Paradox of privacy

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Whether private NBFCs-ML are required to appoint IDs?

– Neha Malu, Associate | finserv@vinodkothari.com

Independent directors have long been regarded as critical instruments of corporate governance. They bring fresh perspectives, specialized knowledge and most importantly, an element of unbiased oversight to board deliberations. Think of them as neutral referees who ensure fair play in business operations and uphold the integrity of boardroom decisions. Their presence helps reduce conflicts of interest, curb excessive promoter influence and encourage more balanced and professionally informed decision-making.

Under the Companies Act, 2013, section 149 read with rule 4 of the Companies (Appointment and Qualifications of Directors) Rules, 2014 lays down the categories of companies that are mandatorily required to appoint independent directors[1]. These categories do not include private companies. The rationale is intuitive: private companies, by their very nature of being closely held, are presumed to function under greater internal control, thereby reducing the perceived need for external board oversight. The whole basis of “privacy” of a private company will be frustrated if there are independent persons on its board.

Further, wholly owned subsidiaries are explicitly exempted from the requirement to appoint independent directors under rule 4(2), regardless of their nature or size.

And accordingly, a point of regulatory discussion arises in the case of (i) private NBFCs and (ii) NBFCs that are wholly owned subsidiaries, classified in the middle layer or above under the SBR Master Directions. While the Companies Act, 2013 does not mandate the appointment of independent directors for private companies and explicitly exempts WOS from such requirement, the corporate governance provisions under the SBR Master Directions require the constitution of certain committees, the composition of which hints towards the presence of independent directors.

This gives rise to a key question: Does a private NBFC or a wholly owned subsidiary, solely by virtue of its classification under the middle layer or above, become subject to an obligation to appoint independent directors?

Committees for NBFC-ML and above, the composition of which includes IDs

Upon classification as an NBFC-ML or above, conformity with corporate governance standards becomes applicable. Below we discuss specifically about the committees, the composition of which also includes IDs:

Name of the CommitteeCompositionRemarks
Audit Committee [Para 94.1 of the SBR Master Directions]Audit Committee, consisting of not less than three members of its Board of Directors. If an NBFC is required to constitute AC under section 177 of the Companies Act, 2013, the Committee so constituted shall be treated as the AC for the purpose of this para 94.1.As per section 177, an AC shall comprise a minimum of  three directors, with Independent Directors forming a majority. Hence, in case the NBFC is not covered under the provisions of section 177, the same may be constituted with any three directors, not necessarily being independent directors.
Nomination and Remuneration Committee [Para 94.2 of the SBR Master Directions]Composition will be as per section 178 of the Companies Act, 2013.The provisions indicate that the NRC shall have the constitution, powers, functions and duties as laid down in section 178. In this context, Companies Act requires every NRC to consist of at least three non-executive directors, out of which not less than one-half should be independent directors.
IT Strategy Committee [Para 6 of the Master Direction on Information Technology Governance, Risk, Controls and Assurance Practices]The Committee shall be a Board-level IT Strategy Committee (a) Minimum of three directors as members (b) The Chairperson of the ITSC shall be an independent director and have substantial IT expertise in managing/ guiding information technology initiatives (c) Members are technically competent (d) CISO and Head of IT to be permanent inviteeChairperson of the Committee is required to be an ID.
Review Committee [Master Direction on Treatment of Wilful Defaulters and Large Defaulters]The Composition of the Committee shall be as follows: The MD/ CEO as chairperson; and Two independent directors or non-executive directors or equivalent officials serving as members.Where the NBFC has not appointed IDs, NEDs or equivalent officials to serve as members of the Committee.

Divergent Market Practices

With respect to appointment of IDs on the Board and induction in the Committees, two interpretations are seen in practice in the case of private companies and WOS:

First, since the Companies Act does not mandate the appointment of independent directors in the case of private companies and explicitly exempts WOS, private NBFCs and WOS often rely on these statutory exemptions. The SBR Master Directions make a general reference to the Companies Act without distinguishing between company categories, which further supports the view that these entities constitute the relevant committees without appointing independent directors.

Second, given that NBFCs in the middle layer or above have crossed the ₹1,000 crore asset threshold and fall under enhanced regulatory scrutiny, some take the view that such entities should align with the intended governance standards and appoint independent directors, even if not required under the Companies Act.

Closing thoughts

The SBR Framework takes into account the systemic concerns associated with different NBFCs and thus classifies them into different layers. The corporate governance norms are applicable to ML, UL and TL NBFCs, which, given their asset sizes, are expected to operate at huge volumes and carry a great magnitude of risks. Such NBFCs may have access to public funds (by way of bank borrowings, debenture issuance etc.), wherein large lenders or public would have exposures and consequent high systemic risks. Hence, looking at the constitution (that is whether the NBFC is a private limited or public limited) becomes less important, and looking at the size, activity and function becomes more important. 

Thus, it may not be right to conclude that NBFCs registered as private companies and WOS can do away with the mandatory composition prescriptions merely due to the constitutional form of their entity. Looking at the intent and idea of SBR Framework, the applicable NBFCs may be required to appoint independent directors irrespective of the form of their constitution. The scale-based regulation emanates from the idea that NBFCs having high risk should be effectively monitored. Thus, the regulations should be followed in spirit to effectively mitigate the risks arising in the course of the NBFC’s functioning.

[1] Pursuant to the provisions of section 149(4) of the Companies Act read with rule 4 of the Companies (Appointment and Qualifications of Directors) Rules, 2014, following companies are mandatorily required to appoint independent directions: listed companies, public companies having paid up share capital of ten crore rupees or more; or turnover of one hundred crore rupees or more; or having in aggregate, outstanding loans, debentures and deposits, exceeding fifty crore rupees as per the latest audited financial statements.

Read more:

What is a non-banking financial company?
Resources on Scale Based Regulations

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Understanding the Governance & Compliance Framework for AIFs

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– Payal Agarwal, Partner | payal@vinodkothari.com

Alternative Investment Funds (AIFs) are private investment vehicles registered with and regulated by SEBI. Private investment vehicles, as is understood, are investment vehicles that pool investments from investors on a private basis, and make investments in investee entities based on the investment objectives disclosed to the investors. The returns from such investments, net of the expenses incurred by the vehicle, is distributed back to the investors. A typical AIF structure would look like:

The general obligations of AIFs are provided in the SEBI (Alternative Investment Funds) Regulations, 2012 read with the circulars issued from time to time. In addition to that, the Standard Setting Forum for AIFs (SFA) formulates implementation standards for various compliance requirements, as required by SEBI from time to time.

