Related Party Transactions

Introduction

A business is an organized entity, or enterprising activity where individuals work together to produce and sell goods or provide services to customers. Simply put, a business is any entity whose primary goal is to generate profit through the channel of buying and selling. In the business world, these businesses usually work with anyone who can generate large amounts of profits for them. However, they always tend to prioritize people they are family with or have an existing profitable relationship, and these deals are often known as Related Party Transactions.

For the purpose of a clearer understanding, a Related Party Transaction can be defined as any transaction for the purpose of the transfer of resources, services or obligations between a company and a “related party,” regardless of a change in price. Unlike in normal business transactions, here the parties involved have a relationship prior to the transaction. A good example is a company buying supplies from a director’s private firm, instead of from a totally different company that produces the same materials. Related Party transactions are more or less like trusting the people around you to deliver adequately on transactions which outsiders could have delivered.

It should be noted that while these deals are very common, especially in the Asian business spaces, they carry a large risk of tunnelling. Tunnelling can be defined as moving value out of a company to benefit insiders at the expense of the overall growth of the company. Moving back to the first example, when the director’s firm is not up to standard, but is being patronized because of the position the owner wields at the expense of the company’s growth or development, that is tunnelling.

Moving further, Related Party Transactions are not indiscriminate or unrelated terms, but are organized legal foundations in business transactions. This simply means that, they comprise of laws and statutes that guide the relations of these businesses, in order to ensure transparency and protect minority shareholders, when the majority refuses to act in the best interest of the company.

Who is a “Related Party”?

Any individual or entity that has a close connection to a business, typically because they can control or significantly influence its financial and operating decisions is a related party. According to the Standard business and accounting guidelines (like IAS 24), related parties generally fall into three categories, and they include; individuals with influence, close family members and connected entities.

Individuals with influence are simply the people who own or run a big part of the company. They are the key management personnels, significant shareholders and senior executives. These people are seen as related parties because they either own a share of the company or are a vital proponent of the company’s development.

The second category is the close family members. Family members are an important part of any person’s life and that applies same to business. However, the family members highlighted in this category are those who could benefit from the business relationship, such as the spouse, children and in some jurisdictions, even the parents and siblings.

The third and final category are the connected entities. Connected entities can basically be defined as other businesses that are part of the same “tree.” In simple terms, they are businesses owned by the same person, and can include, subsidiaries, parent companies, etc. They are related because they either fall in the same line of business and can provide the necessary supplies or because they have one owner.

The Legal Framework: Rules of Related Party Transactions

As earlier mentioned, there are rules guiding Related Party Transactions (RPTs), and these rules differ from country to country, thus the creation of certain general international frameworks to guide usage. It should be noted that the legal frameworks discussed below, is a combination of national laws, international standards and stock exchange rules, designed to protect interests in commercial transactions.

First, the International Accounting Standards (IAS 24). This can be seen as the benchmark for RPTs. Its major objective is to ensure that a company’s financial statements may have been affected by related party dealings. Meaning that, it looks at the economic substance of a relationship and not just its legal structure, which makes it very effective.

Another key framework is corporate law and governance. Corporate law and governance actually refer to the internal structures that are set up by the various countries to control RPTs internally. They include certain rules, such as; Board approval, shareholder approval, etc. A good example of this is the Companies and Allied Matters Act (CAMA) 2020 in Nigeria and the Companies Act in India. 

Next is the “Arm’s Length” Principle. This is a widely accepted principle in Related Party Transactions, which proposes that parties should transact as if they were independent entities. It is of the opinion that business deals must reflect the market value to prevent tunnelling.

Further, stock exchange and security rules. In the stock exchange market, there are certain rules that guide business transactions, and these rules also cover the sphere of RPTs. They provide for fair dealings in the stock market and protect parties from indiscriminate loss.

The Approval & Disclosure Process

Beyond just legal rules, Related Party Transactions follow strict processes to ensure that no party or shareholder is disadvantaged. Before these transactions take place, they must usually go through multiple levels of review, the review processes include; Audit committee review (this is simply having an independent set of directors review the RPTs first, before any decision is taken), this is closely followed by the Board of directors approval (this is the process where the entire board votes on whether or not to go on with the RPT, and members who have personal interests are to rescue themselves from voting), next is the shareholder approval (this is mostly when the transactions exceed certain financial thresholds, the a vote by unrelated shareholders may be required), finally, for routine transactions, the Audit Committee may grant a single Omnibus approval for the entire year, to save time.

Once the RPT has been approved, it is important for it to be made transparent to the public, through financial statement notes and consolidated reporting. They must be made on time and management compensation must be disclosed as well.

Challenges And Impact on Governance

In addition to all these, it is worthy to note that RPTs present a unique challenge to corporate governance, as they can be used to either enhance or exploit a company’s resources. Some of the challenges faced include; valuation complexity. This is because determining the fair market price for unique assets is subjective, thus giving room for terms to be easily manipulated internally. Next, conflict of interests. Key decision makers may prioritize family benefits over company development, thus leading to tunnelling and loss of company resources. And finally, identification and detection. Undisclosed transactions may be difficult to identify, especially in multi-layered or family-run businesses, making it easier for insiders to hide these deals and avoid scrutiny.

Beyond just challenges, the way a business handles its RPTs would impact the strength of its governance system. This is because RPTs serve as a medium to showcase board effectiveness, shareholder confidence and even promote financial integrity within the company. Moving back to the first example, if the director’s firm decides to swindle or add inappropriate terms to the transaction, through effective approval process, it would show that the board is not only effective but it is interested in the protection of minority interests.

Conclusion

In conclusion, an effective Related Party Transaction (RPT) framework is the foundation of investor confidence and board effectiveness. This is because, it not only enhances reliability, but provides a platform, where corporate governance is developed. Aside from this, proper monitoring can ensure effective use of company resources and prevent tunnelling to resources, enhancing development. Thus, as Indian Companies go global, it is important for them to follow these rules for sustainable growth and a fair market.

References

Legislation

1. Companies Act 2013 (India)

2. Companies and Allied Matters Act (CAMA) 2020 (Nigeria)

3. International Accounting Standards (IAS 24)

4. Indian Accounting Standard (Ind AS) 24, Rules 2015

Books

5. Cambridge: The Law and Finance of Related Party Transactions (Edited by Luca Enriques and Tobias H. Troger, Cambridge University Press, 2019)

6. Reinier Kraakman et al, The Anatomy of Corporate Law: A Comparative and Functional Approach (2nd edn, Oxford University Press, 2009)

Reports & Official Sources

7. Related Party Transactions, ‘A review of the Regulation, Governance and Auditing Literature’ https://www.emerald.com 

8. Study.com, ‘Related-Party Transactions | Definitions, Examples and Disclosures’ https://study.com