Government Guarantee for NBFC Pool Purchases by Banks: Analysis, questions, and gaps

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[Updated as on 12th December, 2019]

By Financial Services Division, finserv@vinodkothari.com

The Finance Minister, during the Union Budget 2019-20, proposed to introduce a partial credit guarantee scheme so as to extend relief to NBFCs during the on-going liquidity crisis. The proposal laid down in the budget was a very broad statement. On 13th August, 2019[1], the Ministry of Finance came out with a Press Release to announce the notification in this regard, dated 10th August, 2019, laying down specifics of the scheme.

The Scheme, however, did not sail through, as literally no transactions was conducted under the Scheme until November, 2019. Various stakeholders[1] represented to the MOF to remove the bottlenecks in the structure. Subsequently, on 11th December, 2019, the Union Cabinet approved amendments[2] to the Scheme (Amendments).

The scheme,  known as “Partial Credit Guarantee offered by Government of India (GoI) to Public Sector Banks (PSBs) for purchasing high-rated pooled assets from financially sound Non-Banking Financial Companies (NBFCs)/Housing Finance Companies (HFCs)”, is referred to, for the purpose of this write, as  “the Scheme”.

The Scheme is intended to address the temporary liquidity crunch faced by solvent HFCs/ NBFCs, so that such entities may refinance their assets without having to resort to either distress sale or defaults on account of asset-liability mismatches.

In this write-up we have tried to answer some obvious questions that could arise along with potential answers.

Scope of applicability

1.When does this scheme come into force?

The Scheme was originally introduced on 10th August, 2019 and has been put to effect immediately. The modifications in the Scheme were made applicable with effect from 11th December, 2019.

2. How long will this Scheme continue to be in force?

Originally, the Scheme was supposed to remain open for 6 months from the date of issuance of this Scheme or when the maximum commitment of the Government, under this Scheme, is achieved, whichever is earlier. However, basis the Amendments discussed above, the Scheme will remain open till 20th June, 2020 or till such date when the maximum commitment under the Scheme is achieved, whichever is earlier. The Amendments however, bestows upon the Finance Minister to extend the tenure by upto 3 months.

This signifies that the parties must complete the assignment and execution of necessary documents for the guarantee (see below) within the stipulated time period.

3. Who is the beneficiary of the guarantee under the Scheme – the bank or the NBFC?

The bank is the beneficiary. The NBFC is not a party to the transaction of guarantee.

4. Does a bank buying pools from NBFCs/HFCs (Financial Entities) automatically get covered under the Scheme?

No. Since a bank/ Financial Entities may not want to avail of the benefit of the Scheme, the Parties will have to opt for the benefit of the guarantee. The bank will have to enter into specific documentation, following the procedure discussed below.

5. What does the Bank have to do to get covered by the benefit of guarantee under the Scheme?

The procedural aspects of the guarantee under the Scheme are discussed below.

6. Is the guarantee specifically to be sought for each of the pools acquired by the Bank or is it going to be an umbrella coverage for all the eligible pools acquired by the Bank?

The operational mechanism requires that there will be separate documentation every time the bank wants to acquire a pool from a financial entity in accordance with the Scheme. There is no process of master documentation, with simply a confirmation being attached for multiple transactions.

7. How does this Scheme rank/compare with other schemes whereby banks may participate into originations done by NBFCs/HFCs?

The RBI has lately taken various initiatives to promote participation by banks in the originations done by NBFCs/ HFCs. The following are the available ways of participation:

  • Direct assignments
  • Co-lending
  • Loans for on-lending
  • Securitisation

Direct assignments and securitisation have been there in the market since 2012, however, recently, once the liquidity crisis came into surface, the RBI relaxed the minimum holding period norms in order to promote the products.

Co-lending is also an alternative product for the co-origination by banks and NBFCs. In 2018, the RBI also released the guidelines on co-origination of priority sector loans by banks and NBFCs. The guidelines provide for the modalities of such originations and also provide on risk sharing, pricing etc. The difficulty in case of co-origination is that the turnaround time and the flexibility that the NBFCs claimed, which was one of their primary reasons for a competitive edge, get compromised.

The third product, that is, loans for on-lending for a specific purpose, has been in existence for long. However, recent efforts of RBI to allow loans for on-lending for PSL assets have increased the scope of this product.

This Scheme, though, is meant to boost specific direct assignment transactions, but is unique in its own way. This Scheme deviates from various principles from the DA guidelines and is, accordingly, intended to be an independent scheme by itself.

The basic use of the Scheme is to be able to conduct assignment of pools, without having to get into the complexity of involving special purpose vehicles, setting enhancement levels only so as to reach the desired ratings as per the Scheme. The effective cost of the Financial Entities doing assignments under the Scheme will be (a) the return expected by the Bank for a GoI-guaranteed pool; plus (b) 25 bps. If this effectively works cheaper than opting for a similar rated pool on standalone basis, the Scheme may be economically effective.

A major immediate benefit of the Scheme may be to nudge PSBs to start buying NBFC pools. While the guarantee is effective only for 2 years that does not mean, after 2 years, the PSBs will either sell or sell-back the pools. Therefore, in ultimate analysis, PSBs will get comfortable with buying NBFC pools on direct assignment basis.

The Scheme may go to encourage loan pool transfers outside the existing DA discipline.

8. Is the Scheme an alternative to direct assignment covered by Part B of the 2012 Guidelines, or is it by itself an independent option?

While intuitively one would have thought that the Scheme is a just a method of risk mitigation/facilitation of the DA transactions which commonly happen between banks and Financial Entities, there are several reasons based on which it appears that this Scheme should be construed as an independent option to banks/ Financial Entities:

  1. This Scheme is limited to acquisition of pools by PSBs only whereas direct assignment is not limited to either PSBs or banks.
  2. This Scheme envisages that the pool sold to the banks has attained a BBB+ rating at the least. As discussed below, that is not possible without a pool-level credit enhancement. In case of direct assignments, credit enhancement is not permissible.
  3. Investments in direct assignment are to be done by the acquirer based on the acquirer’s own credit evaluation. In case of the Scheme, the acquisition is obviously based on the guarantee given by the GoI.
  4. There is no question of an agreement or option to acquire the pool back after its transfer by the originator. The Scheme talks about the right of first refusal by the NBFC if the purchasing bank decides to further sell down the assets at any point of time.

Therefore, it should be construed that the Scheme is completed carved out from the DA Guidelines, and is an alternative to DA or securitisation. The issue was clarified by the Reserve Bank of India vide its FAQs on the issue[3].

9. Is this Scheme applicable to Securitisation transactions as well?

Assignment of pool of assets can be happen in case of both direct assignment as well as securitisation transaction. However, the intention of the present scheme is to provide credit enhancements to direct assignment transactions only. The Scheme does not intend to apply to securitisation transactions; however, the credit enhancement methodology to be deployed to make the Scheme work may involve several structured finance principles akin to securitisation.

Risk transfer 

10. The essence of a guarantee is risk transfer. So how exactly is the process of risk transfer happening in the present case?

The risk is originated at the time of loan origination by the Financial Entities. The risk is integrated into a pool. Since the transaction is presumably a direct assignment (see discussion below), the risk transfer from the NBFC to the bank may happen either based on a pari passu risk sharing, or based on a tranched risk transfer.

The question of a pari passu risk transfer will arise only if the pool itself, without any credit enhancement, can be rated BBB+. Again, there could be a requirement of a certain level of credit enhancements as well, say through over-collateralisation or subordination.

Based on whether the share of the bank is pari passu or senior, there may be a risk transfer to the bank. Once there is a risk transfer on account of a default to the bank, the bank now transfers the risk on a first-loss basis to the GoI within the pool-based limit of 10%.

11. What is the maximum amount of exposure, the Government of India is willing to take through this Scheme?

Under this Scheme, the Government has agreed to provide 10% first loss guarantee to assets, amounting to total of ₹ 1 lakh crore. Here it is important to note that the limit of ₹ 1 lakh crore refers to the total amount of assets against which guarantee will be extended and not the total amount of guarantee. The maximum exposure that the Government will take under the Scheme is ₹ 10,000 crores (10% of ₹ 1 lakh crore). Both the amounts, Rs 1 lakh crore, as also Rs 10,000 crores, are the aggregate for the banking system as a whole.

12. What does 10% first loss guarantee signify?

Let us first understand the meaning for first loss guarantee. As the name suggests, the guarantor promises to replenish the first losses of the financier upto a certain level. Therefore, a 10% first loss guarantee would signify that any loss upto 10% of the total exposure of the acquirer in a particular pool will be compensated by the guarantor.

Say for example, if the size of pool originated by NBFC N is Rs. 1000 crores, consisting of 1000 borrowers of Rs. 1 crore each. Assume further that each of the loans in the pool are such that if a default occurs, the crystallised loss is 100% (that is, there is nil recovery estimated at the time of recognising the loan as a bad loan). We are also assuming that the loans in the pool are at least BBB+ rated; therefore, the pool gets a BBB+ rating.

Let us say this pool is sold by N to bank B. N retains a 10%  pari passu share of the pool – thereby, the amount of the assets transferred to the B is Rs 900 crores. Assume that the fair value is also Rs 900 crores – that means, B buys the pool at par by paying Rs 900 crores. Assume B gets the acquisition guaranteed under the Scheme.

After its acquisition by B, assume a loan goes bad (see discussion below), and therefore, N allocates a loss of Rs 90 lacs (assuming there is pari passu sharing of losses) to B. B will claim this money by way of a guarantee compensation from GoI. B will keep getting such indemnification from GoI until the total amount paid by GoI reaches Rs. 90 crores (10% of the guaranteed amount). This, based on our hypothetical assumption of each loan having the same size, will mean loss of 100 loans out of the 1000 loans in the pool.

On the other hand, if it was to be understood that the pool will have to be first credit enhanced at the level of N, to attain a credit rating of BBB+, then N itself may have to provide a first-loss support at the transaction level. This may be, say, by providing a subordination, such that the share of N in the transaction is subordinated, and not pari passu. In that case, the question of any risk transfer to B, and therefore, an indemnification by GoI, will arise only if the amount of losses on account of default exceed the level of first loss support provided by N.

13. When is a loan taken to have defaulted for the purpose of the Scheme?

Para D of the Scheme suggests that the loan will be taken as defaulted when the interest and/or principal is overdue by more than 90 days. It further goes to refer to crystallisation of liability on the underlying borrower. The meaning of “crystallisation of liability” is not at all clear, and is, regrettably, inappropriate. The word “crystallisation” is commonly used in context of floating charges, where the charge gets crystallised on account of default. It is also sometimes used in context of guarantees where the liability is said to crystallise on the guarantor following the debtor’s default. The word “underlying borrower” should obviously mean the borrower included in the pool of loans, who always had a crystallised liability. In context, however, this may mean declaration of an event of default, recall of the loan, and thereby, requiring the borrower to repay the entire defaulted loan.

14. On occurrence of “default” as above, will be the Bank be able to claim the entire outstanding from the underlying borrower, or the amount of defaulted interest/principal?

The general principle in such cases is that the liability of the guarantor should crystallise on declaration of an event of default on the underlying loan. Hence, the whole of the outstandings from the borrower should be claimed form the guarantor, so as to indemnify the bank fully. As regards subsequent recoveries from the borrower, see later.

