Re-appointment of Independent Directors: An Analysis

/5 Comments/in , , /by

Sharon Pinto, Manager, corplaw@vinodkothari.com

Introduction

Proxy advisors are entities that undertake research on corporate governance norms and practices followed across different corporates. They formulate their policies based on their research and appropriately established benchmarks. The proxy advisory firms play a role in strengthening the corporate governance as investor clients access the reports and recommendation of the said advisory firms while forming their opinions. As investors due to their vast shareholding may not be privy to the working of the company, they may rely on the analysis done by the proxy advisors and their recommendations. We have discussed the scope of guidelines issued by proxy advisors in a separate article[1].

While such reports and guidelines as mentioned above can act as a guidance for the investors to take a sound decision, the legal standing of the report can be considered a hiccup in the said process as the same does not obtain regulatory approval. We have discussed the scope and legal validity of such guidelines in a separate article.[2]

One such guideline has been issued w.r.t. re-appointment of Independent Directors under Section 149 (10) of the Companies Act, 2013 (‘the Act’). The said contention has been a question of interpretation with different practices being followed by various companies. In this article we have discussed the interpretation of the said provision while stating the process of re-appointment of Independent Directors (‘IDs’).

Pre-requisites for appointment of IDs

Section 149 (6) of the Act read with Rule 5 of the Companies (Appointment & Qualification of Director) Rules, 2014 states the criteria that shall determine the independence of the director proposed to be appointed. In case of an entity with its specified securities listed on the stock exchange, the conditions set forth by Regulation 16 (1) (b) of SEBI (Listing Obligation and Disclosure Requirements) Regulations (‘SEBI Regulations’) shall also be fulfilled in order to be eligible for appointment as an ID. The said provisions under the Act and SEBI Regulations entail certain pecuniary limits which are necessary to ascertain any monetary relationship of the director with the company, which may affect their independence. As the given criteria is a pre-requisite at the time of appointment of a director, it shall also be mandatory to be fulfilled at the time of re-appointment. Thus, if an ID continues to be eligible as per the said conditions, they shall be proposed to be re-appointed for a second term in the company.

Pursuant to the SEBI (Listing Obligation and Disclosure Requirements), 2021 (Third Amendment Regulations), the criteria of independence prescribed under Regulation 16 (1) (b) has been revised aligning the same with the provisions of the Act. However, while the Act provides for the period of 2 immediately preceding financial years for determining whether the person or his relatives have any material pecuniary relationship with the company, the revised SEBI Regulations now prescribe for a period of 3 immediately preceding financial years for determination of the same.

Further, the conditions prescribed under the Act relating to holding of any interest or security, indebtedness, any guarantee or security provided in connection to indebtedness of a third person or any other pecuniary relationship with the company or its holding or subsidiary or associate company have also been inserted in the SEBI Regulations, which provide for stricter period of compliance of the said conditions. While, the relatives may be employees in the entities stated above, they are prohibited from holding the position of a KMP. As the criteria of independence is to be observed even in the case of re-appointment, these conditions will ensure the independence of the ID.

In addition to the criteria of independence, the existing IDs of the company are required to abide by the code of conduct prescribed under Schedule IV of the Act. Any breach of the code by the directors shall make them ineligible for continuing in the position of ID of the company.

Performance Evaluation

The re-appointment of an existing director for a second term, in addition with the establishment of their independence shall also be subject to performance evaluation. The Act under Section 178 (2) states that the Nomination and Remuneration Committee (‘NRC’) of the company shall formulate a criteria for determining the qualifications, positive attributes, independence for appointment of a director. Further the committee shall also establish a criteria for the evaluation of performance of the Board as well as individual directors. Thus on the basis of such performance evaluation and establishment of independence and possession of requisite skills by the director, the NRC shall recommend the appointment or in case of an existing director, re-appointment of the said director to the Board.

SEBI[3] has detailed an elaborated process to be followed by NRC for selection of ID, including more transparent and enhanced disclosures regarding  the  skills  required  for  appointment  as  an  ID  and  how  the proposed candidate fits into that skillset. As per the Third Amendment Regulations, the said additional disclosures stating the skills and capabilities required for the role and the manner in which the proposed person meets the requirements, will be required to be provided in the notice in the case of re-appointment of an ID. Thus, NRC of the company will be required to undertake an assessment determining whether the person proposed to be re-appointed as the ID possesses the skills required for the position in addition to performance evaluation even in the case of re-appointment.

SEBI under Regulation 17 (10) of the SEBI Regulations has stated that the performance evaluation of the IDs shall be done by the entire Board of Directors where the concerned ID shall not participate in the said discussion. The Board shall consider performance of the director in addition to fulfilment of independence criteria similar to the provisions stipulated under Companies Act, 2013 as discussed above. Thus the director proposed to be re-appointed has to satisfy the afore-mentioned dual conditions.

Process of re-appointment

Section 149 (10) of the Act has specified the process of reappointment of an ID. It states that a director shall be eligible for re-appointment by passing of a special resolution. Thus we may infer that in order to be re-appointed as an ID, a special resolution is required to be passed. Regulation 17 (11) of SEBI Regulations provides for stating recommendation of the Board for every for every special item of business in the explanatory statement annexed to the notice. As discussed above, Board on the basis of performance evaluation carried out and the recommendation of the NRC shall recommend the re-appointment of the ID. Criteria of independence being a pre-requisite for such re-appointment as established herein, the director shall be considered as an additional independent director until approval of shareholders is obtained at the general meeting of the Company.

Further, SEBI vide its consultation paper on Independent Directors[4] had proposed prior approval of shareholders for appointment and re-appointment of IDs, while stating that the existing procedure entails proposal of candidate by the NRC and appointment/re-appointment by Board which is subsequently approved by shareholders by an ordinary resolution in case of appointment whereas special resolution in case of re-appointment. Accordingly, seeking prior approval of shareholders is not a pre-requisite at present.

After end of first tenure of the ID, the office of director shall cease. Accordingly, Board will approve appointment as additional director till ensuing AGM and propose re-appointment as an ID for second term of upto 5 consecutive years.

As discussed above, re-appointment after the end of the tenure is required to be considered akin to fresh appointment of the person, thereby necessitating the confirmation with criteria of independence, assessment of skills and capabilities and the manner in which such appointee continues to meet the requirements of the company. Therefore, the Board has a power to appoint the person as an additional ID, whose appointment shall thereafter be approved at the general meeting.

Timeline for re-appointment

In order to understand the timeline in the case of re-appointment, we will have to consider the revised Regulation 17(1C) SEBI Regulations. Regulation 17 (1C) provides for approval of appointment of a person as a director of the company to be done within the next general meeting or 3 months, whichever is earlier. Since, re-appointment on account of end of term results into fresh appointment, the same shall also apply in case of re-appointment of an ID. Further, Regulation 25 (2A) has now provided for a special resolution to be obtained in case of appointment as well as re-appointment. The same prescribes for the mode of obtaining approval but is silent on the timeline, to be followed, requiring reference to Regulation 17 (1C). For a better understanding of the same, let us look at the following cases.

Case 1: Re-appointment of a person as an ID before the end of his/her tenure:

  1. The NRC of the company will be required to follow the due process for evaluation of the person for re-appointment as stipulated under the revised provisions and recommend the same to the Board.
  2. The Board will thereafter confirm on the skills and capabilities as required for the position and that the proposed appointee possesses the same and provide disclosure of the same to the shareholders in the notice for re-appointment.
  3. At the ensuing general meeting the company may re-appoint the person as ID for a second term by passing a special resolution with effect from the date immediately following the last day of the current tenure.

Case 2: Re-appointment of a person as an ID post the end of tenure:

  1. Since the tenure of the ID has been terminated, the office of the ID will stand vacated and the Board will be required to appoint the person as an Additional Director (Non-executive, ID category).
  2. The process as mentioned under points a & b above in relation to assessment of the candidate and requisite disclosures to be done will be required to be followed.
  3. As per Regulation 17(1C), shareholder approval for the re-appointment will be required to be obtained within 3 months of appointment by the Board as an additional ID or next general meeting, whichever is earlier.

Effect of re-appointment by the Board

The provisions of the Act mandate the shareholders to approve appointment of IDs at general meeting but does not mandate appointment from the date of general meeting. ‘Independent Director’ is the nature of directorship and ‘Additional Director, Non-Executive’ is the category of directorship. It cannot be inferred that the said director was not independent from the date of Board resolution appointing him as Additional Director till the date of general meeting. Therefore, the effective date of appointment can be considered from the date of Board resolution or any subsequent date prescribed by the Board.

The recent changes in the provisions as stated above will result in reducing the gap between appointment of an ID on the Board of the company and approval of the said appointment by shareholders. While it is seen that some companies take up the re-appointment of the IDs by way of postal ballot before the end of tenure in case there exists a gap between the AGM and the end of term, the same shall be construed as a good governance practice, as prior approval of shareholders has not been mandated by law on account of the same not being specifically stated. Thus in case of re-appointment post end of tenure, the same cannot be viewed as a violation of provisions.

