Section 185: As proposed under the Companies (Amendment) Bill, 2017

With the very introduction of Companies Act, 2013, section 185, being a prohibitory section, was of great importance. There was no scope of any carve out or any route to apply to Central Government’s approval for non-applicability of such restrictions, unlike section 295 of the Companies Act, 1956. Further, the said section was applicable to both pubic as well as private companies, which was totally unacceptable by private companies. Then MCA vide exemption notification dated June 5, 2015[1] exempted private companies form the provisions of section 185 which brought great relief to the private companies, however, such relief is even subject to stipulated conditions.

Now, the Companies (Amendment) Bill, 2017 has proposed to replace the existing section 185 there are numerous questions in peoples’ minds about the proposed provisions. The following FAQs mentioned below takes lots of these questions headlong:

  1. What is the need to replace the extant provisions of Section 185?

The intent of the extant provisions of Section 185 is to ensure that directors who hold a fiduciary position with respect to shareholders do not utilize the funds of the company for their own benefit. However, company laws the world over do not provide for a complete blanket prohibition on advancement of such loans/guarantee/security to directors and their related entities[2]. The rationale being that where the shareholders of the company themselves approve the utilization of the funds of the company in the specified manner, the law need not create a bar on the same. Thus, at par 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.

  1. Is section 185 a prohibition or a restriction?

Currently the provisions of section 185 prohibits the granting of loan/guarantee/security to the directors and their related entities.

However, the proposed provisions are partly prohibitory and partly restrictive. The section continues to prohibit the granting of loan/guarantee/security to some, while restricts the others, the following chart represents the same:

It is pertinent to note that though the text of the proposed section uses the word ‘borrowing company’ i.e. the loan should be utilised by the borrowing ‘company’ for its principal business activities, it shall be construed as to include body corporates.

The section provides a restriction by way of passing a special resolution by the company for advancing loan/guarantee/security to the above-mentioned persons.  The condition being that such loans are utilised by the borrower for its principal business activities.

  1. What is the relief brought under the proposed section 185 of the Companies (Amendment) Bill, 2017?

The proposed provisions allows the 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.

A comparison between the current and proposed provisions of section 185 is presented in a tabular form below:

Sl No. Current provisions Proposed provisions
 

1

Prohibition on       giving  of loan/ guarantee/ security to the director of the

Company

Continues to be prohibited
 

2

Prohibition on giving of loan/guarantee/ security to the director of the holding company Continues to be prohibited
 

3

Prohibition on giving of loan/ guarantee/ security to any partner or relative of any such director Continues to be prohibited
 

4

Prohibition on giving of loan/guarantee/

security to any firm in which any such director is a relative or partner

Continues to be prohibited
 

5

Prohibition on giving of loan/guarantee/

security to any private company of which any such director is a director or member

Requires passing of a special resolution
 

6

Prohibition on giving of loan/guarantee/

security to 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

Requires passing of a special resolution
 

7

Prohibition on giving of loan/guarantee/

security to 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

Requires passing of a special resolution
 

8

 

No parallel provision

Loans to be utilised by the borrower for its principal activities

  1. Why are the words “save as otherwise provided in this Act” proposed to be omitted from section 185?

The extant provision of section 185 provides that if there is any other provision of the Act permitting lending as covered by the section then such specific permission shall prevail over this section. This creates confusion as to whether specific sanction of section 186 which starts with “without prejudice to the other provisions” can exclude section 185. To avoid ambiguity the same has proposed to be omitted.

  1. Whether the special resolution as envisaged under the proposed section 185 is required to be prior/post to granting of the loan/guarantee/security?

The Report of the Companies Law Committee, 2016 recommending amendments to section 185 proposed that the special resolution should be a prior resolution. However, the language of section 185 as per the Companies (Amendment) Bill, 2017 does not specify whether the special resolution should be prior to advancing the loan/guarantee/security, unlike section 186 & 188 which provide for the passing of a prior special resolution and resolution respectively.

Further, 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 resolution may be passed after granting of such loan/guarantee/security.

Sinnce the Law explicitly not zsays …post facto

  1. Whether any limits shall apply to loan/guarantee/security granted to entities in which directors are interested under section 185?

The loan/guarantee/security granted under section 185 shall be subject to the provisions of section 186. As per the proposed provisions of section 186 of the Companies (Amendment) Bill, 2017 where such loan/guarantee/security along with the aggregate of loans/guarantees/securities already granted to any person/body corporate and investments already made in body corporates exceed sixty per cent. of the company’s paid-up share capital, free reserves and securities premium account or one hundred per cent. of its free reserves and securities premium account, whichever is higher prior approval by way of special resolution shall be required. Hence, where such loan/guarantee/security is up to the aforesaid limit, as per section 186(5) a resolution sanctioning the same is required to be passed at the meeting of the board, with the consent of all directors present thereat.

  1. Whether there will be any restriction on the rate of interest to be charged for the loans so granted under the proposed section 185?

As per the Report of the Companies Law Committee 2016 the rate of interest for loans granted under section 185 was proposed to be aligned with section 186(7). Further, the report also suggested that it may not be appropriate to apply Indian interest rates bench marks prescribed under 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 should not be less than the prescribed rate under section 186(7).

Though 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 one year, three year, five year or ten 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.

However, as the loan/guarantee/security granted under section 185 will be covered under section 186 accordingly the limits on the rate of interest shall also apply.

  1. Whether the shareholder’s approval for granting of loans/guarantees/securities as per the proposed section 185 should be party specific?

The explanatory statement to the notice of the general meeting to contain the following details:

  • full particulars of the loans given, or guarantee given or security provided;
  • 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;
  • any other relevant fact

Therefore, the companies will have to provide the details of each recipient and the purpose for such grant along with the full particulars of the loans given, or guarantee given or security provided.

However, the loan/guarantee/security granted under section 185 shall be subject to the limit of section 186.

  1. What will be the procedure to be followed for granting of loans/guarantees/securities as per the proposed section 185?

As discussed above the granting of loans/guarantee/security to entities in which directors are interested as proposed under section 185 shall require the passing of passing a special resolution by the company. The following procedure is to be followed when granting such loan/guarantee/security:

  • Prior approval of the public financial institution where the aggregate of the loans/investments/guarantee/security so far made along with the loans/guarantee/security proposed to be made is to exceed the limit as specified in section 186(2) and there is default in repayment of loan installments or payment of interest thereon as per the terms and conditions of such loan to the public financial institution.
  • Convening of a board meeting for considering the granting of loan/guarantee/security and to approve the notice of the general meeting.
  • As per section 179(3) read with section 186(5) the resolution is required to be passed at a board meeting only.
  • As per section 186(5) the resolution is required to be approved by all the directors present at the meeting.
  • The explanatory statement to the notice of the general meeting to contain the following details:
  • full particulars of the loans given, or guarantee given or security provided;
  • 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;
  • any other relevant fact
  • Filing of e-form MGT-14 within 30 days of passing the board resolution as per section 117(3)(g).
  • Convening of general meeting for:
  • Passing of special resolution as per section 185.
  • Passing of special resolution in case the loan/guarantee/security proposed to be made along with the aggregate of loans/guarantees/securities/investments made so far exceeds sixty per cent. of the paid-up share capital, free reserves and securities premium account or one hundred per cent. of its free reserves and securities premium account, whichever is higher as per the proposed section 186(3).
  • Filing of e-form MGT-14 within 30 days of passing the special resolution as per section 117(3)(a).
  • Granting of such loan/guarantee/security to entities in which the directors are interested.
  • The same may be granted prior to passing of the special resolution under section 185.
  • The rate of interest shall be as per section 186(7).
    • Entry in register MBP-2 maintained as per section 186(9).
  • Disclosure in the financial statement the full particulars of the loans/ guarantee/security provided and the purpose for which the loan/ guarantee/security is proposed to be utilized by the recipient as per section 186(4)
  1. Whether private companies will be exempted from the provisions of the section 185 as proposed?

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

  1. When will a private company be required to pass a special resolution under the proposed section 185?

As per the exemption notification dated June 5, 2015 only those private companies which fulfil the prescribed conditions are exempted from the provisions of section 185. Hence, private companies which do not fulfil the conditions prescribed are subject to the prohibition as per the extant section 185. The proposed provisions provide some relief to such private companies as follows:

  • in whose share capital other body corporates have invested money;
  • the borrowings of such a company from banks or financial institutions or any body corporate is more than twice of its paid-up share capital of fifty crores, whichever is less; and
  • such a company has defaulted in repayment of borrowings subsisting at the time of making transactions under section 185.