As may be understood, the AIF takes funds from its investors and makes investments in the investees. As between the sponsor/ manager of the Fund and the investors, there is a fiduciary relationship – since the investment decisions taken by the fund manager is on behalf of the investors, and in accordance with the investment objectives disclosed to the investors. Investor protection and transparency and proper due diligence of the investees become crucial in the context of an AIF. As compared to a traditional company, the AIFs are intermediaries between the investors and investees. This article discusses the various compliance requirements as applicable to AIFs.

Governance structure of AIFs

  • Governing body of AIF: Depending on the legal form of the AIF, the governing body of the AIF may compose of trustee (in case of a trust), directors (in case of a company) or designated partners (in case of an LLP).
  • Manager: The primary responsibility of ensuring compliance with the applicable provisions by an AIF is on the manager of the AIF. Similarly, ensuring compliance with the internal policies and procedures of an AIF is also the responsibility of the manager. The manager is appointed by an AIF, and the Sponsor may also be the manager of the Fund.
  • Investment Committee: Constituted by the manager, the Investment Committee approves the decisions of the AIF and is responsible for ensuring that such decisions are in compliance with the policies and procedures laid down by the AIF. The Investment Committee may be composed of internal members (employees, directors or partners of the Manager) as well as external investors (with the approval of the investors in the AIF/ Scheme). The external members may include ex-officio members who represent the sponsor, sponsor group, manager group or investors, in their official capacity. Pending clarification from RBI, currently non-resident Indian citizens are not permitted to act as an external member in the Investment Committee [Reg 20(7) of AIF Regulations read with Chapter 14 of AIF Master Circular].

The responsibilities of the Investment Committee may be waived by the investors (other than the Manager, Sponsor, and employees/ directors of Manager and AIF), if they have a commitment of at least Rs. 70 crores (USD 10 billion or other equivalent currency), by providing an undertaking to such effect, in the format as provided under Annexure 11 of the AIF Master Circular, including a confirmation that they have the independent ability and mechanism to carry out due diligence of the investments.

  • Key Management Personnel: Key Management Personnel (KMP) of the Manager has been defined to mean:
    • members of key investment team of the Manager, as disclosed in the PPM of the fund;
    • employees who are involved in decision making on behalf of the AIF, including but not limited to, members of senior management team at the level of Managing Director, Chief Executive Officer, Chief Investment Officer, Whole Time Directors, or such equivalent role or position;
    • any other person whom the AIF (through the Trustee, Board of Directors or Designated Partners, as the case may be) or Manager may declare as key management personnel. [Para 13.1.2. of the AIF Master Circular]

The responsibilities of the Manager are complied through the Key Management Personnel of such Manager.

  • Compliance Officer: The Compliance Officer is appointed by the Manager, and is responsible for monitoring of compliance with the applicable laws and requirements as applicable to the AIF. Compliance Officer, shall be an employee or director of the Manager, other than Chief Executive Officer of the Manager or such equivalent role or position depending on the legal structure of Manager [Para 13.1.1. of the AIF Master Circular].

The Compliance Officer is responsible to report any non-compliance observed by him within 7 days from the date of observing such non-compliance.

  • Custodian: The Sponsor/ Manager of the AIF is required to appoint a custodian, registered with SEBI, for safekeeping of the securities of the AIF. An associate[1] of the Sponsor/ Manager may also act as a custodian, subject to compliance with certain conditions[2]. The custodian provides periodic reports to SEBI with respect to the investments of AIFs that are under custody with the custodian in accordance with the standards formulated by SFA.

The various roles and responsibilities at the different levels of the governance structure is discussed below.

Code of Conduct for AIFs [Reg 20(1) of AIF Regulations]

The Code of Conduct, as prescribed under the AIF Regulations, puts forth various requirements applicable to the AIFs and other relevant entities. The Code of Conduct is applicable to various responsibility centers charged with the governance requirements in an AIF. The requirements are given in the Fourth Schedule to the AIF Regulations read with Para 13.3. of the AIF Master Circular.

The applicability to various stakeholders along with the requirements are given in the table below:

Person covered by the CoC Requirements to be adhered to under the CoC
AIF
  • Undertake business activities and investments in accordance with the investment objectives in the placement memorandum and other fund documents [to be ensured by the Manager]
  • Be operated in the interest of all investors, and not limited to select investors, sponsor, manager etc [to be ensured by the Manager]
  • Ensure timely and adequate dissemination of information to all investors
  • Ensure existence of effective risk management process and appropriate internal controls
  • Have written policies for mitigation of any potential conflict of interest
  • Prohibition on use of any unethical means to sell, market or induce any investor to buy its units
  • Have written policies and procedures to comply with anti-money laundering lawsnot offer any assured returns to any prospective investors/unitholders.
  • Manager of AIF
  • KMP of Manager
  • KMP of AIF
  • Abide by the laws applicable to AIFs at all times
  • Maintain integrity, highest ethical and professional standards in all its dealings
  • Ensure proper care and exercise due diligence and independent professional judgment in all its decisions
  • Act in a fiduciary capacity towards investors of AIF and ensure that decisions are taken in the interest of the investors
  • Abide by the policies of AIF in relation to potential conflict of interests
  • Not make any misleading or inaccurate statement, whether oral or written, either about their qualifications or capability to render investment management services or their achievements
  • Record in writing, the investment, divestment and other key decisions, together with appropriate justification for such decisions;
  • Provide appropriate and well considered inputs, which are not misleading, as required by the valuer to carry out appropriate valuation of the portfolio;
  • Prohibition on entering into arrangements for sale or purchase of securities, where there is no effective change in beneficial interest or where the transfer of beneficial interest is only between parties who are acting in concert or collusion, other than for bona fide and legally valid reasons;
  • Abide by confidentiality agreements with the investors and not make improper use of the details of personal investments and/or other information of investors;
  • Not offer or accept any inducement in connection with the affairs of or business of managing the funds of investors;
  • Document all relevant correspondence and understanding during a deal with counterparties as per the records of the AIF, if they have committed to the transactions on behalf of AIF
  • Maintain ethical standards of conduct and deal fairly and honestly with investee companies at all times; and
  • Maintain confidentiality of information received from investee companies and companies seeking investments from AIF, unless explicit confirmation is received that such information is not subject to any non-disclosure agreement.
  • Ensure availability of the PPM to the investors prior to providing commitment or making investment in the AIF and an acknowledgment be received from the investor
  • Ensure scheme-wise segregation of bank accounts and securities accountsnot offer any assured returns to any prospective investors/unitholders.
  • Members of Investment Committee
  • Trustee/ Trustee company
  • Directors of Trustee company
  • Directors of AIF
  • Designated Partners of AIF
  • Maintain integrity and the highest ethical and professional standards of conduct
  • Ensure proper care and exercise due diligence and independent professional judgment
  • Disclose details of any conflict of interest relating to any/all decisions in a timely manner to the Manager of the AIF, adhere with the policies and procedures of the AIF with respect to any conflict of interest and wherever necessary, recuse themselves from the decision making process;
  • Maintain confidentiality of information received regarding AIF, its investors and investee companies; unless explicit confirmation is received that such information is not subject to any non-disclosure agreement.
  • Not indulge in any unethical practice or professional misconduct or any act, whether by omission or commission, which tantamount to gross negligence or fraud
  • Not offer any assured returns to any prospective investors/unitholders.
Compliance with Stewardship Code

