Compliances

Loan to Directors under Section 185 of the Companies Act

MCA has enacted Companies (Amendment) Act, 2017 (“Amendment Act”) on the suggestions made by Company Law Committee (CLC) and notified the same in the official gazette on May 7, 2018 to streamline the existing practices followed by Companies in India and to add more clarity to the provisions of the Companies Act, 2013. It has substituted the existing section 185 of the Companies Act, 2013. This Section-185 was originally brought into effect from September 12, 2013 which corresponds to section 295 of Companies Act, 1956. This section doesn’t apply to Govt. Companies, Private Companies and Nidhi Companies subject to conditions specified in respective exemption notifications issued by the Ministry of Corporate Affairs (MCA).

With the introduction of Companies Act, 2013^[1], the section 185 is a prohibitory section, was of great importance. There was no scope to apply to Central Government’s approval for non-applicability of such restrictions. Further, the section was applicable to both public as well as private companies, which was unacceptable by private companies. Thereafter the MCA vide exemption notification dated June 5, 2015 exempted private companies from the provisions under section 185 which brought great relief to the private companies. Whereas, that relief is even subject to stipulated conditions. Hence, to promote ease of doing business, the entire section has been substituted.

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 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.

The new provisions mentioned under section 185 is partly restrictive and partly prohibitive

The intent of the provisions of Section 185 is manly 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 company laws do not provide for a complete blanket 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 bar on the same. Thus, with the global company laws, 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 section prohibits the granting of loan/guarantee/security to some people, while restricts the others in the following way

-Prohibitive to:

• directors of the company or
• directors of the company which is its holding company or
• any partner of that director; or
• relative of the director

And restrictive to:

• any private company of which any such person is a director or member;
• 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;
• Any corporate, the Board of Director, MD or manager, whereof is accustomed to act in accordance with the directions or instructions of the BOD, or of any director, of the lending company.

The amended provisions have allowed the companies to grant loans/guarantees/securities to any entities in which directors are interested, in the above mentioned restrictive cases, but subject to prior approval of the shareholders by passing a special resolution and on condition that the loans are utilized by the borrower for principal business activities so far.

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 wasting of funds 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 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.

Shareholders’ approval 

It is important that the provisions of amended law do not explicitly require any prior approval, under section 186 and 188 of Companies Act.

Although, the Report of Companies Law Committee, 2016 recommended by the special resolution to a prior resolution. However, the wordings of the amended section 185 do not specify whether the special resolution must be prior to advancing the loan/guarantee/security.

However, as per the provision of the amended law, the explanatory statement to the notice of the general meeting is required to disclose the full details of the loan/guarantee/security given. Thus, one may infer that such a resolution has to be passed after granting of such loan/guarantee/security.

Rate of interest has to be charged for loans granted under amended section

As per the Report of the Companies Law Committee 2016, the rate of interest for loans granted under the section 185 was proposed to be aligned with section 186(7). Further, the report suggested that it may not be appropriate to apply Indian interest rates benchmarks prescribed under the section 186(7) to loans given by companies to foreign entities and the effective yield against the loan given, irrespective of whether the loan is given to a company incorporated outside India must not be less than the prescribed rate under the section 186(7).

Although the exemption provided to companies which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan requires the rate not to be less than the rate of prevailing yield of 1 year, 3 year, 5 year or 10 year Government security closest to the tenor of the loan, however, no such interest rate is provided for the persons falling within the restrictive purview of Section 185.

Extension of the penal provisions

The amended section 185 has extended the penal provisions to an officer of the company, which has been defined in section 2(59) to include 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. Therefore, the ambit of the penal provision has been widely extended.

Status of exemptions provided to the private companies

The amended section 185 seeks to completely replace the existing provisions of section 185 of Companies Act, 2013. However, the exemption notification dated June 5, 2015 has to continue to hold good and the amended provisions of section 185 must be not applicable to private companies subject to the conditions prescribed in the notification.

As per the exemption notification dated June 5, 2015 only those private companies which fulfill the prescribed conditions are exempted from the provisions of section 185. Hence, private companies which do not fulfill the conditions prescribed are subject to the prohibition as per the amended section 185, i.e., the private companies, which do not fulfill the conditions for availing the exemption, will be able to grant loan/guarantee/ security under the restrictive purview.

