A 50:50 Private Company, a Director's Loan and a Pre-emption Clause

The advance is prohibited. Section 185 of the Companies Act, 2013 bars a company from advancing any loan, giving a guarantee or providing security in connection with a loan to a director, to a firm in which a director is a partner, or to a private company in which a director is a director or member.

The exceptions do not fit. After the 2015 amendment, a loan is permissible where it is given to a managing or whole-time director as part of the conditions of service extended to all employees, or under a scheme approved by special resolution; and a company whose ordinary business is lending may lend to a person in whom a director is interested if a special resolution is passed and the borrowing entity uses the money for its principal business activity. A 15 lakh rupee advance for stated personal reasons is none of these, and no special resolution was passed.

Consequences:

• The loan is unlawful and must be recovered from Selvam with interest; the board should demand repayment immediately and record the demand.
• Under section 185(2), the company and every officer in default are punishable with fine from 5 lakh to 25 lakh rupees, and the director or officer who sanctioned it can face imprisonment up to six months, or fine, or both.
• Selvam must indemnify the company against any loss.
• Because Selvam is a related party, disclosure of interest under section 184 was also mandatory.

Answer structure: prohibition, test against exceptions, then recovery plus penalty. Arumugam should put the demand for recovery on the board agenda in writing, so that a refusal becomes evidence in any later proceeding.

The pre-emption clause binds. The articles are a contract between the company and its members and among the members. Selvam had to offer the 2,000 shares to Arumugam before selling to an outsider. Selling without that offer is a breach of the articles as between the members.

What the board should have done: on receiving the transfer instrument, the board had to act within 30 days under section 56(4) either by registering the transfer or by sending notice of refusal with reasons. Here the articles themselves supply a legitimate ground for refusal - breach of the pre-emption clause - so the board could and should have refused, with reasons, and informed Selvi, who would then have had a right of appeal to the Tribunal under section 58 within 60 days of the notice. Registering the transfer instead, with the transferee-director voting, was a breach of duty and of the articles.

Arumugam's remedies, in practical order:

1. Write to the board demanding rectification of the register of members under section 88 and a board resolution recording that the transfer was registered contrary to the articles.
2. Seek rectification through the Tribunal, either by way of a section 58 route if refusal is now recorded, or under sections 241 and 242 as oppression and mismanagement, which suits a 50:50 company where the register has been used to alter the balance of control.
3. A civil suit for breach of the articles against Selvam, and an injunction restraining Selvi from exercising rights as a member.

Note the timing: if the instrument was executed in June and lodged in August, the 60-day delivery window under section 56 was still open, so the delay is not itself a ground of invalidity.

Start with the exemption, not the section. Section 188 covers contracts with a firm in which a director or his relative is a partner. But the second proviso exempts transactions entered into in the ordinary course of business and at arm's length. Here the work is the kind the company does every month and the price is at prevailing market rates, so both limbs are satisfied. No section 188 board or shareholder approval is therefore required, and no ordinary resolution is needed. A resolution in the AGM agenda would be unnecessary, though a note recording that the exemption applies is good practice.

The compulsory step is disclosure of interest under section 184(1). Every director who is directly or indirectly concerned or interested in a contract or arrangement must disclose the nature of his concern or interest at the meeting of the board. The interest here is indirect, through his wife's partnership. Selvam's silence is a contravention, exposure to penalty, and it taints the board's decision.

On voting and quorum: the Act restricts an interested director from being counted for quorum and from voting on that item, and a private company has conditional relief from that restriction for arm's length, ordinary course contracts. The articles should be checked, and the safest course - which also protects the validity of the contract - is for Selvam to disclose, abstain and not be counted. The minute should record the disclosure, the abstention and the reasons why the price is at arm's length, with the quotations or rate comparison attached.