Related party transactions refer to transactions between two parties who are related to each other, such as companies, their promoters, directors, and key managerial personnel, their relatives, and other entities controlled by them.
Importance of Understanding Related Party Transactions
Understanding related party transactions is crucial for investors as they can significantly impact a company’s financial health and profitability.
Related party transactions must be disclosed in the company’s financial statements and approved by the Board of Directors as per the Companies Act, 2013. Failure to disclose such transactions can result in penalties and legal consequences.
Investors must recognize the importance of understanding related party transactions as these transactions can impact a company’s financial statements, potentially influencing investment decisions. They can also pose significant risks, such as potential for abuse, conflicts of interest, and reduced transparency.
By understanding related party transactions investors can make informed investment decisions and mitigate potential risks.
Common Examples of Related Party
Related party transactions can take in many forms. Here are some common examples of related party transactions:
Loans or Guarantees Provided to Related Parties:
Loans or guarantees provided to related parties is a common type of Related Party Transaction that companies engage in. In such transactions, a company provides loans, advances, or guarantees to related parties, including promoters, directors, and key managerial personnel.
While providing loans or guarantees to related parties is not necessarily illegal, it can be used to benefit insiders at the expense of the company and other shareholders. It can also create a conflict of interest between the company and its related parties.
For example, a company may provide a loan to a related party at favorable terms, such as low interest rates or extended repayment periods, which may not be available to other borrowers. This can result in the company losing money and other shareholders losing out on potential profits.
On the other hand, a company may also guarantee a loan taken by a related party from another lender. While this may seem harmless, it can result in a potential liability for the company if the related party defaults on the loan. The company may have to pay off the loan, which can negatively impact its financial health and affect shareholder value.
One high-profile example of loans to related parties is the case of Infrastructure Leasing and Financial Services (IL&FS), a major Indian infrastructure development and finance company.
In 2018, IL&FS defaulted on its loans, which amounted to over Rs 90,000 crore. It was later discovered that IL&FS had provided loans to related parties at favorable terms, resulting in a conflict of interest and contributing to the company’s financial downfall.
To prevent such situations, regulatory bodies like the Securities and Exchange Board of India (SEBI) have mandated that companies disclose all related party transactions in their financial statements.
They have also set guidelines and restrictions on such transactions, including the maximum amount that can be loaned to related parties and the terms and conditions of such loans.
Transactions Involving the Sale or Purchase of Assets:
Transactions involving the sale or purchase of assets between a company and its related parties can pose a risk of potential conflicts of interest, as the related parties may have a vested interest in the transaction.
For example, a company may purchase inventory from a related party at a higher price than what it would have paid to an unrelated party, resulting in an inflated cost of goods sold and lower profit margins.
On the other hand, a company may sell assets to a related party at a lower price than what it could have received from an unrelated party, resulting in a lower income for the company.
This can also result in misrepresentation of the true financial position of the company. For instance, if a company sells assets to related parties at a lower price, it could potentially reduce the value of its assets on the balance sheet, which could mislead investors about the company’s actual financial position.
Moreover, such transactions may also violate the rules of fair market value and transfer pricing, leading to potential legal implications and penalties.
To avoid such situations, companies should ensure that all transactions with related parties are conducted at arm’s length and are supported by proper documentation and approvals.
They should also disclose such transactions in their financial statements and report them to regulatory authorities, as required by law.
Related Party Management Services or Fees:
Related party management services or fees refer to payments made to related parties for management services, including technical services, advisory services, and consulting services.
These transactions can be used by companies to divert funds to related parties or to make them appear more profitable than they actually are.
For example, a company may hire a related party as a consultant for a large fee, even if they do not have the necessary expertise. The related party then returns a portion of the fee back to the company, effectively transferring funds from the company to the related party.
Another example could be a company paying a related party for technical or advisory services, even if those services were not required or were already available within the company. This can be a way to transfer funds to the related party without drawing too much attention to the transaction.