Comparison between the current and amended provisions of section 185

As per Act, 2013	As per Act, 2017
Prohibition on providing of loan/ guarantee/security to the director of the Company	Continues to be prohibited
Prohibition on providing of loan/guarantee/security to the director of the holding company	Continues to be prohibited
Prohibition on providing of loan/ guarantee/security to any partner or relative of any such director	Continues to be prohibited
Prohibition on providing of loan/guarantee/ security to any firm in which any such person can be relative or partner	Continuing the prohibition
Prohibition on providing of loan/guarantee/ security to any private company of which any such person is a director or member	Required passing a special resolution
Prohibition on giving of loan/guarantee/ security to anybody corporate at a general meeting of which must not less than 25% of the total voting power may be exercised or controlled by any of director, or by two or more such directors, together	Requires passing of a special resolution
Prohibition on giving of loan/guarantee/ security to anybody 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	Requires passing of a special resolution
No parallel provision	Loans to be utilized by the borrower for its principal activities

Status of applicability of the section on following transactions

Particulars	As per 2013 Act	As per 2017 Act
Any loan made by a holding company to its wholly owned subsidiary company. Provided that the loans made are utilized by the wholly owned subsidiary company for its principal business activities	Exempted	Continues exempted
Any guarantee/security provided by a holding company in respect of any loan made to its wholly owned subsidiary company. Provided that the loans made are utilized by the wholly owned subsidiary company for its principal business activities.	Exempted	Continues exempted
Any loan made by a holding company to its subsidiary company.	Not exempted	Not to be exempted
Any Guarantee given or Security provided by a holding company in respect of a loan made by any bank or financial institution to its subsidiary company.	Exempted	Continues exempted

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.

In case of	Punishment
Lending Company	Punishable with fine which must not be less than Rs. 5 lakh but which can be extended to Rs. 25 lakh
Officer in default	Punishable with imprisonment for a term which can be extended to 6 months or with fine which must not be less than Rs. 5 lakh but which can be extended to Rs. 25 lakh.
Recipient Director/ Entity	Punishable with imprisonment which can be extended to 6 months or with fine which must not be less than Rs. 5 lakh but which may extend to Rs. 25 lakh, or with both.

Changes Made in Section 186

Incorporating MCA’s clarification in the provisions of law

The amended provision clearly excludes employees of the company from the term ‘person’ to whom a company cannot directly or indirectly give loan exceeding the prescribed threshold. The same was clarified by the Ministry vide its General Circular dated 10th March, 2015. However, the said Circular provided two conditions for such exclusion i.e. the loan being given should be in terms of service policy of the company along with the same being in terms of remuneration policy of the company – these conditions are no more applicable, as the provision directly excludes employees from the term ‘person’.

Exemption from shareholders’ approval in certain cases

As per the amended provisions the shareholders’ approval will not be required where a loan or guarantee is given or where a security has been provided by a company to it’s:

• wholly owned subsidiary company or
• a joint venture company, or
• Acquisition is made by a holding company, by way of subscription, purchase or otherwise of securities of it’s wholly owned subsidiary company.

The exemption will increase the investing power of the company.

Other changes

The exemption of the non-applicability of the provision of section 186 (except the provision related to restriction on layers of subsidiaries) has been extended to a rights issue made by a body corporate specifically to include foreign company.

As per the amended provisions:

a company shall be deemed to be principally engaged in the business of acquisition of shares, debentures or other securities, if its assets in the form of investment in shares, debentures or other securities constitute not less than 50% of its total assets, or if its income derived from investment business constitutes must not less than 50% as the proportion of its gross income.

Conclusion

Section 185(1) prohibits for providing the loan/guarantee/security to certain individuals such as Director of Lending and holding companies and firms in which such director/relative is a partner. The company may provide loan/guarantee/security in connection with any loan taken by any person in whom any of the directors of the company is interested, subject to conditions of prior approval, by ways of special resolution or loan utilization as per section 185(2). According to Section 185(3), the entities and individuals are exempted from section 185(1) and 185(2) such as holding and subsidiary companies, banking companies, NBFCs etc. Further, on non- compliance and contravention with provisions, the punishment is provided in section 185(4). Hence, it can be said the relief brought under both the section will be widely accepted by all.