The AIFs, being institutional investors, it is mandatory for AIFs to comply with the Stewardship Code in terms of Para 13.4 of the AIF Master Circular. This is applicable in respect of investments in listed equity instruments. Annexure 10 of the Master Circular specifies the broad principles of stewardship and provides guidance for its implementation. Further, the AIFs are required to report the status of implementation of the principles atleast on an annual basis (periodicity may differ for different principles), through the website of the AIFs. Such report may also be sent as a part of annual intimation to its clients/ beneficiaries. An article on the stewardship responsibilities of institutional investors may be read here.

Policies to be formulated by AIFs

In order to ensure that the decisions of the AIF are taken in compliance with all applicable laws and regulations, PPM, investor agreements and other fund documents, detailed policies and procedures are required to be kept in place in terms of Reg 20(3). The policies are jointly approved by:

  • Manager and
  • Relevant governing body of the AIF (viz., the trustee/ trustee company/ board of directors/ designated partners etc)

The Manager is required to ensure that the decisions taken by the AIF are in compliance with such policies and procedures.

Further, the policies should be reviewed periodically, on a regular basis and whenever required as a result of business developments, to ensure their continued appropriateness.

Audit

Annual Audit of terms of PPM

The AIF is required to file Private Placement Memorandum (PPM) with SEBI through a Merchant Banker for the launch of Schemes. The format of PPM is specified under Annexure 1 read with the requirements specified under various other circulars from time to time. In order to ensure that the activities of the AIF are in compliance with the terms of PPM, annual audit of the terms of PPM is required to be done. In this regard, the following needs to be noted:

  • Scope of audit: Compliance with all sections of the PPM. Further, audit of the following sections is optional, viz., ‘Risk Factors’, ‘Legal, Regulatory and Tax Considerations’ and ‘Track Record of First Time Managers’. The format of PPM audit report may be accessed here.
  • Eligibility to conduct audit: an internal or external auditor/legal professional
  • Periodicity of PPM audit: Annual
  • Timeline: within 6 months from the end of the Financial Year
  • Reported to: Governing Body (Trustee or Board of Directors or Designated Partners) of the AIF, Board of directors or Designated Partners of the Manager and SEBI
  • Non-applicability: if no funds are raised from investors, subject to submission of a certificate from CA to that effect within 6 months from end of FY
  • Exemptions: (i) Angel Funds, (ii) AIFs/ Schemes with each investor having a minimum commitment of Rs. 70 crores (USD 10 mn or equivalent), upon providing a waiver for the same. 
Audit of accounts

Reg 20(14) of the AIF Regulations require the books of account to be audited by a qualified auditor annually.

Valuation of Investments of AIF

Reg 23 read with Chapter 22 of the AIF Master Circular specifies the requirements with respect to the valuation of the investments of AIF. The valuation is required to be done by an independent valuer, on a half-yearly basis (may be made an annual requirement subject to consent of 75% of investors in value).

Eligibility criteria have been specified for acting as an independent valuer:

  • shall not be an associate of manager or sponsor or trustee of the AIF
  • shall have at least three years of experience in valuation of unlisted securities
  • shall be a registered valuer with IBBI and a member of ICAI, ICSI or ICMAI or shall be a holding or subsidiary of SEBI-registered CRA

The Manager shall specifically inform the investors, the reasons/ factors for deviation in valuation, in case the deviation is more than:

  • 20% between two consecutive valuations, or
  • 33% in a financial year

In case of Cat III AIFs, the listed and unlisted debt securities are required to be valued by an independent valuer, and the NAV is required to be reported on a quarterly basis for close ended funds, and monthly basis for open ended funds.

Investor complaints and Grievance Redressal Mechanism

Resolution of investor complaints is a role of the Manager of AIF [Reg 24 of AIF Regulations]. Reg 24A requires the Manager to redress investor grievances in a prompt manner, but within a maximum of 21 days from receipt of grievances. The AIF is required to be registered on the SCORES portal for receipt of investor grievances. Further, in terms of Reg 25, the dispute resolution mechanism provided by SEBI (SMARTODR) is applicable to AIFs as well. Refer details under Master Circular for Online Resolution of Disputes in the Indian Securities Market dated 28th December, 2023.