Conclusion

The ambit of proxy advisors in India is as prescribed under SEBI regulations and guidelines issued in this regard. While they may issue guidelines based on the best governance practices as established by them and recommend the same to the investors, there is a need to incorporate a check for discerning the nature and scope of such guidelines, so the investor may have a clear view of the propositions put forth. With the process of appointment of IDs being enhanced in the manner specified above, in addition to the newly inserted disclosure requirements, will make the appointment/re-appointment process of IDs more transparent and effective while ensuring greater conformity of their independence.

 

Related presentation – https://vinodkothari.com/2021/08/ensuring-board-continuity-and-balance-of-capabilities/

[1] https://vinodkothari.com/2021/06/scope-of-proxy-advisors-to-issue-general-voting-guidelines/

[2] https://vinodkothari.com/2021/07/proxy-advisors-corporate-decision-making/

[3] https://www.sebi.gov.in/media/press-releases/jun-2021/sebi-board-meeting_50771.html

[4]https://www.sebi.gov.in/reports-and-statistics/reports/mar-2021/consultation-paper-on-review-of-regulatory-provisions-related-to-independent-directors_49336.html

Scope of Proxy Advisors to issue general voting guidelines

/0 Comments/in , , /by

Sharon Pinto, Manager, corplaw@vinodkothari.com

Introduction

The right to vote on decisions of the Company is one of the most significant rights of the investors. Proxy advisors are entities that enable shareholders to function this right effectively. They undertake research on corporate governance practices across various entities and formulate their policies in order to establish benchmarks of the best practices. Based on the said benchmarks, the proxy advisors also provide voting recommendations to the client investors. SEBI had formulated a working group[1] for determining issues relating to proxy advisors in November, 2018 and reviewing the existing provisions of SEBI (Research Analysts) Regulations, 2014 (‘SEBI Regulations’), that govern proxy advisory entities in India.

We have in our previous articles deliberated the concept of proxy advisors and their role in corporate democracy[2] as well as analysed the above-mentioned report of the working group[3] [4]. In recent times, there has been huge hue and cry regarding the certain voting recommendations put forth by proxy advisors. As the advisors have significant influence over institutional investors and may thus affect the voting results, it is necessary to understand the legal ambit of such guidelines and recommendations issued by these entities.

In this article we have discussed the scope of proxy advisors while ascertaining the legal validity of their opinions. The guidelines issued on re-appointment of ID have been discussed in a separate article.

Scope of Proxy Advisors

  1. International practices

1.USA

Investment advisors are required to be registered with the United States Securities and Exchange Commission (‘SEC’) under the Investment Adviser Act of 1940 and Rules[5] made thereunder. Rule 204A-1 of the said Act has prescribed that the investment advisors establish, maintain and enforce a written code of ethics that, at a minimum, includes:

“(1) A standard (or standards) of business conduct that you require of your supervised persons, which standard must reflect your fiduciary obligations and those of your supervised persons;

(2) Provisions requiring your supervised persons to comply with applicable Federal securities laws;

(3) Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically as provided below;

(4) Provisions requiring supervised persons to report any violations of your code of ethics promptly to your chief compliance officer or, provided your chief compliance officer also receives reports of all violations, to other persons you designate in your code of ethics; and

(5) Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.”

Institutional Shareholder Services (‘ISS’) is a registered investment advisor which provides general proxy voting guidelines[6] on various resolutions put forth at the meetings of investors. However, the following disclaimer forms part of the document:

“The Information has not been submitted to, nor received approval from, the United States Securities and Exchange Commission or any other regulatory body. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), or a promotion or recommendation of, any security, financial product or other investment vehicle or any trading strategy, and ISS does not endorse, approve, or otherwise express any opinion regarding any issuer, securities, financial products or instruments or trading strategies.”

Similar guidelines and policies have been issued by Glass Lewis & Co.[7] stating that these proxy voting guidelines are grounded in corporate governance best practices, which often exceed minimum legal requirements. Accordingly, unless specifically noted otherwise, a failure to meet these guidelines should not be understood to mean that the company or individual involved has failed to meet applicable legal requirements.

  1. Australia

Proxy advisers in Australia hold Australian financial services (AFS) licenses for only a portion of the services they provide – giving advice to wholesale investors on votes that relate to dealings in financial products. Providing voting recommendations on other matters (such as director elections and remuneration reports) does not require an AFS licence.

Further, as per the provisions of Section 912A of the Corporations Act, 2001 proxy advisors shall:

  • do all things necessary to ensure that the financial services are provided efficiently, honestly and fairly;
  • have adequate arrangements in place for the management of conflicts of interest that may arise wholly, or partially, in relation to activities undertaken in the provision of financial services;
  • have adequate resources (including financial, technological and human resources) to provide the financial services and to carry out supervisory arrangements;
  • maintain the competence to provide those financial services.

ASIC in its ‘Review of proxy advisor engagement practices’[8] has stated that a draft report shall be provided to the Company for fact-checking or where clarification is sought from the company, proxy advisers should endeavour to provide sufficient time for the company to consider the request and respond. Further, if it is intended that a draft report will be provided to the subject company, proxy advisers may wish to consider doing this in a controlled way, for example, without communicating recommendations or opinions that would be included in the final report. This may reduce disagreements between proxy advisers and companies as to whether errors reported by companies relate to fact or opinion. In case proxy advisors propose to recommend ‘against’ recommendations, ASIC has recommended that they shall notify companies of such recommendations and explain the reasons for those recommendations, to assist companies in understanding concerns held by the proxy adviser and responding to investors in the context of those concerns.

Further, proxy advisors are recommended to disclose the following in their reports:

  1. the nature, extent and outcome of engagement with the subject company;
  2. a summary of the subject company’s view on a particular issue where that view is different from the proxy adviser’s, or any additional information that has been provided by the company as a result of engagement.

At present, there is no prior engagement of the proxy advisors with the client. Similar provisions have been stated under SEBI Regulations and procedural guidelines which are applicable to proxy advisors operating in India, which state that the report shall be provided to the company and the client at the same time.

However, as per the consultation paper issued by The Treasury in April 2021[9], it has been recommended that the proxy advisors in Australia shall provide the report to the corporate entities prior to issuing of the same to clients. Further, communication with the company prior to issue of report in order to diminish any factual errors or mis-interpretation has also been proposed.

  1. Europe

The discussion paper on proxy advisory industry[10] issued by European Securities and Market Authority (ESMA), state that European proxy advisors generally tend not to develop their own guidelines but follow client’s policies or general recommendations. The voting policies and guidelines prepared are based on the relevant corporate governance standards. In the majority of cases these policies are usually formulated through a bottom-up process where information is collected from a diverse range of market participants (including issuers) through multiple channels. This policy can be fully adapted to local circumstances in a given country, or can incorporate more general beliefs about what constitutes good governance. Corporate governance codes, listing rules, company law, local regulations, new market trends, practices and academic research are used to create a set of guidelines against which corporate disclosures can be benchmarked. Moreover, it is a common practice for proxy advisors to integrate feedback from clients and, if available, issuers.

It further states that, certain proxy advisor may hold roundtables with various industry groups or other experts are also a way of receiving information and hearing different perspectives. Some proxy advisors are open for discussion about their policies and guidelines throughout the year while others are only open for discussion after the general meeting session. Proxy advisors, have to make sure voting policies and guidelines are sufficiently flexible to be applicable to the circumstances of each jurisdiction, sector and issuer. There may be issues arising on the accuracy, independence and reliability of the ultimate voting recommendations/proxy advice.

  1. United Kingdom

Proxy advisors that have their registered office or head office in United Kingdom or European Economic Area or in Gibraltar or provide proxy advisor services through an establishment located in the United Kingdom, are governed by the Proxy Advisors (Shareholders’ Rights) Regulations, 2019[11].

Following are the some of the provisions prescribed under the said regulations:

  • Where proxy advisors provide services in accordance with a code of conduct, they shall disclose the following:
  1. a reference to the code of conduct, by means of which any person may readily view it;
  2. a report on the manner in which the code of conduct has been applied; and
  3. in case of any deviation from any of the recommendations contained in the code of conduct, a statement which specifies the recommendations concerned, explains the reason for departing from them, and indicates any measures adopted instead of them.

Further, where the proxy advisors where no such code of conduct has been adopted, the proxy advisors must provide a clear and reasonable explanation for not doing so.

