Companies Act 2013 & The New Clause 49

Impact On Board Governance And Related Party Transactions & The Road Ahead

The Companies Act, 2013 ("2013 Act") paves the way for a sea change in theway in which India Inc. functions and will look like going forward. After much deliberation, the 2013 Act, was gradually notified starting with the first set of notifications arriving on 29 August 2013. With effect from 1 April 2014, the Central Government has notified 282 sections in total and most rules.1 A major part of the 2013 Act is to be governed by the rules.1

This article highlights significant changes in the board constitution, procedures, and discuss aspects of related party transactions under the 2013 Act read with applicable rules as compared with the Companies Act, 1956 ("1956 Act") and in light of the Securities and Exchange Board of India circular dated 17 April 2014 (CIR/CFD/POLICY CELL/2014) ("SEBI Corporate Governance Circular") which has been issued to align the provisions of listing agreement in line with the changes suggested by the 2013 Act to adopt best practices on corporate governance. The article also provides an indicative list of immediate steps to comply with the 2013 Act and the SEBI Corporate Governance Circular has revised clause 49 and clause 35B of the listing agreement. Revised clause 49 will be applicable to all listed companies with effect from 1 October 2014.

What Is New In Board Composition?

An effective board requires its members to bring to the board a blend of experience, integrity and independence. The 2013 Act has endeavoured to achieve that by codifying the concept of an independent director, woman director and resident director.

Changes In Operations Of The Board Meetings

1) Number of Board Meetings

At least 4 meetings required every year with an interval between 2 meetings not exceeding 120 days. Earlier, the requirement was that 1 meeting to be conducted every quarter.

2) Matters to be considered only at the Board Meeting

The 1956 Act provided (Section 292) few matters which were required to be passed at a board meeting. Section 179 of the 2013 Act has added many matters to this list. By way of example, issue of any securities; give guarantee or security in respect of loans; approve amalgamation, merger or reconstruction; appoint or remove key managerial personnel; appoint internal auditors and secretarial auditor; invite or accept or renew public deposits and related matters; etc.3 This move will ensure participation and awareness of the directors on the board.

3) Participation by audio-visual means and video conferencing

The 2013 Act has recognised the importance of technology in the board process and provides that participation by video conferencing or audio-visual means is considered for constituting the quorum. However, matters in relation to approval of the annual financial statements, Board's report, prospectus; audit Committee meetings for consideration of accounts and approval of the matter relating to amalgamation, merger, demerger, acquisition and takeover cannot be dealt with in such meeting.4

4) Restriction on Board's Power

There are some matters which cannot be implemented by the board of directors without approval by general meeting such as selling undertaking(s) of the company, borrowing money, investing otherwise in trust securities and remitting or giving time for repayment of debt due from a director.5 The 1956 Act required only an ordinary resolution for such matters. However, now a special resolution is mandatory under the 2013 Act. Further, private companies were exempted from this requirement. The 2013 Act now covers all companies whether it be private or public companies. This ensures participation by a larger body of members before any key decision is taken vis-à-vis the company.

5) Notice of Board Meeting6

• The 1956 Act did not provide for notice period for board meetings; however, to ensure participation by directors in board meetings, the 2013 Act requires at least 7 days notice.
• Meeting can be called at shorter notice provided at least 1 independent director is present at such meeting.
• In case, there is no independent director or if he is absent, the meeting can still be called at shorter notice, provided the resolution passed in such meeting will need to be circulated to all directors and will be final if ratified at the next meeting.
• Notice for board meeting has to be sent to all directors (whether in India or outside India) as compared to the 1956 Act, which provided that notices be sent only to registered address in India.

Related Party Transactions (RPT)

Under the 2013 Act

The 2013 Act has made the following key changes in the definition of 'related party' and 'related party transactions':7

• Expanded the scope of related parties.8 This results in covering those persons also who are not under direct control of the related party;
• Related parties include persons who are 'accustomed to act'. However, the term has not been defined. The person who is alleged to be a related party will not be one unless it is proved with the help of evidence and by demonstrating facts that he is accustomed to act;9
• Inclusion of 'associate company' will again result in proving a factual situation by adducing evidences whether the alleged related party exercises significant influence over another i.e. whether it has control over business decisions of the other person as there is no set principle given to adjudge what constitutes control over business decisions;10
• Expanded the scope of RPTs. 11 These RPTs have thresholds e.g. sale, purchase or supply of any goods or materials directly or through appointment of agents exceeding or not exceeding 25% of the annual turnover. Similarly, other RPTs have certain thresholds. These thresholds govern their approval requirements;
• Earlier, Central Government approval was required for certain RPT transactions. This route is removed and RPTs have been made a part of the indoor management of the company by either passing a board or special resolution;
• Class of relatives for purposes of RPTs has been restricted to 2nd generation relatives (with the exception of children’s spouses) unlike 1956 Act which would even cover 3rd generation;
• Interested directors and/or shareholders are not allowed to vote. This would require closely held companies to increase their board strength and membership.

These changes will require careful scrutiny by related parties of their past transactions and they may have to accordingly disclose their interest in any such contract or arrangement with the company in order to avoid penalties going forward.

