Legal Risk of Company’s Related Party Transaction

Source:   Time: 2017-12-19 17:36:20  Author: The enforcement of awards of the Court of Arbitration for Sport in China

A related party transactionis a transaction that takes place between two parties who hold a pre-existing connection prior to the transaction. A company's related party transaction is an economic activity. The normal related party transactions can stabilize the business, spread the operation risk and benefit the company's development; but, in practice, controlling company makes use of affiliated relations and controlling position to force subordinate company to transact with itself or other affiliated parties, and therefore harms the interests of subordinate companies and minority shareholders. Regarding this, corporate laws of all countries have the relevant complex or simple provisions of related party transactions, adjust affiliated relation, protect the interests of subordinate companies and minority shareholders.

As to the definition of related relations and related parties, definition standards required by regulation are different in accordance with different laws and regulations. For example, the accounting standard focuses on financial accounting and post-disclosure to reflect the financial information of a complete accounting entity; Tax rules focus on determining transfer pricing and accounting income tax to avoid harming state taxation; the rules of securities focus on decision-making process and prior disclosure, in order to prevent the related party transactions from harming the interests of listed companies and medium and small shareholders.

I. Identification of illegal related party transactions

In the cases involving related party transactions in the people's court, how to determine the illegal related party transactions is the entry point and key of the trial involving related party transactions cases. Article 21 of the corporate law stipulates: "the controlling shareholders, actual controllers, directors, supervisors and senior managers of the company shall not use their affiliated relations to harm the interests of the company." The regulation establishes the legal basis and the principle of regulating related party transactions, outlines the boundaries between legal related party transactions and illegal related party transactions, namely "harm the interests of the company" is a fundamental standard of illegal related party transactions.

In practice, illegal related party transactions harm not only the interests of the company, but also those of minority shareholders and those of creditors, which fall into the category of illegal related party transactions. In judicial practice, it is possible to judge whether the related party transactions are lawful or not based on the following aspects:

1. The procedural requirements to judge whether the related party transaction violates legal provision. Procedural requirements are legal requirements for the behavior process of related party transactions, in order to restrict the illegal behavior in related party transactions, the process conditions for behavior process of related party transactions in all countries are provided, i.e., the disclosure and approval system of related party transactions.

Although full disclosure of information is the key to secure justice and fairness of related party transactions, to disclose or not is not necessarily associated with whether the related party transactions, in essence, are fair and just or not, that is to say, even failure to fulfill the disclosure obligations in related party transactions, it shall not necessarily causes invalidity of related party transactions behavior; Approval system of related party transactions is different from disclosure system, the corporate law in all countries stipulates approval of related party transactions, i.e., related party transactions behavior of the company needs to be approved especially, after being approved by meeting of shareholders and the board of directors, related party transactions can be implemented and have the force of law, otherwise become nullified.

2. Whether the related party transactions behavior violates the provisions of laws and administrative regulations. If related party transactions itself violates the prohibitive or mandatory regulation of laws and administrative rules and regulations, it obviously belongs to illegal related party transactions, for example, company directors and senior managers enter into a contract with the company or conduct transactions, in violation of the provisions of the company's articles of association or without the consent of the shareholders' committee, general meeting of shareholders.

3. Whether the motivation for related party transactions is justified. Motivation is the idea of motivating a person to engage in some kind of behavior. The thought is ideology, although it is not easy to grasp, can be judged according to the behavior of affiliated party. This is actually the standard of good faith and malice in civil law. Related party transactions actually involve the interests of the affiliated parties. In the event of a transaction, it is inevitable that there will be a case of a person violating the transaction obligations. In judicial practice, ought to judge the legitimacy of related party transactions according to whether the purpose of affiliated party transaction behavior is proper, whether motivation for transaction is to manipulate market, transfer profits or property,  present false statements, evade tax.

Whether related party transaction itself violates the rules. The so-called violation of regular transactions, i.e. based on business trading habits the transaction conditions are clearly improper. How to determine whether trading behavior is an unconventional trading activity? In judicial practice, how to evaluate the market price, what procedure you need to perform, if there is no fair and scientific evaluation mechanism, both parties themselves determine an intermediary institution to assess the results they need, it is bound to harm the interests of the company and the creditors. Therefore, the people's court should refer to the market trading practice and refer to the appraisal opinions of professional audit and evaluation bodies. In the event whether related party transaction itself violates the rules, the court judges whether the trading behavior of associated traders brings to the company real or obvious possible loss based on transaction structure. The obvious possible losses shall be paid particular attention.

II. Risk prevention measures for related party transactions of company

Related party transactions have long been widespread in many companies. In order to avoid risks, companies shall pay attention to the following points in related party transactions:

1. Authenticity of related party transactions. True related party transactions refer to the fact that there is a motivation for real transaction, which is consistent with business practices. The false related party transaction not only deviates from the interests of company, but also often hides the violating and illegal factors. For example, some companies make up nonexistent transactions to transfer income and apportionment expenses, or settle interest charges through mutual funds. Once discovered, the company faces penalties and the company's credit is affected. Therefore, companies shall pay attention to the authenticity of related party transactions.

2. Focus on the disclosure of related party transactions. The existence of related party transactions is not the focus of attention, and the timely, in-depth, complete and accurate disclosure of related party transactions has become the focus of public investors' attention and the focus of the supervision department. Only by insisting on the principle of focusing on disclosure instead of existence, the company can make the company run more robustly.

3. The necessity and fairness of related party transactions. The necessary related party transactions are indispensable for the existence and development of the company, such as: comprehensive service agreement, purchase or lease agreement replied on by the main business, etc. This kind of related party transactions is also the related party transactions making company go forward, meanwhile, also the fairness of the related party transactions shall be considered.

4. Focus on protecting the interests of small and medium shareholders in related party transactions. In practice, related party transactions occur between new and old controlling shareholders and their affiliated parties. Although the controlling shareholders are not different from other shareholders in the quality of rights, it is only the difference in quantity, their rights are superior to those of ordinary shareholders. Related party transactions tend to harm the interests of small and medium shareholders, if this problem can’t be dealt with well, it will arouse dissatisfaction of small and medium shareholders, may ensnare the company in litigation, will affect the company's reputation, and hinder to the development of the company.

III. Summary and reflection

The company's related party transactions are inevitable, in general, the company can reasonably make full use of related party transactions to bring benefits to the enterprise. Therefore, legal related party transactions become an important means for high unification of economy, convenience and efficiency. But related party transactions are a double-edged sword for companies. In the long run, the consequences of related party transactions will also have an adverse impact on the company, and there are many legal risks. Companies should be cautious in dealing with related party transactions so as not to swamp the company.

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