It is important for investors to carefully scrutinize these types of transactions and ensure that they are at arm’s length and fair to the company and its shareholders.
Transactions Involving Intellectual Property Rights:
Transactions involving intellectual property rights refer to the licensing or purchase of patents, copyrights, trademarks, and other proprietary information from related parties.
In some cases, companies may enter into such transactions with related parties to obtain exclusive rights to use intellectual property for their business operations. However, such transactions can be used to manipulate financial results.
For example, a company may enter into a licensing agreement with a related party for a higher price than the fair market value of the intellectual property rights. This would result in an increased expense for the company and a corresponding decrease in profits.
On the other hand, if the company is selling the intellectual property rights to a related party, it may sell it at a lower price than its fair market value, resulting in a lower profit or even a loss.
Another example is when a company overstates the value of its intellectual property rights to inflate its assets, which can be used to attract investors or lenders. This can happen when a company purchases intellectual property rights from a related party at an inflated price.
Therefore, it is important for investors to closely examine the transactions involving intellectual property rights with related parties to ensure that they are at arm’s length and at fair market value.
It is essential to recognize these examples of related party transactions as they can have significant implications for a company’s financial health and profitability.
Investors must be aware of the potential risks and conflicts of interest associated with these transactions to make informed investment decisions and avoid potential losses.
Deceptive Use of Related Party Transactions
While related party transactions are legitimate, they can also be used deceptively. Here are some examples of deceptive uses of related party transactions:
Concealing Poor Performance through Related Party Transactions:
One of the ways companies may use related party transactions to hide poor performance is by inflating revenue. For example, a company may sell its products or services to a related party at an inflated price, which would increase its revenue.
The related party may then sell the same products or services to customers at a lower price, resulting in lower revenue for the company. This manipulation can make the company’s financial performance appear better than it actually is.
Another way companies may use related party transactions to conceal poor financial performance is by understating expenses.
For instance, a company may enter into a lease agreement with a related party at a below-market rate, resulting in lower lease expenses. This would make the company’s net income appear higher than it would have been if it had paid a market rate for the lease.
Similarly, a company may engage in other types of related party transactions, such as loans or service agreements, at below-market rates to understate expenses.
Overstating Financial Performance through related party transactions:
Inflating the Value of Assets:
A company may enter into related party transaction to sell assets to a related party at a higher value than what the assets are actually worth. This can make the company’s balance sheet look better than it actually is, as it would show higher asset values and potentially higher profits.
Understating Liabilities:
Similarly, a company may use related party transaction to understate its liabilities. For example, a company could sell a liability to a related party at a lower value than its actual worth, which would reduce the company’s liability and make its financial position look better than it actually is.
Manipulating Accounting Records:
A company may use related party transactions to manipulate its accounting records. For instance, a company may enter into related party transaction to inflate its revenue by selling products or services to a related party at a higher price than what it would sell to an unrelated party.
This would make its financial performance appear better than it actually is, as it would show higher revenue and potentially higher profits.
Manipulating share prices through related party transactions:
Related party transactions can also be used by companies to manipulate share prices. This can be done by conducting transactions with related parties at prices that are not at arm’s length.
In other words, the company may sell shares to a related party at a price that is higher than the market value or buy shares from a related party at a price that is lower than the market value.
Such transactions can create an illusion of high demand for the company’s shares or artificially lower the supply of shares in the market, thereby leading to a rise in share prices.
This can benefit insiders who own a significant amount of shares in the company, as they can sell their shares at a higher price and make a profit.
For example, suppose a company’s CEO owns a significant amount of shares in the company and wants to sell them to make a profit. The CEO could create a related party company and sell the shares to this company at a higher price than the market value.
This creates an impression of high demand for the shares and can lead to an increase in the company’s share price. The related party company can then sell the shares to other investors in the market, thereby making a profit.
In another scenario, the company could buy back its own shares from a related party at a lower price than the market value. This can reduce the supply of shares in the market and create an impression of high demand, leading to an increase in share prices. The company can then sell the shares back to the market at a higher price, thereby making a profit.
