Understanding Section 185 of the Companies Act: Loan to Directors and Related Parties

The Companies Act, 2013 includes several provisions to ensure transparency and prevent conflicts of interest within a company. One such provision is Section 185, which deals with loans, guarantees, and securities provided to directors and related parties. Let's take a closer look at this section and understand its key points:

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Restriction on Loans to Directors and Related Parties:

According to sub-section (1) of Section 185, a company is prohibited from directly or indirectly advancing loans or providing guarantees or securities in connection with loans to certain individuals, including:

a) Directors of the company or director of its holding company.

b) Partners or relatives (Definition of relative is given below) of any such director.

Definition of Relative

?“relative’’, with reference to any person, means any one who is related to another, if—

(i) they are?members?of a Hindu Undivided Family;

(ii) they are husband and wife; or

(iii) one person is related to the other in following manner:

(1) Father (Provided that the term “Father” includes step-father).

(2) Mother (Provided that the term “Mother” includes the step-mother).

(3) Son (Provided that the term “Son” includes the step-son).

(4) Son’s wife.

(5) Daughter.

(6) Daughter’s husband.

(7) Brother (Provided that the term “Brother” includes the step-brother);

(8) Sister (Provided that the term “Sister” includes the step-sister).

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This ensures that directors and their close associates do not misuse company resources for personal gains.

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Loans to Persons in Which Directors are Interested:

Sub-section (2) allows a company to provide loans, guarantees, or securities to individuals in whom any director of the company has an interest (defined below). However, this is subject to certain conditions:

a) The company must pass a special resolution in a general meeting.

The explanatory statement for the meeting should provide full details of the loans, guarantees, or securities, including their purpose and other relevant information.

b) The borrowing company must utilize the loans for its principal business activities.

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This provision enables the company to extend financial support to entities connected to its directors while ensuring transparency and adherence to business objectives.

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Definition of "Persons in Which Directors are Interested":

To clarify the scope of "persons in which directors are interested," the Explanation in sub-section (2) provides the following categories:

a) Private companies in which any director of the lending company is a director or member.

b) Body corporates where not less than twenty-five percent of the total voting power can be exercised or controlled by any director or a group of directors.

c) Body corporates where the Board of Directors, managing director, or manager acts in accordance with the directions or instructions of the lending company's Board or any director(s).

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These definitions help identify situations where conflicts of interest may arise and require proper disclosure and scrutiny.

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Exceptions to the Restrictions:

Sub-section (3) outlines certain exceptions to the restrictions on loans, guarantees, and securities:

a) Loans to managing or whole-time directors can be given as part of their employment terms or through schemes approved by special resolution.

b) Companies engaged in providing loans or guarantees in the ordinary course of business, charging an interest rate not lower than the prevailing yield of government securities.

c) Loans or guarantees provided by a holding company to its wholly owned subsidiary company.

d) Guarantees provided by a holding company in respect of loans given to its subsidiary by a bank or financial institution.

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These exceptions acknowledge legitimate scenarios where loans and guarantees are common and do not pose conflicts of interest.

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Penalties for Contravention:

Sub-section (4) specifies the penalties for contravening the provisions of Section 185:

a) The company itself will face a fine ranging from five lakh rupees to twenty-five lakh rupees.

b) Any officer of the company responsible for the contravention can be imprisoned for up to six months or face a fine ranging from five lakh rupees to twenty-five lakh rupees.

c) Directors or individuals receiving the loans, guarantees, or securities can be imprisoned for up to six months or face a fine ranging from five lakh rupees to twenty-five lakh rupees, or both.

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These penalties act as deterrents and emphasize the importance of adhering to the regulations to maintain the integrity of financial transactions within a company.?

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Exceptions, Modifications and Adaptations?

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Section 185 of the Companies Act sets out the rules for loans given to directors and related parties. However, there are certain exceptions, modifications, and adaptations to this section that we need to be aware of. Let's explore them:

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Exceptions for Private Companies:

Section 185 does not apply to private companies meeting the following criteria:

(a) No other corporate entity has invested money in the company's share capital.

(b) The company's borrowings from banks, financial institutions, or other corporate entities are less than twice its paid-up share capital or fifty crore rupees, whichever is lower.

(c) The company has no outstanding defaults in repaying these borrowings at the time of the transactions under this section. This exception was introduced through a notification on 5th June 2015.

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Exceptions for Nidhi Companies:

For Nidhi companies, Section 185 does not apply if the loan is given to a director or their relative in their capacity as members. This transaction should be disclosed in the annual accounts through a note. This exception was introduced through a notification on 5th June 2015.

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Exceptions for Government Companies:

Government companies are exempted from Section 185 if they obtain prior approval from the Ministry or Department of the Central Government responsible for administratively overseeing the company or from the respective State Government. This exception ensures that the government has oversight before any loans, guarantees, or security are provided. This exception was introduced through a notification on 5th June 2015.

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Exceptions for Specified IFSC Public Companies:

In the Explanation of Sub-section (1) of Section 185, a modification was made for specified International Financial Services Centre (IFSC) public companies. The clause (c) in the Explanation was substituted to state that the director of the lending company can be a director or member of a private company, provided that the lending director does not have any direct or indirect shareholding in that private company through themselves or their relatives. A special resolution is required to be passed to approve this exception. This modification was introduced through a notification on 4th January 2017.

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Exceptions for Specified IFSC Private Companies:

Similar to the above, specified IFSC private companies have the same modification in the Explanation of Sub-section (1) of Section 185. The lending director can be a director or member of a private company, provided that they do not have any direct or indirect shareholding in that private company through themselves or their relatives. Again, a special resolution is required to be passed to approve this exception. This modification was introduced through a notification on 4th January 2017.

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These exceptions and modifications aim to provide flexibility and accommodate specific circumstances for different types of companies, while still maintaining transparency and integrity in financial transactions. It's important for companies to understand these exceptions and ensure compliance with the applicable regulations.

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Section 185 of the Companies Act is important for preventing misuse of company resources and ensuring fairness among directors and related parties. At?InstaBizFilings, our team is highly knowledgeable and well-versed in the Companies Act and its provisions. We understand the complexities of the law and are here to assist you with any questions or clarifications you may need. Whether you require guidance on compliance or a better understanding of the legal framework, we are ready to help. Feel free to reach out to us for expert assistance and reliable support.