Since, the proposed provisions of section 185 allow the granting of loan/guarantee/security by such private companies to entities in which their directors are interested by passing of a special resolution.

  1. Is the section applicable to a banking company?

No, by virtue of clause (b) to sub-section (3), a banking company will be excluded.

  1. Is the section applicable to a non-banking financial company?

Clause (b) to sub-section (3) provides exemption from the section for any loan granted, or security/guarantee provided, where the company in the ordinary course of its business grants such loans or makes guarantees, etc. Not every NBFC is engaged in the business of granting loans or giving guarantees in the ordinary course of its business.

For example, if the company is an investment company, its business consists of making of investments, and not loans. In such a case, the exemption in clause (b) to sub section (3) will not be available. But if making of loans is the ordinary business of the NBFC, the section will not be applicable to the company.

  1. What is the meaning of “ordinary course of business” for the purpose of the exemption in clause (b) of sub-section (3)? Does it depend on the object clause of the Memorandum, or does it depend on the assets or income of the company? If it depends on assets or income, is there any particular percentage of assets/income that must come from the lending business, to regard the business as forming part of the ordinary course of the company’s business?

Before we discuss what is “ordinary course of business” for the purpose of clause (b) of sub section (3) it is important to understand what it is NOT.

The expression does not mean “main business”, “principal business” or “main object”. Hence, mere insertion of an object in the objects clause does not make lending business an ordinary business of the company. At the same time, there is nothing to imply that the lending business should be carried as the principal or main business.

Similar exception, for loans made in ordinary course of business is there in section 2 (e) of the Income-tax Act as well and there have been score of rulings under that section as to what is the meaning of the ordinary course. Given the commonality of intent, that is, to exclude such loans as the company would ordinarily give; the rulings under the Income-tax law will be quite relevant here as well.

There may possibly be an extreme argument to say that whatever is not extra-ordinary is ordinary course of business. Income from extra-ordinary activities is required to separately disclose in the profit and loss account. Such profit/loss from extra-ordinary activities is different from “other income”. “Other income” includes such items which may not be forming part of the operating income, yet cannot be said to be completely beyond the scope of the operations of the company. Interest income is specifically included in the scope of “other income”, and not “extra-ordinary items”. This is clear from the format of Profit and loss account given in Schedule III. By this argument, every interest income will be ordinary, since it is not extra-ordinary.

However, such an extreme argument would not be proper in the context of section 185.

Section 185 is a “conflict of interest” provision – the interpretation should serve the purpose of the section. Hence, in light of this, the section should exclude such lending where the company lends not only to directors/directors’ entities but also to arms’ length parties. If the company is lending merely to directors/directors’ entities, even if such lending happens to be recurring such lending cannot be regarded as ordinary business of the company.

The true meaning of “ordinary course” for the purpose of the exception will not be excluding the section if lending is the ordinary business of the company. In other words, the company is engaged in lending activities with regularity and frequency to imply that the company is carrying lending as its business and not as a mere device to do financial accommodation of directors or related parties.

  1. What is the significance of principal business activity for the purpose of clause (b) of sub section (2) of the proposed section 185?

One of the conditions of granting of loan/guarantee/security by a company to any person in whom any director of the company is interested as envisaged under the proposed provisions of section 185 is that the loan should be utilised by the borrower for its principal business activities and not for further investment or grant of loan.

Acting as a conduit nhi —

  1. Does the section apply to deposits?

The distinction between loans and deposits is well understood in law. There is a large body of case law under Money lending laws, sec. 2 (22) (e) of the Income Tax Act, and section 370 of the Companies Act 1956 prior to its amendment in 1989, whereby courts have distinguished ‘loans’ and ‘deposits’. Succinctly, where the have-not approaches the have, and seeks accommodation, the transaction is called a loan. Where a have approaches a have-not, and seeks parking of money, it is called a deposit. The distinction is highly circumstantial. However, given the fact that the section does not employ the language given in section 370 of the Companies Act 1956, “loans” under the section cannot include deposits.

Also note that auditor of a company is specifically required to report whether the company has shown loans made by it as a deposit, this is intended to nab any effort by a company to describe a loan as a deposit.

  1. Does the section apply to advances?

Loan is a bailment of money. Therefore, the four elements of a loan are:

  1. an amount, a sum which may be in the shape of money or kind;
  2. placing of it with another, called borrower;
  3. an agreement to repay, once again, in form of money; and
  4. a recognition of liability on the part of the borrower, to return it with or without interest.

