Game of Loans: Section 185 of the Companies Act, 2013

With the piecemeal rollout of the provisions of the Companies Act, 2013, September 12, 2013 saw the first phase of notification of several provisions.

The intent behind the new regime seemingly was to decouple the substantive portions from the procedural ones and also to ensure fewer regulatory approvals by promoting self-governance by corporates.

Being mindful of the stress on financial support transactions and its unsettling effects on inter-corporate loans between group companies, this piece is an attempt to demystify the essence of Section 185 of  the 2013 Act which prescribes a tightened regulation governing sanction of loans to directors etc.

Analysing Section 185:

Section 185 of the 2013 Act is the new Section 295 of the 1956 Act. Upon a cursory glance, the key points of departure from the 1956 Act that emerge are the wiping out of any Central Government approvals and the applicability of the restriction to private and public companies alike.

As a slight modification to the old regime, companies are restricted from advancing loans to its directors or to any person in whom the director is interested, except in relation to loans advanced by holding companies to their wholly owned subsidiaries. However, similar to the old regime, companies are restricted from providing any guarantee or security in respect of any loan availed by the director or such other person in whom the director is interested, except those from holding companies to their subsidiaries. It is clarified that such a loan must be utilized for the subsidiary’s principal business activities.

If a subsidiary company is desirous of availing a loan from its holding company or vice versa, a check must be carried out under clauses (c), (d) and (e) of the Explanation to Section 185 to see if the borrowing company is a person in whom the director of the lending company is interested. This brings us to the scenarios in which inter-corporate loans between holding and subsidiary companies are permitted:

Scenario 1: If the borrowing company is a private company, not being a subsidiary of a public company, then, there must be no common directors between the boards of directors of the borrowing and lending companies and none of the directors of the lending company should be shareholders in the borrowing company.

Scenario 2: One or more of the directors of the lending company must not be able to exercise or control twenty five percent or more of the voting power of the borrowing company at its general meeting.

Scenario 3: The board of directors of the borrowing company must not be accustomed to act in accordance with the directions or instructions of the board or of any director(s) of the lending company.

No restrictions are levied on a loan, guarantee or security given by a company to or on behalf of its managing director or whole-time director so long as it is a part of their general service conditions or it is pursuant to a member approved scheme. Similarly, companies providing loans
to other companies in their ordinary course of business are exempt from the provisions of Section 185.

Challenges Ahead

The first blind curve in the road is the interpretation of the phrase “ordinary course of business”. The lack of a definition for the phrase in the 2013 Act, coupled with the limited aid offered by precedents, leaves much room for subjectivity. While, it would be safe to assume that
the said phrase is inclined to exempt Non-Banking Financial Companies, the applicability of the same to investing-cum-operating companies, which often act as the financial muscle for group companies, is anybody’s guess. One may argue that the contemplation of a particular business in the main objects clause of the memorandum of association of a company would suffice for it to qualify as being in the ordinary course of business of the company. On the contrary, the argument that if the said business is not actually being undertaken by the company on a regular basis, the same shall fall short of being in the company’s ordinary course of business, holds equal if not more weight.

Adding to the uncertainties, the expression “accustomed to act in accordance with the instructions” neither finds a definition in the 2013 Act nor in the 1956 Act. Given the dearth of Indian judicial precedents interpreting this phrase, one may, for its persuasive value, borrow the
concept of a ‘shadow director’ from the UK jurisprudence. In Secretary of State for Trade and Industry v Becker [2002] EWHC 2200 (Ch) the Court held that a person will not be held to be a shadow director where a director has only acted on his directions once. There needs to be “proof of a pattern of conduct”. Thus, whether a person is “accustomed to act in accordance with the instructions” of another, becomes largely a fact-based question open to challenge and makes for a breeding ground for litigation.

A drafting faux pas surfaces in the inclusion of the term ‘lending company’ in sub clause (e) of the Explanation to Section 185 without importing its definition from Section 295 of the 1956 Act. A plain reading of the term ‘lending company’ in Section 185 appears to include companies advancing loans only, which can certainly not be the intention of the lawmakers.

Moreover, in introducing the exemption with respect to loans, guarantees and securities provided by a holding company to or on behalf of its wholly owned subsidiary, as though an afterthought, in the Companies (Meetings of Board and its Powers) Rules, 2014, the Ministry of
Corporate Affairs seems to have woken up, slightly belatedly, to the industry rants fueled by the isolated notification of Section 185 devoid of the holding-wholly owned subsidiary exemption under Section 372A of the 1956 Act. The Central Government is empowered under Section 469 of the 2013 Act to make rules for carrying out the provisions of the said Act, including rules on any or all matters that are required to be, or may be, prescribed. Notably, Section 462 empowers the Central Government to exempt a certain class of companies from the provisions of the 2013 Act. However, in the absence of any enabling provision to prescribe rules under Section 185, the validity of the substantive exemption inserted under the aforesaid rules is debatable.

The most practical problem that companies are faced with today is the question as to whether existing loans, guarantees and securities are affected by Section 185. While there is no departmental clarification on this, reference maybe drawn to the repeals and savings clause of
the 2013 Act which inter-alia states that any action undertaken pursuant to any exemption provided under the 1956 Act, shall remain valid. However, companies must note that renewal of the said loans, guarantees and securities is likely to be affected by this Section.

In the wake of the myriad of ambiguities and the punishment for non-compliance having been enhanced exponentially, Section 185 has upset all and sundry. While it appears that the lawmakers have made a head way in self governance and establishment of stricter control under
the 2013 Act, the qualms in Section 185 offer ample food for thought.