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Open in new tab Offline Payment aggregators to be under regulatory scheme: RBI proposes amendments to PA regime
Archisman Bhattacharjee and Manisha Ghosh I finserv@vinodkothari.com
Introduction
On April 16, 2024, the Reserve Bank of India (RBI) issued Draft Directions on the Regulation of Payment Aggregators (PAs) (‘Draft PA Directions’) serving two primary purposes:
- Regulating Offline PAs i.e. PAs operating at physical points of sale, an area previously not covered by existing regulations.
- Amendments to the current guidelines concerning Payment Aggregators, primarily intended to extend the scope of the extant regulations to offline PAs; however, having several additionalities such as PA’s due diligence on the merchants, ongoing merchant monitoring based on business profile, disallowing payment to any other account on specific directions from the merchant etc.
Demand and call loans: Economics and regulatory considerations
Vinod Kothari | finserv@vinodkothari.com
From lenders’ perspective, demand and call loans seem to be as liquid as money in a bank fixed deposit, and yet an option to earn substantially higher interest rates. The practice of demand loans exists in the financial marketplace; at the same time, it is often commonplace in the case of intra-group loans. However, there are various risks, considerations and regulatory implications in case of such lending.
This article goes beyond Reg. 28 of the Scale Based Regulations of the RBI and discusses economics, policy issues, liquidity and credit risk considerations, both for the lender and the borrower, as well as issues like NPA treatment, expected credit losses, etc.
What is a demand/call loan?
The word “call money” is typically used in the banking sector for very short-term loans, which are callable at any time by the lender. Demand loan is a term usually associated with longer-term loans, though with no fixed repayment date, that is to say, the loan may be demanded back by the lender at any time. The following features of demand/call loans are discernible:
- There is no fixed repayment date, but that does not mean there is no outer date for seeking repayment of the loan at all. For example, the terms of the loan may say – the lender may seek repayment of the loan at any time; however, if any earlier repayment is not demanded by the lender, the loan will be repaid on its 1st anniversary. Hence, there is an outer date, subject to the possibility of the lender demanding repayment at any time.
- Given its nature, the loan is also puttable by the borrower, that is, repayable by the borrower at the borrower’s instance. It does not seem logical to impose a prepayment penalty for earlier voluntary repayment by the borrower.
- Does the demand loan have to be repaid immediately upon demand? Except in the case of call loans which are very short-term loans by nature, a demand loan may provide a certain number of days after demand, for example, 14 days after demand is made by the lender.
- Can the repayment of the loan be demanded by the lender partially? The answer seems to be affirmative; of course, the borrower may repay the whole of the loan.
- The principal amount of the loan is payable on demand; how about the interest? The interest should still be serviced regularly. Reg 28.2 (iv) and (v) expect interest to be serviced monthly or quarterly, unless the sanctioning authority records a reason for not insisting on regular interest service.
- In demand loans, liquidity evaluation is as equally as important as the credit evaluation of the borrower. This is quite obvious, because however strong the financial position of the borrower, if the borrower does not have access to ready sources of liquidity, he will not be able to pay on demand.
Some relief in RBI stance on lenders’ round tripping investments in AIFs
– Team Finserv | finserv@vinodkothari.com
The Reserve Bank of India on 19th December 2023 issued a notification[1] imposing a bar on all regulated entities[2] (REs) with respect to their investments in AIFs. We had covered the same in our earlier write-up. The Circular has already created some bloodshed as several banks took a hit in their Q3 results. Though late, yet welcome, the RBI has now come with some relief by a March 27 2023 circular. The following Highlights are based on the original circular, as amended by the March 27th circular :-
What has the RBI done?
- Prohibited all regulated entities (REs), including banks, cooperative banks, NBFCs and All India Financial Institutions from making investments in Alternative Investment funds (AIFs), if the AIF has made any investment in a “debtor company”, other than by way of equity shares of the debtor company. Hence, if the AIF has made investment by way of bonds, structured capital instruments, etc., issued by a debtor company, the bar as above will apply.
- Debtor company means a company in which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months
- The bar applies immediately, that is, effective 19th Dec 2023. No further investments to be made.
- If investments already exist, the RE shall exit within 30 days, that is, by 18th Jan., 2024. Hindsight clearly shows that for most regulated entities, there was no way to cause exit, as AIF investments are evidently illiquid. Hence, most regulated entities took a hit on their P/L.
- Further, if an RE has made an investment in an AIF, and the AIF invests in a debtor company, the RE shall make an exit within 30 days.
- Investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ subject to full deduction from RE’s capital funds. See further discussion on priority distribution model below.
