Can a company give loan to an employee of a company who is relative of director of the company? - MMJC

Background

The assets and cash reserves of any company are inherently for the expansion and interest of the business of the company and its shareholders. Like it is in the case of sole proprietorships and partnership firms that the interest involved are of limited individuals the same cannot be the case for business structures as that of a company.

In case of structures where limited interest is involved as mentioned aforesaid it is easier to use the funds of the business as deemed necessary by the people who run the business but in the case of a company various restrictions are in place as to how to utilise the cash reserves of the company.

Also, the transactions involved in case of a company are highly regulated and must be within the scope of the applicable laws on the Company. The Companies Act, 2013 is one such act which regulates the activities and transactions of the Companies.

Introduction

To use the funds of the company in the most prudent manner is the inherent responsibility of the Board of directors of the company.

Section 166 of the Companies Act, 2013 is the most crucial section which highlights the position of a director as a designated fiduciary. It becomes very crucial how the decisions taken by the Board affect the shareholders of the company.

Directors of the company cannot take access to the funds of the company for their own benefit or the benefit of their relatives directly or indirectly, the same is highlighted under sub section (5) of section 166 of the Act.

Also sub section (1) of section 185 specifically lists out prohibited parties to whom loans cannot be advanced by the company which we will understand in this article going forward.

Further reference can also be drawn to the view of the Justice Cohen Committee Report of June 1943 wherein it states “We consider it undesirable that directors should borrow from their companies. If the director can offer good security, it is no hardship to him to borrow from other sources. If he cannot offer good security, it is no hardship to him to borrow from other sources. If he cannot offer good security, it is undesirable that he should obtain from the company credit which he would not be able to obtain elsewhere.”

Let’s try to understand in this article that whether the directors of the company or their relatives are allowed to obtain loans or finances from the company?

Prohibition imposed by the Act

The primary section which deals with granting of loans to directors of the company is Section 185 of the Companies Act, 2013. The wordings of sub section (1) of section 185 start with the words “No Company shall” which implies that sub section (1) has a negative language, and it imposes prohibition on the company.

Sub section (1) of Section 185 can be read as under:

(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, —

(a) any director of company, or of a company which is its holding company or any partner or relative of any such director; or

(b) any firm in which any such director or relative is a partner. 

So, it can be seen that sub section (1) of section 185 specifically lists out prohibited parties to whom loans cannot be advanced by the company. They can be identified as follows:

• Directors of the company,
• Directors of the Holding company,
• Relatives of the directors of the company,
• Relatives of the directors of the holding company,
• Partners of directors of the company and holding company,
• A firm including LLP wherein the director of the company or its holding company is a partner.

Further, prohibition is also imposed upon the nature and means by which loans can be advanced by the company to the aforesaid identified prohibited parties.

 The scope of sub section (1) of section 185 is very wide as it includes the words such as “indirect” and expressions like “loan represented by book debt”. As per the Oxford dictionary the term “indirect” means not done directly i.e., conducted through intermediaries. So, it implies that the law maker wants to prohibit the director or other aforesaid prohibited parties from being the beneficiary of the advances or finances from the company even in an indirect manner.

The term “book debt” as per Cambridge dictionary means money that a company has not yet received from customers who owe it. This implies that, if the company has given any goods or services to the director or any of the aforesaid prohibited parties listed out in sub section (1) of section 185 and the said person has not paid for the same for abnormally extended periods then such transactions may be considered as a loan in the nature of book debts.

Hence, the purview of section 185 is not only limited to loan in the nature of money but also loan in the nature of kind.

Now after analysing sub section (1) it is clear that certain prohibited parties are identified to whom loans cannot be advanced by the company which also includes relatives of director of the company.

But what if such relative of the director is also an employee of the company and the said person is seeking such loan or finance from the company in the capacity of an employee of the company?

