Prohibition on Loans to Directors

Section 185 of the Companies Act, 2013, is a critical corporate governance provision designed to prevent the misuse of company funds by its directors and persons in whom the directors are interested. It places strict restrictions on a company's ability to advance loans, give guarantees, or provide security in connection with loans to its directors. The underlying principle is that directors hold a fiduciary position of trust and should not use their influence to obtain financial benefits from the company for themselves or their relatives and associated entities, especially on terms that may be prejudicial to the company's interests.

The section prohibits a company from, directly or indirectly, advancing any loan (including a loan represented by a book debt), or giving any guarantee, or providing any security in connection with a loan taken by:

1. Any director of the lending company, or of its holding company.
2. Any partner or relative of any such director.
3. Any firm in which any such director or relative is a partner.

Exceptions to the Prohibition

While the general rule is a strict prohibition, Section 185 provides for certain specific exceptions where a company is permitted to grant a loan, guarantee, or security, subject to the fulfillment of prescribed conditions. These exceptions recognize legitimate business and employment needs.

1. Loan to Managing or Whole-Time Director

A company is permitted to grant a loan to its Managing Director (MD) or a Whole-Time Director (WTD) provided that:

• It is part of the conditions of service extended by the company to all its employees; OR
• It is pursuant to a scheme approved by the members of the company by a Special Resolution.

2. Company in the Ordinary Course of Business

A company whose primary business is the lending of money is allowed to grant loans, guarantees, or securities. This exception applies to entities like Banks and Non-Banking Financial Companies (NBFCs).

• Condition: The loan must be granted in the "ordinary course of its business".
• Interest Rate: A crucial condition is that the interest charged on such loans must not be less than the rate of the prevailing yield of one-year, three-year, five-year, or ten-year Government security closest to the tenor of the loan. This ensures that the director is not receiving the loan at a preferential, below-market rate.

3. Loans and Guarantees to Subsidiary Companies

The law permits a holding company to provide financial support to its subsidiaries. The exceptions are:

• A holding company can grant a loan, guarantee, or security in respect of a loan made to its wholly-owned subsidiary company.
• A holding company can give a guarantee or provide security in respect of a loan made by any bank or financial institution to its subsidiary company (not necessarily wholly-owned).

• Condition: In both cases, the loans must be utilised by the subsidiary company for its principal business activities only. This prevents the funds from being diverted for other purposes.

Consequences of Contravention

Violating the provisions of Section 185 is a serious offence and attracts stringent penalties for the company, its officers, and the person who receives the loan. The law aims to penalize both the giver and the receiver to ensure strict compliance.

Penalty on the Company

If a company contravenes the provisions of Section 185, the company (the lender) shall be punishable with a fine which shall not be less than five lakh rupees (₹5,00,000) but which may extend to twenty-five lakh rupees (₹25,00,000).

Penalty on the Officer in Default

Every officer of the company who is in default (which typically includes directors who authorised the transaction) shall be punishable with:

• Imprisonment for a term which may extend to six months; OR
• A fine which shall not be less than five lakh rupees (₹5,00,000) but which may extend to twenty-five lakh rupees (₹25,00,000).

Penalty on the Director or Recipient

The law also penalizes the recipient of the prohibited loan, guarantee, or security. The director or any other person to whom the loan is advanced or guarantee/security is given shall be punishable with:

• Imprisonment for a term which may extend to six months; OR
• A fine which shall not be less than five lakh rupees (₹5,00,000) but which may extend to twenty-five lakh rupees (₹25,00,000); OR
• Both imprisonment and fine.

These severe penalties underscore the importance the Companies Act, 2013, places on preventing the siphoning of company funds and upholding the fiduciary duties of directors.

First Director

The First Directors of a company are the individuals who hold the office of director from the date of the company's incorporation until the first Annual General Meeting (AGM). They are the founding members of the Board who oversee the initial operations of the newly formed company.

The appointment of First Directors is governed by Section 152 of the Companies Act, 2013. The procedure is as follows:

1. Appointment through Articles of Association (AOA): The most common method is for the promoters to name the First Directors in the company's AOA. The individuals so named are considered the First Directors upon the registration of the company.
2. In the Absence of a Provision in AOA: If the AOA is silent about the appointment of First Directors, then the individual subscribers to the Memorandum of Association (MOA) who are individuals shall be deemed to be the First Directors of the company. They will hold this position until the directors are duly appointed by the members at the first AGM.

It is mandatory for any person being appointed as a director to have a Director Identification Number (DIN). The particulars of the First Directors and their DINs are filed with the Registrar of Companies (RoC) during the incorporation process itself.

Appointment by Members

After the First Directors, the power to appoint subsequent directors lies primarily with the members (shareholders) of the company. This is a fundamental right that allows the owners of the company to choose who will manage its affairs. Directors are appointed by the members by passing an ordinary resolution at a general meeting.

