Loans to Directors and Companies: Sections 185 and 186 of the Companies Act, 2013

Introduction

Finance is the lifeblood of business. No person or entity, whether a company, LLP, partnership firm, AOP or proprietorship concern, can run its business successfully without access to adequate funds at an appropriate cost. For Indian companies in particular, rising interest rates, recession and layoffs have forced them to control and reduce non-operating costs as far as possible, to maintain and grow their bottom line in the years ahead.

One of the ideal sources of finance for companies in such difficult times is the inter-corporate loan, through which they can access funds from related parties or group companies at a reasonably lower rate of interest and on flexible terms. Correspondingly, companies may also provide loans to their directors, their relatives or a director's partner for growing their individual businesses or for their own purposes.

Amid this complex web of transactions, it became necessary for the Government to take cognisance of their implications at both the regulatory and the financial reporting level, and to bring in stringent guidelines for companies providing loans, guarantees and securities in connection with loans. Sections 185 and 186 of the Companies Act, 2013 ("the Act") govern loans to directors and companies, investments in companies, guarantees and securities in connection with loans, and the threshold limits that apply.

Section 185: loans to directors and others

The essence of Section 185 is to draw a fine distinction between the persons to whom a company can provide loans (including loans represented by book debts), guarantees and securities in connection with loans ("LGS"), and those to whom providing them is statutorily prohibited.

Prohibitions under Section 185

Under Section 185(1), a company is prohibited from providing LGS, directly or indirectly, to:

• A director of the company
• A director of the holding company
• Partners of the director
• Partners of the director of the holding company
• Relatives¹ of the director of the company
• Relatives of the director of the holding company
• A firm in which the director of the company or his relative is a partner
• A firm in which the director of the holding company or his relative is a partner

1. If a company advances LGS to any of the above, it contravenes the Act, with serious repercussions in the form of hefty penalties and imprisonment.
2. While the Act prohibits loans to directors, Section 185(3) sets out terms and conditions under which a company can lend to its own director. This exemption is available only for a director of the company, not for a director of the holding company (see the exemptions below).
3. Section 185 prohibits LGS to a director of the holding company. A company may therefore give LGS to directors of subsidiary or associate companies, since no such restriction exists for them.
4. Section 185 prohibits LGS to firms in which the director (including a director of the holding company) or their relatives are partners. No such restriction exists for firms in which a partner of the director is a partner, provided the director is not a partner in that other firm as well.
5. Section 185 uses the words "directly" and "indirectly". Direct sanctioning of LGS is easily understood, but the section gives no guidance on indirect sanctioning.

In the absence of guidance, the Hon'ble Bombay High Court in the case of Dr. Fredie Ardeshir Mehta² delivered a landmark judgement on what constitutes indirect sanctioning, rejecting the Revenue's interpretation. The relevant excerpt reads:

“When section 295 refers to an indirect loan to a director, what it means is that the company shall not give a loan to a director through the agency of one or more intermediaries. The word "indirectly" in the section cannot be read as converting what is not a loan into a loan.”

In that case, the director had purchased immovable property from the company of which he was a director, paying half at the time of the agreement and agreeing to pay the balance in three equal instalments. The Government wrongly treated the balance payable as a loan and initiated action for contravention under Section 295 of the erstwhile Companies Act, 1956. The principle laid down by the Bombay High Court, that "indirect" means providing a loan through the agency of one or more intermediaries, still holds true under the Companies Act, 2013. The Court decided the matter in favour of the director, expressly holding that the transaction was not an indirect loan.

Section 185 also uses the words "loan represented by book debt". Neither Section 185 nor the Act defines a book debt. In common parlance, a book debt is an amount receivable from another person. Suppose a company sells goods or renders services worth INR 2 lakh to its director (in compliance with Section 188) in the ordinary course of business. The receivable is a trade receivable and does not signify financial assistance, because a loan is given with the objective of financial assistance, not to fulfil a performance obligation through the supply of goods or services.

The Government may argue that such a receivable is a loan in violation of Section 185, but the company must be able to demonstrate that it never intended to provide financial assistance. Similarly, a director may use the company's credit card for personal purposes and then reimburse the company. The Government may treat this as financial assistance attracting penalties on the company, the director and the officer in default, and imprisonment. However, the amount receivable is a mere reimbursement of expense and not a loan.

