Date:04/01/2009 URL: http://www.thehindubusinessline.com/bline/iw/2009/01/04/stories/2009010450771400.htm

Back Even companies have ‘relatives’

Terms such as ‘related party’ may be puzzling. Here’s taking a look at the structures that govern business.

Relatives…sometimes friendly, sometimes not.

S.Hamsini Amritha

In the last two weeks, the words “related party” and “corporate governance” were doing the rounds in news channels and papers. Wondering how a company could have “relatives’ or related party transactions when it’s supposed to be an entity independent of its promoters or people who run the company? Here is the explanation:

Who are relatives?

Two are more persons are considered to be related if at any time during a reporting period (usually from April to March) one party has the ability to control or exercise significant influence over the other party in making financial and operating decisions. A holding and subsidiary company would be a typical example.

Transactions between such related parties are termed as related party transactions in accounting parlance. Sale of land and constructed properties by DLF Ltd to its subsidiaries such as DLF Home Developers and DLF Housing and Construction Ltd, is an instance of a related party transaction.

The most common ‘related parties’ found in financial statements are unlisted or private subsidiary companies. Then follow the associates and joint ventures. Individuals who have significant stake in the company (i.e. who hold equity capital of 20 per cent or more), are also termed as related parties to a company.

Azim Premji’s direct stake in Wipro may just be 3.83 per cent. However, there are several non-corporate promoter groups through which he exercises more than 70 per cent of voting capacity. Similarly, key managerial personnel (such as chairman or the managing director) are related parties as they are in a position to exercise significant influence over the company. Relatives to the above two categories of individuals are also considered related parties.

Who regulates these relatives?

Conglomerates carry on various businesses and investment activities through a web of subsidiaries or associates. Take Reliance Industries for an example.

The company has roughly about 62 subsidiary companies and nine associates. Investments in a numerous subsidiaries results in multiple legal vehicles and overlapping activities, making the business structure complex for investors as well as regulators.

Instances of companies using intricate holding structures to reap tax benefits or avoid complex legal requirements are not new in India. Yet transactions made by a company with related parties can involve conflicts of interest with shareholders. To plug this loop hole, law mandates companies to disclose all related party transactions. While the legal aspect is taken care of by the Companies Act, Accounting Standard 18 issued by the Institute of Chartered Accountants of India takes care of the financial presentation.

What needs to be reported?

Any related party transaction needs to be disclosed in the annual report. Some customary transactions are sale and purchase of goods to or from subsidiaries, payment to key managerial personnel, loans given (or taken) to subsidiaries and associates.

Normally, a transaction is considered material if it exceeds 10 per cent of the total related party transaction of the same type. For instance, if over 10 per cent of a company’s total raw material cost is procured from a related party, it is considered material.

Tata Motors had, in 2007-08, purchased a total of Rs 2,354 crore from its related parties. Out of this, some material purchases amounting to Rs 2,230 crore were separately highlighted.

Benefit to investors

As an investor it may not be possible for you to know the intricacies involved in each of these transactions. Luckily, stringent regulations in the country ensure that shareholders are not at the losing end as a result of such transactions.

Further, since most companies are managed by a judicious mix of independent directors, decision-making may be less influenced by directors who have vested interest in the company.

Also, shareholders are vested with more powers to ensure that their earnings are not depleted by mismanagement.

As a small shareholder you may not be as powerful as foreign investors (who were reasons behind the Satyam-Maytas deal not happening).

But what you certainly can do is decide if you want to stay with a company as an investor.

Related party transactions are aplenty in smaller companies, especially those in unorganised sectors.

A very high incidence of related party transactions raises questions on the corporate governance standards of a company. Exercise discretion in judging the integrity of the business and protect your interest.