The provisions of section 185 of the Companies Act, 2013 which particularly prohibits grant of any loans, giving of guarantee or providing of any security to the directors or any other person in whom the director is interested; otherwise than for given exemptions; is by and large the most talked section of the New Law which has already impacted the working of Corporate. While we expect the new law to be more of self regulatory and liberal as compared to Companies Act, 1956 however, this Section 185 is one section which seems to be more stringent that its previous counterpart. The provisions of Section 185 of the Companies Act, 2013 which corresponds to Section 295 of the Companies Act, 1956 provides that:-
- No company shall, directly or indirectly, advance any loan, including any loan represented by a book debt, to any of its directors or to any other person in whom the director is interested or give any guarantee or provide any security in connection with any loan taken by him or such other person.
- Exemptions under the section relate to:-
- the giving of any loan to a managing or whole-time director if it is given as a part of the conditions of service extended by the company to all its employees; or pursuant to any scheme approved by the members by a special resolution; or
- a company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan and in respect of such loans an interest is charged at a rate not less than the bank rate declared by the Reserve Bank of India.
- Herein, the expression “to any other person in whom director is interested” means—
- any director of the lending company, or of a company which is its holding company or any partner or relative of any such director;
- any firm in which any such director or relative is a partner;
- any private company of which any such director is a director or member;
- 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; or
- 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.
The section has been so much in limelight since its notification because it withdrew the exemptions with respect to such transactions among private limited companies, transactions between holding and subsidiary companies as were available under the Companies Act, 1956 and even the provision of undertaking such transaction with the approval of the Central Government.
As this section impacted and caused much difficulties in the operations of large number of companies; lot many representations were made to the Ministry for clarifying the intent of the Section and making the provisions industry friendly.
The Ministry seems clear on the intent that it had taken stringent view in the flow of funds from the company to its directors or other person in whom the Director is interested. More emphasis is likely to be laid on the fiduciary duty of the Directors and for such reason the loans, etc. to Directors and other specified person are prohibited. However, to give a sigh of relief to the industry; the Ministry has in the Final Rules notified on March 27, 2014 with reference to Section 185 of the Companies Act, 2013 exempted the following transactions from the purview of the Section:-
- Transactions amongst holding and wholly owned subsidiary Company with regard to:-
- Any loan made 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 and
- Transactions amongst holding and subsidiary Company
- 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;
wherein such loans are utilised by the subsidiary Company (including wholly owned subsidiary) for its principle business activities.
Besides the aforesaid clarifications and exemptions as provided in the Rules now; there were several confusions which the provision had caused. Let’s see how much the rules have been able to resolve.
- Importantly this section starts with the words; ‘Save as otherwise provided in this Act’ as against ‘Save as otherwise provided in sub-section (2)’ provided in Section 295 of the Companies Act, 1956.
With the usage of words ‘save as otherwise provided under this Act’ in Section 185, whether loans to director and other person in whom Director is interested may also be made after complying with the provisions of such Section 186 of the Act?
It is pertinent to mention here that Section 186 of the Companies Act, 2013 corresponds to Section 372A of the Companies Act, 1956 and provides for provisions relating to loans and investment by Company. If the answer to the aforesaid question is positive, then the whole purpose of legislation to have Section 185 of the New Law seems redundant. On the other hand, if the answer to it is negative, then there seems some drafting error in the legislation or where else do we see the effect of the section in law if not Section 186?
To analyse whether or not with the usage of words ‘save as otherwise provided under this Act’, whether the intent of law is such that once Section 186 of the Companies Act, 2013 comes into effect, loans to director and other person in whom Director is interested may also be made after complying with the provisions of such Section 186; we may refer to the Rule of Harmonious Construction for understanding the intent of legislation.
Rule of Harmonious Construction states:
A statute must be read as a whole and one provision of the Act should be constructed with reference to other provisions in the same Act so as to make a consistent enactment of the whole statute. In other words, when there are two provisions in a statute, which are in conflict with each other, they should be interpreted such that effect can be given to both and the construction which renders either of them inoperative and useless should not be adopted except in the last resort. Bengal immunity Co. vs. State of Bihar (1955) 6 STC 446 (SC)
As we apply the rule of Harmonious Construction to the situation wherein Section 185 and Section 186 of the Companies Act, 2013 exist; if upon exercise of provisions specified under Section 186, Section 185 is rendered inoperative, then both the sections should be read independently so as to give effect to Section 185.
