Partial Credit Enhancement: A Catalyst for Boosting Infrastructure Bond Issuances?

-Abhirup Ghosh (abhirup@vinodkothari.com)

What is partial credit enhancement?

Partial Credit Enhancement (PCE) is a risk-mitigating financial tool where a third party provides limited financial backing to improve the creditworthiness of a debt instrument. It ensures that investors are partially protected against default risk, making it easier for issuers to raise funds at better terms.

The key features of a PCE are as follows:

  1. Parties involved: A typical PCE structure would involve at least three parties:
  • Issuer: A company or an entity that wants to raise funds by issuing debt instruments;
  • PCE Provider or Credit Enhancer: A third party (usually a government agency or a financial institution with strong credibility) that provides the credit enhancement 
  • Investor(s): The one who invests in the debt instruments. 
  1. Multiple forms: Can be structured in various forms, like guarantee, subordinated line of credit, investment in subordinated tranche, cash collateral etc. 
  2. Limited coverage: Unlike full credit enhancement, PCE covers only a portion of the potential losses in case of default. The extent of coverage is pre-fixed and does not extend once the same is exhausted.
  3. Improved Credit Rating: PCE lowers the perceived credit risk, leading to an improved bond rating by credit rating agencies. A higher credit rating results in lower interest rates, benefiting the issuer.

Why has this become so important all of a sudden?

The concept of PCE has been in India for quite some time now, and is commonly used in securitisation transactions. However, the Finance Minister’s announcement during Union Budget 2025 about setting up of a PCE facility under the National Bank for Financing Infrastructure Development (NaBFID) has brought this into the limelight.

How does it help issuance of bonds by an infrastructure entity?

Infrastructure development is the backbone of economic growth, but funding large-scale projects such as highways, railways, power plants, and airports requires substantial capital. Infrastructure projects often face challenges in raising funds due to their long gestation periods, high risks, and lower credit ratings. PCE serves as an effective financial tool to improve the creditworthiness of infrastructure bonds, making them more attractive to investors. By providing a partial guarantee or security, PCE helps reduce the cost of borrowing and widens investor participation, ultimately facilitating infrastructure financing.

Challenges in Infrastructure Bond Issuances

Infrastructure bond issuances face several obstacles that make fundraising difficult. One of the primary challenges is low credit ratings. Infrastructure projects, especially those in their early stages, often receive sub-investment-grade ratings (such as BBB or lower), making them unattractive to investors. Additionally, these projects are subject to high perceived risks, including revenue uncertainty, regulatory hurdles, construction delays, and cost overruns. Since many infrastructure projects rely on user charges, such as tolls or metro fares, their cash flow projections can be unpredictable.

Another major issue is the long maturity period of infrastructure bonds. Most investors prefer short- to medium-term investments, whereas infrastructure bonds typically have tenures of 10 to 30 years. This mismatch reduces the appetite for such bonds in the market. Lastly, lack of institutional investor participation further limits the success of infrastructure bond issuances, as pension funds, insurance companies, and mutual funds prefer highly rated bonds with stable returns.

Enhancing Credit Ratings and Investor Confidence

One of the most significant ways PCE helps infrastructure bond issuances is by improving their credit ratings. When a bank or financial institution provides partial credit enhancement in the form of a guarantee or reserve fund, it reduces the default risk associated with the bond. This leads to a higher credit rating, making the bond more attractive to investors. For example, an infrastructure company with a BBB-rated bond issuance may improve its rating to A with a 20% PCE support, or AA with a 50% PCE support thereby increasing demand from investors. A higher rating not only boosts investor confidence but also expands the pool of potential buyers, including institutional investors such as pension funds and insurance companies.

Reducing Cost of Borrowing

By improving the credit rating of infrastructure bonds, PCE directly leads to a reduction in interest costs. Bonds with higher ratings attract lower interest rates, which helps infrastructure companies secure financing at more affordable terms. For instance, without PCE, a BBB-rated bond may require 12%, whereas a bond upgraded to an AA rating with PCE support may only require 9%. This reduction in interest rates can result in significant savings over the life of the bond. Lower borrowing costs also make infrastructure projects more financially viable, ensuring their timely execution and long-term sustainability.

Attracting Institutional Investors

Institutional investors, such as mutual funds, pension funds, and insurance companies, typically have strict investment guidelines that restrict them from investing in low-rated securities. Since many of these investors require bonds to be rated AA or higher, infrastructure bonds often struggle to meet these requirements. PCE helps bridge this gap by enhancing the credit rating, making infrastructure bonds eligible for investment by these large institutional players. This leads to greater liquidity and stability in the corporate bond market, ensuring a steady flow of capital to infrastructure projects.

Why is issuance of bonds helpful/ important for the infrastructure entity?

PCE contributes to the overall development of the corporate bond market by encouraging more issuers to raise funds through bonds rather than relying solely on bank loans. Traditionally, infrastructure financing in India has been dependent on banks, which exposes them to high asset-liability mismatches due to the long tenure of infrastructure projects. By facilitating infrastructure bond issuances, PCE helps shift the burden away from banks and towards a broader investor base. This not only diversifies funding sources but also enhances financial stability in the banking sector.

As per a CII report (2022), the infrastructure financing gap is estimated at over 5% of GDP. Approx. 80% of the investment in infrastructure space is by government agencies (80%), and the remaining 20% comes from private developers. 

