Inter-Corporate Loans and Loans Advanced to Directors

The Companies Act, 2013 (“The Act”) was introduced to address the concerns in the existing corporate regime. However, The Act witnessed issues on account of implementation and operational inconvenience, as well as extreme sufferings in doing business because of some of the rigid provisions contained therein. In order to facilitate ease of doing business and remove the sufferings faced by the stakeholders, the Ministry of Corporate Affairs ("MCA") constituted the Company Law Committee ("CLC") to take a comprehensive view and suggest changes in The Act and the rules made thereunder keeping in mind the difficulties and challenges faced by the stakeholders.

MCA accordinglypassed Companies (Amendment) Act, 2017 (“Amendment Act”) on the recommendations made by CLC on May 7, 2018 to add more clarity to the provisions of The Act. The Amendment Act substituted the existing Section 185 of The Act. Section 185 corresponds to section 295 of Companies Act, 1956. This section does not applies to Government Companies, Private Companies and Nidhi Companies subject to conditions specified in respective exemption notifications issued by MCA.

The substituted Section 185 deals with the restrictions on the 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 certain compliances under The Act.

The intent of Section 185 is to ensure that directors who hold a fiduciary position with respect to shareholders cannot utilize funds of the company for their own benefit. However, the provisions do not provide for a complete prohibition on the advancement of loans/guarantee/security to directors and their related entities.

It is important to note that where the shareholders of the company, who are the absolute owners, themselves, approve the utilization of the funds of the company in the prescribed manner, the law does not create a barrier on the same. Thus the provision has been amended to remove the prohibition to an extent and provides for the passing of shareholders’ resolution for granting of loans/guarantees/securities to entities in which directors are interested.

The explanation to Section 185(1) of The Actprohibits the granting of loan/guarantee/security to some, while restricts the others:

o   Section 185 prohibit loans to:

1.      directors of the company or

2.      directors of the company which is its holding company or

3.      any partner of that director; or

4.      relative of the director

 

o   Section 185 restrict loans to:

1.      any private company of which any such person is a director or member;

2.      any corporate at a general meeting of which must not be less than 25% of the total voting power may be exercised or controlled by any such director, or by two or more such directors, together;

3.      Any corporate, the Board of Director, Managing Director or manager, whereof is accustomed to act in accordance with the directions or instructions of the Board of Director, or of any director, of the lending company.

The proviso to Section 185(1) of the Act provides for certain exemptions and situations under which, loan can be advanced or guarantee can be given or security can be provided. Such exemptions includes:

 (a) where such director is a managing director or a whole time director and such proposed loan is either a part of the conditions of service extended by the company to all its employees or pursuant to any scheme approved by members vide special resolution;

(b) where the loan is provided by the companies that are in the business of extending loans, provided the interest charged on such loans is not less than bank rate as declared by the Reserve Bank of India; and

(c) where loan is provided 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.

I.            Significance of Principal Business Activity in amended provisions

In order to make sure that the companies do not take advantage of the relief, the amended provisions ensure that there is no misuse of loans received by the companies. As the amount received under the section must be utilized by the borrower for its principal business activities and not for investment or to further grant the loan.

 Also, 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.

II.            Extension of the penal provisions

The amended Section 185 has extended the penal provisions to an officer of the company, as defined in Section 2(59) and includes any director, manager or key managerial personnel or any person in accordance with whose directions or instructions the Board of Directors or any one or more of the directors is or are accustomed to act.

III.            Status of exemptions provided to the private companies

In terms of the abovementioned provisions, there was a restriction on providing loan by the companies to other companies having same directors. The said restriction resulted in difficulties for the companies from availing a loan from its group companies, unless it is a wholly owned subsidiary. In order to provide exemption to such a restriction, the MCA issued a Notification in July, 2015 wherein exemption to private companies was provided pursuant to fulfilment of conditions that:

(a) no member of the company should be a body corporate;

(b) the debt equity ratio should be not more than 2:1 and;

(c) the company should not have defaulted in any past borrowings.

However, such exemption did not result to comfort the companies, because of the conditions attached to it. Most of the companies still found themselves unable to give loans to their group companies (having common directors). This would often hinder genuine transactions due to complete embargo on providing loans to subsidiaries / group companies with common directors.

In terms of the amendment proposed to Section 185 of The Act, a company has been allowed to advance loans or give guarantees or provide security in connection with the loan taken by any person in whom the director is interested, subject to the condition that:

 (a) prior approval of shareholders by way of a special resolution is obtained; and

(b) such loan may only be utilised for the principle business activities of the borrowing company.

IV.            Punishments for the contravention of the provisions of Section 185 of The Act

 

According to Section 185(4) of the Act, if any loan is advanced or any guarantee or security is given or provided or utilized in contravention of the provisions of Section 185, there shall be the following punishments:-

Company:

The company shall be punishable with fine which shall not be less than INR 5 lakh, but which may extend up to INR 25 Lakh.

Officer of the Company:

Every officer of the company who is in default shall be punishable with imprisonment for a term which may extend to 6 months or with fine which shall not be less than INR 5 lakh, but which may extend up to INR 25 lakh

Director or the other person:

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 INR 5 lakh, but which may extend to INR 25 lakh, or with both.

 

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