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Co Act, 2013: Loan to Directors Etc. - An Analysis

CA. Amit G. Chandani 
on 11 April 2014

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The provisions of section 185 of the Companies Act, 2013 which particularly prohibits grant of any loans, giving of guarantee or providing of any security to the directors or any other person in whom the director is interested; otherwise than for given exemptions; is by and large one of the most debated section of the New Act. The section was notified from the first phase of implementation of Companies Act, 2013 i.e. from 12th September, 2013. Still, the section is most debatable and being interpreted differently. 

Section 185 of the Companies Act, 2013 which has been notified on 12th September 2013 replaces the old section 295 of the Companies Act, 1956 which provides for loans to directors. 

This section now applies to all companies including private companies also. Hitherto private companies were exempted from the provisions of the old section 295. So, now companies cannot give any loans to directors or to persons in whom the director is interested, except as provided in Section 185 of new Act.

What does section 185 say?

Loan to Directors etc. 185. (1) Save as otherwise provided in this Act, no company shall, directly or indirectly, advance any loan, including any loan represented by a book debt, to any of its directors or to any other person in whom the director is interested or give any guarantee or provide any security in connection with any loan taken by him or such other person:

This section uses the opening words -‘Save as otherwise provided in this Act’ as against ‘Save as otherwise provided in sub-section (2)’ provided in Section 295 of the Companies Act, 1956.

With the usage of words ‘save as otherwise provided under this Act’ in Section 185, whether loans to director and other person in whom Director is interested may also be made after complying with the provisions of such Section 186 of the Act, which has been notified w.e.f. 01st April, 2014?

It is pertinent to mention here that Section 186 of the Companies Act, 2013 corresponds to Section 372A of the Companies Act, 1956 and provides for provisions relating to loans and investment by Company. If the answer to the aforesaid question is positive, then the whole purpose of legislation to have Section 185 of the New Law seems redundant. On the other hand, if the answer to it is negative, then there seems some drafting error in the legislation or where else do we see the effect of the section in law if not Section 186?

To analyze whether or not with the usage of words ‘save as otherwise provided under this Act’, whether the intent of law is such that coming into force of Section 186 of the Act, loans to director and other person in whom Director is interested may also be made after complying with the provisions of such Section 186; we may refer to the Rule of Harmonious Construction for understanding the intent of legislation.

Rule of Harmonious Construction: A statute must be read as a whole and one provision of the Act should be constructed with reference to other provisions in the same Act so as to make a consistent enactment of the whole statute. In other words, when there are two provisions in a statute, which are in conflict with each other, they should be interpreted such that effect can be given to both and the construction which renders either of them inoperative and useless should not be adopted except in the last resort. [Bengal immunity Co. vs. State of Bihar (1955) 6 STC 446 (SC)]

As we apply the rule of Harmonious Construction to the situation wherein Section 185 and Section 186 of the Companies Act, 2013 exist; if upon exercise of provisions specified under Section 186, Section 185 is rendered inoperative, then both the sections should be read independently so as to give effect to Section 185.

Hence, while the usage of words ‘save as otherwise provided in Act’; seems redundant; on application of the Rule of Harmonious Construction, it may be construed that loans to directors or other person in whom director is interested is restricted by virtue of Section 185 and section 186 of the Act is NOT an enabling provision for such transactions.

So, it shall not be interpreted that section 186 is an enabling provisions for restriction provided in Section 185.

Another interesting aspect of this section is its applicability on book debts. While under the Companies Act, 1956, Section 296 specifically stated that Section 295 shall apply to any transaction represented by a book debt which was from its inception in the nature of a loan or an advance; no separate mention of nature of such book debt is mentioned under the provisions of Section 185 of the Companies Act, 2013 as it straight away includes ‘any loan represented by a book debt’ in its purview. It remains to be seen now whether undertaking of any related party transaction for e.g. relating to purchase or sale of goods or services which are otherwise allowed within the purview of Section 188 of the Companies Act, 2013; for credit (not for cash); also end up in a violation of this section for the Directors and other person in whom Directors are interested. Perhaps the nature of credit extension to directors and other person wherein directors are interested would also be required to be reviewed for each transaction.