An advance is given for a specific purpose, on the condition that either the money will be adjusted to offset obligation of the maker of the advance, or otherwise refunded. While a loan is a money-for-money transaction, an advance is intended to be for some specific pre-identified commercial transaction, for instance, advance for purchase of goods, advance for purchase of services. The goods or the services, for which the advance is given, are usually pre-identified, as it defies commercial reality that one will provide an advance without any purpose.

In Raja of Venkatagiri vs. Krishnayya Rao Bahadur AIR 1948 PC 150[3], the Privy Council has held that normally an advance is not repayable as an advance usually conveys an idea of a prepayment, that is, paying something in advance before it is actually due.

The section is clearly applicable only to loans and not advances. If an advance has been given to a director or directors’ entity, the transaction may well be covered by section 188.

  1. Does the section apply to book debt?

The section is applicable only when there is loan in substance. The provisions of section 296 of the 1956 Act have been subsumed in section 185. Hence, if a book debt is prolonged beyond the usual credit period, so as to allow more time to a debtor, such a debt may also amount to a loan.

  1. Does the section apply to subscription of debentures issued by another company?

The section is applicable only to loans, and not to subscription of debentures. If the director’s entity issues debentures, to which the company subscribes, the company is acquiring a security, and not making a loan. Hence, the section does not apply in such a case.

  1. Is the section applicable to a letter of comfort given by the company?

The section is applicable to giving of guarantee. The word guarantee is defined in the Contracts Act to imply the undertaking of the liability of a principal debtor by the guarantor. It will be a case of a guarantee where the guarantor undertakes to pay the debt of the principal debtor. However, where the commitment of the so-called comforting party is merely to the extent of introducing the principal debtor, or prevailing upon the principal debtor to pay, etc., there may be a moral or reputational obligation, but there is no contractual obligation of the comforting party, and hence, there is no guarantee. The distinction between guarantee and LoC is not merely one of language – it is language and intent put together. If there is a clear contractual liability being assumed by the contracting party, then it is a guarantee irrespective of the nomenclature.

  1. Whether loan/guarantee/security provided by a holding company to its subsidiary/wholly owned subsidiary is exempted from the proposed provisions of section 185?

The current and proposed exemptions from the provisions of section 185 with respect to loan/guarantee/security provided by a holding company to its subsidiary/wholly owned subsidiary are compared in a tabulated form below:

Provision Current provisions Proposed provisions
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 to be 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 to be exempted
Any loan made by a holding company       to its subsidiary company. Not exempted Continues not to be exempted
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.

Exempted Continues to be exempted

  1. What is the true meaning of “accustomed to act in accordance with the directions or instructions” as given in Explanation (c) below sec. 185 (2)?

The question above discussed at length the essence of the phrase ‘accustomed to act’ in accordance with the instructions of board or directors of lending company.

Moreover, the MCA vide its circular dated 12th May 2011[4]  clarified that approval of Central Government should be sought only if the provisions of sub-Section (d) or (e) of Section 295 of the Companies Act are attracted. The intent of the above circular is that sec. 295 (1) (e) cannot be taken as applicable merely due to the presence of common directors. There may, of course, be prima facie situations where one may contend that the Board of the borrower company is nothing but a subset of the Board of the holding company. But such a prima facie contention may be rebutted with circumstantial evidence.

  1. If a loan is given by a lender in violation of the section, is the borrower also liable?

The language of sub-section (4) of section 185 makes it very clear that not only the lender is liable for contravention of any of the provisions of this section but also 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. Further, the proposed provisions has extended the penal provisions to an officer who is in default in addition to directors and the company itself.

 

It should also be clear that where a law provides a prosecution by way of imprisonment, and the offender is a company, the obligation attaches to the officers/persons responsible for the offence.


[1] http://www.mca.gov.in/Ministry/pdf/Exemptions_to_private_companies_05062015.pdf

[2] http://www.india-financing.com/images/Articles/Loans_to_directors_and_related_entities_-_A_Comparative_Analysis.pdf

[3] http://indiankanoon.org/doc/567642/

[4] http://www.mca.gov.in/Ministry/pdf/Circular_24-2011_12may2011.pdf

Team Vinod Kothari & Company (corplaw@vinodkothari.com)

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