This article is written by Uneza Khan. In this article, the author provides a comprehensive analysis of Section 185 of the Companies Act, 2013, along with the recent amendments made to the Act pertaining to the aforesaid section. Additionally, it also discusses the exceptions to this provision and the punishments provided in the 2013 Act in the event of non-compliance.

It has been published by Rachit Garg.

Introduction

The Companies Act, 2013 (hereinafter referred to as the 2013 Act) is an important portion of Indian legislation. It governs the administration, formation, and operation of corporations in the nation.

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The 2013 Act brought various changes replacing the Companies Act, 1956. The Act contains several clauses covering business law, Corporate Social Responsibility (CSR), auditing, financial reporting, and many other topics. It seeks to improve corporate sector responsibility, transparency, and investor protection. The “One Person Company” concept was also introduced by the Act, which greatly changed how Indian businesses are organised and run.

One such provision incorporated in the 2013 Act,  pertaining to a company’s lending and borrowing activities, is Section 185, which is the subject matter of the present article. The provision establishes certain conditions on how the company can provide loans, security, and guarantees to its directors or other individuals, in whom directors have an interest. 

According to Section 185, the Companies are prohibited from granting money to the directors or other interested individuals without necessary checks and balances. Specific requirements are outlined in Section 185 for Companies to grant loans, security, or guarantees to their directors or other individuals in whom directors possess interest.

In this article, we will be discussing in detail about Section 185 of the Companies Act 2013. 

Section 185 of Companies Act, 2013 : an overview 

Public and private companies are prohibited under Section 185 from making loans, advances or guarantees to any of their directors or to any other individual in which the director possesses interests. They are also prohibited from making guarantees or offering security in connection with any loans that the director or that other person may take out. 

Section 185(1) specifies that; 

(1) No company shall advance any loan 

Directly or indirectly, which includes any loan represented by a book debt to, or in connection with any given guarantee or  provided security with any loan taken by

  • any director of the Company, or director of a holding company or any partner or relative of any such director; or
  • in any such firm, the director or relative is a partner.

The motive of the Ministry of Corporate Affairs appears to be transparent which is to take a strict stance on the flow of funds from the company to its directors or other persons in whom the director is interested. The director’s fiduciary duty is more prominent, which is why loans and other credit are restricted to directors and other designated individuals. 

To reduce a few of the industry’s concerns, the Ministry has eliminated the following transactions from Section 185 of the Companies Act, 2013 scope in the Companies (Meetings of Board and its Powers) Rules, 2014, which were notified on March 31, 2014: Transactions between holding companies and their wholly owned subsidiaries concerning: 

  • Any loans made by holding companies to their wholly owned subsidiaries;
  • Any guarantee or security provided  by holding companies regarding any loans made to their wholly owned subsidiaries; and transactions between holding companies and subsidiary companies;
  • Any guarantee or security offered by a holding company concerning a loan that a bank or other financial institution makes to one of its subsidiaries, wherein the subsidiary (including a wholly owned subsidiary) utilises the loan for its primary business operations.

Loan to any person in whom any of the directors of the company possesses their interest 

Section 185(2) states:

In connection with any loan made by a person in which any of the company’s directors has an interest, a company may advance any loan, including any loan represented by a book debt, or offer any guarantee or security, subject to the condition that:

  • The following special resolution is adopted by the company’s general meeting: provided that the explanation to the notice for the pertinent general meeting shall disclose all the details of the loans provided, guarantees provided, or security provided, as well as the purpose for which the recipient of the loan, guarantee, or security is proposed to use it, as well as any other pertinent fact; and
  • The borrowing corporation for its chief business operations uses the loans.

The term “any person in whom any of the directors of the Company is interested” has the following meanings for the purposes of this subsection:

  • any such director is a director or member of any private company;
  • any body corporate at a general meeting of which not less than 25% of the total voting power may be exercised or controlled by any such director, or by 2 or more such directors, jointly; or
  • any body corporate, the Board of Directors, management, or management committee.

As per Section 2(11), a Company incorporated outside India is included in ‘body corporate’ or ‘corporation’, and it excludes any cooperative society registered under any law related to cooperative society and any other body corporate which is specified by notification by the Central Government.

Conditions

Subsection (2) of section 185 states the conditions to be fulfilled for giving a loan or guarantee.

  • The loan to directors or other businesses made in a corporation should be in accordance with Section 185,
  • The loan must be authorised by the board of directors resolution and by shareholders special resolution. 
  • The resolution must outline the loan’s purpose, size, terms of repayment, and security, if any, for the loan, among other details. 
  • Section 185  also restricts the company’s ability to advance or lend money. The company’s 60% paid-up share capital, free reserves, and securities premium account is the maximum it can lend.

