Prosecution of company directors for day-to-day operational issues: SC ruling provides relief

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By Dibisha Mishra (dibisha@vinodkothari.com; corplaw@vinodkothari.com)

Introduction:

While directors are the brain and neural control center of companies, but it is evident that the day to day affairs of  companies are not run by the board of directors , or even the executive directors of companies. Under circumstances can directors be prosecuted, merely because they hold board positions, for something as operational as the lack of safety measures in a smoking zone in a hotel? The SC in a recent ruling[1] of Shiv Kumar Jatia vs. State of NCT of Delhi has taken forward its earlier rulings in the case of Maksud Saiyed vs. State of Gujarat & Ors[2] and Sunil Bharti Mittal vs. CBI[3], and has held the doctrine of vicarious liability cannot be applied to offences under the IPC unless specifically provided for.

The concept of a corporate structure is based on the very premise of a business idea brought into by a group of persons [also known as promoters], backed up with funds from shareholders and creditors and set to implementation by directors who are elected by the shareholders. While shareholders continue to hold certain decision making powers, the directors are broadly responsible for the functioning and performance of the company. Having said so, it is also to be understood that a director of a company is not always in charge of everyday affairs. It depends upon the respective role assigned to different officers in a company.

Liability of officers for offences under Companies Act

The Companies Act, 2013 (‘the Act’), has explicitly identified officers who are in default for the purpose of the Act which includes directors and KMP.

Further, Section 149(12)(ii) of the Companies Act 2013 provides that liability of a NEDs arises only with respect to such acts of omission or commission by a company which had occurred with his knowledge, attributable through Board processes, and with his consent or connivance or where he had not acted diligently. Hence, obligation is on the ROC to verify relevant information and records before initiating prosecution against independent or nominee directors.

However, it is to be noted that the above provisions are to be considered only where there has been any contravention with the provisions of the Companies Act while in case of other statutes, respective provisions is to be seen.

Liability for criminal felonies

When a Corporate gets accused of a criminal offence, the individual to be prosecuted for the same remains a matter of consideration. The extent of liability of Non-Executive Directors in case of offences has been discussed in our earlier article[4]. The present article discusses the Supreme Court’s judgment[5] on the case of Shiv Kumar Jatia vs. State of NCT of Delhi which quashed the impugned order of the High Court and freed the Managing Director from the criminal liability imposed on the basis of doctrine of ‘vicarious liability’.

Facts of the case:

Shiv Kumar Jatia is the Managing Director of M/s. Asian Hotels which looks after Hyatt Regency Hotel. He had authorized Mr. PR. Subramanian to apply for lodging license of the hotel.

There was a contravention the condition of the lodging license which led to a hotel guest enter into a semi lit under-construction terrace for smoking. The guest fell from the terrace of 6th floor to the 4th floor and got injured. Case was brought before the High Court which ordered for prosecution the Managing director along with the other three accused by relying on the case of Sushil Ansal vs. State through CBI[6].

Shiv Kumar Jatia appealed before the Apex Court against such impugned order of the High Court where the case was decided in his favour vide judgment dated 23rd August, 2019.

Provisions of law considered:

Alleged offences under Section 336 and 338 of the Indian Penal Code

Section 336:

“Whoever does any act so rashly or negligently as to endanger human life or the personal safety of others, shall be punished with impris­onment of either description for a term which may extend to three months, or with fine which may extend to two hundred and fifty rupees, or with both.”

Section 338:

“Whoever causes grievous hurt to any person by doing any act so rashly or negligently as to endanger human life, or the personal safety of others, shall be punished with imprisonment of either description for a term which may extend to two years, or with fine which may extend to one thousand rupees, or with both.”

Apex court stated that the essential elements to prove an alleged offence under section 336 are:

  • an act
  • done rashly or negligently
  • to endanger human life or personal safety

while for section 338, the condition of grievous hurt is to be met in additional to elements in section 336.

Doctrine of vicarious liability

Under the doctrine of vicarious liability, one person is held responsible for the wrong doing of the other. Such liability arises only when both persons are somehow connected to each other like employee-employer relationship or principal-agent relationship. In case of corporates, the applicability of the said doctrine is to be determined on the basis of provisions of statute dealt with.