Further, in terms of Para 17.4 of the AIF Master Circular, the AIFs are required to maintain data on investor complaints received against the AIF/ its Schemes on a quarterly basis within 7 days from the end of the quarter, in addition to the disclosure in the PPM. The data includes the following:

S. No. Investor Complaints received from Pending as at the end of the last quarter Received Resolved Total Pending at the end of the quarter Pending complaints > 3months Average Resolution time ^ (in days )
1 Directly from Investors            
2 SEBI (SCORES)            
3 Other Sources            

Matters requiring consent of investors of AIF

The AIFs act in a fiduciary capacity towards the investors, and manage the funds of the investors invested in the AIF. Thus, the decisions of AIF are required to be taken in the interests of the investors. Some matters require approval of the investors of a specified majority, prior to undertaking such activity:

Regulatory reference Matter requiring approval Requisite majority in terms of value of investment 
Reg 9(2) Material alteration to fund strategy 2/3rd of unitholders
Reg 13(5) Extension of tenure of close-ended funds (upto 2 years) 2/3rd of unitholders
Reg 15(1)(e) Investment in associates or units of AIFs managed/ sponsored by its Manager, Sponsor or associates of its Manager or Sponsor 75% of investors
Reg 15(1)(ea) Purchase or sale of investments from/ to: Associates Schemes of AIF managed or sponsored by its Manager, Sponsor or associates of its Manager or Sponsoran investor who has committed to invest at least fifty percent of the corpus of the scheme of AIF 75% of investors, excluding investor covered under (c) where purchase/ sale is from such investor
Reg 20(10) Appointment of external members (other than ex-officio members) in Investment Committee other than as disclosed in the fund documents 75% of investors
Reg 23(2) Reducing frequency of valuation of investments from six months to 1 year 75% of investors
Reg 29(9) In-specie distribution of investments of AIF due to lack of liquidity or enter into liquidation period 75% of investors

Disclosure to investors

The funds of the investors invested in the AIF are managed by the Manager and Sponsor in a fiduciary capacity. In order to ensure transparency, various disclosure requirements apply in terms of Reg 22 of the AIF Regulations – either on a periodic basis or upon the happening of certain events.

Periodic disclosures

The periodic disclosures include:

  • financial, risk management, operational, portfolio, and transactional information regarding fund investments
  • any fees ascribed to the Manager or Sponsor; and any fees charged to the AIF or any investee company by an associate of the Manager or Sponsor

Further, in terms of clause (g) of Reg 22, the following information is required to be disclosed within 180 days from the year end (60 days from the end of each quarter for Cat III AIF):

  • financial information of investee companies.
  • material risks and how they are managed which may include:
    • concentration risk at fund level;
    • foreign exchange risk at fund level;
    • leverage risk at fund and investee company levels;
    • realization risk (i.e. change in exit environment) at fund and investee company levels;
    • strategy risk (i.e. change in or divergence from business strategy) at investee company level;
    • reputation risk at investee company level;
    • extra-financial risks, including environmental, social and corporate governance risks, at fund and investee company level.

Any changes in terms of PPM or other fund documents are required to be intimated to the investors on a consolidated basis within 1 month from the end of each financial year [Para 2.5.3. of AIF Master Circular]

Event-based disclosures

These events are required to be disclosed ‘as and when occurred’:

  • any inquiries/ legal actions by legal or regulatory bodies in any jurisdiction
  • any material liability arising during the AIF’s tenure
  • any breach of a provision of the placement memorandum or agreement made with the investor or any other fund documents
  • change in control of the Sponsor or Manager or Investee Company
  • any significant change in the key investment team

Matters requiring reporting to SEBI

Reg 28 provides power to SEBI to seek such information from the AIFs, as may be required, from time to time. In addition to such powers, there are various specific reporting requirements that are applicable on AIFs under various applicable provisions. These include:

Regulatory reference Matters requiring reporting to SEBI Timelines
Reg 20(12) Any material change from the information provided at the time of application Promptly
Reg 26 Information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks) when so required by SEBI
Para 2.5.2 Any changes in the terms of PPM and other fund documents, along with DD certificate from Merchant Banker  within 1 month from the end of FY
Para 15.1 Reporting on investment activities of AIF in the format specified by SFA 15 calendar days from end of each quarter
Para 15.2 Any violations reported in the Compliance Test Report (refer detailed discussion below) As soon as possible
Reg 20(11) r/w Para 15.4. Investments of AIF that are in custody of the custodian Quarterly

Compliance with provisions applicable to SEBI-registered intermediaries

An AIF, in its capacity of a SEBI-registered intermediary, is required to comply with the SEBI (Intermediaries) Regulations, 2008 read with the circulars issued thereunder. These include, for instance, compliance with the circulars/guidelines as may be issued by SEBI with respect to KYC requirements, Anti-Money Laundering and Outsourcing of activities [Para 13.5 of AIF Master Circular].

The guidelines with respect to anti-money laundering and KYC requirements are contained in a Master Circular dated 6th June, 2024 on the subject. Our various resources on KYC and anti-money laundering can be accessed here.

Compliance Test Report

The manager of AIF is required to report the compliances with various applicable provisions of the AIF Regulations read with the circulars made thereunder, on an annual basis. CTR is submitted within 30 days from the end of the financial year, to the sponsor and trustee (in case AIF is set up as a trust). The trustee/ sponsor provides their comments on the CTR to the manager within 30 days from the receipt of CTR, based on which the manager shall make necessary changes and provide a response within the next 15 days. 

A significant aspect of the CTR is that any violation observed by the trustee/ sponsor is required to be intimated to SEBI, as soon as possible. This requirement is in addition to the obligation of the Compliance Officer to report a non-compliance, within 7 days of becoming aware of the same. The format of CTR is provided in Annexure 12 of the AIF Master Circular.

Other compliances

SEBI specifies various compliances applicable to the AIFs from time to time. The compliances as applicable to the AIFs for the first time during FY 25-26 has been dealt with in our article Regulatory landscape for AIFs: what’s new? Further, there are certain requirements applicable on special categories of AIFs, viz., angel funds, Special Situation Funds, Social Venture Funds etc. Further, there are various prudential requirements applicable to receipt of funds from investors and making of investments by the AIFs.

See our other resources on AIFs:

[1] Associate means:

  • a company or a limited liability partnership or a body corporate
  • in which a director or trustee or partner or Sponsor or Manager of the Alternative Investment Fund or a director or partner of the Manager or Sponsor
  • holds, either individually or collectively, more than fifteen percent of its paid-up equity share capital or partnership interest, as the case may be

[2] The conditions include:

(a) Minimum net worth of the Sponsor or Manager of at least twenty thousand crore rupees at all points of time;

(b) fifty per cent or more of the directors of the Custodian do not represent the interest of the Sponsor or Manager or their associates;

(c) the Custodian and the Sponsor or Manager of AIF are not subsidiaries of each other;

(d) the custodian and the Sponsor or Manager of AIF do not have common directors; and

(e) the Custodian and the Manager of AIF sign an undertaking that they shall act independently of each other in their dealings of the schemes of AIF.

