Companies Act Section 185-186: Related Party Loan Rules and the Approval Cascade

When the board of an Indian private or unlisted public company sits down to approve a loan to a fellow group entity, two provisions of the Companies Act 2013 sit on the table together. Section 185 polices the relationship between the company and its own directors and their relatives. Section 186 caps the company's lending, guarantee, and investment exposure to the outside world. Together they form what practitioners call the related-party loan cascade, a layered approval regime where the cost of error is personal director liability. This explainer walks through both sections as they stand on indiacode.nic.in after the Companies (Amendment) Act 2017 (effective 7 May 2018) and the 2020 amendment.

The Statutory Question

The statutory question is narrow. How far can a board lend, invest, or guarantee under its own authority, and at what point must shareholders be brought in by special resolution? The answer turns on two ceilings that operate independently and must both be cleared before a rupee leaves the account.

Section 185, as substituted by the Companies (Amendment) Act 2017, draws three concentric circles. The innermost circle (Section 185(1)) is an outright bar: a company cannot, directly or indirectly, advance any loan, give any guarantee, or provide any security in connection with a loan taken by any director of the company, any director of its holding company, any partner or relative of such a director, or any firm in which such director or relative is a partner. There is no shareholder approval that can rescue a transaction in this category; the prohibition is absolute. The middle circle (Section 185(2)) covers loans to any private company in which a director is a member or director, to bodies corporate where directors together hold 25 per cent or more voting power, or to bodies corporate whose board acts on the directions of the lending company's directors. These are permitted only if the company passes a special resolution and the borrower applies the loan to its principal business activities. The outer circle (Section 185(3)) lists carve-outs - loans to a managing or whole-time director under a scheme approved by special resolution, loans by companies whose ordinary business is lending at rates not below the prevailing RBI yield, holding-to-subsidiary loans utilised by the subsidiary for its principal activities, and guarantees by a holding for its wholly owned subsidiary's working capital limits.

Section 186 layers a second test. Even where a transaction passes the Section 185 filter, the aggregate of all loans, guarantees, securities, and securities-acquisitions cannot exceed the higher of (a) 60 per cent of paid-up share capital plus free reserves plus securities premium, or (b) 100 per cent of free reserves plus securities premium, without prior approval by special resolution under Section 186(3). The question for any company secretary is therefore not just whether Section 185 permits the loan, but whether the cumulative book in the company's Form MBP-2 register has enough headroom.

What the Court Held

Indian Kanoon at indiankanoon.org/doc/74324013 catalogues the line of authority shaping Section 185 and 186 jurisprudence. Two interpretive principles emerge consistently from National Company Law Tribunal orders, High Court rulings, and adjudication orders passed by Registrars of Companies under Section 454.

The first principle is that Section 185 is structural, not procedural. A loan that falls within Section 185(1) cannot be cured by post-facto shareholder ratification, by board minutes recording good faith, or by repayment with interest. The bar attaches at the moment the loan is sanctioned and survives the entire life of the advance. This is why the Companies (Amendment) Act 2017 substituted the original Section 185 with a more granular three-tier structure - the legislature accepted that an absolute bar on every director-related loan was crippling for closely held groups, but it preserved the absolute bar at the innermost circle precisely because the courts had refused to read down the language of the unamended Section 185.

The second principle is that Section 186 is a cumulative ceiling, not a transaction-by-transaction one. The 60-per-cent or 100-per-cent test has to be applied to the running aggregate of all outstanding loans, all live guarantees, all subsisting securities, and all securities investments held by the company at the moment a fresh proposal is placed before the board. A loan that fits comfortably within the limits in isolation can still trigger Section 186(3) if it tips the running total over the threshold. Tribunals have refused to entertain the argument that a single transaction in isolation respects the cap, because the section's text speaks of "exceeding" the limits and the natural reading is aggregate exposure.

A third strand deals with the unanimous-board-resolution requirement under Section 186(5). Every loan, guarantee, security, or investment under Section 186 requires the consent of all directors present at the board meeting. Simple majority will not do. This requirement is independent of the special-resolution requirement under Section 186(3); even within the limits, the board acts only by unanimous vote. Adjudication orders read the rule strictly: where the minutes record an abstention or a dissent, the resolution fails.

Reasoning

The reasoning across the orders rests on three pillars: legislative purpose, the corporate veil, and the protection of public deposits. Each is worth unpacking on its own terms because the practical takeaways flow directly from these foundations.

