Friday, March 14, 2014

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

2 comments:

Anonymous said...

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.

Anonymous said...

Can a foreign holding company give loans to its subsidiaries in India