Navigating Compliance of Loan to Directors, Managing Directors and Related Entities

Navigating Compliance of Loan to Directors, Managing Directors and Related Entities

6 July 2024 • Harsh Chetiwal

In the intricate world of corporate governance, few sections wield as much influence as Section 185 of the Companies Act, 2013. It’s not just a set of regulations; it’s a safeguard against potential conflicts of interest, a beacon guiding companies towards transparency and ethical conduct.

In this article, we explore provisions, exemptions and exceptions of loans to directors which includes guarantee and security. But our exploration doesn’t stop there. We pivot to a landmark case which extended the ambit of Section 185 through this riveting case study, we witness the collision of corporate power, familial ties, and the stark realities of regulatory oversight.

And for those seeking clarity amid the complexity, we’ve curated a compendium of FAQs, demystifying the nuances of loans to directors and related entities.

I. BRIEF OVERVIEW OF SECTION 185 OF THE COMPANIES ACT, 2013

This section regulates the provision of loans, guarantees, and securities by Companies to their directors, managing director and certain other entities. It imposes significant restrictions on companies regarding loans, guarantees, and securities to directors and related entities. Companies must comply with these provisions with careful attention to detail, ensuring that any exemptions are precisely documented and justified through passing of special resolutions and adequate disclosures. Non-compliance can lead to severe penalties, emphasizing the importance of adherence to these regulations.

II. DIRECTORS LOAN DILEMMA: FROM PROHIBITION TO PERMISSIBILITY

III. CASE STUDY: RETROACTIVE REACH UNRAVELING DIRECTORS LIABILITY

Facts-

In the case of Hewlett Packard Enterprise India Pvt. Ltd. (HPE India) vs. Registrar of Companies, Karnataka, HPE India was alleged to have contravened Section 185 of the Companies Act, 2013 by advancing a substantial inter-corporate loan amounting to Rs. 3,60,40,00,000/- to its fellow subsidiary, Hewlett Packard Enterprise Global Soft Pvt. Ltd., without securing the mandatory prior approval through a special resolution.

Subsequent Action-

The Registrar of Companies identified this transaction as a breach of statutory requirements and initiated legal action against HPE India and its officers. HPE India subsequently filed a petition for the compounding of the offense under Section 441 of the Companies Act.

The National Company Law Tribunal (NCLT), Bengaluru Bench, adjudicated the matter, ultimately imposing a penalty of Rs. 10,00,000/- on HPE India and Rs. 5,00,000/- on Mr. Som Prakash, the Managing Director. The Tribunal also directed the Registrar of Companies to prosecute other directors who had not applied for compounding, underscoring the accountability of all officers involved in ensuring compliance with corporate governance norms and legal provisions.

Mr. Som Prakash Satsangi contended that loan was disbursed in 2017 at an arm’s length basis at a rate of interest not less than the `Applicable Rate’, declared by the Reserve Bank of India and at the time of Disbursement of Loan he was `employed’ with the HPE India but was not a director/officer of the company, and therefore, cannot be held liable under the unamended Section 185 for the non-compliance. He argued that penal provisions should be interpreted strictly and cannot have retrospective application unless expressly stated.

The pivotal question that emerges from the order of the National Company Law Appellate Tribunal is whether an authorized signatory, who was not a director or officer of the company at the time of advancing a loan, can subsequently be held liable under amended Section 185 of the Companies Act for that transaction, upon being appointed as a director at a later date?

On one hand, the unamended Section 185, which governed the transaction at the time of its execution, imposed liability solely upon the company and the recipient of the loan. The authorized signatory, acting merely as a representative of the corporate entity, could arguably be shielded from personal liability, as their actions were undertaken in their official capacity and not as a director or officer bestowed with fiduciary duties.

However, the subsequent amendment to Section 185, extending liability to “every officer of the company who is in default,” injects a layer of complexity into the equation.

Extending the Ambit of Section 185

Its applicability can extend to past transactions if the non-compliance persists after the amendment comes into force, and the individual, who was previously involved in the  violation, subsequently assumes the position of an “officer in default.”

The key factors that determine the potential liability of an authorized signatory, who later becomes a director or officer are:

• Their active involvement and knowledge of the non-compliance with Section 185 while advancing the loan, even though they were not a director/officer at that time.
• The continuation of the non-compliant loan transaction after the amendment came into effect.
• The individual’s subsequent assumption of the role of an “officer in default” by virtue of their new position as a director or officer coupled with their previous involvement in the non-compliant act.

Therefore, if an authorized signatory was actively involved in the decision-making process of advancing a loan in violation of Section 185, and the non-compliant loan remains outstanding after the amendment came into effect, they can potentially be held liable under the amended Section 185 as an “officer in default,” upon their subsequent appointment as a director or officer of the company.

IV. FAQ’s ON LOAN TO DIRECTORS 

1. Which companies are covered under prohibition of Section 185? 

It applies to both public and private companies but following private companies shall be exempt from the prohibitions of Section 185 if:

• The company has no investments from any other body corporate
• The borrowings of the company from banks or financial institutions or anybody corporate is less than twice its paid-up share capital or Rs. 50 crore, whichever is lower; and
• The company has no default in repayment of such borrowings subsisting at the time of making transactions under this section.

