Disclosure of Interest and Related Party Transactions

Three occasions, and they are the answer to MU's label "Declaration by the Directors". On joining, annually, and on any change.

Note that it includes the shareholding. It is not a bare statement of which boards he sits on.

The specific declaration: section 184(2)

Every director who is in any way, whether directly or indirectly, concerned or interested in a contract or arrangement, or a proposed contract or arrangement, entered into or to be entered into:

• (a) with a body corporate in which such director, or such director in association with any other director, holds more than two per cent shareholding of that body corporate, or is a promoter, manager or Chief Executive Officer of that body corporate; or
• (b) with a firm or other entity in which such director is a partner, owner or member,

shall disclose the nature of his concern or interest at the meeting of the Board in which the contract or arrangement is discussed, and shall not participate in such meeting.

Two obligations, and the second is the important one. He must disclose, and he must not participate. Not merely not vote: not participate.

The thresholds. Under clause (a), more than two per cent shareholding, which may be held by the director in association with any other director, or any of three offices: promoter, manager or Chief Executive Officer. Under clause (b), being a partner, owner or member of a firm or other entity, with no percentage at all.

The proviso: an interest acquired later. A director not interested when the contract was entered into must, if he becomes interested afterwards, disclose forthwith when he becomes so concerned or interested, or at the first Board meeting held after that.

The consequence of not disclosing: section 184(3)

A contract or arrangement entered into by the company without disclosure under sub-section (2), or with participation by a director who is concerned or interested in any way, directly or indirectly, in the contract or arrangement, shall be voidable at the option of the company.

Voidable at the option of the company, not void. So the company may keep a bargain that turned out well and set aside one that did not. Note the two triggers: no disclosure, or participation by an interested director even if he did disclose.

Section 184(4): the penalty. A director contravening sub-section (1) or (2) is liable to a penalty of one lakh rupees.

And the office goes. Under section 167(1)(c) and (d) a director who acts in contravention of section 184, or fails to disclose his interest in contravention of it, vacates his office. That is a far heavier consequence than the penalty, and it is the point to make in an answer.

Section 184(5): two savings.

• (a) nothing in the section prejudices any rule of law restricting a director from having any concern or interest in any contract with the company; and
• (b) the section does not apply to a contract between two companies, or between one or more companies and one or more bodies corporate, where the directors of one, singly or two or more together, hold not more than two per cent of the paid-up share capital in the other.

Clause (b) is the de minimis rule. A director with a trivial holding in the counterparty does not have to withdraw.

Who is a related party: section 2(76)

"Related party", with reference to a company, means:

• (i) a director or his relative;
• (ii) a key managerial personnel or his relative;
• (iii) a firm in which a director, manager or his relative is a partner;
• (iv) a private company in which a director or manager or his relative is a member or director;
• (v) a public company in which a director or manager is a director and holds, along with his relatives, more than two per cent of its paid-up share capital;
• (vi) any body corporate whose Board, managing director or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager;
• (vii) any person on whose advice, directions or instructions a director or manager is accustomed to act,

with a proviso that sub-clauses (vi) and (vii) do not apply to advice, directions or instructions given in a professional capacity, and further clauses covering holding, subsidiary and associate companies and other prescribed persons.

Note the symmetry of (vi) and (vii). One catches the body the director controls; the other catches the person who controls the director.

And note the difference between (iv) and (v). A private company needs only membership or a directorship, with no percentage. A public company needs a directorship and more than two per cent held with relatives.

Related party transactions: section 188(1)

Except with the consent of the Board given by a resolution at a meeting of the Board, and subject to such conditions as may be prescribed, no company shall enter into any contract or arrangement with a related party with respect to:

• (a) sale, purchase or supply of any goods or materials;
• (b) selling or otherwise disposing of, or buying, property of any kind;
• (c) leasing of property of any kind;
• (d) availing or rendering of any services;
• (e) appointment of any agent for purchase or sale of goods, materials, services or property;
• (f) such related party's appointment to any office or place of profit in the company, its subsidiary company or associate company; and
• (g) underwriting the subscription of any securities or derivatives thereof, of the company.