15. Does the recognition of loss by the bank on a defaulted loan have anything to do with the excess spreads/interest on the other performing loans? That is to say, is the loss with respect to a defaulted loan to be computed on pool basis, or loan-by-loan basis?

A reading of para D would suggest that the claiming of compensation is on default of a loan. Hence, the compensation to be claimed by the bank is not to be computed on pool basis.

16. Can the guarantee be applicable to a revolving purchase of loans by the bank from the NBFC, that is, purchase of loans on a continuing basis?

No. The intent seems clearly to apply the Scheme only to a static pool.

17. If a bank buys several pools from the same NBFC, is the extent of first loss cover, that is, 10%, fungible across all pools?

No. The very meaning of a first loss cover is that the protection is limited to a single, static pool.

18. From the viewpoint of maximising the benefit of the guarantee, should a bank try and achieve maximum diversification in a pool, or keep the pool concentric?

The time-tested rule of tranching of risks in static pools is that in case of concentric, that is, correlated pools, the limit of first loss will be reached very soon. Hence, the benefit of the guarantee is maximised when the pool is diversified. This will mean both granularity of the pool, as also diversification by all the underlying risk variables – geography, industry or occupation type, type of property, etc.

19. Can or should the Scheme be deployed for buying a single loan, or a few corporate loans?

First, the reference to pools obviously means diversified pools. As regards pools consisting of a few corporate loans, as mentioned above, the first loss cover will get exhausted very soon. The principle of tranching is that as correlation/concentricity in a pool increases, the risk shifts from lower tranches to senior tranches. Hence, one must not target using the Scheme for concentric or correlated pools.

20. On what amount should the first loss guarantee be calculated – on the total pool size or the total amount of assets assigned?

While, as we discussed earlier, there is no applicability of the DA Guidelines in the present case, there needs to be a minimum skin in the game for the selling Financial Entity. Whether that skin in the game is by way of a pari passu vertical tranche, or a subordinated horizontal tranche, is a question of the rating required for attaining the benefit of the guarantee. Therefore, if we are considering a pool of say ₹ 1000 crores, the originator should retain at least ₹ 100 crores (applying a 10% rule – which, of course, will depend on the rating considerations) of the total assets in the pool and only to the extent the ₹ 900 crores can be assigned to the purchasing bank.

The question here is whether the first loss guarantee will be calculated on the entire ₹ 1000 crores or ₹ 900 crores. The intention is guarantee the purchasing banks’ share of cash flows and not that retained by the originator. Therefore, the first loss guarantee will be calculated on ₹ 900 crores in the present case.

Scope of the GoI Guarantee

21. Does the guarantee cover both principal and interest on the underlying loan?

The guarantee is supposed to indemnify the losses of the beneficiary, in this case, the bank. Hence, the guarantee should presumably cover both interest and principal.

22. Does the guarantee cove additional interest, penalties, etc.?

Going by Rule 277 (vi) of the GFR, the benefit of the guarantee will be limited to normal interest only. All other charges – additional interest, penal interest, etc., will not be covered by the guarantee.

23. How do the General Financial Rules of the Government of India affect/limit the scope of the guarantee?

Para 281 of the GFR provides for annual review of the guarantees extended by the Government. The concerned department, DFS in the present case, will conduct review of the guarantees extended and forward the report to the Budget Division. However, if the Government can take any actions based on the outcome of the review is unclear.

Bankruptcy remoteness 

24. Does the transaction of assignment of pool from the Financial Entity to the bank have to adhere to any true sale/bankruptcy remoteness conditions?

The transaction must be a proper assignment, and should achieve bankruptcy remoteness in relation to the Financial Entity. Therefore, all regular true sale conditions should be satisfied.

25. Can a Financial Entity sell the pool to the bank with the understanding that after 2 years, that is, at the end of the guarantee period, the pool will be sold back to the NBFCs?

Any sale with either an obligation to buyback, or an option to buy back, generally conflicts with the true sale requirement. Therefore, the sale should be a sale without recourse. However, retention of a right of first refusal, or right of pre-emption, is not equivalent to option to buy back. For instance, if, after 2 years, the bank is desirous of selling the pool at its fair value, the NBFC may have the first right of buying the same. This is regarded as consistent with true sale conditions.

26. If off-balance sheet treatment from IFRS/Ind-AS viewpoint at all relevant for the purpose of this transaction?

No. Off balance sheet treatment is not relevant for bankruptcy remoteness.

Buyers and sellers 

27. Who are eligible buyers under this Scheme?

As is evident from the title of the Scheme, only Public Sector Banks are eligible buyers of assets under this Scheme. Therefore, even if a Private Sector Bank acquires eligible assets from eligible sellers, guarantee under this Scheme will still not be available.

This may be keeping in view two points – first, the intent of the Scheme, that is, to nudge PSBs to buy pools from Financial Entities. It is a well-known fact that private sector banks are, as it is, actively engaged in buying pools. Secondly, in terms of GFR of the GoI, the benefit of Government guarantee cannot go to the private sector. [Rule 277 (vii)] Hence, the Scheme is restricted to PSBs only.

28. Who are eligible sellers under this Scheme?

The intention of the Scheme is to provide relief from the stress caused due to the ongoing liquidity crisis, to sound HFCs/ NBFCs who are otherwise financially stable. The Scheme has very clearly laid screening parameters to decide the eligibility of the seller The qualifying criteria laid down therein are:

  1. NBFCs registered with the RBI, except Micro Financial Institutions or Core Investment Companies.
  2. HFCs registered with the NHB.
  3. The NBFC/ HFC must have been able to maintain the minimum regulatory capital as on 31st March, 2019, that is –
    • For NBFCs – 15%
    • For HFCs – 12%
  4. The net NPA of the NBFC/HFC must not have exceeded 6% as on 31st March, 2019
  5. The NBFC/ HFC must have reported net profit in at least one out of the last two preceding financial years, that is, FY 2017-18 and FY 2018-19.
  6. The Original Scheme stated that the NBFC/ HFC must not have been reported as a Special Mention Account (SMA) by any bank during year prior to 1st August, 2018. However, the Amendment even allows NBFC/HFC which may have slipped during one year prior to 1st August, 2018 shall also be allowed to sell their portfolios under the Scheme.

29. Can NBFCs of any asset size avail this benefit?

Apparently, the Scheme does not provide for any asset size requirement for an NBFC to be qualified for this Scheme, however, one of the requirement is that the financial institution must have maintained the minimum regulatory capital requirement as on 31st March, 2019. Here it is important to note that requirement to maintain regulatory capital, that is capital risk adequacy ratio (CRAR), applies only to systemically important NBFCs.

Only those NBFCs whose asset size exceeds ₹ 500 crores singly or jointly with assets of other NBFCs in the group are treated as systemically important NBFCs. Therefore, it is safe to assume that the benefits under this Scheme can be availed only by those NBFCs which – a) are required to maintained CRAR, and b) have maintained the required amount of capital as on 31st March, 2019, subject to the fulfilment of other conditions.

30. The eligibility criteria for sellers state that the financial institution must not have been reported as SMA-1 or SMA-2 by any bank any time during 1 year prior to 1st August, 2018 – what does this signify?

As per the prudential norms for banks, an account has to be declared as SMA, if it shows signs of distress without slipping into the category of an NPA. The requirement states that the originator must not have been reported as an SMA-1 or SMA-2 any time during 1 year prior to 1st August, 2018, and nothing has been mentioned regarding the period thereafter.

Therefore, if a financial institution satisfies the condition before 1st August, 2018 but becomes SMA-1 or SMA-2 thereafter, it will still be eligible as per the Scheme. The whole intention of the Scheme is eliminate the liquidity squeeze due to the ILFS crisis. Therefore, if a financial institution turns SMA after the said date, it will be presumed the financial institution has fallen into a distressed situation as a fallout of the ILFS crisis.

Eligible assets

31. What are the eligible assets for the Scheme?

The Scheme has explicitly laid down qualifying criteria for eligible assets and they are:

  1. The asset must have been originated on or before 31st March, 2019.
  2. The asset must be classified as standard in the books of the NBFC/ HFC as on the date of the sale.
  3. The original Scheme stated that the pool of assets should have a minimum rating of “AA” or equivalent at fair value without the credit guarantee from the Government. However, through the Amendment, the rating requirement has been brought down to BBB+.
  4. Each account under the pooled assets should have been fully disbursed and security charge should have been created in favour of the originating NBFCs/ HFCs.
  5. The individual asset size in the pool must not exceed ₹ 5 crore.
  6. The following types of loans are not eligible for assignment for the purposes of this Scheme:
    1. Revolving credit facilities;
    2. Assets purchased from other entities; and
    3. Assets with bullet repayment of both principal and interest

Pools consisting of assets satisfying the above criteria qualify for the benefit of the guarantee. Hence, the pool may consist of retail loans, wholesale loans, corporate loans, loans against property, or any other loans, as long as the qualifying conditions above are satisfied.

32. Should the Scheme be deployed for assets for longer maturity or shorter maturity?

Utilising the Scheme for pools of lower weighted average maturity will result into very high costs – as the cost of the guarantee is computed on the original purchase price.

Using the Scheme for pools of longer maturity – for example, LAP loans or corporate loans, may be lucrative because the amortisation of the pool is slower. However, it is notable that the benefit of the guarantee is available only for 2 years. After 2 years, the bank will not have the protection of the Government’s guarantee.

33. If there are corporate loans in the pool, where there is payment of interest on regular basis, but the principal is paid by way of a bullet repayment, will such loans qualify for the benefit of the Scheme?

The reference to bullet repaying loans in the Scheme seems similar to those in DA guidelines. In our view, if there is evidence/track record of servicing, in form of interest, such that the principal comes by way of a bullet repayment (commonly called IO loans), the loan should still qualify for the Scheme. However, negatively amortising loans should not qualify.

34. Is there any implication of keeping the cut-off date for originations of loans to be 31st March, 2019?

As per the RBI Guidelines on Securitisation and Direct Assignment, the originators have to comply with minimum holding requirements. The said requirement suggests that an asset can be sold off only if it has remained in the books of the originator for at least 6 months. This Scheme has come into force with effect from 10th August, 2019 and will remain open till 30th June, 2020.

Already substantial amount of time has passed since the cut-off date, and even if we were to assume that the loan is originated on the cut-off date itself, it would mean that closer to the end of the tenure of the Scheme, the loan will be at least months seasoning as on the date of passing the Amendments. Such high seasoning requirements might not be motivational enough for the originators to avail this Scheme.

35. Is there is any maximum limit on the amount of loans that can be assigned under this Scheme?

Yes, the Scheme has put a maximum cap on the amount of assets that can be assigned and that is an amount equal to 20% of the outstanding standard assets as on 31st March, 2019, however, the same is capped to ₹ 5000 crores.

36. Is there a scope for assigning assets beyond the maximum limits prescribed in the Scheme?

Yes, the Scheme states that any additional amount above the cap of ₹ 5,000 crore will be considered on pro rata basis, subject to availability of headroom. However, from the language, it seems that there is a scope for sell down beyond the prescribed limit, only if the eligible maximum permissible limit gets capped to ₹ 5,000 crores and not if the maximum permissible limit is less than ₹ 5000 crores.

