Credit Default Swaps (Global and Indian Scenario)

Credit default swaps (what is happening in global markets and the recommendations of the working group)

Other ‘I am the best’ presentations can be viewed here

Our other resources on related topics –

      1. https://vinodkothari.com/wp-content/uploads/RBIa%CC%82%C2%80%C2%99s-Guidelines-on-Credit-Default-Swaps-for-Corporate-Bonds.pdf
      2. https://vinodkothari.com/2021/02/rbi-issues-draft-directions-on-credit-derivatives/
      3. https://vinodkothari.com/isda_new_definition_credit-derivs_impact/
      4. https://vinodkothari.com/2013/12/secnews-110810/
      5. https://vinodkothari.com/rbi-new-cds-guidelines-feeble-effort-start-non-starting-product/

Registration under Money-Lending laws

Aanchal Kaur Nagpal and Parth Ved (corplaw@vinodkothari.com)

Introduction

More often than not, the term ‘lending activities’ instantaneously brings the ‘Reserve Bank of India’ (‘RBI’) to mind. However, lending business is not the domain of RBI alone. Amidst multiple RBI guidelines governing numerous financial institutions, the state legislations on money-lending have become long forgotten.

Money-lending laws were introduced with an intention to curb non-regulated indigenous lenders from charging exorbitant interest rates to borrowers. These laws typically require licensing of money lenders, impose a ceiling on rate of interest that money lenders can charge, and generally provide that a court shall not take cognizance of a matter filed by an unlicensed money lender.

While financial entities such as non-banking financial companies (‘NBFCs’), banks, insurance companies etc. have been exempted from obtaining money-lending licence as these are regulated by other laws, the question arises whether non-regulated entities undertaking the ‘business’ of lending would require to register under the money-lending laws.

Who are money lenders?

Although there is a strong network of financial institutions, recourse to such institutions, at most times, is not accessible to the rural parts of the country. Further, it is difficult for banks to extend loans to small farmers due to their rigid requirements for KYC and collateral. Money lenders perform a gap-filling function as they majorly cater to a class of borrowers whom other financial institutions, including banks, cannot reach.

Since they have been such an important link between the formal lending sector and the informal borrowing sector, there was a need for a strong framework to regulate their working. According to Entry 30 of List II (i.e. State List) of the Seventh Schedule to the Constitution of India, the State Legislature has exclusive power to make laws on activities relating to money-lending. To regulate the transactions of money-lending in the State of Maharashtra, the state legislature has enacted Maharashtra Money-Lending (Regulation) Act, 2014 (‘Money Lending Act’). However, other states too, have their respective money-lending laws. Our article deals with provisions under the Maharashtra Money Lending Law.

Applicability for registration and exemption

The Money Lending Act states that no money lender shall carry on the business of money-lending except in the area for which he has been granted a licence. The term used here is “business of money-lending”. Business of money-lending is defined as the business of advancing loans whether in cash or kind and whether or not in connection with, or in addition to any other business.

The above definition provides clarity on the following aspects –                                            

  • Money-lending transactions should constitute a business for the lender.
  • It may or may not be the primary business of the lender.
  • It may or may not be in cash.

This raises an important question as to what constitutes ‘business of money-lending’. Are there any lending transactions which are excluded from its purview? The money lending laws exclude certain kinds of loans and lenders. Accordingly, below we discuss various transactions which may not be classified as business of money-lending:

Exclusions from business of money-lending

1.     Secluded or isolated lending transactions

Including secluded or isolated lending transactions in the definition of money-lending business could result in classification of any loan of any amount given by anyone as a business of money-lending. Surely this could not have been the intention of the legislature. Recognising this, the Hon’ble Bombay High Court in Mandubai Vitthoba Pawar v. The State of Maharashtra & Ors. observed:

“11.             …for constituting a business of money lending there has to be a continuous and systematic activity by application of labour or skill with a view of earning income and then it could be called “business”. In order to do business of money lending, it would be necessary for the State to point out multiple activities of money lending done by the petitioner. Merely referring to one isolated transaction claimed to be a loan transaction or money lending would not be enough to attract the provisions of the Act and to brand the petitioner to be a person involved in business of money lending without having any license.”

This was again reiterated in Uttam Bhikaji Belkar vs The State of Maharashtra. This makes it clear that there has to be a continuous lending activity with profit motive to constitute a business of money-lending. If this condition is satisfied, the money lender has to obtain a valid license to carry on such business. Therefore, providing one-time loans with no intention to carry on the business of lending money, will not trigger the requirement of adhering to the money lending laws.