As per the National Infrastructure Pipelines, the total investment target was set at INR 111 trillion (USD 1.34 trillion) for the period between FY 20 and FY 25; and only 6-8% (INR 6.66-8.88) of the such targets were expected to be met by bond issuances. Reliance on bond markets is planned to the extent of 6% to 8% (INR 6.66 – 8.88 trillion). As per the said estimates, the average annual issuances should have been INR 1.480 trillion. However, between FY18 and FY22, the issuance of infrastructure bonds has been at INR 5.37 trillion, that is, an average of INR 1.07 trillion per annum, that is a shortfall of ~30% compared to the target.

Furthermore, the issuances have been highly concentrated in the top 5 PSUs. The charts below show the annual bond issuances between FY 18 – FY 22, and share of issuance by top 5 PSUs and others:

Source: CRISIL

The market is dominated by highly rated issuers. In general approx. 75% of bond issuers are rated AAA, and more than 90% of the issuances are by AA and above rated entities. The reason for this dominance by highly rated issuers is the fact that for practical purposes, the most acceptable rating in the infra bonds space is AA, as long term investors like insurance companies, pension funds etc. are by regulation required to invest in AA or above rated papers. 

PCE support from a credible source will help a lot of infrastructure operators, who are stopped at the gate, with ratings in the range of A, with easy access to the market. 

Existing scheme for PCE – why has it not found takers

The existing scheme for PCE was notified by the RBI in 2015. In a nutshell, the scheme provides for the following:

Form of PCE: To be structured as a non-funded, irrevocable contingent line of credit. This facility can be drawn upon in the event of cash flow shortfalls affecting bond servicing.

Limitations: The total PCE extended by a single bank cannot exceed 20% of the bond’s total size; however, overall, the PCE provided by all banks, in aggregate, cannot exceed 50% of the bond’s total size.

Further, PCE can be provided only to bonds which have a pre-enhanced rating of BBB- or above.

Capital Requirements: The bank providing PCE does not hold capital based only on its PCE amount. Instead, it calculates the capital based on the difference between:

  • The capital required before credit enhancement.
  • The capital required after credit enhancement.

The objective is to ensure that the PCE provider should absorb the risks that it covers in the entire transaction. Illustrating with an example:

Assume that the total bond size is Rs. 100 crores for which PCE to the extent of Rs. 20 crore is provided by a bank. The pre-enhanced rating of the bond is BBB which gets enhanced to AA with the PCE. In this scenario:

  1. At the pre-enhanced rating of BBB (100% risk weight), the capital requirement on the total bond size (Rs.100 crores) is Rs.9.00 crores.
  2. The capital requirement for the bond (Rs.100 crores) at the enhanced rating (AA, i.e., 30% risk weight)) would be Rs.2.70 crores.
  3. As such, the PCE provider will be required to hold the difference in capital i.e., Rs.6.30 crores (Rs.9.00 crores – Rs.2.70 crores).

As can be seen, the capital has to be maintained on the total bond issuance, and not just the exposure. Ironically, this capital has to be maintained until the outstanding principal of bonds falls below the extent of PCE provided​. Usually, the bonds are amortising in nature – that is, the actual exposure of the guarantor continues to come down. Given, however, that default in bonds may be back-ended, the capital has still to be maintained till the redemption of the bonds​. This requires the PCE provider to maintain huge regulatory capital for a significantly long period of time; which also gets reflected in the ultimate cost to the beneficiary, therefore, making it unviable. 

How to make it work?

The FM’s announcement though comes with a lot of promise, as it shows a positive intent. But to make things work, there are quite a few things that should be put into place:

  1. Specific applicability: Currently, the PCE framework applies only to banks. For NaBFID to commence its PCE operations, it would be ideal to receive explicit approval from the RBI, even if the requirement is minor or procedural in nature.
  1. Limitations: Currently, the RBI’s PCE framework restricts a single entity to providing only 20% of the total 50% PCE limit for a bond issuance. It is recommended that a single institution, such as NaBFID, be allowed to provide the entire PCE, which would enhance flexibility.  The existing framework is not particularly attractive for banks in India. In the infrastructure finance sector, a 20% PCE contribution from a single entity may not be sufficient to secure a strong rating from credit rating agencies. Removing this 20% sub-limit would grant NaBFID greater flexibility while also reducing the time required to identify multiple institutions to fulfill the remaining PCE. Additionally, this change would lead to a reduction in operational expenses associated with coordinating multiple PCE providers.
  1. Capital treatment: The current setting of capital requirement makes the transactions very costly. There has to be an alternative way of achieving the objective. Setting the capital requirement as a fixed proportion of the outstanding bond value may not be appropriate, as defaults can occur at any stage. A more effective approach would be to apply the capital treatment for structured credit risk transfer under the Basel III framework, that is SEC ERBA.  Under Basel III, capital requirements are not linked to the total bond issuance size but are instead based on the rating of the tranche and the extent of exposure undertaken. This method ensures that capital is aligned with the actual risk exposure, rather than a fixed percentage of the bond size. Additionally, it accounts for the possibility of defaults occurring later in the bond’s lifecycle, providing a more efficient risk management framework.
  1. Credit risk transfer: The PCE framework should specifically allow credit risk transfer by the PCE provider – this will help the PCE provider reduce its exposures, and consequently, extent of capital to be maintained on the PCE provided​. This will help in reducing the cost of the PCE support as well.