There is no vicarious liability unless the statute specifically provides so.

  • The court referred to the judgment[7] of Maksud Saiyed vs. State of Gujarat & Ors, where the Court held that the Penal Code does not contain any provision of vicarious liability on the part of the Managing Director/ Director of the company where the accused is a company.
  • Further, the case of Sunil Bharti Mittal vs. CBI[8] was also referred to wherein it was held that:

“a corporate entity is an artificial person which acts through its officers, directors, managing director, chairman etc. If such a company commits an offence involving mens rea, it would normally be the intent and action of that individual who would act on behalf of the company. It would be more so, when the criminal act is that of conspiracy. However, at the same time, it is the cardinal principle of criminal jurisprudence that there is no vicarious liability unless the statute specifically provides so.”

This means where the statutory provision itself does not specifically attract the doctrine of vicarious liability, an individual cannot be implicated under the same.

Existence of Active Role and Criminal Intent

It was stressed that in the absence of any statutory provision incorporating vicarious liability, an individual cannot be made accused, unless there is a sufficient evidence of his ‘active role coupled with criminal intent’. Further such criminal intent must have direct nexus with the accused.

In the given case, the Managing Director was outside the country on the day of the accident. Moreover, mere authorizing an official for obtaining license cannot be construed to his active role with criminal intent. Hence, the same was also failed to be established before the Court.

Judgment

The Apex Court held that there is no specific provision of applicability of doctrine of vicarious liability in the Indian Penal Code. Further, the allegations made on the Managing Director could not establish any active role coupled with criminal intent having direct nexus with the accused.

Concluding the same, the Court passed the judgment that the allegations made on the Managing Director was vague in nature and the criminal proceedings against Shiv Kumar Jatia as passed by the High Court were quashed.

Time and again the court have taken the view that merely because of holding the position as a director/managing director, a person cannot be vicariously held liable for offence committed by Companies. It has to be proved how he was responsible for, or in control of, or negligent in conducting the affairs of the company. In the absence of definite averments, a director cannot be deemed to be liable.

 

[1] https://sci.gov.in/supremecourt/2018/31728/31728_2018_6_1502_16190_Judgement_23-Aug-2019.pdf

[2] https://indiankanoon.org/doc/159121041/

[3] https://indiankanoon.org/doc/159121041/

[4] http://vinodkothari.com/wp-content/uploads/2017/03/Umesh_K_-Modi_vs_Deputy_Directorate_of_Enforcement.pdf

[5] https://sci.gov.in/supremecourt/2018/31728/31728_2018_6_1502_16190_Judgement_23-Aug-2019.pdf

[6] https://indiankanoon.org/doc/152261427/

[7] https://indiankanoon.org/doc/159121041/

[8] https://indiankanoon.org/doc/159121041/

Introduction of Digital KYC

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Anita Baid (anita@vinodkothari.com)

The guidelines relating to KYC has been in headlines for quite some time now. Pursuant to the several amendments in the regulations, the KYC process of using Aadhaar through offline modes was resumed for fintech companies. The amendments in the KYC Master Directions[1] allowed verification of customers by offline modes and permitted NBFCs to take Aadhaar for verifying the identity of customers if provided voluntarily by them, after complying with the conditions of privacy to ensure that the interests of the customers are safeguarded.

Several amendments were made in the Prevention of Money laundering (Maintenance of Records) Rules, 2005, vide the notification of Prevention of Money laundering (Maintenance of Records) Amendment Rules, 20191 issued on February 13, 2019[2] (‘February Notification’) so as to allow use of Aadhaar as a proof of identity, however, in a manner that protected the private and confidential information of the borrowers.

The February Notification recognised proof of possession of Aadhaar number as an ‘officially valid document’. Further, it stated that whoever submits “proof of possession of Aadhaar number” as an officially valid document, has to do it in such a form as are issued by the Authority. However, the concern for most of the fintech companies lending through online mode was that the regulations did not specify acceptance of KYC documents electronically. This has been addressed by the recent notification on Prevention of Money-laundering (Maintenance of Records) Third Amendment Rules, 2019 issued on August 19, 2019[3] (“August Notification”).

