RBI Regulation of Investment Companies: Futile, counter-productive and counter-intuitive

–Vinod Kothari | finserv@vinodkothari.com

The RBI has launched a major base-layer study of “base-layer NBFCs”, whereby audit firms will be surveying these NBFCs. Apparently, the audit firms will visit their offices to see if there is a physical office (which means a name plate outside the office), whether that physical office houses other offices too (an anachronistic objective in the age of co-working spaces), track the directors and the beneficial owners of such companies. The RBI’s definition of “beneficial owners” is remarkably different from the very same concept under section 90 of the Companies Act, which, after huge rounds of discussion, settled on certain rules for determination of such beneficial owners, and given the fact that the Companies Act is already tracking beneficial owners, it is interesting to note that the RBI would do its own enquiry into such beneficial owners.

Understandably, this massive exercise, with a budget of Rs. 2.36 crores, has been launched to do a reality check on the 9471 entities forming part of the so-called “Base layer”, which, by the regulators’ own determination, are entities which do not matter much for the financial system. Once again, out of these base layer entities, approximately 97% of the entities qualify as “investment and credit companies”.

Investment and credit: A merger of unequals

Credit companies or so-called loan companies are those that extend loans. Investment companies, on the other hand, are those that make investments in stocks and securities. These categories used to be different before the RBI notification dated 22nd February 2019^[1]  when they were merged into a common functional category.

Essentially, painting an investment company and a credit-granting company with the same brush is fundamentally wrong. Investment companies invest in the capital markets, just like individuals, family offices or non-financial companies do. The investment may be in the stocks of listed or unlisted companies, which are entities duly operating and issuing traded or unlisted stocks to investors as per the applicable law to them, or the investees are investment vehicles (such as mutual funds), which, in turn, are a part of the capital market.

Investment into capital markets, admittedly, is not the domain of the RBI: there is a separate regulator for the same. What type of investor should invest in what type of securities, and with what precautions, is taken care of by SEBI. RBI may justifiably regulate the liability side of investment vehicles, but do note that the RBI has not permitted a single NBFC  to accept or hold public deposits over the last 25 years or so. Therefore, even if an investment company chooses to leverage its balance sheet, it would have little choice except to depend on borrowings from regulated entities, which, in turn, are RBI regulated entities. If the RBI had any concerns about a lender lending for the purpose of making investment in capital markets, the right place to put checks in place is the lender who gives such loans, and not the borrower taking such loans. And nay, such regulations are already in place – there are rules on loans against shares, disclosure requirements for capital market exposure, concentration on exposures, etc.

The completely un-understandable implication of the regulation that treats investment activity also as  a financial activity is that an entity, with no access to public funds in any manner, investing into capital markets, is regarded as an NBFC. The following is not an exaggeration, and is an ironic reality faced by many: A business entity has accumulated, say Rs 100 crores of wealth over time, and now wants to invest it into a diversified portfolio of stocks, shares or funds. First thing, because the major income and major investment in assets is what is regarded, by definition of the RBI Act, as “financial income” and “financial assets”, this company becomes an NBFC. Before this company, therefore, “starts” its business (read, makes these investments), it must take registration with the RBI as an NBFC.

And, registration, as one knows, is not like a prayer easily answered.  Because the RBI treats investment and credit companies alike, one is likely to get responses, completely counterintuitive to the fundamentals of an investment company. . For example, the standard response may be: your board or management does not have a person with retail lending experience. You would possibly revert: why do I need such an experience, because I am not going to lend the money out at all, let alone to retail borrowers. The applicant will also be in pains to answer concerns as to  “fit and proper” qualification of the directors, whereas, all you are trying to do is to invest your own money into what you think is a good investment. Come to think of it: which rationale justifies that a company investing its own net worth, with no public stake and no external funding of any sort, should be precluded from doing it because it does not have an NBFC license? Does a family office, or an individual, or any other unincorporated, or incorporated non-financial entity, need such a registration? And if I don’t have such registration or the registration request is not granted (the chances of which are very very high), I am told that I should keep my money invested in bank fixed deposits or liquid mutual funds. Once again, is there any rationale as to why someone with his own money does not have the right to invest, in legal modes of investment, based on his judicial choice? Such a prescription, in an age of ease of doing business, seems a restraint on doing business.

In fact, the preamble to the RBI Act refers to the currency and credit markets, and stability of the monetary system. The preamble nowhere seems to be referring to investment vehicles or investment activity. And investment in capital markets, which itself is aptly regulated by the capital market regulator, is not a part of the financial system at all.

A Parliamentary Committee Report, 20 years ago

The RBI is the regulator, and not the lawmaker, and therefore, there is a plausible contention: that the meaning of what is “financial institution”, implicitly defining what is financial business, is hardcoded in the RBI Act, which, ever since 1963, has included investment in securities as a part of financial business.