Union Budget 2025: Key Highlights and Reforms focusing on Financial Sector Entities

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Guidelines on Settlement of Dues of borrowers by ARC

– Team Finserv (finserv@vinodkothari.com)

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Can CICs invest in AIFs? A Regulatory Paradox

-Anshika Agarwal (finserv@vinodkothari.com)

Core Investment Companies (CIC) and Alternative Investment Funds (AIF) are two very common modes to channelise investments in the Indian market. Both are regulated by different regulators; while CICs are regulated by the RBI, AIFs are regulated by the SEBI. Under their respective regulatory frameworks, both are technically permitted to invest in one another. However, this permissibility introduces an intriguing paradox, especially for a CIC, which is allowed to invest in group companies. It points out that this approach effectively creates two investment pools—one directly under the CICs and another through the AIFs. This dual-pool structure complicates what could otherwise be a straightforward process, introducing unnecessary layers of complexity, thus deviating from the primary purpose of CICs to hold and manage investments efficiently within group companies. 

The following article examines the implications of Paragraph 26(a)1 of the Master Direction – Core Investment Companies (Reserve Bank) Directions, 2016 (“CIC Master Directions”), but before delving into the specifics, it may be worthwhile to discuss in brief the concepts of AIF and CIC. 

What are AIFs (Alternative Investment Funds)?

AIFs have gained prominence as a pivotal part of the financial ecosystem, providing investors with access to diverse and innovative investment opportunities. The key features of an AIF are as follows:

  1. An AIF is a privately pooled investment vehicle, therefore, it cannot raise money from public at large through a public issue of units;
  2. The investors could be Indian or foreign – there is no bar on the nature of the investor who can invest.
  3. The investments made by the fund should be in accordance with the investment policy.
  4. There are three categories of AIFs, depending on the kind of investments they make, and each category is regulated differently:
    1. Category 1 which invests in start up or early stage ventures or social ventures or SMEs or infrastructure or other sectors or areas which the government or regulators consider as socially or economically desirable and shall include venture capital funds, SME Funds, social venture funds, infrastructure funds and such other Alternative Investment Funds as may be specified.
    2. Category 2 which does not fall in Category I and III and which does not undertake leverage or borrowing other than to meet day to day operational requirements and as permitted in these regulations. It includes private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other regulator shall be included.
    3. Category 3 which employs diverse or complex trading strategies and may employ leverage including through investment in listed or unlisted derivatives.

What are Core Investment Companies (CICs)?

CICs are a specialized subset of Non-Banking Financial Companies (NBFCs) established with the primary purpose of holding and managing investments in group companies. CICs do not engage in traditional financial intermediation but play a vital role in maintaining financial stability within the ‘group companies’. CICs are governed under the CIC Master Directions to ensure that their activities align with regulatory standards. 

Below given graph explains the regulatory permissibility of the kind of investments a CIC can make:

In addition with the aforesaid, it may further be noted that CICs are permitted to carry out the following financial activities only:

  1. investment in-
    1. bank deposits,
    2. money market instruments, including money market mutual funds that make investments in debt/money market instruments with a maturity of up to 1 year.
    3. government securities, and
    4. bonds or debentures issued by group companies,
  2. granting of loans to group companies and
  3. issuing guarantees on behalf of group companies. 

It may be noted that the RBI’s FAQs on Core Investment Companies, particularly Question 92 has clarified about the 10% of Net Asset – 

What items are included in the 10% of Net assets which CIC/CIC’s-ND-SI can hold outside the group?

Ans: These would include real estate or other fixed assets which are required for effective functioning of a company, but should not include other financial investments/loans in non group companies.

Who are included in Group Companies?

The term “group companies” is defined under Para 3(1)(v) of the CIC Master Directions. It refers to an arrangement involving two or more entities that are related to each other through any of the following relationships:

Subsidiary – Parent (as defined under AS 21),
Joint Venture (as defined under AS 27),
Associate (as defined under AS 23),
Promoter-Promotee (as per the SEBI [Acquisition of Shares and Takeover] Regulations, 1997 for listed companies),
Related Party (as defined under AS 18),
Entities sharing a Common Brand Name, or
Entities with an investment in equity shares of 20% or more

The Issue with Paragraph 26(a): The paradox

Para 26A of the CIC Master Directions deals with Investments in AIFs. The language of the provisions suggest that CICs are permitted to invest in AIFs. However, this provision introduces a significant legal contradiction that undermines the regulatory framework governing CICs. According to the Doctrine of Colorable Legislation, a legal principle ensuring legislative consistency, what cannot be achieved directly cannot be permitted indirectly. By allowing CICs to invest in AIFs, Para 26(a) effectively circumvents the explicit restriction on investments outside group companies. This indirect allowance is inconsistent with the foundational objectives of the CIC Master Directions and creates substantial legal and operational confusion.

Can there be an AIF which in turn invests in the group only? 

