In many companies, business relationships often exist between people who already have some connection with the company. For example, a company may purchase goods from a firm owned by one of its directors. Or it may lease property from a business owned by a promoter’s family member.
These kinds of dealings are called Related Party Transactions.
Such transactions are not automatically wrong. In fact, they happen quite frequently in business. However, because the parties involved may have close relationships, company law requires extra transparency and proper approval processes. Let’s understand how related party transactions work in Indian companies and why they are carefully regulated.
A Situation That Explains Related Party Transactions
Imagine a manufacturing company that needs a new office building. One of the directors owns a real estate company that has a suitable property available for lease.Now the company has two possible options:
- lease the property from the director’s company
- lease a similar property from an unrelated landlord
If the board decides to lease the director’s property, there is a possibility that personal interests could influence the decision. This situation is called a related party transaction because the company is entering into a business arrangement with someone who has a connection to the company’s leadership.
What Is a Related Party Transaction?
In simple terms, a related party transaction occurs when a company enters into a business deal with a person or entity that has a close relationship with the company. These relationships may include:
- directors
- key managerial personnel
- relatives of directors or executives
- companies in which directors have significant interest
- subsidiaries or associate companies
Because these parties may influence decision-making, additional governance safeguards are required.
Why Related Party Transactions Are Regulated
From practical experience, related party transactions can create situations where personal interests conflict with the company’s best interests. Without proper oversight, such transactions could lead to:
- unfair pricing
- preferential treatment
- misuse of company resources
Company law therefore requires companies to review, approve, and disclose these transactions carefully. This helps ensure that the transaction is conducted fairly and transparently.
Common Types of Related Party Transactions
Related party transactions can take many forms depending on the company’s business activities. Some common examples include:
1. Sale or Purchase of Goods
A company may buy products or raw materials from a business owned by one of its directors or their relatives.
For example, a textile company might purchase fabric from a supplier that is partly owned by a director. Such transactions must be reviewed carefully to ensure that prices and terms are reasonable.
2. Leasing or Renting Property
Sometimes companies lease property owned by directors or their relatives. For instance, a company might rent office space from a building owned by a promoter’s family. Because of the relationship involved, such arrangements must be approved through proper governance procedures.
3. Providing Services
A company may hire consulting services or professional services from an entity connected to one of its directors. For example, a company might appoint a consulting firm where a director’s relative works as a partner. Again, transparency and fair pricing become important considerations.
4. Appointment to Certain Positions
Related party transactions can also occur when a company appoints someone connected to a director to a position within the company that provides financial benefits. These situations require careful oversight to ensure fairness.
How Related Party Transactions Are Approved
Because of the potential conflict of interest, companies follow specific approval processes. Typically, the process involves several steps. First, the proposed transaction is reviewed by the board of directors.
Directors who have an interest in the transaction usually do not participate in the discussion or voting. This helps maintain fairness during the decision-making process. In certain situations where the transaction is significant, the company may also seek approval from shareholders.
Example
Let’s imagine a food processing company that needs packaging materials. One of the directors owns a packaging company that offers to supply the materials at a competitive price. The proposal is presented to the board. Because the supplier company belongs to a director, this becomes a related party transaction. The board reviews questions such as:
- Are the prices comparable to market rates?
- Are the contract terms fair to the company?
- Would choosing another supplier produce better value?
The interested director does not participate in the decision. After careful review, the board may approve the transaction if it believes the arrangement benefits the company.
Why Transparency Matters
Transparency is the key principle behind regulating related party transactions. When such transactions are disclosed properly, investors and regulators can understand how company resources are being used. Companies often include information about related party transactions in their financial statements and annual reports.
This allows shareholders to review these arrangements and understand their impact.
In many corporate groups, related party transactions are quite common. For example, companies within the same business group may trade goods or provide services to each other. However, experienced boards usually establish clear policies to ensure that such transactions are conducted at fair market terms. This helps prevent conflicts of interest from affecting business decisions.
Some beginners assume that related party transactions are always unethical or illegal. That is not the case. Many legitimate business arrangements fall into this category.
The key requirement is that these transactions must be transparent, fairly priced, and properly approved. When these conditions are met, related party transactions can function just like any other business deal.
Companies often maintain a register of related party transactions. This record helps track all such dealings and ensures that they are properly disclosed during audits and financial reporting. Maintaining proper documentation strengthens governance and accountability.
Conclusion
Related party transactions occur when companies enter into business arrangements with individuals or entities that have close connections with the company. While such transactions are common in business, they must be handled carefully to avoid conflicts of interest.
Through board review, shareholder approval where necessary, and transparent disclosures, companies ensure that these transactions remain fair and accountable.
For beginners learning about corporate governance, understanding related party transactions highlights an important principle: business relationships must be managed responsibly when personal connections are involved.