Legislative purpose: separating the company from the controller

The 2013 Act carries forward the policy of Section 295 of the Companies Act 1956 but tightens it. The 1956 regime allowed director loans with Central Government approval; the 2013 regime in its original form removed even that escape valve. The 2017 amendment restored a measured shareholder route through Section 185(2), but only for the outer two circles. Any ambiguity at the inner-circle boundary must therefore be resolved in favour of prohibition - the legislative trend is towards stronger separation of the company's purse from the controller's pocket.

This is why "indirectly" carries weight in Section 185(1). A loan routed through an intermediate body corporate, a back-to-back arrangement, or a circular guarantee structure is tested against substance, not form. Companies that have routed director loans through subsidiaries, joint ventures, or trust structures have found that adjudication orders look through the chain.

The 60 per cent ceiling and the higher-of test

Section 186(2) sets the cap as the higher of two formulae. The arithmetic matters because the choice of formula can change the headroom by a wide margin. For a company with paid-up share capital of Rs 50 crore, free reserves of Rs 20 crore, and securities premium of Rs 10 crore:

The board can lend, guarantee, or invest cumulatively up to Rs 48 crore without seeking shareholder approval. Anything beyond that requires a special resolution under Section 186(3), passed by at least a three-fourths majority of votes cast at the general meeting. The threshold is the same regardless of whether the additional exposure is a loan, a guarantee, a security, or an investment in another body corporate's securities.

Interest rate floor and the public-deposit shield

Section 186(7) prevents companies from extending sweetheart loans below market rates. It requires that the rate of interest charged on any loan granted under Section 186 cannot be lower than the prevailing yield of one-year, three-year, five-year or ten-year Government Security closest to the tenor of the loan. A company cannot, for instance, lend at 2 per cent per annum to an associate where the comparable G-Sec yield is 7 per cent. This protects the company's profit-and-loss and, by extension, its creditors, depositors and minority shareholders.

Section 186(8) layers a separate condition: a company that has defaulted in repayment of any deposits accepted before or after the commencement of the 2013 Act, or in payment of interest on those deposits, cannot give any loan or guarantee or make any investment under Section 186 until the default has been made good. This is the public-deposit shield - the shareholders' loan permission cannot be invoked while the company is failing in its prior obligations to deposit-holders.

Practical Takeaways

For company secretaries, in-house counsel, and independent directors, the cascade collapses to a checklist that should be ticked before any related-party loan resolution is moved.

Before tabling a Section 185 loan resolution:

• Confirm in writing which of the three Section 185 circles the proposed borrower falls into. Is the borrower a director, a relative, or a firm of a director (inner circle - prohibited absolutely)? A private company in which a director is a member or director, or a body corporate where directors hold 25 per cent voting power (middle circle - special resolution route)? Or a wholly owned subsidiary or a managing-director loan under an employee scheme (outer circle - exempt subject to conditions)?
• For middle-circle loans, draft an explanatory statement under Section 102 disclosing the full particulars of the loan, the purpose for which the borrower will utilise it, and the specific principal business activities of the borrower the loan will fund.
• Obtain a written undertaking from the borrower that the loan will be applied only to the principal business activities and that no part will be on-lent to any further connected party.

Before tabling a Section 186 loan, guarantee, security or investment:

• Pull the running aggregate from Form MBP-2 register maintained at the registered office under Section 186(9). The entry must include the date of the loan, name of borrower, amount, purpose, and rate of interest.
• Calculate the headroom against both 60 per cent and 100 per cent tests and apply the higher figure as the cap.
• Confirm that no public deposit default subsists. The company's compliance officer must certify this in the board note.
• Verify the proposed interest rate against the closest-tenor G-Sec yield published by RBI on rbi.org.in and ensure the loan rate is at or above that floor.
• Ensure the board resolution will be passed unanimously by directors present. A single abstention defeats Section 186(5).
• Obtain prior approval of the public financial institution where the company has subsisting term loans, unless the aggregate stays within the Section 186 limits and the company has no default on the institution's loan.

Penalty exposure if the cascade fails:

Readers should consult the live text on indiacode.nic.in for the exact quantum, since both sections were touched by the Companies (Amendment) Act 2020 decriminalisation programme and the figures have shifted from earlier periods.

