All About Loans to Directors – Section 185- Companies Act, 2013

Introduction

Through the Companies (Amendment) Act, 2017 (“Amendment Act”), the existing Section 185 of the Companies Act, 2013 (‘the Act’), which deals with Loan to directors, etc has been completely substituted with the new provisions w.e.f 7^th May,2018.

The substituted Section 185 deals with the restrictions on part of the Companies in advancing any loan or giving any guarantee or providing any security and to those whom a Company can provide such loan or guarantee or security subject to compliances under the Act. Also, section provides relaxation for Individuals and Entities from the provisions of Sec. 185 subject to certain conditions and Punishment for those who contravene the same.

This article aims to bring a clear vison on the newly substituted provisions of Sec 185 and the practical issues prevailing thereon.

Rationale Behind Substitution of Section 185

Sec. 185 was completely substituted with the new section through the Amendment Act, 2017. The Amendment Act was based on suggestions of the Companies Law Committee, constituted by the Ministry of Corporate Affairs (MCA), in its report dated 1^st February 2016, with the aim to strengthen corporate governance and ease doing business in the country. Recommendations for amendment along with the reasons were clearly reported in the report.

The Extract of the committee’s report w.r.t Sec. 185 is reproduced below for reference:

“Loans to Directors, etc.

12.14 The Committee acknowledged that there are difficulties being faced in genuine transactions due to the complete embargo on providing loans to subsidiaries with common directors, but at the same time there is no doubt that the route has been misused in the past for siphoning of funds by controlling shareholders. The Committee noted that limited relaxation has already been provided to private companies not having other body corporates invested in them and therefore any further relaxation should be subject to greater safeguards. The Committee, therefore, recommended, that it may be considered to allow companies to advance a loan to any other person in whom director is interested subject to prior approval of the company by a special resolution. Further, loans extended to persons, including subsidiaries, falling within the restrictive purview of Section 185 should be used by the subsidiary for its principal business activity only, and not for further investment or grant of loan.

12.15 The Committee also felt that there was no rationale as to why the interest rate prescribed in the proviso (b) to Section 185(1) should not be aligned with the rate prescribed under Section 186(7). Thus, it recommended that this be aligned, keeping in mind further changes suggested to the provision, in the succeeding paragraphs dealing with other issues in Section 186.”

Facts about Section 185 of the Act

a) Sec. 185 brought to force from 12th September, 2013 and Corresponds to Sec.295, 296 of the Companies Act, 1956.

b) There are no rules prescribed, at present, for Sec. 185 under the Companies Act, 2013.

c) Other sections of the Act relating to Sec. 185 are Sections 177, 179 and 186.

d) This section shall not apply to a Govt. Companies, Private Companies and Nidhi Companies subject to conditions specified in MCA’s Exemption Notification dated 5^th June, 2015 and 13^th June 2017.

e) Sec. 61 of the Companies (Amendment) Act, 2017 completely substituted the existing Sec. 185 with new provisions w.e.f 7th May,2018.

Provisions of Substituted Section 185 (After the Amendment Act, 2017)

Subsection 1 states that a Company (Private & Public whether small, OPC, Start-ups etc.) shall not directly or indirectly, advance any loan (including loan represented by a Book debt) OR give any guarantee OR provide any security in connection with any loan take by:

a) Any director of the company; or

b) Any director of its holding company; or

c) Any partner of any such director; or

d) Relative of any such director;

e) Any firm in which any such director is a partner; or

f) Any firm in which the relative of any such director is a partner;

(Note: The Term “any Such” would mean in reference to the director of the lending company and/ or in relation to the director of its holding company)

This subsection strictly prohibits providing Loan or Guarantee or Security to the aforesaid Individuals and firms.

Subsection 2 states that a Company can advance any loan (including Book debt) or give any guarantee or provide any security in connection with any loan taken by

(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 25% of the total voting power may be exercised or controlled by

a. any such director, or

b. 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

a. Board; or of

b. any director or directors, of the lending company.

However, the above provisions are subject to following conditions that:

a) A special resolution is passed by the Company in general meeting; and

b) The loans are utilised by the borrowing company for its principal business activities.

Subsection 2 allows companies to provide loan/guarantee/security to other Companies / body corporates subject to conditions. This was earlier prohibited and now relaxed.

