Related Party Loans & Section 185/186 Compliance

Related party lending is one of the more common ways companies unintentionally fall out of compliance under the Companies Act 2013. A promoter lends the company's spare cash to a director for a personal need, or one group company funds another without checking the numbers, and both can trigger a breach even when the intent was entirely routine. Sections 185 and 186 govern these two different situations, and confusing one for the other is where most mistakes happen.

Section 185: Loans to Directors, Prohibited by Default

Section 185 restricts a company from directly or indirectly advancing a loan, including a loan represented by a book debt, or giving a guarantee or security in connection with a loan, to any of its directors, a director of its holding company, or any partner or relative of such a director, or a firm in which such a director or relative is a partner. The provision is drafted as a prohibition, not a permission-with-conditions clause, which is the key difference from Section 186.

There are exceptions, and they are narrow. A company can give a loan to a managing or whole-time director if it is part of the conditions of service extended to all employees, or if it is pursuant to a scheme approved by a special resolution. Loans made by a holding company to its wholly-owned subsidiary, or a guarantee/security given by a holding company for a loan taken by its wholly-owned subsidiary, are also exempted, provided the loan is used for the subsidiary's principal business activities. Any structure outside these exceptions should be assumed to be caught by the prohibition until confirmed otherwise.

Section 186: Inter-Corporate Loans, Guarantees, and Investments

Section 186 governs a company's loans, guarantees, and investments made to any other body corporate or person, and unlike Section 185 it is permissive: the transaction is allowed, subject to a numerical ceiling and an approval process that scales with the amount involved.

The combined limit on loans given, guarantees or security provided, and investments made under this section is 60% of the company's paid-up share capital, free reserves, and securities premium account, or 100% of its free reserves and securities premium account, whichever is higher. This is a cumulative, running limit across all such transactions, not a per-transaction cap, so a company needs to track its aggregate exposure rather than clearing each new loan against the limit in isolation.

Going beyond this limit is not automatically barred; it requires prior approval by a special resolution passed at a general meeting, before the loan, guarantee, security, or investment is made. Approval after the fact does not cure the breach.

Two further conditions apply to every loan made under this section, whether or not it crosses the ceiling:

• Board approval is required with the consent of all directors present at the meeting, and where the company has any term loan subsisting from a public financial institution, prior approval of that institution is also needed unless the aggregate of the proposed transaction and existing loans/investments is within the limit and there is no default in repayment.
• Interest rate floor: no loan can be given at a rate lower than the prevailing yield of the one-year, three-year, five-year, or ten-year government security closest to the tenor of the loan, so intra-group loans at nominal or zero interest are not permitted.

Certain transactions are exempted from the specific approval machinery of Section 186, notably loans, guarantees, or investments made to a wholly-owned subsidiary, and investment in shares of a joint venture company, though the particulars still need to be disclosed in the financial statements as required under the section.

Why These Two Sections Get Confused

The practical trigger for confusion is a director who is also a shareholder or promoter in a related company. If the company lends money to that related company, and the director's involvement is incidental, Section 186 applies. If the loan is, in substance, being extended to benefit the director personally, rather than as a genuine inter-corporate transaction, Section 185 exposure can still arise even if the paperwork is structured as a loan to an entity. Getting the structuring and documentation right at the outset, rather than after a loan has already been disbursed, is the difference between a routine board resolution and a compliance breach that needs remediation.

Penalties for Non-Compliance

A contravention of Section 185 attracts a monetary penalty on the company and every officer in default, and separately on the director or other person to whom the loan, guarantee, or security was given. A contravention of Section 186 similarly attracts penalties on the company and every officer in default. In both cases, the loan itself is not automatically voided by the contravention, which can leave the company in an awkward position of holding a non-compliant transaction on its books that still needs to be disclosed, explained to auditors, and often unwound. This is exactly the kind of related-party structuring question worth raising with your CA before the transaction is executed, alongside the broader annual ROC filing disclosures these loans eventually feed into.