  • The proxy advisors are also required to provide the following disclosure w.r.t. assurance about accuracy and reliability of information:
  1. the essential features of the methodologies and models applied for the provision of those services;
  2. the main sources of information used for the provision of those services;
  3. the procedures put in place to ensure that firm’s research, advice and voting recommendations are of an adequate quality and are prepared by staff who are suitably qualified to prepare them;
  4. whether national market, legal, regulatory and company-specific conditions have been taken into account, if yes how;
  5. the essential features of the voting policies applied for each market;
  6. whether there is a dialogue with the company which is the object of research, advice or voting recommendations, or with persons who have a stake in that company, if yes, the extent and nature of the dialogue; and
  7. policy regarding the prevention and management of potential conflicts of interest.
  • Functioning of proxy advisors in India

Proxy advisors are governed by SEBI Regulations. The entities functioning as proxy advisors or research analysts are required to obtain a certificate of registration from the Board under these regulations. The regulations have stipulated the following w.r.t. contents of the report published by the advisory firms:

  1. Research analyst or research entity shall take steps to ensure that facts in its research reports are based on reliable information and shall define the terms used in making recommendations, and these terms shall be consistently used.
  1. Research analyst or  research  entity that  employs  a  rating  system  must  clearly  define the meaning  of  each  such  rating  including  the  time  horizon  and    benchmarks  on  which  a  rating  is based.
  2. If a research report contains either a rating or price target for subject company’s securities and the research analyst or research entity has assigned a rating or price target to the securities for at least one  year,  such  research  report  shall  also  provide  the  graph  of  daily  closing  price  of  such securities for the period assigned or for a three-year period, whichever is shorter.

Further, the procedural guidelines issued by SEBI for proxy advisors[12] states that the report of the proxy advisors shall be shared with its clients and the company at the same time. The timeline for receiving comments from the Company may be defined by the proxy advisors and all comments/clarifications received from the company, within timeline, shall be included as an addendum to the report. It also states that if the company  has  a  different  viewpoint  on  the  recommendations  stated  in  the  report  of  the  proxy advisors, then proxy advisors, after taking into account the said viewpoint, may either revise the recommendation in the addendum report or issue an addendum to the report with its remarks, as considered appropriate.

Similar to the regulatory provisions in USA, the proxy advisors registered in with SEBI shall abide by the code of conduct prescribed under Regulation 24 of SEBI Regulations.

As the views of proxy advisors are based on the best corporate governance practices and research thereon, they are required to clearly  disclose  in  their  recommendations the  legal requirement  vis-a-vis higher  standard  they  are  suggesting if  any, and  the rationale behind the  recommendation  of higher standards.

Legal position of guidelines issued by proxy advisors

  1. Research oriented

Proxy advisors undertake extensive research of the corporates to determine and set benchmarks. As evident from the global scenario and the working of proxy advisors in India as discussed above, one can opine that such guidelines are formed on the basis of the research undertaken by the said entities.

2.Interpretation of law

The said guidelines are a manifestation of the best governance practices that the companies may strive to achieve, which may at times exceed the prescribed legal requirements. They form the basis of opinions of the proxy advisory firms and are specifically the views of the issuing firms. Thus, the opinions of the advisory firms may be subject to other interpretations.

3.Generality of policies

Due to the generality of the guidelines issued, certain factual or practical factors may not be considered if the said guidelines are applied to the agenda items of various companies. The case to case specific factors, company or director backgrounds, etc may not be considered while applying the policies and hence may not depict a comprehensive view of the decision of the company.

4. Lack of overview by regulator

Since, these guidelines are not subject to approval of regulators, they are solely the opinions of the proxy advisory firms. Hence, a deviation from these guidelines cannot be construed as non-compliance of the prescribed laws. There is thus a need for including a statement to the said effect to establish a comprehensive standing of the recommendation or guidelines issued.

Safeguards against misleading statements

The procedural guidelines[13] issued by SEBI state that in case the proxy advisors have provided their recommendation based on higher standard, the rationale and such higher standard along with the legal requirement shall be clearly stated in the report published. Further, they shall provide their to the clients and the company simultaneously and are required to add as an addendum to their report, the comments and clarification received by the company in case of difference of opinions.

The report of the Working Group stated above recommended that if the proxy advisors have a different interpretation from the company and the same is not on the basis of factual errors, the proxy advisors are not obligated to publish both view-points, in case the company has enough resources to publish their response.

In case of any dispute arising between the proxy advisor and the corporate, which is a violation of the code of conduct prescribed under the SEBI (Research Analyst) Regulations, 2014, the same may be referred to SEBI. However, the same shall not be a means to refute the interpretation of the proxy advisor, rather only cases of misuse of power in violation of the said code of conduct can be reported to SEBI. However, there is no statutory requirement prescribed for including a disclaimer in the report of the proxy advisor stating that the views mentioned in the report are solely of the advisory firm and there may exist other interpretations as the said report is not sanctioned by any regulator.

Conclusion

It is necessary that the investors take an independent view bearing into mind the scope of the guidelines while considering the voting recommendations of the proxy advisors. They must also be aware of the scope of policies issued by the advisory firms. While the concept of proxy advisors acts as a tool for strengthening corporate governance and enabling investors to take sound investment decisions, there is a need for establishing better safeguards for portraying a clear picture to the investors so that they may formulate independent views.

[1]https://www.sebi.gov.in/reports/reports/jul-2019/report-of-working-group-on-issues-concerning-proxy-advisors-seeking-public-comments_43710.html

[2]http://vinodkothari.com/wp-content/uploads/2017/03/Dance_of_Corporate_democracy-_rise_of_proxy_advisors-1.pdf

[3] http://vinodkothari.com/wp-content/uploads/2020/08/SEBI-prescribes-stricter-regime-for-proxy-advisors.pdf

[4]http://vinodkothari.com/wp-content/uploads/2019/08/SEBI-revisits-the-regulatory-framework-for-Proxy-Advisors.pdf

[5]https://www.ecfr.gov/cgi-bin/text-idx?SID=e0ff318417c1a2b70a9ea2ce5f0307aa&mc=true&node=pt17.5.275&rgn=div5

[6] https://www.issgovernance.com/file/policy/active/asiapacific/Asia-Pacific-Regional-Voting-Guidelines.pdf

[7] https://www.glasslewis.com/wp-content/uploads/2020/11/US-Voting-Guidelines-GL.pdf?hsCtaTracking=7c712e31-24fb-4a3a-b396-9e8568fa0685%7C86255695-f1f4-47cb-8dc0-e919a9a5cf5b

[8] https://www.asic.gov.au/media/4778954/rep578-published-27-june-2018.pdf

[9] https://treasury.gov.au/sites/default/files/2021-04/c2021-169360_consultation_paper.pdf

[10] https://www.esma.europa.eu/sites/default/files/library/2015/11/2012-212.pdf

[11] https://www.legislation.gov.uk/uksi/2019/926/made

[12] https://www.sebi.gov.in/legal/circulars/aug-2020/procedural-guidelines-for-proxy-advisors_47250.html

[13] https://www.sebi.gov.in/legal/circulars/aug-2020/procedural-guidelines-for-proxy-advisors_47250.html

Dividend restrictions on NBFCs

/1 Comment/in /by
– Financial Services Division (finserv@vinodkothari.com)

Background

The Reserve Bank of India (RBI) vide a notification dated 24th June, 2021[1] imposed restrictions on distribution of dividends by non-banking financial companies (‘Notification’). The restrictions cover both systemically important NBFCs as well non-systemically important ones. The guidelines have been issued in line with the draft guidelines for the declaration of dividends by NBFC issued in December 2020. Restrictions on dividend payout essentially force financial sector entities to plough back a minimal part of their profits, and therefore, result in creation of a profit conservation. Such restrictions are common in case of financial institutions world-over, and are also imbibed as a part of Basel III capital adequacy requirements. Similar restrictions exist in case of banking entities[2]. In case of NBFCs, such restrictions were proposed by the RBI vide Draft Circular on Declaration of Dividend by NBFCs dated December 9, 2020[3]. Dividend Payout Ratio (DP Ratio) is an important policy measure for companies for shareholder wealth maximisation. A conservative dividend distribution policy ensures churning of profits thereby ensuring organic growth of the net worth, and assisted by leverage, a return on shareholders’ funds higher than what the shareholders can fetch on distributed money. On the other hand, aggressive dividend distribution policy entails that profits be returned to the shareholders as there are less business investment opportunities, thus wealth of shareholders be returned. The foregoing arguments does not encompass stictict dividend payout criteria, but a broad policy objective which organisations seek to achieve. However, in the case of financial institutions like Banks and NBFCs  the motivation of regulators to limit the dividend payout is from the perspective of prudential regulation. The limit on dividend distribution allows regulators to ensure that adequate capital conservation buffers are maintained at all times by the financial institutions. Most NBFCs follow very conservative dividend policies, and based on publicly available data, the DP Ratios of some of the NBFCs for FY 2019-20 are as follows:
  1. Manappuram- 18.86%
  2. Cholamandalam- 12.78%
  3. Bajaj Finserv- 11.93%
  4. Muthoot Finance- 19.91%
  5. Tata Capital Financial Services- 32.96%
  6. DCM Shriram- 17.19%

