Is your related party transaction on arm's-length terms?
The Corporations Act prohibits responsible entities (REs) from providing a financial benefit to a related party without obtaining the consent of the members, unless the financial benefit is given on arm's-length terms.
Our clients often provide financial benefits to related parties due to the separation of the role of the RE from that of the manager in many instances and the creation of multiple trust structures. Here, partner Langton Clarke and lawyer Sandhya Susindar explain the test and what an arm's-length relationship means in practical terms.
When determining whether the financial benefit was given on "arm's-length terms", the court will ask whether the terms of the transaction would reasonably be achieved by a hypothetical RE in the same position dealing with an unrelated party.
In applying the test, the court will assume the RE is—
- unrelated to the other party to the transaction in any way (financially or through ties of family, affection or dependants)
- free from any undue influence or pressure
- through its relevant decision-makers, sufficiently knowledgeable about the circumstance of the transaction, sufficiently experienced in business and sufficiently well advised to be able to form a sound judgment as to what is in its interests, and
- concerned only to achieve the best available commercial result for itself in the circumstances.
WHAT IS A REASONABLE COMMERCIAL RESULT?
In determining what a reasonable commercial result might be the courts have said—
What is a reasonable commercial result for the public company in the transaction is, of course, in itself, a matter of judgment upon which honest and experienced commercial minds may legitimately differ. The court may receive expert evidence as to what would be within the range of reasonable outcomes of the transaction for the public company. Common experience or usual terms of trade in a particular market may sometimes also prove a useful guide.
The court is not, however, bound to rely only upon such expert evidence and to blind itself to common sense and obvious commercial prudence. A transaction may be so clearly improvident from the public company's point of view that the court can see for itself that the transaction could never have resulted from an arm's-length dealing in which the public company was able to advance and protect its own commercial interests.
WHAT IS AN ARM'S-LENGTH RELATIONSHIP?
Importantly, the onus is on the RE to prove the financial benefit was given on arm's-length terms. The party alleging the transaction was not on arm's-length terms does not have the burden of proof.
The Supreme Court in Victoria has reviewed the authorities about what arm's-length might mean and said—
The concept of an arm's-length relationship is distinct from that of an arm's-length dealing or transaction. Unrelated parties may collude or otherwise deal with each other in an interested way, so that neither the dealing nor the resultant transaction may properly be considered arm's-length. Where the parties are not in an arm's-length relationship, it is recognised that the inference may be drawn that they did not deal with the other at arm's-length. Related parties may, nevertheless, in some circumstances, demonstrate a dealing which displaces the inference based on their relationship. They may engage in the disinterested bargaining characteristic
of strangers, applying independent separate wills. The circumstances of the impugned transaction may be such that, despite the parties' connection or common interest, the interposition of some independent process ensures that the transaction itself is arm's-length.
Usually when we are asked to consider these types of transactions, we are focused on the outcome and whether the outcome is similar to what two disinterested parties in the market might have concluded. It is of increasingly greater significance that the process by which the decision was made is also analysed and evidence produced about the bargaining that occurred to reach the ultimate arm's-length outcome.