Such manipulative practices can lead to market distortion and can undermine investor confidence in the stock market. Regulatory bodies around the world have implemented strict guidelines and regulations to prevent such practices and ensure transparency in share transactions.
Investors must be aware of these deceptive practices to make informed investment decisions and avoid potential losses.
Warning Signs of Fraudulent Related Party Transactions
Stock market Investors must be aware of warning signs of fraudulent related party transactions to protect themselves from potential losses. Here are some common warning signs:
Lack of Transparency and Disclosure:
Transparency and disclosure are crucial when it comes to related party transactions in the corporate world. As per the Companies Act, 2013, companies must disclose all related party transactions in their financial statements. Failure to do so can lead to a lack of transparency, and investors may not trust the company’s management.
For instance, if a company has a related party transactions with a promoter, and it is not disclosed in the financial statements, investors may not have complete information about the company’s financial position. This lack of transparency could lead to a lower valuation of the company and ultimately affect its share price.
In contrast, a company that fully discloses all related party transactions is seen as transparent, and investors are more likely to trust the management. This, in turn, can have a positive impact on the company’s valuation and share price.
Moreover, non-disclosure of related party transactions can also be a red flag for regulatory authorities. For instance, if the tax authorities find that a company has not disclosed related party transactions in its tax filings, it may lead to an investigation, and the company may be penalized for non-compliance.
Thus, it is essential for companies to maintain transparency and disclosure in their related party transactions to avoid any legal, regulatory or reputational risks.
Companies involved in related party transactions must disclose these transactions in their financial statements as per the Companies Act, 2013. Failure to do so may indicate a lack of transparency and suggest that the company is hiding information from investors.
Unusual Timing or Volume of Transactions:
Unusual timing or volume of transactions involving related parties may be a sign of fraudulent activity or manipulation.
For example, a company may suddenly engage in a large volume of transactions with a related party in a short period of time, particularly if those transactions fall outside of the company’s regular business activities.
For instance, if a company is primarily in the business of selling consumer goods, sudden and frequent purchases of real estate from a related party may raise red flags.
Similarly, if a company engages in a large volume of transactions with a related party just before reporting its financial results, it may be trying to artificially inflate its revenue or profit figures.
Such behavior may indicate that the company is attempting to hide poor financial performance or manipulate its financial statements through related party transactions.
Therefore, investors should be cautious and closely scrutinize any unusual timing or volume of transactions involving related parties.
Transactions with Unreasonably High Prices or Rates:
Related party transactions conducted at unreasonably high prices or rates can raise concerns about the integrity of the transaction. In such cases, the company may be manipulating the transaction to benefit related parties.
For example, if a company purchases goods or services from a related party at a price that is much higher than the market price, it may indicate that the company is trying to funnel money to the related party or trying to manipulate its financial performance.
Similarly, if a company provides a loan to a related party at an interest rate that is much higher than the market rate, it may indicate that the company is trying to siphon money away from its operations and into the pockets of its related parties.
These kinds of transactions can negatively impact the financial performance of the company and can lead to a loss of investor confidence.
Therefore, it is crucial for investors to pay close attention to the prices and rates at which related party transactions are conducted to ensure that they are fair and at arm’s length.
Companies must also disclose such transactions in their financial statements as per the Companies Act, 2013, to maintain transparency and avoid any suspicion of fraudulent activity.
Poor Financial Performance despite a large number of related party transactions:
When a company engages in a large number of related party transactions and yet has poor financial performance, it could indicate that the company is manipulating its financial statements through related party transactions.
For instance, the company may be inflating revenue or understating expenses through related party transactions to hide poor performance.
For example, in 2018, Infrastructure Leasing and Financial Services (IL&FS) Group, one of India’s largest infrastructure finance companies, was found to have engaged in fraudulent activities through a large number of related party transactions.
