Conversion of Loan into Equity : Under the Companies Act, 2013

Picture this: A company, in its quest for financial sustenance, may find solace in loans from its director, their kin, or even other corporate entities. These funds serve myriad purposes, from greasing the wheels of day-to-day operations to amplifying existing infrastructures. Now, here’s the kicker: while obligated to settle its debts within agreed-upon terms, this company has a sneaky little ace up its sleeve. Instead of the mundane ritual of repayment, it can charm its lenders by offering to morph those loans into shares – a sort of financial shape-shifting, if you will. 

And guess what? 

It’s all legit, courtesy of Section 62(3) of the Companies Act of 2013. 

Talk about turning debt into dividends, right?

Can the director or their relative give a loan to the company?

(Section 73(2) of the Companies Act, 2013 read with Companies (Acceptance of Deposits) Rules, 2014) “Loan received from the Directors of the Company shall be considered as Exempted Deposit.” Loans accepted by a private limited company from its directors or their relatives is allowed (out of own fund) and is considered as an exempt category deposit.

Can the Shareholders give loans to a Company?

Rule 3 of Companies (Acceptance of Deposits) Rules, 2014 , restricts company from accepting or renewing deposit from its members if the amount of such deposits together with the amount of other deposits outstanding as on the date of acceptance or renewal of such deposits exceeds 35% [thirty-five per cent] of the aggregate of the Paid-up share capital, free reserves and securities premium account of the company.  Notification issued by MCA dated June 13, 2017 exempts Private Limited Companies  from the restriction of accepting deposit only up to 35% from its members and they can accept it beyond 35% but subject to the  following conditions:  i) The amount of deposit should not exceed 100% of the aggregate of the paid up share capital, free reserves and securities premium account; or ii) It  is a start-up, for five  years from the date of its incorporation; or  iii) which fulfills all of the following conditions, namely: – (a) Which is not an associate or a subsidiary company of any other company;  (b) The borrowings of such a company from banks or financial institutions or any Body corporate is less than twice of its paid-up share capital or fifty crore rupees, whichever is less; and  (c) such a company has not defaulted in the repayment of such borrowings subsisting at the time of accepting deposits under section 73  Provided also that all the companies accepting deposits shall file the details of monies so accepted to the Registrar in Form DPT-3.

Limits of Borrowings & Approvals required, if any

Pursuant to MCA Notification dated June 05, 2015, the provisions of Section 180 of the Companies Act, 2013 is not applicable to the private limited Companies.

Sections	Requirements
Section 180 (1) (c) of the Act, 2013	This section states that the Board of Directors of a company shall exercise the Borrowing powers only with the consent of the company by a special resolution where the money to be borrowed, together with the money already borrowed by the company will exceed aggregate of its paid-up share capital, free reserves and securities premium, apart from temporary loans obtained from the company’s bankers in the ordinary course of business.
Section 180(2)	Every special resolution passed by the company in general meeting in relation to the exercise of the powers referred to in clause (c) of sub-section (1) shall specify the total amount up to which monies may be borrowed by the Board of Directors.
Section 180 (5)	No debt incurred by the company in excess of the limit imposed by clause (c) of sub-section (1) shall be valid or effectual, unless the lender proves that he advanced the loan in good faith and without knowledge that the limit imposed by that clause had been exceeded

Section 62(3) under the Companies Act of 2013 Groundbreaking shift in the financial landscape

The introduction of Section 62(3) under the Companies Act of 2013 marked a groundbreaking shift in the financial landscape. This provision allows companies to metamorphose loans into equity, but with a quirky catch. Only loans that come with an in-built option for future equity conversion, approved by shareholders through a special resolution, can take this magical transformational journey.

Now, let’s delve into the spellbinding process of converting these loans. Suppose a company has borrowed an unsecured loan from its directors and dreams of turning it into equity down the line. To make this enchantment happen, it must first forge a debt conversion agreement with said directors, sealing the pact. Then, through the mystical power of a special resolution, the company can set the wheels in motion for the conversion.

But wait, there’s more! Before the magic unfolds, the company must seek a declaration from the director or their kin, as per Rule 2(c)(viii) of the Companies (Acceptance of Deposits) Rules, 2014. This declaration is like a potion, ensuring that the borrowed sum isn’t conjured from thin air but has a tangible source i.e. such amount is not being given out of borrowed funds and the same is disclosed in the board report.

And thus, through this bewitching procedure, loans are transmuted into equity, weaving a tale of financial alchemy that dances between the realms of loans and shares.

Compliances to be undertaken at the time of taking loans

1) Hold a Board Meeting & pass a resolution

• For accepting a loan with an option to convert it to equity in future.
• To fix time, date and place of extra ordinary general meeting & to approve the draft notice along with explanatory statement of extra ordinary general meeting.

2) Hold Extra Ordinary General Meeting and Pass a special resolution for accepting the loan with an option to convert it to equity in future and giving authority to enter into loan conversion agreement

• Execute a loan conversion agreement between the company and lenders.
• File form MGT-14 within 30 days of passing the special resolution.

Compliances to be undertaken at the time of Converting loans to Equity

Hold a Board Meeting & Pass a Resolution for Allotment of Shares by converting the loan to equity

• Finalize list of allottee to whom the allotment is to be made pursuant to such conversions.
• File Return of Allotment in Form PAS-3 within 30 days of passing Board Resolutions.
• Payment of stamp duty & issue share certificates to the lender.
• Enter the name of the Member in the Statutory Registers of Members.

Benefits and Drawbacks of Converting Loan into Equity

Transforming loans into shares presents a tantalizing array of benefits for both companies and lenders alike. For companies, this maneuver provides a convenient escape from the burdens of debt repayments, potentially bolstering their financial metrics in the process. Meanwhile, lenders stand to gain a foothold in the company’s ownership structure, forging a symbiotic relationship wherein their fortunes are intricately tied to the company’s prosperity.

Yet, amid the allure of these advantages, it is crucial to cast a discerning eye on the potential pitfalls lurking in the shadows. The conversion process may cast a spell of dilution upon existing shareholders, diminishing their ownership stakes and potentially stirring unrest within the company’s ranks. Additionally, the mercurial nature of equity ownership introduces an element of unpredictability for lenders, as they navigate the turbulent waters of market fluctuations and volatility.

Thus, while the alchemy of converting loans into shares may promise riches, it is prudent for both companies and lenders to tread carefully, weighing the glittering rewards against the shadows of potential risks. After all, in the realm of finance, every enchantment carries its own set of enchantments and perils.

Conclusion

Converting loans into shares stands as a strategic financial maneuver, but it demands meticulous scrutiny and compliance with legal and regulatory frameworks. To embark on this journey successfully, one must grasp the benefits and drawbacks, meticulously weigh practicalities, and seek expert guidance. 

Through such diligent navigation of complexities, companies and lenders can unlock the unique advantages inherent in loan-to-share conversions while effectively managing associated risks. In essence, it’s a delicate dance where careful steps pave the way to financial opportunity and compliance.