Should you expect adjustment in profits for “Expected Credit Loss”?

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– Customised profits for CSR and managerial remuneration under Section 198 of the CA, 2013

– Pammy Jaiswal and Sourish Kundu | corplaw@vinodkothari.com

Background

The presentation of the profit and loss account has been outlined under the Schedule III of the Companies Act, 2013  (‘Act’) and the profit computation method has been provided for under the applicable accounting standards [See IND AS 1]. The basic principle is to showcase a true and fair view of the financial position of a company. Having said that, it is also significant to mention that the Act provides for an alternative method for computing net profits, the basic intent of which is to arrive at an adjusted net profit which does not have elements of unrealised gains or losses, capital gains or losses and in fact any item which is extraordinary in its very nature. The same is contained under the provisions of section 198 of the Act. This section, unlike the general computation method, has a limited objective i.e., calculation of net profits for managerial remuneration as well as corporate social responsibility. 

There are four operating sub-sections under section 198 which provides for the adjustment items:

  1. Allowing the credit of certain items – usual income in the form of govt subsidies
  2. Disallowing the credit given to certain items – unrealised gains, capital profits, etc.
  3. Allowing the debit of certain items – usual working charges, interests, depreciation, etc
  4. Disallowing the debit of certain items – capital losses, unrealised losses, usual income tax, etc

It is important to note that items other than those mentioned above need not be specifically adjusted unless their nature calls for adjustment under the said section. Now if we discuss specifically for items in the nature of Expected Credit Loss (‘ECL’) for companies following IND AS, it is important to understand the nature of ECL in the context of making adjustments under section 198 of the Act. See our write on Expected Credit Losses on Loans: Guide for NBFCs.

Understanding ECL and Its Accounting Treatment

Reference shall be drawn from Ind AS 109 which defines ‘credit loss’ as ‘the difference between all contractual cash flows that are due to an entity in accordance with the contract and all the cash flows that the entity expects to receive (i.e. cash shortfalls), including cash flows from the sale of collateral held.’ ECL is essentially a way of estimating future credit losses, even on loans that appear to be fully performing at the time of such analysis (Stage 1 assets). It is based on expected delays or defaults, and the estimated loss is recorded as a charge to the profit and loss account, based on a 12-month probability of default.

As per Ind AS 109, ECL is used for the recognition and measurement of impairment on financial assets both at the time of origination as well as at the end of every reporting period. ECL is a forward-looking approach that requires entities to recognize credit losses based on the probability  of future defaults/ delays.

However, this does not result in a reduction in the carrying value of the asset (unless the asset is already credit-impaired, i.e., Stage 3). In that sense, while ECL reflects asset impairment, it does not operate like a direct write-down. And unlike conventional provisioning, ECL is not a “provision” under traditional accounting – it is a loss allowance rooted in forward-looking estimations. Further, it is also important to understand that the booking of ECL does not mean that there has been a credit loss in the actual sense, the same is a methodical manner of estimating the probable default risk association with the asset value.

Treatment of ECL under Section 198 

Section 198 requires excluding unrealised or notional adjustments, such as fair value changes or revaluation impacts in terms of Section 198(3) of theAct.

The section also refers specifically to actual bad debts, under  Section 198(4)(o). This raises the natural interpretational question: should model-driven, probability-weighted ECL charges – which do not reflect realised losses – really be allowed to remain deducted while computing such customised profits? Well, the answer lies in the requirement and nature of such an item being required to be deducted from the profit and loss account under IND AS 109.  

Alternative approaches -Treatment of ECL

The question around the treatment of ECL can be viewed from two perspectives. The first being the nature of ECL and the second on the routine treatment and calculation of ECL. If we look at the nature, it is clear that while it is imperative for companies to compute ECL at the time of origination as well as at the end of every reporting period, it is important to note that there is no loss or default in the actual sense. This means that the amount computed as ECL has not been an actual default. 

On the other hand, if we look at the need for such computation and the methodical approach to arrive at the value of ECL, the same is likely to be considered as a usual working charge which is charged to the profit and loss account. Accordingly, we have come across two possible and permissible approaches to the treatment of ECL while computing the profits under section 198. The same has been discussed below with the help of illustrations.

Approach 1: Disallowing ECL in the year of its booking and subsequent adjustment of bad debt

Year 1Year 2
PBT – 1000
Depreciation – 20
ECL – 40
Loss on sale of fixed asset – 15		PBT – 1200
Depreciation – 20
ECL – 35
Actual Bad Debt – 15
Profit on sale of equity shares – 25
Year 1AmountYear 2Amount
PBT                                                                                  1000PBT                                                                                  1200
Depreciation                                                                     –Depreciation                                                                    –
Add: ECL                                                                            40Add: ECL                                                                            35
Add: Loss on sale of fixed asset                                    15Less: Profit on sale of equity shares                                                    (25)
PBT u/s 198                             1055PBT u/s 198                                  1210

Notes: 

  • ECL has been ignored in profit computation u/s 198 considering the same is an unrealised loss and therefore reversed.
  • Depreciation and actual bad debt has not been adjusted again as it has already been deducted under normal profit computation.
  • Capital gains and losses have been adjusted/ reversed under the computation.

Approach 2: Allowing ECL in profit computation and netting off actual bad debt from the same in subsequent period

Year 1Year 2
PBT – 1000
Depreciation – 20
ECL – 40
Loss on sale of fixed asset – 15		PBT – 1200
Depreciation – 20
ECL recovered – 35
Actual Bad Debt – 15
Profit on sale of equity shares – 25
Year 1AmountYear 2Amount
PBT                                                                                 1000PBT                                                                                 1200
Depreciation                                                                    –Depreciation                                                                     –
ECL                                                                                     –ECL                                                                                      –
Add: Loss on sale of fixed asset                                   15Actual bad debt                                                                           –
ECL recovered                                                                    –
Less: Profit on sale of equity shares                          (25)
PBT u/s 198                            1015PBT u/s 198                           1185

Notes:

  • ECL has been considered in profit computation u/s 198  and therefore, not adjusted to reverse the impact
  • Similarly, ECL recovered has been considered part of normal or routine adjustment and hence, not reversed.
  • Actual bad debt is not to be considered at the time of profit computation under  the regular computation since it can be adjusted from the ECL already booked.
  • Capital gains and losses have been adjusted/ reversed under the computation.