The following numerical examples will help us to understand this better:

Total outstanding standard assets as on 31st March, 2019 ₹ 20,000 crores ₹ 25,000 crores ₹ 30,000 crores
Maximum permissible limit @ 20% ₹ 4,000 crores ₹ 5,000 crores ₹ 6,000 crores
Maximum cap for assignment under this Scheme ₹ 5,000 crores ₹ 5,000 crores ₹ 5,000 crores
Amount that can be assigned under this Scheme ₹ 4,000 crores ₹ 5,000 crores ₹ 5,000 crores
Scope for further sell down? No No Yes, upto a maximum of ₹ 1,000 crores

37. When will it be decided whether the Financial Entity can sell down receivables beyond the maximum cap?

Nothing has been mentioned regarding when and how will it be decided whether a financial institution can sell down receivables beyond the maximum cap, under this Scheme. However, logically, the decision should be taken by the Government of India of whether to allow further sell down and closer towards the end of the Scheme. However, we will have to wait and see how this unfolds practically.

38. What are the permissible terms of transfer under this Scheme?

The Scheme allows the assignment agreement to contain the following:

  1. Servicing rights – It allows the originator to retain the servicing function, including administrative function, in the transaction.
  2. Buy back right – It allows the originator to retain an option to buy back its assets after a specified period of 12 months as a repurchase transaction, on a right of first refusal basis. Actually, this is not a right to buy back, it is a right of first refusal which the NBFC/ HFC may exercise if the purchasing bank further sells down the assets. See elsewhere for detailed discussion

Rating of the Pool

39. The Scheme requires that the pool must have a rating of BBB+ before its transfer to the bank. Does that mean there be a formal rating agency opinion on the rating of the pool?

Yes. It will be logical to assume that SIDBI or DFS will expect a formal rating agency opinion before agreeing to extend the guarantee.

40. The Scheme requires the pool of assets to be rated at least BBB+, what does this signify?

As per the conditions for eligible assets, the pool of assets to be assigned under this Scheme must have a minimum rating of “BBB+” or equivalent at fair value prior to the guarantee from the Government.

There may be a question of expected loss assessment of a pool. Initially, the rating requirement was pegged at “AA” or higher and there was an apprehension that the originators might have to provide a substantial amount of credit enhancement in order to the make the assets eligible for assignment under the Scheme. Subsequently, vide the Amendments, the rating has been brought down to BBB+. The originators may also be required to provide some level of credit enhancements in order to achieve the BBB+ rating.

Unlike under the original Scheme, where the rating requirement was as high as AA, the intent is to provide guarantee only at AA level, then the thickness of the guarantee, that is, 10%, and the cost of the guarantee, viz., 25 bps, both became questionable. The thickness of support required for moving a AA rated pool to a AAA level mostly is not as high as 10%. Also, the cost of 25 bps for guaranteeing a AA-rated pool implied that the credit spreads between AA and a AAA-rated pool were at least good enough to absorb a cost of 25 bps. All these did not seemed and hence, there was not even a single transaction so far.

But now that the rating requirement has been brought down to BBB+, it makes a lot of sense. The credit enhancement level required to achieve BBB+ will be at least 4%-5% lower than what would have been required for AA pool. Further, the spread between a BBB+ and AAA rated pool would be sufficient to cover up the guarantee commission of 25 bps to be incurred by the seller in the transaction.

Here it is important to note that though the rating required is as low as BBB+, but there is nothing which stops the originator in providing a better quality pool. In fact, by providing a better quality pool, the originator will be able to fetch a much lower cost. Further, since, the guarantee on the pool will be available for only first two years of the transaction, the buyers will be more interested in acquiring higher quality pools, as there could be possibilities of default after the first two years, which is usually the case – the defaults increase towards the end of the tenure.

Risk weight and capital requirements

41. Can the bank, having got the Pool guaranteed by the GoI, treat the Pool has zero% risk weighted, or risk-weighted at par with sovereign risk weights?

No. for two reasons –one the guarantee is only partial and not full. Number two, the guarantee is only for losses upto first 2 years. So it is not that the credit exposure of the bank is fully guaranteed

42. What will be the risk weight once the guarantee is removed, after expiry of 2 years?

The risk weight should be based on the rating of the tranche/pool, say, BBB+ or better.

Guarantee commission

43. Is there a guarantee commission? If yes, who will bear the liability to pay the commission?

As already discussed in one of the questions above, the Scheme requires the originators to pay guarantee commission of 25 basis points on the amount of guarantee extended by the Government. Though the originator will pay the fee, but the same will be routed through purchasing bank.

44. The pool is amortising pool. Is the cost of 25 bps to be paid on the original purchase price?

From the operational details, it is clear that the cost of 25 bps is, in the first instance, payable on the original fair value, that is, the purchase price.

Invocation of guarantee and refund

45. When can the guarantee be invoked?

The guarantee can be invoked any time during the first 24 months from the date of assignment, if the interest/ principal has remained overdue for a period of more than 90 days.

46. Can the purchasing bank invoke the guarantee as and when the default occurs in each account?

Yes. The purchasing bank can invoke the guarantee as and when any instalment of interest/ principal/ both remains overdue for a period of more than 90 days.

47. To what extent can the purchasing bank recover its losses through invocation of guarantee?

When a loan goes bad, the purchasing bank can invoke the guarantee and recover its entire exposure from the Government. It can continue to recover its losses from the Government, until the upper cap of 10% of the total portfolio is reached. However, the purchasing bank will not be able to recover the losses if – (a) the pooled assets are bought back by the concerned NBFCs/HFCs or (b) sold by the purchasing bank to other entities.

48. Within how many days will the purchasing bank be able to recover its losses from the Government?

As stated in the Scheme, the claims will be settled within 5 working days.

49. What will happen if the purchasing bank recovers the amount lost, subsequent to the invocation of guarantee?

If the purchasing bank, by any means, recovers the amount subsequent to the invocation of the guarantee, it will have to refund the amount recovered or the amount received against the guarantee to the Government within 5 working days from the date of recovery. However, if the amount recovered is more than amount of received as guarantee, the excess collection will be retained by the purchasing bank.

Modus operandi

50. What will be the process for a bank to obtain the benefit of the guarantee?

While the Department of Financial Services (DFS) is made the administrative ministry for the purpose of the guarantee under the Scheme, the Scheme involves the role of SIDBI as the interface between the banks and the GoI. Therefore, any bank intending to avail of the guarantee has to approach SIDBI.

51. Can you elaborate on the various procedural steps to be taken to take the benefit of the guarantee?

The modus operandi of the Scheme is likely to be as follows:

  1. An NBFC approaches a bank with a static pool, which, based on credit enhancements, or otherwise, has already been uplifted to a rating of BBB+ or above level.
  2. The NBFC negotiates and finalises its commercials with the bank.
  3. The bank then approaches SIDBI with a proposal to obtain the guarantee of the GOI. At this stage, the bank provides (a) details of the transaction; and (b) a certificate that the requirements of Chapter 11 of General Financial Rules, and in particular, those of para 280, have been complied with.
  4. SIDBI does its own evaluation of the proposal, from the viewpoint of adherence to Chapter 11 of GFR and para 280 in particular, and whether the proposal is in compliance with the provisions of the Scheme. SIDBI shall accordingly forward the proposal to DFS along with a specific recommendation to either provide the guarantee, or otherwise.
  5. DFS shall then make its decision. Once the decision of DFS is made, it shall be communicated to SIDBI and PSB.
  6. At this stage, PSB may consummate its transaction with the NBFC, after collecting the guarantee fees of 25 bps.
  7. PSB shall then execute its guarantee documentation with DFS and pay the money by way of guarantee commission.

52. Para 280(i)(a) of the GFR states that there should be back-to-back agreements between the Government and Borrower to effect to the transaction – will this rule be applicable in case of this Scheme?

Para 280 has been drawn up based on the understanding that guarantee extended is for a loan where the borrower is known by the Government. In the present case, the guarantee is extended in order to partially support a sale of assets and not for a specific loan, therefore, this will not apply.

Miscellaneous

53. Is there any reporting requirement?

The Scheme does provide for a real-time reporting mechanism for the purchasing banks to understand the remaining headroom for purchase of such pooled assets. The Department of Financial Services (DFS), Ministry of Finance would obtain the requisite information in a prescribed format from the PSBs and send a copy to the budget division of DEA, however, the manner and format of reporting has not been notified yet.

54. What are to-do activities for the sellers to avail benefits under this Scheme?

Besides conforming to the eligibility criteria laid down in the Scheme, the sellers will also have to carry out the following in order to avail the benefits:

  1. The Asset Liability structure should restructured within three months to have positive ALM in each bucket for the first three months and on cumulative basis for the remaining period;
  2. At no time during the period for exercise of the option to buy back the assets, should the CRAR go below the regulatory minimum. The promoters shall have to ensure this by infusing equity, where required.

 

[1] http://pib.gov.in/newsite/PrintRelease.aspx?relid=192618

Other related articles-

 

[1] Including Indian Securitisation Foundation

[2] https://pib.gov.in/PressReleseDetailm.aspx?PRID=1595952

[3] https://www.rbi.org.in/Scripts/FAQView.aspx?Id=131

FAQs: NBFCs not to charge foreclosure / pre-payment penalties on floating rate term loans for Individual borrowers

/1 Comment/in , , , /by

-Kanakprabha Jethani and Julie Mehta

finserv@vinodkothari.com

 

RBI has vide notification[1] dated August 02, 2019 issued a clarification regarding waiver of foreclosure charges/ prepayment penalty on all floating rate term loans sanctioned to individual borrowers, as referred to in paragraph 30(4) of Chapter VI of Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 and paragraph 30(4) of Chapter V of Master Direction – Non-Banking Financial Company – Non-Systemically Important Non-Deposit taking Company (Reserve Bank) Directions, 2016.

As per the fair practice code, NBFCs cannot charge foreclosure charges/ pre-payment penalties on all floating rate term loans sanctioned to individual borrowers

RBI has further clarified that NBFCs shall not charge foreclosure charges/ pre-payment penalties on any floating rate term loan sanctioned for purposes other than business to individual borrowers, with or without co-obligant(s).

To understand its implication and for further understanding, please refer to the list of ‘frequently asked questions’ listed below:

Basic understanding

  1. What is pre-payment or foreclosure?

 Ans. Prepayment or foreclosure is the repayment of a loan by a borrower, in part or in full ahead of the pre-determined payment schedule.

However, the distinguishing factor is that pre-payment means early payment of scheduled instalments, while foreclosure means early payment of the entire outstanding amount leading to early closure of the loan term. To extend, pre-payment is partial in nature whereas foreclosure is the closure of the loan account before the due-date.

  1. How do foreclosure charges and pre-payment penalties differ?

Ans. Conceptually, both have the same meaning. The only difference is in the terminology as the charges levied at the time of foreclosure are termed as foreclosure charges and charges levied at the time of pre-payment of an instalment are termed as pre-payment penalties.

  1. What is a term loan?

Ans. A term loan means a loan for which the term for repayment is pre-determined. This is unlike a demand loan in which the borrower has to repay on demand of repayment by the lender.

  1. How is a floating rate term loan different from a fixed rate term loan?

Ans. A fixed-rate term loan refers to interest rates that remain locked throughout the loan period, while floating-rate term loan refers to interest rates that are subject to fluctuate owing to certain factors.

