Applicability of Section 185 in the Companies Act,2013

Loans to Directors, etc. – Applicability of Section 185 in the Companies Act,2013 -

Some perspectives

• Section 185 in the Companies Act,2013(hereinafter “the Act”) was one of the few sections to be notified as early as on September 12, 2013 and the same is legally enforceable. Before going into the nitty-gritty of the provision ,it would be appropriate to examine its legislative intent.

Legislative Intent

• The legislative intent of the provision in the Act has not been expressly stated, contrary to normal convention particularly when a new provision or a statute is introduced. Be that as it may, it is obvious that the objective of the Section is to impose fetters on the provision of loans/ Guarantees to directors / companies in which they are interested in the manner contemplated in the Section, which was earlier permissible under Section 295 of the Companies Act, 1956(hereinafter “the old Act”) albeit, with the approval of the Central Government. It must be understood that the Section intends to regulate only provision of loans to directors or persons/ companies and other non-corporate entities in which the directors of the lending company are interested both directly and through their relatives. Its purpose is  to ensure that the directors do not misuse their position to benefit themselves by facilitating provision of loans /financial guarantees from the Companies with which they are associated either to themselves or to entities in which they are interested.

The underlying objective of Section 185 is to ensure that the instrumentality of the Company is not perpetrated to any form of abuse by the Directors. The Section is intended to evidently avoid a conflict of interest and can thus be termed as a “conflict of interest provision”.

• It is pertinent to note that the intent of Section 185 is not to regulate inter- corporate loans . Section 186 in the Act is intended to regulate Inter-corporate loans and investments. This Section acts as a composite code by itself and is therefore independent of section 185.

• Section 185 dissected

Section 185 commences with the words “Save as otherwise provided in the Act”. The meaning of the above expression needs to be firstly understood. It  contemplates that except where it is otherwise permitted under the Act,  the fetter imposed by Section 185 as far as grant of loans to Directors will prevail, given the fact that the provision is in the nature of a specific provision .

• Section applies to every company

The Section universally applies to all types of Companies, be it private or public .This is  perfectly justified , considering its objective.

• Application to loans given both “directly or indirectly”

The Section puts an embargo on loans or other kinds of accommodation provided whether directly or indirectly under some kind of a subterfuge. Therefore any form of “round  tripping” to circumvent the provision is strictly to be abhorred.

• Loan includes “Book Debt” also

The term “loan” is being given an extended connotation in the Section to cover any book debts due from a Director. This suggests that if any amount is due from a Director say, by way of rent against accommodation taken by him from the Company or against the value of goods supplied to him by the company on credit, it would tantamount to a “loan” and the outstanding will have to be necessarily squared off by the Director to ensure that it does not come within the ambit of the Section. Any “Book Debts” of the genre stated above which pre-existed prior to the coming into force of the Section has also been effectively drawn into the vortex of the Section, effective September 12,2013.

• Provision of Guarantee or Security barred

The Section also comes in the way of the company providing any guarantee or any  security in respect of a loan obtained by the Director from any other person.

• Exceptions carved out by the Proviso to the Section

Proviso under sub-section (1) lays down the exemption clause of the Section. The provision of any loan to the Managing Director or whole time director is insulated  from the rigors of the section provided the same has been given as part of the conditions of service extended to all the employees of the company or is pursuant to any scheme approved by the members by special resolution. It follows from the above that the company cannot extend any loan to a non- executive Director and further the loan facility should be extendable to all the employees of the Company. Alternatively, the loan should be extended pursuant to any scheme which has the approval of the members by special resolution.

The second limb of the proviso exonerates a company which, in the ordinary course of its business , provides loans or guarantees subject to the condition that the interest charged on the loan is at a rate which is not less than the bank rate declared by the RBI. The question that springs to mind from the above is whether a company belonging to the above category can provide loans to its directors under the shelter of this proviso. The answer would appear to be “yes’ as long  as the interest charged is in keeping with the rate stipulated above. Secondly it would indeed be in the ordinary course of it business to lend to any entity including its Directors subject to their credit worthiness being satisfactory. It should be ensured however that if loans are provided to its Directors, the same terms as applicable to other borrowers should be applied, lest the company should fall foul of section 185.

