Related Party Transactions and the Limits of Approval

Why procedural approval can fall short

Related party transactions are among the most heavily proceduralised areas of Indian company law, and among the most reliably mishandled. The procedure is well understood: identify the related party, place the transaction before the audit committee, obtain board approval, obtain shareholder approval where thresholds are crossed, disclose in the financial statements and the board’s report.

Companies execute this sequence carefully and still end up with an adverse finding. The reason is that the sequence is a process for reaching a conclusion, and the regulator is interested in the conclusion.

Approval is not evidence of soundness

A municipal committee must approve building plans before construction. Suppose it meets, minutes the application, votes unanimously and issues the permission — without anyone having checked whether the structure can bear its own load.

Every procedural requirement has been met. The permission is validly issued. And it establishes nothing whatsoever about whether the building will stand. Approval was designed to be the visible output of an examination; here it became a substitute for one.

Examine the conflict and the transaction

The statutory architecture around related party transactions exists to manage a conflict of interest, and it does so by requiring that the transaction be examined by persons who do not hold the conflict. The approval is evidence that the examination occurred. It is not itself the protection.

This makes the content of the examination the substantive obligation. Two questions define it. Is the transaction in the ordinary course of business? And is it on an arm’s length basis? Both are questions of fact, and neither is answered by a resolution reciting that they are satisfied.

Arm’s length here means what it means elsewhere: terms an unrelated party would have accepted. Establishing it requires something outside the transaction — a comparable quotation, a market rate, an independent valuation, a documented tender, a cost build-up with a defensible margin. Where such evidence has not been obtained, the correct conclusion is not that the transaction is at arm’s length; it is that the company does not know, and the approval should say so.

The examination must also be continuous. Omnibus approvals are permitted and useful, but they are approvals of a defined arrangement within stated limits. When the volume, pricing or nature of what actually happens drifts from what was approved — and over a few years it usually does — the approval no longer covers the transaction being carried out.

Keep evidence and approved limits under review

Put the evidence in front of the audit committee, not the conclusion. A note that states "the transaction is at arm’s length" gives the committee nothing to examine. A note that sets out the comparable, the derivation and the margin allows the committee to do the job the statute assigns to it — and creates the record that later demonstrates it was done.

Maintain the related party register as a live document owned by a named person. Related party status changes with directorships, shareholdings, key managerial appointments and relatives’ interests, and a register refreshed annually at year end will be wrong for most of the year in which it matters.

Reconcile approved limits against actual transactions every quarter. The most common finding in this area is not an unapproved transaction; it is an approved transaction that quietly outgrew its approval.