  1. How is floating rate determined?

Ans. Lenders determine the floating rate on the basis of certain base rate. Usually, the floating rate is some percentage points more than the base rate. Base rate is determined by taking into account the cost of funds of the lender.

  1. Where do we find such floating rate term loans?

Ans. Floating rates are generally found in loans of long-term as the cost of funds is likely to fluctuate in the long run. However, certain medium term loans also have floating interest rate depending upon the agreement between the lender and borrower.

  1. Can a borrower make pre-payment of a term loan?

 Ans. Courts have, in many cases, given judgements stating that in the absence of specific provision in the agreement between the lender and the borrower (Loan Agreement), the borrower has the inherent right to make pre-payment of a loan. This puts light on the principle that ‘every borrower has an inherent right to free himself from the loan’.[2]

In case a lender requires that the loan amount should not be prepaid, such a restriction must be expressly mentioned in the Loan Agreement.

  1. Can a lender levy foreclosure charges/pre-payment penalty?

Ans. Unlike the provisions relating to pre-payment of loan by the borrower, the provisions for levy of foreclosure charges/pre-payment penalties are largely governed by the terms of the Loan Agreement. A lender can levy only those charges which form part of the Loan Agreement.

If provisions for levy of foreclosure charges/pre-payment penalties are expressly mentioned in the Loan Agreement, the lender can levy such charges/penalty. In absence of such provision, the lender does not have the right to levy such charges/penalty.

Further, for entities regulated by RBI, it is mandatory to mention all kinds of charges and penalties applicable to a loan transaction in the loan application form.

  1. What happens on prepayment of loan?

 Ans. Pre-payment of loan amount by the borrower has dual-impact. One is saving of interest cost and the other is reduction in the loan period. When a borrower pre-pays the loan, huge interest cost is saved, specifically in case of personal loans, where the interest rates are quite high.

  1. Why are borrowers charged in event of pre-payment?

Ans. Lenders pre-determine a schedule in terms of the specified term of a loan, including the repayment schedule, and the interest expectation. An early prepayment disrupts this schedule and also means that the borrower has to pay lesser interest (since interest is calculated from the time the loan is disbursed, till it is repaid).

Pre-payment charges are used as a client retention tool to discourage borrowers to move to other lenders, who may offer better interest for transferring the outstanding amount. It puts a limitation to the number of choices a customer can have due to market competition.

To compensate for such loss, pre-payment charges exist.

  1. What is the rate at which pre-payment charges are imposed?

Ans. The rate is determined by the opportunity cost foregone due to pre-payment/foreclosure. The future cash flows are discounted at a relatively lower rate and accordingly imposed. The rate differs from bank to bank depending on their relevant factors and policies. For example: several banks charge early repayment penalties up to 2-3% of the principal amount outstanding.

  1. How do banks benefit from the pre-payment penalties?

Ans. The prepayment penalty is not charged with the motive to generate revenue, but to recover costs incurred due to mismatch in assets and liabilities. It is believed that when long-term loans are offered to borrowers, lending facility raises long-term deposits to match their assets and liabilities on their balance sheet. So when the loans are pre-paid with respect to their scheduled payments, lenders continue to have long-term deposits on their books, leading to a mismatch

  1. What are the other factors that need to be kept in mind for pre-payment or foreclosure of loan?

Ans. The applicable rate at which penalty shall be charged is a major factor as it should not result in higher cost to the borrower. Other factors include the process of undergoing pre-payment/foreclosure, lock-in period associated with the option, documentation etc.

  1. What has been clarified?

Ans. Earlier, the FPC provided that NBFCs shall not charge foreclosure charges/prepayment penalties from individuals on floating rate term loans.

The clarification that has been provided by the RBI is that the foreclosure charges/prepayment penalties shall not be charged floating rate term loans, provided to individuals for purposes other than business i.e. personal purposes loans

Applicability

  1. On whom will this restriction be applicable?

Ans. The change shall be applicable to all kinds of NBFCs, including systemically important as well as non-systemically important NBFCs who are into business of lending to individuals. However, NBFCs engaged in lending to non-individuals only are not required to comply with this requirement.

  1. What kinds of loans will be covered?

Ans. All floating rate term loans provided to individuals for purposes other than business shall be covered under the said restriction.

  1. How will the lender define that loan is for purposes other than business?

 Ans. Before extending loans, documentation and background checks are performed. This process includes specification of the purpose for which the loan is taken. This gives a clear picture of the nature of the agreement and helps distinguish between business purpose and personal purposes.

  1. Why is this restriction on floating rate term loans only and not on fixed rate terms loans?

 Ans. Fixed rate loans involve no fluctuations in interest rates in the entire loan term. Thus in case of pre-payment, the interest foregone can be computed and realised to evaluate pre-payment penalties to be imposed.

While floating rate loans involve fluctuations based on the underlying benchmark and thus interest foregone cannot be estimated. There lies no confirmation of the lender being in the loss position. There is no way to realise interest rate sulking or hiking. Thus there is no basis on which overall loss might be estimated. In response to this situation, restrictions are on floating rate term loans and not on fixed rate term loans.

  1. Are there any other entities under similar restriction?

 Ans. RBI has put restrictions, similar to this, on banks and Housing Finance Companies as well. Banks are not permitted to charge foreclosure charges / pre-payment penalties on home loans / all floating rate term loans, for purposes other than business, sanctioned to individual borrowers. HFCs are not permitted to charge foreclosure charges/ pre-payment penalties in case of foreclosure of floating interest rate housing loans or housing loans on fixed interest rate basis which are pre-closed by the borrowers out of their own sources.

  1. When does this clarification come to effect?

Ans. It is noteworthy that this is a clarification (and not a separate provision) issued by the RBI in respect of a provision which is already a part of RBI Master Directions for NBFCs. Therefore, this clarification is deemed to be in effect from the date the corresponding provision was issued by the RBI by way of a notification[3] i.e. August 01, 2014.

Implication

  1. What is the borrower’s perspective?

Ans. Borrower’s may choose to pre-pay due to their personal obligations/burden, or if they obtain their funds which were earlier stuck, or by borrowing from a cheaper source to repay. This waive off of penalty charges, might be a sign of relief to them as they would get out of the obligation of an existing loan arrangement by paying off early and save the compounding interests and explore from the other options available in the market.

  1. What will happen after such clarification?

Ans. Prior to this clarification, the provision seemed to be providing a safe shelter to individual borrowers where they could foreclose or pre-pay any loan taken by them. Sometimes, the borrowers misused this facility by availing funds at a lower cost from some other lender to pre-pay the loans of higher interest rate. This resulted in disruptions in the forecasts of lenders, sometimes also resulting in loss to the lender.

This clarification limits the benefit of pre-payment to loans of personal nature only which are not availed very frequently by a borrower and are generally prepaid when borrowers have genuine savings or capital inflows.

 

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11647&Mode=0

[2] https://indiankanoon.org/doc/417200/

[3] http://pib.nic.in/newsite/PrintRelease.aspx?relid=107879

RBI eases end-use ECB norms for Corporates and NBFCs

/2 Comments/in , , /by

Timothy Lopes, Executive, Vinod Kothari & Company

Introduction

The Reserve Bank of India (RBI) has wide press release[1] dated 30. 07. 2019 revised the framework for External Commercial Borrowings based on feedback from stakeholders, and in consultation with the Government of India, by relaxing the end-use restrictions with a view to ease the norms for Corporates and NBFC’s. The changes brought about can be found in the RBI Circular[2] on External Commercial Borrowings (ECB) Policy – Rationalisation of End-use Provisions dated 30. 07. 2019

Corporate sector continue to face liquidity crunch and this move from RBI is certainly a welcome move.

ECB are commercial loans raised by eligible borrowers from the recognised lenders for the permitted end use prescribed by RBI.

The ECB framework in India is mainly governed by the Foreign Exchange Management Act, 1999 (FEMA). Various provisions in respect of this type of borrowing are also included in the Foreign Exchange Management (Borrowing and Lending) Regulations, 2018[3] framed under FEMA.

The RBI has also issued directions and instructions to Authorised Persons, which are compiled and contained in the Master Direction – External Commercial Borrowings, Trade Credit, and Structured Obligations[4].

Relaxation granted in end-use restrictions

 

In the earlier framework as covered in the Master Direction – External Commercial Borrowings, Trade Credit, and Structured Obligations (Master Directions), ECB proceeds could not be utilized for working capital purposes, general corporate purposes and repayment of Rupee loans except when the ECB was availed from foreign equity holder for a minimum average maturity period (MAMP) of 5 years.

Further on-lending out of ECB proceeds for real estate activities, investment in capital market, Equity investment, working capital purposes, general corporate purposes, repayment of rupee loans was also prohibited. These restrictions were made under the end-uses (Negative list) of the Master Direction.

With a view to further liberalize the ECB Framework in view of current hardship being faced by corporate sector; RBI has decided to relax these end-use restrictions.

Accordingly the said relaxations by RBI reflect as under:

Revised ECB Framework
Particulars ECBs Availed from By Permitted End-uses MAMP
Erstwhile Provision Foreign Equity Holder Eligible Borrower ·         Working capital purposes

·         General corporate purposes or,

·         Repayment of Rupee loans

 5 Years
Amended Provision Recognised Lenders* Eligible Borrower ·         Working capital purposes and,

·         General corporate purposes

 10 Years
Recognised Lenders* NBFC’s ·         On-lending for:

o   Working Capital purposes and,

o   General Corporate Purpose

 10 Years
Recognised Lenders* Eligible Borrowers including NBFC’s ·         Repayment of Rupee loans availed domestically for capital expenditure and,

·         On-lending for above purpose by NBFC’s

 7 Years
Recognised Lenders* Eligible Borrowers including NBFC’s ·         Repayment of Rupee loans availed domestically for purposes other than capital expenditure and,

·         On-lending for above purpose by NBFC’s

 10 Years
*ECBs will be permitted to be raised for above purposes from recognised lenders except foreign branches/ overseas subsidiaries of Indian Banks and subject to Para 2.2 of the Master Direction dealing with limit and leverage.

 

Relaxation for Corporate borrowers classified as SMA-2 or NPA

 

Further, Eligible Corporate Borrowers are now permitted to avail ECB for repayment of Rupee loans availed domestically for capital expenditure in manufacturing and infrastructure sector if classified as Special Mention Account (SMA-2) or Non-Performing Assets (NPA), under any one time settlement with lenders.

Permission to Lender Banks to assign loans to ECB lenders

Lender banks are also permitted to sell, through assignment, such loans to eligible ECB lenders, except foreign branches/ overseas subsidiaries of Indian banks, provided, the resultant ECB complies with all-in-cost, minimum average maturity period and other relevant norms of the ECB framework.

These permissions would reduce the burden of the lender banks who classified borrower’s account as SMA-2 or NPA.

Conclusion

Liberalization of the ECB policy by RBI acts as a step toward increased access to global markets by eligible Indian borrowers. In the current scenario of an economic slowdown, these changes come as a push upwards for the Indian economy.

Besides the above-mentioned changes in the Master Direction, all other provisions of the ECB policy remain unchanged.