Hence, while the usage of words ‘save as otherwise provided in Act’; seems redundant; on application of the Rule of Harmonious Construction it may be construed that loans to directors or other person in whom director is interested is restricted by virtue of Section 185 of the Companies Act, 2013 and section 186 is not an enabling provision for such transactions.
Further the following issues under section 185 of the New Law are worth consideration:-
- Besides exempting grant of loan to Managing or Whole-time Director under given circumstances, the law has also granted exemption to companies which is ordinary course of its business provides loan or gives guarantee or securities for due repayment of loan with specified interest rate. Now a significant question here is whether the intent here is to cover just Banking Companies or NBFCs or for that matter, any other entity which undertake such transaction with bonafied intent to achieve its main objects i.e. in ordinary course of its business? The term ‘ordinary course of its business’ being very subjective in itself leaves lot of scope for different interpretations.
Does the usage of word ‘its’ in the phase ‘ordinary course of its business’; creates any difference; as far as interpretation of the phase is concerned?
The issue still remains unanswered and the phase seems open to subjective interpretations.
To us it seems that, in order to be within the ordinary course of business, a transaction must adhere to the practices and customs that are considered normal for an industry. It would not be unusual for businesses in the same industry to engage in transactions similar to a transaction under examination. Determining whether something is within the ordinary course of business or not can involve evaluating similar types of businesses and industries to see if they engage in similar types of transactions. Other tests can include questioning the parties to the transaction and checking regulations to see if they outline any practices for a given profession or industry.
Hence, the provision might not just include Banking Companies or NBFCs in its purview.
- Further one of the relationship with reference “to any other person in whom director is interested” which intends to cover 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.It seems that all wholly owned subsidiaries would be covered within the purview of this provisions while for identifying whether or not other subsidiaries (not wholly owned) are included in its purview of not; some analysis would be required especially for listed subsidiary which tend to have Independent Directors on its Board. Fact here remains that there being no specific yardstick or parameter to address or analyse such issue; this criteria has added much subjectivity to the provision and thus leaving scope for different interpretations. More so, because under Section 295 of the Companies Act, 1956 subsidiaries were excluded from the scope of Section 295; hence this issue has gained so much impetus.Anyhow now the rules have specifically exempted the transactions made with wholly owned Subsidiaries from the purview of the section and also with other subsidiaries as far as the transactions related to grant of guarantee or security is concerned, if such transaction are relating to principle business activity. Thereby, the intent of the section to include subsidiary companies in its purview is clarified.
With this exemption; the transactions of giving loans to subsidiary (not wholly owned) are completely prohibited or should we say that the case to case analysis is still possible?
In other words more specifically, whether there is a possibility of a subsidiary claiming that the Board, managing director or manager, of such Company is not accustomed to act as per the instructions of the Board?
- Another interesting aspect of this section is its applicability on book debts. While under the Companies Act, 1956, Section 296 specifically stated that Section 295 shall apply to any transaction represented by a book debt which was from its inception in the nature of a loan or an advance; no separate mention of nature of such book debt is mentioned under the provisions of Section 185 of the Companies Act, 2013 as it straight away includes ‘any loan represented by a book debt’ in its purview. It remains to be seen now whether undertaking of any related party transaction for e.g. relating to purchase or sale of goods or services which are otherwise allowed within the purview of Section 188 of the Companies Act, 2013; for credit (not for cash); also end up in a violation of this section for the Directors and other person in whom Directors are interested. Perhaps the nature of credit extension to directors and other person wherein directors are interested would also be required to be reviewed for each transaction.
Regarding the aspect of this section as to its applicability on book debts; it is pertinent to refer to the case of Pennwalt India Ltd. v. RoC , wherein the Hon’ble High Court of Bombay has held that to ascertain whether a transaction is a loan or not, surrounding circumstances, relationship and character of the transaction and the manner in which parties treated the transactions will have to be considered. Hence, with reference to each transaction with Directors and other person in whom the Directors are interested; the nature of transactions has to be studied, in case they relates to book debts.
While the Ministry has, through the exemption provided in the Rules attempted to meet the requirement of the Industry by allowing obvious transactions between holding-subsidiary companies; it’s important to note that the Private Companies do not per se fall in the exempted category yet. It would be important to notice in long run whether the New Law is able to create India Inc. meet the requirement of global challenges and liberalisation and at the same time protect stakeholders’ interest.