2.     Inter-corporate deposits

The intention of a company giving an Inter-corporate Deposit (ICD) is not to engage in a money-lending transaction but to earn a surplus on the idle funds available with them. In Pennwali India Ltd. and others vs Registrar of Companies it was observed that there exists a relationship of a debtor and a creditor in both cases – loans and deposits. But ICDs could also be for safe-keeping or as a security for the performance of an obligation undertaken by the depositor. Further, in the case of ICD, which is payable on demand, the deposit would become payable when a demand is made. In Housing and Urban Development Corporation Ltd. v. Joint Commissioner of Income Tax, the Hon’ble Income Tax Appellate Tribunal, Delhi Bench held:

“22. …the two expressions loans and deposits are to be taken different and the distinction can be summed up by stating that in the case of loan, the needy person approaches the lender for obtaining the loan therefrom. The loan is clearly lent at the terms stated by the lender. In the case of deposit, however, the depositor goes to the depositee for investing his money primarily with the intention of earning interest.”

Therefore, the money-lending transactions shall not include ICD and companies shall not be required to obtain a license for undertaking such transactions.

3.     Loans to group companies (subsidiary, associate etc.)

In lending transactions between companies within the same group, the intention is not to earn interest on such loan but to facilitate availability of funds to the group company for furtherance of business. Further, loans by companies are governed by Section 186 of the Companies Act, 2013. Section 2(13)(i) of the Money Lending Act states that “a loan does not include a loan to, or by, or deposit with any corporation (being a body not falling under any of the other provisions of this clause), established by or under any law for the time being in force which grants any loan or advance in pursuance of that Act”. Including such transactions under the scope of money-lending business would not be in line with the objects of the Money Lending Act which is to prevent the harassment to the farmers-debtors at the hands of the money lenders or to curb charging exorbitant interest rates.

4.     Parking of money

Parking of or investing idle funds in fixed deposits with Banks is in the nature of investments to earn a surplus on idle funds. Further, since regulation of banking and financial corporations is a matter of List I (i.e. Union List) of the Seventh Schedule to the Constitution of India, Section 2(13)(h) of the Money Lending Act explicitly states that “a loan shall not include a loan to, or by, a bank”, thereby excluding Banks from its purview.

5.     Loans by Non-banking Financial Companies

The term money lender, as defined in the Money Lending Act, includes individuals, HUF, companies, unincorporated bodies of individuals who carry on the business of money-lending or have a principal business place in Maharashtra.

However, it has excluded from its purview, non-banking financial companies (NBFC) since they are regulated by RBI under Chapter IIIB of the Reserve Bank of India Act, 1934.

Further, other regulated entities such as insurance companies, banks etc. from its purview.

Our write-up giving a detailed analysis of the definition of NBFC can be accessed here.

Accordingly, NBFCs shall not be required to obtain a license to carry out money-lending business in the State of Maharashtra.

Lending in multiple states

In case a company lends in multiple states,  it will have to adhere to provisions under the money lending laws of each such State.

Consequences of non-registration

Section 39 of the Money Lending Act states that whoever carries on the business of money-lending without obtaining a valid licence, shall be punished with –

  • imprisonment for a term which may extend to 5 years; or
  • with fine which may extend to Rs.50,000; or
  • with both.

Conclusion

Even though getting a valid license under the Money Lending Act helps money lenders to carry on business lawfully and have legal recourse against the defaulters, one of the major reasons for non-registration is the ceiling on interest rate. Many lenders are not even aware about the requirement of such registration. Considering the serious nature of punishment for lending money without a valid license, it’s imperative for entities to identify if they are undertaking business of money-lending and whether they have a valid license to do so.

A Guide to Accounting of Collateral and Repossessed Assets

-Financial Services Team ( finserv@vinodkothari.com )

The purpose of reporting in accordance with International Financial Reporting Standards (IFRS) is to provide financial information about the reporting entity that is useful to various stakeholders in making decisions about providing resources to the entity.

To satisfy the objective of IFRS/Ind AS reporting, to a large extent, based on estimates, judgements and models rather than exact depictions. In other words, the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability.