Under the SEBI (Alternative Investment Funds) Regulations, 2012, the primary objective of an Alternative Investment Fund (AIF) is to pool funds from investors and allocate them across diverse investment opportunities. However, structuring an AIF to invest predominantly or exclusively in entities within the same group raises concerns regarding compliance with SEBI’s regulatory framework, particularly its diversification. SEBI imposes strict investment concentration limits, as outlined in one of its Circular3

For Category I and II AIFs, no more than 25% of their investable funds can be allocated to a single investee company, while Category III AIFs are restricted to 10%. These regulations inherently prevent AIFs from focusing solely on group entities unless the investment structure strictly adheres to these limits. For CICs intending to invest in AIFs, these restrictions pose significant limitations if the goal is to channel funds primarily into group companies. 

Can AIFs be a Group Entity in a CIC’s Group Structure?

Technically, the answer is affirmative—AIFs can be part of a group entity within a group if it satisfies any of the conditions mentioned in the definition. However, if CICs invest in AIFs within the same group structure, it fails to resolve the underlying issue. AIFs often invest outside the group companies, exposing CICs indirectly to entities external to the group. This contradicts the core purpose of CICs, which is to focus investments within their own group companies. Such a structure not only undermines the original intent of CICs but also raises compliance concerns. The RBI adopts a pass-through approach in these cases and is likely to view such practices as non-compliant. 

Conclusion

The regulatory paradox of allowing CICs to invest in AIFs under Para 26(a) of the CICs Master Direction raises important questions about the practicality and purpose of this provision. At its core, CICs are meant to simplify and streamline the management of investments within their group companies. However, the inclusion of AIFs creates an unnecessary layer of complexity, dividing investments into dual investment pools and making it harder to track, manage, and maintain transparency.

This arrangement doesn’t just complicate operations, it also moves CICs away from their original purpose. By routing investments through AIFs, CICs are exposed to entities outside their group, which can lead to compliance risks, regulatory confusion, and inefficiencies. Even from a taxation perspective, the setup offers no real benefits, adding financial burdens without meaningful gains. Paragraph 26(a) of the CICs Master Direction has been taken from the SBR Master Direction, which is applicable to NBFCs. However, including it in the CICs Master Direction, which provided regulation specifically for CICs NBFC does not appear to serve any purpose. Even if it were to be amended, its relevance of stating the same for CICs NBFC would still remain questionable.

  1.  Reserve Bank of India, Master Direction – Core Investment Companies (Reserve Bank) Directions, 2016. Available at:https://www.lawrbit.com/wp-content/uploads/2021/05/Master-Direction-Core-Investment-Companies-Reserve-Bank-Directions-2016.pdf (Accessed: 19 January 2025). ↩︎
  2. FAQs on Core Investment Companies, available at: https://www.rbi.org.in/commonman/english/scripts/FAQs.aspx?Id=836 (Accessed: 19 January 2025). ↩︎
  3.  SEBI (Alternative Investment Funds) Regulations, 2012 available at: https://www.sebi.gov.in/legal/regulations/apr-2017/sebi-alternative-investment-funds-regulations-2012-last-amended-on-march-6-2017-_34694.html ↩︎

Can NBFCs “outsource” internal audit functions to external auditors? 

– Anshika Agarwal (finserv@vinodkothari.com)

The Reserve Bank of India (RBI) has consistently emphasized the significance of robust internal control systems; where gaps are found by the supervisor, it has penalised  regulated entities for non-compliance. Recently, the RBI imposed a penalty on an NBFC for outsourcing one of its core management functions, i.e., internal audit to an external auditor, thereby raising doubts as to whether internal audit for NBFCs can be conducted by external auditors. Does the very fact that internal audit is being conducted not internally but by an external chartered accountancy firm amount to “outsourcing” of core management function?  This article examines outsourcing in the context of internal audit function,  and the conditions subject to which internal audit may be conducted by external agencies. 

Understanding the concept of ‘Outsourcing’

Outsourcing is defined under the Basel 2005 document1 as “a regulated entity’s use of a third party (either an affiliated entity within a corporate group or an entity that is external to the corporate group) to perform activities on a continuing basis that would normally be undertaken by the regulated entity, now or in the future.” Similarly, the IOSCO Consultation Paper2 refers to outsourcing as “a business practice in which a regulated entity uses a service provider to perform tasks, functions, processes, or activities that could otherwise be undertaken by the regulated entity itself.

NBFCs, especially those with asset-light models or limited resources, opt for outsourcing to manage financial as well as non-financial functions. Outsourcing by NBFCs typically involves delegating tasks such as loan application processing, collection of documents, data processing, IT support, customer service, and back-office operations to third-party providers. While outsourcing boosts operational efficiency, they also carry risks, particularly when core management functions are outsourced. Notably, outsourcing is distinct from availing professional services like legal, audit, consulting, or property management, which are ancillary to the NBFC’s core business. In case of outsourcing of financial functions by regulated entities, there are specific guidelines issued by the RBI to regulate the arrangements. Clear regulatory oversight is crucial to strike a balance between leveraging external expertise and maintaining ethical, efficient practices in the financial services sector.

Regulatory Framework: The RBI’s Perspective

The RBI guidelines are specifically aimed at managing risks related to outsourcing of financial services. Master Direction – Reserve Bank of India (Non-Banking Financial Company – Scale Based Regulation) Directions, 2023 (‘SBR Directions’)3, particularly Annexure 13 on Instructions on Managing Risks and Code of Conduct in Outsourcing of Financial Services by NBFCs (‘Outsourcing Guidelines’), Para 2 lays down stringent conditions for outsourcing to ensure compliance, accountability, and effective risk management. While outsourcing can support operational efficiency, core management functions must remain under the direct control of the regulated entity.

