Loans to Directors

• (a) any director of the company, or of a company which is its holding company, or any partner or relative of any such director; or
• (b) any firm in which any such director or relative is a partner.

Four features to draw out.

"Directly or indirectly" defeats routing the money through a third party.

"Including any loan represented by a book debt" defeats recording it as a trade receivable rather than as a loan.

Three transactions are covered, not one: a loan, a guarantee, and the provision of security. Guaranteeing a director's personal bank borrowing is as much a breach as lending him the money.

The circle is wide: the company's own directors, directors of its holding company, the partners and relatives of either, and firms in which any of them is a partner.

And there is no way round it. Sub-section (1) admits of no resolution and no approval. Only the four exemptions in sub-section (3) take a transaction outside it.

The permitted route: section 185(2)

A company may advance a loan, including one represented by a book debt, or give a guarantee or provide security in connection with a loan taken by any person in whom any of the directors of the company is interested, subject to:

• (a) a special resolution passed by the company in general meeting. Proviso: the explanatory statement to the notice shall disclose the full particulars of the loans given, or guarantee given or security provided, and the purpose for which it is proposed to be utilised by the recipient, and any other relevant fact; and
• (b) the loans are utilised by the borrowing company for its principal business activities.

Both conditions, and the second is a continuing one. The special resolution authorises; the use of the money must then actually match.

The Explanation defines "any person in whom any of the director of the company is interested":

• (a) any private company of which any such director is a director or member;
• (b) 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
• (c) any body corporate whose Board, managing director or manager is accustomed to act in accordance with the directions or instructions of the Board, or of any director or directors, of the lending company.

Note the three tests. Clause (a) is office or membership in a private company, with no percentage at all. Clause (b) is twenty-five per cent of total voting power, and it may be held by two or more directors together. Clause (c) is the shadow control test, the same idea as section 2(69)(c) for promoters.

The four exemptions: section 185(3)

Nothing in sub-sections (1) and (2) shall apply to:

(a) A loan to a managing or whole-time director:

• (i) as a part of the conditions of service extended by the company to all its employees; or
• (ii) pursuant to any scheme approved by the members by a special resolution.

So a housing loan scheme open to all employees may include the managing director; and a scheme confined to him needs a special resolution.

(b) A company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan, provided that in respect of such loans an interest is charged at a rate not less than the rate of prevailing yield of one year, three years, five years or ten years Government security closest to the tenor of the loan.

Two conditions here, and students remember only the first. The company must be a lender in the ordinary course, and the interest must be at least the Government security yield for the closest tenor. A lending company that charges its director a token rate is outside the exemption.

(c) Any loan made by a holding company to its wholly owned subsidiary, or any guarantee or security given by a holding company in respect of a loan made to its wholly owned subsidiary.

(d) Any guarantee or security given by a holding company in respect of a loan made by any bank or financial institution to its subsidiary company.

The proviso to (c) and (d): the loans so made must be utilised by the subsidiary company for its principal business activities.

Note the difference between (c) and (d), because it is examined. Clause (c) covers a wholly owned subsidiary and covers the holding company's own loan as well as its guarantee. Clause (d) covers any subsidiary, not only a wholly owned one, but only a guarantee or security for a loan by a bank or financial institution, not a loan by the holding company itself.

The punishment: section 185(4)

If any loan is advanced, or a guarantee or security given or provided or utilised, in contravention:

• (i) the company shall be punishable with a fine of not less than five lakh rupees and up to twenty-five lakh rupees;
• (ii) every officer of the company who is in default shall be punishable with imprisonment up to six months, or with a fine of not less than five lakh rupees and up to twenty-five lakh rupees; and
• (iii) the director or the other person to whom the loan is advanced, or the guarantee or security given, shall be punishable with imprisonment up to six months, or with a fine of not less than five lakh rupees and up to twenty-five lakh rupees, or with both.

Three separate defendants, and the recipient is one of them. A director who takes the money is punished in his own right, and note that he alone faces imprisonment or fine or both, while the officer in default faces imprisonment or fine.

And note the word "utilised" in the opening line. A facility lawfully given but then used in breach, for example a section 185(2) loan spent otherwise than on the borrower's principal business, is itself a contravention.

A worked example

Solapur Polymers Limited has four directors, including Mr Jadhav, who is also a director of its holding company.

Case one, the hard ban. Mr Jadhav asks the company for a personal loan of thirty lakh rupees. Section 185(1)(a) forbids it absolutely. So does a loan to his wife, being a relative, or to his business partner, or to a firm in which he or his wife is a partner under clause (b). No special resolution can authorise any of them.

A guarantee is the same thing. The company cannot instead guarantee his bank loan or pledge its fixed deposit as security for it: all three limbs, loan, guarantee and security, are covered.

Nor a book debt. Recording the advance as a trade receivable does not help: the sub-section covers any loan represented by a book debt.

Case two, the permitted route. Latur Coatings Private Limited wants a loan of two crore rupees, and Mr Jadhav is a member of it. By Explanation (a) it is a person in whom a director is interested, because it is a private company of which he is a director or member, with no percentage threshold.

So the company may lend, but only if:

• the members pass a special resolution, and the explanatory statement discloses the full particulars of the loan and the purpose for which the borrower will use it; and
• Latur Coatings uses the money for its principal business activities.