Example 1: XYZ Private Limited, has a paid-up share capital of Rs. 100 crore. It has received investments of Rs. 10 crore in share capital from another company. Its total borrowings from banks and financial institutions amount to Rs. 150 crore. The company has no defaults in repaying these borrowings.

In this case, the Company does not meet the first condition for exemption, as it has received investments from another body corporate. Therefore, despite meeting the other two conditions, XYZ Private Limited will not be exempt from the prohibitions under Section 185.

Example 2: PQR Private Limited has a paid-up share capital of Rs. 40 crore. It has not received any investments from other body corporates. Its total borrowings from banks and financial institutions amount to Rs. 30 crore. However, the company has defaulted in repaying some of its borrowings.

In this case, PQR Private Limited meets the first two conditions for exemption but it does not meet the third condition as it has defaulted in repaying its borrowings. Therefore, PQR Private Limited will not be exempt from the prohibitions under Section 185.

2. Section 185 uses the phrase “advance any loan”. Are loans and advances considered the same under Section 185 of the Companies Act, 2013?

The term “loan” involves a sum of money borrowed with an obligation to repay, whereas “advance” typically refers to a payment made beforehand which may or may not have a repayment obligation.

This distinction is supported by various judicial rulings such as the Hon’ble Supreme Court in Shree Ram Mills Ltd. vs. Commissioner of Excess Profit Tax (1953) and the Hon’ble Madras High Court in KM. Mohammed Abdul Kadir Rowther vs. S. Muthia Chettiar (1959). The Bombay High Court in Pennwalt India Ltd. v. RoC emphasized considering the nature of the transaction and the relationship between parties.

Section 185 uses the phrase “advance any loan,” implying that it addresses loans specifically and not general advances. Therefore,, loans and advances are not considered the same under Section 185 of the Companies Act, 2013.

3. Can the advancement of a loan to a group company be ratified by a special resolution after the loan has been advanced?

The key issue in Eastern Condiments Pvt. Ltd. vs. ROC, Kerala where the company advanced a loan to its group company and passed special resolution post such advancement. The ROC, Kerala, contended that this was a violation of provision of the Companies Act, 2013. The court imposed a fine of Rs. 5 lakhs on the Company, emphasizing the importance of compliance with the statutory requirements to prevent such violations in the future. Under Section 185 and Section 186 of the Companies Act, 2013, a company must obtain prior approval through a special resolution.

4. Is it possible for a company to provide a loan to another company where one of its directors is a director in the borrowing company as well?

Yes, a company can provide a loan to another company where one of its directors is also a director in the borrowing company, provided that conditions specified in Section 185 sub-section (2) are met. (Refer para II (2) above)

5. Can a company provide a loan to a trust in which a director is a trustee?

Since a trust is not included in the definition of a body corporate under Section 2(11) of the Act, regardless of whether a director is a trustee, the company cannot extend a loan to a trust. Such an act shall be seen as contravention of the provisions of Section 185.

6. Can a company advance loan to relative of director?

Pursuant to Section 185 sub-section (1) clause (a), the company cannot advance loan to relative of director of the company whether directly or indirectly.

Provided that since the company is being exempted from advancing loan to director of the company who is either managing director or whole time director under Section 185 sub-section (3) clause (a), the relative of such director is also outside the purview of the restriction under this section.

7. Can a company advance loan to relative of director who is its employee?

Usually the loan advanced to employee of company being relative of director is considered as loan to directors and this type of transaction is prohibited under Section 185 of the Act.

Only such loans and advances to employees which states where loans/advances are provided to employees in accordance with their conditions of service and remuneration policy, shall not be considered as loan to directors and are allowed (Section 186 read with MCA general circular no. 04/2015).

8. Can a company advance loan to its employee?

Yes, explanation of section 186 subsection (2) provides the cases in which the company (directly/indirectly) cannot advance loan/guarantee/security to any person or body corporate but individuals who are in employment of the Company are excluded from the purview of ‘person’.  

MCA general circular no. 04/2015 provides applicability of section 186 on employees in two possible scenarios-

9. Can a subsidiary company provide a loan to another subsidiary of the same holding company under Section 185?

While Section 185 allows for loans between holding and subsidiary companies under exceptions. However, a subsidiary company providing a loan to another subsidiary of the same holding company does not fall under these exceptions. Such transactions must be evaluated for compliance with the provisions pertaining to Inter-corporate Loans and Investments i.e., Section 186 of the Companies Act, 2013.

But in cases where both the subsidiary companies have common director(s) then requirements as stated under Section 185 (2) shall be complied. (Refer para II (2) above).

10. Are there any disclosure requirements for permissible transactions under Section 185?

Yes, such loans must be disclosed in the company’s financial statements as per the applicable accounting standards. Further, transactions with related parties, including directors and their relatives, are additionally subject to disclosure requirements under Section 188 of the Companies Act, 2013 i.e., Related party transactions.

You may like to read:

• Exemptions to Private Companies