These are classic examples of routine transactions with a director where the book debt (for goods or services, or reimbursement of credit card expenses) is a normal trade receivable or recovery of expenses, not a loan. The company must, however, recover such amounts within a reasonable period so that it does not appear the director is taking undue advantage of his position.

Exemptions and instances where Section 185 does not apply

Section 185(2) is both a restrictive and an enabling provision, allowing a company to provide LGS subject to conditions. A company can provide loans to any party in which the director of the company is "interested", subject to:

• Passing a special resolution; and
• An explanatory statement attached to the notice of the general meeting giving details of the proposed loan, the purpose for which it will be used and any other relevant information

Section 185(2) lists the parties considered "interested" from the perspective of the director of the company:

• A private company in which the director of the company is a director or member
• A body corporate at a general meeting of which at least 25% of the voting power is held by one or more directors of the company
• A body corporate whose board of directors, managing director or manager is accustomed to act on the directions of the director of the company

This section permits loans to interested parties of the director of the company, not to interested parties of the director of the holding company. Section 185(2) also places the onus on the company to ensure that LGS provided to interested parties is used by the borrower solely for its principal business activity. LGS provided for any other purpose is a serious offence under Section 185, attracting hefty penalties and imprisonment.

Apart from these, government notifications grant complete exemption from Section 185 to the following classes of companies:

• Government company[^3] (Notification No. G.S.R. 463(E) dated 5 June 2015, as amended by G.S.R. 582(E) dated 13 June 2017), having obtained prior approval of the Central or State Government and having complied with Section 92 (filing of annual return) and Section 137 (filing of financial statements).
• Private company (Notification No. G.S.R. 464(E) dated 5 June 2015, as amended by G.S.R. 583(E) dated 13 June 2017), having complied with Sections 92 and 137; where no other body corporate has invested in its share capital (equity or preference); with borrowings from banks, public financial institutions ("PFI") or bodies corporate below the lower of two times its paid-up share capital or INR 50 crore; and with no subsisting default in repaying such borrowings.
• Nidhi company (Notification No. G.S.R. 465(E) dated 5 June 2015), where a loan is given to a director, or to a relative of a director, in their capacity as a member and is appropriately disclosed in the annual accounts.

Section 185 is also not attracted in the following situations:

• A loan to the managing director or whole-time director that is approved by a special resolution, or extended as part of conditions of service applicable to all employees. This exemption is not available when a subsidiary lends to the managing director or whole-time director of its holding company.
• A loan given in the ordinary course of business, provided the rate of interest is not less than the prevailing yield on government securities of corresponding tenure.
• LGS given to a wholly owned subsidiary, provided it is used for the principal business activities of that subsidiary.
• A guarantee or security provided to a subsidiary (not wholly owned) in connection with a loan from a bank or PFI, solely for the principal business activity of the subsidiary. Had the company instead given the loan itself to such a subsidiary, Section 185 would apply and no exemption would be available.

Special considerations

A company should consider the following issues when assessing whether LGS falls within Section 185:

1. Amounts paid to a director in the ordinary course of business to be spent for the company, not for personal use, are outside Section 185. Examples include travelling expenses, sitting fees, fees for professional work and fuel expenses.
2. A security deposit paid by the company for a director's accommodation, where the accommodation forms part of the service agreement, is outside Section 185.
3. Club membership fees paid by the company on a corporate basis, where the directors enjoy the club's facilities, are outside Section 185.

A company must acknowledge the requirements of Section 185 and ensure that any LGS to its directors or to entities mentioned in Sections 185(2) and 185(3) is duly handled, given the large number of Section 185 cases that the Registrar and the NCLT deal with every day.

Penalty and imprisonment

The penalty and imprisonment prescribed under Section 185(4) are as follows:

Section 186: loans and investments by a company

Sections 185 and 186 are complementary provisions that operate hand in hand. While Section 185 lays down the law on providing LGS, Section 186 sets threshold limits on the loans and investments a company can make.