Understanding Collateral

Collateral is one or more assets that a borrower offers to a lender as security for a loan, with the intent that if the borrower defaults in making the promised loan payments, the lender has the right to seize the collateral, sell the same and realise the amounts due. Since collateral offers   a security to the lender should the borrower default, loans that are secured by collateral typically carry lower interest rates than unsecured loans.

Needless to say, secured lending forms a very important segment of the world of finance.

Although the legal rights that flow from collateral are typically specified in the loan agreement, law in some jurisdictions might specify particular overriding rights, obligations, restrictions, etc. In some cases, at the commencement of the loan, collateral is physically transferred from the borrower to the lender. These security interests are called possessory security interests – a pledge is an example of a possessory security interest. There are other types of security interests which are non-possessory, which are known as hypothecation, lien or charge in different jurisdictions. A mortgage in English and Indian law has a different connotation – it creates a property right in favour of the lender to secure the loan; hence, it results into transfer of specific title[1].

Irrespective of the form of collateral, it is clear that collateral is merely security interest, and not property interest. While covenants of security documentation may differ, the most common security document allows the lender to sell or cause the sale of the collateral upon default of the borrower.

Accounting of Collateral

Secured Loans:

When a financial institution (FI) extends a secured facility, it recognises  loan as its asset, as the benefits accruing to the entity would be on account of loan provided. The security would only act as backstop measure in case the performance of the loan deteriorates.  Further, the entity’s interest lies in the loan not in the charged asset.

However, this does not imply that security on a loan would go unnoticed while accounting for the loan asset. Collateral and other credit risk mitigants are important factors in an entity’s estimate of Expected credit losses (ECL).

Consequently, IFRS 7 Financial Instruments: Disclosures specifies that an entity must disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period and how those risks have been managed by the entity (paragraphs 31 and 32). When relevant, an entity’s risk management disclosure would include its policies and procedures for taking collateral and for monitoring the continuing effectiveness of collateral in mitigating counterparty credit risk. Paragraph 35K of IFRS 7 requires information that will enable users of financial statements to understand the effect of collateral and other credit enhancements on the amount of expected credit losses.

The Division III of Schedule III to the Companies Act, 2013 prescribes a separate disclosure for secured and unsecured advances. Further the impairment loss allowance for both asset categories is also presented along with the specific asset  .

In short, disclosure of the collateral and credit enhancements is an important disclosure. The existence of the collateral itself may not change the carrying value of the loan, but it may have repercussions on the value of the ECL, as also, in case of fair-valued loans, on the risk-adjusted value by impacting the credit spread that is deployed as a part of the discounting rate.

Collateral and SPPI test

Simply payment of principal and interest (SPPI) test is one of the two tests that are required to be passed for a financial asset to be classified either as subsequently measured at Amortised Cost or at FVOCI. The test says that the contractual cash flows from the asset, on specified dates, should comprise only of principal payments and interest payments on the principal amount outstanding.

Paragraph BC4.206(b) of the Basis for Conclusions on IFRS 9 explains the IASB’s view that financial assets can still      meeting the SPPI test, i.e., the contractual cash flows may consist solely payments of principal and interest, even though they are collateralised by assets.     . Consequently, in performing the SPPI test an entity disregards the possibility that the collateral might be foreclosed in the future unless the entity acquired the instrument with the intention of controlling the collateral.

Accounting of Repossessed Assets

Assume the following facts: FI had a loan of Rs 1000 outstanding, which was in default. FI forecloses and repossesses the collateral, say a machinery, which is valued Rs 700 on the date of repossession. FI keeps the machinery pending disposal, and on the reporting date, the machinery is still in stock. Eventually, in the next reporting period, the machinery is sold, say for a net realisation of Rs 600.

Several questions arise – on the date of repossession, can FI remove loan to the extent of Rs 700 and debit it to machinery held for sale? What happens to the loss of Rs 100 on the sale – is it loss related to the loan, or loss related to disposal of machinery?

Questions like this are faced by financial institutions all the time.

Though accounting standards provide ample guidance on taking cognizance of collateral, specifically for credit risk assessment and asset recognition, the clarity is lost at the issue of accounting for repossessed assets. Accounting standards do not provide a clear view on how an asset should be treated when the entity enforces its right to foreclose and repossess the asset, and the asset is pending disposal. If the disposal of the asset has already been done, then the question of any accounting for collateral does not arise, as the collateral has already      been disposed off. However, the accounting for the collateral itself, as discussed below, will affect the accounting for the disposal as well.