Digital KYC Process

The August Notification has defined the term digital KYC as follows:

“digitial KYC” means the capturing live photo of the client and officially valid document or the proof of possession of Aadhaar, where offline verification cannot be carried out, along with the latitude and longitude of the location where such live photo is being taken by an authorised officer of the reporting entity as per the provisions contained in the Act;

Accordingly, fintech companies will be able to carry out the KYC of its customers via digital mode.

The detailed procedure for undertaking the digital KYC has also been laid down. The Digital KYC Process is a facility that will allow the reporting entities to undertake the KYC of customers via an authenticated application, specifically developed for this purpose (‘Application’). The access of the Application shall be controlled by the reporting entities and it should be ensured that the same is used only by authorized persons. To carry out the KYC, either the customer, along with its original OVD, will have to visit the location of the authorized official or vice-versa. Further, live photograph of the client will be taken by the authorized officer and the same photograph will be embedded in the Customer Application Form (CAF).

Further, the system Application shall have to enable the following features:

  1. It shall be able to put a water-mark in readable form having CAF number, GPS coordinates, authorized official’s name, unique employee Code (assigned by Reporting Entities) and Date (DD:MM:YYYY) and time stamp (HH:MM:SS) on the captured live photograph of the client;
  2. It shall have the feature that only live photograph of the client is captured and no printed or video-graphed photograph of the client is captured.

The live photograph of the original OVD or proof of possession of Aadhaar where offline verification cannot be carried out (placed horizontally), shall also be captured vertically from above and water-marking in readable form as mentioned above shall be done.

Further, in those documents where Quick Response (QR) code is available, such details can be auto-populated by scanning the QR code instead of manual filing the details. For example, in case of physical Aadhaar/e-Aadhaar downloaded from UIDAI where QR code is available, the details like name, gender, date of birth and address can be auto-populated by scanning the QR available on Aadhaar/e-Aadhaar.

Upon completion of the process, a One Time Password (OTP) message containing the text that ‘Please verify the details filled in form before sharing OTP’ shall be sent to client’s own mobile number. Upon successful validation of the OTP, it will be treated as client signature on CAF.

For the Digital KYC Process, it will be the responsibility of the authorized officer to check and verify that:-

  1. information available in the picture of document is matching with the information entered by authorized officer in CAF;
  2. live photograph of the client matches with the photo available in the document; and
  3. all of the necessary details in CAF including mandatory field are filled properly.

Electronic Documents

The most interesting amendment in the August Notification is the concept of “equivalent e-document”. This means an electronic equivalent of a document, issued by the issuing authority of such document with its valid digital signature including documents issued to the digital locker account of the client as per rule 9 of the Information Technology (Preservation and Retention of Information by Intermediaries Providing Digital Locker Facilities) Rules, 2016 shall be recognized as a KYC document. Provided that the digital signature will have to be verified by the reporting entity as per the provisions of the Information Technology Act, 2000.

The aforesaid amendment will facilitate a hassle free and convenient option for the customers to submit their KYC documents. The customer will be able to submit its KYC documents in electronic form stored in his/her digital locker account.

Further, pursuant to this amendment, at several places where Permanent Account Number (PAN) was required to be submitted mandatorily has now been replaced with the option to either submit PAN or equivalent e-document.

Submission of Aadhaar

With the substitution in rule 9, an individual will now have the following three option for submission of Aadhaar details:

  • the Aadhaar number where,
    1. he is desirous of receiving any benefit or subsidy under any scheme notified under section 7 of the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 or
    2. he decides to submit his Aadhaar number voluntarily
  • the proof of possession of Aadhaar number where offline verification can be carried out; or
  • the proof of possession of Aadhaar number where offline verification cannot be carried out or any officially valid document or the equivalent e-document thereof containing the details of his identity and address;

Further, along with any of the aforesaid options the following shall also be submitted:

  1. the Permanent Account Number or the equivalent e-document thereof or Form No. 60 as defined in Income-tax Rules, 1962; and
  2. such other documents including in respect of the nature of business and financial status of the client, or the equivalent e-documents thereof as may be required by the reporting entity

The KYC Master Directions were amended on the basis in the February Notification. As per the amendments proposed at that time, banking companies were allowed to verify the identity of the customers by authentication under the Aadhaar Act or by offline verification or by use of passport or any other officially valid documents. Further distinguishing the access, it permitted only banks to authenticate identities using Aadhaar. Other reporting entities, like NBFCs, were permitted to use the offline tools for verifying the identity of customers provided they comply with the prescribed standards of privacy and security.

The August Notification has now specified the following options:

  1. For a banking company, where the client submits his Aadhaar number, authentication of the client’s Aadhaar number shall be carried out using e-KYC authentication facility provided by the Unique Identification Authority of India;
  2. For all reporting entities,
    1. where proof of possession of Aadhaar is submitted and where offline verification can be carried out, the reporting entity shall carry out offline verification;
    2. where an equivalent e-document of any officially valid document is submitted, the reporting entity shall verify the digital signature as per the provisions of the IT Act and take a live photo
    3. any officially valid document or proof of possession of Aadhaar number is submitted and where offline verification cannot be carried out, the reporting entity shall carry out verification through digital KYC, as per the prescribed Digital KYC Process

It is also expected that the RBI shall notify for a class of reporting entity a period, beyond which instead of carrying out digital KYC, the reporting entity pertaining to such class may obtain a certified copy of the proof of possession of Aadhaar number or the officially valid document and a recent photograph where an equivalent e-document is not submitted.

The August Notification has also laid emphasis on the fact that certified copy of the KYC documents have to be obtained. This means the reporting entity shall have to compare the copy of the proof of possession of Aadhaar number where offline verification cannot be carried out or officially valid document so produced by the client with the original and record the same on the copy by the authorised officer of the reporting entity. Henceforth, this verification can also be carried out by way of Digital KYC Process.

[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11566#F4

[2] http://egazette.nic.in/WriteReadData/2019/197650.pdf

[3] http://egazette.nic.in/WriteReadData/2019/210818.pdf

MCA revisits IEPF rules – Amends forms, timelines, nodal officer requirements etc

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Injeti Srinivas’s Committee: Changes recommended in provisions of Corporate Social Responsibility

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Provisions relating to DVR & DRR- stands amended

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Amendments introduced in Companies (Share Capital and Debentures) Amendment Rules, 2019

by Smriti Wadehra (smriti@vinodkothari.c0m)

The recent Notification of Ministry dated 16th August, 2019 has amended the provisions of Companies (Share Capital and Debentures) Rules, 2014 with respect to quantum of holding of equity shares with differential voting rights by a Company and provisions pertaining to creation of debenture redemption reserve. The amended provisions are applicable from the date of notification in the e-gazette i.e. 16th August, 2019.

Differential Voting Rights

SEBI in its Board Meeting dated 27th June, 2019 proposed insertion of the provisions of DVRs in SEBI ICDR Regulations. The proposal was w.r.t inter alia to cap the total voting rights of superior rights shareholders (including ordinary shares) at 74% of the total voting power. The respective amendments are still awaited. Meanwhile, the Ministry vide the aforesaid Notification amended the provisions under CA, 13 related to DVRs. The Notification has escalated the limit of DVR shares in the Company from 26% of total post-issue paid up equity capital of the Company to 74% of the total voting power.

The erstwhile provisions of the Companies (Share Capital and Debentures) Rules, 2014 permitted issuance of equity shares with differential rights subject to compliance of conditions mentioned in Rule 4(1) of the said Rules. One of criterion for issuance of equity shares with differential rights by a Company was that shares with differential rights should not exceed 26% of total post-issue paid up equity capital of the Company at any point of time. However, the amendment has increased this limit to 74% of the total voting power at any point of time. Notably, this is another significant highlight of the amendment  that the erstwhile cap of 26% was based on the post-issue paid up equity capital which has now been changed to 74% of the voting power.