Appointment at Annual General Meeting (AGM)

The primary forum for the appointment of directors is the AGM. Unless a director is appointed for life (which is rare and generally only possible in private companies if their AOA permits), directors are subject to retirement by rotation.

Retirement by Rotation (Section 152(6))

This mechanism ensures that directors are periodically subject to the approval of shareholders, promoting accountability. The rules are as follows:

• This provision applies only to public companies.
• Unless the Articles provide for the retirement of all directors at every AGM, not less than two-thirds (2/3) of the total number of directors must be "rotational directors" (i.e., persons whose period of office is liable to determination by retirement of directors by rotation).
• Of these rotational directors, one-third (1/3), or the number nearest to one-third, must retire from office at every AGM.
• The directors who have been longest in office since their last appointment retire first.
• The vacancy created by the retiring director can be filled by re-appointing the same director or by appointing some other person.

Separate Resolution for Each Director (Section 162)

To ensure that shareholders can vote on the merits of each individual candidate, Section 162 mandates that at a general meeting, a motion for the appointment of two or more persons as directors of the company by a single resolution shall not be moved unless a proposal to move such a motion has first been agreed to at the meeting without any vote being cast against it. This prevents the "bundling" of popular and unpopular candidates into a single vote.

Appointment by Board

While the ultimate power to appoint directors rests with the shareholders, the Board of Directors is empowered to make certain appointments to fill specific vacancies or to bring in new expertise between two AGMs. This power must be granted to the Board by the company's Articles of Association.

Additional Director (Section 161(1))

The Board may appoint any person as an additional director if such power is conferred by the AOA. This is a useful provision to induct a person with valuable skills onto the Board without waiting for the next AGM.

• Tenure: An additional director holds office only up to the date of the next Annual General Meeting or the last date on which the AGM should have been held, whichever is earlier.
• Regularisation: For the additional director to continue beyond the AGM, their appointment must be regularized by the members by passing an ordinary resolution at the AGM.

Alternate Director (Section 161(2))

An alternate director is a temporary substitute appointed by the Board to act in the place of a director who is going to be absent from India for a period of not less than three months.

• Purpose: To ensure that the original director's position on the Board is represented during their absence, so the Board's functioning is not impaired.
• Tenure: An alternate director holds office only as long as the original director is absent. They must vacate the office as soon as the original director returns to India.

Nominee Director (Section 161(3))

A nominee director is appointed by the Board on the nomination of a third party, typically a financial institution, bank, or a major investor, pursuant to an agreement or a legal provision.

• Purpose: To represent and protect the interests of the nominating institution on the Board of the company. For example, a bank that has given a large loan to a company may nominate a director to the company's Board to monitor the use of funds and the company's financial health.

Director to Fill a Casual Vacancy (Section 161(4))

If the office of any director appointed by the members in a general meeting is vacated before their term of office expires (e.g., due to death or resignation), the resulting vacancy is called a "casual vacancy". The Board of Directors may appoint a director to fill this vacancy.

• Tenure: The director so appointed shall hold office only up to the date to which the director in whose place they are appointed would have held office if the vacancy had not occurred.

Appointment by Tribunal or Central Government

This form of appointment is not a normal mode but is an exceptional power exercised by judicial or governmental authorities to protect the interests of the company and its stakeholders, particularly in cases of corporate mismanagement.

Appointment by the National Company Law Tribunal (NCLT)

Under Section 242 of the Companies Act, 2013, if any members of a company file an application to the NCLT alleging that the affairs of the company are being conducted in a manner that is oppressive to them or prejudicial to the public interest (i.e., in cases of Oppression and Mismanagement), the NCLT has wide-ranging powers.

To bring an end to the matters complained of, the NCLT may, among other things, terminate the appointment of the existing directors and appoint one or more persons as new directors. These directors are appointed by the order of the Tribunal to manage the company's affairs and report back to the NCLT. They are not beholden to the majority shareholders and act as fiduciaries of the court to set the company's affairs in order.

Appointment by Central Government

In specific situations, such as under the Industries (Development and Regulation) Act, 1951, the Central Government has the power to take over the management of an industrial undertaking and appoint its own directors to the board if it believes the company is being managed in a manner highly detrimental to the industry or public interest.

Disqualifications for Appointment

The Companies Act, 2013, does not prescribe any specific academic or professional qualifications for a person to be appointed as a director. The primary qualifications are that the person must be an individual, competent to enter into a contract, and must hold a valid Director Identification Number (DIN).

However, the Act lays down specific grounds for disqualification in Section 164. A person who falls under any of these grounds is ineligible to be appointed as a director, or to continue as a director of any company.

The disqualifications can be divided into two categories as per Section 164(1) and Section 164(2).