Approval Mechanism Under The 2013 Act

Under the SEBI Corporate Governance Circular

• A related party transaction is a transfer of resources, services or obligations between a company and a related party, regardless of whether a price is charged. As evident from the above definition, the scope of related party transactions has been widened far more than in the case of unlisted companies. Further, the exemption in relation to transactions entered in the ordinary course of business and at arm’s length (under section 188 of the 2013 Act) is not available under the SEBI Corporate Governance Circular.
• A ‘related party’ is a person or entity that is related to the company. Parties are considered to be related if one party has the ability to control the other party or exercise significant influence over the other party, directly or indirectly, in making financial and/or operating decisions and includes the following:

  1. A person or a close member of that person's family is related to a company if that person:
  

  1. is a related party under section 2(76) of the Companies Act, 2013;or
  

  2. has control or joint control or significant influence over the company; or
  

  3. is a key management personnel of the company or of a parent of the company; or
  

  2. An entity is related to a company if any of the following conditions applies:
  

  1. The entity is a related party under Section 2(76) of the Companies Act, 2013; or
  

  2. The entity and the company are members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others); or
  

  3. One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member); or
  

  4. Both entities are joint ventures of the same third party; or
  

  5. One entity is a joint venture of a third entity and the other entity is an associate of the third entity; or
  

  6. The entity is a post-employment benefit plan for the benefit of employees of either the company or an entity related to the company. If the company is itself such a plan, the sponsoring employers are also related to the company; or
  

  7. The entity is controlled or jointly controlled by a person identified in (1).
  

  8. A person identified in (1)(b) has significant influence over the entity (or of a parent of the entity); or
  

• This shows clearly that the related party transactions for listed entities are kept under tighter scrutiny.

Approval Mechanism under the SEBI Corporate Governance Circular

Under the SEBI Corporate Governance Circular

• Unlike the 2013 Act, there are no grounds for exemption but materiality of the transaction determines whether special resolution is required or not.
• All existing material related party contracts or arrangements as on 17 April 2014, which are likely to continue beyond 31 March 2015 are required to be placed for approval of the shareholders in the first General Meeting subsequent to 1 October 2014. However, a company may choose to get such contracts approved by the shareholders even before 1 October 2014. This would require companies to revisit their existing transactions to determine their materiality and whether it is a related party transaction and accordingly convene shareholders meeting for their approval, if needed.
• Further, for all prospective transactions, special resolution will be required if the test of materiality and related party/relater party transactions meets.

Some Immediate Steps

Whether exemption for RPT is workable?

S. 188 of the 2013 Act provides that in case of transactions entered into by the company in its ordinary course of business other than transactions which are not on an arm's length basis, the requirement of obtaining board or special resolution is not applicable.

The term 'arm's length' means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest. Second, the term 'ordinary course of business' is not defined under the 2013 Act. Both of these terms do not set out certain parameters to arrive at what is an arm's length transaction or what is a transaction entered in the ordinary course of business. Jurisprudence shows that in order to determine whether a transaction falls within 'ordinary course of business' or not, the transaction must demonstrate uniformity of dealings and a certain degree of routine in business practice.12 This places the onus on the board to decide what could be exempted unless clear principles are set out.

And as discussed above, this exemption is not available in case of listed companies under the SEBI Corporate Governance Circular.

Conclusion

The changes introduced by the 2013 Act have aimed at bringing transparency in the board. Inclusion of woman directors would ensure gender equality and independent directors would ensure independence of the board and protect minority shareholders. Putting more checks on RPTs would make sure that funds of the company are used primarily for the business of the company and not to advance the personal interests of controlling shareholders. Similarly, the SEBI Corporate Governance Circular would ensure better and efficient accountability in case of listed companies to ensure that interests of public shareholders are not undermined. A greater scrutiny of related party transactions will also secure their interests. More is likely to unfold during the course of implementation!

Footnote:
1 For sections and rules which have been notified, please visit http://mca.gov.in/MinistryV2/companiesact.html (last visited on 30 April 2014). For the rules which have been gazetted, please visit http://www.egazette.nic.in/ 2 Financial thresholds are to be computed as per last audited balance sheet. 3 Section 279 of the 2013 Act read with Rule 8 of the Companies (Meetings of Board and its Powers) Rules, 2014. 4 Section 174 of the 2013 Act read with Rule 4 of the Companies (Meetings of Board and its Powers) Rules, 2014; 5 Section 180 of the 2013 Act and section 293 of the 1956 Act; 6 Section 173 (3) of the 2013 Act; 7 Under the 1956 Act, related party transactions were covered under section 297. 8 Section 2(76) of the 2013 Act read with Rule 2(e) of the Companies (Meetings of Board and its Powers) Rules, 2014; 9 In Re: Swastik Textile Mills Ltd. and In Re: Phaltan Sugar Works Ltd., (1983) 85 BOMLR 244; 10 As per section 2(6) of the 2013 Act, "associate company", in relation to another company, means a company in which that other company has a significant influence, but which is not a subsidiary company of the company having such influence and includes a joint venture company. Explanation.-For the purposes of this clause, "significant influence" means control of at least twenty per cent. of total share capital, or of business decisions under an agreement; 11 Section 188 of the 2013 Act read with Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014; 12 Kalapnath Singh v/s Surajpal Singh And Ors., AIR 1949 All 425; 13 However not amending the Articles of Association is likely to affect the contractual rights under the existing arrangement.

Disclaimer - The information provided in the article is intended for informational purposes only and does not constitute legal opinion or advice. Readers are requested to seek formal legal advice prior to acting upon any of the information provided herein.