What was the intent?
- Since several REs have affiliated AIFs, routing the money through AIFs to borrowers might have led to ever greening. That is, the AIF would invest the money into a debtor company, and consequently, the debtor company would keep its account as a performing asset. In essence, the AIF was acting as a stopover in the process of round tripping of the money back to a debtor company, from where it will be used to pay off the lender.
What will be the impact of the Circular?
- Most of the larger REs have affiliated AIFs. Flow of funds to them from the RE would stop completely.
- The sweep of the circular is wide and non-discriminatory. Not only affiliated AIFs, but any AIF in general will be dried of funding from REs. While the bar is only for those AIFs which have invested in “debtor companies”, it will be practically tough for REs to avoid overlapping investments. Given the severe implications of a breach, compliance-sensitive REs will avoid investing in AIFs.
- There is an immediate disinvestment pressure on AIFs, as there may be overlapped investments. AIFs’ assets are mostly illiquid – ensuring exit to RE investors may be tough. In many cases, there are lock-in restrictions as well.
- Not only has the RBI expressed concerns, SEBI also issued a consultation paper for enhancement of trust in the AIF ecosystem, citing use of AIFs for regulatory arbitrage. See our write up on the SEBI proposals.
Direct or indirect investments:
- As the Circular is driven by concerns of round-tripping, widening the circuit by creating more stop-overs does not help. For example, if a lender invests in an AIF, which invests in an intermediate entity, which in turn invests in a debtor entity, the trail of the money is clear. Likewise, the lender may be making an indirect investment in an AIF.
- However, where there is no round-tripping of the money to a “debtor company”, there should be no concern. For example, if a lender makes a loan to an entity, where an AIF of the group has also made investments, there is no flow of money from the lender to the AIF, for the purpose of the downstream investment by the AIF into the debtor company.
Investments through mutual funds and FOFs exempt:
- The 27th March circular exempts instances where investments are made by lenders into mutual funds or FoFs, and those in turn have some exposure in either an AIF or in a debtor entity.
Priority distribution model or structured AIFs
- In addition to the concerns on downstream investments by AIFs in debtor companies, the RBI also had concerns on the so-called structured AIFs or AIFs with a distribution waterfall. Whether AIFs can at all have a priority distribution waterfall is currently under SEBI examination and SEBI has stopped AIFs from using structured distribution schemes (by way of accepting fresh commitment or making investment in a new investee company) . However, several existing schemes have such models.
- If a lender makes an investment in the subordinated units of a structured AIF scheme such investments will get deducted from the regulatory capital of the lender. The March 27 circular now clarifies that the deduction will be equally from Tier 1 and Tier 2 capital. Further, it also clarifies that the subordinated exposures in the AIF schemes could be in the form of subordinated exposures, including investment in the nature of sponsor units.
Concern areas
- Ideally, the bar should have been limited to affiliated AIFs. Affiliated AIFs could have been defined appropriately – for example, a related party, or where the investment manager, or sponsor is a related party of the RE. Extending the bar to all AIFs is quite far from the intent of the circular – which is, admittedly, to curb evergreening. It is difficult to see how unrelated AIFs can be used by an RE to evergreen, as investment decisions of these AIFs are not exercised by the investors.
- Ideally, the bar should have been limited only to Cat 1 and Cat 2 AIFs. Cat 3 AIFs, widely known as hedge funds, typically play in equity long/short strategies, or do other leveraged trades. REs find such investment a useful way to diversify their funds into hedge funds. Hedge fund investments are common by institutional investors all over the world; an outright curb on these investments by REs is, once again, beyond the stated intent. Notably, given the wide range of investments that Cat 3 AIFs make, avoiding an overlap with the RE’s borrowers will be quite impractical.
- Practical implementation of this circular, if at all a RE invests in an AIF, will be quite tough. AIFs will have to share their potential investment list, which will be against any investment manager’s choice. Assuming there is an overlapped investment, the RE will have to exit within 30 days, which will create liquidity issues for AIFs, in addition to challenging the lock-in restrictions.
- Most of the regulated entities took a provision in the 3rd quarter. The 27th March circular of the RBI gives some relief by saying that the provision will be required only to the extent of the downstream investment in a debtor entity.
In our view, there is a need to review the regulatory mechanism for AIFs, as currently, AIFs are being used as instruments of regulatory arbitrage.
