An Insight on Direct Selling Guidelines, 2016 Pyramid Schemes vis-a-vis MLM

By Saloni Mathur (finserv@vinodkothari.com)

Introduction

There has been a shift in the paradigm of the performance of the direct selling agents. The role and responsibilities of the direct selling agents have witnessed a revolution, where they are required to comply with certain codes as prescribed by the government from time to time, and follow certain practises while discharging their responsibilities. The RBI’s master directions[1]on the outsourcing norms have put stringent compliances on the service providers while discharging their functions, and increased responsibility and monitoring on the part of the non-banking financial companies. The question that arises here is whether those non- banking companies complying with the outsourcing guidelines, fall under the ambit of the direct selling guidelines also and if they, then what is the nature of the applicability of these direct selling guidelines on them.

According to a report on the Indian direct selling industry published by FICCI and KPMG, the direct selling market in India has grown at a CAGR of 16 per cent over the past five years to reach INR75 billion today.[2] Due to this unprecedented rise in direct selling industry and the growth of a large distribution base, major scams have been witnessed over the years in reputed companies owing to the nature of marketing methods adopted by them.

The Government of India, Ministry of consumer affairs, food and public distribution, department of consumer affairs, vide its notification number F.No.21/18/2014-IT (vol II) dated 09th September, 2016 modelled certain guidelines on the direct selling regulating the business of direct selling and the multi-level marketing.

This article is an attempt to envisage the rationale behind these guidelines and the applicability of these guidelines on the direct selling agents and the various compliances that are required to be made by the direct selling entities and the direct sellers.[3] Further this article also takes into account the concept of Multi-level marketing and the pyramid schemes with reference to the applicability on the direct selling agents.

Rationale behind the launch of the Scheme

The direct selling industry has brought about with itself a huge reservoir of marketing, selling and distribution base for the goods and services, which has given rise to various fraudulent practises in the marketing and the distribution system. Instances can be drawn from the famous Amway and the Qnet case where entire money in the chain was earned only through the recruitment of new members and adding more participants to the channels of distribution, rather than the actual sale of the goods and services. Though the Amway was convicted of “illegal pyramid scheme” it could finally escape all criticism under the umbrella of the “the Amway safeguard rules”. However, the case has left strong marks of scepticism in the validity of the direct selling business.

The companies which were engaged in multi-level marketing were carrying out various frauds through the recruitment of large number of participants in the system. Thus, a need was felt where a robust system of direct selling guidelines was required to protect the interest of the consumers.

Defining the Pyramid and the MLM schemes

Defining the Pyramid Scheme

“Pyramid Scheme” as defined in the guidelines mean a multi layered network of subscribers to a scheme formed by subscribers enrolling one or more subscribers in order to receive any benefit, directly or indirectly, as a result of enrolment, action or performance of additional subscribers to the scheme. The subscribers enrolling further subscriber(s) occupy higher position and the enrolled subscriber(s) lower position, thus, with successive enrolments, they form multi-layered network of subscribers.

The key feature of the pyramid is that as the entrants in the last layer of the pyramid continue to get more and more participants who pay money. By way of this a hierarchy is created and the sponsor who holds the top most position is the recipient of the highest commission. The Amway case is the perfect example of the “illegal Pyramid scheme” where the purpose of the scheme was to make money through recruiting more distributors at various levels.

The pyramid scheme is illegal in India under the Prize chits and Money Circulation Schemes (banning) act, 1978. Hence there is a non-applicability of this scheme.

Following are some of the key constituents of the Pyramid Schemes

High registration fees

The basic quality of a pyramid scheme is that there is a high registration and entry fees upfront that the participants in the scheme have to pay. The entry fee is so high that the participants holding top position get a very high commission fees.

Goods sold at a price higher than the fair value and a higher quantity that is generally sold in the market

The goods and services under the pyramid schemes are not sold at the fair value. Fair value means the price at which the goods and services are generally available in the market. If the goods are sold to the consumers at a price higher than what is a general fair market price, it is a pyramid scheme.  Similarly, if the goods are sold at a quantity higher than what is expected to be consumed by, or sold, resold to consumers, it will constitute to be a pyramid scheme. The price of the goods and services have a higher component of commission cost rather than the actual product price. The price of the product generally has 70% commission cost and remaining 30% cost of the product.