[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47736

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11636&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11441&Mode=0

[4] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11510#1

Other relevant articles of interest can be read here –

  1. http://vinodkothari.com/wp-content/uploads/2018/05/Revised-Article-on-revised-ECB-framework-2.pdf
  2. http://vinodkothari.com/2019/03/consolidation-of-new-ecb-and-trade-credit-framework/
  3. http://vinodkothari.com/2019/02/rbi-revises-ecb-framework-aligns-with-fema-borrowing-and-lending-regulations-2018/

Indian Securitisation Market opens big in FY 20 – A performance review and a diagnosis of the inherent problems in the market

/1 Comment/in , , , /by

By Abhirup Ghosh , (abhirup@vinodkothari.com)(finserv@vinodkothari.com)

Ever since the liquidity crisis crept in the financial sector, securitisation and direct assignment transactions have become the main stay fund raising methods for the financial sector entities. This is mainly because of the growing reluctance of the banks in taking direct exposure on the NBFCs, especially after the episodes of IL&FS, DHFL etc.

Resultantly, the transactions have witnessed unprecedented growth. For instance, the volume of transactions in the first quarter of the current financial year stood at a record ₹ 50,300 crores[1] which grew at 56% on y-o-y basis from ₹ 32,300 crores. Segment-wise, the securitisation transactions grew by whooping 95% to ₹ 22,000 crores as against ₹ 11,300 crores a year back. The volume of direct assignments also grew by 35% to ₹ 28,300 crores as against ₹ 21,000 crores a year back.

The chart below show the performance of the industry in the past few years:

Direct Assignments have been dominating market with the majority share. During Q1 FY 20, DAs constituted roughly 56% of the total market and PTCs filled up the rest. The chart below shows historical statistics about the share of DA and PTCs:

In terms of asset classes, non-mortgage asset classes continue to dominate the market, especially vehicle loans. The table below shows the share of the different asset classes of PTCs:

Asset class

 Q1 FY 20 share Q1 FY 19 share FY 19 share
Vehicle (CV, CE, Car) 51% 57% 49%
Mortgages (Home Loan & LAP) 20% 0% 10%
Tractor 6% 0% 10%
MSME 5% 1% 4%
Micro Loans 4% 23% 16%
Lease Rentals 0% 13% 17%
Others 14% 6% 1%

Asset class wise share of PTCs

Source: ICRA

Shortcomings in the current securitisation structures

Having talked about the exemplary performance, let us now focus on the potential threats in the market. A securitisation transaction becomes fool proof only when the transaction achieves bankruptcy-remoteness, that is, when all the originator’s bankruptcy related risks are detached from the securitised assets. However, the way the current transactions are structured, the very bankruptcy-remoteness of the transactions has become questionable. Each of the problems have been discussed separately below:

Commingling risk

In most of the current structures, the servicing of the cash flows is carried out of the originator itself. The collections are made as per either of the following methods:

  1. Cash Collection – This is the most common method of repayment in case of micro finance and small ticket size loans, where the instalments are paid in cash. Either the collection agent of the lender goes to the borrower for collecting the cash repayments or the borrower deposits the cash directly into the bank account of the lender or at the registered office or branch of the lender.
  2. Encashment of post-dated cheques (PDCs) – The PDCs are taken from the borrower at the inception of the credit facility for the EMIs and as security.
  3. Transfer through RTGS/NEFT by the customer to the originator’s bank account.
  4. NACH debit mandate or standing instructions.

 

In all of the aforesaid cases, the payment flows into the current/ business account of the originator. The moment the cash flows fall in the originator’s current account, they get exposed to commingling risk. In such a case, if the originator goes into bankruptcy, there could be serious concerns regarding the recoverability of the cash flows collected by the originator but not paid to the investors. Also, because redirection of cash flows upon such an event will be extremely difficult to implement. Therefore, in case of exigencies like the bankruptcy of the originator, even an AAA-rated security can become trash overnight. This brings up a very important question on whether AAA-PTCs are truly AAA or not.

 

This issue can be addressed if, going forward, the originators originate only such transactions in which repayments are to happen through NACH mandates. NACH mandates are executed in favour of third party service providers which triggers direct debit from the bank account of the customers every month against the instalments due. Upon receipt of the money from the customer, the third party service providers then transfer the amount received to the originators. Since, the mandates are originally executed in the name of the third party service providers and not on the originators, the payments can easily be redirected in favour of the securitisation trusts in case the originator goes into bankruptcy. The ease of redirection of cash flows NACH mechanism provides is not available in any other ways of fund transfer, referred above.

Will the assets form part of the liquidation estate of the lessor, since under IndAS the assets continue to get reflected on Balance Sheet of the originator?

With the implementation of Ind AS in financial sector, most of the securitisation transactions are failing to fulfil the complex de-recognition criteria laid down in Ind AS 109. Resultantly, the receivables continue to stay on the books of the originator despite a legal true sale of the same. Due to this a new concern has surfaced in the industry that is, whether the assets, despite being on the books of the originator, be absolved from the liquidation estate of the originator in case the same goes into liquidation.

Under the current framework for bankruptcy of corporates in India, the confines of liquidation estate are laid in section 36 of the IBC. Section 36 (3) lays what all will be included therein. Primarily, section 36 (3) (a) is the relevant provision, saying “any assets over which the corporate debtor has ownership rights” will be included in the estate. There is a reference to the balance sheet, but the balance sheet is merely an evidence of the ownership rights. The ownership rights are a matter of contract and in case of receivables securitised, the ownership is transferred to the SPV.

The bounds of liquidation estate are fixed by the contractual rights over the asset. Contractually, the originator has transferred, by way of true sale, the receivables. The continuing balance sheet recognition has no bearing on the transfer of the receivables. Therefore, even if the originator goes into liquidation, the securitised assets will remain unaffected.

Conclusion

Despite the shortcomings in the current structures, the Indian market has opened big. After the market posted its highest volumes in the year before, several industry experts doubted whether the market will be able to out-do its previous record or for that matter even reach closer to what it has achieved. But after a brilliant start this year, it seems the dream run of the Indian securitisation industry has not ended yet.

[1] https://www.icra.in/Media/OpenMedia?Key=94261612-a1ce-467b-9e5d-4bc758367220

An analysis of the Model Tenancy Act, 2019

/1 Comment/in , , /by

1.      Introduction

In India, every state has its own law on tenancy matters. The matters, which are not covered by state legislations are governed by the Transfer of Property Act, 1882 (“TPA”), which is central legislation dealing with the matters between tenants and landlords. However, it covers transaction between tenant and landowner in the form of a lease. Codified legislation dealing exclusively on rent related matters in the real estate market has been long ignored in India. Lack of an exclusive legal framework hampered the growth of rental housing segment and resulted in low investments in the rental housing sector. The draft Model Tenancy Act, 2015 was an effort made earlier to codify the law on tenancy. but majority of states never implemented the same. In Union Budget 2019, it was proposed that in order to promote rental housing, new tenancy laws will be formulated to remove the archaic laws currently in use. In furtherance to the said proposition, Ministry of Housing and Urban Affairs (MHUA) released the draft Model Tenancy Act, 2019 (“MTA”) on July 10, 2019, which aims to regulate rental housing by a market-oriented approach while balancing interests of landowner and tenant at the same time. The article points out current problems of rental housing in India along with the issue that how MTA is going to compensate for these problems. It also presents an overview of MTA and loopholes present in it.

2.      Need for rental housing

Housing is one of the basic necessities of life. The rapid pace of urbanization in India has resulted in severe shortage of housing. People go for rental housing because  low-income or people are not ready to build their own house.In spite of government’s prime consideration to affordable housing, many poor households live in congested conditions, which indicates that housing is unaffordable for a large section of population, be it ownership or rental.

The Draft National Urban Rental Housing Policy, 2015 (“the Policy”) pointed out that there is a huge housing shortage in urban areas and on the other hand, there are massive stocks of vacant houses.[1]Possible reasons ascertained for vacant houses could be  low rental yield, fear of repossession, lack of incentives etc. The Policy defines rental housing as a property occupied by someone other than the owner, for which the tenant pays a periodic mutually agreed rent to the owner.[2] The policy suggested that if these vacant houses are made available for rental housing, then some, if not most of the urban housing shortage, could be addressed.[3] Hence, the need for rental housing can be understoodunder the following heads-

  1. An alternative to eliminate the problem of housing shortage in view of ever-increasing population of India.
  2. Prevention of future growth of slums by providing affordable housing to all.
  3. Rental housing could be turned as a steady source of income for the landlords, making investment in rental market attractive.

3.      Current problems of rental housing in India

Rental housing is a subject on which States have exclusive right to legislate. It is a state subject as mentioned under item 18 in List II of Seventh Schedule of the Constitution of India. Although, Central Government can guide the states as we have a quasi-federal structure in India, therefore, Central Government has power to make model law on rent control or tenancy.

At present, nearly every state has its own law governing matters relating to rental housing in their jurisdiction in the name of Rent Control Laws. However, these rent control laws are not adequate to satisfy the need for rental housing in true sense. Because, issues, such as lack of affordable housing, lack of investment in rental housing etc., are still present in the country.

The problems of rental housing in India, as present under different existing rent control laws, can be encapsulated as follow:

  1. Fixation of standard rent:

Existing rent control laws provide for standard rent or fair rent, which is calculated on the basis of cost of construction involved, when the premise was built and does not include present market value of the premise as a consideration to determine standard rent. This proves to be major disincentive for landlords and investors, who want to invest in rental market as it will give very low rate of return.

  1. Overstaying problem of tenants:

Existing rent control laws do not provide for any remedy for when tenants do not vacant the rent premises even after termination of the tenancy period. Therefore, landlords often fear that they might lose control on their premises and had to go long litigation process for recovering their premises.

  1. Reduced liquidity for landlords:

Freeze of availability of rental housing is evident in light of the long litigation proceedings relating to recovery of rental premises by the landlord or proceedings relating to eviction of tenants. When the proceedings are undergoing, it is difficult to rent out the premises which are lis pendens in court of law and thereby it reduces liquidity for landlords in the market.

  1. Security deposit:

From the point of view of tenants, it is unfair to give limitless amount to the landlords in the name of security deposit or pugree. Existing rent control laws do not provide for any upper cap as far as security deposit is concerned and tenants have to suffer in the hands of landlords, who demand lump sum amount as much as they want at the beginning of tenancy period. Because of this practice, poor households choose to live in slum areas as they cannot afford to give arbitrary amount of security deposit, which leads to lack of affordable housing in the Country.

  1. Landlord’s right to evict the tenant on false grounds:

It has been seen in many cases that landlords file false cases to evict tenants on the ground of non-payment of rent because most of the existing rent control laws do no mandate receipt of rent to be given by the landlord.

  1. Lease under Transfer of Property Act, 1882:

Section 105 of the aforesaid Act defines lease as “a lease of immoveable property is a transfer of a right to enjoy such property, made for a certain time, express or implied, or in perpetuity, in consideration of a price paid or promised, or of money, a share of crops, service or any other thing of value, to be rendered periodically or on specified occasions to the transferor by the transferee, who accepts the transfer on such terms. The transferor is called the lessor, the transferee is called the lessee, the price is called the premium, and the money, share, service or other thing to be so rendered is called the rent.” It is to be noted that in case of a lease agreement, terms of the same cannot be changed until the expiry of the lease period unlike tenancy agreement. In practice, landlords often opt for tenancy agreement under rent control laws where they can execute tenancy on a month-to-month basis and can alter its terms.. However, in areas with high vacancy rate of rental premises, landlords choose for lease agreement under Section 105 and thereby make the use of rent control laws fatal. In addition, TPA and rent control laws do not mandate a written agreement to be executed, which is another problem to enforce the rights of either party to the oral agreement and leads to never-ending litigation proceedings in case of disputes.