The company concealed its poor financial performance by inflating revenue through related party transactions with its subsidiaries, associates, and other related parties.
It was also found to have understated its expenses through related party transactions. The company’s fraudulent activities led to a major financial crisis, causing panic in the stock markets and a loss of investor confidence.
Another example is the case of Satyam Computer Services, where the company’s founder and chairman, Ramalinga Raju, confessed to inflating profits through related party transactions.
The company showed fictitious revenues of about $1.5 billion through a complex web of related party transactions. This fraudulent activity led to the collapse of the company and a loss of investor confidence.
Thus, a large number of related party transactions, coupled with poor financial performance, can be a red flag for investors, indicating potential fraudulent activities.
It is important for investors to closely scrutinize a company’s financial statements and disclosures to identify any unusual or suspicious related party transactions.
Recognizing these warning signs can help investors make informed investment decisions and avoid potential losses.
Protecting Yourself from Losses Due to Related Party Transactions
Related party transactions can pose significant risks for investors in the stock market. Here are some ways investors can protect themselves from potential losses due to related party transactions:
Conducting thorough due Diligence before Investing:
Conducting thorough due diligence before investing is a critical step in making informed investment decisions. It involves researching the company’s financial statements and other relevant information to identify any potential red flags or risks.
This process helps investors make informed decisions by evaluating the legitimacy of related party transactions and assessing the potential conflicts of interest.
One of the key steps in conducting due diligence is to review the company’s financial statements. This includes analyzing the income statement, balance sheet, and cash flow statement to assess the company’s financial health, profitability, and cash flow.
By reviewing these financial statements, investors can identify any potential discrepancies, such as inconsistent or unusual revenue growth, high debt levels, or significant cash outflows.
Another important aspect of due diligence is to investigate any related party transactions. These transactions involve any financial dealings between the company and its insiders, such as executives or board members.
Related party transactions can present a risk to investors because they may not be conducted at arm’s length, and there may be a conflict of interest that could impact the company’s financial performance.
For example, if the company’s CEO owns a separate business that provides services to the company, this could create a potential conflict of interest. The CEO may be more inclined to use his or her own company for services, even if it is not the most cost-effective option for the business.
Similarly, if the company leases property from a related party, there may be concerns about whether the lease agreement is fair and reasonable.
To evaluate the legitimacy of related party transactions, investors should review the company’s disclosures and assess whether these transactions are properly disclosed and accounted for in the financial statements.
They should also consider whether these transactions are consistent with industry norms and whether they provide any financial benefit to the company.
Diversifying your portfolio to reduce risk:
Investing in a diversified portfolio of stocks can help reduce the impact of any potential losses due to related party transactions in a single stock. A diversified portfolio can spread risk across different sectors, companies, and geographies.
Staying up-to-date with regulatory guidelines and enforcement:
Investors should stay informed about regulatory guidelines and enforcement related to related party transactions. Regulators play an essential role in preventing abusive related party transactions and ensuring transparency and fairness in the stock market.
One way for investors to stay informed about regulatory guidelines and enforcement related to related party transactions is to regularly review the websites of regulatory authorities.
For example, the Securities and Exchange Board of India (SEBI) provides guidelines related to related party transactions, and investors can access these guidelines on SEBI’s website.
Additionally, SEBI’s website provides information about enforcement actions related to related party transactions, which can help investors identify potential red flags in companies.
Another useful resource for investors is corporate governance rating agencies. These agencies assess companies’ corporate governance practices, including their Related party transaction policies, and assign ratings based on their assessments.
Investors can access these ratings on the websites of rating agencies such as CRISIL, ICRA, and CARE Ratings.
Investors can also access information about related party transactions through financial news websites and business publications.
These sources often report on companies’ related party transactions and regulatory enforcement actions, providing investors with insights into potential risks.
Some examples of financial news websites and publications in India include Economic Times, Business Standard, and Mint.
By conducting due diligence, diversifying portfolios, and staying informed about regulatory guidelines and enforcement, investors can mitigate the risks associated with RPTs and protect themselves from potential losses.