The level of unsold inventory

Under the pyramid schemes the unsold inventories of the participants is not generally brought back by the distributor.

Emphasis on the recruitment of more members

There is a greater emphasis on the recruitment of more members rather than promoting and distributing the product. The purpose here is to fetch higher commissions for the sponsors at the top most level.

No material contract between the direct selling entity and the direct seller

There is no material agreement entered between the direct selling entity and the direct seller on buy back, refund, repurchase policy of the unsold inventory.

No cooling off period

There is no cooling off period given to the direct sellers up to which they can cancel the contract.

Defining the Multi-level Marketing (MLM) scheme

In an MLM structure, multi-level marketing or the network marketing are used to sell the products directly to the consumers in which the salesmen are compensated not only for the work done by them but also for the sales of the people who have joined the company through them.[4]

The main purpose of the MLM scheme is to ensure wide distribution of the products or services and the intent is to sell the product through a network of wide range of distributors. Thus, it is just a marketing strategy unlike a fraudulent pyramid scheme where there are tangible distribution of the goods and services.

Comparing the MLM and the ‘Pyramid’

The big difference between multilevel marketing and a pyramid scheme is in the way the business operates. The entire purpose of a pyramid scheme is to get distributors’ money and then use it to recruit other distributors. The entire purpose of MLM is to move the product and ultimately achieve the sales of the product. The theory behind MLM is that the larger the network of distributors in a chain, the more products the business will be able to sell. Therefore, whether it is a pyramid scheme or an MLM approach depends upon the legality of the schemes and the purpose behind their operation as the Pyramid scheme is illegal.

Defining key concepts under the ‘direct selling guidelines 2016’

‘Direct selling’ has been clearly defined in regulation 6 which means marketing, distribution and the sale of the goods or providing of any services as a part of network of direct selling other than under a pyramid scheme.

Thus, what constitutes to be a direct selling is based on four conditions i.e direct selling has to be marketing, distribution, and selling of the goods and services as a part of network of direct selling. Thus all the four conditions need to be qualified simultaneously for determining direct selling. Thus, a direct selling agent, if restricts its services only to marketing of products and not to selling and distribution would not be required to comply with these guidelines.

Similarly, the network is defined as an arrangement of intersecting horizontal and vertical lines. To be a network it is therefore necessary that there is a hierarchy of a direct selling agents such that there is a superior subordinate relationship at all levels of distribution

The ‘network of direct selling’ means a network of direct sellers at different levels of distribution who may recruit or sponsor further levels of the direct sellers, who they then support. “Network of direct selling” shall mean any system of distribution or marketing adopted by a direct selling entity to undertake direct selling business and shall include the multi-level marketing method of distribution.

This network of direct sellers also includes the multi-level marketing method of distribution.

Thus, network of direct selling shall be hierarchical. Single level of distribution would not constitute any network.

Comparing the network, the Pyramid and the MLM

The network may be at a horizontal level also. For example, if there is one direct selling entity selling goods and services through a single level of the direct sellers, all at the same level shall constitute a network. However, Pyramid necessarily has to be a vertical hierarchy such that there should a superior subordinate relationship. Multi-level marketing shall have to a be a legal marketing strategy and not a fraudulent scheme.

Understanding the applicability of the scheme

The applicability of the above guidelines on the direct and selling agents have to be checked from the following facts:

This scheme is applicable on the following companies.

  1. Companies engaged in marketing as well as selling and distributing the products simultaneously under the network of direct selling.
  2. All the multi-level marketing schemes such that there are different levels of distribution and the participants are at different distribution levels. Here the participants at the same level of distribution shall not be required to comply with the scheme.
  3. Company carrying its operations through a hierarchical multi-level system.
  4. Companies appointing the direct selling agents in such a way, such that they are sponsoring or carrying out recruitment further so that a large network of distribution is created
  5. Companies that have relevant clauses in the outsourcing agreement and which specifically reflect the outsourcing or subcontracting of the service to the third parties.
  6. Companies requiring direct selling agents to pay high membership fees and greater entry costs.

