Does section 185 apply to holding-subsidiary transactions?

The following post is
contributed by Vinod Kothari of
Vinod Kothari & Co. He may be contacted at
vinod@vinodkothari.com
This follows a previous
post
on this topic by Jayant Thakur]
Does
section 185 apply to transactions of loans, guarantees or provision of
security, in holding-subsidiary financial transactions? This question is
evidently one of the most significant questions facing the corporate sector
right at this time, as most banks are renewing their loan sanctions. The banks
have gone conveniently by the advice of their legal advisers; some banks have
circulated a draft apparently suggested by a leading law firm whereby companies
should alter the objects clause of their memorandum to include the business of
guarantees or provision of securities. Banks have apparently been advised that
if the borrower companies made such an amendment, then giving of guarantees
will become an “ordinary business activity” of the client company, and thereby,
client company will be eligible for the exemption given in proviso (b) to sec
185 (1). One may scoff at the suggestion that the mere alteration of the
objects clause would lead to creation of an “ordinary business”, whereas
company law practitioners will certainly understand that (a) objects clause is
a statement of what the company can
do, rather than what the company does;
(b) no amount of object clause insertion can result into a business being
ordinary, if the company has been doing nothing except giving guarantees for
its subsidiaries, and more so, where the company is charging no consideration
for the guarantee.
Several
people, including Mr Jayant Thakur, have commented
that hurried implementation of sec 185, without giving carve-outs for
holding-subsidiary transactions, private companies, etc. has led to a chaotic
situation where companies are engaging in a completely unproductive
exercise  of defending practices which
are completely unquestionable. Mr Thakur has also commented that the MCA
circular
of 14 Feb 2014 has added to the confusion rather than clearing the
understanding.
There
are primarily 2 types of cases affected by sec 185 – one is the case of private
companies lending to their group companies. Second is the case of public companies,
mostly large, listed companies, supporting their subsidiaries, in India or
abroad, by guarantees or loans.  The
former category may not bother us, as evidently, these companies may be able to
wriggle out ways out of section 185. However, it is in case of larger
companies, trying to support their subsidiaries, where the existing scheme of
interpretation of the law by leading law and accounting firms has created a
total chaos.
Are transactions between holding
and subsidiaries intended to be covered by sec 185?
A
crucial question arises – is section 185 at all applicable to transactions
between a holding and its wholly-owned subsidiary? Assume the following facts –
H Ltd wants to support its subsidiary, S Ltd or S (P) Ltd with a loan, or a
guarantee or a security for a loan taken. How does section 185 at all apply
here?
On
plain reading, sec 185 nowhere mentions the expressions “subsidiary company”,
“holding company”, “associate company” , etc., which expressions are otherwise
splashed all over the Act. It is not that the lawmakers did not know what a
subsidiary company, or associate company is. The lawmakers have used almost the
same clauses as were there in sec 295 of the 1956 Act. Section 295 had a
carve-out for holding-subsidiary transactions – which is missing in the present
section. It would be a wrong strand of logic to say that the deletion of the
exemption indicates the mind of the lawmaker to include holding-subsidiary
transaction. There can be no regulation by silence – it has to be explicitly
spelt out.
Ideally,
given the nature and intent of sec 185, there is no reason why transactions
between holding and subsidiary companies should be covered at all. If section
185 is admittedly there in the statute to curb the misuse of powers by
directors, whereby they do not use their fiduciary powers for self-benefit, and
move the funds of the company away to their personal bank accounts, there is no
question of personal interest of directors where the company lends or supports
its subsidiary companies. If it is no wrong to have subsidiaries, it cannot be
a wrong to support subsidiaries. If the subsidiary does well, it augments the
asset value of the holding company – therefore, the well-being of the
subsidiaries is the well-being of the company. If the directors of the company
are helping the subsidiaries, they are helping the business of the company,
which the very purpose for which they exist.
None
of the clauses of Explanation below sec 185 (1 ) specifically refer to
subsidiaries. Clause (d) refers to companies in which 25% or more of the voting
power is held by the directors. Admittedly, in case of a wholly-owned
subsidiary, the voting control is with the holding company and not with the
directors. Though the directors are the brain of the company, but that does not