Role of Regulators in Preventing Abusive Related Party Transactions
Regulators play a critical role in preventing abusive related party transactions in the Indian stock market. Here are some ways regulators prevent abusive related party transactions:
Regulatory guidelines for related party transactions:
Regulators, such as the Securities and Exchange Board of India (SEBI), provide guidelines for companies to follow when conducting related party transactions. These guidelines ensure transparency, fairness, and compliance with applicable laws.
Enforcement of regulations through audits and inspections:
Regulators also enforce regulations related to related party transactions through audits and inspections. Companies found to be violating regulations may face penalties, including fines, sanctions, or legal consequences.
Legal consequences for companies and individuals found guilty of fraudulent related party transactions:
Companies or individuals found guilty of fraudulent related party transactions may face legal consequences, such as criminal charges, fines, or imprisonment. These consequences serve as a deterrent to prevent abusive related party transactions in the future.
Regulators play a crucial role in ensuring transparency, fairness, and compliance with applicable laws in the Indian stock market. Investors can stay informed about regulatory guidelines and enforcement to make informed investment decisions and protect themselves from potential losses due to abusive related party transactions.
Conclusion
Related party transactions are a common occurrence in the Indian stock market, but they can also pose significant risks for investors. Understanding related party transactions and their potential implications is essential for investors to make informed investment decisions and protect themselves from potential losses.
Key takeaways for investors to protect themselves from losses due to related party transactions include conducting thorough due diligence, diversifying portfolios, staying up-to-date with regulatory guidelines and enforcement, and recognizing warning signs of fraudulent related party transactions.
Investors should assess the legitimacy of related party transactions, evaluate the financial performance of a company, and assess any potential conflicts of interest associated with related party transactions before making investment decisions.
Regulators in the Indian stock market play a crucial role in preventing abusive related party transactions by providing guidelines for RPTs, enforcing regulations through audits and inspections, and imposing legal consequences on companies and individuals found guilty of fraudulent related party transactions.
In conclusion, understanding related party transactions and their potential implications is essential for investors in the Indian stock market. By adopting strategies to protect themselves from potential losses and staying informed about regulatory guidelines and enforcement, investors can make informed investment decisions and mitigate the risks associated with related party transactions.
Questions & Answers
What are related party transactions?
Related party transactions refer to transactions between two parties who are related to each other, such as companies, their promoters, directors, and key managerial personnel, their relatives, and other entities controlled by them.
Why is it important for investors to understand related party transactions?
Understanding related party transactions is crucial for investors as they can significantly impact a company’s financial health and profitability. related party transactions must be disclosed in the company’s financial statements and approved by the Board of Directors as per the Companies Act, 2013. Failure to disclose such transactions can result in penalties and legal consequences. Investors must recognize the importance of understanding RPTs as these transactions can impact a company’s financial statements, potentially influencing investment decisions.
What are some common examples of related party transactions?
Some common examples of related party transactions include loans or guarantees provided to related parties, transactions involving the sale or purchase of assets to or from related parties, related party management services or fees, and transactions involving intellectual property rights.
What are some warning signs of fraudulent related party transactions?
Some common warning signs of fraudulent related party transactions include a lack of transparency and disclosure, unusual timing or volume of transactions, transactions with unreasonably high prices or rates, and poor financial performance despite a large number of related party transactions.
How can investors protect themselves from potential losses due to related party transactions?
Investors can protect themselves from potential losses due to related party transactions by conducting thorough due diligence before investing, diversifying portfolios to reduce risk, staying up-to-date with regulatory guidelines and enforcement, and recognizing warning signs of fraudulent related party transactions.
What role do regulators play in preventing abusive related party transactions?
Regulators play a critical role in preventing abusive related party transactions in the Indian stock market by providing guidelines for related party transactions, enforcing regulations through audits and inspections, and imposing legal consequences on companies and individuals found guilty of fraudulent related party transactions.