Under corporate law, especially Section 185 of the Companies Act, 2013, the granting of loans by a corporation to its directors is a legal matter. The Act seeks, in general, to remove the abuse of corporate cash, minimise the possibility of conflict of interest, and hence promote good corporate governance. It usually disallows companies from making loans or providing guarantees or security to their directors or to companies where such directors have a direct or indirect interest. This strict prohibition is a plus for shareholders, as it gives them the assurance that the directors will not use corporate money for their financial gain, and for the creditors as well. Nevertheless, the Act admits the legitimacy of business needs and hence allows conditional permissions and specific exemptions, such as loans to Managing Directors or Whole-Time Directors under sanctioned schemes or to lending companies in the course of business.
What is Section 185 of the Companies Act 2013?
Section 185 of the Companies Act, 2013 specifies the restrictions on loans, guarantees, or securities a company can provide to its directors as well as to any other individual or business in whom the director is interested.
The Companies (Amendment) Act, 2017, has significantly changed Section 185 to create a more practical and business-friendly environment than the widespread prohibitions in the earlier version.
1. Core Prohibition Under Section 185(1)
Section 185(1) imposes an outright ban. A company is prohibited from, directly or indirectly:
- Advance any loan
- Provide any guarantee
- Provide any security
To the following individuals:
- Any Director of the Company – No director shall directly receive any loan or other financial accommodation from the company.
- Any Director of the Holding Company
- Any partner or relative of such director
- Any Firm in Which Such Director or Relative is a Partner
Thus, these prohibitions are absolute; even approval through a special resolution cannot validate such transactions.
2. Conditional Permission Under Section 185(2)
The Act permits loans, guarantees, or securities to specific entities in which directors have an interest, but only under the following conditions:
- A special resolution must be approved in the general meeting.
- There has to be full disclosure of the loan details and their purpose.
- Private companies where directors are members or directors
- Corporate bodies in which 25% or more of the voting power is held by one or more of these directors
- Any corporate entity whose board, managing director, or manager acts upon the instructions or directions of the lending company’s directors
- The transaction must be used to finance the borrower’s main business operations and not for further lending or investment.
Exemptions under Section 185 of Companies Act 2013
Though Section 185 places stringent limitations on loans, guaranties, and securities involving their directors and affiliated parties, Section 185(3) lists several major exceptions that would not be covered by the prohibition under Section 185(1).
1. Loans to Managing Director or Whole-Time Director
A loan can be granted by a company to its MD or WTD, subject to the following:
- The facility has a service rule or policy that applies to all employees, allowing for such loans, or
- The loan is under a scheme that has been approved by shareholders with a special resolution.
This allows companies to facilitate key managerial personnel as per the employment benefits.
2. Loans, Guarantees or Security by a Company Engaged in Lending (i.e., NBFC-like companies)
If lending is integral to the ordinary course of business, the company may:
- Give loans
- Grant guarantees
- Offer securities
Provided the rate of interest applied is not less than the prevailing rate of interest as decided by RBI for NBFCs.
3. Loans for Director’s Principal Residence (Through Banks/FIs)
A company can give a guarantee or security for the loan taken by any of its directors from a bank or financial institution, subject to the condition that:
- The loan is used to acquire the director’s principal residential property, and
- The property is not already owned by the director.
4. Section 185(2) – Transaction Approvals Under Special Resolution Applicability
Though not exactly an exemption, section 185 permits loans/ guarantees to particular parties in which directors have an interest, subject to a special resolution passed and full disclosures provided. In which they guarantee legitimate business activities are not needlessly hampered while guarding against the abuse of company money, these exceptions embody a balancing mechanism between good governance and operational flexibility.
Consequences of Non-Compliance
Section 185 imposes strict restrictions on loans, guarantees, and securities granted to directors and related parties. Any violation attracts severe penalties to the company, its officers, and the recipient.
1. Substantial Penalties to the Company
In case of violation of Section 185 by a company:
- Fine ranging from ₹5,00,000 to ₹25,00,000.
- This monetary penalty adversely affects the financial standing and governance credibility of the company.