Applicability

Who all are covered? The opening statement of the Notification provides that the Notification is applicable on all NBFCs regulated by RBI. Further, reference is made to the term ‘Applicable NBFCs’  as defined under the respective RBI Master Directions on NBFC-ND-SI and NBFC-ND-NSI. The concept of Applicable NBFC is relevant to determine the applicability of the provisions of the aforesaid RBI Master Directions. Accordingly, it can be understood that, along with the ‘Applicable NBFCs’, the following categories of NBFCs shall be covered under the ambit of the Notification-
  1. Housing Finance Companies (HFCs),
  2. Core Investment Companies (CICs),
  3. Government NBFCs,
  4. Mortgage Guarantee Companies,
  5. Standalone Primary Dealers (SPDs),
  6. NBFC-Peer to Peer Lending Platform (NBFC-P2P)
  7. NBFC- Account Aggregator (NBFC-AA).
  8. NBFC-D (deposit taking NBFCs)
  9. NBFCs-ND (non-deposit taking NBFCs) (both SI and NSI)
  10. NBFC-Factor (both SI and NSI)
  11. NBFC-MFI (both SI and NSI)
  12. NBFC-IFC (both SI and NSI)
  13. IDF-NBFC
However, it is to be noted that For NBFCs that do not accept public funds and do not have any customer interface no limit has been imposed with regards to the dividend payout ratio. Effective from which financial year? Effective for declaration of dividend from the profits of the financial year ending March 31, 2022 and onwards. Which all dividends are covered? Proposed dividend shall include both dividend on equity shares and compulsorily convertible preference shares. However, other than CCPS, dividends declared on preference shares are not included under the Notification. Note that the issue of bonus shares is, in essence, capitalisation of profits, and therefore, is not affected by the present requirement.

Computation of dividend payout ratio:

Besides the upfront conditionalities such as capital adequacy ratio, leverage ratio, etc., the stance of the present Notification is limitation on dividend payout ratio. Hence, the meaning of the DP ratio becomes important. The Notification defines the same as : ‘the ratio between the amount of the dividend payable in a year and the net profit as per the audited financial statements for the financial year for which the dividend is proposed.’ As we discussed elsewhere, the word “dividend” shall be restricted to only equity and CCPS dividend. Hence, dividend on redeemable preference shares shall be excluded. Also note that the word “profit for the year” refers to profits after tax. There is no question of adding the brought forward profits of earlier years, whether parked in reserves or retained as surplus in the profit and loss account. In case of companies adopting IndAS, there are always questions on what constitutes distributable profits – whether the gains or losses on fair valuation, taken to P/L are a part of the distributable profits or not. The relevant provisions of the Companies Act, viz., proviso to sec. 123 (1) shall have to be borne in mind.

Eligibility Requirement and Quantum Restrictions

Category Eligibility Requirement Quantum*
NBFCs (including SDPs) meeting prudential requirements ●  Complies with applicable regulatory capital adequacy requirements/leverage restrictions/Adjusted net-worth for each of the last three financial years including the financial year for which the dividend is proposed

○ For SPDs, minimum CRAR of 20% to be maintained for the financial year for which dividend is proposed.

● Net NPA ratio shall be less than 6% in each of the last three years, including as at the close of the financial year for which dividend is proposed to be declared.

○ Calculation of NNPA

● Complies with the provisions of Section 45 IC of the RBI Act/ Section 29 C of the NHB Act, as the case may be, that is to say, has transferred 20% of its net profits to the regulatory reserve fund ● No explicit restrictions placed by the regulator on declaration of dividend		 ●  Type I NBFCs- No limit●  CICs and SPDs- 60% ●  Other NBFCs- 50%
NBFCs (other than SPDs) not meeting prudential requirements ● Complies with the applicable capital adequacy requirements/ leverage restrictions in the financial year for which dividend is proposed to be paid● Has net NPA of less than 4% as at the close of the financial year. 10%
As regards NBFC-ND-NSI, the applicable regulatory capital requirement, as mentioned in Annex I[4] of the Notification,  seems to suggest that if there is a breach of leverage ratio at any time since 2015, the NBFC is disqualified. This however, does not seem to be the intent of the regulator. The meaning of the aforesaid restriction should be that the provision became applicable from 2015; however, it should not be leading to a conclusion that a dividend distribution will ensure that there is no breach of leverage ratio at any time in the history of the said NBFC. We are of the view that each of the ratios (CRAR or Leverage of Adjusted Net worth, as the case may be) need to be observed ideally at the time of distribution (last three FYs including the year for which dividend is declared), and even conservatively, during the year in question. *The Notification has prescribed the same limits on quantum for a certain class of NBFCs, however, the draft guidelines had prescribed the limits based on the CRAR or adjusted net-worth of the NBFCs. (Refer Annex I of draft guidelines)

Reporting Requirements

NBFC-D, NBFC-ND-SIs, HFCs & CICs declaring dividend shall report details of dividend declared during the financial year as per the prescribed format within a fortnight after declaration of dividend to the Regional Office of the RBI/Department of Supervision of NHB, as the case may be. There seems to be a lack of clarity w.r.t. the disclosure requirement for NBFC-MFIs and NBFC-IDFs. Though they are covered under the definition of ‘Applicable NBFCs’ under the RBI Master Directions, however, they are not generally classified as NBFC-ND-SI. Hence, whether the disclosure requirement is applicable to them or not seems to create confusion. In our view, going by prudence, this must be adhered to by such systemically important MFI and IDFs as well. Accordingly, it can be inferred that the disclosure requirements shall not be applicable to following:
  • Mortgage Guarantee Companies,
  • Standalone Primary Dealers (SPDs),
  • NBFC-Peer to Peer Lending Platform (NBFC-P2P)
  • NBFC- Account Aggregator (NBFC-AA).
  • NBFCs-ND-NSIs

Comparison with the dividend regulations on Banks

Criteria Bank NBFCs
Eligibility Only those banks would be eligible to declare dividends who have a CRAR of at least 9% for preceding two completed financial years and the accounting year for which it proposes to declare dividend and Net NPA less than 7% NBFC-ND-NSI with leverage upto 7 times and NBFC-ND-SI with a CRAR of not less than 15% for last three years (including the FY for which dividend is declared) and Net NPA less than 6% in each of the last three years
In case not meeting eligibility In case any bank does not meet the above CRAR norm, but has a CRAR of at least 9% for the accounting year for which it proposes to declare dividend, it would be eligible to declare dividend provided its Net NPA ratio is less than 5% In case any NBFC does not meet the above eligibility criteria for each of the previous three FY, but meets the capital adequacy for the accounting year, for which it proposes to declare dividend and has a Net NPA ratio of less than 4% at the close of the FY, it shall be allowed to declare dividend, subject to a maximum of 10% on the DP ratio.
Quantum Dividend payout ratio shall not exceed 40 % and shall be as per the prescribed matrix CIC’s and SPDs shall ensure the maximum dividend payout ratio does not exceed 60%, while the other NBFCs shall not exceed 50% of the DP ratio. For Type I NBFCs there is no limit.
Reporting All banks declaring dividends should report details of dividend declared during the accounting year as per the proforma furnished by RBI NBFC-Ds, NBFC-ND-SIs, HFCs & CICs declaring dividend should report the details of dividend within a fortnight after declaration of dividend to RBI/NHB, as may be applicable.

Immediate Actionables

NBFCs, who already have a Dividend Distribution Policy in place, may have to amend the policy in line with the Notification. As per SEBI LODR Regulations, top 1000 listed companies are mandatorily required to have a dividend distribution policy.  Further, NBFCs may also have voluntarily adopted a policy. The dividend distribution policy includes the following parameters:
  • the circumstances under which the shareholders may or may not expect dividend;
  • the financial parameters that shall be considered while declaring dividend;
  • internal and external factors that shall be considered for declaration of dividend;
  • policy as to how the retained earnings shall be utilized; and
  • parameters that shall be adopted with regard to various classes of shares
The eligibility requirements and limits on quantum of dividend, as provided in the Notification,  may be additional criterias for such NBFCs to declare dividend. In such a case, the existing dividend distribution policy shall be required to be amended in order to include the additional parameters. It is noteworthy here that, as per regulation 43A of the LODR, if a listed entity proposes to amend its dividend distribution policy, it shall disclose the changes along with the rationale for the same in its annual report and on its website. [1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12118&Mode=0 [2] https://www.rbi.org.in/scripts/FS_Notification.aspx?Id=2240&fn=2&Mode=0 and other associated circulars [3] https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50777 [4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/NBFCS24062021_A1.pdf Our related write-ups:
FAQs on Dividend Distribution Policy
Our presentation on dividends – https://vinodkothari.com/2021/09/an-overview-of-the-regulatory-framework-of-dividends/ Watch our YouTube video on Restrictions on dividend distribution on NBFCs

Revising minimum public holding requirements for large issuers and companies under CIRP

/0 Comments/in /by

Securities Contract (Regulations) Amendment Rules, 2021 notified

Payal Agarwal, Executive ( corplaw@vinodkothari.com )

Background

SEBI had released a consultation paper on 20th November, 2020 order to review the requirements of minimum public offer for large issuers. The Consultation Paper proposed to reduce the requirements of minimum public offer for large issuers while also reducing the time period to meet the minimum public shareholding requirement (“MPS”). Further, SEBI had released another consultation paper on 19th August, 2020 for review of minimum public shareholding requirements for companies undergoing CIRP under IBC, wherein the Consultation Paper suggested three different modes of recalibrating the requirement for MPS upon approval of resolution plan.