Position as an employee v/s Position as a relative of director of the Company:

Sub section (1) of section 185 prohibits the giving of loan to the relatives of directors of the company and relatives of directors of holding company. It does not include persons who are only the employees of the company and are not related to the directors of the company or the directors of the holding company.

Further if we read sub section (3) of section 185 it provides an exception to sub section (1) i.e. it allows giving of loan to the Managing Director or Whole Time Directors of the Company as a part of service conditions extended to all the employees or pursuant to any scheme approved by the members by a special resolution. But interestingly it does not provide for loan to relatives or partners of directors as part of even service contract.

Thus, sub section (3) of section 185 which is the exemption clause of Section 185 does not give a carve out to a person receiving loan from the company in the capacity of an employee and who is also the relative of the director of the company or the relative of director of the holding company. In this case, if we apply the interpretation principle that express mention of one thing implies exclusion of other, then it can be interpreted that as sub-section (3) of section 185 expressly allows giving of loan to managing or whole time director being employee of the company, therefore relatives of director of the company or holding company being an employee of the company will not be exempt from provisions of sub-section (1) of section 185 as it does not expressly provide for same.

Having an analysis of the aforesaid explanation, a view can be taken that relatives of directors of the company or holding company, even though employees of the company cannot be covered under the purview of sub section (3) of section 185 and hence shall fall within the ambit of sub section (1) of section 185.

Here we have to say that the position of the individual receiving the loan is more dominant as a relative of a prohibited person i.e.as the relative of the director of the company or director of the holding company vis a vis his position as an employee of the company.

This again draws us to a question that as an employee of a company in times of genuine financial needs the employee usually looks up to his company or employer for assistance, so will an employee just because he is a relative of prohibited person be deprived of such support from the company?

A possible solution

If we refer to the provisions of Companies Act 2013 with respect to grant of loan to employees, we may notice that all sections regulating grant of loans like sub section (3) of section 67, sub section (2) of section 186 etc. exempt loans to employees. Further subsection (3) of section 185 also talks about grant of loan to employee as a service available to all employees of the company. Therefore, looking at the intention of the Act it does not appear that the Act wants to prohibit the companies from giving loans to its employees whether or not they are relatives of directors.

Nevertheless, considering the prohibitions mentioned under sub section (1) of section 185, when loan is being given to an employee who is relative of director, company should take some precautions in order to avoid misuse of funds and non-compliance of law. For example, the facility under which the loan is being given to employee who is relative of director, must be a genuine facility used by various employees from time to time. The purpose of taking loan should be genuine and interest should be charged as per market rates. In other words, company should take care that such loan transaction should be at arm’s length basis.

Audit committee approval

If we refer to definition of related party clause (i) of section 2(76) of Companies Act 2013, we understand that relative of a director is the related party of the company and clause (iv) sub section (4) of section 177 states that all transactions with related parties should be approved by audit committee.

So, in cases where there is a genuine need of the employee of the company who is also a relative of director of the company it can be said that such transaction of advancing loan to the employee of the company being a transaction with related party, can be routed through Audit committee as an additional good governance. The rationale being that Audit committee consists of external experts such as independent directors which are capable of examining the veracity and need of such transactions.

Conclusion

To sum up a view can be taken that depending upon the genuineness of the situation a call must be taken to grant or not to grant loans to relatives of prohibited parties.

In cases where it is applicable routing the same through audit committee would ensure that the veracity and genuine need of such transaction is evaluated, provided proper record of the transaction is maintained and fair and proper disclosures in this regard are made to the Audit committee.

This article is published in Taxmann. The link to the same is as follows: –

https://www.taxmann.com/research/company-and-sebi/top-story/105010000000023566/can-a-company-give-loan-to-an-employee-of-a-company-who-is-relative-of-director-of-the-company-experts-opinion

This article is written by Ms Rutuja Umadikar – RND Team – rutujaumadikar@mmjc.in and Mr Shravan Pai – Management Trainee