Seven transactions, and they should be learned as a list.

The four provisos

First: members' approval for larger companies and transactions. No such contract shall be entered into, in the case of a company having a paid-up share capital of not less than such amount, or transactions exceeding such sums, as may be prescribed, except with the prior approval of the company by a resolution.

Second: the related party may not vote. No member shall vote on such resolution to approve any contract or arrangement which may be entered into by the company, if such member is a related party.

Third: the closely held exception. The second proviso does not apply to a company in which ninety per cent or more members, in number, are relatives of promoters or are related parties. In such a company nobody would be left to vote.

Fourth: ordinary course and arm's length. Nothing in this sub-section shall apply to any transactions entered into by the company in its ordinary course of business other than transactions which are not on an arm's length basis.

Read that double negative carefully, because it is the most misread sentence in the section. The section does not apply to a transaction that is both in the ordinary course of business and on an arm's length basis. If either is missing, section 188 applies.

Fifth: wholly owned subsidiaries. The requirement of a members' resolution under the first proviso does not apply to transactions between a holding company and its wholly owned subsidiary whose accounts are consolidated with the holding company and placed before the shareholders at the general meeting for approval.

The two Explanations

"Office or place of profit" means an office where a director holding it receives from the company anything over and above the remuneration to which he is entitled as director, by way of salary, fee, commission, perquisites, rent-free accommodation or otherwise; or where an office held by any other individual, firm, private company or body corporate carries any such receipt at all.

Note the difference. For a director it is remuneration beyond his director's remuneration; for anybody else it is any remuneration.

"Arm's length transaction" means a transaction between two related parties that is conducted as if they were unrelated, so that there is no conflict of interest.

Reporting, undoing and recovering: section 188(2), (3) and (4)

Section 188(2). Every such contract shall be referred to in the Board's report to the shareholders along with the justification for entering into it. This is what section 134(3)(h) requires from the other side.

Section 188(3): ratification, or the contract falls. Where a contract is entered into by a director or any other employee without the Board's consent or the members' approval, and is not ratified by the Board or the shareholders within three months of the date it was entered into, it shall be voidable at the option of the Board or of the shareholders; and if the contract is with a related party to any director, or is authorised by any other director, the directors concerned shall indemnify the company against any loss.

Three months is the window, and the indemnity is personal.

Section 188(4). Without prejudice to sub-section (3), it is open to the company to proceed against a director or any other employee who entered into such a contract in contravention for recovery of any loss sustained.

Section 188(5) provides the punishment: for a listed company, a penalty of twenty-five lakh rupees on the director or employee in default, and for any other company five lakh rupees.

And a conviction under section 188 is a disqualification. Under section 164(1)(g) a person convicted of the offence dealing with related party transactions under section 188 at any time during the last preceding five years is not eligible for appointment as a director.

The register: section 189

Section 189(1). Every company shall keep one or more registers giving separately the particulars of all contracts or arrangements to which section 184(2) or section 188 applies, in the prescribed manner and particulars; and after the particulars are entered, the register shall be placed before the next meeting of the Board and signed by all the directors present at the meeting.

Section 189(2). Every director or key managerial personnel shall, within thirty days of his appointment or relinquishment of office, disclose to the company the particulars specified in section 184(1) relating to his concern or interest in the other associations required to be included in the register, or such other information relating to himself as may be prescribed.

Section 189(3). The register shall be kept at the registered office, open for inspection during business hours, extracts may be taken, and copies shall be furnished to any member to such extent, in such manner and on payment of such fees as may be prescribed.

Section 189(4). The register shall also be produced at the commencement of every annual general meeting and remain open and accessible during the meeting to any person having the right to attend.

Section 189(5): two exclusions from sub-section (1).

• (a) a contract for the sale, purchase or supply of any goods, materials or services where the value does not exceed five lakh rupees in the aggregate in any year; and
• (b) a contract by a banking company for the collection of bills in the ordinary course of its business.

Section 189(6): the penalty. Every director who fails to comply is liable to a penalty of twenty-five thousand rupees.