[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0
[2] Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative Banks, All-India Financial Institutions, Non-Banking Financial Companies (including Housing Finance Companies)
Other articles related to the topic:
- RBI bars lenders’ investments in AIFs investing in their borrowers
- AIFs ail SEBI: Cannot be used for regulatory breach
- SEBI’s standard approach, standardising valuation for AIFs
- Comparison between non-deposit accepting NBFC – Investment and Credit Company (NBFC-ND-ICC), Core Investment Company (CIC) and an Alternative Investment Fund (AIF)
- Snippet on credit of existing & issue of new units of AIFs in demat form
- SEBI amends framework for Large Value Funds
Choppy landing for soft lending: Regulatory concerns on quality of lending
– Vinod Kothari, finserv@vinodkothari.com
Some of the RBI’s recent stringent actions, with stop-business directions, raise an alarm amongst financial sector entities. Are these concerns limited to a particular type of lending, or can they lead to any general observations on the quality of lending? One shouldn’t be tunnel-visioned and believe that these regulatory objections are limited to specific types of collateral – gold lending, IPO funding or loans against share trading. In fact, underlying these concerns is a general philosophy – lenders must do a close introspection of their lending practices.
Read more →Streamlined Regulatory Reporting Across Specified Entities
– Archisman Bhattacharjee & Kaushal Shah | finserv@vinodkothari.com
What is the circular about?
In order to harmonise the procedure of filing of regulatory returns across Supervised Entities (SEs) and create a single reference point, the RBI has issued Master Directions RBI (Filing of Supervisory Returns) Directions, 2024 (‘Returns Master Directions’) on February 27, 2024. As stated in the Statement on Developmental and Regulatory Policies dated August 10, 2023, these directions consolidate and harmonize instructions for filing supervisory/ regulatory returns.
Who is it applicable on?
The Returns Master Directions cover the following entities, collectively referred to as Supervised Entities (‘SEs’):
- All Commercial Banks including:
- Public Sector Banks,
- Private Sector Banks,
- Small Finance Banks,
- Payments Bank,
- Local Area Banks, and
- Foreign Banks.
- (excluding Regional Rural Banks)
- Primary (Urban) Co-operative Banks.
- All India Financial Institutions (including Exim Bank, NABARD, NHB, SIDBI, and NABFID)
- All NBFCs (excluding HFCs)
- HFCs are excluded as their supervisory role is undertaken by NHB
- All Asset Reconstruction Companies
From when are the new Returns Master Directions effective?
These Master Directions are effective immediately as on the date of notification (i.e. February 27, 2024).
Read more →The Promise of Predictability: Regulation and Taxation of Future Flow Securitization
Dayita Kanodia | Executive | finserv@vinodkothari.com
The most reliable way to predict the future is to create it
– Abraham Lincoln
Surely, Lincoln did not have either securitisation or predictability in mind when he wrote this motivational piece; however, there is an interesting and creative use of securitisation methodology, to raise funding based on cashflows which have some degree of predictability. In many businesses, once an initial framework has been created, cashflows trickle over time without much performance over time. These situations become ideal to use securitisation, by pledging this stream of cashflows to raise funding upfront. Surely, traditional methods of on-balance-sheet funding fail here, as there is very little assets on the balance sheet.
Read more →Securing the Beat: Tuning into Music Royalty Securitization
Dayita Kanodia | finserv@vinodkothari.com
“Music can change the world”
–Ludwig van Beethoven
This quote by Beethoven remains relevant today, not only within the music industry but also in the realm of finance. In the continually evolving landscape of finance, innovative strategies emerge to monetize various assets. One such groundbreaking concept gaining traction in recent years is music royalty securitization. This financial mechanism offers investors a unique opportunity to access the lucrative world of music royalties while providing artists and rights holders with upfront capital.
The roots of this innovative financing technique can be traced back to the 1990s when musician David Bowie made history by becoming the first artist to securitize his future earnings through what became known as ‘Bowie Bonds’. This move not only garnered attention but also paved the way for other artists to follow suit. Bowie Bonds marked a significant shift in how music royalties are bought, sold, and traded.
As per the S&P Global Ratings[1], the issuance of securities backed by music royalties totaled nearly $3 billion over the two-year span 2021-22. The graph below shows a recent surge in issuance of securities backed by music royalties.
Data showing the growth of Music Royalty Securitization
This article discusses music royalty securitization, its mechanics, benefits, challenges along with implications for the music industry.
Understanding Music Royalties:
Before exploring music royalty securitization, it’s essential to understand the concept of music royalties. In the music industry, artists and rights holders earn royalties whenever their music is played, streamed, downloaded, or licensed for use. These royalties are generated through various channels, including digital platforms, radio, TV broadcasts, live performances, and synchronization licenses for commercials, movies, and TV shows. However, it’s important to note that artists only earn royalties when their music is utilized, whether through sales, streaming, broadcasting, or live performances.