Core Management Functions: Non-Negotiable Responsibilities 

The Outsourcing Guidelines explicitly prohibits NBFCs from outsourcing core management functions vital to governance, decision-making, and risk management. The core management functions are those that are vital and crucial for the existence as well as operations of the entity. These have been defined to include:

These functions are critical for ensuring the organization’s stability and operational integrity. For example, internal audit functions identify risks, ensure regulatory compliance, and assess control effectiveness. Entrusting such functions to external entities could compromise decision-making and erode organizational trust.

Contractual Engagement for Internal Audit

While the internal audit function itself is a core management process, the Outsourcing Guidelines in the same lines allows regulated entities to engage internal auditors on a contractual basis. This means external professionals can be brought in to execute internal audits, provided their engagement adheres to regulatory standards, independence is maintained, and the entity retains oversight and control rather than putting all the responsibility on a third party. 

For example, an entity may handle several operational tasks related to an audit, such as preparing documentation, organizing records, or conducting initial reviews. However, the ultimate responsibility for decision-making, oversight, and ensuring compliance with regulations rests with the audit committee or the entity’s senior management. This approach ensures that the internal management retains control over key aspects of the audit process, even while delegating specific tasks or availing expertise support. In contrast, the action of outsourcing shifts the entire responsibility for the audit to a third-party. This means the external firm is accountable for managing and executing all aspects of the audit, from operational tasks to final implementation. Such an outsourcing may reduce the internal workload, however, it also transfers control and accountability to an external entity, which may not align entirely with the entity’s internal objectives and strategic priorities. 

In other words, what is permitted is to avail the expertise services of a third party for carrying out the internal audit function but not the transfer of the entire responsibility of carrying out internal audit to a third party.

ICAI Standards: Expertise and Independence in Internal Audits

The Institute of Chartered Accountants of India (ICAI) Standards on Internal Audit4 states that “Where the Internal Auditor lacks certain expertise, he shall procure the required skills either though in-house experts or through the services of an outside expert, provided independence is not compromised”. 

The aforesaid guidance from the ICAI emphasizes maintaining expertise and independence. While not explicitly addressing outsourcing, these standards recognize that internal auditors may lack certain specialized skills. In such scenarios, they encourage engaging in-house or external experts while safeguarding independence.

The standards indirectly allow for outsourcing when:

  • Specific expertise is unavailable in-house,
  • Independence remains uncompromised

By availing the services of experts ensures that internal audit teams possess the necessary skills to perform effective reviews, while the entity retains oversight and accountability.

Companies Act, 2013: Flexibility in Internal Audit Assignments

Section 138 of the Companies Act, 2013 (‘CA 2013’)5, specifies the requirement for internal audits for certain classes of companies. It allows the appointment of internal auditors, which may include chartered accountants, cost accountants, or other professionals, as decided by the Board. Explanation of Rule 13 of the Companies (Accounts) Rules, 2014, states that “the internal auditor may or may not be an employee of the company”.

The aforesaid provision also enables companies to engage external auditors to perform internal audits, even if they are not part of the organization. While the CA 2013 does not explicitly prohibit outsourcing of internal audit functions, it places the ultimate responsibility for conducting and reporting on internal audits with the Board. This also clarifies that companies may utilize external expertise while maintaining oversight and control of the audit process.

Conclusion

In conclusion, the RBI’s recent penalties underscore the importance for regulated entities to maintain strict compliance with outsourcing regulations, particularly regarding core management functions. While the Outsourcing Guidelines as well as the provisions of CA 2013 permit engaging external auditors on a contractual basis to perform operational tasks related to audits, accountability and strategic control such as having audit plan approved by the audit committee, regular reporting to the audit committee, discussion of the board and audit committee on the conduct of audit,implementing remedial measure on the oversight of the audit committee or senior management must remain firmly within the organization. Adherence to these principles will help maintain the fine distinction between outsourcing the internal audit function and appointing external auditors as internal auditors, specifically in the context of internal audits.

Read our other related resources –

  1. UNDERSTANDING THE CONCEPT OF OUTSOURCING- ENVISAGING A TOUGH ROAD AHEAD FOR THE SERVICE PROVIDERS
  2. Draft framework for Financial Services Outsourcing

  1.   https://www.bis.org/publ/joint12.pdf (last accessed in November 2024) ↩︎
  2.   https://www.iosco.org/library/pubdocs/pdf/IOSCOPD654.pdf (last accessed in November 2024) ↩︎
  3.  Reserve Bank of India, Master Direction – Scale Based Regulation (SBR): A Revised Regulatory Framework for NBFCs, October 22, 2021. Available at: https://rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12550 ↩︎
  4.  Institute of Chartered Accountants of India, Standard on Internal Audit (SIA) 2: Basic Principles Governing Internal Audit. Available at: https://resource.cdn.icai.org/52727iasb-basicprinciples-3.pdf ↩︎
  5.  The Companies Act, 2013, Ministry of Corporate Affairs, Government of India. Available at: https://www.mca.gov.in/. ↩︎

Shastrartha 13 – DPDP Rules for Lenders

In this edition of Shastrath, we address key concerns and considerations for lenders in light of the Draft DPDP Rules published on January 03, 2025, and discuss steps to take in order to ensure readiness and compliance. 