Further, in this regard, condition on companies issuing shares with differential rights having consistent track record of distributable profits for the last three years have been done away with.

Debenture Redemption Reserve

The erstwhile provisions of Section 71(4) read with Rule 18(1)(c) of the Companies (Share Capital and Debentures) Rules, 2014 required every company issuing redeemable debentures to create a debenture redemption reserve (“DRR”) of at least 25% of outstanding value of debentures for the purpose of redemption of such debentures. Apart from creation of DRR, such companies were required to either deposit, before April 30th each year, in a scheduled bank account, a sum of at least 15% of the amount of its debentures maturing during the year ending on 31st March of next year or invest in one or more securities enlisted in Rule 18(1)(c) of Debenture Rules.

Under the erstwhile framework, the following classes of companies were required to comply with the provisions relating to DRR:

  1. NBFCs registered with RBI under section 45-IA of RBI Act, 1934 issuing debentures through public issue;
  2. Other listed companies coming up with public issue or private placement;
  3. Unlisted companies issuing debentures on private placement basis.

With a view to liberalise the legal framework surrounding issuance of debentures by NBFCs, the FinMin proposed Union Budget of 2019-20 proposed to scrap off the requirement of creation of DRR for publicly issued debentures also so as to motivate NBFCs.  Subsequently, the MCA came out with notification to amend the Companies (Share Capital and Debentures) Rules, 2014.

The amended provisions has exempted NBFCs registered with RBI and HFCs registered with National Housing Bank from creation of DRR in case of public issue of debentures. Further, the requirement of listed companies to create DRR has been done away with. The amended Rules have also lowered down the quantum of funds to be transferred to DRR by unlisted companies. However, as a flipside to the exemptions granted, the MCA has knowingly or unknowingly, unsettled an otherwise settled matter on creation of debenture redemption fund as per Rule 18(7).

Under the erstwhile provisions required creation of debenture redemption fund only by those companies on which DRR was applicable. However, under the current set of rules, the requirement to create DRF will apply to all listed companies, other than AIFIs or other FIs as per the clause of section 2(72). This new rule applies even to NBFCs.

It is pertinent to note that until now, NBFCs were required to create debenture redemption reserve only for publicly issued debt securities. However, under the new rule, all listed NBFCs will have to create a DRF even in case of private placement of debentures. This change in the rules seems to be contradicting the intention of proposal in the Union Budget.

The intention of the proposal was to promote NBFCs to explore Bond markets more often for fund raising, however, the language of the new rule has jeopardised the existing cases of debenture issuances, let alone be new debenture issuances. Considering the ongoing liquidity crisis, the entire financial system is going through, the implications of this requirement could be severe.

Creation of DRR is somewhat a liberal requirement then creation of DRF, this is because, where the former is merely an accounting entry, the latter is investing of money out of the Company and the fact the new rule casts an exemption from the first and not from the second makes the situation a bit awkward. Therefore, where there is no requirement even for annually conserving a part of their profits, the requirement of creating a fund out of the same becomes completely illogical.

Hence, in our view, the amendments have actually slashed the expectation to relax issuance of debentures by NBFCs and on the other hand has also taken away the available exemption to the NBFCs for not creating DRF in case of issuance of debt securities through private placement. The actual intent of the amendment would have been to reduce the requirement of DRR from somewhat say 25% to 10%, however, in a completely unexpected move, the requirement for parking liquid funds, in form of a debenture redemption fund (DRF) has been extended to all bond issuers except unlisted NBFCs (which are hardly any in India), irrespective of whether they are covered by the requirement of DRR or not.

In this regard, the notification also fails to clarify the basic question that is whether the requirement will be applicable to debentures/bonds already issued, before the date of the notification or only after the date of notification. Though, the language suggest that the same shall be applicable on debentures due for redemption after the date of notification, i.e. for debentures maturing during the year ending on 31st March, 2020. However, in our view, one should try to create a DRF for the debentures maturing within 31st March, 2020 itself. Lastly needless to say, the MCA notification needs to be considered immediately.