Contracts of employment: section 190

Every company shall keep at its registered office a copy of the contract of service with a managing or whole-time director where it is in writing, or a written memorandum setting out its terms where it is not; and those copies shall be open to inspection by any member without payment of fee. The section does not apply to a private company.

A worked example

Mr Naik is a director of Ratnagiri Foods Limited. He is also a partner in Naik and Sons, a firm, and holds three per cent of Konkan Packaging Limited, a public company of which he is also a director.

The annual declaration. At the first Board meeting he attended as a director, and at the first meeting of every financial year since, he must disclose his concern or interest, including his shareholding, in all those bodies: section 184(1). If his interests change, he must disclose again at the first Board meeting after the change.

A particular contract. The Board considers buying packaging from Konkan Packaging. He holds more than two per cent of it and is a director of it, so section 184(2)(a) applies. He must disclose the nature of his concern or interest at that meeting, and must not participate in it.

If he stays and speaks. The contract is voidable at the option of the company under section 184(3), even if he disclosed, because there was participation by an interested director. He is liable to a penalty of one lakh rupees under section 184(4), and under section 167(1)(c) his office becomes vacant.

Is it also a related party transaction? Konkan Packaging is a public company in which a director is a director and holds, with his relatives, more than two per cent of its paid-up share capital, so it is a related party under section 2(76)(v). The transaction is a purchase of goods, within section 188(1)(a).

So section 188 applies too, unless the transaction is both in the ordinary course of business and on an arm's length basis. Ratnagiri Foods buys packaging every week at market rates, so it is in the ordinary course, and if the price and terms are as they would be between strangers it is at arm's length. Both being satisfied, section 188 does not apply by the fourth proviso.

Change the facts. Suppose the price is thirty per cent above market. It is no longer at arm's length, so section 188 applies: Board consent by resolution at a meeting is required, and if the company's paid-up capital or the transaction size crosses the prescribed limits, prior approval of the members by resolution. On that resolution Mr Naik, being a related party member, may not vote: second proviso.

Naik and Sons. A separate contract is proposed with the firm in which he is a partner. Section 184(2)(b) applies with no percentage threshold, and the firm is a related party under section 2(76)(iii).

An office of profit. The Board proposes to appoint Mr Naik's son as a consultant to the company at eighteen lakh rupees a year. He is a relative of a director, so a related party under section 2(76)(i), and the appointment is to an office or place of profit within section 188(1)(f). Because he is not a director, any remuneration makes it an office of profit under Explanation (a)(ii).

No approval is taken. The contract is entered into anyway. If it is not ratified by the Board or the shareholders within three months, it is voidable at the option of the Board or the shareholders, and because it is with a related party of a director, the directors concerned must indemnify the company against any loss: section 188(3). The company may also proceed against them to recover its loss: section 188(4).

The register. All these contracts go into the register under section 189(1), which is then placed before the next Board meeting and signed by all the directors present. It is kept at the registered office, open for inspection during business hours with copies to members on payment of fees, and produced at the annual general meeting, open to any person entitled to attend.

One that does not. A contract to buy stationery worth three lakh rupees in the year is outside the register, because section 189(5)(a) excludes goods, materials or services not exceeding five lakh rupees in the aggregate in any year. Note that it is excluded from the register, not from sections 184 and 188.

And the Board's report must refer to every section 188 contract with the justification for entering into it: section 188(2), matching section 134(3)(h).

Distinctions that carry marks

What this does NOT mean

It does not mean disclosure alone is enough under section 184(2). He must also not participate in that meeting, and participation makes the contract voidable even where he disclosed.

It does not mean every related party transaction needs members' approval. Board consent by resolution is the general rule; members' prior approval is required only for prescribed companies or transaction sizes.

It does not mean an ordinary course transaction is always outside section 188. It must be in the ordinary course and on an arm's length basis. Either one alone will not do.

It does not mean the section 189(5) exclusion removes the transaction from the Act. It excludes it from the register, not from sections 184 and 188.

