Loans to Directors

In one line

A company may not lend to its own directors or their close connections at all, but it may lend to entities in which a director is merely interested if the members pass a special resolution and the money is used for the borrower's main business.

In exam wording: section 185(1) prohibits a company, directly or indirectly, from advancing any loan, giving any guarantee or providing any security to a director of the company or of its holding company, a partner or relative of such a director, or a firm in which such a director or relative is a partner; section 185(2) permits such a facility to a person in whom a director is interested, on a special resolution and on the condition that the loan is used for the borrower's principal business activities; and section 185(3) lists four exemptions.

Why the law has this at all

A loan from a company to its own director is the simplest way to take money out of a company without calling it remuneration or a dividend. It escapes the limits in section 197, it escapes the profit requirement in section 123, and it appears in the balance sheet as an asset rather than as a distribution.

Worse, the director is on both sides. He decides whether the company lends, on what security, at what rate and whether to enforce repayment. There is no arm's length bargaining anywhere in the transaction.

So the Act draws two circles.

The inner circle is absolutely barred. The director himself, his relatives and partners, and firms in which they are partners. No resolution can authorise it, because the conflict is total.

The outer circle is permitted but policed. A company in which the director happens to be a member or which he can influence is a genuine commercial counterparty as well as a possible conduit. So section 185(2) lets the company lend, but only if the members are told the full particulars and approve by special resolution, and only if the money goes into the borrower's principal business, not into the director's pocket.

Some words this chapter uses

A book debt is a debt due to the company recorded in its books; a "loan represented by a book debt" is a loan dressed up as a trade receivable. A relative is defined in section 2(77). A guarantee is a promise to answer for another's debt; security here means property pledged for it. Principal business activities are the borrower's main business. Government security yield is the return on Government bonds of the stated tenor.

The absolute prohibition: section 185(1)

No company shall, directly or indirectly, advance any loan, including any loan represented by a book debt, to, or give any guarantee or provide any security in connection with any loan taken by: