Section 188 Related Party Transactions: A Complete Compliance Guide

Must Know Related Party Transaction Rules Under Section 188 of the Companies Act

Ask a company secretary what makes board meetings long, and compliance with related party transactions is often one of the entries on the list. That is, until a normal transaction with a promoter’s relative or a group company gets flagged and everyone is forced to check whether Section 188 was applicable in the first place. This is where the real importance of this issue comes in.

Definition of Related Party

A related party is defined under Section 2(76) of the Companies Act, 2013, as a director or key managerial personnel and their relatives; a firm in which a director or manager is a partner; or a private company in which a director or manager is a member or director.

A public company in which a director or manager is a member or director holding shares along with their relatives; holding subsidiary and associate companies; and any person on whose advice or instructions a director is accustomed to act. excluding purely professional advice. It is a pretty broad net, and businesses often don't realize it includes situations other than the obvious family member cases.

Transactions to which Section 188 Applies

There is no limitation on the type of transaction in section 188. It has a predetermined list of transactions with related parties, including:

1. The sale, purchase, or provision of goods or materials
2. Sale or purchase of property of any kind
3. Leasing out of property
4. Providing or using services.
5. Appointment of a related party to any office or place of profit in the company, its subsidiary or associate
6. The appointment of an agent to purchase or sell goods, materials, services, or property
7. Subscription to the company’s securities or derivatives underwriting.

Transactions with a related party have to be approved by the board and, depending on the value thresholds, require shareholder approval.

Governing Law

The core provision is Section 188 of the Companies Act, 2013, read with Rule 15 of the Companies (Meetings of Board and its Powers) Rules, 2014. For listed companies, there's an additional layer under Regulation 23 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, which brings its own definitions and thresholds into play.

Section 188 vs. LODR: Where the Two Actually Differ

1. Where the Two Differ:

2. Section 188 vs. LODR 

That is where a lot of the confusion comes in, especially for public companies that are trying to run both frameworks at the same time. Section 188 applies to all companies, whether listed or not, and is based on the Companies Act definition of related parties. LODR Regulation 23, however, is applicable only to listed entities and is far-reaching and applies to entities that are part of the promoter group or have a certain shareholding even if they are not covered by the Companies Act definition. Also, the approval mechanisms are different. Section 188 requires board approval for all related party transactions and provides that shareholder approval is required only if the specified monetary thresholds are exceeded.

LODR, in contrast, mandates prior approval of the audit committee for all related party transactions of a listed entity and shareholder approval through an ordinary resolution once a transaction is classified as material based on the prescribed turnover-linked threshold. A transaction that comfortably clears Companies Act thresholds can still need audit committee sign-off purely because LODR applies a stricter yardstick.

The following are the prerequisites to achieve this correctly:

Before engaging in any related party dealings, certain things need to be in place:

1. A related party register is maintained in Form MBP-4 and updated as and when relationships change.
2. A director who has an interest in a resolution is excluded from voting on it and must disclose his interest at board meetings.
3. The entities listed are required to obtain the approval of the audit committee before the completion of the transaction and not after.
4. Documentation showing the transaction is arm’s length and in the ordinary course of business, if the exemption is being invoked
5. The disclosure of details in Form AOC-2 is in the board’s report.

Penalties for Getting It Wrong

Failure to comply is not a minor administrative error that can be quietly fixed later on. Where companies are listed, any director or employee who authorizes or enters into a related party transaction in violation of Section 188(5) may be sentenced to up to one year's imprisonment, or fined an amount between twenty-five thousand and five lakh rupees, or both.

In the case of unlisted companies, the penalty is limited to a fine. Moreover, a contract concluded without the necessary approval from the board or the shareholders is voidable at the board's option, and if not ratified within three months, the concerned director may be required to indemnify the company for any losses that result.

Exemptions Worth Knowing

Transactions that are carried out in the normal course of business and on an arm's length basis are exempt from the need for shareholder approval under Section 188, although it is still necessary to have proper board oversight and to adequately document the arm's length nature of the transactions. One of the more common ways in which companies end up on the wrong side of a compliance review is to rely on this exemption without having a sound justification.

The compliance concerning related party transactions lies at the point where company law and securities regulation meet, and if there is an error in its classification, the approval procedure or the disclosures made, penalties or disputes from shareholders could result later on.

Corpzo provides companies with advice on how to properly structure related party transactions in accordance with both Section 188 and SEBI LODR, on dealing with the documentation required by the board and the audit committee, on making the AOC-2 disclosures, and on providing an arm's length justification, thereby ensuring that businesses remain compliant without having to second-guess each transaction involving a connected party.