Consequently, the Ministry of Finance has notified the Securities Contract (Regulations) Amendments Rules, 2021 (“the Amended Rules”) on 18th June, 2021 to amend Rule 19 and 19A of the Securities Contract (Regulations) Rules, 1957 (“the Rules”) giving effect to the above-mentioned proposals.

Reduction in minimum public shareholding requirement for large issuers

Who are large issuers?

Large issuers are issuers with post issue market capitalisation (‘MCap’) equal to or above Rs. 4000 crores. Currently all issuers with an MCap of Rs. 4000 crores are required to dilute 10% of an IPO to public shareholding. Large issuers have now been bifurcated into large issuers (MCap of Rs. 4000 crores and above) and very large issuers (MCap of Rs.  1 lakh crores).

New minimum public offer requirements for large issuers as per the Amended Rules

The post issue MCAP requirement for large and very large issuers has now been amended as below –

Accordingly, a flat rate of 10% has been set for large issuers while an incremental rate has been set for very large issuers with a post issue MCap of Rs. 1 lakh crores and above. For issuers below these thresholds, the existing requirements continue.

New MPS requirement

Currently, companies are required to meet the MPS within 3 years from the date of listing. However, in case of large issuers, the MPS is to be met as follows –

Rationale as proposed in the Consultation Paper

The reduction in the minimum public offer requirements for large issuers was proposed due to the following reasons –

  • The compliance of such minimum public shareholding requirements is cumbersome for the large issuers.
  • The large issuers already have investments from strategic investors who are classified as “public shareholders” post listing. Therefore, the requirement of minimum public offer results in unnecessary dilution of control of promoters thereby imposing constraints on issuers.

Minimum public shareholding requirement for companies under Resolution Plan

Further, amendments have been made in Rule 19A of the Rules, with respect to the minimum public shareholding requirements for a company under CIRP under Insolvency and Bankruptcy Code, 2016 (‘IBC’).The Amended Rules provide a strict-er timeline for post-CIRP companies to comply with the MPS requirements upon implementation of resolution plans

Change in the requirements as per the Amended Rules are as follows –

Particulars Requirement before amendment Requirement as per Amended Rules
Public shareholding falls below 25% Bring to 25% within 3 years of such fall No change
Public shareholding falls below 10% Bring to 10% within maximum 18 months of such fall Bring to 10% within maximum 12 months from such fall
Minimum public shareholding to be maintained No such requirement Shall not fall below 5%

Rationale as proposed in the Consultation Paper

The relaxations with respect to the strict enforcement of Rule 19 of the Rules have been given in order to ensure revival of a Corporate Debtor pursuant to a resolution plan. However, while the same seems to be in favour of Corporate Debtors, specifying no MPS requirement may result in cases where the public shareholding will become extremely low, leading to less float, thereby hampering the market integrity and price discovery in secondary market.

The Consultation Paper suggested three different alternatives out of which the second one has been preferred since the MPS of 5% being a lower threshold will incentivise the companies to stay listed post-CIRP whereas higher thresholds may cause total delisting

The said requirement shall have significant ramifications for resolution applicants who otherwise are more focused on operational aspects over regulatory requirements. While resolution plans relaxes several requirements like an open offer under SAST regulations, it is significant to note that requirements w.r.t. MPS were never completely waived off. The present step of giving more stringent timelines is introduced with the objective of protecting the investors’ interest and shielding them from the possible loss of value due to delayed MPS adherence. The loss of value can be on account of delisting of such corporate debtors under CIRP, whereas the shareholders may recover potential value from the shares of such corporate debtor if it continues to remain listed post implementation of resolution plan.

CEOs as deemed Managers: Ascertaining their true role and liability

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Sharon Pinto, Manager, corplaw@vinodkothari.com 

Introduction

The Board of directors of a Company typically comprises of executive and non-executive directors. The Board is supported by the Key Managerial Personnel (‘KMP’) and senior management i.e. personnel of the company who are members of its core management team excluding Board of Directors comprising all members of management one level below the executive directors, including the functional heads. KMPs have been defined under Section 2 (51) of Companies Act, 2013 (‘Act’/ ‘CA, 2013’) to include Chief Executive Officer (‘CEO’) or Managing Director (‘MD’) or Manager, thus placing them on the same pedestal while differentiating the said posts on the basis of mere nomenclature. Due to the said differentiation in nomenclature, it is often seen that companies have a practice of regarding the person designated as CEO different from Manager of the company. Thus, the person holding a position at the head of the organisational hierarchy, is interpreted to not be the Manager on account of only being designated as CEO of the company. The result of this rationale / categorisation results in avoidance of the restrictions and procedures for appointment and remuneration as enlisted under the Act under Section 196 and 197 which specifically prescribe that the terms of appointment shall be placed before the shareholders, for a Manager in case of appointment of a CEO.

The position of a ‘Manager’ in the corporate organisational structure has been around for decades. It has been defined under Companies Act, 1956 which can also be seen in the Companies Act, 2013. In recent times, corporates have developed a pattern of designating the head of the corporate organisation, with substantial powers of the management, as CEO who is often a professional, rather than designating the said person as Managing Director or Manager and appointing them on the Board. A few examples of such corporates which have the CEO as the head of the organisation include Microsoft, Pepsico, Google Inc, etc.

We have in our previous article[1] deliberated on the various combinations of KMP positions that can legally be held by two different individuals. In this article we shall discuss the concept of CEO and analyse whether the same is different from the positions of a Manager and MD.

Concept of CEO

  • Companies Act

The term CEO was not mentioned under Companies Act, 1956. It was included and defined under the Act, 2013 and formed part of the definition of KMP. As per the Report of JJ Irani Committee[2], as KMPs play a significant role of formulating and executing company policies. Thus, in order to provide a legal recognition to KMPs and also to define their liabilities arising out of such a position held, the committee recommended the following to be identified as KMP:

  1. Chief Executive Officer (CEO)/Managing Director
  2. Company Secretary (CS)
  3. Chief Finance Officer (CFO)

The committee further recommended key managerial personnel including WTDs and MDs shall not be in whole time employment of more than one company.

The report of the Company Law Committee[3] dated February 2016, recommended that a whole time KMP may hold more than one position in the company in order to reduce cost of compliance and to facilitate optimum utilisation of their skills and competencies. The committee further recommended flexibility in appointing other officers of the company in whole-time employment as KMP, pursuant to which the definition of KMP was expanded to include ‘such other officer, not more than one level below the directors who is in whole-time employment, designated as key managerial personnel by the Board’ under its ambit.

Section 2 (18) of the Act defines a CEO as ‘an officer of a company, who has been designated as such by it.’ Thus the position of CEO is designation oriented and the role is not specifically defined under the Act. Therefore, a person performing the role of any other KMP as specified under the Act, may be designated as a CEO.

  • Listing Regulations

Regulation 2 (1) (e) of SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (‘Listing Regulations’), have defined CEO as the person so appointed in terms of the Act. The erstwhile Listing Agreement vide Clause 49 (IX) stated as follows:

“The CEO, i.e. the Managing Director or Manager appointed in terms of the Companies Act, 1956 and the CFO i.e. the whole-time Finance Director or any other person heading the finance function discharging that function shall certify to the Board that:”

In order to harmonize the provision with the newly inserted definition of KMP under Companies Act, 2013, the said clause was amended[4] as follows:

“The CEO or the Managing Director or manager or in their absence, a Whole Time Director appointed in terms of Companies Act, 2013 and the CFO shall certify to the Board that :”

The above-mentioned provision also specifies that CEO shall be the officer so designated by the Company, who may have the role of a Manager or a Managing Director on line with the specification under the Act.

Analysis of the role and function of CEO, Manager, MD

The Act under Section 2 (53), defines Manager as ‘an individual who, subject to the superintendence, control and direction of the Board of Directors, has the management of the whole, or substantially the whole, of the affairs of a company, and includes a director or any other person occupying the position of a manager, by whatever name called, whether under a contract of service or not’. Whereas an MD is defined under Section 2(54) as ‘a director who, by virtue of the articles of a company or an agreement with the company or a resolution passed in its general meeting, or by its Board of Directors, is entrusted with substantial powers of management of the affairs of the company and includes a director occupying the position of managing director, by whatever name called. In Regina v. Boal, (1992) BCLC 872 (CA[5]), it was held that assistant general manager of its bookshop, had responsibility for the day to day running of the shop but had been given no training in management, health and safety at work or fire precautions. Thus only those who were in a position of real authority, who had both the power and the responsibility to decide corporate policy would be construed to be ‘Manger’ for the purpose of the Act. It also needs to be noted that the person occupying the position of a ‘Manager’ should be under the superintendence of the Board.