Regarding the aspect of this section as to its applicability on book debts; it is pertinent to refer to the case of Pennwalt India Ltd. v. RoC , wherein the Hon’ble Bombay High Court 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. Hence, 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.

Exemptions provided in Section 185

First proviso to Section 185 provides certain exemptions from the operation of Section 185 to certain transactions. These are as follows:

(a) the 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 the members by a special resolution

Thus, the company can give loan or advance to its managing or whole-time director which is according to the terms and conditions of service framed by the company for all its employees and not particularly for managing or whole director. Secondly, loan or advance can also be granted to the managing or whole-time director pursuant to any scheme approved by the members by a special resolution. Such schemes may include Housing Loan scheme, Education loan scheme, ESOP etc.

(b) a company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan and in respect of loans an interest is charged at a rate not less than the bank rate declared by the Reserve Bank of India.

The law has also granted exemption to companies which is ordinary course of its business provides loan or gives guarantee or securities for due repayment of loan with specified interest rate. Now a significant question here is whether the intent here is to cover just Banking Companies or NBFCs or for that matter, any other entity which undertake such transaction with bonafide intent to achieve its main objects i.e. in ordinary course of its business? The term ‘ordinary course of its business’ being very subjective in itself leaves lot of scope for different interpretations.

Does the usage of word ‘its’ in the phase ‘ordinary course of its business’; creates any difference; as far as interpretation of the phase is concerned?

The issue still remains unanswered and the phase seems open to subjective interpretations.

It seems that, in order to be within the ordinary course of business, a transaction must adhere to the practices and customs that are considered normal for an industry. It would not be unusual for businesses in the same industry to engage in transactions similar to a transaction under examination. Determining whether something is within the ordinary course of business or not can involve evaluating similar types of businesses and industries to see if they engage in similar types of transactions. Other tests can include questioning the parties to the transaction and checking regulations to see if they outline any practices for a given profession or industry.Hence, the provision does not just include Banking Companies or NBFCs in its purview.

Besides above, Rule 10 of The Companies (Meeting of Board and its Powers) Rules, 2014 also exempts loans/advances/guarantee/security made by holding company to its subsidiaries. This Rule exempts following transactions from the requirements of Section 185 of Act.

1. Transactions amongst holding and wholly owned subsidiary Company with regard to:

a. Any loan made by a holding company to its wholly owned subsidiary company or;

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

2. Transactions amongst holding and subsidiary Company with regard to:

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;

wherein such loans are utilized by the subsidiary Company (including wholly owned subsidiary) for its principle business activities.

After the notification of Section 185 of Act but prior to notification of Section 186,lot of banks in the country, only on account of narrow and wrong interpretations of Section 185 of the New Companies Act 2013, stopped taking Corporate Guarantee as a security as one of security from holding companies for sanctioning loans to its subsidiary.Ultimately, this narrow interpretation created speed breaker or bottlenecks in the flow of loaned funds from banks to corporate which affected the economic growth of the resources starved nation like India. To clarify this ambiguity, the Ministry of Corporate Affairs brought a General Circular No. 03/2014 dated 14th February, 2014 clarifying that any guarantee given or security provided by a holding company in respect of loans made by abank or financial institution to itssubsidiary company, exemption as provided in clause (d) of sub-section (8) of section372A of the Companies Act, 1956 shall be applicable till section 186 of the Companies Act, 2013 is notified. This clarification was, however, applicable for cases where loans so obtained were exclusively utilized by the subsidiary for its principle business activities.

Fortunately, the new notified rules have now exempted such transactions between the holding company and its subsidiary from the requirements of section 185.The eventual purpose of Section 185 of the New Companies Act, 2013 is to put additional restrictions on loan to directors only and not on giving of Corporate Guarantee by the holding company to its subsidiary company.