mean voting power is exercised by the directors and not the company. It is the
existence of voting power which is the very basis of holding-subsidiary
relationship.
The
only possible clause under which holding-subsidiary transactions may be stretched
to come under sec 185 is clause (e) of the Explanation, which has the age-old
expression “accustomed to act”. The plain meaning of this clause is that if the
board of the borrowing is nothing but a shadow of the board of the lending
company, then the directors of the lending company  are remote-controlling the borrower, in which
case the borrower company is economically under the reign of the directors.
Can “acting as per instructions” be
presumed for any director?
The
expression “accustomed to act” is not new – it has been there in the 1948 UK
Companies Act, was there in 1956 Act, and is found laws of several other
countries as well. There are several rulings that have discussed the meaning of
this expression. See article
by the author.
Can
it be presumed that the directors of the subsidiary are acting as per
instructions of the directors of the holding company? At a first blush of
argument, since the holding company has voting control, it is presumed that the
holding company has management control over the subsidiary as well, and therefore,
the directors of the subsidiary are accustomed to take instructions from the
parent. However, one needs to read section 166 (3) that deals with the duties
of directors. The section mandatorily requires a director due and reasonable
care and skill, and act as per independent judgement. If an allegation is made
that any director or director of the subsidiary company is taking instructions
from others, then prima facie, such director must first be prosecuted for not
abiding by the statutory duty of a director, since sec 166 (7) provides for a
prosecution for violating any of the duties. If there was a presumption that
the board of the subsidiary company is acting at the behest of the board of the
parent, then we are presuming that sec 166 (3) is violated in every case of
holding-subsidiary relationship. This will the “duties of directors”
meaningless.
In
fact, even where the directors are common, it cannot be argued that a common
director is taking instructions from the parent. “Taking instructions” means a
brainless, spineless person who is simply acting as a puppet of a shadow
director.  No one can be his own shadow –
hence, it cannot be argued that merely due to presence of common directors, the
board of the subsidiary acts as per instructions of the board of the lender.
Clause (e) of Explanation below sec 185 (1) is circumstantial – it has to be
proved by the person who makes it, and can be rebutted by the person who
defends it.
Does MCA circular give an
exemption?
As
is evident from most of MCA circulars that come lately, certain drafting issues
remain open for debate. However, in this case, the MCA seems to have concluded that
transactions between holding and subsidiary companies are actually prohibited
by sec 185 (1). It says: “Whereas section 185 of the Companies Act, 2013
prohibits guarantee given or any security provided by a holding company in
respect of any loan taken by its subsidiary company, except in the ordinary
course of business”. One wonders: what is the basis of this conclusion?
It
is unfortunate that the while the government has tried to sanctity the
prevailing confusion by the 14 Feb 2014 circular. If there was confusion
whether section 185 covered such transactions, the best way would have been to
exempt such transactions. The so-called “harmonious interpretation” between sec
372A and sec 185 made absolutely no sense at all. There is no question of any
harmony between sec 185 and section 186 (corresponding to sec 372A). Section
186 puts limit on the amount of loans/investments, without looking at who the
borrower is. Section 185 looks at who the borrower is, without bothering about
the quantum. Those two sections exist for completely different purposes, and
have existed for almost 60 years without implying any disharmony at all.
In
fact, the whole basis on which the all-inclusive approach of the new Act was
being justified all these years ever since the JJ Irani report was that the MCA
will use its powers under sec 462 to exempt situations that warrant exemption.
This was also the explicit argument taken by the MCA before the Parliamentary
committees as well. If that was the case, the half-hearted reconciliatory
circular which actually scoffs at the understanding of sections 185 and 372A
makes no sense at all. At the same time, the legal opinions being circulated by
law firms saying section 185 prohibits holding -subsidiary transactions need a
serious second look.


Vinod Kothari

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

2 comments

  • Can a foreign holding company give loans to its subsidiaries, as restriction under section 185(1) seems to apply only to companies – ie Indian companies.

    However, the mca circular uses the term 'holding company' which means a body corporate.

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