Thanks to Bollywood, we all know what "Nepotism" means. But Bollywood’s not the only industry that suffers from nepotism. It can have a huge impact on business deals, and SEBI knows that very well.
Just recently, it has warned Vedanta for going ahead with a related party transaction worth Rs. 1,407 crores with Hindustan Zinc Limited, a subsidiary of the Vedanta Group, without the approval of the company's audit committee.
But what are related party transactions and why do they need to be pre-approved and regulated?
Well, related party transactions are how nepotism is exercised in businesses. A related party transaction is any transaction with, you guessed it, a related party. The Companies Act has a long definition for it: but in essence, it could be a subsidiary, other companies where the promoters have an important position or a company in which a director or their relatives are partners.
Basically, all the powerful people of the company and their connections are put under the scanner. Their transactions with the company are separately dissected to spot any foul play.
Wait, foul play? What's wrong with conducting business with the people you know? Why will there be foul play?
Well, it's because sometimes these business deals may not benefit the company but rather only the related parties, and so it will be harmful to its shareholders. Yet at other times, while everyone benefits from the deal the government may lose out on taxes.
How?
Say there is a company, Company A and it has a subsidiary, Company B. Now, A orders raw materials from B and pays a price that is higher than normal. While the move is good for B, it is not so good for A and its shareholders, as the company's profits will decline.
To prevent such situations and losses, approvals around related parties were put in place.
But shouldn't companies be allowed to conduct business on their own terms? Well, these strict regulations were formed after one of India's biggest scams was unearthed in 2009.
Yes. We are talking about the Satyam scam which was worth Rs. 7,000 crores.
The misdoings at Satyam came to light after shareholders disapproved of the IT company buying a real estate firm Maytas. What was wrong with Maytas?
It was run by the family of Satyam Chairman Ramalinga Raju. The company wanted to acquire Maytas because it had been cooking its books, painting a fake picture of how much money it was earning. The acquisition would fill some of the gaps in the books and keep the company in business for a longer period of time.
But since the company's investors protested so vehemently against the decision, Satyam decided not to go ahead with it, and soon its founders had to reveal all the scams they had been doing.
Seeing how risky related party transactions could be, the SEBI (for listed companies) and the Ministry of Corporate Affairs (for all companies) had introduced and tightened many laws.
But once again the companies found creative ways to indulge in newer varieties of Related Party Transactions. As per a study conducted by the CFA Society of India on a select basket of companies, the related party purchases had increased at a CAGR of 14% from ~Rs. 41,400 crores (12.6%) in FY14, to Rs. 79,700 crores (17.6%) by FY18.
For example, Suzuki, the parent company of Maruti, had been charging the company very high royalties back in the 2000s. Royalties grew by 6.6 times from 2000 to 2015, and Maruti was paying ₹ 21,415 per vehicle sold in India. These payments accounted for 5.7% of Maruti's net sales and 36% of profits before tax and royalty in 2014-15. This obviously did not sit right with the investors, as it affected Maruti's ability to pay dividends to them.
Yet the company could go through with the transactions because the laws weren’t as strict. But finally, SEBI is catching up. It has introduced new rules that will be applicable from April 2022.
Now, all promoters, irrespective of the stake they hold, will be considered related parties. Any related party transaction that involves a considerable amount, will now need to be approved by shareholders.
There are more such new and improved rules to ensure that the ones who have power don’t exploit the companies for their own needs.
But will these rules be enough?
Only time will tell…
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