Concluding remarks

All listed companies are required to comply with Ind AS and given that an instance of a company having nil receivables is a rare occurrence, the discussion on how ECL is to be treated while computing net profit in terms of Section 198 becomes more than just an academic debate.

As long as the impact of any P&L item being extra ordinary in nature is taken off from the profits computed u/s 198, the same serves the purpose and intent of section 198 of the Act. ECL, while valid for accounting, is fundamentally an estimated, non-actual loss. It exists because accounting standards demand alignment of income with credit risk  and not because a real outflow has occurred. However, it cannot be said that ECL already deducted while calculating profit before tax as per applicable accounting standards will be reversed while calculating profits in terms of Section 198. 

Further, given that ECL is based on expectation calculated using due accounting principles, the actual bed debt, if within the ECL limit, does not impact the P&L. On the contrary, in case of the actual bad debt being in excess, the P&L warrants a subsequent debit of the net amount. For example, under approach 2 if the actual bad debt would have been 50, i.e. in excess of the ECL booked in the previous period by 10, the normal profit computation would have allowed a debit of 10.

In fact, both the approaches lead to the fulfilment of the intent of section 198 and hence, it is not necessary to consider any one approach as correct. Having said that, it is imperative to follow uniform practice in this regard in the absence of which the profits u/s 198 may be impacted. 

Therefore, where the statutory and accounting frameworks intersect – but are not necessarily aligned – companies must adopt a carefully considered, principle-based approach as even a single line item like ECL can materially influence the base for managerial remuneration and CSR spending unlike other estimate based items such as revenue deferrals viz. sales returns or warranties, which are made as a matter of accounting prudence, but does not represent outflows for statutory computation purposes. Accordingly, there is no reason for deviating from the Indian GAAP principles for the purpose of customised calculation of net profits for specific purposes. 

Read more: 

Cash in Hand, But Still a Loss? 

Impact of restructuring on ECL computation

Knowledge Centre for Corporate Social Responsibility (CSR)

FAQs on Standards for minimum information to be disclosed for RPT approval

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FAQs on Revised RPT ISN_05.09.2025Download

Our brief note on the Industry Standards can be read here.

Our other resources on RPTs can be accessed here.

Tailored to Fit Practically: Disclosure for RPTs under Revised Industry Standards

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Disclosure requirements rationalised and simplified under the ISN for RPTs

Team Corplaw | corplaw@vinodkothari.com

  • Revised regulatory regime on RPT disclosures before Audit Committee & Shareholders
    • Reg 23 of LODR Regulations
    • Industry Standards Note on Minimum information to be provided to the Audit Committee and Shareholders for approval of Related Party Transactions  (as revised) dated June 26, 2025 (“RPT ISN”).
  • Applicability of RPT ISN
    • with effect from 1st September, 2025 (‘Effective Date’)
Approval of ACApproval of shareholders (in case of material RPTs)Date of execution of RPTsApplicability of RPT ISN
Before Effective DateBefore Effective DateAfter Effective DateNot Applicable
Before Effective DateAfter Effective DateAfter Effective DateNot Applicable
After Effective DateAfter Effective DateAfter Effective DateApplicable
  • Any subsequent material modification, renewal, ratification etc. after the Effective Date should require detailed disclosures as per RPT ISN
  • Exemption from applicability of RPT ISN
    • Exempted RPTs: RPTs exempt from approval requirements under Reg 23(5) of LODR
    • Small value RPTs: Transactions with a related party for an aggregate value of upto Rs. 1 crore in a FY
    • RPTs placed for quarterly review under Reg. 23(3)(d).
  • Minimum information to AC divided into 3 parts
    • Part A – Minimum information of the proposed RPT, applicable to all RPTs (Para A1 to A5)
    • Part B – Additional information applicable to proposed RPTs of specified nature (Para B1 to B7)
    • Part C – Additional information applicable to Material RPTs (as per Reg 23 of LODR) of specified nature (Para C1 to C6)
  • Certification requirement to AC (‘KMP certificate’)
    • From
      • CEO/ Managing Director/ Whole-time Director/ Manager and
      • CFO of the listed entity
    • To the effect that
      • RPTs proposed to be entered are in the interest of the listed entity
    • Role of AC
      • To review the certificate – the fact to be disclosed in the notice to shareholders
  • Minimum information to shareholders
    • Information as may be required under CA, 2013
    • Information as placed before AC in terms of RPT ISN
      • AC may approve redaction of commercial secrets and such other information that would affect competitive position of listed entity
        • Subject to affirmation that, in its assessment, the redacted disclosures still provide all the necessary information to the public shareholders for informed decision making
    • Justification as to the transaction in the interest of the listed entity
    • Basis for determination of price and other material terms and conditions of RPTs
    • Affirmation that AC has reviewed the KMP certificate on proposed RPTs
    • Disclosure of approval of AC and recommendation of board
    • Web-link and QR code of third-party reports/ valuation report, if any, considered by AC
  • Role of Management
    • Management to provide information against each line-item
      • Indicate NA, where field is not applicable along with reason for non-applicability
  • Comments/ decision of AC
    • AC may provide comments on any line-item, based on its discretion
    • Rationale to be disclosed, in case an RPT is not approved
    • Comments and rationale to be minutised
  • Furnishing of valuation/ third party report
    • To be furnished to AC, if any
    • Web-link and QR code to be disclosed in shareholders’ notice, if considered by AC

Our analysis of the detailed disclosure requirements on relevant line-items are being collated in the form of FAQs. Keep checking our website for more.  

Our other resources

Related Party Transactions- Resource Centre

ESOPs for founders: Well intended relief, garbled by language?