A brief analysis of the amendments are discussed below:

Applicability of DRR and Debenture Redemption Fund

a)    All India Financial Institutions and Banking Companies

b)   NBFCs registered with RBI under section 45-IA of RBI Act, 1934 and Housing Finance Companies registered with National Housing Bank

  1. Other companies

Synopsis of amendments in DRR provisions

Sl. No. Particulars Type of Issuance DRR as per erstwhile provisions DRR as per amended provisions DRF as per erstwhile provisions DRF as per amended provisions
1. All India Financial Institutions Public issue/private placement

 

 × × × ×
2. Banking Companies Public issue/private placement

 

 × × × ×
3.

 

 Listed NBFCs registered with RBI under section 45-IA of the RBI Act, 1934 and HFC registered with National Housing Bank

 

 Public issue √

 

25% of value of outstanding debentures

 × √ √
Private Placement

 

 × × × √
4. Unlisted NBFCs registered with RBI under section 45-IA of the RBI Act, 1934 and HFC registered with National Housing Bank

 

 

 Private Placement

 

  

×

  

×

  

×

  

×
5.

 

 Other listed companies

 

 Public Issue

 

 √

 

25% of value of outstanding debentures

 

 × √ √
Private Placement

 

 √

 

25% of value of outstanding debentures

 

 × √ √
6. Other unlisted companies Private Placement √

 

25% of value of outstanding debentures

 

 √

 

10% of the value of outstanding debentures

 √ √

 

Provisions updated as on 5th June, 2020 maybe viewed here

Easing of DRF requirement

 

 

 

 

 

Government credit enhancement for NBFC pools: A Guide to Rating agencies

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Vinod Kothari Consultants P Ltd (finserv@vinodkothari.com)

 

The partial credit enhancement (PCE) Scheme of the Government[1], for purchase by public sector banks (PSBs) of NBFC/HFC pools, has been discussed in our earlier write-ups, which can be viewed here and here.

This document briefly puts the potential approach of the rating agencies for rating of the pools for the purpose of qualifying for the Scheme.

Brief nature of the transaction:

  • The transaction may be summarised as transfer of a pool to a PSB, wherein the NBFC retains a subordinated piece, such that the senior piece held by the PSB gets a AA rating. Thus, within the common pool of assets, there is a senior/junior structure, with the NBFC retaining the junior tranche.
  • The transaction is a structured finance transaction, by way of credit-enhanced, bilateral assignment. It is quite similar to a securitisation transaction, minus the presence of SPVs or issuance of any “securities”.
  • The NBFC will continue to be servicer, and will continue to charge servicing fees as agreed.
  • The objective to reach a AA rating of the pool/portion of the pool that is sold to the PSB.
  • Hence, the principles for sizing of credit enhancement, counterparty (servicer) risk, etc. should be the same as in case of securitisation.
  • The coupon rate for the senior tranche may be mutually negotiated. Given the fact that after 2 years, the GoI guarantee will be removed, the parties may agree for a stepped-up rate if the pool continues after 2 years. Obviously, the extent of subordinated share held by the NBFC will have to be increased substantially, to provide increased comfort to the PSB. Excess spread, that is, the excess of actual interest earned over the servicing fees and the coupon may be released to the seller.
  • The payout of the principal/interest to the two tranches (senior and junior), and utilisation of the excess spread, etc. may be worked out so as to meet the rating objective, provide for stepped-up level of enhancement, and yet maintain the economic viability of the transaction.
  • Bankruptcy remoteness is easier in the present case, as pool is sold from the NBFC to the PSB, by way of a non-recourse transfer. Of course, there should be no retention of buyback option, etc., or other factors that vitiate a true sale.
  • Technically, there is no need for a trustee. However, whether the parties need to keep a third party for ensuring surveillance over the transaction, in form of a monitoring agency, may be decided between the parties.

Brief characteristics of the Pool

  • For any meaningful statistical analysis, the pool should be a homogenous pool.
  • Surely, the pool is a static pool.
  • The pool has attained seasoning, as the loans must have been originated by 31st March, 2019.
  • In our view, pools having short maturities (say personal loans, short-term loans, etc.) will not be suitable for the transaction, since the guarantee and the guarantee fee are on annually declining basis.