Non-Applicability of the guidelines to Pyramid schemes and companies having only one level of distribution

The guidelines shall not be applicable to the pyramid scheme. This is because these schemes are generally money-making schemes and not any legal marketing strategy. This comes from the fact that pyramid schemes are generally created not to market the products, but to create a distributor base for earning large money through promotion. Thus, the direct selling guidelines take a legal view and apply to only legal MLM schemes and direct selling.

Further the companies having only a horizontal distribution base such that they are not recruiting or sponsoring further levels in the chain shall be kept out of the purview of these guidelines.

Quick compliance checklist for direct selling guidelines 2016

  1. All direct selling companies in India shall submit an undertaking to the department of the consumer affairs within 90 days from 12th September 2016.
  2. Direct seller cannot receive remuneration or incentive for the recruitment/enrolment of the new participants.
  3. Direct sellers can only receive remuneration derived from the sale of goods or services
  4. Direct seller shall carry its identity card and not visit the customers premises without prior intimation/approval.
  5. Direct selling company cannot force its direct sellers to purchase more goods or service than they can expect to consume or sell.
  6. Direct selling company cannot demand any entry fee/registration fee.
  7. Company must provide every participant written contracts describing the material terms (buy back, re-purchase policy, cooling period, warranty and refund policy.
  8. Mandatory orientation session with accurate information for the newly recruited direct selling agents
  9. There shall be prohibition of the pyramid scheme and the money circulation scheme.
  10. There shall be a monitoring authority to deal with the issues related to the direct selling.

Conclusion

There is no scepticism regarding the benefits of the direct selling guidelines on the interest of the consumers in prevention of the frauds against them, however comprehending the applicability of these directions is a hard nut to crack for various entities who are in a dilemma to comply with these guidelines. The guidelines do not specifically state the extent of the applicability; however, they do give certain apparent indications to the entities to whom these guidelines shall be applicable.

Thus, any company desirous of increasing their distribution base for selling wide range of products or services and who intend to do it by creating a hierarchical distribution that requires further outsourcing and recruitment shall be required to comply with the guidelines. Further the outsourcing agreement between the DSA and the service provider shall clearly state the provisions regarding contracting and the sub-contracting, subsequent to which only a network of distributors could be created.


[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT87_091117658624E4F2D041A699F73068D55BF6C5.PDF

[2] https://www.souravghosh.com/blog/direct-selling-guidelines-2016/

[3] http://consumeraffairs.nic.in/writereaddata/Direct%20Selling%20guidelines.pdf

[4] https://www.icsi.edu/WebModules/LinksOfWeeks/JuneCS_2014.pdf

Performance of NBFCs in 2016-17

By Mayank Agarwal (finserv@vinodkothari.com)

2016-17 could be summed up as a year of ‘Coming of age’ for Non-Banking Financial Institutions(NBFIs) as they finally fulfilled their potential by displaying a resilient performance against the backdrop of revised regulatory frameworks, widened credit gap due to sluggish performance by banking institutions and providing specialized services to the sector to which they cater. As per the recently released ‘Trend and Progress of Banking in India’ report by RBI,[1] NBFCs have given a stiff competition to established banks in the country, having finally edged ahead in the financial credit race in the country as their portfolio of loans grew at 14.9% during the first half of 2017-18, compared to 6.2% in the case of banks. The share of NBFCs in the total credit granted by NBFCs as well as Banks rose from 9.5% in 2008 to 15.5% as of March 2017, thus showing the increasing popularity of NBFCs as a source of finance. The credit granted by NBFCs as a percentage of GDP rose to 8%, displaying their significance in the country’s financial ecosystem. While the bank credit reached a historical low during 2016-17, NBFCs recorded an increased credit performance during the same year, highlighting the growing popularity in the country.

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UNDERSTANDING THE CONCEPT OF OUTSOURCING- ENVISAGING A TOUGH ROAD AHEAD FOR THE SERVICE PROVIDERS

By Saloni Mathur (finserv@vinodkothari.com)

INTRODUCTION

Mr. Le Kuan Yu, Singapore’s founding father once said, “If you are depriving yourself of the outsourcing business and your competitors do not, you are putting yourself out of the business.” These words reflect upon the importance of outsourcing as a function that has become a necessity for the business organizations in the current scenario, to manage their core as well as ancillary functions through the specialized services of the third parties. This business process re-engineering can reap bundle of benefits to the organizations and its inevitability can be based on the fact that these activities can help organizations to access skilled expertise, reduce overhead, offer flexible staffing, increase efficiency, enhance technological know-how, reduce turnaround time, and eventually generate more profits for the business houses.

