Related party transaction
A deal between a company and a party connected to its controllers — promoters, their relatives, group firms. Watched because it can enrich the promoter group at minority shareholders' cost.
In plain language
A company buys its packaging from a firm owned by the promoter's brother. Nothing wrong with that — if the price is what any independent supplier would charge. If it is higher, profit that belongs to every shareholder quietly moves to the promoter family.
That is why Chapter 7 lists related party transactions among the tests of corporate governance, and why promoter influence is described as both a comfort and a risk: the same control that keeps management aligned with shareholders lets a promoter push through deals that benefit the promoter group.
How it works
Section 7.6.2, item (vii), sets out what good governance looks like and what the regulation requires, as the workbook states it:
- The aim is to prevent unscrupulous related party transactions that enrich the promoter group or other majority shareholders at the cost of minority shareholders.
- Ideally, all material related party transactions should go to the audit committee for pre-approval.
- The workbook says SEBI regulation "does not mandate pre-approval but requires placement of all related party transactions in front of the audit committee".
- If a transaction is not on an arm's-length basis, the company must provide justification.
The audit committee matters here, which is why the workbook also wants it composed of independent directors (SEBI requires at least two-thirds). Section 7.6.3 names related party transactions as the example of an action a promoter group might push that benefits it at minority shareholders' cost.
The Chapter 13 checklist asks for major observations from the corporate governance report.
A worked example
Illustrative figures. A listed FMCG company, 55% owned by its promoter, buys packaging worth Rs 180 crore a year from a firm owned by the promoter's brother. Independent suppliers quote Rs 160 crore for the same volume.
Overpayment = 180 − 160 = Rs 20 crore a year (12.5% above market)
Minority shareholders' share of lost profit = 45% × 20 = Rs 9 crore
Promoter's share of lost profit = 55% × 20 = Rs 11 crore
Promoter family's gain via the brother's firm = Rs 20 crore
Net gain to the promoter family = 20 − 11 = Rs 9 crore a year
The promoter family comes out Rs 9 crore a year ahead, funded entirely by the minority. On a P/E of 30 that is roughly Rs 600 crore of market value (20 × 30) that the company does not have, before tax.
If the audit committee demands justification for a price 12.5% above independent quotes, the deal either moves to market terms or the justification is on record for shareholders and analysts to judge.
Why NISM asks about it
Chapter 7 (Company Analysis – Business and Governance) covers related party transactions in the corporate governance checklist (section 7.6.2) and in the discussion of promoter holdings (section 7.6.3). Questions ask whose interests are at risk, which committee should see these transactions, and what "arm's length" means.
Common exam traps
- The victim is the minority shareholder. The beneficiary is the promoter group or other majority shareholders.
- The audit committee is the forum, not the remuneration or nomination committee.
- Not on arm's length? Justification required — the workbook does not say such transactions are banned.
- Stale regulatory text — flag it. The workbook says SEBI does not mandate pre-approval, and elsewhere cites SEBI's Clause 49 of the listing agreement as the governance standard. Clause 49 was replaced by the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, under which related party transactions need the prior approval of the audit committee, and material ones also need shareholder approval. Answer a workbook-style question as the workbook states it, and know the current rule.
- A related party transaction is not automatically improper. Group companies trade with each other all the time; the question is price and process.
Check yourself
1.A company places every related party transaction before its audit committee only AFTER the transaction is executed, and publishes a justification for one transaction that was not at arm’s length. Which is correct?
- a)This breaches SEBI regulation, which mandates pre-approval of all related party transactions
- b)This meets the current SEBI requirement, though pre-approval of material transactions is the ideal
- c)This breaches SEBI regulation because non-arm’s-length transactions are prohibited outright
- d)Related party transactions need not be reported to the audit committee at all
Show the answer
Answer: (b) This meets the current SEBI requirement, though pre-approval of material transactions is the ideal
The workbook draws this distinction deliberately: "Ideally all material related party transactions should be presented to the audit-committee for pre-approval. Currently, the SEBI regulation does not mandate pre-approval but requires placement of all related party transaction in front of the audit committee. If the transaction is not on an arms-length basis, then the regulation also requires that the company should provide justification for the same."
So the company has done both things SEBI requires — placement, plus justification for the non-arm’s-length transaction. Option A imports the ideal into the regulation and is the most-chosen wrong answer. Option C is wrong because non-arm’s-length RPTs are not banned; they require justification. Option D contradicts the requirement of placement entirely.
The reason RPTs matter at all: they can enrich the promoter group or other majority shareholders at the cost of minority shareholders.
Where this is taught
Free preparation for NISM Series XVRelated terms
- Audit committeeThe board sub-committee responsible for reviewing a company's financial statements and nominating its auditors, which SEBI requires to be at least two-thirds independent directors.
- Conflict of interestAny interest of the analyst's own — a shareholding, a fee, a relationship — that could bias the research, and which the regulations require to be disclosed rather than merely avoided.
- Contingent liabilityAn obligation that may or may not arise, depending on the outcome of an uncertain future event — a lawsuit, a tax dispute, a guarantee — disclosed in the notes rather than booked in the accounts.
- Corporate governanceThe rules, processes and procedures followed in running a company, judged by an analyst against a checklist of board, audit and related-party tests rather than by reputation.
- Key Management PersonnelThe key investment team of an AIF's manager, the employees who decide on behalf of the fund, and anyone else the AIF or manager declares as such — named in the PPM and bound by the Code of Conduct.
- Independent directorA director who is neither part of management nor otherwise connected to the company — at least half the board where the chairman is executive, and one-third otherwise.
- Agency riskThe risk that a company's management, who control day-to-day decisions, pursue their own interests rather than those of the shareholders who actually own the business.
- Keyman riskThe risk that a company depends so heavily on one or a few individuals that a change at the top can derail its decision making.
- Financial creditorUnder the Insolvency and Bankruptcy Code, a creditor who receives consideration against the time value of money — in other words, one who earns interest on the amount outstanding.
- Passive breachA portfolio manager's investment limit being crossed by market movement rather than by a fresh purchase — the client's earlier consent does not cover it, and it still has to be recorded, disclosed and rectified.