Inter-Corporate Lending in India A Comprehensive Review of Legal Frameworks and Implications
Introduction: Overview of Inter-Corporate Lending Regulations
Indian investment regulations govern the lending and investment activities between corporations. Businesses frequently engage in lending money to or investing in other businesses. Inter-corporate loans & investments are what they are called. Section 186 of the Companies Act of 2013 provides and regulates the provisions for inter-corporate loans & investments. Once a firm has received approval from its shareholders and complied with all applicable regulations, it can offer loans and guarantees, purchase shares, or engage in other business ventures. Companies must comply with the restrictions outlined in Section 186 of the Companies Act, 2013 when engaging in inter-corporate loans and investments.
Legislative History of Inter-Corporate Laws
Previously, Sections 370 and 372 of the Companies Act, 1956 (the “1956 Act”) governed the permitting of inter-corporate loans, investments, & guarantee provisions. These sections required prior Central Government approval and adherence to additional strict guidelines notified by the Corporate Affairs Ministry before granting loans, guarantees, or security exceeding the limits specified under the sections. Section 372A of the 1956 Act, which was enacted by the Companies (Amendment) Act, 1999, changed this position.
The self-regulatory process replaced the previous requirement for government permission, now necessitating shareholder approval through a special resolution for inter-corporate loans, guarantees, or securities exceeding the defined limits could be granted. It is important to remember that English company law does not provide a comparable legislative framework for controlling inter-corporate loans, guarantees, & investments. This is true even though the “English Companies Act of 1948” served as the model for the 1956 Act nearly entirely. The 1956 Act’s Sections 370 and 372 served as the foundation for Indian law on this topic. In 1999, Section 372A was created to consolidate these provisions, while Section 186 of the 2013 Act established a more stringent system.
The report of Joint Parliamentary Committee (JPC Report) on “Stock Market Scam and Matters related thereto” is the source of the tougher legal regime under Section 186. Following the revelation of the extent of the financial irregularities in the “Ketan Parekh scam”, the JPC & the former Department of Company Affairs (DCA) put out proposals to guarantee that businesses refrain from using inter corporate loans as a “subsidiary route” to embezzle money. The question of whether Section 186 of the 2013 Act should impose any limitations on loans, guarantees, or security given to wholly owned subsidiaries (WOS), or whether they should be eliminated entirely in accordance with Section 372A of the 1956 Act, was discussed by the Parliamentary Standing Committee in 2009. However, the PSC decided against this after observing that businesses, particularly those with a high no. of subsidiaries, were abusing the subsidiary route to dishonestly take out money.
Understanding Investment Layers Under Section 186(1)
Section 186 of the Companies Act, 2013 was developed with the intention of controlling the terms and circumstances under which a company may lend money to another or make investments. In order to safeguard the interests of market participants and owners, as well as to avoid excessive loans, investments, and share dilution, this legislation was necessary. Accordingly, layers of investment are discussed in Section 186(1) of the Companies Act, 2013. According to Section 186(1), an organization is not allowed to invest in more than two tiers of investment businesses. Investments flowing from any holding company to its two levels of subsidiaries are referred to as two layers of investment companies. For example, if company A owns Company B, which in turn owns Company C. as a result, firm A’s initial investment is in company B. This investment will be regarded as holding company A’s second layer investment if it continues to flow to business C. Company A can’t make any further levels of investments because this covers its two layers of investment. To be clear, layers in relation to a holding company refer to the subsidiary or subsidiaries listed in Section 2(87) of the Companies Act, 2013.
The exception to the “two layers” requirement is that an Indian firm may purchase shares and invest in an investment company incorporated outside of India in excess of two levels, provided that the Indian laws allow for such additional layers of investment. Since the investment company is incorporated and operates outside of India, it will not be prohibited from this investment under the two tiers of restrictions set forth by Indian law.
Limits on Loans and Investments Under Section 186(2)
The restrictions & sectoral ceilings placed on these intercorporate loans & investments are covered in Section 186(2). In order to preserve equilibrium & control over investments made or loans made to investment businesses, restrictions were added to inter-corporate loans & investments under the Companies Act, 2013. Loans, guarantees, and investments made directly or indirectly to any individual, business, or other body corporate are restricted under Section 186(2). These restrictions apply to all capital expenditures, including loans, investments, guarantees, and the purchase of securities and shares. According to Section 186(2):
- Loans or investments cannot exceed:
- 60% of total paid-up share capital plus free reserves plus securities premium.
- The entire amount (100%) of securities premium and free reserves.