SOURCE– KPMG INSTITUTES.COM, “THE RADICAL NEW
WAY OF OUTSOURCING FOR TECHNOLOGY RELATED SERVICES

According to a report of the Boston consulting group ‘21st annual analysis of the outsourcing industry’, the average number of functions outsourced by the organizations across the world has risen by 225% over the past 5 years and are expected to keep on growing. Outsourcing has been moving from the peripheral activities to the core ones. The recent survey report of the ‘Statistita on Global market size of the Outsourced services from 2000-2016, March 2017’ says that  the use of outsourcing in the Indian financial services sector is projected to increase by 36% in the next 3 years, with a CAGR of 7.6%.[1]

Suffice it to say, that the competition between banks, financial institutions in India have increased significantly in the last decade and the consumers now have even higher expectations than in the past when it comes to customer experience and service for which they are using the services of specialised entities. However, such rampant outsourcing of key functions are coming at the cost of loss of managerial control, threat to security and confidentiality and the quality problems, owing to the fact that these institutions are responsible for the funds of the general public. Therefore, it is the need of the hour to have a robust regulatory mechanism which shall ensure appropriate norms for the outsourcing, in order to safeguard the interest of both the customers and the organization.

WHAT IS OUTSOURCING OF FINANCIAL SERVICES?

The transferring of financial services to the third parties for using their specialised services, which otherwise could be performed by them itself, would amount to outsourcing. However, using the services of the third parties for actions that could not be taken in-house would not be considered as outsourcing. For example, statutory audits of the companies cannot be conducted in house itself, thereby keeping them out of the purview of the concept, outsourcing. Similarly, the payment gateway services and agreements would not constitute to outsourcing because these cannot be taken by the companies itself and require the services of the third parties for a speedy and an efficient process.

Thus, the agreements in the nature of debt recovery and repossession agreements, the agreements with the direct selling agents, the agreements related to cash management with the third party would constitute to outsourcing.

Hence organizations have to clearly demarcate between what is outsourcing and what is not,  thereby applying this code of conduct only to the key areas of outsourcing.

AN OVERVIEW OF THE RBI’S MASTER DIRECTIONS ON OUTSOURCING BY NBFC’S

The RBI’s master directions [2]on the outsourcing norms have put stringent compliances on the service providers while discharging their functions, and increased responsibility and monitoring on the part of the non-banking financial companies. The RBI has come up with more tougher norms, where the new directions prohibits the NBFC’s to outsource the core management functions to the third parties including the internal audit, the strategic and compliance functions, and the decision-making functions. However, they can be outsourced within the same group/conglomerate subject to the compliance and instructions in para 6 of the master directions, which states that the NBFC’s shall have a board approved policy and service level arrangements with the group entities prior to entering into such transactions with them.

Further the scope of these directions and new code of conduct applies only to the ‘outsourcing of the financial services’ keeping, general IT related services, and management services like janitorial services, housekeeping, catering of staff out of the purview of this code. Further the code requires NBFC’s strict compliance and monitoring of the activities of the service providers, where the service providers shall not impede or interfere with the RBI during the monitoring of its functions.

RATIONALE BEHIND THE NEW NORMS

The RBI is of the view that over the years, increased outsourcing in the financial sector have posed major risks to the organizations in terms of strategy, reputation, compliance operational, legal, concentration and the country risk. As we could see the rapid outsourcing in different sectors of the services, the underlying principles behind these directions emphasise that the regulated entity shall ensure that outsourcing arrangements neither diminish its ability to fulfil its obligations to customers and RBI nor impede effective supervision by RBI. NBFCs, therefore, have to take steps to ensure that the service provider employs the same high standard of care in performing the services as is expected to be employed by the NBFCs, if the activities were conducted within the NBFCs and not outsourced.

REGULATORY IMPACT ANALYSIS OF THE NEW MASTER DIRECTIONS

ANALYSING MATERIAL OUTSOURCING

The  board of directors and the senior management shall have to observe the materiality while outsourcing the key functions in terms of the business operations, reputability, profitability and customer service. The materiality would be based and assessed on the following parameters.