Disqualifications under Section 164(1)

These disqualifications are related to the individual's personal standing. A person shall not be eligible for appointment as a director of a company, if—

Unsound Mind

A person is disqualified if he is of unsound mind and stands so declared by a competent court. The mere fact of being of unsound mind is not a disqualification; there must be a formal declaration by a court of law.

Undischarged Insolvent

A person is disqualified if he is an undischarged insolvent or has applied to be adjudicated as an insolvent and his application is pending. An undischarged insolvent is a person who has been declared bankrupt by a court but has not yet been legally freed from that status. The disqualification ends once the person is discharged by the court.

Conviction for Certain Offences

A person is disqualified if he has been convicted by a court of any offence, whether involving moral turpitude or otherwise, and sentenced in respect thereof to imprisonment for not less than six months. This disqualification continues for a period of five years from the expiry of the sentence. However, if a person is convicted and sentenced for seven years or more, they become disqualified for life.

Order of Disqualification Passed by Court or Tribunal

A person is disqualified if an order disqualifying him for appointment as a director has been passed by a court or the National Company Law Tribunal (NCLT), and the order is in force. Such orders are typically passed in cases of corporate fraud or mismanagement.

Non-payment of Calls

A person is disqualified if he has not paid any calls in respect of any shares of the company held by him, whether alone or jointly with others, and six months have elapsed from the last day fixed for the payment of the call.

Conviction for Related Party Transactions

A person is disqualified if he has been convicted of the offence dealing with related party transactions under Section 188 at any time during the last preceding five years.

Disqualifications under Section 164(2)

This is a significant provision that disqualifies a person based on the default of a company in which they are or were a director. It states that no person who is or has been a director of a company which—

• has not filed financial statements or annual returns for any continuous period of three financial years; OR
• has failed to repay the deposits accepted by it or pay interest thereon or to redeem any debentures on the due date or pay interest due thereon or pay any dividend declared and such failure continues for one year or more,

shall be eligible to be re-appointed as a director of that defaulting company or appointed in any other company for a period of five years from the date on which the said company fails to do so. This provision aims to hold directors accountable for the compliance failures of their companies.

Vacation of Office of Director (Section 167)

Section 167 of the Companies Act, 2013, specifies the circumstances under which the office of a director becomes vacant automatically. This is different from resignation (which is a voluntary act) or removal (which is an act by the shareholders).

The office of a director shall become vacant in case he/she:

1. Incurs any of the disqualifications specified in Section 164. If a director becomes disqualified (e.g., is convicted of an offence), their office in all companies becomes vacant immediately. However, if the disqualification is due to a company's default under Section 164(2), the directorship becomes vacant in all companies *except* the defaulting company itself.
2. Absents himself from Board Meetings. If a director absents himself from all the meetings of the Board of Directors held during a period of twelve months, with or without seeking leave of absence from the Board.
3. Contravenes Section 184. If a director acts in contravention of the provisions of Section 184 relating to entering into contracts or arrangements in which he is directly or indirectly interested, without making the proper disclosures.
4. Fails to disclose interest. If a director fails to disclose his interest in any contract or arrangement in which he is interested, in contravention of the provisions of Section 184.
5. Becomes disqualified by an order of a court or the Tribunal.
6. Is removed by the provisions of the Act. For example, removed by shareholders under Section 169.
7. Was appointed by virtue of holding an office or other employment, and he ceases to hold such office or other employment. For example, a director appointed by a financial institution ceases to be an employee of that institution.

If a person functions as a director even when they know that their office has become vacant under this section, they shall be punishable with imprisonment for up to one year or with a fine up to five lakh rupees, or with both.

Resignation of Director (Section 168)

A director has the right to resign from their office at any time by giving a notice to the company. The procedure for resignation is laid out in Section 168 of the Companies Act, 2013.

Procedure for Resignation

1. Notice of Resignation: The resigning director must give a notice in writing of their resignation to the company.
2. Board to take Note: The company shall, on receipt of such notice, take note of the same, and the Board shall place this information in the report of directors (Board's Report) laid in the immediately following general meeting.
3. Intimation to RoC: The company is required to intimate the Registrar of Companies (RoC) about the director's resignation by filing e-Form DIR-12 within 30 days from the effective date of resignation.
4. Director's Intimation to RoC: The resigning director also has the option to forward a copy of their resignation along with detailed reasons for the resignation to the RoC in Form DIR-11 within 30 days from the date of resignation. This allows the director to have an official record of their resignation, protecting them from future liabilities.

Effective Date of Resignation

The resignation of a director shall take effect from:

• The date on which the notice is received by the company; OR
• The date, if any, specified by the director in the notice,

whichever is later.

Liability of Resigning Director

It is important to note that the resignation of a director does not absolve them from any liabilities. The director shall continue to be liable for any offences which occurred during his tenure as a director. The resignation only frees them from liabilities related to acts done by the company after their resignation has taken effect.