However, let us understand two things: first, no statute is a bolt from the blue. The circumstances that prevailed in 1963 do not prevail 60 years later. There was no capital market regulator then; now we have very clearly defined sectoral regulators. It is completely a wrong argument to plead that the regulator is bound by the law. The very law that defines investment activity as financial activity also defines insurance business as financial activity. But clearly enough, there is no RBI’s intervention in regulation of insurance, or, for that matter, stock broking, merchant banking, etc. The RBI has come out clearly with generic scope exemptions excluding what was covered as a financial business by the 1963 version of the statute.

Secondly, even if it is agreed, for the sake of argument, that investment activity is inseparably included in other financial activity, there is nothing stopping the regulator from putting pure investment companies, not having public lending activity, from the regulatory attention. The type of exercise of company-by-company survey of what is treated as an NBFC by an expansive definition wouldn’t have been needed if investment companies were excluded from the regulatory radar, as, certainly enough, 70-80% of the base layer entities would not have been the RBI’s concern at all. Both the regulator, and the regulated, would have been a lot easier.

Is this argument, that investment companies have no reason to come under the RBI regulation, an exceptional, never-before contention? Far from this. In fact, 20 years ago, a Standing Committee of Parliament on regulation of finance companies had gone into this question. Here are some excerpts:

21. An opinion has also been expressed that it is prudent to exclude investment companies and Special Purpose Vehicles (SPVs) which are limited companies and which do not take deposits, from the purview of the Bill in view of their catalytic role as tools for development and growth of investment activity. While reacting to the proposal, the Government in their reply stated that the nature of business rather its name should be the determining factor. Some SPVs may be doing financial business which would require regulation by the RBI. However, RBI, in their written reply furnished to the Committee submitted as under:- “We agree with the suggestion that it is prudent to exclude investment companies and special purpose vehicles from the purview of the Bill. If the suggestion regarding exclusion of non-deposit taking financial companies from the purview of the Bill is implemented, investment companies and special purpose vehicles which are limited companies and which do not take deposits would stand excluded.” 22. The Committee after having considered the viewpoints of the Government and the Reserve Bank of India are of the opinion that the Reserve Bank of India should concentrate on regulation of those incorporated bodies only which are accepting deposits. They are of the considered opinion that the non-deposit taking financial companies, investment companies, Special Purpose Vehicles (SPVs) may be excluded from the purview of the Bill to enable the RBI to adequately and appropriately monitor the activities of deposit taking incorporated bodies.”

The Report notes that the RBI itself has submitted that it is prudent to exclude investment companies and SPVs from the purview of finance company regulation. To put the record clear, the Standing Committee report was on some finance company regulation which never got enacted. However, what is important to note is that the RBI itself has agreed that the regulation of investment companies is neither the intent of the RBI nor its domain area.

How do other countries do it?

We also need to realise that India is today a part of the global financial system; there are things that other regulators learn from us, but we cannot pretend that we don’t need to learn from other regulators.

Neither does the USA or the UK or EU regulate financial business the way we do in our country. US regulation is focused on deposit-taking and playing a role in the payment and settlement system. In the UK, the regulated credit activities in the Regulated Activities Order of the Financial Conduct Authority are essentially consumer lending and mortgage lending.  In Singapore too, it is borrowing money from public and lending money to public which is regarded as “financial business”.

In short, it is hard to think of countries which would regulate investment activity, unless it is a pooled investment vehicle, such as an investment fund, collective investment fund, etc. The term “investment companies” in US parlance [Investment Company Act, 1940] mostly refers to mutual funds or similar intermediaries who source money from the public to invest in the capital market.

Concluding thoughts

Treating investment companies as NBFCs does damage in many ways. First, since there is no borderline distinguishing between an investment company and a loan company, it is perfectly valid for an investment company to start lending activities. Therefore, the data that the RBI collects and analyses with so much effort is blurred by the huge number of companies investing their own shareholders’ money in either their group shares or in the capital markets in general. Secondly, the legacy registrations which were granted to some 30000 odd companies in 1998 are being used as a valuable, transferable asset by companies – with premiums ranging from Rs 30-50 lacs for a mere NBFC registration. While the change of control provisions try to safeguard trafficking in licenses, but the crux of the question is – why create a situation where an NBFC registration becomes a tradable asset?

Third and very significantly, it is a huge burden on the regulator, as also the regulated. The door-to-door survey by the RBI as is being done currently is a one-off exercise, but year on year, there are RBI queries on “fair practices code”, credit information company registration, change of directorship, etc. to companies who never really intended to do any financial business. Auditors engage in giving reports on breaches from the regulations which were never designed to apply to their auditees s. Regulations require compliance – compliance has wide and deep costs. On the whole, the big question would be – is the regulation serving any meaningful purpose? .

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^[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11483&Mode=0