Thus, companies board first need to determine the materiality of the activities being outsourced. For example, an agreement with the direct selling agents, direct marketing agents, debt recovery agents, to market the company’s products would be material outsourcing, because here the brand value of or the reputation would be at stake if the service provider fails. Further such kind of outsourcing would be material in nature because of the huge operational costs in direct marketing and high DSA’s pay-outs.

CONCLUDING REMARKS

The new directions on outsourcing can be envisaged as careful and robust approach by the RBI in safeguarding the NBFC’S from certain risk exposures with the service providers. Initiatives like a holistic code of conduct for the direct selling agents, the setting up of the internal and the external audit committees to monitor the outsourcing activities, the increased role of RBI to have a close eye on the operations, substantially drafted service agreements that deal with all the risks that could arise and the subsequent clauses to address them,  set up of a grievance redressal mechanism, could pave a way for a better regulatory environment and protection of the interests of the public, the NBFC’S and the service providers.

  1. http://www.kpmg.institutes.com/content/dam/kpmg/sharedservicesoutsourcinginstitute/pdf/2015/spps-it-outsourcing-infographic-2014-15.pdf
  2. ttps://rbidocs.rbi.org.in/rdocs/notification/PDFs/NT87_091117658624E4F2D041A699F73068D55BF6C5.PDF

 

Cautious Approach to be taken by NBFCs while outsourcing activities ancillary to financial services

By Mayank Agarwal & Anita Baid, ( finserv@vinodkothari.com)

The Reserve Bank of India (RBI), on the 9th of November, 2017 released a notification bringing out the Directions on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Non-Banking Financial Companies (NBFCs).[1] (“Directions”) These Directions are a much awaited outcome of the draft guidelines[2] which had been issued long back, in the year 2015. The Directions come in the wake of ever-increasing need to outsource ancillary activities such as applications processing (loan origination, credit card), document processing, marketing and research, supervision of loans, data processing and back office related activities in order to provide the customers best possible services associated with the core business of the company. The Directions have been issued to ensure that there exists no possibility of discrepancy or fallibility that could affect the customer as well as the NBFC in an adverse manner.

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Mandatory linking of Aadhaar and PAN under PMLA

By Anita Baid, (finserv@vinodkothari.com)

PML Second Amendment Rules

The Ministry of Finance on 1st June, 2017 vide notification No. G.S.R. 538(E) issued the [1]Prevention of Money-Laundering (Maintenance of Records) Second Amendment Rules, 2017 (hereinafter referred to as “Second Amendment Rules”) mandating all account holders of the reporting entities i.e., banks and financial institutions to link Aadhaar number issued by the Unique Identification Authority of India and Permanent Account Number (PAN) or Form No. 60 as defined in Income-tax Rules, 1962. The timelines for the same were as below- Read more

RBI’s P2P Regulations: A step forward or backward?

The Reserve Bank of India issued a Master Directions – Non Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017 (hereinafter referred to as “Directions”) on 4th October, 2017[1], which is an extensive statement outlining in detail the various rules and regulations that all existing and prospective entities carrying on or intending to carry on the business of Peer-to-Peer (P2P) lending (hereby known as NBFC-P2P) will have to comply with. These Directions shall come in force with immediate effect and shall apply to all NBFC-P2Ps, i.e. with effect from the date of issuance of the Master Directions, mentioned above.

1. Registration

1.1. Eligibility criteria

The basic eligibility criteria for carrying on the business of setting up a P2P lending platform are as follows:

  • Only a Non-Banking Financial company shall undertake the business of P2P lending platform.
  • All NBFC-P2Ps that are either commencing or carrying on the business of Peer-to-peer lending platform must obtain a Certificate of Registration (CoR) from the bank.
  • Every existing and prospective NBFC-P2P must make an application for registration to the Department of Non-Banking Regulation, Mumbai of RBI.
  • Any company seeking registration as an NBFC-P2P must have Net Owned Funds of at least Rs. 2 Crores or higher as RBI may specify.
  • The RBI has imposed the condition that the company seeking registration must be incorporated in India and must have a robust IT system in place. The management must act in public interest and the directors and promoters must be fit and proper.