Thus, the definition of Manager can be construed to be function based, irrespective of the designation of the individual. The same has been held in the SC judgment of Ramchandiram Mirchandani v. The India United Mills Ltd., AIR 1962[6] wherein the apex court held that the definition of the word “manager” is very wide, and whatever be the nomenclature employed by the parties, if large powers of management of substantially the whole business of the company are vested in a person then that person becomes the manger. In Basant Lal v. The Emperor[7] it was held that it was held that a person who is not in charge of the entire business of the company cannot be deemed to be a manager. In the case of Commissioner Of Income-Tax, Kerala Vs.Alagappa Textile (Cochin) Ltd. 1980[8], the Supreme Court held that Manager must be an individual, having the management of the whole or substantially the whole affairs of the company, subject to the superintendence, control and directions of the Board of Directors in the matter of managing the affairs of the Company. The key difference between a Manager and an MD is that an MD has substantial powers of management and is also on the Board of the company, while a Manager has the management of whole or substantially the whole of the business of the Company. There are judicial precedents that indicate that while both enjoy substantial powers of management, the source from which this power arises is different. In case of manager his power is natural and in case of an MD, it has to be entrusted by the Board in him.

On perusal of the above roles of the MD and Manager, basis the provisions, it is evident that an individual who has been entrusted with whole or substantial powers of management, shall be said to be performing the role of a Manager. Further, if the said individual is a director of the company he may be designated as the MD. However, companies may choose to designate the individual otherwise i.e. CEO of the company, if the said role and powers of management rest with the concerned officer. Thus, one can opine that the person who is at the top of the corporate hierarchy, with whole or substantially whole powers of the management and affairs of the company, in cases where not explicitly designated as ‘Manager’ shall be deemed to be a Manager of the company. CEO is a designation and the position of Manager is based on function. Merely, by not designating an individual as a Manager, compliance under the provisions of the Act cannot be avoided.

Compliances relating to appointment and remuneration

As per the analysis stated above, the procedure and restrictions relating to the appointment of a Manager shall be applicable to a CEO who holds such a position of a deemed Manager of a company. Thus, the company is required to comply with the provisions of Section 196 for appointment of such a person. The term of the deemed Manager shall not exceed 5 years at a time, wherein the re-appointment shall be done not less than 1 year before the end of the term. Further, the appointee shall have to satisfy the criteria and conditions specified in sub-section 3 of Section 196 in order to get appointed. As per the said provisions, the terms of the appointment and remuneration will be subject to approval of shareholders. Further, Part I of Schedule V has set forth certain conditions to be fulfilled in order to be appointed as a Manager. In case of appointment in variance of these conditions, the company in addition to approval by shareholders, is also required to obtain approval from the Central Government by stating the rationale of appointing such a person.

Similarly, the provisions relating to managerial remuneration specified in Section 197 read with Part II of Schedule V as applicable to a Manager shall be applicable to a deemed Manager. Thus the deemed Manager shall be entitled to remuneration as per the limits specified in this regard under Section 197 subject to approval of shareholders. Therefore, while determining the cap of total managerial remuneration i.e. 11% of the net profits of the company, the remuneration paid to CEO who plays the role of deemed Manager will also be required to be included. If there is an increase in the said cap, it will require approval from the shareholders of the company. Further, the said provisions also place a bar on the individual limits of remuneration paid to the Manager, which shall not exceed 5% of net profits of the company in case of not more than one MD/WTD/Manager and 10% of total remuneration payable to more than one MD/WTD/Manager. If the company wishes to pay in excess of the limits thus prescribed it may do so by obtaining approval of the shareholders in the form of a special resolution.

In case the company has inadequate or no profits, it is required to abide by the limits prescribed under Part II of Schedule V subject to approval of shareholders. Further, in case the company wishes to pay in excess of the said thresholds, the shareholders approval will be required to be obtained in the form of a special resolution.

The above-mentioned provisions of the Act do not cover the appointment and remuneration of KMPs other than MD, WTD and Manager. Since the CEO is considered to be different from Manager, their appointment and remuneration in many cases are not approved by the shareholders of the Company. However as per the analysis stated above, in case of a CEO having substantial powers of the management and being on the head of the organisational hierarchy, there is a need that their terms of appointment and remuneration to be paid is placed before the members of the company.

Circumstances which would result in consideration as deemed Manager under the Act

Particulars of cases Whether Manager under the Act Rationale
Branch Manager × A Branch Manager does not have whole or substantial powers of the management of the company in addition to not being under the superintendence of the Board.
Factory Manager × Similar as in the case of a Branch Manager, a Factory Manager has limited powers relating to a specific unit of the company.
CEOs appointed for specific business verticals of the company × As the powers and responsibility of the said CEO would be limited to the specific business division of the company and would not entail overseeing the overall affairs of management.
CEO where the company has a separate MD or Manager × In case the company has an MD, the powers of the MD shall include substantial control over the management and affairs of the company as per Section 2 (54) of the Act.
CEO where the company does not have an MD or Manager √ In case of no MD/Manager, the CEO shall be the deemed Manager of the company on account of having whole or substantially whole powers over the affairs of the company.
Person designated as CEO and MD √ A Manager as defined under Section 2 (53) includes a director occupying the position of a Manager, by whatever name called.

Conclusion

The intent of defining KMPs of the company separately under the Act was to ascertain the legal liability and to define their roles on account of them being the visionary and executive authority carrying out the policies and functions of the company. With power comes responsibility and it is lucid from the discussion above that the person having the requisite powers would be subject to the restrictions and procedures prescribed under the provisions in this regard, irrespective of the designation assigned to the post.

 

Kindly find below additional resources on the above-discussed topic:

  1. http://vinodkothari.com/?s=remuneration
  2. http://vinodkothari.com/wp-content/uploads/2018/10/Appointment-and-Remuneration-of-Managerial-Personnel.pdf
  3. http://vinodkothari.com/wp-content/uploads/2019/09/Manangerial-Remuneration_IMTB-_26.08.pdf
  4. http://vinodkothari.com/2018/09/managerial-remuneration-a-five-decades-old-control-cedes/
  5. http://vinodkothari.com/2018/10/applications-with-cg-for-managerial-remuneration/
  6. http://vinodkothari.com/wp-content/uploads/2018/09/Defaulter-companies-to-seek-lenders-nod-to-pay-managerial-remuneration-1-1.pdf

[1]http://vinodkothari.com/wp-content/uploads/2017/03/The_Combinations_of_KMP_positions_in_a_Company_Unravelling_a_mystery.pdf

[2] https://www.mca.gov.in/bin/dms/getdocument?mds=TRnXREiyG027hEwjF77x3w%253D%253D&type=open

[3] https://www.mca.gov.in/Ministry/pdf/Report_Companies_Law_Committee_01022016.pdf

[4] https://www.sebi.gov.in/sebi_data/attachdocs/1410777212906.pdf

[5] http://www.uniset.ca/other/cs4/1992QB591.html

[6] https://indiankanoon.org/doc/106177/

[7] https://indiankanoon.org/doc/879077/

[8] https://indiankanoon.org/doc/1799476/

Retrospective Operation of S. 29A & OTS under IBC – Analysing Prospects

/1 Comment/in /by

– Megha Mittal

[resolution@vinodkothari.com]

The Hon’ble NCLAT vide its order Martin SK Golla v. Wig Associates, 2019[1] has set aside the order of the Adjudicating Authority which had accepted a one-time settlement-cum-resolution plan submitted by a connected person of Corporate Debtor, who later on, after the implementation of section 29A became ineligible to submit a plan. Hence, the question before the Hon’ble Tribunal was whether sec 29A of IBC will be applicable with retrospective effect in section 10 proceedings which were initiated prior to sec 29A came into force?

The Hon’ble NCLAT held that the reason that once CIRP is commenced, provisions as existing on the day of the petition would continue to apply even in the face of amendment brought about by way of 29A- cannot be maintained, and as such the one time settlement-cum-resolution plan, offered by the connected person of the Corporate Debtor cannot be considered good under law.

In this article, along with the issue of retrospective applicability of section 29A and its likely impact on the stakeholders, the Author also delves into the question whether a one-time settlement scheme could tantamount to a resolution plan under the Code.