When making investments or extending loans, the investing firm has the option to select one of the two alternative limits. Notably, investment businesses are subject to the two tiers of the investment rule. Nonetheless, investments can also be made in body corporates through the purchase or subscription of shares and securities. However, the business that this investment may pass through to a body corporate must be an investment company, and the two layers rule applies to the top and bottom layers of these businesses.
Legal Requirements for Board Approval Under Section 186
Board’s Approval: Under Section 186, a corporation must legally acquire the board of directors of the investment company’s prior approval before making any loans or investments in other companies. Regardless of the loan size or investment type, or number of layers (more than 2 layers of investment), getting the board’s approval is a must. The board of directors must unanimously approve every plan before it can be implemented. A board meeting’s suggested investment plan can only be considered accepted if a unanimous resolution is passed. All of the company’s directors must be present for such a meeting, and they must all have approved the idea that was presented to them. It is mandatory to seek the board’s permission in the prescribed manner.
Member Approval Requirements for Loans and Investments: In situations where the amount of a loan, guarantee, investment, or the purchase of shares & securities exceeds the limit specified by Section 186(2) of the Companies Act, 2013. Section 186(3) further requires the approval of the company’s members by a special resolution in addition to the board of directors’ approval. For this reason, a general meeting is required, during which the details of the proposed loan or investment must be thoroughly discussed. The corporation cannot proceed with the investment unless proposed strategy is authorized by a special majority (75% of people present and voting). In the meeting all the details such as the amount of investment, reasons for exceeding the limit, the company which is receiving the investment etc. should be disclosed.
Disclosure Obligations Under Section 186(4) The Companies Act 2013’s statutory disclosure obligations for inter-corporate loans & investments are discussed in Section 186(4). The interests of the company’s members are taken into consideration when making this provision. It makes sure that openness is upheld and that members are aware of the company’s financial operations. Consequently, in order to uphold clarity and transparency, the corporation is required under Section 186(4) to disclose the following in its annual financial statements:
- Details about loans arranged, investments made, guarantees offered.
- Reasons for issuing loans or guarantees.
- Any further disclosures that the board may find appropriate.
Public Financial Institution Approval Requirements: As we know, getting the consent of every board director is necessary before making any kind of investment, loan, guarantee, or security. Section 186(5) additionally provides for getting the consent of the relevant public financial institution if any term loan is in existence, following the board’s approval. Before making any loans, investments, guarantees, or securities, a corporation that has borrowed must obtain approval from the relevant public financial institution before proceeding with investments and any others, if applicable.
According to Section 186(5), this clause is required because it gives the Public Financial Institution, whose funds are at risk, some discretionary power. When a corporation borrows money from a public financial institution, it must first get their approval before using the funds for investments or lending to other businesses or body corporates. This directive, however, is applicable in cases when the investment business is seeking member and board of directors’ consent before proposing to invest more than the authorized amount.
Restrictions on Companies with Defaults: A restriction is placed on firms that have defaulted in the past and those defaults are still in effect by “Section 186 (8) of the Act”. This clause applies to a business that has taken deposits in past and either holds them now or has held them in past as loans or investments. When a business finally defaults on its debts, its instalments, or its interest, and these defaults continue, the legal requirement of this Section 186 clause becomes necessary. In accordance with “Section 186(8) of the Companies Act 2013”, a company is barred from making new investments or extending credit while defaults are ongoing. Therefore, in order to be able to make investments, grant loans, or purchase shares & securities in another firm, it is imperative that a company with ongoing defaults first resolve these issues.
Exceptions to Section 186 Applicability
The Companies Act 2013’s Section186 contains general guidelines that apply to businesses that conduct business in India. Nevertheless, sub-section (11), Section 186 discusses a few limitations to their applicability as follows:
- Government companies involved in defence-related activities.
- Banking firms operating within their regular business scope.
Penalties for Violating Section 186
Penalties for violating Section 186 of the Companies Act 2013 are same as for any other violation. Penalty provisions are indicated in Section 186, sub-section (13). This section offers two types of punishment (penalty): one for company violations and another for the officials who committed such violations. When a company violates any of the provisions of Section 186 of the Companies Act 2013, it faces penalties including a minimum fine of Rs. 25,000 and may extend up to Rs. 5 lakhs. Additionally, each officer found to be in default faces a maximum sentence of 2 years in prison and a fine of Rs. 25,000 to Rs.1 lakhs, depending on how serious the violation was.