If Latur Coatings then uses the two crore to buy a flat for Mr Jadhav, the facility has been utilised in contravention, and section 185(4) applies to the company, the officers in default and the recipient.

Case three, twenty-five per cent. Beed Chemicals Limited is a public company in which Mr Jadhav and another director together control twenty-eight per cent of the total voting power. That is not less than twenty-five per cent, and two or more directors together may be counted, so Explanation (b) applies and the section 185(2) route is available.

Case four, shadow control. Nanded Packaging Limited's Board is accustomed to act on Mr Jadhav's instructions, though he holds nothing in it. Explanation (c) catches it.

The exemptions.

A staff loan scheme. The company has a vehicle loan scheme open to all its employees. The managing director may take a loan under it: section 185(3)(a)(i). A scheme confined to the managing director alone would need a special resolution under clause (a)(ii).

A lending business. Had Solapur Polymers been a company that provides loans in the ordinary course of its business, clause (b) would exempt it, but only if the interest charged were not less than the prevailing yield on the Government security closest in tenor to the loan.

A wholly owned subsidiary. The company lends to Solapur Films Private Limited, its wholly owned subsidiary. Clause (c) exempts it, provided the subsidiary uses the money for its principal business activities.

A bank loan to a subsidiary. The company guarantees a bank loan to Solapur Logistics Limited, a subsidiary that is not wholly owned. Clause (d) exempts the guarantee, because it covers any subsidiary where the lender is a bank or financial institution. Had the company itself lent to that subsidiary, clause (c) would not have helped, because that subsidiary is not wholly owned.

The consequences of getting it wrong. The company pays five to twenty-five lakh rupees; every officer in default faces six months' imprisonment or five to twenty-five lakh rupees; and Mr Jadhav, as the recipient, faces six months' imprisonment or five to twenty-five lakh rupees, or both.

Distinctions that carry marks

What this does NOT mean

It does not mean all loans to directors can be approved by resolution. Sub-section (1) is absolute; only the sub-section (3) exemptions take a transaction outside it.

It does not mean only loans are caught. Guarantees and the provision of security are equally within the section.

It does not mean a lending company may lend to its directors freely. Clause (b) requires both that it lends in the ordinary course and that the interest is at least the Government security yield of the closest tenor.

It does not mean a section 185(2) loan is safe once approved. Using it otherwise than for the borrower's principal business activities is itself a contravention under section 185(4).

Quick revision

• 185(1): no loan, guarantee or security, directly or indirectly, including a loan represented by a book debt, to a director of the company or of its holding company, a partner or relative of such a director, or a firm in which any of them is a partner. Absolute.
• 185(2): permitted to a person in whom a director is interested, on (a) a special resolution with full particulars and the purpose disclosed in the explanatory statement, and (b) use for the borrower's principal business activities.
• Explanation: (a) a private company where the director is a director or member; (b) a body corporate where twenty-five per cent or more of total voting power is controlled by such a director or two or more together; (c) a body corporate accustomed to act on the lending company's directions.
• 185(3): (a) a loan to an MD or whole-time director under a scheme for all employees, or a scheme approved by special resolution; (b) a company lending in the ordinary course, at interest not less than the closest-tenor Government security yield; (c) a holding company to its wholly owned subsidiary; (d) a holding company's guarantee for a bank or financial institution's loan to any subsidiary. Proviso to (c) and (d): the subsidiary must use it for its principal business activities.
• 185(4): company five to twenty-five lakh rupees; officer in default, six months' imprisonment or the same fine; the recipient, six months' imprisonment or the same fine or both. Contravention includes a facility utilised in breach.

Test yourself

1. To whom may a company never lend under section 185(1)? Any director of the company or of a company which is its holding company, any partner or relative of such a director, and any firm in which such a director or relative is a partner. The prohibition covers, directly or indirectly, any loan including one represented by a book debt, any guarantee, and any security.

2. On what conditions may a company lend to a person in whom a director is interested? On a special resolution of the company in general meeting, the explanatory statement disclosing the full particulars of the loan, guarantee or security and the purpose for which it will be used; and provided the loan is utilised by the borrowing company for its principal business activities: section 185(2).

3. Who is "a person in whom a director is interested"? A private company of which such a director is a director or member; a 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 such a director or by two or more such directors together; or a body corporate whose Board, managing director or manager is accustomed to act in accordance with the directions or instructions of the lending company's Board or directors.

4. When may a company lend to its managing director? Where the loan is part of the conditions of service extended by the company to all its employees, or is made pursuant to a scheme approved by the members by a special resolution: section 185(3)(a).

5. Distinguish the exemptions in clauses (c) and (d). Clause (c) exempts a holding company's loan, guarantee or security in favour of a wholly owned subsidiary. Clause (d) exempts only a guarantee or security given by a holding company for a loan made by a bank or financial institution to any subsidiary, not merely a wholly owned one. Under both, the subsidiary must use the money for its principal business activities.

6. Who is punished for a contravention? The company, by a fine of five to twenty-five lakh rupees; every officer in default, by imprisonment up to six months or the same fine; and the director or other person who received the loan, guarantee or security, by imprisonment up to six months or the same fine or both: section 185(4).