  1. Leave and License Contract:

Apart from rent control laws and lease under the TPA, people often use leave and license contract as given under the Indian Easements Act, 1882. Section 52 of the said Act defines license as- “where one person grants to another, or to a definite number of other persons, a right to do, or continue to do, in or upon the immovable property of the grantor, something which would, in the absence of such right, be unlawful, and such right does not amount to an easement or an interest in the property, the right is called a license.” Hence, the licensor gives the license to the licensee to use the property, which includes usage same as applicable to rental market without transferring a specific interest in the immovable property. Thus, to execute a landlord-tenant relationship, there exist different contracts under the different names and different procedures, the ambiguities of which can be used by the landlord or tenant to influence the law as per their needs.

4.      Overview of MTA

MTA has been drafted with a view to balance the interests of the landowner and tenant and to provide for speedy dispute redressal by establishing adjudicatory bodies under MTA. It also tries to create an accountable and transparent environment for renting the premises and promotes sustainable ecosystem to various segments of society including migrants, professionals, workers, students and urban poor. To understand what MTA proposes for tenants and landlords, a brief overview has been presented here under the following heads-

4.1       Institutional framework – regulatory and judicial bodies-

Rent Authority-

Section 29 of MTA provides for the appointment of Rent Authority to be an officer who is

not below the rank of Deputy Collector. Rent Authority exercises same power as vested in Rent Court in the following matters-

  1. Upload details of tenancy agreement on a digital platform in the local vernacular or state language in the form prescribed and provide a unique identification number to the parties[4];
  2. Fix or revise the rent on an application by the landowner or tenant[5];
  3. Investigate the case and pass an order in case of deposit of rent by the tenant with the rent authority, if the landowner does not accept the rent[6];
  4. Allow the tenant, if requested, to vacate the premises if it becomes uninhabitable in absence of repairs by the landlord.[7]
  5. Conduct an inquiry and allow compensation or levy penalty in case of an application made to it by the landlord or tenant if any person cuts-off or withholds any essential supply or service in the premises occupied by the tenant or the landowner.[8]

Rent Court and Rent Tribunal-

Section 32 and 33 provides for the constitution of Rent Court and Rent Tribunal respectively. Section 34 gives exclusive jurisdiction to Rent Court and Rent Authority to hear and decide the applications relating to disputes between landowner and tenant and matters connected with and ancillary thereto. For speedy disposal of cases, Rent Court or Rent Tribunal has to dispose the case within 60 days from the date of receipt of the application or appeal and shall record the reasons in writing in case of disposal of case exceeds 60 days period.[9]Appeal from the orders of the Rent Court lies to the Rent Tribunal.[10] In addition, order of Rent Court or Rent Tribunal shall be executable by as a decree of a civil court.[11]Following reliefs can be given by the Rent Court[12]:

  1. Delivery of possession of the premises to the party in whose favor the decision is made;
  2. Attachment of bank account of the losing party for the satisfaction of the amount to be paid;
  3. Appoint any advocate or any other competent person including officers of the Rent Court or local administration or local body for the execution of the order.

4.2       Scope of coverage-

MTA applies to any premises, which is, let separately for residence or commercial or educational use except industrial use.[13] However, MTA does not provide what constitutes residence/commercial/educational/industrial use. Besides, MTA does not apply to the following premises[14]–

  1. Hotel, lodging house, dharamshala or inn etc.;[15]
  2. Premises owned or promoted by-
    1. The Central/ State/ UT Government, or
    2. Local Authority, or
    3. Government undertaking or enterprise, or
    4. Statutory body, or
    5. Cantonment board;
  3. Premises owned by a company, university or organization given on rent to its employees as part of service contract;
  4. Premises owned by owned by religious or charitable institutions as may be specified by notification;
  5. Premises owned by owned by any trust registered under the Public Trust Act of the State;
  6. Premises owned by owned by Wakfs registered under the Wakf Act, 1995;
  7. Any other building specifically exempted in public interest through notification.

However, if the owner of any of the premises mentioned under in (b) to (g) wishes a tenancy agreement to be regulated under MTA, then he can inform the same to the Rent Authority.

4.3       Protection of landlord-

As stated above the prime object of the MTA is to eliminate the fear among landlords regarding repossession of their premises and increase the growth of investment in rental sector of the market. Keeping this view, MTA proposes to give protection to landlord in following manner-

  1. Subletting of rented premises cannot be effected without prior consent of landlord in
  2. writing along with disclosure of all details of sub-letting to landlord by the tenant. .[16]
  3. Landlord is allowed to make deduction from security deposit amount for any liability of the tenant.[17]
  4. Landlord is allowed to deduct the amount from the security deposit or can ask the amount payable from the tenant, in case the tenant refuses to carry out scheduled or agreed repairs in the premises.[18]
  5. Landlord can file an application to the Rent Authority against the tenant in case of cut-off or withhold of any essential supply or service in the premises by the tenant.[19]
  6. Landlord can evict the tenant on an application made to the Rent Court on any of the grounds mentioned under Section 21. These grounds are-
  7. Failure of agreement on rent payable;
  8. Failure of tenant to pay the arrears of rent in full and other charges payable unless the payment of the same within 1 month of notice being served on the tenant;
  9. Tenant has parted with the possession of whole or any part of the premises without obtaining the written consent of the landlord;
  10. Tenant has continued misuse of the premises even after receipt of notice from the landowner to stop such misuse;
  11. The premises are required by the landlord for carrying out any repairs, additions, alterations etc., which cannot be carried out without the premises being vacated unless re-entry of tenant has been pre-agreed between the parties;
  12. The premises or any part thereof are required by the landlord for carrying out any repairs, additions, alterations etc. for change of its use as a consequence of change of land use by the competent authority;
  13. Tenant has given written notice to vacate the premises and in consequence of that notice, the landlord has contracted to sell the accommodation or has taken any other step, as a result of which his interests would seriously suffer if he is not put in possession of that accommodation.
  14. In case of overstay of the tenant beyond tenancy period, the landlord is entitled to get compensation of double of the monthly rent for 2 months and 4 times of the monthly rent.[20]
  15. Landlord can make any construction or improvement to the rented premises after permission of the Rent Court obtained in this behalf.[21]
  16. Landlord is allowed to fix or revise the rent payable by the tenant, provided the same should be agreed by the tenant in the tenancy agreement.[22]

4.4       Protection of tenant-

MTA has not only given protection to landlords but balances the interests of the tenants as well. With this view, MTA proposes to give protection to landlord in the following manner-

  1. In the event of death of the tenant, his/her successors will have the same rights and obligations as agreed in tenancy agreement for the remaining period of the tenancy.[23]
  2. Rent cannot be increased during the tenancy period, unless the amount of increase or method for increase is expressly set out in the Tenancy Agreement.[24]
  3. Tenant is entitled to get refund of the security deposit amount at the time of vacating the premises after deduction of amount of liability, if any.[25]
  4. Tenant is entitled to get a written acknowledgment rent receipt by the landlord.[26]
  5. Where the landlord refuses to accept the rent, tenant may deposit it with the Rent Authority.[27]
  6. Tenant is allowed to deduct the amount from periodic rent, in case the landlord refuses to carry out the scheduled or agreed repairs in the premises.[28]
  7. Where the premises becomes uninhabitable and landlord refuses for repairs, thenthetenant has the right to vacate the premises after giving 15 days notice in writing to the landlord or with the permission of the Rent Authority, in case the.[29]
  8. Tenant can file an application to the Rent Authority against the landlord in case of cut-off or withhold of any essential supply or service in the premises by the landlord.[30]
  9. Tenant is entitled to get refund of such an advance amount and interest, in case of default, after deduction of rent and other charges in case of eviction proceedings initiated by the landlord under Section 21.[31]
  10. Tenant may give up possession of the premises on giving a one-month prior notice or notice as required under the tenancy agreement to the landlord.[32]

5.      How will the MTA help rental housing issue?

MTA recommends eradicating the existing rental housing problems by incorporating needful provisions. MTA has recognized the problems in existing rent control laws in its preamble as lack of growth of rental housing segment and lack of the landlords renting out their vacant premises. For better understanding of these needful provisions in MTA, a comparison of key provisions of existing rent control laws and MTA has been produced in Annexure A. In conclusion, the table suggests that MTA provides for market-oriented approach by leaving the fixation of rent amount on parties[33], who may fix or revise it considering current market value of the premises and thereby increasing the possibilities of high rate of return to the investors in the rental housing market. On the other hand, to remove the fear of the landlords of losing possession of the premises has been taken care by MTA by giving a remedy in form of compensation to the landlord[34].

6.      What do the state governments have to do?

As mentioned above, housing is a state subject and States have exclusive right to legislate upon it. MTA proposes only a model on how the issues relating to rental housing as existed under current laws relating to tenancy can be eliminated. It is completely on the states to adopt or not adopt MTA in their state. For better functioning of the rental housing in the state and to resolve the issues as point out above, state should adopt MTA. Moreover, States are free to make amendments in the proposed provisions in MTA while incorporating the same in their states.[35]

7.      What incentives will the state governments have for enacting the MTA?

MTA only proposes a model and States are under no obligation to enact MTA in their respective jurisdictions. Therefore, what the states will get for enacting MTA is equally an important question to consider. Section 46 of MTA provides that if any difficulty arises in giving effect to the provisions MTA, the State/UT Government may, by order, not inconsistent with the provisions MTA, remove the difficulty. Hence, any State enacting MTA is empowered to remove difficulty or amend the provision in their jurisdiction, if there arises any difficulty in implementation of the MTA.

Moreover, housing is one of the basic needs of life and raising the standard of living of its people is one of the primary duties of State as enshrined under the Article 47 of the Constitution of India. Therefore, States shall make every endeavor to resolve the issue of affordable housing in the best manner possible and MTA serves this objective well.