• Coverage of Section

Explanation under Section 185 (1) provides the canvas to the provision and amplifies the expression ”to any other person in whom director is interested” to mean:

(a) Any director of the lending company, of a company which is its holding company or any partner or relative of any such director;

(b) Any firm in which the such director or relative is a partner;

(c) Any private company of which any such director is a director or member;

(d) Any body corporate at a general meeting of which not less than 25% of the total voting power maybe exercised or controlled by any such director or two or more of such directors, together;

(e) 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.

As may be observed from the above Explanation, its tentacles are intended to extend far and wide. Its ramifications therefore run deep. A plain reading of Clauses (a) and (b) above suggests that these clauses put fetters on the provision of any loan to the director of a lending company, the Director of its Holding company or to any partner or relatives of such a director as also to any firm in which such a Director, namely the director of the lending company or the Director of the holding company or his relative is  a partner. Thus the conflict of interest in the above two clauses can arise either through the direct interest of the concerned Director or through his relatives. The term “Relative”  shall carry the meaning given to it by Section by 2(77) in the Act. The extension to the term “Relative” as provided in clause (iii) in section 2(77) may be found in Rule 4 of the companies(Specification of Definitions Details)Rules,2014.

Clauses (c), in the Explanation ibid, envisages only a situation where the Director is involved directly in his individual capacity. Therefore the provision of any loan to a private company in which such a director is a Director or member would be hit by clause (c), if the interest of the Director in the Private company is in the capacity of a member

. Even if his shareholding in the private company is minuscule, the above Clause (c) shall become applicable.

Clause (d) contemplates that where any loan is to be provided to a company in which 25% or more of the total voting power in General meeting is exercisable or controlled by such a director either individually by himself or together by two or more directors of the lending company, the provision of the loan or security shall be barred. It is pertinent to note that clause (d) considers control or exercise of voting power over 25% of the total voting power of the borrower company in General Meeting. Such control over the voting power can be through the direct holding of the Director himself or may be by two or more directors of the lending company. In either situation the exercise of voting power should be by the directors in their individual capacity and not indirectly. Control over voting power indirectly through relatives, partners etc. does not fall within the ambit of clause (d). It would be also appropriate at this juncture to draw a distinction  between the use of the expression “control” as contained in Section 2(27) of the Act and in clause (d) to the Explanation in Section 185. The definition of “control” in section 2(27) is much wider and it encapsulates exercise of control over the Management of a company, by exercise of the authority to appoint majority of directors or to control the management or policy decisions, exercise of shareholding rights .in the company. The usage of the word ”controlled” in clause (d) above is in an altogether different context.

Further clause (d) above is restricted in application only to the extent of exercise of control over 25% or more of the total voting power exercisable in General Meeting

. The word ‘controlled’ in Clause (d) is used in the form of a verb with reference to 25% of the voting rights of a company at general meeting, as against which ’control’ in Section 2(27) is used in the form of a noun to connote control over a company, be it through exercise of voting rights or management rights or shareholders’ agreement or in any other manner. Thus the term “control” as used in section 2(27) and in the above clause (d) are not to be considered as synonymous with each other.

As conventionally, only Equity shares of a company carry voting rights, in our view, the reference to the total voting power as stated in clause (d) should be only to Equity shares. It is common knowledge that in a General Meeting, voting power is exercisable only by the holders of Equity shares. Therefore unless the circumstances laid down in

Section 87 (2) in the 1956 Act which corresponds to Section 47 in the Act come into play, voting rights bestowed through holding of preference shares are not to be taken into consideration in determining the threshold voting power laid down in clause (d). It is again reiterated that the voting rights in Clause (d) will have to be considered only on the basis of the direct holding of the directors of the concerned company or its holding company. Indirect holdings through relative, firms etc. shall not be considered as the above Clause (d) clearly states that the voting power shall be exercised by “such director” or by “such directors”.

The Supreme court in Ombalika Das and another -vs- Hulisa Shaw (2002) 4SCC 539 had occasion to explain the intent in the usage of the adjective ”such” in legal parlance.

The Apex Court opined that the adjective ”such” when prefixed to a noun has to be read in the same sense as is attributable to it in the preceding part of the sentence. Going by this analogy, it may be stated that a company cannot advance loan or provide security or guarantee to a company limited by shares, in which more than 25% of the voting rights is exercised by the director(s) of the lending company or either singly or together with two or more Directors.