Read more →

Leveling the playing field for all Microfinance Lenders

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RBI proposes uniform regulatory framework for the Microfinance Sector ( finserv@vinodkothari.com )

The microfinance sector, in India, has proved to be fundamental for promoting financial inclusion by extending credit to low-income groups that are traditionally not catered to by lending institutions. The essential features of microfinance loans are that they are of small amounts, with short tenures, extended without collateral and the frequency of loan repayments is greater than that for traditional commercial loans. These loans are generally taken for income-generating activities, although they are also provided for consumption, housing and other purposes. There exist various market players in the microfinance industry viz. scheduled commercial banks, small finance banks, co-operative banks, various NBFCs extending microfinance loans and NBFCs-MFIs.

The microfinance industry has reached 6 crores of live borrowers base the end of the calendar year of 2020. Book size of the microfinance industry as on 31st December is 228,818 crore[1]. The sector grew by 16% from December 2019 to December 2020 (based on outstanding loan portfolio size) and has witnessed phenomenal growth over the last two decades.

Source- SIDBI Microfinance Pulse Report, April 2021

Source- SIDBI Microfinance Pulse Report, April 2021

While banks are leading by contributing 42% towards total portfolio outstanding and 39% towards active loans, NBFC-MFIs are the second highest contributors in the microfinance sector. When compared to the total portfolio size of all microfinance lenders, NBFC-MFIs only contribute to a little over 30% of the total size. However, the framework regulating microfinance has been made applicable solely to NBFC-MFIs (‘NBFC-MFI Regulations’ as provided under the respective Master Directions) while the other lenders that hold a lion’s share of the sector are not subjected to similar regulatory conditions/ restrictions. These include cap on multiple lending, ceiling on maximum lending amount, various customer protection measures etc. Absence of regulatory control has led to various problems such as multiple lending by borrowers resulting in overindebtedness, increased defaults, coercive recovery methods by lenders at the prejudice of borrowers etc.

As a solution to the same, RBI has issued a consultative paper on regulation of microfinance on June 14, 2021[2] (‘Consultation Paper’) with an intention to harmonise the regulatory frameworks for various regulated lenders (‘RE’s) in the microfinance space while also proposing a slew of changes to the existing norms for NBFC-MFIs and NBFCs.

RBI has invited comments, suggestions and feedback on the proposed regulation by July 31, 2021 from all stakeholders. The proposed norms intend to have uniform regulations applicable to microfinance loans provided by all entities regulated by the RBI and are aimed at protecting the microfinance borrowers from over-indebtedness as well as enabling competitive forces to bring down the interest rates by empowering the borrowers to make an informed decision. The key proposals of the Consultative Document have been discussed herein below in this article:

Regulations for all Microfinance Loans

MFIs encompass a host of financial institutions engaged in advancing loans to low-income groups. However, except NBFC-MFIs, none of the other entities are regulated by microfinance-specific regulations.

Resultantly, RBI has proposed to introduce a common regulatory framework for all microfinance lending institutions, irrespective of their form. The intent behind the same is to ensure that all lenders under the microfinance sector are subject to the same rules. This would not only protect borrower interest but also ensure that all lenders are operating on a level playing field thereby passing the benefit of competition to the ultimate borrower. Further, considering the total indebtedness of borrowers vis-a-vis their repayment capacity seems more fitting rather than indebtedness only from NBFC-MFIs.

Common definition of ‘Microfinance’ for all REs

RBI has proposed to revise the definition of ‘microfinance loans’ and in order to avoid over-indebtedness and multiple lending, the same is proposed to be applied uniformly to all entities regulated by the RBI (REs) and operating in the microfinance sector.

 

Annual Household Income Threshold

Common definition of microfinance borrowers

Under extant regulations for NBFC-MFIs, a microfinance borrower is identified by annual household income not exceeding ₹1,25,000 for rural and ₹2,00,000 for urban and semi-urban areas. In order to ensure a common definition, the said criteria for classification is proposed to be extended to all regulated entities (REs).

RBI has proposed to base the threshold on the income of the entire household rather than that of an individual, similar to the existing guidelines for NBFC-MFIs. The reason being that income in such households is usually assumed to be pooled.

For this purpose, ‘household’ shall mean a group of persons normally living together and taking food from a common kitchen. Even though the determination of the actual composition of a household shall be left to the judgment of the head of the household, more emphasis has been advised to be placed on ‘normally living together’ than on ‘ordinarily taking food from a common kitchen’. Note that a household differs from a family. Households include persons who ordinarily live together and therefore may include persons who are not related by blood, marriage or adoption but living together, while a family may comprise persons who are living apart from the household.

Methodology for assessment of household income

Assessment of household income in a predominant cash-based economy might pose certain difficulties. However, applying a uniform methodology may not be appropriate for such assessment, especially of low-income households, since the practice may differ based on the different types of borrowers and lenders. The same should be left at the discretion of the lender in the form of a policy. However, broad parameters/ factors may be provided. These can include deriving income from expenditure patterns, assessment of the borrower’s occupation and the ordinary remuneration flowing thereof, assessment of cash flows etc.

Criteria dropped from the existing definition –

  1. Absolute cap on the permissible amount of loan to be extended, is no longer relevant due to linking of loan to income in terms of debt-income ratio and therefore has been removed;
  2. Minimum tenure requirement is also to be be removed since longer tenures for larger loans will not be appropriate (since the absolute cap for amount of loans has been removed);
  • The existing NBFC-MFI regulations require at least 50% of the total amount of loans extended by NBFC-MFIs to be given for income generation. This means part (i.e. maximum of 50 per cent) of the aggregate amount of loans may be extended for other purposes such as housing repairs, education, medical and other emergencies. However, aggregate amount of loans given to a borrower for income generation should constitute at least 50 per cent of the total loans from the NBFC-MF. It has been realised that while microfinance loans should ideally be used for income-generating activities, placing too much emphasis on the same may lead to borrowers availing informal and more expensive modes of lending for their other financial needs. Therefore, the said requirement not being conducive, has been proposed to be removed;
  1. Restriction on lending by two NBFC-MFIs to be dropped due to overall restriction in terms of debt-income ratio (discussed below).

Maximum Permissible level of indebtedness in terms of debt-income ratio

One of the major risks in microlending has been the issue of overborrowing, with nearly 35% of the borrowers having access to two or more lenders.(source PWC report)

It is proposed to link the loan amount to household income in terms of debt-income ratio.  The payment of interest and repayment of principal for all outstanding loans of the household at any point of time is proposed to be capped at 50% of the household income i.e. total indebtedness of any borrower will not increase 50% of his/her total income. This has been proposed keeping in mind various factors such as –

  • Low savings therefore taking into account that half of their income should be available to meet their other expenses necessary for survival
  • Possibility of repayment towards other forms of informal lending from friends and family
  • Likely inflation of income to avail higher loans.

However, individual REs will be permitted to adopt a conservative threshold as per their own assessments and Board approved policy. Since, the level of indebtedness for a particular borrower is proposed to be regulated, the current stipulation that limits lending by not more than two NBFC-MFIs to the same borrower will no longer be required.

Grandfathering of existing facilities

The aforesaid threshold shall become effective from the date of introduction of the proposed regulations. However, existing loans to the households which are not complying with the limit of 50% of the household income, shall be allowed to mature. Although, in such cases, no new loans will be provided to such households till the limit is complied with.

Collateral-free loans

Microfinance borrowers belong to the low income group and generally do have the available assets to be provided as collateral for availing financial facilities. The assets possessed by them are usually those that are essential for their survival and losing them in case of a default will be detrimental to their existence. Therefore, it has been proposed that to extend the collateral free nature of microfinance loans, as applicable to NBFC-MFIs, to all REs.

Prepayment Penalty

In case of NBFC-MFIs, the borrowers are allowed prepayment without charging any penalty. It has now been proposed that microfinance borrowers of all REs shall be provided with the right of prepayment without attracting penalty.

Repayment Schedule

As per the extant regulations, microfinance borrowers of NBFC-MFIs are permitted to repay weekly, fortnightly or monthly instalments as per their choice. With a view to keep the repayment pattern at the discretion of the borrowers that will suit their repayment capacity and/or preference, all REs will be required to provide repayment periodicity to such borrowers as per a Board approved policy.

Minimum NOF for NBFC-MFIs

RBI had issued a Discussion Paper on ‘Revised Regulatory Framework for NBFCs – A Scale-Based Approach’ on January 22, 2021 proposing to revise the minimum net owned fund (NOF) limit for all NBFCs including NBFC-MFIs, from ₹2 crore to ₹20 crore.

At present, NBFC-MFIs are required to have a minimum NOF of ₹5 crore (₹2 crore for NBFC-MFIs registered in the North Eastern Region). RBI has sought the view of stakeholders whether the proposed minimum NOF of ₹20 crore for NBFCs under scale-based regulations is appropriate for NBFC-MFIs or not.

