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Holding-subsidiary loans prohibition - Respite under company law

By Dinesh Babu Eedi

Prelude

On 2nd December, 2014, the Union Cabinet, approved the Companies (Amendment) Bill, 2014 (‘Amendment Bill’) for introduction in Parliament (Lok Sabha) to make certain amendments in the Companies Act, 2013 (‘2013 Act’).  The 2013 Act was brought into force partly on 12th September, 2013, and on 1st April, 2014, of 470 Sections of the 2013 Act, 283 Sections and 22 sets of related rules have been brought into force so far. The Amendment Bill was drafted with the intent to improve the “ease of doing business” by correcting certain lacunae, clarifying issues and addressing concerns raised by industry on the 2013 Act.

Proposed amendment

The Amendment Bill seeks to clarify the issues on Section 185 of the 2013 Act, which deals with the issue of loans to the Directors by their companies. For the purpose of easy reference, the proposed amendment to the above referred Section is as follows:

In section 185 of the principal Act, in sub-section (1), in the proviso, after clause (b), the following clauses and proviso shall be inserted, namely
"(c) any loan made by a holding company to its wholly owned subsidiary company or any guarantee given or security provided by a holding company in respect of any loan made to its wholly owned subsidiary company; or
 (d) any guarantee given or security provided by a holding company in respect of loan made by any bank or financial institution to its subsidiary company:
Provided that the loans made under clauses (c) and (d) are utilized by the subsidiary company for its principal business activities".

The existing Section 185 – 2013 Act     Section 185 of 2013 Act, contains a blanket prohibition on companies from giving loans, guarantee or security to its directors or ‘any other person in whom the director is interested’.

The only exception to the above mentioned blanket prohibition is that the restriction contemplated under Section 185 is not applicable to the loans given to a managing director or whole-time director consequent to the conditions of services extended by the company to all its employees or pursuant to any scheme approved by the members through a special resolution. Section 185 also does not apply to companies which provide loans or give guarantees in the ordinary course of its business as long as interest not less than the bank rate declared by the Reserve Bank of India is charged.

The entities/person covered in the ambit of ‘any other person in whom the director is interested’ is exhaustive and means:
a) Any director of the lending company, or of a company which is its holding company or any partner or relative of any such director;
(b) Any firm in which any 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 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
(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.
Since all subsidiary companies would be required to act on the directions/instructions of the Board of the lending company, Section 185 (e) seemed to include in its prohibition the giving of loans, securities and guarantees provided by holding companies to its subsidiaries.

However, related Rule 10 of the Companies (Meetings of Board and its powers) Rules 2014, clearly envisaged and exempted from the restrictions of Section 185:
(a) loans, guarantees or security given by a holding company to its wholly owned subsidiary  and
(b) guarantees and securities provided by holding companies to its subsidiaries with respect to loans given by a bank or a financial institution.
The issuance of the rule created more confusion than clarification since a rule cannot override the provisions of the Act and further a distinction, whether intended or not was carved out for loans to wholly owned subsidiaries and guarantees and security for subsidiaries (not necessarily wholly owned). This led to an unusual situation of loans by holding companies to subsidiaries not permitted by allowing guarantees and security.

Further, Section 185 is applicable only when a ‘company’ gives loan to its director or any person in whom the director is interested. However, the definition of a ‘company’ under Section 2(20) means only a company incorporated under 2013 Act or any previous company law. So, the restriction in Section 185 will not apply when a holding company incorporated outside India gives a loan, guarantee or security to its Indian subsidiary.

Section 185 & 186 of 2013 Act – The unanswered issues

Previously, Section 295 of the Companies Act, 1956 (“1956 Act”) required public companies or private companies which were subsidiaries of public companies to obtain  central government’s approval for granting loans, guarantee or security. However, the said section was not applicable to private companies or to such transactions provided by a holding company to its subsidiary. Whereas, the corresponding Section 185 of the 2013 Act applies to all companies irrespective of a company being a private or a public company and levies a blanket prohibition on loans to directors by any of such companies, except under the exception cited hereinabove.

Further, Section 295 of 1956 Act in addition to the exceptions provided therein, it also carved out an exception for the banking companies from the applicability of such Section. Whereas, Section 185 instead of limiting the exception to banking companies, had widened the exception to include the companies giving loans, guarantee or security in their ‘ordinary course of businesses’ and had thereby included entities such as non banking financial companies into the small bracket of exceptions.

The most important difference is that, Section 295 had in itself contemplated an exception to the loans given, guarantee or security provided for a loan, to subsidiary company by the holding company. Whereas, Section 185 prohibits such transaction merely if a director of the holding company is a director of the subsidiary as well.

It is relevant to note that Section 2(87) of 2013 Act defines the term ‘subsidiary/Subsidiary Company’ to mean ‘a company in which the holding company control the composition of the Board of Director or exercises/controls more than one-half of the total share capital either at its own or together with one or more of its subsidiary companies’.