Clause (e) in the Explanation to section 185 comes into play where the Body corporate, the Board of directors, the Managing Director or Manager of the company seeking the borrowing are accustomed to act in accordance with the directions or instructions of the Board or of any director or directors of the Lending company. The expression “Accustomed to act in accordance with the directions or instructions of the Board or of any Director or Directors of the lending company” clearly suggests that it has to be circumstantially proved or established by a series of events or as may be explicitly provided by any agreement or documents, that the directors have acted in accordance with the directions or instructions of any director or directors or the Board of the lender company.

In order to prove the above, it must be established that the directors of the borrower company do not exercise any discretion or judgment of their own, but act in accordance with the directions of the director(s)/Board of the Lender Company. It would be appropriate at this juncture to refer to a decision in Hydrodam(Corby) Ltd. Re, (1994) 2 BCLC 180, where it was held that where a parent company gave its sanction to a subsidiary for the disposal of the subsidiary’s assets, this would not make the parent company a shadow director of the subsidiary. The sanction was given by the holding company in the capacity of a majority shareholder and not a controller from behind. As long as the decision was made by the directors of the subsidiary, exercising their own independent discretion and judgment, and the parent company only approved  or authorized the decision, the parent company would not be considered as a shadow director.

Evidence such as the existence of an agreement between the lender and the borrower companies in terms of which there is an express assertion that the Borrower company shall abide by the directions of the Directors of the Lender company would be pointer in that direction.

The decision of the Bench in Secretary of State for Trade and Industry Vs. Becker (2003) 1 BCLC 555, that, to show that a person is a shadow director, it  must be proved that de jure directors followed a consistent pattern of compliance with the instructions of the shadow director makes interesting reading. It must however be borne in mind that in this case, the Board was found to be working at the behest of a person who though not being part of the Board had all the trappings of being a de facto Director. We must point out that Clause (e) is restricted in application to only those who are de jure Directors and not de facto Directors which shadow directors are.

• Clauses (d) and (e) in Explanation cover Companies incorporated outside India

It is also pertinent to point out that in both clauses (d ) and (e) in the Explanation cited above, the expression ”Body Corporate” has been used in contrast to the earlier clauses (a) , (b) and (c ) where the reference is to a “company” .The term “body corporate” or “corporation” has been defined in Section 2(11) of the Act to include a company incorporated outside India. A co-operative society registered under any law relating to co-operative Societies and any other body corporate which is not a company as defined in the Act which the Central Government may by notification specify in this behalf do not come within the frame work of  a “body corporate’’. Thus the provision of loans and guarantees to companies incorporated outside India will also come within the ambit of the Section if the circumstances contemplated in clauses (d) and (e) exist.

• Head note to the Section does not tell the full story

Section 185 carries on the Statute Book, the head note ”Loans to Directors, etc.” As one can see from our discussion this head note is somewhat misleading in that the fetter imposed by the Section extends not only to loans and guarantees extended to directors but also to companies and bodies corporate in which the circumstances enumerated in clauses (c ),(d) and (e) in the Explanation exist. Viewed from this perspective, the provision overlaps in a limited sense with Section 186 of the Act which as we have said in our elucidation is a composite code for regulating Inter-corporate loans and Investments.

• Penalties for contravention

Any contravention of the Section is intended to be dealt with very severely with cash penalties on both the company and the errant Directors and other persons to whom the loan/guarantee has been provided which is extendable up to Rs 25 lacs ,apart from imprisonment which may extend to six months or both. In case of imprisonment, the errant Director will also invite disqualification and vacation of office under Section 164 and 167 respectively.

Conclusion

In our exposition we have endeavored to explain the law on the subject at length. What we consider conspicuous in the legislation is that if the provision of a loan or guarantee comes within the framework of the Section, there is no way that the same can be sanctified even through the process of Government approval in contrast to the predecessor provision in the 1956 Act. Secondly the Section applies to every company as opposed to Section 295 which did not apply to a private company unless it happened to be a subsidiary of a public company. Last but not the least is the fact that the section also includes “pseudo loans” in that it ropes in book debts due from a Director. Private companies which were profligate in the matter of providing loans to their Directors under the previous regime should be extremely wary of the pitfalls that lie ahead !.

RamaswamiKalidas