[Hrishikesh is a student at Jindal Global Law School.]
Section 188 of the Companies Act 2013 and Rule 15 of the Companies (Meetings of Board and its Powers) 2014 regulate related party transactions (RPT) by unlisted companies. RPTs by listed companies, however, are regulated by the Securities and Exchange Board of India (SEBI) through the SEBI (LODR) Regulations 2015 (LODR Regulations).
Regulation 2(zc) of the LODR Regulations inter alia provides that from 1 April 2023, a transaction involving transfer of resources or services between a listed entity or any of its subsidiaries on the one hand, and any other unrelated individual or entity on the other hand, the purpose and effect of which is to benefit a related party of the listed entity or its subsidiaries, shall be considered to be an RPT. The purpose and effect test, as provided under the above-mentioned provision, brings about a considerable change in the current regulatory scenario. As is evident from the SEBI Working Group report (WG Report), this provision appears to be inspired from the UK’s Premium Listing Rules (Listing Rules). This article aims to critically analyze the purpose and effect test and the impact it would have on transactions entered into by listed entities with independent / unrelated third parties.
WG Report: Understanding SEBI's Intent behind the Purpose and Effect Test
The WG Report lays down the intention of SEBI behind introducing the purpose and effect test under Regulation 2(zc) of the LODR Regulations. The WG Report took into consideration some of the recent issues with regards to RPTs; it observed a troubling commonality in major corporate RPT scandals. Shell companies and unrelated companies were reportedly being used to siphon off large sums of money through complex transactional structures, thus avoiding the framework of RPT as provided under the LODR Regulations. The WG Report further provided certain scenarios such as the use of complex transactional structuring, transactions entered into by a listed entity with an unrelated party in order to directly / indirectly benefit related parties and also loans being provided by listed entities to unrelated parties, which in turn forwards the same amount as a loan to a related party to the listed entity.
Concerned by the complicated nature / web of transactions entered into by listed entities to avoid the regulatory framework for RPTs under the LODR Regulations, the WG Report scrutinized the definition of RPT under Regulation 2(zc) of the LODR Regulations with the intention of making it water-tight. It thus recommended widening the scope of the definition of RPT to include transactions undertaken by a listed entity with an unrelated third party the “purpose and effect” of which is to benefit a related entity. The WG Report further cited provisions from other jurisdictions such as the UK wherein a similar provision exists. Rule 11.1.5 (3) of the Listing Rules also includes transactions / arrangements by a listed entity with an unrelated individual / entity the purpose and effect of which is to benefit a related entity within the ambit of RPT. However, the WG Report has overlooked an important exception in the above-mentioned UK provision which is discussed later in the article.
The SEBI board note further states that including transactions of listed entities with unrelated parties the purpose and effect of which is to benefit a related entity within the ambit of RPT is desirable. The note further states that it is important to consider the substance / essence of transactions rather than mere legal form.
Purpose and Effect Test: Complex Structures vis-à-vis Ordinary Transactions
The intention of SEBI behind introducing the purpose and effect test within the definition of RPT under Regulation 2(zc) of the LODR Regulations becomes clear when referring to the WG Report and the board note as discussed previously. However, here, it has to be evaluated whether the purpose and effect test specifically addresses the issue of listed companies using complex structures to escape regulatory framework for RPT under the LODR Regulations.
A plain reading of the test would lead to transactions in the ordinary course of business to be declared as RPTs. If the test is interpreted and applied as it is, any and every transaction, in the ordinary course of business, with a third party which directly or indirectly benefits a related party would be declared as an RPT. This would jeopardize scores of transactions a listed entity would have entered into with unrelated parties to synergize business operations. For instance, a listed entity which has entered into a transaction with an unrelated construction entity regarding the construction of a production unit for its entire group, which would also include its associate and subsidiary companies, for synergizing its business operations would be jeopardized as, under the plain reading of the purpose and effect test, it would fall within the ambit of Regulation 2(zc) of the LODR Regulations because the purpose and effect of the transaction benefits the related parties of the listed entity. However, it is a transaction entered in the ordinary course of business, that is, for synergizing business operations. Thus, a plain / literal reading of the test would lead to incongruity.
Endangering Well Negotiated Group Transactions
Listed entities are usually part of a larger business conglomerate wherein it has a multitude of subsidiary and associate companies. It is a common practice for these companies to undertake negotiations with independent third-parties on behalf of the group companies for getting access to raw-materials, large properties, contracts, etc. This is done so as to ensure that the group companies get access to the concerned commodity at a well-negotiated price. This clearly differs from a scenario wherein a listed entity re-routes funds to a related party through an unrelated entity. Therefore, a plain interpretation of the purpose and effect test would jeopardise transactions collectively negotiated by the listed entity for the benefit of its group companies.
Rule 11.1.5 A of the Listing Rules: A Provision Overlooked by the WG Report
While Rule 11.1.5(3) of the Listing Rules does approve of the purpose and effect test, it also has an exception which has been overlooked by the WG Report. It specifies that any transaction / arrangement, other than a transaction in the ‘ordinary course of business’, between a listed company and any other unrelated entity the purpose and effect of which is to benefit a related party, shall fall within the definition of RPT.
While Rule 11.1.5(3) carves out the above exception, Rule 11.1.5A lays down the criteria to determine whether a transaction is in the ordinary course of business or not. The provision provides that when determining whether a transaction falls within the ordinary course of business or not, the Financial Conduct Authority, the financial regulatory body of the UK, shall look into the size and the incidence of the transaction, and it shall also scrutinize the terms and conditions of the transaction to locate anything unusual. While the WG Report was quick to identify the purpose and effect test incorporated under Rule 11.1.5 of the Listing Rules, it failed to identify the key exception provided under the provision to transactions in the normal course of business and also the bright-line provided to determine whether a transaction is in the normal course of business or not under Rule 11.1.5 A.
Conclusion
In Prakash Gupta v. SEBI, the Supreme Court of India observed that it should refrain from substituting its own wisdom over SEBI’s actions. The same was reiterated by the apex court in Vishal Tiwari v. Union of India and Others. Building upon the observation laid down in the former, the Supreme Court of India laid down the principle that courts cannot act as advisors to regulatory bodies on policy matters which they are entitled to formulate. Thus, the apex court will not digress from the interpretation of the purpose and effect test imparted by the WG Report.
The purpose and effect test was introduced to address innovative structures used by listed entities to circumvent LODR regulations pertaining to RPTs and not transactions in the normal course of business. Thus, introducing an exception for transactions in the ordinary course of business akin to the Listing Rules and laying down a bright-line test to determine whether a transaction is in the ordinary course of business would be in the best interest of listed companies.