As per Subsection 3, the following entities and individuals are exempted from complying with subsection 1 & 2 as explained above, subject to certain conditions:

a) giving of any loan to a managing or whole-time director – (i) as a part of the conditions of service extended by the company to all its employees; or (ii) pursuant to any scheme approved by way of special resolution;

b) Company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan e.g Banking Companies and Loan NBFCs. (In respect of such loans an interest shall be charged at a rate not less than the rate of prevailing yield of 1 year, 3 years, 5 years or 10 years Government security closest to the tenor of the loan);

c) 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; (in case of WOS complete relaxation from Sec. 185).

d) 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. (Unlike class ‘C’ (i.e WOS) only Guarantee & Securities provided for loan made by any bank or financial institution are allowed for subsidiary company).

Provided that the loans made under clauses (c) and (d) are utilized by the subsidiary company for its principal business activities.

(In order to ensure that the companies do not take advantage of the relief, the provision ensure that there is no siphoning of funds received by the companies, as the amount received under this section should be utilised by the borrower for its principal business activities and not for further investment or grant of loan.)

(Even though ‘principal business activity’ has not been defined under the Act, generally the activities provided in the main objects of the MOA will qualify as the principal business activity of that company)

Subsection 4 talks about the punishment, where any loan advanced or a guarantee or security given or provided or utilized in contravention of the provisions of this section.

Under this subsection, specific offence of contravention in utilization of loan and punishment for officers in default is introduced vide the Amendment Act.

In Simple words,

Substantial Changes made under Section 185 by the Amendment Act

> New section omitted the words “save as otherwise provided in the Act” to avoid confusion as to whether the provisions of section 186, which starts with “without prejudice to the other provisions”, can exclude section 185.

> By this new section, Companies are allowed to grant loans, guarantees and security to entities in which directors are interested, in certain cases, subject to prior approval of the shareholders by a special resolution and on the condition that such loans are used by the borrower for its principal business activities.

> Interest rate prescribed in the proviso (b) to Section 185(3) is aligned with the rate prescribed under Section 186(7) of the Act. Prior to amendment it was “interest at a rate not less than the bank rate declared by the Reserve Bank of India”.

> The ambit of the penalties has been widened and as a result, the obligations of every “officer” of a company (as defined in Section 2(59) of the Act) have been increased to ensure that all loans, security and guarantees are in compliance with the provisions of the Act failing which officer of the company who is in default shall be liable for penal actions and may also attract criminal liability. Also, in the list of offenses under this section, specific offence of contravention in utilization of loan has been added.

Exemptions from Section 185

Other Provisions of the Companies Act relating to Sec. 185

While providing the Loan or Investment or Security and guarantee, in addition to Sec. 185, the Company shall also comply with the following provisions of the Act:

Section 177 (4) (v): Every Audit Committee shall scrutiny of inter-corporate loans and investments.

Section 179(3) (e): The Board of Directors of a company shall exercise the power to invest the funds of the company by means of resolutions passed at meetings of the Board.

Section 180(1)(d): To remit, or give time for the repayment of, any debt due from a director.

Section 186: Loan and Investment by Company.

Practical Problems / Case Laws for better understanding

Problem: Abc Ltd is a Computer manufacturing company. One of the Directors Mr. A is setting up an Office for which he will also need to buy Computers. Mr. A asks the Company to give him 20 Computers for a long credit period. Whether is there any restriction on this transaction?

Solution: As per Sec. 185 (1) providing loan either directly or indirectly, including any loan represented by a book debt to any director of company, is prohibited. Hence, this transaction is prohibited and violation of Sec. 185.

Further, in the case of “Pennwalt India Ltd. v. RoC”, wherein the Hon’ble High Court of Bombay has held that to ascertain whether a transaction is a loan or not, surrounding circumstances, relationship and character of the transaction and the manner in which parties treated the transactions will have to be considered. Therefore, with reference to each transaction with Directors and other person in whom the Directors are interested, the nature of transactions has to be studied, in case they relates to book debts.

Question: Whether a company can lend through intermediary to the persons who are otherwise related with the lending company?

Answer: Under subsection 1 of Sec. 185 a company shall not advance any loan either directly or indirectly. Further, in the case of Dr. Fredie Ardeshir Mehta V. Union of India [1991] 70 Comp. Cas. 210 (Bom.), the term Indirect used in the Section 295 of CA, 1956 (now Sec.185 of CA, 2013) is interpreted as “When Section 295 refers to indirect loan to director, what it means is that the company shall not give a loan to a director through the agency of one or more intermediaries.” The word “indirectly” used in Sec. 295 cannot be read as converting what is not a loan into a loan. Therefore, the company shall not lend through intermediary to the persons who are otherwise related with the lending company.