Data requirement

The data required for the analysis will be same as data required for securitisation of a static pool.

Documentation

  • Between the NBFC and the PSB, there will be standard assignment documentation.
  • Between the Bank and the GoI:
    • Declaration that requirements of Chapter 11 of the GFR have been satisfied.
    • Guarantee documentation as per format given by GOI

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

Other Related Articles :

Government Credit enhancement scheme for NBFC Pools: A win-win for all

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Vinod Kothari (vinod@vinodkothari.com)

The so-called partial credit enhancement (PCE) for purchase of NBFC/HFC pools by public sector banks (PSBs) may, if meaningfully implemented, be a win-win for all. The three primary players in the PCE scheme are NBFCs/HFCs (let us collectively called them Originators), the purchasing PSBs, and the Government of India (GoI). The Scheme has the potential to infuse liquidity into NBFCs while at the same time giving them advantage in terms of financing costs, allow PSBs to earn spreads while enjoying the benefit of sovereign guarantee, and allow the GoI to earn a spread of 25 bps virtually carrying no risks at all. This brief write-ups seeks to make this point.

The details of the Scheme with our elaborate questions and answers have been provided elsewhere.

Modus operandi

Broadly, the way we envisage the Scheme working is as follows:

  1. An Originator assimilates a pool of loans, and does tranching/credit enhancements to bring a senior tranche to a level of AA rating. Usually, tranching is associated with securitisation, but there is no reason why tranching cannot be done in case of bilateral transactions such as the one envisaged here. The most common form of tranching is subordination. Other structured finance devices such as turbo amortisation, sequential payment structure, provisions for redirecting the excess spread to pay off the principal on senior tranche, etc., may be deployed as required.
  2. Thus, say, on a pool of Rs 100 crores, the NBFC does so much subordination by way of a junior tranche as to bring the senior tranche to a AA level. The size of subordination may be worked, crudely, by X (usually 3 to 4) multiples of expected losses, or by a proper probability distribution model so as to bring the confidence level of the size of subordination being enough to absorb losses to acceptable AA probability of default. For instance, let us think of this level amounting to 8% (this percentage, needless to say, will depend on the expected losses of respective pools).
  3. Thus, the NBFC sells the pool of Rs 100 crores to PSB, retaining a subordinated 8% share in the same. Bankruptcy remoteness is achieved by true sale of the entire Rs 100 crore pool, with a subordinated share of 8% therein. In bilateral transactions, there is no need to use a trustee; to the extent of the Originator’s subordinated share, the PSB is deemed to be holding the assets in trust for the Originator. Simultaneously, the Originator also retains excess spread over the agreed Coupon Rate with the bank (as discussed below).
  4. Assuming that the fair value (computation of fair value will largely a no-brainer, as the PSB retains principal, and interest only to the extent of its agreed coupon, with the excess spread flowing back to the Originator) comes to the same as the participation of the PSB – 92% or Rs 92 crores, the PSB pays the same to the Originator.
  5. PSB now goes to the GoI and gets the purchase guaranteed by the latter. So, the GoI has guaranteed a purchase of Rs 92 crores, taking a first loss risk of 10% therein, that is, upto Rs 9.20 crores. Notably, for the pool as a whole, the GoI’s share of Rs 9.20 crores becomes a second loss position. However, considering that the GoI is guaranteeing the PSB, the support may technically be called first loss support, with the Originator-level support of Rs 10 crores being separate and independent.
  6. However, it is clear that the sharing of risks between the 3 – the Originator, the GoI and the Bank will be as follows:
  • Losses upto first Rs 8 crores will be taken out of the NBFC’s first loss piece, thereby, implying no risk transfer at all.
  • Losses in excess of Rs 8 crores, but upto a total of Rs 17.20 crores (the GoI guarantee is limited to Rs 9.20 crores), will be taken by GoI.
  • It is only when the loss exceeds Rs 17.20 crores that there is a question of the PSB being hit by losses.
  1. Thus, during the period of the guarantee, the PSB is protected to the extent of 17.2%. Note that first loss piece at the Originator level has been sized up to attain a AA rating. That will mean, higher the risk of the pool, the first loss piece at Originator level will go up to protect the bank.
  2. The PSB, therefore, has dual protection – to the extent of AA rating, from the Originator (or a third party with/without the Originator, as we discuss below), and for the next 10%, from the sovereign.
  3. Now comes the critical question – what will be the coupon rates that the PSB may expect on the pool.
    1. The pool effectively has a sovereign protection. While the protection may seem partial, but it is a tranched protection, and for a AA-rated pool, a 10% thickness of first loss protection is actually far higher than required for the highest degree of safety. What makes the protection even stronger is that the size of the guarantee is fixed at the start of the transaction or start of the financial year, even though the pool continues to amortise, thereby increasing the effective thickness.
    2. Assume risk free rate is R, and the spreads for AAA rated ABS are R +100 bps. Assume that the spreads for AA-rated ABS is R+150 bps.
    3. Given the sovereign protection, the PSB should be able to price the transaction certainly at less than R +100 bps, because sovereign guarantee is certainly safer than AAA. In fact, it should effectively move close to R, but given the other pool risks (prepayment risks, irregular cashflows), one may expect pricing above R.
    4. For the NBFC, the actual cost is the coupon expected by the PSB, plus 25bps paid for the guarantee.
    5. So as long as the coupon rate of the pool for the NBFC is lower than R+75 bps, it is an advantage over a AAA ABS placement. It is to be noted that the NBFC is actually exposing regulatory and economic capital only for the upto-AA risk that it holds.