As regards accounting for the repossession of the collateral, some guidance comes from the Para B5.5.55 of IFRS 9/Ind AS 109 :

“…….Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the relevant recognition criteria for an asset in this or other Standards.”

The extract clarifies that mere fact that the asset is repossessed would not make it eligible for being recognised as an asset on the books, as the entity’s interest still lies in recovery loan, the entity would have no interest in the asset if not for dues under the loan.

Further, Para 7 of IAS 16 / Ind AS 16 states that

“The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:

(a) it is probable that future economic benefits associated with the item will flow to the entity; and

(b) the cost of the item can be measured reliably”

Hence, the FI can capitalise and record only such assets whose future economic benefits would accrure to the financial institution in question, that is, the lender. PPE classification is possible  It may also be possible for an entity to hold the asset as an investment property, for disposal. There may be cases where the collateral may consist of shares, securities or other financial assets, or may consist of stock in trade or receivables.

Irrespective of the type of asset, the key question would be – has the lender acquired a property interest in the collateral, so as to have risks and rewards in the same, or the lender has simply acquired possession over the collateral for causing disposal?

Legal rights in case of collateral

The accounting here is impacted by the legal rights in case of collateral. To  reiterate, we are stating here generic legal position, and it is possible that collateral documents bring rights of the lender which are differential. Further, the legal rights may vary depending upon the kind of security interest being created on the assets, e.g. a pledge would differ from a mortgage.

In the case of Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd[2] the Supreme Court, while also indicating the very distinction between a pawn and a mortgage, observed that even after a pledge is enforced, the  legal title to the goods pledged  would not  vest in the pawnee. the pawnee has only a special  property. A pawnee has no right of foreclosure since he never had absolute ownership at law and his equitable title cannot exceed what  is specifically granted by  law. The right  to property vests in the pledged only so far as is necessary  to secure the debt.[3]

Although, pledge has to be differentiated from a mortgage which wholly passes the thing in the property conveyed[4] However, as noted in     , Narandas Karsondas vs. S.A Kamtam and Anr[5] it is important to note that the mortgagor does not lose the right of redemption until the sale is complete by registration. In selling the property, the mortgagee is not acting as the agent of the mortgagor but under a different (read: superior) claim. No equity or right in property is created in favour of the purchaser by the contract between the mortgagee and the proposed purchaser.

We have mentioned above that the legal rights of a lender differ (a) based on the law of the jurisdiction, as also consistent practices; (b) legal documentation. For instance, in case of mortgage, the common law provides two different rights of a mortgagee – the decree of sale and the decree of foreclosure [Section 67 of Transfer of Property Act, 1882]      Decree of sale implies that the mortgagee may simply cause the sale of the mortgaged property. Decree of foreclosure is foreclosure of the mortgagor’s      right of redemption, and the mortgagee, therefore, becoming absolute owner of the property. There are exceptional circumstances when this is possible, for example, in case of a mortgage by conditional sale.

In case of pledges too, while the general rule as set out in Lallan Prasad vs Rahmat Ali[6]  and GTL Textiles vs IFCI Ltd.[7] is that the pledgee only has the right to cause sale.

In case of US practices, it is quite a common practice of mortgage lenders to hold the foreclosed property as Real Estate Owned.

Thus, there can be two situations:

  • Case 1 – Lender acquires the asset as means of recovery and does not acquire  any risk and reward in the property;
  • Case 2 – Lender acquirers the property in the full and final settlement of the loan.

Our analysis of broad principles is as follows:

Acquisition as means of recovery

The lender could repossess the property as a result of the borrower’s default with the intention securing the possession of the collateral. The seeking of possession of the collateral is simply seeking the custody of the collateral. This is preventive – to ensure that the asset or its value is not  prejudiced. This is intent when a court, receiver, arbitrator or similar agency seeks control over the collateral. The intent is custodial and not proprietary. The actual sale proceeds of the asset, as and when disposed of by the lender, will go to the credit of the borrower; any amounts received in excess of the mortgage balance will be refunded to the borrower; and any shortfall remains the obligation of the borrower.

The FI may continue to charge interest on the outstanding balance. The lender remains exposed to interest rate risk on the  collateral but is not exposed directly to property price risk.

In such cases, there is no question of the loan being set off against the value of the collateral, until the collateral is actually disposed off. While giving the particulars  of the collateral, the lender may separately classify collateral in possession of the lender, as distinct from collateral which is in possession of the borrower or third parties. However, the classification of the loan remains unchanged.

