Section 185 Companies Act 2013: Prohibitions on Loans to Directors & Others

Introduction:

Section 185 of Companies Act, 2013 talks about Loan to Directors, their relatives, entities in which such Directors are interested and also Loan to Subsidiaries of the lending company. This section covers both Prohibitions and restrictions to give loans to the above-mentioned parties. Prohibition indicates, the clear denial of such activities of giving loans, guarantees etc. Restrictions meant to include certain pre requisites that need to be followed while giving loan to such entities which will be discussed hereunder.

What transactions are prohibited under section 185 of Companies Act, 2013?

Section 185 (1) clearly states that “No company shall, directly or indirectly, advance any loan, including any loan represented by a book debt to, or give any guarantee or provide any security in connection with any loan taken by, —

(a) any director of company, or of a company which is its holding company or any partner or relative of any such director; or

(b) any firm in which any such director or relative is a partner.”

Explanation of the term:

“Loan represented by Book Debt” means such loans which are actually not shown as loan, but a loan shown by way of Debtors or Credit sales in the Balance Sheet and such other indirect loan which are not shown directly as Loan in the Books of a Company.”

“Guarantees”, includes only Guarantees which are in connection with loans or financial guarantees and it does not cover Performance Guarantee.”

From the above-mentioned section, it is clear that the section starts with the words “No Company shall”, which clearly explains that such transactions are completely prohibited under the Act. So, the transactions such as giving loans, guarantee or any securities in connection with any loans taken by,

• Any Director of Lending Company; Or
• Any Director of Holding Company of the Lending Company (Subsidiary which advance the Loan); Or
• Any Partner or Relative of any such above covered Directors; Or
• Any firm (includes both registered and unregistered partnership) in which any of the above covered Director(s) or their relative(s) are partner or partners.

Thus, giving loans, guarantee or any securities in connection to the above said persons are strictly prohibited by the Companies Act, 2013.

Who are all eligible to receive loans or guarantee from a company?

“A company may advance any loan including any loan represented by a book debt, or give any guarantee or provide any security in connection with any loan taken by any person in whom any of the director of the company is interested, subject to the condition that—”

Explanation. —For the purposes of this sub-section, the expression “any person in whom any of the director of the company is interested” means—

(a) any private company of which any such director is a director or member;

(b) any body corporate at a general meeting of which not less than twenty-five per cent. of the total voting power may be exercised or controlled by any such director, or by two or more such directors, together; or

(c) any body corporate, the Board of directors, managing director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

From the above-mentioned explanation, it is clear that “any person in whom any of the director of the company is interested” means,

• Any Private Company in which any of the Directors, who are covered under sub-section (1), is/are Director(s) or Member(s). Even if a director holds single share, he will be covered under this explanation in case of Private Company.
• Any Body Corporate (includes public limited companies and such other body corporates) in which 25% or more of voting rights can be exercised or controlled (By way of beneficiary or under any influence indirectly) in the general meeting of such body corporate by any such Directors or by two or more such directors.
• Any Body corporate, in which the Board of directors, managing director or manager of such body corporate is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

The above covered companies are eligible to get Loan or advances including the securities or guarantees from a lending company subject to the fulfillment of certain conditions which are discussed below.

What are the conditions to be fulfilled for giving Loan or Guarantee to the Eligible Persons?

Sub-section (2) of Section 185 covers the parties who are eligible to receive loans or guarantees from a company subject to certain conditions imposed by the Act. It states as follows—

“A company may advance any loan including any loan represented by a book debt, or give any guarantee or provide any security in connection with any loan taken by any person in whom any of the director of the company is interested, subject to the condition that—

• a special resolution is passed by the company in general meeting.

Provided that the explanatory statement to the notice for the relevant general meeting shall disclose the full particulars of the loans given, or guarantee given or security provided and the purpose for which the loan or guarantee or security is proposed to be utilised by the recipient of the loan or guarantee or security and any other relevant fact; and;

• The loans are utilised by the borrowing company for its principal business activities.”

Thus, to grant loan or securities to the eligible company, the Lending company must pass a Special Resolution, the notice of such meeting must include an explanatory statement with all the disclosures required in the above-mentioned section and the Company which receive loan must use the proceeding only for its principal business activities.

Exemptions available under Section 185 of Companies Act, 2013:

The following items are exempted from Prohibitions and Restrictions under sub-section (1) and (2) of Section 185:

1. Giving Loan to Managing Director or Whole-time Director (Only Loan is permitted no guarantee or securities are allowed):

• as a part of the conditions of service extended by the company to all its employees (must be paripassu with the conditions bind on all other employees and no special privileges are allowed to MD or WTD); or
• pursuant to any scheme approved by the members by a special resolution;

Or

2. A company which in the ordinary course of its business provides loans or gives guarantees or securities (includes Banks and NBFCs) for the due repayment of any loan and in respect of such loans an interest is charged at a rate not less than the rate of prevailing yield of one year, three-year, five-year or ten-year Government security closest to the tenor of the loan;

Or

3. Any loan made by a holding company to its wholly owned subsidiary company or any guarantee given or security provided by a holding company in respect of any loan made to its wholly owned subsidiary company;

Thus, it is clear that a Holding Company can give Loan or provide guarantee or security in connection with any loan from third party without any restriction. Provided that the loans availed under this exemption must be utilised by the wholly owned subsidiary company only for its principal business activities.

4. any guarantee given or security provided by a holding company in respect of loan made by any bank or financial institution to its subsidiary company.

Thus, it is clear the Guarantees given and Securities provided by the holding company only in respect of Loans provided by any Banks or Financial Institutions to its Subsidiary (Not wholly owned Subsidiary) are exempted, but the restriction still applies for giving Direct Loan to Subsidiaries.

Provided that the loans availed under this exemption must be utilised by the subsidiary company for its principal business activities only.

Ref: Section 185(3) of Companies Act, 2013.

Consequences of Contravention of Section 185:

If any loan is advanced or a guarantee or security is given or provided or utilised in contravention of the provisions of this section,

• The company shall be punishable with fine which shall not be less than 5 lakh rupees but which may extend to 25 lakh rupees,

                                                                                               and

• The director or the other person to whom any loan is advanced or guarantee or security is given or provided in connection with any loan taken by him or the other person, shall be punishable with imprisonment which may extend to six months or with fine which shall not be less than five lakh rupees but which may extend to twenty-five lakh rupees; Or

• With both.

Conclusion:

Section 185 has been introduced to curb the loans which is to be given to the subsidiaries for any purpose other than for the principal business activities and to restrict the siphoning of funds by way of loans. This section avails the shareholders to have a knowledge, control over such loans to subsidiaries and would made aware the shareholders about such transactions which allow them to take active decisions regarding the same which will act as a check on Directors own discretion.