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NBFCs get another chance to reinstate NOF

By Falak Dutta, (finserv@vinodkothari.com)

Since the Sarada scam in 2015, the Reserve Bank of India (RBI) had been on high alert and had been subsequently tightening regulations for NBFCs, micro-finance firms and such other companies which provide informal banking services. As of December 2015, over 56 NBFC licenses were cancelled[1]. However, recently in light of the uncertain credit environment (recall DHFL and IF&LS) among other reasons, RBI has cancelled around 400 licenses [2]in 2018 primarily due to a shortfall in Net Owned Funds (NOF)[3] among other reasons. The joint entry of the Central Govt. regulators and RBI to calm the volatility in the markets on September 21st, 2018 after an intra-day fall of over 1000 points amid default concerns of DHFL warrants concern. Had it been two isolated incidents the regulators and Union government would have been unlikely to step in. The RBI & SEBI issued a joint statement on September saying they were prepared to step in if market volatility warrants such a situation. This suggests a situation which is more than what meets the eye.

Coming back to NBFCs, over half of the cancelled NBFC licenses in 2018 could be attributed to shortfall in NOFs. NOF is described in Section 45 IA of the RBI Act, 1934. It defines NOF as:

1) “Net owned fund” means–

(a) The aggregate of the paid-up equity capital and free reserves as disclosed in the latest

Balance sheet of the company after deducting therefrom–

(i) Accumulated balance of loss;

(ii) Deferred revenue expenditure; and

(iii) Other intangible assets; and

(b) Further reduced by the amounts representing–

(1) Investments of such company in shares of–

(i) Its subsidiaries;

(ii) Companies in the same group;

(iii) All other non-banking financial companies; and

(2) The book value of debentures, bonds, outstanding loans and advances

(including hire-purchase and lease finance) made to, and deposits with,–

(i) Subsidiaries of such company; and

(ii) Companies in the same group, to the extent such amount exceeds ten per cent of (a) above.

At present, the threshold amount that has to be maintained is stipulated at 2 crore, from the previous minimum of 25 lakhs. Previously, to meet this requirement of Rs. 25 lakh a time period of three years was given. During this tenure, NBFCs were allowed to carry on business irrespective of them not meeting business conditions. Moreover, this period could be extended by a further 3 years, which should not exceed 6 years in aggregate. However, this can only be done after stating the reason in writing and this extension is in complete discretion of the RBI. The failure to maintain this threshold amount within the stipulated time had led to this spurge of license cancellations in 2018.

However, the Madras High Court judgement dated 29-1-2019 came as a big relief to over 2000 NBFCs whose license had been cancelled due a delay in fulfilling the shortfall.

 

THE JUDGEMENT[4]

The regulations

On 27-3-2015 the RBI by notification No. DNBR.007/CGM(CDS)-2015 specified two hundred lakhs rupees as the NOF required for an NBFC to commence or carry on the business. It further stated that an NBFC holding a CoR and having less than two hundred lakh rupees may continue to carry on the business, if such a company achieves the NOF of one hundred lakh rupees before 1-04-2016 and two hundred lakhs of rupees before 1-04-2017.

The Petitioner’s claim

The petition was filed by 4 NBFCs namely Nahar Finance & Leasing Ltd., Lodha Finance India Ltd., Valluvar Development Finance Pvt. Ltd. and Senthil Finance Pvt. Ltd. for the cancellation of CoR[5] against the RBI. The petitioners claim that they had been complying with all the statutory regulations and regularly filing various returns and furnishing the required information to the Registrar of Companies. These petitions were in response to the RBI issued Show Cause Notices to the petitioners proposing to cancel the CoR and initiate penal action. The said SCNs were responded to by the petitioners contending that they had NOF of Rs.104.50 lakhs, Rs.34.19 lakhs, Rs.79.50 lakhs and Rs.135 lakhs respectively, as on 31.03.2017.

