Inter-corporate loan regime needs relook

S Muralidharan

A good deal of time is devoted by the Company Law Board (CLB) in disposing of cases of alleged mismanagement of companies. And more often than not, it turns out that diversion of funds by those at the helm, aided by a friendly regime on inter-corporate loans, is the crux of the problem.

The last boom in the stock market, which lasted for a while, is reported to have been bankrolled to a great extent by inter-corporate loans through clever but discernible ‘layering’, a euphemism for the indirect, circuitous and often tortuous process through which the funds travel before winding up at the desired destination.

Taking a cue from the judgements of the CLB in catena of cases involving diversions as well as from the landmark verdict of the Supreme Court in Delhi Development Authority vs Skipper Construction (P) Ltd case, thanks to which the gullible investing public in flats got back their money after it was retrieved from a clutch of companies that were the handmaiden of the dubious promoters of Skipper, the government, one hoped, would tighten the relevant provisions of the Companies Act, 1956 (the company law).

But the ushering in of Section 372A, an omnibus provision regulating inter-corporate loans, investments and guarantees, vide the Companies (Amendment) Act, 1999 came as a damp squib.

Its salient features are:
l A company can give loans and guarantees to, and make investments in, another company (hereinafter referred to for the sake of brevity as inter-corporate funding) up to an amount which in aggregate does not exceed sixty per cent of its paid-up share capital and free reserves put together, or hundred per cent of its free reserves, whichever is more;

l Inter-corporate funding in excess of the above limits can be made only with the blessings of the shareholders conferred through a special resolution passed in a general meeting;

l Unanimous resolution at a meeting of the board of directors is needed in any case, no matter what the size of the loan is and no matter whether the funding is within the limits prescribed or is in pursuance of the loosening of purse strings by the shareholders;

l If any term loan from a public financial institution is subsisting, prior approval of such institution is necessary before any inter-corporate funding can be done if the proposed funding would result in the aggregate of inter-corporate funding exceeding sixty per cent of the aggregate of paid up share capital and free reserves.
However, such prior approval is required, no matter the size of the aggregate funding to other companies, if there is a default by the company in honouring its commitment to such institution.

l No inter-corporate loans shall be made at a rate of interest lower than the prevailing bank rate.

The last one is hardly going to hurt anyone, given the fact that the funds diverted often earn a great deal more for the esoteric club, that is, the ultimate beneficiaries of such diversion.

At the risk of sounding pedantic, one must ask what exactly ‘prevailing bank rate’ means. Does it refer to the one prevailing when the loan is given or the one prevailing from time to time?

In the latter case, different rates may have to be applied for different time spans according to which rate was prevailing during the relevant span.

But there are more significant issues involved. Why at all should a company be permitted to use its funds for inter-corporate funding up to such generous limits? A company with a paid-up share capital of, say, Rs 100 crore and having free reserves of say Rs 500 crore, has the license to divert, as it were, of as much as Rs 500 crore without any let or hindrance especially if it has no subsisting term loan from a public financial institution. Should, however, there be such loan subsisting, the institution may breathe down the neck of the company.
The full Board approval will hardly be a problem given the reality that often board members believe in mutual back scratching. Conscientious ones may prefer to stay away from the board meeting, rather than courting embarrassment by attending it.

Alas, if only we had intrepid takeover tycoons like Kirk Kerkorian, who not long ago created ripples by picking up stakes in the US auto giant Chrysler and demanded return of huge pile of cash accumulated by the company to the shareholders.

Cash-rich companies ought to reward the shareholders suitably unless, of course, they have opportunities to recycle the funds in a manner which promises greater returns to shareholders. A regime which facilitates siphoning off of funds definitely needs a fresh look.

There have been instances in India where companies had greater amounts blocked in investments and loans than in their bread and butter activity.

The Reserve Bank of India has, of course, from time to time rapped the nominee directors of public financial institutions on the boards for looking askance but Parliament has not bestirred.

Flouting of buyback law
A company cannot buy its own shares directly or indirectly. This is the mandate of Section 77. Section 77A tempers this rigidity by permitting buyback of shares subject to an elaborate procedure designed to safeguard the interests of creditors in the main. Section 77(2) prohibits giving of loans the purpose of which is to enable the recipient to buy the shares of the company.

But media reports say that a few cash-rich companies have given loans through ‘layering’ precisely for the purpose prohibited by Section 77(2)—buying the shares of the company advancing the loan with a view to propping up its value in the stock market. Of course, this is not something new as to arouse public outcry.
The practice is perhaps as old as the company law itself.

What perhaps emboldens companies and their promoters to be so brazen is the fact that there is no deterrent penalty for violating Section 77.

Section 77(4) says if a company acts in contravention of sub-sections (1) to (3) thereof, the company and every officer of the company in default, shall be punishable with fine, which may extend to Rs 10,000. Before the 1999 amendment, the penalty was even less deterrent—just Rs 1,000.

There is, therefore, an urgent need to recast the regime for inter-corporate funding. The extant one not only lends itself to easy abuse but is also a butt of joke. It encourages one to cock a snook at the prohibition imposed by Section 77 as well.

(The writer is a Delhi-based chartered accountant)