2. Punishment and Imprisonment of Defaulting Officers
Every director or officer who is found in default faces harsh consequences:
- Imprisonment for a period of up to 6 months, or
- A fine extending from ₹5,00,000 to ₹25,00,000, or
- A combination of imprisonment and a fine.
This implies a very high degree of personal responsibility for any improper financial assistance.
3. Penalties and Imprisonment for the Recipient
The director or connected person who accepts the prohibited loan, guarantee, or security is also punished as:
- Imprisonment up to 6 months, or
- A fine extending from ₹5,00,000 to ₹25,00,000, or
- Both
This measure ensures that corporate funds are not misused for personal benefit.
4. The Transaction is Not Valid
Any loan, guarantee, or security issued in violation of Section 185 is voidable at the option of the company, entitling it to demand immediate repayment or repudiate the validity of the transaction.
5. Serious Consequences in Governance and Compliance
Non-compliance also reflects poor governance and insufficient internal controls, possibly leading to:
- Increased regulatory scrutiny
- Negative comments by auditors
- Erosion of creditor and investor confidence
6. Investigation Risk
- Section 206–207 (inspection)
- Section 212: Investigation by SFIO
- Any instance of non-compliance with Section 185 is followed by zero tolerance to avoid diversion of funds and to maintain corporate governance ethically.
Checklist for Companies to Deal With Section 185
Section 185 deals with loans, guarantees, and securities by directors or their associated entities. To ensure compliance, a company needs to have a systematic internal checklist related to approvals, documentation, and monitoring.
1. Identify the Related Parties Covered under Section 185
Compile and maintain the current listing of:
- Company directors
- Directors of the holding company
- Directors’ relatives
- Partners of directors or their relatives
- Firms of which they are partners
- Entities in which directors have ≥25% voting rights
- Companies operating under the control of directors
- Make sure to check every proposed transaction against this list.
2. Check If the Proposed Transaction Is Prohibited
No loan, guarantee, or security should be granted to
- Any director
- Director’s relative or partner
- Any firm of which they are partners
Find out if the recipient is classified as an ‘absolute prohibition’ within Section 185(1).
3. Check Eligibility for Conditional Permission – Section 185(2)
If the recipient is an entity in which directors are interested, ensure that
- A special resolution is passed
- The notice contains full disclosure of the purpose.
- Funds will be used exclusively for main business purposes
4. Verify Exemptions Under Section 185(3)
Qualify the transaction, whether it is:
- A loan to the MD/WTD under an employment policy or a shareholder-approved scheme
- A loan or guarantee or security provided by a company engaged in lending at RBI-prescribed interest rates
- A bank or financial institution has guaranteed or provided security against a housing loan for a director.
5. Perform Board-Level Review
- Submit each proposal first to the Board of Directors.
- Ensure that directors who have an interest in the transaction declare their interest and abstain from voting.
6. Ensure Proper Documentation
- Minutes of the board and general meeting
- Loan Agreement, Guarantee Deed or Security Document
- Purpose statements from borrowers
- Proof of interest rate compliance (for lending companies)
7. Establish Internal Monitoring Controls
- Periodic review of outstanding loans/guarantees
- Reports on auditor verification and compliance
- Annual director declarations and conflict-of-interest disclosures
8. Ensure Timely Report of Audit Compliance
- Give statutory auditors financial statement disclosures when appropriate.
- Under Section 185, a disciplined checklist enables firms to circumvent governance problems, fines, and breaches.
Conclusion
Section 185 of the Companies Act, 2013, fortifies corporate governance through clear-cut restrictions on loans, guarantees, and securities granted to directors or to any other person in whom the director is interested. In intent, it aims to avoid conflict of interest, misutilisation of company funds, and decisions based on personal profits, rather than organisational welfare.
Although the section has stringent prohibitions, it also has carefully designed exemptions and conditional permissions to accommodate legitimate business requirements, especially in respect of key managerial personnel and loan advanced companies. It ensures transparency and accountability for financial transactions by providing for disclosures, special resolutions, and purpose-based utilizations. Companies that deliberately follow it not just avoid the harsh consequences but also inspire trust among their investors, authorities, and other stakeholders.
Section 185 basically emphasises ethical conduct, promotes responsible management, and greatly improves the credibility and integrity of company operations in India.
