Column: New companies law makes cross-financing tougher

Updated: Dec 30 2013, 10:04am hrs
One of the avowed objectives of the new Companies Act, 2013, is to provide Indian companies with an evolved legal framework that is attuned to international standards. Needless to say, the new Act affects all constituents of the economy at a fundamental level including manufacturers, service providers, financing institutions and everything else in-between. In this context, it is interesting to analyse how the new Act affects cross-financing among companies and to question whether its actually conducive to growth.

A basic tenet of business expansion is that a well established company will leverage its financial strength to nurture other group entities during their formative stages, particularly in matters of raising capital. Typically, the stronger company will either provide support in the form of cash (investment or loan) or non-cash measures (say, guarantee or security for a bank loan). However, to safeguard the interests of stakeholders in the stronger company, the law has provisions that govern the manner and extent of such financial support.

Our analysis focuses on two specific provisions of the new Actsection 185 (governs loans to directors and persons related to directors) and section 186 (governs loans, investments and guarantees by a company). While section 185 is already in force since September 12, 2013, section 186 hasnt been notified as yet. Conceptually, one expects that these two provisions should operate harmoniously such that section 186 enables companies to support each others financial needs whereas section 185 ensures that directors do not arrogate a companys funds to the detriment of others. However, a closer look suggests that the two sections create undue (and perhaps unintended) restrictions on inter-corporate financing.

Section 185 (which corresponds to section 295 of the earlier Companies Act, 1956) casts a blanket restriction whereby no company can directly or indirectly provide financial support (in the form of loan, security or guarantee) to its directors or to persons in whom directors are interested.

Further, the coverage of the section is so wide that most group companies are likely to get covered one way or the other; the immediate consequence of section 185 is that most group companies (whether private or public) become ineligible to receive loans or non-cash support in the form of security/ guarantee. And the section is worded expansively enough to prohibit creative structures that indirectly achieve the same objective of financing.

Interestingly, the old section 295 provided three exemptions which were used by companies for group financingthe section was inapplicable to private companies and to transactions between a company and its subsidiary; thirdly, approval of Central Government could also be sought for director related transactions. Sadly, none of the three exemptions find mention in the new section 185, though it does provide an exemption for companies that provide financial support in the ordinary course of business. Typically, such an exemption is best availed by financial institutions such as banks or NBFCs; however, one could make out a case for the groups holding company too. The restrictions of section 185 are also waived in cases where loans are provided to the managing director or whole time director as part of conditions of service provided to all employees or as part of a scheme approved by members via special resolution; however, these avenues dont help financing of other group companies.

Section 186 (which corresponds to section 372A of the earlier Companies Act, 1956) provides that a company may give loans or provide security/guarantee upto 60% of its (paid up capital + free reserves + securities premium) or 100% of (free reserves + securities premium), whichever is higher. For transactions exceeding these limits, approval of members is required to be sought by way of a special resolution. If one were to ignore the provisions of section 185 for a moment, it would seem that the principal governing section for investments by a company would be section 186, which permits investments so long as they have either Board or shareholder sanction. Further, section 185 starts with the words Save as otherwise provided in this Acthence, one could argue that section 186 enjoys some degree of superiority on a relative basis. The challenge with such a view is that it would essentially render section 185 redundant, which may not be the intention of law.

Ever since 98 sections of the new Act have come into force in September 2013, a number of representations were made to the Government regarding the conflicts posed by section 185 and (yet to be notified) section 186. The Ministry of Corporate Affairs sought to address problems by notifying that section 372A of the old Act (and not section 186 of the new Act) would govern inter-corporate investments. One is not clear how this allays the concerns of corporates, since the dominant benefit of section 372A (compared to section 186) in this context is the non-applicability to transactions between a company and its wholly-owned subsidiary. It doesnt do away with much else.

In summary, it is clear that section 185 imposes a genuine restriction on fresh inter-corporate financing transactions (pre-existing transactions should be grandfathered). However, any amendment of the Act itself will require political consensus which may be difficult in the current circumstances. Is there a possibility of some relief in the form of Rules

Rajendra Nalam

The author is partner, BMR Advisors. Views are personal