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SEBI’s explanation remains ambiguous on share options granted to start-up promoters

– Payal Agarwal, Partner & Sakshi Patil, Executive

Starting a company often means wearing multiple hats. In these early stages, many founders structure their compensation through Employee Stock Option Plans (“ESOPs”) rather than traditional salaries. This arrangement makes perfect sense when resources are tight and every rupee earned needs to be reinvested into growth of the company. ESOPs align founders’ interests with the company’s long term success.

But here’s when things get complicated: the companies grow and prepare to go ‘public’; the founders find themselves classified as “promoters” under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”). With more risks than rewards, they find themselves in a position, where their earlier ESOP grants, reflecting the growth of the company built by them, though perfectly valid during the grant, may now be taken away.

Recognising this unfair situation, at its meeting held on June 18, 2025, SEBI has approved an amendment providing regulatory relief for founders of companies who hold ESOPs and are subsequently classified as promoters at the time of an IPO. The amendment seeks to clarify the position of ESOPs and other share based benefits, granted to promoters and promoter group members prior to categorisation as such, and permit the exercise of such grants even after listing of the company.

While the amendments seek to enable founders in IPO-bound companies to avail of the share based benefits granted to them, the language of the explanation falls short of the intent. In this article, we discuss the need for the amendments in line with the existing scenario, how the amendments seek to meet the need and the gap that remains.

Proposal laid down in Consultation Paper

The proposal approved by SEBI in its recent BM is based on the proposal contained in its consultation paper dated March 20, 2025 to include an explanation under Regulation 9(6) of SBEB Regulations.

As per the Para 3.5.1 of the Consultation paper, SEBI had proposed to include an explanation may be inserted under regulation 9(6) of SBEB Regulations which would state:

Explanation 2: an  employee, identified  as  a “promoter”  or  “promoter  group”  in the draft offer document filed by a company in relation to an initial public offering, who was granted  options, SARs or other benefits  under  any  scheme prior to being identified as a “promoter” or “promoter group”, as the case may be, shall be eligible to continue to hold, exercise or avail any such option, SAR or benefit, in accordance with its terms and granted, prior to one year from the date when the Company (i.e. its’ Board) decides to undertake Initial Public Offering and, in compliance with these Regulations.

The proposed explanation provides a clarification with respect to holding or exercise of share options or other similar benefits granted to an employee, identified as promoter/ promoter group in the DRHP, subject to the following conditions:

  1. The grant of options or benefits must have been made prior to the employee being identified as a ‘promoter’ or ‘promoter group’; and
  2. The grant must have occurred at least one year prior to the Board’s decision to undertake an IPO.

These conditions have been discussed in detail in the later part of this article. Before that, it is necessary to understand the need for the amendment.

Need for the amendment: prohibition on promoters holding ESOPs

An explanation to Rule 12(1) of the Companies (Share Capital and Debentures) Rules, 2014 excludes a promoter or a person belonging to the promoter group from the definition of ‘employee’, in the context of eligibility for grant of ESOPs.

However, pursuant to Companies (Share Capital and Debentures) Third Amendment Rules, 2016 Dated July 19, 2016, a proviso has been added to the aforesaid explanation that provides an exemption for start-up companies up to ten years from the date of its incorporation or registration. Therefore, in case of a start-up, a promoter or member of promoter group may also be issued ESOPs upto 10 years from the date of its incorporation.

Similar prohibition applies to a listed entity, as per Reg  2(1)(i) of SEBI (Share Based Employee Benefits and Sweat Equity) Regulations, 2021, pursuant to  which, an employee does not include a promoter or a person belonging to promoter group. There is no exemption for a start-up company under the said Regulations.

Founder or promoter : a question of identity

The term ‘promoter’ is defined in an almost similar fashion in both Companies Act, 2013 (“ and ICDR Regulations.  As per the definition, there are three limbs to the definition of promoter, being:

  1. Promoter by proclamation: that is, the person who is named as promoter in the offer documents or the annual return.
  2. Promoter by control: that is, a person having control over affairs, whether as shareholder, director or otherwise, directly or indirectly.
  3. Promoter by absentee control: that is, by orchestrating the affairs of the company by giving instructions to the board of directors, which the latter is accustomed to adhere to.

Further, the term ‘promoter group’, is not a defined term under the Companies Act, 2013 and hence, may be open to interpretation.

On the question of whether or not every founder may be considered as promoters, what needs to be understood is that while the founder may be the one who initiates the idea of the start-up, it may so happen that subsequent to new investors coming in, the founder may gradually lose his powers to control the affairs of the company. The board becomes independent, the private equity investors get to have a call in various matters, and the powers get diluted, pursuant to which the founder may not be recognised as a promoter after all.

However, the stock exchanges apply various additional criteria for considering a person as ‘promoter’, some of which may categorise a Founder as promoter, regardless of whether the same is holding ‘control’ in the company or not. 

For instance, as per news reports[1], the guidance issued by NSE for promoter categorisation in case of an IPO-bound company, requires founders to be categorised as promoters if:

  1. They hold a position or have the right to be nominated, as a director or KMP/SMP; and
  2. They have a collective shareholding of 10% or more of the equity shares (including options which are vested till the date of listing) of the company, either directly or through any legal entities or persons controlled by such founder or his/her immediate relatives.

Therefore, even when a founder may not be holding ‘control’ in a company, he may be categorised as a promoter by holding options if they are crossing the 10% threshold.

Fate of ESOPs issued to founders, later turned promoters

The SBEB Regulations, as discussed above, do not allow promoters to hold ESOPs or other share based benefits in a listed entity. Although applicable to listed entities, the compliance is required to be ensured at the stage of filing of DRHP, and hence, IPO-bound companies are also covered.

While the Regulations exclude the promoters from the definition of an employee eligible for the receipt of ESOPs, it does not clarify the treatment of options that are already granted to promoters, prior to such classification. This led to a confusion in case of options issued to Founders-turned-Promoters, putting the fate of such granted options in a grey area.

In case a view is taken that such options need to be liquidated, and the benefits thus accruing, has to be foregone, at the time of identification as a promoter, the same would not be justified. It is not on their own wish to become a promoter, and since the options are part of the remuneration of the Founders as employees, granting them an immunity for  such options is needed.

Decoding the conditions for exemption

1.     Grant of options prior to identification as promoter or promoter group

The purpose of the amendments is to primarily cover the ‘founders’ of start-up companies, where it would be typical to give share based options to incentivise the founders and as a remuneration against the services offered by such employees.