Register your interest here: https://docs.google.com/forms/d/e/1FAIpQLSf0uZidJDf8oqK0GfGygo0BmuCKRg9wMo2bXRtwRMIra7Zx5Q/viewform

Credit Information Reporting: Actionables under the New Directions

– Anshika Agarwal (finserv@vinodkothari.com)

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Draft DPDP Rules: Heightened data concerns for financial sector entities

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Chains of control: Change of control approval keeps NBFCs perplexed, often non-compliant 

– Vinod Kothari (vinod@vinodkothari.com)

Paragraph 42 of the Master Direction – Reserve Bank of India Non-Banking Financial Company – Scale Based Regulation) Directions, 2023 (‘SBR Directions’), mandates obtaining prior approval from the RBI for any change in shareholding of 26% or more or any change in management amounting to 30% or more. Before we get into details of the requirement, it is important to start with two observations. 

First, this regulation, requiring RBI’s approval for change of control, shareholding or management, applies to all NBFCs, large or small. Given the expanse of the definition, exacerbated by the lack of clarity, this regulation is a constant pain for most NBFCs, particularly the smaller ones.

The second point – the regulation is worded quite vaguely. As the discussion below will reveal, what is change in shareholding of 26% does not come clearly from the language at all. When the language is unclear, the subjects are exposed to erring on the safer side of the law, and end up doing superfluous compliances.

Language may not be clear, but the intent or object of the regulations is clear; one would wish the interpretation of the provision does justice to the intent.

NBFCs must seek the prior permission/ approval from the RBI before strategic changes such as takeovers, acquisition of major shareholding, or significant management changes from the viewpoint of entry of new persons on board. What is the intent of seeking this approval: the RBI granted registration to an NBFC after examination of its control, shareholding and management. The RBI had to satisfy itself that the persons behind the NBFC are “fit and proper”. In a manner of speaking, the RBI is handing the keys of an access to the financial system – therefore, it wanted to be fully sure of who the person taking the keys are.

It is a person acquiring control, coming into management, or building up a significant shareholding, who needs to be tested from the viewpoint of “fit and proper”. There is no question of the person, who is admittedly already in control, from earning that qualification. Also, there is no question of the person walking out of control or transferring out significant shareholding to need approval.

Regulatory carve outs

There are two exceptions, viz., if shares are bought back with court (now NCLT) approval, or, in case of change of management, if directors are re-elected on retirement by rotation. But even with exceptions, NBFCs still need to inform the regulator about any changes in their directors or management.

Note that the carve-out in case of buybacks is only for such buybacks as are coming for NCLT approval, which would mean reduction of capital u/s 66 of Companies Act 2013. As regards buybacks done with board or shareholders’ approval, in view of the limit of 10%/25% of the equity shares, usually a single buyback should not cause a change of control, but it may so happen that one significant shareholder stays back, and other takes a buyback and exits, causing the former’s shareholding to gain majority or significant shareholding (as discussed below). In such a case, exceptions from RBI approval will not be available.

And the other carve-out of reappointment of directors is not a change in management at all. If, at a general meeting, the existing director(s) is rotated out, and a new director comes in place, there is surely no exception in that case.

Three situations requiring approval

There are three situations requiring approval of the RBI; all of these have to be seen in light of the purpose of getting the supervisor’s sign off by way of a “fit and proper” person check. The three situations are:

  1. Takeover or acquisition of control

This is required to be read in light of the definition of “control” in SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (‘SAST regulations’) [by virtue of reg 5.1.5].  There is an inclusive definition of “control” in SAST Regulations, which is far from giving any bright-line test of when control is said to have been acquired[1]. There is no definition of “takeover” in the SAST Regulations, even though the title of the Regulations is “substantial acquisition of shares” and “takeovers”. A view might be that “substantial acquisition of shares” is a case of takeover. In that case too, there are two different situations covered by SAST Regulations – first time acquisition of 25% or more of the equity shares [Reg 3 (1), or a creeping acquisition of 5% or more in a financial year, by a person already holding 25% or more [Reg 3 (2)]. 

Acquisition of control is covered separately by Reg 4. The question, in the context of NBFCs is, whether “takeovers” and “change of control” are to be read as two separate situations, and if yes, what will be the meaning of “takeover”? Can it be said that every “substantial acquisition of shares” is a takeover, and if so, whether only the first-time acquisition or the creeping acquisition as well? First of all, there is no reason to include creeping acquisition here, as the relevance of the same is limited to equity listed companies. In fact, the way creeping acquisition is defined in SAST Regulations, there may actually be no change in shareholding at all, and still an acquirer may have hit the creeping acquisition limit.

Acquisition of “control”, though subjective, has been interpreted in several leading SC and SAT rulings. The definition of “control” in sec. 2 (27) of the Act and Reg. 2 (1) (e) of SAST Regulations is an inclusive one: it does not define control, but extends the meaning of the term to include management control or the right to appoint majority directors. The more common mode of control is voting control. The expression “control” has been subject matter of several leading rulings such as Arcelormittal India Private V.  Satish Kumar Gupta, in which the Supreme Court defined the expression “control” in 2 parts; de jure control or the right to appoint a majority of the directors of a company; and de facto control or the power of a person or persons acting in concert, directly or indirectly, in any manner, can positively influence management or policy decisions. In Shubhkam Ventures V. SEBI, the meaning of control was extensively discussed by the SAT, it was held that the test is to see who is in the driving seat, the question would be whether he controls the steering, the gears and the brakes. If the answer to this question is affirmative, then alone would he be in control of the company. In other words, the question to be asked in each case would be whether he is the driving force behind the company and whether he is the one providing motion to the organization. If yes, he is in control but not otherwise.