Restriction of layers in investment and its exemption

1. No company may make an investment through more than two layers of investment companies⁴.
2. Control must be considered when making an investment. Control generally exists where a company holds more than half of the voting rights or paid-up share capital of another company, but factors such as domination over the management of another entity, where that management is accustomed to act on the first company's directions, must also be considered.
3. Guidance in Ind AS 110 or AS 21 on consolidated financial statements may also be used to determine control.
4. Layering is considered on a vertical basis, not a horizontal basis.

In a horizontal arrangement, a company can have any number of subsidiaries; Section 186 places no restriction on horizontal layering. In vertical layering, however, a company cannot have more than two layers of investment companies. In the vertical structure shown above, it is legitimate for Company A to have Company B and Company C in its group. But Company C acquiring a controlling stake in Company D would breach the maximum permissible layers of investment companies.

Under vertical layering, one wholly owned subsidiary of the holding company is excluded when counting the layers of investment companies. The exclusion is limited to one wholly owned subsidiary; any others are still counted.

The layering restriction does not apply where:

• An Indian company acquires control of a foreign company which has investment subsidiaries beyond two layers, as permitted under the laws of that foreign country; or
• A subsidiary has investment subsidiaries beyond two layers because of a requirement of any law or statute

Limits on loans and investment

Unless a special resolution is passed in a general meeting, a company may not make investments or provide LGS exceeding the higher of:

1. The limit does not apply to loans to employees of the company (other than the managing director and whole-time director) where providing such loans is not in the company's ordinary course of business.
2. Where existing and proposed LGS and investments together exceed the 60%/100% limit, the company may proceed only after passing a special resolution in a general meeting.
3. Whether or not the limit is exceeded, a board resolution authorising the LGS or investment is mandatory, and it must be passed unanimously; otherwise the company cannot proceed.
4. A special resolution is not required for LGS to a wholly owned subsidiary or joint venture, or for investment in a wholly owned subsidiary. As noted above, Section 185 does not apply to LGS to a wholly owned subsidiary (provided the loan is used for its principal business activity), and Section 186 likewise does not require a special resolution for it. Such amounts must still be counted when calculating the 60%/100% limit.
5. Adequate disclosure of such LGS and investments must be made in the financial statements, for example in disclosures under Ind AS 24 or AS 18 on related party transactions.

Additional compliances

1. A company must obtain the prior approval of the PFI if LGS or investment exceeds the 60%/100% limit. No such approval is needed where both existing and proposed LGS or investment are within the limit and there is no default in repaying loans or interest to the PFI.
2. A company registered under Section 12 of the Securities and Exchange Board of India Act, 1992 (including stock exchanges, share brokers, sub-brokers and share transfer agents) must comply with the 60%/100% limits when providing LGS or making investments, and must disclose this appropriately in its financial statements.
3. On interest, Sections 185 and 186 share a similar view: the rate of interest on loans must not be lower than the prevailing yield of government securities of corresponding tenure. This does not apply to a Section 8 company providing funds for industrial research and development projects in furtherance of its objects, at least 26% of whose paid-up share capital is held by the Central Government, a State Government or both.
4. The company must maintain records of LGS and investments in a register in Form MBP-2 at its registered office.

Exemptions from Section 186

The following are exempt from Section 186 when LGS or investment is made in the ordinary course of business:

• A banking company
• An insurance company
• A housing finance company
• A company engaged in the business of financing industrial enterprises or providing infrastructural facilities

Section 186 also does not apply to investments made:

• By an investment company
• Through the acquisition of rights shares under Section 62(1)(a)
• By an NBFC whose principal business is the acquisition of securities (such as core investment companies)

The following companies are kept outside the ambit of Section 186:

• A government company engaged in defence production
• An unlisted government company, subject to compliance with Sections 92 and 137 and the prior approval of the concerned ministry

Penalty and imprisonment

Non-compliance with Section 186 attracts the following penalties:

Additional reporting by auditors and management

Auditor's responsibility. Under Section 143(11), the auditor appointed under Section 139 must report under clause (iv) of paragraph 3 of the Companies (Auditor's Report) Order, 2020 on whether the company has complied with Sections 185 and 186.

Management's responsibility. Under Section 134(3), the board of directors must give particulars of LGS in its report.