As a result, the cash flows from these royalties being uncertain are received over time and continue to be received for an extended period. Consequently, artists experience a delay in receiving substantial amounts from these royalties, sometimes waiting for several years before seeing significant income.
The Birth of Music Royalty Securitization:
Securitization involves pooling and repackaging financial assets into securities, which are then sold to investors. The idea is to transform illiquid assets, such as mortgage loans or in our case, music royalties, into tradable securities. Music royalty securitization follows a similar principle, where the future income generated from music royalties is bundled together and sold to investors in the form of bonds or other financial instruments.
Future Flows Securitization:
Music royalty securitization is a constituent of future flows securitization and therefore before discussing the constituent, it is important to discuss the broader concept of future flows securitization.
Future flows securitization involves the securitization of future cash flows derived from specific revenue-generating assets or income streams. These assets can encompass a wide range of future revenue sources, including export receivables, toll revenues, franchise fees, and other contractual payments, even future sales. By bundling these future cash flows into tradable securities, issuers can raise capital upfront, effectively monetizing their future income. Future flows securitization differs from the traditional asset backed securitization by their very nature as while the latter relates to assets that exist, the former relates to assets that are expected to exist. There is a source, a business or infrastructure which already exists and which will have to be worked upon to generate the income. Thus, in future flows securitization the income has not been originated at the time of securitization. The same can be summed up as: In future flow securitization, the asset being transferred by the originator is not an existing claim against existing obligors, but a future claim against future obligors.
Mechanics of Music Royalty Securitization:
Music royalty securitization involves packaging the future income streams generated by music royalties into tradable financial instruments. The process begins with the identification of income-generating assets, which are then bundled into a special purpose vehicle (SPV). The SPV issues securities backed by these assets, which are sold to investors. The revenue generated from the underlying music royalties serves as collateral for the securities, providing investors with a stream of income over a specified period.
The process of music royalty securitization typically involves several key steps:
Asset Identification: Rights holders, such as artists, record labels, or music publishers, identify their future royalty streams eligible for securitization.
Valuation: A valuation is conducted to estimate the present value of the anticipated royalty income streams. Factors such as historical performance, market trends, and artist popularity are taken into account.
Selling the future flows: The future flows from royalties are then sold off to the Special Purpose Vehicle (SPV) to make them bankruptcy remote. The sale entitles the trust to all the revenues that are generated by the assets throughout the term of the transaction, thus protecting against credit risk and sovereign risk as discussed later in this article.
Structuring the Securities: These future cash flows are then structured into securities. This may involve creating different tranches with varying levels of risk and return.
Issuance: The securities are then issued and sold to investors through public offerings or private placements. The proceeds from the sale provide upfront capital to the rights holders.
Revenue Collection and Distribution: The entity responsible for managing the securitized royalties collects the revenue from various sources which is then distributed to the investors according to the terms of the securities.
Importance of Over-collateralization:
Over-collateralization is an important element in music royalty securitization. In music royalty securitization and in all future flows transactions in general, the extent of over-collateralization as compared to asset backed transactions is much higher. The same is to protect the investors against performance risk, that is the risk of not generating sufficient royalty incomes. Over-collateralization becomes even more important since subordination structures generally do not work for future flow securitizations. This is because the rating here will generally be capped at the entity rating of the originator.
Why go for securitization ?
Now the question may arise as to why an artist or a right holder of a royalty has to go for securitization of his music royalties in order to secure funding. Why cant he simply opt for a traditional source of funding ? The answer to this question is two folds:
Firstly, the originator in the present case generally has no collateral to leverage and hardly there will be a lender willing to advance a loan based on assets that are yet to exist.
Secondly even if they are able to obtain funding it will be at a very high cost due to high risk the lender perceives with the lending.
Music royalty securitization, could be his chance to borrow at a lower cost. The cost of borrowing is related to the risks associated with the transaction, that is, the risk the lender takes on the borrower. Now, this risk includes performance risk, that is the risk that the work of the originator does not generate enough cash flows. While this risk holds good in case of securitization as well, it however takes away two major risks – credit risk and sovereign risk.
Credit risk, as divested from the performance risk would basically mean that the originator has sufficient cash flows but does not pay it to the lender. This risk can be removed in case of a securitization by giving the SPV a legal right over the cash flow.
Sovereign risk on the other hand emanates only in case of cross-border lending. This risk arises when an external lender gives a loan to a borrower whose sovereign later on in the event of an exchange crises either imposes a moratorium on payments to external lenders or may redirect foreign exchange earnings. This problem is again solved by giving the SPV a legal right over the cash flows from the royalties arising in countries other than the originator’s, therefore trapping cash flow before it comes under the control of the sovereign.
