Section 186, Companies Act - Intent and Impact

Inter-corporate lending and borrowing is a popular means by which companies raise monies, especially in case of bridge-funding to tide over urgent capital requirements. In this case, Section 186 of the Companies Act, 2013, is an important compliance requirement which needs to be met. Further, if lenders require third party guarantees and securities while extending financing to corporates, again, compliance of Section 186 becomes an important parameter.

What is so critical about Section 186? This Section is essentially a protection mechanism to the shareholders/ stakeholders of a company proposing to grant loans or give security/ guarantees for loans granted to another body corporate, so that the persons who are managing the company cannot and should not give loans/ guarantees/ securities in excess of limits prescribed, which would be in excess of their capacity and could land the company in deep trouble should there be a default of the loan lent (Urban Infraprojects Private Limited v EDCL Infrastructure Limited - MANU/WB/01234/2024).

To put it succinctly, Section 186 provides that in case a company proposes to -

(i)  grant a loan; or

(ii) provide security or guarantee to secure third party loans,

then, if such loan, guarantee or security exceeds 60 per cent of its paid-up share capital, free reserves and securities, premium account or 100 per cent of its free reserves and securities premium account, whichever is more, then it needs the consent of its shareholders by way of a special resolution before such loan, guarantee or security can be given.

The consequences of non-compliance of this provision are mentioned in the Section itself, which provides for both monetary penalty and/ or imprisonment on the concerned company and its officers in default.

Now, an interesting question which arises, and which has been dealt with by the National Company Law Tribunals of various States in the recent past, is - what happens to a loan or security or guarantee which is given in violation of Section 186, specifically where the consent of the shareholders by way of special resolution was not obtained by the concerned company before granting such loan or extending such guarantee or security?

In the recent case of Proplarity Infratech Private Limited v. Sky High Technobuid Private Limited, decided on July 23, 2024 by the Principal Bench of the National Company Law Tribunal (“NCLT”), Delhi (now pending appeal), it was alleged by the borrower company that the lender had extended the purported loan far beyond the limits set by Section 186 without getting the necessary shareholder approval through a special resolution. The NCLT ruled that in view of non-compliance with Section 186, the granting of such a loan becomes an ultra vires act, and therefore not a legally enforceable debt.

A similar decision was also given in the matter of M/s UKG Steel Pvt. Ltd. Vs M/s Erotic Buildcon Pvt. Ltd - MANU/NC/2967/2022.

However, a contrary view has been taken by NCLT, Kolkata (Urban Infraprojects Private Limited v EDCL Infrastructure Limited) where a borrower attempted to avoid its repayment obligations under a loan on the basis that the lender had not obtained the necessary consent of its shareholders under Section 186. In this case, the NCLT, Kolkata, held that the aggrieved party in a violation under Section 186, would be the shareholder/ stakeholders of the lending company; and that it was not open for a borrower to take shelter under such violations and refuse to repay money borrowed.

Similarly, in the case of Sarveshwar Creations Pvt. Ltd. v. Union Bank of India - MANU/NL/0889/2022, decided by the National Company Law Appellate Tribunal in New Delhi, it may be noted that similar rules apply under Section 185 of the Companies Act, 2013, which deals with loans to directors. Like Section 186, Section 185 requires a special resolution for extending guarantees that do not meet its rules. In this case also, the tribunal held that that this is the provision which the company has to comply with internally and if it fails to comply, the necessary punishment is available in the same section - both monetary penalty and/or imprisonment.

A reading of the above reflects the different views taken by the authorities on non-compliance with Section 186 - one view of treating the financial transaction as ultra vires and not enforceable, and the other view of treating it as a breach on the part of the company for which the necessary penal consequences will follow without impacting the financial transaction itself.

The author supports the latter view as a violation or breach on the part of the company extending the loan, security or guarantee should not allow the borrower to wrangle itself free from its repayment obligations. Setting aside financial transactions on this ground will lead to an anomaly where a borrower, after obtaining financial assistance, can avoid its repayment liability by taking this plea of an internal non-compliance with Section 186 on the part of the lender. This also goes against the very objective of the Section which is to protect the interest of the shareholders of a company. By declaring the loan itself to be unenforceable, there is no hope for the company to get the repayment of its loan, which is to the complete detriment of the company and hence its shareholders.

An even more dangerous analogous situation can arise where a bank or financial institution obtains a third-party security or guarantee from a group company of the borrower and where such security provider or guarantor may not be in compliance with Section 186. If this results in the guarantee or security transaction itself being treated as void or ultra vires and hence, unenforceable, it will lead to a situation of a party taking advantage of its own wrong, which is clearly disallowed under established jurisprudence. A corporate guarantor or security provider cannot be rewarded for its own breach of Section 186, by terming such a transaction as void or ultra vires on account of its own internal non-compliance.

That being said, in light of various contrary views being taken by the judicial authorities on the subject, it would be prudent on the part of lenders to conduct their own reasonable financial diligence to ascertain whether the limits of Section 186 are being breached on the part of a corporate guarantor or security provider, which may be supported by compliance certificates of independent chartered accountants or statutory auditors; and if the limits are in fact being crossed, the lenders should insist on getting a copy of the corresponding shareholders resolution instead of merely relying on company representations. 

About the authors: Devyani Dhawan is an Of-Counsel and Carishma Bhargava is an Associate at SNG & Partners.

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