Question: Is the section applicable to a letter of comfort (LoC) given by the company?

Answer: No, Guarantee has been covered, however, LoC is not covered by sec 185. In case of Guarantee, guarantor undertakes the liability of principal debtor, whereas In case of letter of Comfort, intention is to give introduction of debtor, without undertaking the liability of principal debtor. The word guarantee is defined in the Contracts Act to imply the “undertaking of the liability of a principal debtor by the guarantor”. However, in case of letter of comfort, the commitment of comforting party is merely to the extent of introducing the principal debtor, but there may be a moral obligation, but there is no contractual obligation of the comforting party, and hence, there is no guarantee. Therefore, LoC is not covered under the Sec. 185.

Problem: Abc Ltd provided corporate guarantee to Xyz Pvt Ltd ( Mr. A, shareholder of Abc Ltd is also a director in Xyz Pvt Ltd) on 01.07.2018. Later on in the view of conditional exemption u.s 185(2), the Abc Ltd obtained approval of shareholders for the said corporate guarantee on 20.07.2018. Whether this transaction is violative of Sec. 185? Whether Prior Approval of shareholders are required for loans to certain entities under Sec. 185 (2)? 

Solution: As per the substituted Section 185, Company may provide loan/guarantee to any person in which director is interested u/s185(2), subject to the condition that A special resolution is passed. This condition has to be prior approval, because only after meeting with this condition, company is allowed to give loan/guarantee to any person as specified under Section 185(2). Hence, this transaction is violative of Sec. 185 and prior approval of members is mandatory.

Problem: ABC Ltd grants loan to its director Mr. A for Construction of flat / house pursuant to a Loan Scheme approved by the shareholders by way of Special Resolution. Whether the same violates Sec. 185? Also, whether the director is criminally liable?

Solution: Yes, as per Sec. 185 (3), giving of any loan to a managing or whole-time director alone is exempted from the provisions of Sec. 185 subject to the condition that it was provided pursuant to scheme approved by the members by a special resolution. Hence, providing loan to Mr. A who is not WTD or MD is violation of Sec. 185 and the director is criminally liable.

Problem: Abc Ltd, Lender Company and also Subsidiary of Xyz Pvt Ltd. Abc Ltd wants to give Loan/Guarantee/ Security to Holding Company. Whether the same is possible in the following scenario i) Where Directors of Abc Ltd are also shareholders of Xyz Pvt Ltd. ii) If the holding Company is Public Limited.

Solution: (i) Where Directors of Lender Company are Directors or shareholder of Holding Company, it will fall under u/s 185(2). Therefore, Subsidiary can give loan to holding Company by complying with conditions of subsection 2 of Sec.185 i.e prior approval of the shareholders by a special resolution and such loans are used by the borrower for its principal business activities.

(ii) If the Holding Company is Public Limited Company, Lender (Subsidiary) can give loan to such holding Company and such transaction will not fall u/s 185.

Problem: ABC Pvt Ltd and XYZ Pvt Ltd does not have any common director. In ABC Private Limited, Mr. R is a Director and in XYZ Private Limited, the wife of Mr. R is a Director. In this scenario whether the provisions of Sec. 185 will attract?

Solution: In such a situation, the loan can be given by ABC Pvt Ltd to XYZ Pvt Ltd. The condition mentioned u.s 185(2) is common directorship i.e “private company of which any such director is a director or member”. It clearly excludes the relative of director and hence the provisions of Sec. 185 will not attract.

Conclusion

When the section was originally introduced, there were complete prohibition on loan to its directors and other entities and it was felt that the said changes were much required for better governance & transparency in the affairs of the Companies keeping in view the fiduciary character of the directors.

However, the section was quite harsh when it came to implementation, even the deserving and genuine cases were debarred from raising Loans from the Companies. Considering the same and for ease of doing business in India, the relief has been given to certain entities vide the substituted provisions, while at the same time providing adequate safeguards and additional responsibility on the part of company and its officers.

DISCLAIMER: The information given in this document has been made on the basis of the provisions stated in the Companies (Amendment) Act, 2017 and Companies Act, 2013. It is based on the analysis and interpretation of applicable laws as on date. The information in this document is for general informational purposes only and is not a legal advice or a legal opinion. You should seek the advice of legal counsel of your choice before acting upon any of the information in this document. Under no circumstances whatsoever, we are not responsible for any loss, claim, liability, damage(s) resulting from the use, omission or inability to use the information provided in the document.