Note that control may be direct or indirect. Indirect control typically arises when the controlling person controls an intermediate entity or entities, which in turn have a control over the target entity. 

  1. Any change in shareholding resulting in acquisition/transfer of 26% shareholding

This clause may have a lot of interpretational difficulties. First question – is 26% the magnitude of change in shareholding, or is the threshold which cannot be crossed? For example, if a shareholder was holding 25% shares in the NBFC, and now proposes to acquire another 1%, is this subject to regulatory approval? The answer should be clearly yes, because the shareholder will now be having what is regarded by the regulation as significant shareholding. On the contrary, if the person is already holding 26%, he is a significant shareholder already, either by virtue of having such shareholding at the time of formation of the NBFC, or based on the acquisition approved by the RBI. So, what will be the next level that will require regulatory approval? Logically, it seems that the person has already been approved to come as a significant shareholder, and therefore, an increase in shareholding should not require any intervention. In other words, the regulatory approval is required for the first time acquisition and not for the creeping acquisition. It may, however, be argued that if the creeping acquisition makes the equity holding cross 50%, then it amounts to acquisition of control, and that falls under the first clause.

In short, regulatory approval is required for first time acquisition of 26% equity stake or higher, or 50% or higher.

There are many other points that arise in connection with the change in shareholding.

First, is the transfer in shareholding here inward transfer, or can it mean outward transfer as well? Every transfer has a transferor and a transferee, but it is logical to assume the context of the regulation requires the supervisor to approve the transferee. It is the transferee who is coming in control. This is also evident from the word of the proviso to reg 42.1.1 (ii), which is obviously an exception to the main clause, and uses the words “prior approval would not be required in case of any shareholding going beyond 26 percent”. It implies that the concern of the regulator can only be for shareholding going beyond 26% and not reduction of the level of shareholding. The same intent also becomes evident from use of the word “progressive increases over time”. Note that there is inclusivity in the regulation – evident from words like “including”. Further, someone may extract a meaning from the language “transfer” – saying even a transfer out is also a transfer. This is precisely the point we made earlier – that this provision, worded loosely and applied universally, gives a lot of scope for an ambitious regulator to ask for approvals where approvals may not have any relevance.

Secondly, the expression is transfer of “shareholding” – should it include preference shares and convertible debt instruments as well? On the face of it, a preference shareholder or debenture holder does not have control over the entity. If the shares or debentures are either compulsorily or optionally convertible, then the threshold of 26% should be computed by taking the post-dilution equity base. Also, sometimes, preference shares may come with terms which give the preference holders some degree of control. For example, several decisions may be made subject to preference holders’ okay. Or the preference shares may be participating preference shares. In these cases, excluding preference shares altogether may not be proper.

Third, if there are two shareholders, both holding 26% each, and now, one transfers the holding to the other, this may be a case of change of control, as the acquirer now will have 52% holding.

Fourth, when it comes to acquisition of control or significant shareholding, one must take a substantive view, and should not be hamstrung by literal interpretation. For example, if entity A is the NBFC, and entity B is the holding company whose business or assets, almost entirely, constitutes the holding of shares in the NBFC, then, one should apply the change of control at the holding company level as well. Note that even as per SAST Regulations, if a holding vehicle is, to the extent of 80% or above, invested in the target company, acquisition of stake in the holding vehicle will be taken as direct acquisition of stake in the target entity.

Fifth, if some shareholders are acting in concert, or are deemed to be acting in concert, the increase in shareholding should be seen at a group level. Whether certain persons are acting in concert is left to facts or the surrounding situations.

Sixth, transfers of shares may require approval, but if the vesting of shares happens due to a transmission, there is no question of approval for the acquisition. However, if this leads to a change in management, the same shall require approval.

Change in Control:

  1. Change in management

This clause is admittedly the most vague clause, and may result into situations which have no correlation with a change in control, yet coming for regulatory approval. The actual language says: “Any change in the management …which would result in change in more than 30 percent of the directors”. This should really mean a change in management or directorships, which is connected with or arising out of a change of control. If control changes or shifts, usually management also shifts. However, there may be a change in board positions irrespective of any change in control or real change of management at all. Appointment and removal of independent directors are not considered for this purpose. However, nominee directors have not been excluded. Therefore, any appointment or removal of nominee directors will require prior approval if such appointment breaches the limit of 30%.

In reality, the language rules the meaning, and the interpretation is that if there is a change in directorships to the extent of 30% or more, excluding independent directors, the same will require a change of control process, even though there is not even a slightest change in control. 

Here again, one may use literal interpretation and argue that “change in directorships” may include directors going out, or coming in. However, in the context, there can never be an intent to control the exit of directors. Exit may happen purely for involuntary or personal reasons – death, resignation, incapacity, etc. The supervisor is to be concerned with the directors who come in, who have to earn the label of being “fit and proper”.

In case of entities with smaller boards, say having 2 or 3 board members, change of even one director may cause change of 30% or more, though there is no real change of management or management control.