While the eligibility criteria remains same for those already into business and prospective ones, however, there is a slight difference in the way the application process of these two categories will be dealt with by the RBI.

1.2. Prospective P2Ps

An entity intending to set up a P2P lending platform will have to make an application to the RBI and at the time of making the application, it should achieve net-owned funds of Rs. 2 crores which must be parked into Fixed Deposit.

Upon submission of the application, if the RBI is of the view that the aforesaid conditions have been fulfilled, it will grant an in-principle approval for setting up of a P2P lending platform, subject to such conditions which it may consider fit to impose. This approval will be valid for a maximum of 12 months from the date of granting of the approval. Within this period of 12 months, the company must put in place the technology platform, enter into all other legal documentations required. We are of the view that during this period, the entity will be allowed to break the fixed deposit and utilize that money to incur capital expenditure as the ones mentioned above. The entity will have to report position of compliance with the terms of grant of in-principle approval to the RBI.

Once the systems are in place and the RBI is satisfied that the entity is ready to commence operations, it shall grant the Certificate of Registration as an NBFC–P2P.

This high NOF requirements and the long gestation can deter prospective players from entering into the market.

1.3. Existing P2Ps

The situation will be different for entities who are already into the business. Any entity carrying out the business of Peer-to-peer lending platform as on the effective date of these Directions, can continue to do so provided that they apply for registration as an NBFC-P2P to the RBI  within 3 months from the date of effect of these Directions. This will however, not hamper their business, as the RBI allows them to carry on the business, during the pendency of the application and until the application for issuance of CoR is rejected. If the application is rejected, the applicant will have to wind up its business.

2. Scope of Activities

The Master Directions, next, discuss about the Dos and Don’ts of the P2P lending platforms. Let us first discuss about the Dos.

2.1. Dos

An NBFC-P2P can only act as an intermediary that provides an online platform to the participants, i.e., borrowers and lenders, involved in P2P lending. It should ensure adherence to legal requirements applicable to the participants as prescribed under relevant laws, which means this includes the KYC Directions prescribed by RBI.  It is also required to store and process all data relating to its activities and participants on hardware located within India. It is permitted to invest in instruments specified by RBI provided they are not traded in.

Another important function that has been added to the scope of the NBFC-P2P credit assessment and risk profiling of the borrowers, the findings of which must be disclosed to the prospective lenders. Earlier, only few of the platforms carried out underwriting on behalf of the lenders, but, henceforth, this is something that a platform will have to carry out mandatorily.

In addition to the above, NBFC-P2Ps will have to get themselves registered with all the Credit Information Companies (CICs) in the country and file the credit information (relating to borrowers), and update them regularly on a monthly basis or at such shorter intervals as may be mutually agreed upon between the NBFC-P2P and the CICs.

NBFC-P2Ps shall also ensure that appropriate agreements are executed between the participants and the platform, which should categorically specify the terms and conditions agreed between the borrower, lender and the platform. The interest rates to be charged on the loans must be displayed in Annualized Percentage Rate (APR) format on the website of the platform.

2.2. Don’ts

Despite being an NBFC, NBFC-P2Ps are prohibited from lending on its own. It shall ONLY act as an intermediary and nothing more. It should not provide or arrange any credit enhancement or credit guarantee and also all loans intermediated must be purely unsecured in nature. It is required to maintain an escrow account to transfer funds and should not hold on its own balance sheet any funds received from lenders for lending, or from borrowers for repayment. It is prohibited from cross-selling any product on its platform except for loan specific insurance products. International flow of funds is also not permitted for NBFC-P2Ps.

During surveys we have observed that some P2Ps have been engaged in lending through their own platforms. This will have to be stopped now. P2Ps are not allowed to carry on any other activity other than P2P loan intermediation. This is much stricter regulation than for any other type of NBFC.  Mortgage guarantee companies are allowed to take up any other activity up to 10% of its total assets. All other NBFCs must in general satisfy the principality requirements- at least 50% of its total assets must be financial assets and at least 50% of its total income must be from these assets. This is far more lenient than that being allowed for P2Ps.

