Related Party Transactions Under Section 188: A Founder Plain-English Guide

What does Section 188 actually require?

Section 188 of the Companies Act, 2013 applies to contracts and arrangements between a company and a related party in specified categories: sale, purchase or supply of goods or materials; selling, disposing of or buying property of any kind; leasing of property of any kind; availing or rendering of services; appointing an agent for buying or selling goods, materials, services or property; a related party's appointment to an office or place of profit in the company, its subsidiary or associate; and underwriting of the company's securities.

It is procedural rather than prohibitory. The section does not stop a company from dealing with people connected to its directors. It says such dealings need the consent of the board, given by a resolution at a meeting of the board rather than by circulation, and where the transaction crosses prescribed thresholds, prior approval of the shareholders by an ordinary resolution.

The interested director should disclose the interest and is expected not to participate in the board discussion on that item. At the shareholder stage, the Act restricts members who are related parties from voting on the resolution, although private companies have relief from this restriction under an exemption notification issued in 2015. Your company secretary will know which version applies to you.

Who counts as a related party?

The definition in Section 2(76) is wider than most founders expect. It includes a director or key managerial personnel and their relatives, a firm in which a director, manager or their relative is a partner, a private company in which a director or manager or their relative is a member or director, a body corporate whose board is accustomed to act on the advice of a director or manager, and holding, subsidiary and associate companies, among others.

Relative has a specific meaning under Section 2(77) and the rules made under it: members of a Hindu Undivided Family, spouse, father, mother, son, son's wife, daughter, daughter's husband, brother and sister, with step-relations included. A cousin, an uncle or a brother-in-law is not a relative for this purpose, although a transaction with one may still raise conflict questions in diligence.

The definition catches entities, not just people. A private company in which your spouse is a shareholder is a related party even if your spouse has no role in managing it.

The exemption most founders miss: ordinary course and arm's length

A proviso to Section 188(1) takes out of the section any transaction entered into by the company in its ordinary course of business, other than transactions which are not on an arm's length basis. Both limbs matter. The transaction has to be the kind of thing the company does in its normal business, and the terms have to be what unrelated parties would agree.

The Act explains an arm's length transaction as one between two related parties conducted as if they were unrelated, so that there is no conflict of interest. In practice that means evidence: comparable quotes, rate cards, market rent data, or the price the company pays unrelated suppliers for the same thing.

Founders sometimes rely on this exemption by assumption, never writing anything down. That is the weak version. A short board note recording why the transaction is in the ordinary course and why the price is market, with the supporting quotes attached, turns an assertion into a record. Where there is real doubt, taking board approval anyway costs little.

The transactions founders actually run into

• Paying a consultancy or services company owned by a founder or a founder's relative.
• Taking office premises on lease from a director, a relative, or an entity they control.
• Employing a founder's spouse, sibling or parent in the company, which is an office or place of profit.
• Buying equipment or services from a business connected to a director.
• Group arrangements where two companies share founders and one invoices the other for staff, rent or software.
• Licensing a trademark or code that a founder still holds personally to the company.

When is shareholder approval needed?

Board approval is the starting point. Shareholder approval by ordinary resolution is additionally required where a transaction crosses the thresholds in Rule 15(3) of the Companies (Meetings of Board and its Powers) Rules, 2014. These are set mainly as percentages of turnover or net worth, and are measured for the transaction individually or taken together with earlier transactions in the same financial year. The table summarises them as they stand at the time of writing; rules are amended, so have your company secretary confirm the current figures.

A worked example

Suppose a private company with a turnover of ₹3 crore in the last audited year takes its office from a company owned by a founder's wife at ₹1.5 lakh a month, or ₹18 lakh a year. The lessor is a related party. Leasing premises is arguably not the company's ordinary course of business, so the safer course is board approval at a meeting, with the interested founder disclosing the interest. Since ₹18 lakh is below 10% of turnover, which is ₹30 lakh, a shareholder resolution is not needed for this lease alone.

Now suppose the same company hires the founder's brother as head of operations at ₹3 lakh a month. That is an appointment to an office or place of profit at a monthly remuneration above ₹2.5 lakh, so shareholder approval by ordinary resolution is required in addition to board consent. If he were hired at ₹2 lakh a month, board approval would generally be enough, assuming the appointment is not covered by the ordinary course exemption.

In both cases, paper the transaction itself: a written lease at market rent, and an appointment letter for the brother on the same terms as other staff at that level.

What happens if you skip the approval?

Under Section 188(3), where a director or employee enters into a contract without the required board consent or shareholder approval, and it is not ratified by the board or the shareholders within three months of being entered into, the contract becomes voidable at the option of the board or the shareholders. If the contract is with a party related to a director, or was authorised by another director, the directors concerned can be required to indemnify the company against any loss.

Section 188(5) adds penalties for the directors and employees who entered into or authorised the contract in breach of the section. The amounts have been revised by amendments over the years, so check the current figures rather than relying on older articles.

The more common practical consequence is commercial rather than penal. Related-party dealings are a standard diligence line item. Unpapered ones become questions, then disclosure schedules, then conditions precedent to closing, and occasionally a price adjustment.

Why it matters even when the deal is fair

Most of these transactions are entirely reasonable. A founder who owns a design studio doing the company branding at market rates is not doing anything improper. The difficulty is that the fairness is asserted rather than documented, and a later reader has no way to distinguish it from a transaction that was not at arm's length.

That later reader is usually an investor or an acquirer. A board minute and quotes from the time answer their questions in five minutes. Without them, the same questions can take weeks.

Loans and guarantees are a separate question

Sections 185 and 186 address different ground. Section 185 restricts a company from advancing loans to its directors, giving guarantees or providing security for their loans, and allows such loans to entities in which a director is interested only through a special resolution and subject to conditions. There are limited exceptions, such as loans to a managing or whole-time director under a scheme approved by shareholders, and certain private companies with no corporate shareholders and limited borrowings are exempt under a 2015 notification, subject to its conditions. Section 186 caps and conditions loans, guarantees and investments made by a company more generally.

Founders frequently move money between a company and themselves informally in the early years, and these are the provisions that make that a live issue rather than a bookkeeping detail. A director current account with an unexplained debit balance is a common diligence finding. Money flowing the other way, from a director into the company, raises its own questions under the deposit rules, which usually require a declaration that the funds are the director's own and not borrowed.

Practical hygiene

• Maintain a list of related parties, including relatives and entities they control, and update it when directors or shareholdings change.
• Collect each director's disclosure of interest in Form MBP-1 at the first board meeting of every financial year and whenever it changes, as Section 184 requires.
• Enter related-party contracts in the register of contracts under Section 189.
• Decide for each transaction whether it is ordinary course and arm's length, and record the reasoning with supporting quotes.
• Where approval is needed, pass the board resolution at a meeting, and an ordinary resolution of shareholders above the thresholds.
• Paper the transaction itself with a written agreement at market terms.
• Disclose the transactions in the board's report in Form AOC-2 where required.

Sample board resolution wording

A simple board resolution might read: 'Resolved that, pursuant to Section 188 of the Companies Act, 2013 and the rules made under it, consent of the Board be and is hereby accorded to the Company entering into a lease of premises at [address] with [lessor], a related party, at a monthly rent of ₹[amount] for a term of [period], on the terms placed before the Board, the Board having noted that the rent is in line with the market comparables tabled.' Record in the minutes that the interested director disclosed the interest and did not participate. Your company secretary will adapt this to your facts.