Exceptions to Section 185 of Companies Act, 2013

Section 185(3) provides exceptions to which Subsections (1) & (2) shall not apply.

The company may provide loans, guarantees or security to:

  • The whole time Director or the Managing Director as a part of the condition of service offered by the company to all its members; or
  • In accordance with a scheme accepted by the members through a special resolution. 

In this the approval of the board of directors of a Company is necessary and it should be mentioned in the company’s financial statements. 

The loan amount should not surpass either 100% of the free reserves and securities premium account or 60% of the paid-up share capital and free reserves, whichever is higher. 

  • Subject to certain restrictions, a Company may provide any loan, guarantee, or offer security in relation to any loan to a director who is neither a Managing Director nor a Full-time Director with prior approval from the Board of Directors.

The maximum loan amount is one crore rupees, or twenty-five percent of the paid-up share capital, free reserves, and securities premium account, whichever is less. 

  • a company that, as part of its regular operations, makes loans, guarantees repayment of loans, or pledges securities for repayment of loans, and charges interest on those loans at a rate not lower than the current yield on the longest-term government security (one year, three years, five years, or ten years), depending on the length of the loan;
  • any loan made to a wholly owned subsidiary firm by a holding company, as well as any guarantee or security offered in connection with such a loan by a holding company;
  • a holding company may offer a guarantee or security in exchange for a loan that a bank or other financial institution makes to one of its subsidiary companies, provided that the subsidiary company for its core business operations uses the loans

A firm or company in which the director is a partner or director, or a person who is a director’s relative, is included in a person in whom the director has an interest.

  • Exceptions for Wholly Owned Subsidiaries

Section 185 does not apply to loans or advances given by a company to its Wholly Owned Subsidiary 

Subsidiary 2(87) under the Companies Act 2013 states in relation to other companies means a company in which the holding company has control over the board of directors composition or controls more than 50% of the total voting power.

  • Exceptions for Government Companies 

Government Companies are excluded from the ambit of Section 185 in case such a company acquire prior approval before providing any loan or guarantee or security under the amended section (Notification No. G.S.R. 463(E) dated June 5, 2015, of the State Government or the Ministry of the Central Government which is responsible for the administration of the company. 

  • Exceptions for Private Companies 

Introduced through the Notification on 5th June 2015. The provision of Section 185 shall not apply to a Private Company-

  • in whose share capital any money is invested by a body corporate;
  • if the company’s borrowings from banks or financial institutions or any body corporate is less than twice its paid-up share capital or fifty crore rupees whichever is less; and
  • under this section, such a company repayment default of such borrowings existing at the time of establishing transactions.
  • Exceptions for Nidhi Companies 

Section 185 shall not apply to a Nidhi Company as introduced by a notification on 5th June 2015, provided that the loans provided to the Director or his relative in their capacity as members and by a note such transaction will be revealed in the annual accounts.

  • Exceptions for IFSC( International Finance Service Centres) Companies 

Clause ‘c’ was substituted in subsection (1) of Section 185 (Introduced through Notification on 4th January 2017) which stated that The director of a lending company can be a director or member of a private company, in which the director of the lending company does not have direct or indirect shareholding either through themselves or their relatives and to this effect a special resolution is passed. 

Punishment for non-compliance to Section 185 of Companies Act, 2013

Section 185(4) of the Companies Act provides the punishment for non-compliance of this Section. 

It states that, if any guarantee or advanced security for any loan is provided, specified or utilised in violation of the provisions of this section,

  • the company shall be subject to a fine that shall not be less than Rs. 5 lakhs but may not exceed Rs. 25 lakhs; 
  • default by any officer of the company shall be subject to either imprisonment for a term that may not exceed six months or a fine that shall not be less than Rs. 5 lakhs but may not exceed Rs. 25 lakhs; and
  • Imprisonment which may extend to six months or a fine of not less than five lakh rupees but not more than twenty-five lakh rupees, or both, may be imposed as punishment on the director or any other individual to whom any loan is advanced or guarantee or security is given or provided in relation with any loan taken by him or the other person.

The objective of Section 185 of Companies Act, 2013

Section 185 of the 2013 Act addresses loans and advances to directors and any affiliated organisations. The principle objective of Section 185 is to protect the shareholders’ and other stakeholders’ interests and to stop directors from abusing their positions. 

The rationale behind this Section is 

  • to avert the stealing or fraud of public funds granted by Banks and Financial Institutions, 
  • Public issue proceeds,

This Section notably prohibits a company from advancing loans or providing guarantees or securities using the proceeds of any public issue for:

-Section 185 ensures that the funds raised through the public issue are related to the purpose stated in the prospectus (which includes basic information regarding the company in the form of advertisement, circulars, and notice inviting the public for the offering)of the company and are not used for personal gains of directors. 