Section 185 was brought into force through notification on 12th September 2013 [see end note 1] and Section 186 which corresponds to Section 372A of 1956 Act dealing with Inter-corporate loans and investments was brought into force on 1st April, 2014 [see end note 2]. Further, as the concept of providing loans, security and guarantees by the holding company to the subsidiary is a common business practice in India, introduction of Section 185 had put the Indian companies in distress. As a temporary fix, clarifications were issued by the Ministry of Corporate Affairs initially in November, 2014 [see end note 3] and finally on 14th February 2014 [see end note 4]. The said clarification had addressed the issue of applicability of Section 185 of the 2013 Act by exempting Section 372A of the 1956 Act from its ambit.  By way of the said clarification, the Ministry stated that Section 372A would stay in force till Section 186 of the New Act is notified and thereby had harmonized the provisions of Section 185 and 372A.

On principle grounds this blanket prohibition under Section 185 received quite a negative response from the industry. Understanding the nature and intent of Section 185, there seems no reason to justify prohibition of loan, guarantee or security transactions between holding and subsidiary companies merely if a director of the holding company is a director of the subsidiary as well. Section 185 seeks to curb the misuse of powers by the directors, so that they do not siphon away the company’s funds. On the contrary, helping out a subsidiary company in general, does not benefit personal interest, unless the subsidiary company itself has been set up as a sham to siphon the funds to personal accounts through such channel. In genuine transactions, if the subsidiary does well, it is ultimately for the benefit of the holding company itself, and this would help in developing the overall business of the company.

In the present situation where Section 185 and 186 both stand notified and by virtue of Section 186 in operation its predecessor Section 372A stands repealed, there is no scope in the present provisions of 2013 Act to provide for such transactions as between the holding and subsidiary company which have a director in common, to be valid. However, the Rules for Chapter XII [see end note 5] that came into operation along with Section 186 on 1st April 2014, provided that –
“(11) Where a loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company, by way of subscription, purchase or otherwise of, the securities of its wholly owned subsidiary company, the requirement of sub-section (3) of section 186 shall not apply. Provided that the company shall disclose the details of such loans or guarantee or security or acquisition in the financial statement as provided under sub-section (4) of section 186” [see end note 6]
It is relevant to note that the said rules and the exemption contemplated therein had added to the woes of the industry. On one hand, the principal provisions of the 2013 Act i.e. both 185 and 186 do not per se allow loans, guarantee or security for subsidiary companies in cases where i) the directors are interested and ii) beyond 60% of the paid-up of share capital of the holding company respectively. However, as against the bar contemplated by the above sections, the above extracted Rule had carved out an exemption for such loans if Sub-Section (4) of Section 186 is complied with.

Thus, the legislature seems to have realized that such an intricate issue is to be resolved and had proposed to insert the amendment extracted herein above into Section 185.

Issues in relation to the proposed amendment

The Amendment Bill provides exemption for loans made by holding company to its wholly owned subsidiaries and guarantees/securities provided by the holding company in respect of loans made to its wholly owned subsidiary company. The Amendment Bill also states that the guarantees/securities provided by a holding company in respect of loan made by bank or financial institution to its subsidiary company are exempted.

It is relevant to note that 2013 Act did not provide any specific definition defining the term ‘wholly owned subsidiary’. It is a natural proposition that all wholly owned subsidiaries are subsidiaries but all subsidiaries may not be wholly owned subsidiaries. Therefore, in accordance with the aforesaid proposed amendment, it is clear that the exemption is only for the loans made by the holding company to its wholly owned subsidiaries and not to include the ‘subsidiaries’ as defined in 2013 Act. It is also relevant to note that the proposed exemption is not covering the subsidiaries incorporated outside India.

It may be noted that the purpose mentioned for the aforesaid amendment of Section 185 in the Amendment Bill approved by the Cabinet is ‘as a matter of abundant caution’. The Hon’ble Supreme Court had categorically held in Addl. District Magistrate (Rev.) Delhi Administration Vs Shri Siri Ram [see end note 7] that the exemption should come under the Act itself and Rules should not provide what is not provided in the Act. Therefore, in order to avoid judicial review of constitutional validity of the Rules, the said amendment is necessary rather than being merely cited as ‘as an abundant caution’.

The Draft Amendment Bill ought to have covered above issues to overcome the problems faced by India inc. and put the uncertain issues under Sections 185 and 186 to rest.

[The author is a Senior Associate, Lakshmikumaran & Sridharan, Hyderabad]

End Notes:
  1. MCA Published in the Gazette of India, dated 12th September 2014
  2. The Gazette of India, Extraordinary, Regd. No. D.L.-33004/99, dated 26th March 2014
  3. MCA General Circular No.18 of 2013 dated 9th November 2013
  4. MCA General Circular No. 3 of 2014 dated 14th February 2014
  5. The Gazette of India, Extraordinary, Regd.No. D. L.-33004/99, dated 31st March 2014
  6. Ibid.
  7. AIR 2000 SC 2143
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