Companies Act Section 188

Companies Act, Section 188: Regulation of Related Party Transactions

Section 188 of the Companies Act, 2013 governs related party transactions (RPTs), i.e., transactions between a company and its related parties that could potentially lead to conflicts of interest or misuse of company resources. This provision ensures that such transactions are undertaken transparently, with appropriate approvals and disclosure requirements, to protect the interests of shareholders, especially minority stakeholders.

1. Requirement of Board Approval for Related Party Transactions

According to Section 188(1), a company cannot enter into certain contracts or arrangements with a related party unless it has obtained the consent of the Board of Directors through a resolution passed at a meeting of the Board, and subject to any prescribed conditions.

Transactions Requiring Board Approval:

The following types of transactions with a related party require prior Board approval:

(a) The sale, purchase, or supply of any goods or materials.

(b) The sale, purchase, or disposal of property of any kind.

(c) The leasing of property of any kind.

(d) The availing or rendering of services.

(e) The appointment of an agent for the purchase or sale of goods, materials, services, or property.

(f) The appointment of a related party to any office or place of profit in: The company itself, a subsidiary company, or an associate company.
(g) Any arrangement for the underwriting of the subscription of any securities or derivatives of the company.

These transactions are particularly sensitive as they may give rise to situations where a related party benefits at the expense of the company or other stakeholders, hence the requirement for formal approval and oversight.

2. Prior Shareholder Approval in Certain Cases

In addition to Board approval, prior approval of the shareholders by way of a resolution in a general meeting is required if:

The paid-up share capital of the company is not less than a prescribed threshold, or
The value of the transaction(s) exceeds prescribed monetary limits.
These thresholds are specified in the relevant rules (Companies (Meetings of Board and its Powers) Rules, 2014).

Exception to the Voting Restriction:

This voting restriction does not apply where 90% or more of the members of the company (by number) are relatives of promoters or related parties. In such closely held companies, the intent is that there is effectively no independent shareholder interest to protect, hence the exemption.

3. Exception- Ordinary Course of Business and Arm’s Length Transactions

Section 188(1) does not apply to transactions that meet both of the following criteria:

Entered into in the ordinary course of business of the company; and
Conducted on an arm’s length basis.
Explanation:

Ordinary Course of Business refers to activities that are normal or routine for the company’s business operations.
Arm’s Length Transaction means a transaction between two related parties conducted as if they were unrelated, ensuring there is no conflict of interest and the terms are fair and reasonable.
4. Additional Exemption for Holding and Wholly-Owned Subsidiary Companies

The requirement of passing a shareholder resolution for related party transactions is not applicable to transactions between:

A holding company and its wholly owned subsidiary, provided that:
The accounts of the subsidiary are consolidated with those of the holding company, and
The consolidated accounts are placed before the shareholders for approval at the general meeting.
This recognizes the economic unity of such entities and the limited risk of abuse when financials are consolidated and transparently disclosed.

5. Definitions and Explanations under Section 188(1)

Office or Place of Profit

A person is considered to hold an office or place of profit in a company if:

If held by a director: they receive any remuneration in addition to their director’s entitlement, such as salary, fee, commission, perquisites, or rent-free accommodation.
If held by a non-director or a firm/body corporate: they receive any remuneration, salary, fee, commission, perquisites, etc., from the company for holding the position.
Arm’s Length Transaction

A transaction between related parties that is conducted as if they are unrelated, ensuring no preferential treatment, and terms are based on market conditions.

6. Disclosure in Board’s Report

Under Section 188(2), every related party contract or arrangement approved under subsection (1) must be:

Disclosed in the Board’s Report to the shareholders,
Accompanied by a justification for entering into such contract or arrangement.
This is a transparency mechanism to allow stakeholders to evaluate the fairness and rationale behind related party transactions.

7. Consequences of Non-Compliance and Ratification

Under Section 188(3):

If a related party transaction is entered into without prior approval of the Board or shareholders (where required), the transaction must be:
Ratified by the Board or shareholders within three months from the date of entering into the contract.
If not ratified, the contract or arrangement is:
Voidable at the option of the Board or shareholders, and
If the transaction was with a director’s related party or authorised by a director, the concerned director(s) must indemnify the company against any losses incurred.
8. Recovery of Losses by the Company

Section 188(4) provides that the company is entitled to proceed against any director or employee who entered into or authorised a related party transaction in contravention of the law, for the recovery of any loss suffered as a result.

This is a key enforcement mechanism ensuring personal accountability for misuse of position or negligence.

9. Penalties for Violations

Under Section 188(5):

If a director or employee of a company enters into or authorizes a related party transaction in violation of the section, they are liable for penalties as follows:

In case of a listed company: Penalty of ?25,00,000 (twenty-five lakh rupees).
In case of any other company: Penalty of ?5,00,000 (five lakh rupees).
This distinction reflects the greater public interest and disclosure obligations associated with listed companies.