 

 

3. Prudential Norms

Like all other Directions issued by the RBI for NBFCs, these Directions also lay down the prudential regulations for this class of entities. They are as follows:

  1. Leverage: The outside liabilities of a platform must not exceed 2 times of its owned funds;
  2. Concentration limits: The Directions provide for several concentration limits, which are:
    1. Maximum that a single lender can lend across all P2P platforms – Rs. 10 lakhs;
    2. Maximum that a single borrower can borrow across all P2P platforms – Rs. 10 lakhs;
  • Maximum that a single lender can lend to a single borrower across all P2P platforms – Rs. 50,000;

One apparent concerns that we can point out in this regard is as follows:

Say for instance, a borrower requires a funding of Rs. 5 lakhs, in such case, the platform will have require at least 20 lenders empanelled with itself to meet the requirements of the borrower. Thus, the platforms will have to have large lender base to survive and be able to satisfy loan requirements of borrowers. Therefore, the success of the platforms will be directly related to the scalability of their business.

The P2Ps are also required to obtain a certificate from the borrower and lender, as applicable, that the aforementioned limits are being adhered to.

  1. Tenure: The tenure of the loans extended through the platforms cannot exceed 36 months.

4. Operational Guidelines

An NBFC-P2P is required to have a Board approved policy in place specifying the eligibility criteria, pricing of services and rules for matching participants on its platform.

The Directions explicitly state that the obligation of an NBFC-P2P does not diminish towards those activities that it has outsourced. It will be held responsible for the actions of its service providers including recovery agents and the confidentiality of information pertaining to the participant that is available with the service provider.

5. Transparency

The Directions has provided for one way transparency. On one hand, it states that the NBFC-P2Ps must disclose to the lender details about the borrower including:

  • personal identity;
  • required amount;
  • interest rate sought; and credit score as per the P2P’s credit rating mechanism;
  • terms and conditions of the loan, including
    • likely return; and
    • fees and taxes associated with the loan.

On the other hand it requires the NBFC-P2Ps to make the following disclosures to the borrowers:

  • amount of loan proposed by the lender
  • the interest rate offered by the lender etc.

However, it restricts the platform to give out the personal identity and contact details of the lender to the borrower.

Therefore, the Directions provide for full transparency with respect to borrower’s information but partial transparency with respect to lender’s information.

Apart from information of the participants, the Directions require the platforms to provide the following information on its website:

  1. overview of credit assessment/score methodology and factors considered;
  2. disclosures on usage/protection of data;
  3. grievance redressal mechanism;
  4. portfolio performance including share of non-performing assets on a monthly basis and segregation by age; and
  5. its broad business model.

6. Signing of the loan terms

One of the requirements of the Direction is that no loan shall be disbursed unless the individual lender has approved the individual recipient of loan and all the concerned parties have signed the loan contract.

Here it is important to take a note that while signing the terms of loan, sufficient measures must be taken by the platform to ensure that the personal and contact details of the lender continues are not revealed to the borrower, owing to the restrictions imposed by the Directions on the platform with respect to transparency.

7. Fund Transfer Mechanism

RBI has put a lot of focus on implementing an efficient fund transfer mechanism in order to eliminate any fears of money laundering or usage by the company for its benefit. The Directions stipulate that Fund transfer between the participants on the Peer-to-peer lending platform must take place through escrow accounts which will be operated by a trustee, who must mandatorily be promoted by the bank maintaining the escrow accounts. At least 2 escrows accounts must be maintained – one comprising funds received from lenders and pending disbursal, and the other for collection from borrowers as repayment of loans. All forms of transfer of funds must take place through bank accounts ONLY and cash transactions are prohibited. The graphical representation of the proposed mechanism was included in the Directions, the same has been reproduced below for your reference.

 

The graphic provided on the Directions for the funds transfer mechanism is somewhat ambiguous as it shows only one escrow account, and also shows direct flow of instructions between the lender/borrower and the Trust, which is odd, as it is the platform who should control the flow of information to the Trust.

8. Fair Practices Code

NBFC-P2Ps are required to follow the usual NBFC related Fair Practices Code (FPC) with the approval of its board. They are further required to disclose the same on their website for the information of various stakeholders.

