Explained: Related Party Transactions and its impact on your investment

A Related Party Transaction (RPT) is a transaction between two related parties for the transfer of resources, services or obligations. This is irrespective of whether a price is charged and can have an effect on the profit or loss statement and financial position of an entity. 

For Example, if company ABC buys goods or services from its director XYZ, it counts as an RPT. Similarly, if company ABC takes on rent premises owned by XYZ, a relative of its director, it is also an RPT. 

RPTs are subjected to stringent norms because there is an attached risk that the related party may be favoured with terms that could harm the interests of the company's shareholders. That said, RPTs have been used by corporations across the globe, especially in cases where the business interests of Board members overlap with that of companies in which they have a stake. 

These transactions come in all shapes and size like lending transactions to the company and from the company, investment in the company and from the company, sales & purchases to the company and from the company, consulting services provided to the company and from the company etc. 

Below are some different types of RPTs that an investor should pay attention to as they have the potential to shift economic benefits from the company to the promoters.

1.    Lending transactions between the company and the promoters 

 Many times, companies give loans to the promoters and simply write them off at a later date, essentially giving out money to the promoters. This may also come in the form of interest-free/cheap loans to promoters and their entities. It is the minority shareholders who bear the cost of the funds especially if the company has taken out loans from the banks to lend to the promoters. 

On the other hand, companies take loans from promoters too and pay high interest rates to the promoters - much higher than what it would pay had it taken these loans from the banks. As a result, the promoter's gains at the cost of minority shareholders of the company. 

2.    Buying and selling assets/equity stake between the company and promoters’ entities 

 This represents a situation where the promoters sell their assets to the company at a price much higher than it would get from the market. This can either be a direct transaction between the company and the promoter or through a joint venture. In the case of a joint venture, the promoters and company start a new business and later when the business fails, the company buys the stake of the promoters to bail them out. 

Many times, the promoters make the company buy assets from the market and then the promoters use these assets for their personal use, at no cost to themselves. Investors would have noticed instances of promoters using the company money to purchase expensive items that promoters use for their personal purposes. In all the above cases, the minority shareholders end up bearing the cost for the promoters’ gains. 

3.    When companies enter into sale/purchase/consulting/contracting business transactions with promoters 

 This scenario mostly happens with many Indian companies. In most cases, it is the promoters who decide how much business or how much margin they will keep for themselves and how much they will leave for the listed company. It is the promoters who get to dictate the terms and the minority shareholders are at the mercy of the promoters. 

4.    When promoters own competing businesses in their personal capacity 

This is a situation wherein, the promoters own competing businesses, they can easily decide how much business to allocate between the listed company and their personal business. The personal business of the promoters are kept running at full capacity and may even outsource their contract work to the listed company, thereby keeping the high margin for themselves. In this situation too, the minority shareholders of the listed company are left facing losses. 

5.    When companies provide guarantees to lenders on behalf of promoter group entities 

 This type of RPT is not easily spotted because at first glance it may seem that the listed company has not entered into any monetary transaction with the promoters. However, any guarantee given by the listed company ensures that the promoters enjoy the fruits of their personal business as long as it runs successfully. In the case wherein the personal business fails, then the banks will recover their loans from the guarantor i.e. the listed company. The risk again is borne by the minority shareholders giving the guarantee via the company.