Another point to discuss here is, like in case of shareholding, does the change in directorships include progressive changes too? For example, if a company’s board consists of 6 directors, and one is rotated out or replaced in year 1, and the other one, say, after a year or two, without any concerted action, have we reached a change in directorships of 30% or more? In case of shareholding, progressive increases are specifically included; not so in case of change of directorships.

In the author’s view, the provisions of Reg 42 cannot be stretched to imply that every appointment of a director in an NBFC requires RBI’s approval – if such was the intent, the intent could have been spelt out. Neither is there a reason for such micro regulation, since the focus has to be on change of control. However, as a practical expedient, NBFCs are encouraged to intimate the periodic changes in board positions to the RBI by way of an intimation. Therefore, the regulator has an intimation of the changes that take place over time. If the changes in board positions are part of the same intent or design, and are merely phased over time, the same will usually also be associated with a change in shareholding. In any case, if even independent of a shareholding change, if the changes in management happening over time are mutually connected and a part of the attempt to gain management of the NBFC, the same will require regulatory approval. Given the subjectivity involved, NBFCs may want to play safe and place the facts before the RBI for its guidance.

Intra-group transfers

The meaning of “intra- group” transfers is the shareholding which is spread across members of a group. A group should mean here entities either have common control, or common significant influence, or those where persons have been disclosed as acting in concert for holding shares in the NBFC. The following is a question from the RBI’s FAQs relating to intra-group transfers. It is difficult to get the meaning of the response. Once again, the 26% is not the total magnitude of change, but crossing the threshold. Therefore, in the answer below, 26% cannot be read as the total shifting of shares within the group. The group is already above 26%, and now, there is movement of shares within the group. Is the regulator trying to say once the group is holding 26%, any realignment of shares within the group will require approval? Also, in most cases, the shifting of intra-group shareholding does not happen within a closed group. For example, if there are 4 entities of a group holding shares, one of the members of the group may transfer shares to a 5th entity. The lack of any basis for the response is evident from the approach – apply to us by way of a letter, and then we will let you know whether approval is needed or not. It is sad that a regulator/supervisor sits to decide whether the matter comes within the regulatory ambit.

Here is an excerpt from the RBI FAQs:

26. Whether acquisition/ transfer of shareholding of 26 per cent or more of the paid up equity capital of an NBFC within the same group i.e. intra group transfers require prior approval of the Bank?

Yes, prior approval would be required in all cases of acquisition/ transfer of shareholding of 26 per cent or more of the paid up equity capital of an NBFC. In case of intra-group transfers, NBFCs shall submit an application, on the company letter head, for obtaining prior approval of the Bank. Based on the application of the NBFC, it would be decided, on a case to case basis, whether the NBFC requires to submit the documents as prescribed at para 3 of DNBR (PD) CC.No. 065/03.10.001/2015-16 dated July 9, 2015 for processing the application of the company. In cases where approval is granted without the documents, the NBFC would be required to submit the same after the process of transfer is complete.

Corporate Restructuring

Corporate restructuring in the NBFC sector involves reorganizing the company’s structure, operations, or finances to improve efficiency, address financial distress, or comply with regulatory requirements. This process can include mergers, demergers, amalgamations, and such other changes in corporate structure.

Given that corporate restructuring is a strategic decision for the structure and existence of the NBFC, it becomes important to evaluate the need for regulatory approvals in this regard. The intent of the regulator, as discussed above, is to require the prior approval in case of substantial acquisitions and change in shareholding beyond the threshold of 26%, with the intent to acquire ‘control’. Hence, in case the corporate restructuring leads to such a change in control or shareholding, with or without the change in management, the same must be done with the consent of the RBI.

For instance, if ABC Ltd. is the holding company of an NBFC and the NBFC intends to merge with the holding company. There is no change in control as such pursuant to such merger. However, as per RBI FAQ No. 84, this shall require the prior approval from RBI.

Another instance could be that ABC Ltd (being non-NBFC) intends to merge with an NBFC. As per RBI FAQ No. 85, where a non-NBFC mergers with an NBFC, prior written approval of the RBI would be required if such a merger satisfies any one or both the conditions viz.,

  1. any change in the shareholding of the NBFC consequent on the merger which would result in a change in shareholding pattern of 26 per cent or more of the paid-up equity capital of the NBFC.
  2. any change in the management of the NBFC which would result in change in more than 30 per cent of the directors, excluding independent directors.

Even if an NBFC intends to amalgamate with another NBFC, as per FAQ No. 86, the NBFC being amalgamated will require prior written approval of the RBI.

It may be noted that the prior written approval of the RBI must be obtained before approaching any Court or Tribunal for seeking orders for merger/ amalgamation in all such cases which would ordinarily fall under the scenarios discussed above.

[1] Read our detailed analysis on the topic here- https://vinodkothari.com/2017/09/sebi-aborts-brightening-of-fine-lines-of-control/ (last accessed in November, 2024)

[2] Refer to our article on- https://indiacorplaw.in/2016/03/choosing-between-blurred-line-and.html

[3] Read Our FAQs on Change in Management and Control : https://vinodkothari.com/2016/06/faqs-on-change-in-control-or-management-of-an-nbfc/

Financial Sector Regulator – ‘Rule of Law’ Review

– Aditya Iyer (adityaiyer@vinodkothari.com)

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