Valluvar Development Finance also sent a reply stating that they had achieved the required NOF on 23-10-2017, attaching a certificate from the Statutory Auditor to support its claim. The other petitioners however submitted that due to significant change in the economy including the policies of the Govt. of India during the fiscal years 2016-17 and 2017-18 like de-monetization and implementation of Goods & Services Tax, the entire working of the finance sector was impaired and as such sought extension of time till 31-03-2019 to comply with the requirements.

Now despite seeking extension of time, having given explanations to the SCNs, the CoRs were cancelled without an opportunity for the NBFCs to be heard.

 

The Decision

It was argued that there is a remedy provided against the cancellation of the CoRs, the petitioners had chosen to invoke Article 226 contending violation of the principles of justice. The proviso to Section 45-IA(6) relates to the contentions in regards to cancellation of the CoRs.

“45-IA. Requirement of registration and net owned fund –

(3) Notwithstanding anything contained in sub-section (1), a non-banking financial company in existence on the commencement of the Reserve Bank of India (Amendment) Act, 1997 and having a net owned fund of less than twenty five lakhs rupees may, for the purpose of enabling such company to fulfill the requirement of the net owned fund, continue to carry on the business of a non-banking financial institution–

(i) for a period of three years from such commencement; or

(ii) for such further period as the Bank may, after recording the reasons in writing for so doing, extend,

subject to the condition that such company shall, within three months of fulfilling the requirement of the net owned fund, inform the Bank about such fulfillment:

Provided further that before making any order of cancellation of certificate of registration, such company shall be given a reasonable opportunity of being heard.

(7) A company aggrieved by the order of rejection of application for registration or cancellation of certificate of registration may prefer an appeal, within a period of thirty days from the date on which such order of rejection or cancellation is communicated to it, to the Central Government and the decision of the Central Government where an appeal has been preferred to it, or of the Bank where no appeal has been preferred, shall be final:

Provided that before making any order of rejection of appeal, such company shall be given a reasonable opportunity of being heard.

The decision was taken on two grounds. First, the statute specifically provides for an opportunity of personal hearing besides calling for an explanation. The amended provision is very particular that opportunity of being personally heard is mandatory, as the very amendment relates to finance companies, which are already carrying on business also. Not affording this opportunity would cripple the business of the petitioners.

Second, the amended section provides NBFCs sufficient time to enhance their NOF by carrying on business and comply with the notifications. For the aforesaid reasons, the orders by the RBI requires interference. Resultantly, the respondents (RBI authorities) are directed to restore the CoR of the petitioners and also extend the time given to the petitioners.

 

CONCLUSION

This was a landmark hearing in the case of NBFCs as they had been under increasing pressure as of recent times. Many NBFCs can now apply for restoration of their licenses and might already have. The case doesn’t just stand the case for NOF conflicts but will also ring in the minds of regulators in the future, compelling greater caution and concern. The last statement of the judgement stands apt here. The brief sentence read,” Consequently connected miscellaneous petitions are closed.”

[1] https://economictimes.indiatimes.com/news/economy/finance/rbi-cancels-license-of-56-nbfcs-bajaj-finserv-gives-away-license/articleshow/50045835.cms?from=mdr

[2] https://www.businessinsider.in/indias-central-bank-has-scrapped-the-licenses-of-nearly-400-nbfcs-so-far-this-year/articleshow/65698193.cms

[3] https://www.firstpost.com/business/ilfs-dhfl-shocks-may-be-temporary-triggers-but-the-bad-news-for-indian-financial-markets-do-not-end-there-5248071.html

[4] https://enterslice.com/learning/wp-content/uploads/2019/02/Madras-high-court-Judgement-on-NBFC-License-Cancellation.pdf

[5] Certificate of Registration

Section 94B: Thin capitalization rules may impede operations of NBFCs, by Nidhi Bothra & Kanishka Jain, 24th May, 2017

Genesis of the thin capitalization rules

The genesis of the thin capitalization rules lies in the distinction between tax treatment of debt and equity.  A company typically finances its projects either through equity and debt or mixture of both, equity being costly in terms of cost and ownership is less attractive than the debt financing where interest is a deductible expense. Debt is not only less expensive to service, it also reduces tax liabilities and enhances return on equity.

Read more