Two Sides of Related Party Transactions- A Big jigsaw puzzle?

#Related Party Transaction or Jigsaw Puzzle Game for Corporate usually played around in compliance with statutory requirement but skeptically remains a big Corporate Governance issue. The RPT transactions are always discouraged by financial institutions and banks due to threat of diversion of funds. There appears to be no uniformity in prudential norms of Financing and the RPT compliances of various sections given here under and therefore one of the reasons to check and keep control over assessment of working capital and other cash flow of company/ business entity becomes complex in compliance for Bank’s/FI’s.

For instance, when an advance is disbursed in the form of overdraft/cash credit and the account remains out of order for more than 90 days. An overdraft/ cash credit account is considered to be out of order when the outstanding balance remains continuously in excess of the sanctioned limit/drawing power. Usually while calculating drawing power (hereinafter referred to as “DP”) the receivables for sales or invoices raised on associates/sister concerns (In other words Related Party or entity) shall be excluded to arrive at actual Drawing Power. It means financial institutions or Banks generally do not encourage to finance transactions of sale or purchase or, otherwise any service related transactions like job work, where the chances of limits assigned to borrower appears to be more in the nature of diversion/siphoning of funds.

So, in a nutshell, on one side the FI’s/Banks are not comfortable in financing such Related Party transactions and block their sanctioned limits, whereas on the other side the borrower takes the shelter of making compliances of related provisions applicable under various statutes and uses judiciously the route of such compliances and enters into the transactions which may have an impact of blocking funds or diversion of funds.

The following are the few stipulations of Banks’s negative covenants while sanctioning various limits to borrower;

  • The drawing power in the accounts would be arrived at after deducting the unpaid creditors, outstanding balance, if any. In case of book debts, no drawings would be allowed against book debts on sister concerns and also those which are more than 90 days old although total book debts would be charged to Bank as security;
  • The company/firm shall not, without prior permission of bank’s/FI’s in writing, effect any investment by way of share capital in or lend or advance funds to or place deposits with any other Company/concern (including group companies/ associates) /persons. Normal trade credit or security deposit in the normal course of business or advance to employees can however be extended.
  • The company/firm shall not, without prior permission of bank’s/FI’s in writing, effect to undertake any guarantee obligations on behalf of any other Company/person.

Contrary to that, the various statutes as stated below permit such Related Party Transactions after stated Compliances therein, to list a few;

  • The relevant section for compliance of an RPT transaction is section 188 of The Companies Act 2013 wherein Related party is defined under section 2(76) of CA, 2013.
  • IAS-124 related to Related Party Transactions.
  • AS-18 Disclosure of Related Party Transactions.
  • Regulation-23 of SEBI (LOADR) Regulations 2015 for compliance of Related Party Transactions.
  • Rule 3(4) of GST Valuation Rules defines about Related Party Transaction Valuation.
  • Section 92 of Income Tax Act deals with Transfer pricing where RPT are of domestic or international nature.

As seen above, it can be concluded that if the entity is complying with various statutes then apparently in the view of Law, the entity is fully compliant with various laws and can enter into transactions which are not permitted or encouraged by FI’s/Banks. Invariably, there shall be uniformity in all such compliances so as to curb, at least to some extent the diversion or misuse of funds of the Banks.

Even Section 186 of Companies Act, 2013 permits investment of the funds of the company with certain approval routes, however, the banks outright mandates the borrower to take prior approval before such investment as there is apprehension that funds which are given by Bank/s have a chance to divert as funds are given for meeting working capital expenses and borrower makes investment/s in Sister Concern/Associate Concern/Subsidiary or wholly owned subsidiary which in a way disturb the cash flow of borrower and hampers the routine liquidity and working capital of the borrower and therefore while calculating net owned funds of the Borrower usually such kinds of Investments in related party entities are deducted by the Bank to arrive at Net Adjusted Owned funds.

Another instance is Section 180 of Companies Act, 2013 where the entity/borrower needs to take the approval of members to borrow funds in excess of its paid up capital and free reserves, but once the resolution is passed and submitted to the Bank, on paper it appears to be compliance. However, if one looks closely, if such entity has issued some Corporate Guarantee on behalf of some borrowings by its associate/sister/subsidiary company in compliance with provisions of Section 185 read with 186 of the Companies Act 2013, the same appears to be compliance, nevertheless such Corporate Guarantees need prior approval of the Bank’s/FI’s before the same are given/issued for the reason that Banks are not comfortable if the Borrower’s financials are not satisfactory or financials are under observation or leverage is not available. Some Banks even consider such Corporate Guarantee as Indirect Debt and while appraising borrower under Credit Monitoring Analysis, treat such Corporate Guarantee as risk and treat under overall liabilities of the borrower and deduct the same to arrive at Net Worth of the Borrower, to the extent of amount of Corporate Guarantee is offered. Ironically, Section 180 has no reference of such Corporate Guarantee which is in the nature of Debt and therefore it remains silent which is a risky proposition.

Last but not the least, Insolvency and Bankruptcy Code, 2016 also discourages such types of Related Party Transactions since of late, newly introduced section 29A of IBC, 2016 makes Related Parties (Section 2(24) and 2(24A)) outright ineligible as parties to either submit resolution plan (with exception to MSME) or to bid to e-auction in case asset sale under liquidation process. Apart from that Section 43 of IBC Code also states about implication of preferential transactions with related parties during the resolution process or under liquidation.

To summarise the aforementioned, the author views that there should be uniformity which must prevail in lending norms vis a vis compliance with various statutes, otherwise the public or investors, whose money is invested either with Bank or in Borrower’s entity are always at high risk either due to such kind of mis-match in maintaining financial and Law Compliance discipline or due to nondisclosure of certain facts which even an experienced professional may miss to observe much less something an ordinary investor can investigate, identify and consecutively decide to take informed decision on to invest. The uniformity in financial and various statute’s compliance along with stricture disclosure and control compliance may be the only solution to prevent the diversion of funds or siphoning off funds of public money.

Disclaimer:‐ we express no opinion on any other issue. These views are solely in respect of the general practice and the applicable laws of India as in effect on the date hereof and as they presently apply to the facts as they presently exist. The views/opinion expressed hereinabove are our own views which neither form any judgment nor verdict.

Author: Mr. Sandip Sheth and Mr. Prashant Prajapati, Partners of M/s. Sandip Sheth & Associates, a Peer reviewed firm of Company Secretaries in whole time practice based at Ahmedabad, Gujarat.

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