Win-win for all

If the structure works as above, it is a win-win for all:

  • For the GoI, it is a neat income of 25 bps while virtually taking no real risks. There are 2 strong reasons for this – first, there is a first loss protection by the Originator, to qualify the pool for a AA rating. Secondly, the guarantee is limited only for 2 years. For any pool, first of all, the probability of losses breaching a AA-barrier itself will be close to 1% (meaning, 99% of the cases, the credit support at AA level will be sufficient). This becomes even more emphatic, if we consider the fact that the guarantee will be removed after 2 years. The losses may pile up above the Originator’s protection, but very unlikely that this will happen over 2 years.
  • For the PSB, while getting the benefit of a sovereign guarantee, and therefore, effectively, investing in something which is better than AAA, the PSB may target a spread close to AAA.
  • For the NBFC, it is getting a net advantage in terms of funding cost. Even if the pricing moves close to AAA ABS spreads, the NBFC stands to gain as the regulatory capital eaten up is only what is required for a AA-support.

The overall benefits for the system are immense. There is release of liquidity from the banking system to the economy. Depending on the type of pools Originators will be selling, there may be asset creation in form of home loans, or working capital loans (LAP loans may effectively be that), or loans for transport vehicles. If the GoI objective of buying pools upto Rs 100000 crores gets materialised, as much funding moves from banks to NBFCs, which is obviously already deployed in form of assets. The GoI makes an income of Rs 250 crores for effectively no risk.

In fact, if the GoI gains experience with the Scheme, there may be very good reason for lowering the rating threshold to A level, particularly in case of home loans.

Capital treatment, rating methodologies and other preparations

To make the Scheme really achieve its objectives, there are several preparations that may have to come soon enough:

  • Rating agencies have to develop methodologies for rating this bilateral pool transfer. Effectively, this is nothing but a structured pool transfer, akin to securitisation. Hence, rating methodologies used for securitisation may either be applied as they are, or tweaked to apply to the transfers under the Scheme.
  • Very importantly, the RBI may have to clarify that the AA risk retention by Originators under the Scheme will lead to regulatory capital requirement only upto the risk retained by the NBFC. This should be quite easy for the RBI to do – because there are guidelines for securitisation already, and the Scheme has all features of securitisation, minus the fact that there is no SPV or issuance of “securities” as such.

Conclusion

Whoever takes the first transaction to market will have to obviously do a lot of educating – PSBs, rating agencies, law firms, SIDBI, and of course, DFS. However, the exercise is worth it, and it may not take 6 months as envisaged for the GoI to reach the target of Rs 1 lakh crores.

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