-This Section also puts restrictions on persons on whom the director possesses interest.

  • To prevent misuse by conveying funds to directors’ private businesses,

This section also prohibits loans and advances to the directors and the person related to them in order to prevent any misuse of the company’s funds for personal benefit.

  • Providing financial institutions securities and corporate guarantees in order to secure directors’ personal gains.

Section 185 had a prominent effect on structured lending transactions which were supported by collateral, credit support, or guarantee either from a group or parent company. The Companies (Amendment) Act, 2017 addressed the major obstacles faced by the market players in raising funds and collateral and credit support by intra groups.

In view of this, Section 185 of the 2013 Acts, has been amended to eliminate the prohibition to some limit by providing for a way out in the form of a shareholders’ resolution for allowing loans/guarantees/securities to individuals or organisations in which directors possess some interest or for common controlled group companies.

After the aforesaid Amendment, every officer of the Company has more obligations to ensure that all loans, securities, and guarantees are in accordance with the Companies Act of 2013 because after the amendment the provisions have significantly broadened the scope of the penalties which is mentioned in Section 185(4) of the Companies Amendment Act 2017. 

Conclusion

In order to circumvent any conflicts of interest, encourage good governance, and safeguard the interests of shareholders and stakeholders, Section 185 of the Companies Act 2013 plays a vital role. The clause improves responsibility and transparency in company affairs by placing restrictions on loans and advances to directors. To ensure smooth operations and maintain trust in the company’s environment, it is critical for companies and directors to understand the complexities of Section 185, abide by its regulations, and evolve strong governance procedures.

Frequently Asked Questions 

What are the prohibitions under Section 185?

Section 185(1) states the prohibitions. 

  • No corporation may give a loan in advance to its “directors” or to “other persons in whom directors are interested” either directly or indirectly.
  • In connection with any loan accepted by him or that other person, no company may issue a guarantee or a security. 
  • The company cannot grant the aforementioned persons a loan that is represented by a book debt.

“Loan represented by Book Debt” refers to loans that aren’t really shown as loans in the books of the company but are instead represented in the balance sheet by debtor or credit sales, among other indirect loans. 

“Guarantees” does not include performance guarantees; rather, it only includes guarantees related to loans or financial guarantees. 

What is the penalty under Section 185?

Section 185(4) states the penalty if the provision of Section 185 is not complied with. It provides that, if the loan is advanced in contravention of Section 185 the Lender Company shall be liable with a fine between Rs. 5 lakh and Rs. 25 lakh. 

Further, a director or other person to whom any loan is issued or a guarantee or security is given shall be liable for imprisonment which may extend to 6 months; or with a fine between Rs. 5 lakh and Rs. 25 lakh; or both.

Can a deposit be treated as a loan? 

Whether a deposit shall be treated as a loan or not will depend upon the nature of the transaction and the facts gathered from the terms and conditions attached to the transaction. The essential requirement of a loan is the advance of money upon the understanding that it shall be returned and it may or may not carry interest, as held in the case of Dr Freddie Ardeshir Mehta v. Union of India (1998) by Bombay High Court.

What are the changes brought in Section 185 after the 2013 Amendment?

Public Companies cannot provide any loan or security in connection with a loan to a Director or any other person in whom the Director possesses an interest, excluding the Managerial Director and Whole-time Director as prescribed. It ensures appropriate checks and balances on providing loans or guarantees.

What are the changes brought in Section 185 after the 2017 Amendment?

Section 185 after the amendment by the Companies Amendment Act, 2017:

  • Restricts the prohibition on loans, advances etc. to the Directors of the Company or its holding company or any partner of the director or any firm, the director or relative is a partner
  • Permits the company to provide any loan or guarantee or provide any security in relation to any loan to any individual or organisation in whom the director possesses interest, provided that a special resolution should be passed by the company in a General Meeting. The borrowing company shall utilise the loan exclusively for its primary business undertakings.
  • The scope of Subsection 4 of Section 185 of the Act is expanded by including an officer in default of the Company which is mentioned in Section 2(59) to include any director, manager or Key Managerial personnel or any person in accordance with whose orders or instructions the Board of Directors or any one or more director’s is or are accustomed to act. 

Is LLP included in the ambit of Section 185 of the Companies Act 2013?

No, The LLP is not included under the Companies Act, 2013 as LLP is required to comply with the provisions of the Limited Liability Partnership Act, 2008. Thus, they do not have to abide by Section 185 of the Companies Act, 2013 while providing loans to their partners.

References 

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