Quick revision

• 184(1): disclose concern or interest, including shareholding, at the first meeting he attends, at the first meeting of every financial year, and at the first meeting after any change.
• 184(2): disclose the nature of his interest at the meeting where the contract is discussed and do not participate, where the counterparty is a body corporate in which he, alone or with another director, holds more than two per cent or is promoter, manager or CEO, or a firm or entity in which he is a partner, owner or member. Proviso: an interest acquired later must be disclosed forthwith or at the first Board meeting after.
• 184(3): breach makes the contract voidable at the company's option. 184(4): penalty one lakh rupees. 184(5): existing rules of law preserved, and a holding of not more than two per cent in the counterparty is outside the section. Section 167(1)(c) and (d): the office is vacated.
• 2(76): director or relative; KMP or relative; a firm where a director, manager or relative is a partner; a private company where any of them is a member or director; a public company where a director or manager is a director holding with relatives more than two per cent; a body corporate accustomed to act on his directions; and a person on whose directions he is accustomed to act, professional advice excepted.
• 188(1), seven transactions: sale, purchase or supply of goods; buying or disposing of property; leasing; availing or rendering services; appointing an agent; appointment to an office or place of profit; and underwriting the company's securities.
• Provisos: members' prior approval by resolution for prescribed companies or sums; a related party member may not vote; that does not apply where ninety per cent or more members in number are relatives of promoters or related parties; the sub-section does not apply to transactions in the ordinary course of business that are on an arm's length basis; and the members' resolution is not needed for a holding company and its wholly owned subsidiary whose accounts are consolidated and laid before the shareholders.
• 188(2), (3), (4), (5): referred to in the Board's report with the justification; unratified within three months means voidable, with the directors concerned indemnifying the company; the company may recover its loss; penalty twenty-five lakh rupees listed, five lakh rupees otherwise.
• 189: a register of all section 184(2) and section 188 contracts, placed before the next Board meeting and signed by all directors present; directors and KMP disclose within thirty days of appointment or relinquishment; kept at the registered office, open to inspection, copies to members on fees, produced at the AGM to any person entitled to attend; excluding goods, materials or services not exceeding five lakh rupees a year and a banking company's bill collection; penalty twenty-five thousand rupees.
• 190: a copy of the service contract of a managing or whole-time director, or a memorandum of its terms, kept at the registered office, open to any member without fee; not applicable to a private company.

Test yourself

1. When must a director make a general disclosure of his interests? At the first meeting of the Board in which he participates as a director, thereafter at the first meeting of the Board in every financial year, and, whenever there is a change in the disclosures already made, at the first Board meeting held after the change: section 184(1). The disclosure includes his shareholding.

2. What must an interested director do when the contract comes up, and what if he does not? He must disclose the nature of his concern or interest at the meeting in which the contract is discussed and shall not participate in that meeting: section 184(2). Failure to disclose, or participation by an interested director, makes the contract voidable at the option of the company (section 184(3)), attracts a penalty of one lakh rupees (section 184(4)), and vacates his office under section 167(1)(c) and (d).

3. Name the seven transactions in section 188(1). Sale, purchase or supply of goods or materials; selling, disposing of or buying property; leasing of property; availing or rendering services; appointing an agent for purchase or sale of goods, materials, services or property; the related party's appointment to any office or place of profit in the company, its subsidiary or associate; and underwriting the subscription of the company's securities or derivatives.

4. When does section 188 not apply to a transaction in the ordinary course of business? The fourth proviso excludes transactions entered into in the ordinary course of business other than transactions which are not on an arm's length basis. So the exclusion operates only where the transaction is both in the ordinary course and at arm's length; if either is missing, section 188 applies.

5. What happens to a related party contract entered into without approval? If it is not ratified by the Board or by the shareholders within three months of the date it was entered into, it is voidable at the option of the Board or of the shareholders; and where the contract is with a related party to any director, or authorised by any other director, the directors concerned shall indemnify the company against any loss: section 188(3). The company may also proceed against them to recover its loss: section 188(4).

6. Which contracts are excluded from the register under section 189? A contract for the sale, purchase or supply of goods, materials or services where the value does not exceed five lakh rupees in the aggregate in any year, and a contract by a banking company for the collection of bills in the ordinary course of its business: section 189(5).