareholders. RP’s may receive goods, services, or financial benefits on more favorable terms than would be available under market conditions, which can be detrimental to the company’s financial health.
Finding of the study may be used for creating a suitable structure for protecting minority shareholders without impacting the sprit of clean and legitimate business transaction.
Galactik Views