Cross-border angle for NRI promoters:

Where the director or relative is non-resident, the loan must also clear the Foreign Exchange Management Act 1999 and the Foreign Exchange Management (Borrowing and Lending) Regulations 2018, and the Income-tax Act 1961 transfer-pricing regime if the parties are associated enterprises. A loan permitted under Section 185(2) on a special resolution can still be a FEMA contravention if the funds cross the border without an appropriate route. Promoters with NRI exposure should model the post-loan cash flow using the NRI tax calculator and verify the repatriation calculator outputs against the USD 1 million per financial year NRO repatriation limit.

Readers working through the broader recovery and enforcement landscape may also find our prior pieces on CIBIL defaulter removal under the RBI 2024 master circular and Lok Adalat bank recovery strategy under Section 89 CPC useful, since a Section 185 or 186 default frequently triggers downstream credit and recovery consequences for the connected directors personally.

FAQ

Can a private company lend to its director if all shareholders are also directors?

No. The bar in Section 185(1) operates independently of shareholder consent and applies even to a wholly closely held company where the entire shareholder body is on the board. The structural prohibition cannot be lifted by unanimous shareholder resolution because Section 185(1) speaks to a director loan in any form, direct or indirect. The only escape is to fit the loan into Section 185(2) as a loan to a body corporate where the director holds the qualifying voting interest, and even that requires the special resolution and the principal-business-activity test.

What counts as "free reserves" for the Section 186 ceiling?

Free reserves under Section 2(43) of the Companies Act 2013 mean reserves which, as per the latest audited balance sheet, are available for distribution as dividend. Revaluation reserves, capital redemption reserves, share application money pending allotment, and unrealised gains on fair valuation are excluded. Securities premium account is added separately under Section 186(2), so it is counted alongside free reserves in both the 60 per cent and 100 per cent legs of the test. Always rely on the audited figures, not the management accounts, when setting the cap.

Does Section 186 apply to loans by a banking company or an NBFC?

Section 186(11) carves out loans, guarantees, and securities given by banking companies, insurance companies, housing finance companies in the ordinary course of business, and companies established with the object of financing industrial enterprises or providing infrastructural facilities. It also exempts investments made by an investment company. The carve-out is purpose-driven; a bank does not need a Section 186 special resolution every time it sanctions a corporate loan, but a manufacturing parent that occasionally lends to its trading subsidiary is fully within Section 186.

Can the board approve a loan by majority, or must it be unanimous?

Section 186(5) requires the consent of all directors present at the board meeting. This is a unanimity requirement and applies even where the loan is well within the 60 per cent ceiling and would not need a special resolution. A dissent or abstention recorded in the minutes defeats the resolution. Directors who oppose the proposal therefore have a real veto. Where a director foresees a conflict of interest, the safer course is to recuse and not be "present" within the meaning of the section.

What rate of interest is the floor under Section 186(7)?

The floor is the prevailing yield, on the date of sanction, of one-year, three-year, five-year, or ten-year Government Security closest to the tenor of the proposed loan. The board note should attach the relevant G-Sec yield published by the Reserve Bank of India on rbi.org.in. A loan at a lower rate is a violation even if the borrower agrees and the parties document a commercial rationale; the section does not allow the parties to contract out of the floor.

Do these sections apply to a Section 8 company?

Section 8 companies, formed for charitable objects, are covered by Section 185 and Section 186 with limited modifications notified under Section 462. The Ministry of Corporate Affairs has issued exemption notifications carving out specific sub-sections for Section 8 companies, the most recent set being available on mca.gov.in. The general principle is that the prohibition on director loans applies, but the Section 186 unanimity rule and certain disclosure obligations are relaxed where the lending is in furtherance of the company's charitable objects.

What happens to a loan made in breach - is it void?

The statutes do not expressly declare a non-compliant loan void, but the practical consequences are severe. The director or recipient is personally liable to repay the loan with interest, the company and its officers in default face the penalties under Section 185(4) or Section 186(13), and the auditor is bound under the Companies (Auditor's Report) Order 2020 to report the non-compliance in CARO. Where the loan was indirect or routed through an intermediate vehicle, the Registrar's adjudication can lift the corporate veil and trace the recovery to the ultimate beneficiary. Boards should treat a Section 185 or 186 violation as a recoverable advance plus a regulatory exposure, not as a contractual loan that can be rolled over.