The evolution of regulatory framework for NBFCs may recall, the NOF requirement for NBFCs was Rs 25 lacs in 1990s. Then, it was increased to Rs 2 crores, Rs. 5 crores in case of NBFC-MFIs. The regulator is now proposing to increase the same to Rs 20 crores – a 10 fold increase. The underlying rationale is to have a stronger entry barrier, and to ensure that NBFCs have the initial capital for investing in technology, manpower and establishment. However, such a sharp hike in entry point requirement will keep smaller NBFCs out of the fray. Smaller NBFCs, especially NBFC-MFIs, have been doing a useful job in financial inclusion and having a stricter entrance will only prove to demotivate the sector.  You may read further on the scalar based approach framework by RBI in our article here.

Revised Definition of ‘microfinance’ for ‘not for profit’ Companies

Section 8 companies engaged in micro-finance and not accepting public deposits, are exempt from obtaining registration under section 45IA of the RBI Act, 1934 as well as from complying with sections 45-IB (Maintenance of percentage of assets) and 45-IC (Reserve Fund).

The exemption is applicable to all not-for-profit NBFC-MFIs that meet the above criteria irrespective of their size.  However, it has been proposed to bring Section 8 companies above a certain threshold in terms of balance sheet size (say, asset size of ₹100 crore and above) under the regulatory ambit of the RBI. This is because Section 8 companies are dependent on public funds including borrowings from banks and other financial institutions for their funding needs and any risk of failure in these companies will have a resultant impact on the financial sector.

Further, not-for profit MFIs operate in an almost similar manner to that of for-profit MFIs but the latter enjoys exemptions from various requirements. The mandatory requirement for registration will ensure that not-for-profit MFIs with considerably large asset size, are effectively regulated.

The revised criteria for exemption is proposed to be as under:

‘Exemption from Sections 45-IA, 45-IB and 45-IC of the RBI Act, 1934 shall be available to a micro finance company which is

  1. engaged in micro financing activities i.e. providing collateral-free loans to households with annual household income of ₹1,25,000 and ₹2,00,000 for rural and urban/semi urban areas respectively, provided the payment of interest and repayment of principal for all outstanding loans of the household at any point of time does not exceed 50 per cent of the household income;
  2. registered under Section 8 of the Companies Act, 2013;
  3. not accepting public deposits; and
  4. having asset size of less than ₹100’

Review of Specific Regulations for NBFC-MFIs

Qualifying Asset Criteria

In order to be classified as a ‘qualifying asset’, a loan is required to satisfy the following criteria:

  1. Loan which is disbursed to a borrower with household annual income not exceeding ₹1,25,000 and ₹2,00,000 for rural and urban/semi-urban households respectively;
  2. Loan amount does not exceed ₹75,000 in the first cycle and ₹1,25,000 in subsequent cycles;
  • Total indebtedness of the borrower does not exceed ₹1,25,000 (excluding loan for education and medical expenses);
  1. Minimum tenure of 24 months for loan amount exceeding ₹30,000;
  2. Collateral free loans without any prepayment penalty;
  3. Minimum 50 per cent of aggregate amount of loans for income generation activities;
  • Flexibility of repayment periodicity (weekly, fortnightly or monthly) at borrower’s choice.

The following changes have been proposed –

  1. The household income limits have been retained under the revised definition of microfinance loans and made applicable to all REs
  2. Absolute cap is no longer relevant due to linking of loan to income in terms of debt-income ratio
  • Minimum tenure requirement to be removed since longer tenures for larger loans will not be appropriate (since the absolute cap for amount of loans has been removed)
  1. Collateral free loans and absence of prepayment penalty have been retained in the revised definition.
  2. The existing NBFC-MFI regulations require at least 50% of the total amount of loans extended by NBFC-MFIs to be given for income generation. This means part (i.e. maximum of 50 per cent) of the aggregate amount of loans may be extended for other purposes such as housing repairs, education, medical and other emergencies. However, aggregate amount of loans given to a borrower for income generation should constitute at least 50 per cent of the total loans from the NBFC-MF. It has been realised that while microfinance loans should ideally be used for income-generating activities, placing too much emphasis on the same may lead to borrowers availing informal and more expensive modes of lending for their other financial needs. Therefore, the said requirement not being conducive, has been proposed to be removed.

Limit of lending by two NBFC-MFIs

Owing to an overall restriction based on debt-income ratio of 50% for all REs, the restriction of lending by only two NBFC-MFIs to a borrower will be withdrawn.

Pricing of Credit by NBFC-MFIs

Given the vulnerable nature of the borrowers of microfinance loans, the NBFC-MFI regulations imposed an interest cap to prevent exorbitant interest rates charged to such borrowers.

The interest rate cap prescribes multiple ceilings rather than a single one. Accordingly, NBFC-MFIs have been permitted to charge interest with a maximum margin cap of 10% and 12% over and above the cost of funds, depending on the size of loan portfolio (₹100 crore threshold) or 2.75 times of the average base rate of five largest commercial banks, whichever is lower.

The latter criterion provides a linkage with the prevailing interest rate in the economy and ensures that higher borrowing costs for NBFC-MFIs with riskier business models are not transmitted to the end borrowers. Further, NBFC-MFIs are not permitted to levy any other charge except for a processing fee (capped at 1% of the loan amount) and actual cost of insurance to ensure that interest rate ceilings are not bypassed by NBFC-MFIs through other hidden charges.

However, the regulatory ceiling on interest rate is applicable only to NBFC-MFIs. Nearly 70% of the microfinance sector, comprising banks and small finance banks, is deregulated in terms of pricing. It has also been observed that an unintended consequence of creating a regulatory prescribed benchmark for the rest of the entities operating in the microfinance segment. Lenders, such as banks, though having a lower cost of funds, still charge a higher interest rate. This has led to borrowers being deprived of benefits of economies of scale and competition in the microfinance market.

The provision of such interest rate ceilings was suitable in an environment where NBFC-MFIs were the primary lenders. However, currently, as discussed, NBFC-MFIs contribute to only 30%. Proposing a fixed benchmark for interest rate in the microfinance industry may not be appropriate considering the differences in the cost of funds, financial or otherwise, among different types of entities.

Based on the above rationale, it has been proposed to remove such interest rate ceiling limits and align the interest rate model for NBFC-MFIs with that of regular NBFCs.  NBFC-MFIs will now be permitted to adopt interest rates based on a Board approved policy while adhering to fair practice code to ensure disclosure and transparency. However, necessary regulation must also be put in place to avoid charging usurious interest rates. The intention is to enable the market mechanism to reduce the lending rates for the entire microfinance sector.

Fair Practice Norms

The above relaxation from interest rate ceiling, comes with its own set of fair practice norms to ensure transparency and protecting interests of borrowers.

  1. Disclosure of information on pricing

To allow borrowers to make an informed decision, REs will mandatorily be required to disclose pricing information by way of a standardised and simplified disclosure format (specified under table III of the Consultation Paper). Such information will enable borrowers to compare interest rates as well as other fees associated with a microfinance loan in a more readable and understandable manner. The pricing related fact sheet shall be provided to every prospective borrower before on-boarding.

  1. Board Policy for determining charges including interest rate

Boards of all REs will be required to frame suitable internal principles and procedures for determining interest rates and other charges to arrive at an all-inclusive usurious interest rate.

  1. Display of interest rates

All REs will be required to display the minimum, maximum and average interest rates charged by them on microfinance loans. The manner of display is still to be prescribed.

  1. Scrutiny by RBI

The above information will also be incorporated in returns submitted to RBI and shall be subjected to the supervisory scrutiny.

[1] Source- SIDBI Microfinance Pulse Report, April 2021

[2] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=51725

Presentation on LODR Amendments

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RBI Guidelines at odds with the Companies Act on appointment of Auditor

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A comparative analysis between the Companies Act, SEBI Guidelines and SEBI Circular dated 18th Oct. 2019

– Ajay Kumar K V | Manager (corplaw@vinodkothari.com)

Introduction

The Reserve Bank of India has issued Guidelines[1] for Appointment of Statutory Central Auditors (SCAs)/Statutory Auditors (SAs) of Commercial Banks (excluding RRBs), UCBs and NBFCs (including HFCs) under Section 30(1A) of the Banking Regulation Act, 1949, Section 10(1) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980 and Section 41(1) of SBI Act, 1955; and under provisions of Chapter IIIB of RBI Act, 1934 for NBFCs, on 27th April 2021.

The Guidelines provide for appointment of SCAs/SAs, the number of auditors, their eligibility criteria, tenure and rotation as well as norms for ensuring the independence of auditors.

However certain provisions of these Guidelines are either completely different or stringent as compared to the provisions of the Companies Act, 2013 (Act). Further, in case of listed entities the question would arise whether the SEBI circular CIR/CFD/CMD1/114/2019[2] dated 18th October 2019 shall be applicable, where the existing auditor is ineligible to continue as the auditor of the company and a new auditor is to be appointed.

In this write up, we have discussed the requirements under both RBI Guidelines as well as the Act.

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