Ordinary course of business is not guaranteed

By Devyani Dhawan and Aditya Vikram Dua, SNG & Partners

Section 185 of the Companies Act, 2013 (act), governs transactions involving loans or the provision of guarantees or securities to companies in which a director is interested. Certain loans and guarantee or security transactions are prohibited while others are permitted provided the company obtains the approval of shareholders by passing a special resolution and provided that they are used by the borrowing entity for its principal business activities.

Devyani Dhawan,SNG & Partners,Ordinary course
Devyani Dhawan
Of counsel
SNG & Partners

Section 185 contains another key exemption from its requirements. This is in relation to “a company which in the ordinary course of its business provides loans or gives guarantees or securities for the due repayment of any loan …”. This article analyses whether a guarantee or security provided by a company to secure a loan obtained by a director or a company in which such director is interested can be regarded as being in the ordinary course of business of the guarantor or security provider so as to bring the company within the exemption.

The exemption has been debated in many lending transactions. Borrowers argue that they are exempt from compliance with section 185 on the basis that the company regularly provides guarantees for group companies, that the provision of guarantees is covered in its memorandum and that it receives interest income from providing such guarantees and securities. Based on such reasoning, there is a growing market practice among lenders to accept a certificate issued by chartered accountants in practice confirming that the security provider or guarantor provides the security or guarantee in its ordinary course of business. Relying on such a certificate, lenders and their legal advisers proceed on the basis that the exemption is available. While the term “ordinary course of business”, is often used in the act, but has not been defined therein.

Aditya Vikram Dua,SNG & Partners,Ordinary course
Aditya Vikram Dua
Senior associate
SNG & Partners

The provisions of the corresponding section 295 of the Companies Act, 1956, allowed the exemption only to banking companies that gave guarantees or created security. However, section 185 provides exemptions to all companies which in the ordinary course of business provide loans or give guarantees or securities. There are two views of this. One is that the exemption was widened only to include non-banking financial companies (NBFC) which provide loans, guarantees and securities in their ordinary courses of business as providing these services would be construed as financial activity. The contrary view is that if the legislature has expanded the exemption to include all companies that give loans, guarantees and securities in their ordinary courses of business, this exemption should not be limited to NBFCs and should be extended to all other companies.

The courts have attempted to define the term “ordinary course of business”. Most recently in the case of Anuj Jain v Axis Bank Limited and Ors, the Supreme Court stated that “even when furnishing a security may be one of normal business practices, it would become a part of ordinary course of business of a particular corporate entity only if it falls in place as part of the undistinguished common flow of business done and was not arising out of any special or particular situation.” The Supreme Court relied on the definition of the High Court of Australia in the case of Downs Distributing Co: “The transaction must fall into place as part of the undistinguished common flow of business done … it should form part of the ordinary course of business as carried on, calling for no remark and arising out of no special or particular situation.”

In Seksaria Biswan Sugar Factory v Commissioner of Income-Tax, the Bombay High Court held the fact that an activity is mentioned in the objects clause of the memorandum of association makes it permissible under that memorandum, but does not thereby make it in the ordinary course of business.

The Institute of Company Secretaries of India has issued a guidance note on Related Party Transactions in which it lists the factors to be considered in deciding whether an activity is within the ordinary course of business. These include whether the activity is included in the objects clause of the memorandum of association; whether the activity is in furtherance of the business; whether the activity is routine, and what is its frequency, income, and revenue generated from such activity.

It is clear that the exemption with respect to “ordinary course of business” cannot be obtained generally and the facts and circumstances of each case must be considered. Lenders should not just rely on a chartered accountant’s certificate to ascertain whether a loan, guarantee or security is provided in the ordinary course of business and this becomes even more crucial at the risk of being categorized as an NBFC.

Devyani Dhawan is an of counsel and Aditya Vikram Dua is a senior associate at SNG & Partners.

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