8.      Drawbacks of the MTA

Despite all the good attempts made in the provisions of MTA to remove the current problems relating to rental housing, MTA shortfalls on following grounds:

  1. Moreover, the term ‘Landlord’ covers ‘Lessor’ and the term ‘Tenant’ covers ‘Lessee’ in its definitions, but the MTA nowhere provides that it will override the provisions relating to Lease under the Transfer of Property Act, 1882. Therefore, usage of the term lessor/lessee would create conflict in practice since application of the Transfer of Property Act, 1882 is not clarified under the MTA .
  2. Lodging house and hotels are kept outside the scope of MTA. Therefore, application of the MTA to premises providing paying guest facilities is not clear.
  3. MTA provides for prospective application and gives no redress to tenancies, which are already in existence, prior to the commencement of MTA. Hence, position regarding existing tenancies is left untouched.
  4. Successor-in-interest has not been included in the definition of the term ‘tenant’ under Section 2 (m) of the MTA. However, Section 6 provides for successors of the tenant to come into the shoes of tenant in case of his/her death. This provision creates anomaly that after death of tenant, his/her successor-in-interest may deny acceptance of tenancy agreement on the ground that he/she is not covered within the definition of the term ‘tenant’.
  5. The term ‘rent’ is not defined under the Act, because of which, the form of rent payable is not clear, i.e. whether it has to be necessarily in cash or kind or crops or services rendered.
  6. The MTA does not address the situation in case of failure to execute tenancy agreement, failure to obtain consent of landowner for subletting, failure to refund security deposit at the time of taking over vacant possession of the premises by the landlord, failure to observe obligations imposed on parties. Although specific establishment of adjudicatory bodies has been provided under the MTA but the same results in increase of litigation matters before judicial bodies established under the MTA.
  7. MTA is open to be adopted by the States and does not necessarily impose application of its provisions to State.
  8. MTAdoes not talk about weak bargaining power of tenants and allows parties to agree on rent amount, which may cause prejudice to weaker sections of the society.
  9. MTA does not talk about over-riding effect of MTA on existing laws on tenancy, lease under the TPA, license under the Indian Easements Act, 1882 to uphold the objectives of the MTA.

9.      Conclusion

MTA is a welcoming step in rental matters relating to any premises. Establishment of the adjudicating authorities is going to lessen the burden on lower courts in the country in the matters relating to tenancy. However, application of the MTA would be interesting to see as to how many states actually implement MTA because it is only a model and not mandatory for states to adopt it.

 

 

Annexure-A

Comparison of Existing Rent Control Laws and MTA:

The author has tried to analyze some of the major existing rent control laws[36]in comparison with the MTA. The same has reproduced in a table form below:

Point of difference Existing Laws MTA Comments
Purpose of the Act 1.      Control of rent and protection of tenant from payment of rent more than the standard rent, and

2.      Protection of tenants from eviction,

 

 It provides not only for protection of tenants but also provides for protection of landowners. Most of the existing rent control laws are tenant-centric; whereas MTA balances the interests of landowner and tenant.
Exemption  Premises belonging to the Government are exempted but no specific provision is present regarding exemption of religious or charitable premises and premises owned by a university except Maharashtra Rent Control Act, 1999.[37] MTA exempts any premises owned by the Government, religious or charitable institutions, and premises owned by a company, university or organization given on rent to its employees as part of service contract.[38] MTA applies to all kind of government occupied premises and publicly used premises unlike existing rent control laws.

 
Definition of ‘Landlord’ If the premises were let to a tenant then landlord means a person who-

1.      is receiving, or is entitled to receive the rent of any premises, or

2.      trustee, guardian or receiver, who is receiving or is entitled to receive rent, on behalf of, or for the benefit of, any other person who cannot enter into a contract (such as minor, person with unsound mind etc.).

 

 If the premises were let to a tenant then landlord (Landowner/Lessor) means a person who[39]–

1.      is receiving, or is entitled to receivethe rent of any premises,and

2.      includes successor-in-interest,

3.      trustee, guardian or receiver, who is receiving or is entitled to receive rent, on behalf of, or for the benefit of, any other person who cannot enter into a contract (such as minor, person with unsound mind etc.).

 MTA covers Lessor within the term ‘Landlord’ and includes successor-in-interest unlike existing rent control laws.

 
Definition of ‘Premises’ Premises mean any building or part of a building rented out, and includes-

1.      Gardens, garages or outhouses, any furnituresupplied by the landlord,

2.      any fittings affixedto such building.

However, premises do not include hotel, lodging house.

 

 

 Premises mean any building or part of a itrented out for the purpose of residence or commercial or educational use, (except for industrial use) and includes[40]–

1.      the garden, garage or closed parking area, grounds and out-houses, appertaining to such building or part of the building,

2.      any fitting to such building or part of the building for the more beneficial enjoyment thereof,

However, premises do not include hotel, lodging house, dharamshala or inn etc.[41]

 State RCAs do not explicitly exclude industrial use, unlike MTA and do not specifically recognize a particular purpose of use of building to be cover within the term ‘premises’.
Definition of ‘Tenant’ Some of the rent control laws do not provide definition of term ‘tenant’. And others include tenant as a person-

1.      who is paying the rent, or

2.      deemed tenant, or

3.      sub-tenant,

4.      member of tenant’s family in case of death of tenant.

 Tenant/Lesseemeans a person[42]–

1.      by whom the rent is payable, or

2.      on whose behalf the rent is payable, and

3.      includes a sub-tenant,and

4.      any person continuing in possession after the termination of his tenancy whether before or after the commencement of this Act.

However, tenant does not include any person against whom any order or decree for eviction has made.

 MTA does not include successor-in-interest within the definition of tenant.
Standard rent Standard rent means a rent fixed by the Controller under rent control laws. No provision is made. MTA does not provide for the definition of the term ‘rent’.
Tenancy agreement It was not necessary and tenancy can be affected even without entering into tenancy agreement. It means a written agreement executed by the landowner and the tenant.[43] Moreover, it is mandatorycondition for a tenancy to come into effect.[44] MTA making the tenancy agreement mandatory unlike existing rent control laws.
Sub-letting No provision regarding prior written consent of landlord for sub-letting by tenant. Prior written consent of the landowner is madecompulsory.[45] More stringent provision.
Fixation of rent Rent fixed (standard rent) based on the value of land andcost of construction when built. The rent is the amount agreed between the landowner and the tenant as per the terms of the tenancy agreement.[46] Standard rent or fair rent concept has removed in MTA.
Increase in rent It is unilateral by the landlord with the approval of the controller. Revision of rent between the landowner and the tenant shall be as per the terms set out in the Tenancy Agreementor on a prior 3 months notice to the tenant.[47] Mutually agreed increase in rent is provided under MTA unlike rent control laws.
Temporary recovery of possession The landlord is entitled to get possession of the building, if bona fide, it is required by him to carry out repairs, alterations or additions, which cannot be carried out without the building being vacated, after which the building will again be offered to the tenant.

 

 Rent Court may on an application made to it, make the order that the landlord is entitled to get possession of the premises or any part thereof on account of any repairs or rebuilding or additions or alterations or demolition, which cannot be carried out without the premises being vacated, provided that such re-possession has to be mutually agreed to between the landowner and the tenant and the new tenancy agreement has to submitted with the Rent Authority.[48] More requirements that are stringent have been put on the parties under MTA.
Deposit of rent Many of state rent control lawsdo not provide for deposit of rent lawfully payable to the landlord in respect of the building, before the authority as may be prescribed. Explicit provision provided for deposit of rent with the Rent Authority where the landowner does not accept the rent or refuses to give a receipt or if landowner does not accept the rent.[49] Transparency and accountability enabled provision.
Overstay of tenant No deterrent provision, therefore landlords fear to give their houses on rent, which in turn reduces the supply of renting houses in the market. It provides for compensation i.e. four times the rent, to the landlord.[50] MTA provides Remedy in favour of landlord.
Rent Receipt on payment of rent No provision. Every tenant is entitled to get a written receiptfrom the landowner for the amount paid to him.[51] Tenant friendly provision to eliminate abuse against tenants.
Security deposits No explicit provision existed for security deposits/ pugree in addition to rent. MTA provides for 2 months’ rent in residential property, 1-month rent in non-residential property as security deposit.[52] MTA provides elimination of abuse against tenants.
Inheritance of tenancy Order of inheritance has provided in most of the state RCAs. No order of successors has given in MTA.[53] MTA introduces more wide import in case of inheritance of tenancy.
Structural alteration to the rent premises Rent control laws provide for structural alteration without consent of tenant and increase rent. MTA provides for structural alteration to rent premises only if the same is provided in the  agreementwith the tenant and increase the rent.[54] Tenant friendly provision to eliminate abuse against tenants.
Adjudicatory Authority Controller or Civil Courts Rent Authority, Rent Court, Rent Tribunal[55] Specific adjudicatory bodies introduced in MTA for speedy disposal of rent related matters.

 

 

 

[1]Draft National Urban Rental Housing Policy, 2015, p 10.

[2]Id. At p 5.

[3]Id.

[4] Section 4 (4), MTA, 2019.

[5] Section 10, MTA, 2019.

[6] Section 14 (2), MTA, 2019.

[7] Section 15 (5), MTA, 2019.

[8] Section 20, MTA, 2019.

[9] Section 35 (2), MTA, 2019.

[10] Section 37, MTA, 2019.

[11] Section 36 (7), MTA, 2019.

[12] Section 38 (1), MTA, 2019.

[13] Section 2 (e), MTA, 2019.

[14] Section 3, MTA, 2019.

[15]Id.

[16] Section 7, MTA, 2019.

[17] Section 11 (2), MTA, 2019.

[18] Section 15 (3), MTA, 2019.

[19] Section 20, MTA, 2019.

[20] Section 22, MTA, 2019.

[21] Section 25, MTA, 2019.

[22] Section 8 & 9, MTA, 2019.

[23] Section 6, MTA, 2019.

[24] Section 9 (4), MTA, 2019.

[25] Section 11 (2), MTA, 2019.

[26] Section 13 (2), MTA, 2019.

[27] Section 14, MTA, 2019.

[28] Section 15 (4), MTA, 2019.

[29] Section 15 (5), MTA, 2019.

[30] Section 20, MTA, 2019.

[31] Section 23, MTA, 2019.

[32] Section 28, MTA, 2019.

[33] Section 8, MTA, 2019.

[34] Section 22, MTA, 2019.

[35] Section 46, MTA, 2019.

[36]Maharashtra Rent Control Act, 1999; Delhi Rent Control Act, 1958; Andhra Pradesh Buildings (Lease, Rent and Eviction) Control (Amendment) Act, 1960; The West Bengal Premises Tenancy Act, 1997.

[37] Section 3, Maharashtra Rent Control Act, 1999.

[38] Section 3, MTA, 2019.

[39] Section 2(b), MTA, 2019.

[40] Section 2(e), MTA, 2019.

[41]Id.

[42] Section 2(m), MTA, 2019.

[43] Section 2(a), MTA, 2019.

[44] Section 4, MTA, 2019.

[45] Section 7 (1), MTA, 2019.

[46] Section 8, MTA, 2019.

[47] Section 9, MTA, 2019.

[48] Section 9 (6), MTA, 2019.

[49] Section 14 (1), MTA, 2019.

[50] Section 22, MTA, 2019.

[51] Section 13 (2), MTA, 2019.

[52] Section 11, MTA, 2019.

[53] Section 6, MTA, 2019.

[54] Section 9 (6), MTA, 2019.

[55] Chapter VI & VII, MTA, 2019.

Unregulated Deposit Banning Bill passed by Lok Sabha,2019

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The Unregulated Deposit Banning Bill, 2019[1] was introduced in the Lok Sabha on 24th July, 2019 and has since been passed.

The Bill enacts into law the provisions promulgated by a Presidential Ordinance[2] from 21st February 2019.

From our preliminary comparison, it appears that the Bill is largely the same as the text of the Ordinance.