The NBFC-P2Ps are prohibited from providing any assurances on the recovery of loans.
The platform is required to post the following disclaimer on its website –

“Reserve Bank of India does not accept any responsibility for the correctness of any of the statements or representations made or opinions expressed by the NBFC-P2P, and does not provide any assurance for repayment of the loans lent on it”

The Board of Directors shall also provide for periodic review of the compliance of the Fair Practices Code and the functioning of the grievances redressal mechanism at various levels of management. A consolidated report of such reviews shall be submitted to the Board at regular intervals, as may be prescribed by it.

9.Information Technology Framework

Given the fact that the core operation of P2P lending platforms depends on a robust IT framework, the Directions state that the technology must be scalable in nature to handle growth in business. The Directions also stipulate that there should be adequate safeguards built in its IT systems to ensure that it is protected against unauthorized access, alteration, destruction, disclosure or dissemination of records and data. The RBI also reserves the right to, from time to time, prescribe technical specifications, as deemed fit. The rest of the IT laws are same as those issued to NBFC-SIs in general.

10.Fit and Proper Criteria

An NBFC-P2P must ensure that a policy is put in place with the approval of Board of Directors, setting out the ‘Fit and Proper’ criteria to be met by its directors and also obtain a Deed of Covenants signed by the Directors. RBI may, if it deems fit and in public interest, may independently assess the directors and have the power to remove the concerned directors.

The guidelines have, surprisingly, been kept at par with NBFC-SI. The Deed of Covenants, regular reporting requirements etc. are all observed by NBFCs which are systemically important i.e. NBFCs having asset size of over 500 crores. For P2P platforms to have to observe these is perhaps over-regulation.

11.Requirement to obtain prior approval of the Bank for allotment of shares, acquisition or transfer of control of NBFC-P2P

Given the fact that most P2P lending platforms are start-ups in nature, the requirements are very restrictive in nature. The Directions stipulate that prior approval from the banks will be required in case of:

  1. any allotment of shares which will take the aggregate holding of an individual or group to equivalent of 26 per cent and more of the paid up capital of the NBFC-P2P;
  2. any takeover or acquisition of control of an NBFC-P2P, which may or may not result in change of management;
  3. any change in the shareholding of an NBFC-P2P, including progressive increases over time, which would result in acquisition by/ transfer of shareholding to, any entity, of 26 per cent or more of the paid up equity capital of the NBFC-P2P;
  4. any change in the management of the NBFC-P2P which would result in change in more than 30 per cent of the Directors, excluding independent Directors;
  5. any change in shareholding that will give the acquirer a right to nominate a Director

A public notice of at least 30 days shall be given before effecting the sale or transfer of the ownership.

The format for application for prior approval is the same as for other NBFCs.

This is quite unprecedented level of regulation and will seriously increase the bureaucracy PE/VC investors and startups have to go through before a funding round can be closed.  Even a 1% allotment which takes one’s shareholding past 26%, then prior permission will be required. Again, should an investor want the right to nominate a Director, then prior approval will be required. This level of regulation is higher than for regular NBFCs and would slow down the process of investments in P2P platforms in India.

12. Reporting Requirements

NBFC-P2Ps must submit a statement showing number and amount of loans during, at the closing of and outstanding at the beginning and end of quarter, including the number of lenders and borrowers outstanding as at the end of quarter to RBI regional office within 15 days after the quarter to which they relate.

They must also disclose the amount of funds held in the Escrow Account, with credit and debit summations for the quarter. Further, number of complaints outstanding at the beginning and end of quarter and disposed of during the quarter, bifurcated between the lenders and borrowers must also be disclosed in order to constantly improve the state of the industry.

13. Conclusion

The regulations on P2P platform was much awaited, but the way the Directions have been crafted, this could cause serious damage to these platforms. To start with, the requirement of maintaining NOF of Rs. 2 crores is not justified since the business is not a capital intensive one. Next, we also feel that RBI has taken a very cautious approach with respect to the credit concentration, however, we feel that this may be enhanced in the future looking at the performance of the sector. Next, the time required for registration of new P2P platforms also seems to be on the higher side. Further, the list of instances for which prior approval will have to be sought from RBI by the platform, may act as a deterrent for the investors who may interested in investing in P2P platforms.

Having said that, the attempt of giving a regulatory shape to the P2P businesses in India, itself must be applauded.


[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11137