As discussed above, there may be situations where a person, though a founder of the company, was not categorised as promoter under CA, 2013. However, pursuant to the categorisation conditions followed by the SEs, during filing of DRHP, may get covered as a ‘promoter’ or ‘promoter group member’.

The explanation refers to grant of share based benefits, prior to being identified as a “promoter” or “promoter group”, and thus, refers to such employees/ founders who were not categorised as promoter/ promoter group prior to grant of options.

However, consider the case of a founder of a start-up who was identified as a promoter since inception, but was granted ESOPs pursuant to the exemption available to start-ups under CA, 2013. If the company later decides to go for listing, it remains unclear whether such ESOPs would remain valid under this proposed explanation. This is because, technically, the first condition requiring that the ESOP grant be made before the individual was identified as a promoter, is not satisfied in such cases.

This condition risks contradicting the very objective of the amendment, which is to safeguard pre-IPO entitlements granted to founders while ensuring regulatory safeguards for promoters are maintained at the time of listing. The start-up related exemption, as available to the promoters under CA, 2013 is with the objective of permitting the founders, whether promoter or otherwise, to be benefitted from the growth of the company and be entitled to share based benefits.

2.     Grant must have occurred at least one year prior to the Board’s decision to undertake an IPO

The condition requires the options or other benefits to have been granted at least 1 year prior to the board’s decision of undertaking an IPO. The clause provides a cooling off period between the grant of options and the company’s IPO decision, so as to prevent situations where companies might quickly issue ESOPs or other share based benefits to promoters just before going public, thus taking benefit in ingenuine cases.

The one year requirement is a reasonable safeguard, as it helps protect the interest of public shareholders and ensure that such grants are made in advance to genuine employees only as a reward for their contribution to the company and not as an opportunistic benefit tied to the IPO.

Conclusion

While SEBI’s proposal to introduce an explanation under Regulation 9(6) of the SBEB Regulations is a well-intended step towards addressing the gaps affecting founders of start-ups, its current framing leaves room for ambiguity.

The final wording of the amendment, once notified, will be pivotal in determining whether this balance between protecting founders’ rights and maintaining necessary safeguards for promoters. It is hoped that SEBI will clearly address this issue in the final version, so that the real purpose of the amendment is not lost in technical wording.

[1] https://www.moneycontrol.com/news/business/ipo/executive-startup-founders-holding-more-than-10-stake-may-be-categorised-as-promoters-12508551.html

Read more:

FAQs on Share Based Employee Benefits

Yeh Rishta kya kahlaata hai! – the strange case of “promoters-in-law”

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Vinod Kothari | vinod@vinodkothari.com

Here is a tale of three families, and trust, almost every business family in the country may fit in the tale. (All names are completely hypothetical.)

Family One – Jaani family, owning large number of listed companies in the country. Ashok, son of the founder, got married to Rani, daughter of the founder of Maani family.

Maani family – once again another leading industrial houses in the country. Rani, daughter of the founder, has two siblings – Prashik, and Vimla. Prashik runs the family’s businesses. Vimla got recently married to Varun, from Dhyaani family.

Camera shifts to Dhyaani family, where Vimla got married to Varun. Relations are made between equals – hence, Dhyaani family is no less in stature than the Maani family and the Jaani family.

All the families have variety of listed and unlisted companies in their control. In most cases, shareholdings of operating entities are through investing vehicles, which are held in the name of individuals of the families.

Given the definition of “promoter group”, Ashok is a promoter. Ashok’s wife, Rani is obviously an “immediate relative” and hence a part of promoter group.

By definition (if we read it to mean parents, brother, sister and child of the spouse too), Rani’s father, the founder of the Maani family, becomes a part of the “promoter group” for Jaani family. So also will be Prashik. Vimla, though married in Dhyaani family, being sister of Rani, will also be part of “promoter group”.

Now look at the consequences. All bodies corporate where 20% shareholding is held by the individuals of Maani  family – founder, Prashik and Prashik’s mother, will form part of the promoter group of the Jaani family. 

We don’t stop here – all entities where Vimla, now a part of Dhyaani family, will also need to identify bodies corporate where she holds 20%, and these entities will be reported as a part of the PG for Jaani family.

The same process will have to run for Maani family and Dhyaani family – hence, the focus may actually shift over to the country’s business tycoons one by one.

The sweep of the definition of “promoter group” may have had its own intent, but it cannot be stretched to include सगे सम्बन्धी where there is no evidence of commonality. Sadly enough, SEBI rules require a listed company to list out the names of all such सगे सम्बन्धी entities, no matter whether there is a shareholding overlap or not. And all these entities will be identified as “related parties” too.

Our other resources on promoter/promoter group can be accessed below:

From Rooftops to Ratings: India’s Green Securitisation Debut

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– Payal Agarwal, Partner | finserv@vinodkothari.com

Probably the first in India, green securitisation has finally found an entry with the recent issuance of pass-through certificates backed by residential rooftop solar loan receivables in India. The loans were originated by a ‘green-only’ NBFC focussed on climate-positive lending. The present issuance is in the form of green collateral securitisation – since the securitised receivables qualify as ‘green’. Further, given the activities of the originator, it seems that the same may qualify to be a green capital securitisation, with the freed capital of the originator being utilised towards creation of green assets. 

Notably, as per a recent publication of Climate Policy Initiative, the Global Landscape of Climate Finance 2025, India has been ranked as the leading country in the South Asia region in terms of mobilisation of climate finance (as per the data for 2023). Green securitisation may act as a catalyst to the growth of green finance in India. See a whitepaper on the same here.

A broader concept in the context of climate finance is sustainable securitisation, our whitepaper on the same can be accessed here. The recent guidelines of SEBI also permits the issuance and listing of sustainable securitised debt instruments, based on the recommendations of the Working Group constituted for the review of SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts)  Regulations, 2008, chaired by Mr. Vinod Kothari. An article on the concept of sustainable SDIs may be accessed here.

Our various resources on sustainability finance is available at – https://vinodkothari.com/resources-on-sustainability-finance/

Our various resources on securitisation is available at – https://vinodkothari.com/2025/01/securitisation-resource-centre/