Archive for category: NBFCs

– By Saloni Mathur (finserv@vinodkothari.com)

Introduction

Just when the NBFCs were grappling with the outburst of RBI’s Ombudsman Scheme which was proposed to come into effect from 23^rd February, 2018, FIU-IND released the list of ‘High risk NBFCs’[1] (‘List’) on account of non-compliance with the Prevention of Money Laundering Act, 2002 (‘PMLA Act’)[2] and the Prevention of Money Laundering (Maintenance of Records) Rules, 2005[3] (‘PMLA Rules’).

The Financial Intelligence Unit in the List laid down 9500 high risk NBFC’s that are coming under the ambit of the non-compliance with the PMLA Act and the PMLA Rules in respect of non-registration of the Principal Officer(PO) as on 31.01.2018.

Rationale

The intent of the Financial Intelligence Unit seems quite rational. Post demonetization in 2016 it has been strongly witnessed that several NBFCs were taking advantage of their business models by allegedly converting banned currency notes and accepting cash as deposits, and subsequently violating the provisions of the PMLA Act and the PMLA Rules. In order to curb this malpractice, the FIU has issued a warning to the NBFCs by categorizing them as ‘high risk NBFCs’ on the basis of non-compliance with the PMLA Act and the PMLA Rules with regard to non-appointment of the Principal Officer and the kind of repercussions that these may encounter in the case of any further non-compliance.

Legality emanating the ‘High Risk Classification’

The legality that governs the above high-risk classification of the NBFCs has its roots from the PMLA Act, PMLA Rules and the RBI directions titled, ‘The Reserve Bank of India (Know Your Customer (KYC)) Directions, 2016’ applicable to all the Regulated Entities (RE’s) as defined in 3(b)(xiii) of the said directions[4].

Clause wa of Chapter 1 of the PMLA Act, 2002 defines Reporting entity:

“Reporting entity” means a banking company, financial institution, intermediary or a person    carrying on a designated business or profession.”

Clause f of the PMLA (Maintenance of Records) Rules, 2005 defines Principal Officer:

“Principal Officer” means an officer designated by a Reporting Entity.”

Rule 3 of the PMLA( Maintenance of Records) Rules 2005 deal with the maintenance of the records and the transactions of following nature and value:

• “All cash transactions of the value of more than 10 lakhs or its equivalent in the foreign currency
• All series of cash transactions integrally connected to each other which have been individually valued below rupees ten lakh or its equivalent in foreign currency where such series of transactions have taken place within a month and the monthly aggregate exceeds an amount of ten lakh rupees or its equivalent in foreign currency.”
• All transactions involving receipts by non-profit organizations of value more than rupees ten lakh, or its equivalent in foreign currency.
• All cash transactions where forged or counterfeit currency notes or bank notes have been used as genuine or where any forgery of a valuable security or a document has taken place facilitating the transactions;
• All suspicious transactions whether or not made in cash and by way of-
• deposits and credits, withdrawals into or from any accounts in whatsoever name they are referred to in any currency maintained by way of-
• cheques including third party cheques, pay orders, demand drafts, cashier cheques, or any other instrument of payment of money including electronic receipts or credits and electronic payments or debits, or
• travellers cheques, or
• transfer from one account within the same banking company, financial institution and intermediary, as the case maybe including from or to nostro and Vostro accounts, or
• any other mode in whatsoever name it is referred to;
• all cross border wire transfers of the value of more than five lakh rupees or its equivalent in foreign currency where either the origin or destination of fund is in India.
• All purchase and sale by any person of immovable property valued at fifty lakh rupees or more that is registered by the reporting entity, as the case maybe.”

Following table represents various compliances by the reporting entity and their respective principal officers in respect to the above functions under various legal regulations:

 Impact of such release on NBFCs

The publication of names is primarily a step by the FIU to make the public aware that these NBFCs are not law compliant and they should refrain from indulging into transactions with them. Through this release NBFCs are being urged to comply with this ‘basic obligation’ of appointing a principal officer who would oversee the compliances under the PMLA Act and the PMLA rules.

The Financial Intelligence Unit has come out with this list with an intent to warn the NBFCs in case of non-compliance with the PMLA Act, 2002 and the PMLA Rules, 2005. Further failure to comply with the provisions of the PMLA Act, 2002 and the PMLA Rules, 2005 specifically non-registration of the Principal officer would require stringent penal proceedings against the NBFC as specified in Section 13(2) of the PMLA Act, 2002.

Section 13(2) of the PMLA Act, 2005 prescribes certain standing instructions and monetary penalty for all applicable entities. These are as follows:

Standing instructions that might be imposed by the FIU

• Director may issue a warning in writing.
• Direct such reporting entity or its designated director on the board or any of its employees, to comply with the specific instructions
• Direct reporting entity to send reports at regular intervals as may be prescribed

Monetary Penalty that might be imposed by the FIU

• Penalty shall not be less than ten thousand rupees but may exceed to one lakh rupees for each failure.

The intent of this circular does not seem so stringent in nature presently. NBFCs who have not appointed Principal officer as on date are required to appoint them in order to remove the name from this list. This warning is issued in the nature of a standing instruction, which soon has to be complied by all the NBFCs who are not complying with the provisions of the Act.

Quick Actionable by the NBFCs

• Appoint Principal Officer
• Ensure communication of name, designation and address of the Principal Officer to the director, FIU-IND
• Ensure that the Principal Officer reports all transactions under rule 3 of the PMLA( Maintenance of Records) Rules, 2005 to the director, FIU-IND.

Conclusion

Generation of the above list can be viewed as a measure by the Financial Intelligence Unit a standing instruction to all the NBFC’s to comply with provisions of the PMLA Act, 2002 and the respective Rules regarding the appointment of the Principal Officer

This standing instruction may turn into severe stringent penalty in case of further non-compliance. Thus if the principal officer is failed to get appointed until now, NBFCs can ensure their appointment now in order to escape any further penalties that may arise in this regard.

[1] http://fiuindia.gov.in/pdfs/quicklinks/High%20Risk%20NBFCs%20as%20on%2031.01.2018.pdf

[2] http://lawmin.nic.in/ld/P-ACT/2003/The%20Prevention%20of%20Money-laudering%20Act,%202002.pdf

[3] http://www.enforcementdirectorate.gov.in/pmla_rules.pdf

[4] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/18MDKYCD8E68EB13629A4A82BE8E06E606C57E57.PDF

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 12^th 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] https://consumeraffairs.nic.in/sites/default/files/file-uploads/direct-selling/Direct%20Selling%20Guidelines%20Final%20_0.pdf

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

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.

Read more →

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 ‘21^st 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