Case Studies on Inter-Corporate Lending
Jindal Vijayanagar Steel Ltd. vs Assistant Commissioner Of Income-Tax, [2003] 87 ITD 630
The case revolves around a public limited company incorporated on March 15, 1994, which focused on producing iron and steel while engaging in various ancillary activities, including the import and export of goods, engineering consultancy, real estate development, and financial operations such as lending and investing. The company obtained its certificate of commencement of business on July 8, 1997, after fulfilling the necessary formalities. It raised share capital and inter-corporate loans and issued debentures through private placements. The Board of Directors authorized borrowing up to Rs.3300 crores, leading to extensive financial transactions involving bank deposits, equipment leasing, personal loans, and structured financing.
The key legal issue at hand was whether the costs associated with excess share applications could be classified as revenue costs. The court referenced previous rulings that emphasized different treatments for expenses incurred before and after a business commences operations. Ultimately, the court ruled in favour of the company, approving the incurred expenses without reservations since it had already commenced operations. It deemed the corporate treasury division’s expenses of Rs.15,43,40,694 allowable after excluding an improper donation of Rs.6,91,701. Additionally, following the precedent set by the Supreme Court in India Cements Ltd., expenses related to resolving non-convertible debentures totalling Rs.10,77,53,775 were also accepted as revenue expenditure. Consequently, the Assessing Officer was directed to treat all receipts amounting to Rs.11.07 crores as business revenue while deducting the aforementioned expenses from this total. Furthermore, consequential relief was mandated for interest assessed under Section 23(4B) of the Act. This case highlights the complexities involved in classifying business expenses and reinforces the importance of understanding legal precedents in corporate finance, underscoring that once a company has commenced operations, it can claim certain expenses as revenue costs essential for its ongoing business activities.
Narendra Kumar Agarwal & Anr. v. Monotrone Leasing Pvt. Ltd. & Anr.(2021) ibclaw.in 25 NCLAT
In this case the Respondent, Monotrone Leasing Pvt. Ltd., filed an application with the National Company Law Tribunal (NCLT) under Section 7 of the Insolvency and Bankruptcy Code, 2016 (I&B Code). The Respondent sought to initiate the Corporate Insolvency Resolution Process (CIRP) against the Appellants, Narendra Kumar Agarwal and another. The Respondent claimed to be a “Financial Creditor” of the Appellants, asserting that they had extended an inter-corporate loan of Rs. 25,00,000, which carried an annual interest rate of 15%.
The central issue in this case was whether the inter-corporate loan constituted “Financial Debt” as defined by Section 5(8) of the I&B Code. This classification is crucial as it determines the eligibility of the Respondent to file for insolvency proceedings against the Appellants.
The Appellate Tribunal ruled in favour of the Respondent, affirming that the nature of the contract and the definitions of “Financial Creditor” and “Financial Debt” found in Sections 5(7) and 5(8) of the I&B Code were applicable. The Tribunal concluded that the inter-corporate loan met the criteria for financial debt, as it involved a debt that was disbursed against the consideration for the time value of money. Consequently, the Tribunal upheld the Respondent’s application for the initiation of the CIRP, recognizing that the Appellants had failed to repay the acknowledged debt, which exceeded the threshold of Rs. 1,00,000.
This case serves as a significant reference point in understanding the classification of inter-corporate loans within the framework of the Insolvency and Bankruptcy Code. It highlights the rights of financial creditors and the implications of financial debt in insolvency proceedings.
For businesses involved in inter-corporate lending, this ruling emphasizes the importance of clear financial agreements and the potential consequences of default. As the corporate landscape evolves, this case stands as a reminder of the legal complexities surrounding financial transactions and the critical role of regulatory frameworks in protecting creditor rights.
Conclusion
India is centre of innovation and a rising force in entrepreneurship. Every day we witness the power of recently established businesses. Funds are needed for the operations and management of these breakthroughs and fledgling businesses. There are also a lot of established businesses whose operations demand significant capital expenditures. Companies commonly engage in inter-corporate lending and investment in order to meet these needs and profit from them. In order to benefit from the operations and income of the firm they invested in, one company lends money to another, invests in them, or purchases securities and shares in them. This environment benefits both businesses and fosters a win-win scenario for them both, which in turn propels the stock market upward. Regulation is necessary since inter-corporate loans and investments are so common in India. Section 186 of the Companies Act, 2013 has provisions for this purpose. The Companies Act, 2013’s Section 186 lays forth the rules a corporation must adhere to in terms of mandatory requirements, procedural requirements, and intercorporate loans and investments. It also covers the circumstances in which a business can or cannot make investments and loans amongst itself. To preserve the interests of investors & stakeholders in the market, the corporation must adhere to the disclosure obligations outlined in Section 186.