The lack of these two types of risks might reduce the cost of borrowing for the originator; thus making music royalty securitization a lucrative option.
Accounting Treatment:
As discussed, there is no existing asset in a music royalty transaction. In terms Ind AS 39, an entity may derecognize an asset only when either the contractual rights to the cash flows from the financial asset have expired or if it transfers the financial asset. However, here asset means an existing asset and a future right to receive does not qualify as an asset in terms of the definition under Ind AS 32.
Accordingly, the funding obtained through the securitization of music royalties should be shown as a liability in books as the same cannot qualify as an off-balance sheet funding.
Regulatory Framework in India:
It is crucial to discuss the applicable regulatory framework on securitization currently prevalent in India and whether music royalty securitization would fall under any of these:
- Master Direction – Reserve Bank of India (Securitization of Standard Assets) Directions, 2021(‘SSA Master Directions)
- SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008 (SDI Framework)
- Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
While the SSA Master Directions primarily pertain to financial sector entities, and will not directly apply to this domain; however, there exists a possibility that the securitization of music royalties could fall under the purview of SEBI’s SDI Framework.
The same has been discussed in detail in the artcile- The Promise of Predictability: Regulation and Taxation of Future Flow Securitization
Benefits of Music Royalty Securitization:
Music royalty securitization offers a range of benefits for both investors and rights holders:
Diversification: Investors gain exposure to a diversified portfolio of music royalties, potentially reducing risk compared to investing in individual songs or artists.
Steady Income Stream: Music royalties often provide a stable and predictable income stream, making them attractive to income-oriented investors, such as pension funds and insurance companies.
Liquidity: By securitizing music royalties, rights holders can access immediate capital without having to wait for future royalty payments, providing liquidity for new projects or business expansion.
Risk Mitigation: Securitization allows rights holders to transfer the risk of fluctuating royalty income to investors, providing a hedge against market uncertainties and industry disruptions.
Challenges and Considerations:
While music royalty securitization presents compelling opportunities, it also poses certain challenges and considerations:
Market Volatility: The music industry is subject to shifts in consumer preferences, technological disruptions, and regulatory changes, which can impact the value of music royalties.
Due Diligence: Thorough due diligence is essential to assess the quality and value of music assets, including considerations such as copyright ownership, market demand, and revenue potential.
Potential Risks:
- Market Risk: Changes in consumer behavior, technological advancements, or regulatory developments could impact the value of music royalties.
- Legal Risk: Disputes over ownership rights, copyright infringement, or licensing agreements could lead to litigation and financial losses.
- Concentration Risk: Investing in a single music catalog or genre exposes investors to concentration risk if the popularity of that catalog or genre declines.
- Cash Flow Variability: While music royalties can provide steady income, fluctuations in streaming revenues or changes in licensing agreements may affect cash flow stability.
- Reputation Risk: The success of music royalty securitization depends on the ongoing popularity and commercial success of the underlying music assets. Negative publicity, controversies, or declining relevance can adversely affect investor confidence and returns.
Implications for the Music Industry:
While music royalty securitization presents exciting opportunities, it also raises certain considerations for the music industry:
Artist Empowerment: Securitization can empower artists by providing them with alternative financing options and greater control over their financial destiny.
Industry Evolution: The emergence of music royalty securitization could reshape the traditional music business model, fostering innovation and collaboration between artists, labels, and investors.
Way Forward
Music royalty securitization offers a compelling investment opportunity for investors seeking exposure to the lucrative music industry. By securitizing future royalty streams, music rights owners can unlock liquidity while providing investors with access to a diversified portfolio of music assets.
As the music industry continues to evolve, music royalty securitization is likely to play an increasingly prominent role in the financial landscape, providing new avenues for capital deployment and revenue generation. It has the potential to transform the rhythm of creativity into the melody of investment opportunity.
See also our article on:
[1] https://www.spglobal.com/ratings/en/research/articles/240220-abs-frontiers-music-royalty-securitizations-are-getting-the-band-back-together-13003585
[2] https://incometaxindia.gov.in/Pages/acts/income-tax-act.aspx
[3] https://www.rbi.org.in/scripts/bs_viewmasdirections.aspx?id=12165
[4] https://www.sebi.gov.in/sebiweb/home/HomeAction.do?doListingAll=yes&search=Securitised%20Debt%20Instruments
[5] https://www.indiacode.nic.in/bitstream/123456789/2006/1/A2002-54.pdf