Acquisition of proprietary interest in the collateral:

The lender could repossess the property, which in terms of the law or contract, gives the lender absolute rights in the property. The lender may have the right to collect the unrealised amount from the borrower, or the obligation to refund the excess, if any,  realised, but the issue is, does the lender acquire proprietary interest in the collateral, and whether the lender now is exposed to the risks and rewards, or the variability in the value of the collateral?

However, FASB has prescribed following guidelines to determine whether the charged asset would replace the loan asset. The FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure[8]  provides that “a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either upon

(1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or

(2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. “

In line with above, where the entity has acquired complete right over the asset there is no doubt that the loan account is closed, and the entity now hold interest entirely in the repossessed asset. Hence the company shall derecognise the loan asset and recognise the charged asset in their books. Whether the asset will be a real asset, financial asset, stock in trade, receivables, PPE or other investment property, will depend on the asset and the intent of the entity in holding it till disposal.

Accounting for repossession of the collateral:

In the above case, the entity should fair value the collateral on the date of seeking repossession, and to the extent of the fair value, the asset should be debited, crediting the loan. Whether the asset will continue to be subjected to fair valuation, or historical cost valuation, will depend on the applicable accounting standard for the type of asset in question.

any subsequent movement in the value of the collateral will affect the entity, and not the borrower.

Conclusion

Given the current stress in the economy, the rates of default on loans collateralized by all kinds of properties – residential real estate, commercial real estate, vehicles, consumer durables, etc., have zoomed up. There will be substantial collateral calls in time to come, and therefore, the need to have clarity on accounting for collateral is more today than ever before.

This article has tried to fill an apparent gap in literature on accounting for collateral. We will want to develop this article further, with numerical examples, by way of further updates.

[1] Different forms of security interests are discussed at length in Vinod Kothari: Securitisation, Asset Reconstruction and Enforcement of Security Interests. Lexis Nexis publication

[2] Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd

[3] Gtl Limited vs Ifci Ltd

[4] Lallan Prasad vs Rahmat Ali

[5] Narandas Karsondas vs. S.A Kamtam and Anr

[6] Lallan Prasad vs Rahmat Ali

[7] GTL Textiles vs IFCI Ltd

[8] FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure

 

Banking & Finance units in IFSC- A regulatory overview

– Siddarth Goel (finserv@vinodkothari.com)

Introduction- IFSCs

The stage of development of financial markets infrastructure in a country, amongst many other things, is a mirror of sound legal regulations, corporate governance, judicial certainty, and debtor protection regime within the country. The inflow of global capital is quintessential for financial markets development and allocation of adequate capital resources in growth sectors. In a move to make India a hub for global capital flow, Gujarat International Finance Tech-City (GIFT) has been established as a globally benchmarked International Financial Service Centre (GIFT-IFSC). GIFT-IFSC is India’s first dominant gateway for global capital flows in and out of the country.  The GIFT IFSC supports a gamut of financial services inter alia, banking, insurance, asset management, and other financial market activities. Prior to dealing with the regulatory framework governing financial units established in GIFT-IFSC, it is important to understand the broad function of an IFSC.

IFSCs are the Offshore Financial Centers (OFCs) that cater to customers outside their own jurisdiction. IMF defines OFCs as any financial center where the offshore activity takes place. However, this does not limit financial institutions in OFCs from undertaking domestic transactions. Therefore practical definition propounded by IMF is;

“OFC is a center where the bulk of financial sector activity is offshore on both sides of the balance sheet, (that is the counterparties of the majority of financial institutions liabilities and assets are non-residents), where the transactions are initiated elsewhere, and where the majority of the institutions involved are controlled by non-residents.”

Units set up in GIFT-IFSC can broadly be categorised on the basis of business activity intended to being undertaken by the entity.

 

This write-up covers regulations governing banking and financial services undertaken by Banking Units and Finance Companies set up in IFSC. The first part touches upon the benefits of setting up a unit in IFSC. The second part covers Banking Units and permitted financial activities. The third part covers Financial Companies in IFSC along with permissible activities and capital requirements. The fourth part covers financial service transactions to and fro between a financial unit based in IFSC and domestic tariff area (DTA). The last part deals with the applicable  KYC/PMLA compliances and the currency of transactions with units based in IFSC.

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