Restricted parties under Section 185

The Section 185 not only restricts loan/advances/guarantee to directors but also covers ‘to any other person in whom director is interested. According to explanation provided in Section 185(1) - For the purposes of this section, the expression “to any other person in whom director is interested” means—

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

Relative, with reference to such Director includes any of following persons, related to such Director. (Section 2(77) of the Act read with list of relatives provided in Rule 4 of The Companies (Specification of definition details) Rules, 2014)

(i) Members of same Hindu Undivided Family.

(ii) Spouse.

(iii) Father (“Father” includes step-father).

(iv) Mother(“Mother” includes the step-mother).

(v) Son (“Son” includes the step-son).

(vi) Son’s wife.

(vii) Daughter.

(viii) Daughter’s husband.

(ix) Brother (“Brother” includes the step-brother).

(x) Sister (“Sister” includes the step-sister).

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

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

(d) 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

The term ‘control’ is defined in section 2(27) of the Act which shall include “the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any”.

(e) 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.

It seems that all wholly owned subsidiaries would be covered within the purview of this provisions while for identifying whether or not other subsidiaries (not wholly owned) are included in its purview of not; some analysis would be required especially for listed subsidiary which tend to have Independent Directors on its Board. Fact here remains that there being no specific yardstick or parameter to address or analyze such issue; this criteria has added much subjectivity to the provision and thus leaving scope for different interpretations. Anyhow now the rules have specifically exempted the transactions made with wholly owned subsidiaries from the purview of the section and also with other subsidiaries as far as the transactions related to grant of guarantee or security is concerned, if such transaction are relating to principle business activity.  Thereby, the intent of the section to include subsidiary companies in its purview is clarified.

Punishment for violation

According to sub-section 2 of Section 185 of the Act, if any loan is advanced or a guarantee or security is given or provided incontravention of the provisions of sub-section (1):

a. 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

b. 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 6 months or with fine which shall not be less than 5 lakh rupees but which may extend to 25 lakh rupees, or with both.

Options still available

Some options are still available for making the flow of funds available for Group companies having common directorship and membership. Some of them are:

1. Providing loans or giving any guarantee or security for due repayment of any loan in the ordinary course of business and in respect of such loans, an interest is charged at a rate not less than Bank rate declared by Reserve Bank of India (presently 9.00%).

2. Changing the composition of the Board of Borrowing Company in a manner such that the Directors of the Lending Company are neither the Directors nor the Shareholders in the Borrowing Company, and nor their relatives.

3. Changing the composition of group partnership firm in a manner that the Directors of the Lending Company are neither the partners, and nor their relatives.

4. Making Borrowing Company asa wholly owned subsidiary of the Lending Company.

5. Converting group partnership firms and private limited companies into Limited Liability Partnership (LLP). LLP is a body corporate and if LLP has specifically mentioned to hold meetings at particular intervals in its agreement and conducts meeting accordingly then section 185 may apply to LLP. If more than 25% of voting rights is held by any of the partner of LLP who is Director of the Lending Company then such LLP will also be covered under ‘to any other person in whom director is interested’. Converting of partnership firm into LLP does not have any income tax implication but the conversion of private limited company into LLP shall be made in accordance with Section 47(xiiib) of The Income Tax Act, 1961 in order to avoid capital gain tax.

6. Converting group private limited company into public limited company and restructuring the Board in such a manner that the voting power of common directors is kept below 25% in such public limited company.

Reference to Act means Companies Act, 2013 unless stated otherwise.

Some of the reference in this article has been taken from website

Views are personal and may not be relied as an opinion on any statutory act, section or rule.

Thanks for reading!!

-CA. Amit G. Chandani

ACA, ACMA, Lic. ICSI, B.Com

(@) amitgchandani@icai.org  


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