However, a very significant, though very vague, amendment is the insertion of section 41 in the Bill which provides as under: “The provisions of this Act shall not apply to deposits taken in the ordinary course of business”

Of course, one will keep wondering as to what does this provision imply? What exactly is deposit taking in ordinance course of business? Is it to exclude deposits or loans taken for business purposes? Notably, almost all the so-called deposits that were taken during the Chit funds scam in West Bengal were apparently for some business purpose, though they were effectively nothing but money-for-money transactions. While the intent of this exception may be quell fears expressed across the country by small businesses that even taking of loans for business purposes will be barred, the provision does not jell with the meaning of excluded deposits which gives very specific carve-outs.

Also, one may potentially argue that deposit-taking itself may be a business. Or, deposits sourced may be used for money-lending business, which is also a deposit taken in ordinary course of business.

Basically, the insertion of this provision in section 41 may completely rob the statute of its intent and impact, even though it has an understandable purpose.

Please see our write ups on the Ordinance

 

[1] http://164.100.47.4/BillsTexts/LSBillTexts/PassedLoksabha/182C_2019_LS_Eng.pdf
[2]https://www.prsindia.org/sites/default/files/bill_files/Banning%20of%20Unregulated%20Deposit%20Schemes%20Ordinance%2C%202019.pdf

Introspection of RBI’s new requirement for greater inspection

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-Finserv Division

finserv@vinodkothari.com

 

The Union Budget 2019 had many odd talking points, especially for the banking and financial sector. From proposed recapitalization of public sector banks, relief in levy of Securities Transaction Tax (STT), proposing changes in factoring laws to increased supervision of NBFCs among others, this year’s budget created mixed emotions. One of the major changes that took everyone by surprise was granting exceptional power to the Reserve Bank of India for regulating and supervising non-banking financial companies (NBFC). One can say much of it is inspired by the ILFS saga.

In this article, we intend to pick up one such insertion in the Reserve Bank of India Act, 1934 which, we think, has escaped critic’s eye, that is section 45NAA. This, according to the author, is likely to have an overarching impact not only on the NBFCs but also on their non-financial group companies if any.

Insertion of section 45NAA

While much have been said about the other insertions in the RBI Act, that is, RBI’s right to remove directors or supersede the Board of the NBFC or initiative resolution of the NBFCs, one section which has been devoid of the much deserved attention is section 45NAA.

The section allows the RBI to inspect or audit of the books of all the group companies of an NBFC, including the non-financial entities in the group.

The text of the law has been provided below:

“45NAA. (1) The Bank may, at any time, direct a non-banking financial company to annex to its financial statements or furnish separately, within such time and at such intervals as may be specified by the Bank, such statements and information relating to the business or affairs of any group company of the non-banking financial company as the Bank may consider necessary or expedient to obtain for the purposes of this Act.

(2) Notwithstanding anything to the contrary contained in the Companies Act, 2013, the Bank may, at any time, cause an inspection or audit to be made of any group company of a non-banking financial company and its books of account.”

In other words, the RBI will be able to assess and inspect the books of non-financial institutions like manufacturing or service companies, even though its jurisdiction implicitly lies within the domain of financial institutions.

Despite being a recent addition to the NBFC sector, extended auditing power by the RBI is a prevalent norm in banking. The following is an excerpt of Section 29A from the Banking Regulation Act[1], 1949, which provides the power to the RBI on similar lines:

“(2) Notwithstanding anything to the contrary contained in the Companies Act, 1956(1 of 1956), the Reserve Bank may, at any time, cause an inspection to be made of any associate enterprise of a banking company and its books of account jointly by one or more of its officers or employees or other persons along with the Board or authority regulating such associate enterprise.”

However, there is a slight difference between the aforesaid provisions. On one hand, section 45NAA pertaining to NBFCs refer to the books of accounts of ‘group companies’ whereas, section 29A pertaining to banks refer to ‘associate enterprises’. To gauge the similarities between the sections, one has to look into the definition of the terms. The following is an excerpt from Section 45NAA-

(a) “group company” shall mean an arrangement involving two or more entities related to each other through any of the following relationships, namely:––

(i) subsidiary— parent (as may be notified by the Bank in accordance with Accounting Standards);

(ii) joint venture (as may be notified by the Bank in accordance with Accounting Standards);

(iii) associate (as may be notified by the Bank in accordance with Accounting Standards);

(iv) promoter-promotee (under the Securities and Exchange Board of India Act, 1992 or the rules or regulations made thereunder for listed companies);

(v) related party;

(vi) common brand name (that is usage of a registered brand name of an entity by another entity for business purposes); and

(vii) investment in equity shares of twenty per cent. and above in the entity;

(b) “Accounting Standards” means the Accounting Standards notified by the Central Government under section 133, read with section 469 of the Companies Act, 2013 and subsection (1) of section 210A of the Companies Act, 1956.”

Further, the relevant extract of section 29A of the Banking Regulations Act, relating to associate enterprises, is reproduced herein below-

“associate enterprise” in relation to a banking company includes an enterprise which–

(i) is a holding company or a subsidiary company of the banking company; or

(ii) is a joint venture of the banking company; or

(iii) is a subsidiary company or a joint venture of the holding company of the banking company; or

(iv) controls the composition of the Board of Directors or other body governing the banking company; or

(v) exercises, in the opinion of the Reserve Bank, significant influence on the banking company in taking financial or policy decisions; or

(vi) is able to obtain economic benefits from the activities of the banking company.

Despite some similarities in the two definitions, scope of “group companies” appear to be wider given the inclusion of related parties (defined under Ind AS-24[2]) and entities using a common brand or registered name. The meaning of the term “related party” has been obtained from Ind AS 24 and the same has numerous connotations including subsidiary, associates or entities upon which the reported entity has significant power of influence.

Undoubtedly, this is based on the learnings from the large number of scams that surfaced lately, especially the ones involving financial sector entities, but the amount of the power that has been bestowed upon the RBI is enormous. The intention is to allow RBI free access to all areas if it suspects anything foul happening in an NBFC.

Conclusion

A greater scrutinizing power bestowed to the RBI through section 45NAA has both positive, and, otherwise connotations. The power can be extended to inspect into corporate malpractices like accounting frauds, restrictive investment practices and undisclosed related party transactions through subsidiaries and associates that the RBI has reason to suspect. On the other hand, it also gives RBI discretionary powers to intervene and effect changes in private, non-financial companies on trivial grounds of misconduct, which is not always desirable. Control and corruption are opposite sides of the same coin. The coin has been flipped. Only time will show, on which side it lands.

[1] https://rbidocs.rbi.org.in/rdocs/Publications/PDFs/BANKI15122014.pdf

[2] http://www.mca.gov.in/Ministry/pdf/Ind_AS24.pdf

Private virtual currencies out: India may soon see regulated virtual currency

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-Kanakprabha Jethani | executive

kanak@vinodkothari.com

Background

A high-level Inter-ministerial Committee (IMC) (‘Committee’) was constituted under the chairmanship of Secretary, Department of Economic Affairs (DEA) to study the issues related to Virtual Currencies (VCs) and propose specific action to be taken in this matter. The Committee came up with its recommendations[1] recently. These recommendations include, among other things, ban on private VCs, examination of technologies underlying VCs and their impact on financial system, viability of issue of  ‘Central Bank Digital Currency (CBDC)’ as  legal tender in India, and potential of digital currency in the near future.

The following write-up deals with an all-round study of the recommendations of the committee and their probable impacts on the financial systems and the economy as a whole.

Major recommendations of the Committee.

The report of the Committee focuses on Distributed Ledger Technologies (DLT) or blockchain technology and their use to facilitate transactions in VCs and their relation to financial system. Following are the major recommendations of the Committee.

  • DEA should identify uses of DLT and various regulators should focus on developing appropriate regulations regarding use of DLT in their respective areas.
  • All private cryptocurrencies should be banned in India.
  • Introduction of an official digital currency to be known as Central bank digital currency (CBDC) which shall be acceptable as legal tender in India.
  • Blockchain based systems may be considered by Ministry of Electronics and Information Technology (MEITY) for building low-cost KYC systems.
  • DLT may be used for collection of stamp duty in the existing e-stamping system.

Why were these recommendations needed?

  • DLT uses independent computers (called ‘nodes’), linked together through hash function, to record, share and synchronise transactions in their respective distributed ledgers. The detailed structure of DLTs and their functions and uses can be referred to in our other articles.[2]

Among its various benefits such as data security, privacy, permanent data retention, this system addresses one major issue linked to digital currency which is the problem of double-spend i.e. a digital currency can be spent more than once as digital data can be easily reproduced. In DLT, authenticity of a transaction can be verified by the user and only validated transactions form a block under this mechanism.

  • Many companies have been using Initial Coin Offerings (ICO) as a medium to raise money by issuing digital tokens in exchange of fiat money or a widely accepted cryptocurrency. This way of raising money has been bothering regulators as it has no regulatory backing and such system can collapse any time. The regulators also fail to reckon whether ICO can be even considered as a security or how it should be taxed.
  • Some countries allow use of VCs as a mode of payment but no country in the world accepts VCs as legal tender. In India, however, no such permissions are granted to VCs. Despite the non-acceptability of VCs in India, investors have been actively investing in VCs like bitcoin, which is a sign of danger for the economy as it is draining the financial systems of fiat money. Further, they pose a risk over the financial system as they are highly volatile, with no sovereign backing and no regulators to oversee. It has been witnessed in the recent years that there have been detrimental implications on the economy due to volatility of VCs such as bitcoins. the same has been dealt with in detail in our report[3] on Bitcoins. They are also suspected to have been facilitating criminal activities by providing anonymity to the transactions as well as to the persons involved.
  • The future is of digitisation. An economy with everything running on physical basis will not survive in the competitive world. A universally accepted system for digital payments would require digitisation of currency as well.

What is the regulatory philosophy in the world?

As a mode of payment: Countries like Switzerland, Thailand, Japan and Canada permit VCs as a mode of payment while New York requires persons using VCs to take prior registration with a specified authority. Russia allows only barter exchange through use of virtual currency which means that such exchange can only take place when routed through barter exchanges of Russia. China prohibits use of VCs as a mode of payment.

For investment purposes: Russia, Switzerland, Thailand, New York and Canada permit investment in VCs and have in place frameworks to regulate such investments. Further, countries like Russia, Thailand, japan, New York and Canada have also allowed setting up of crypto exchanges and have a framework for regulating the setting up and operations such exchange and subsequent trading of VCs on them. On the other hand, China altogether prohibits investments and trading in VCs and the law of Switzerland is silent as to allowing setting up of crypto exchanges.

Further, China has imposed a strict ban on any activity in cryptocurrencies and has also taken measures to prohibit crypto mining activities in its jurisdiction. No country in the world has allowed acceptance of virtual currency as legal tender. It is noteworthy that though Japan and Thailand allow transactions in VCs, such transactions are restricted to approved cryptocurrencies only.

Tunisia and Ecuador have issued their own blockchain based currency called eDinar and SISTEMA de Dinero Electronico respectively. Venezuela has also launched an oil-based cryptocurrency.

Issue of official digital currency

Sensing the keen inclination of financial systems towards technological innovation and witnessing declining use of physical currency in various countries, the Committee is of the view that a sovereign backed digital currency is required to be issued which will be treated at par with any other legal tender of the country.

Various legislations of the country need to be reviewed in this direction. This would include amendments to the definition of “Coin” as per Coinage Act for clarifying whether digital currency issued by RBI shall be included in the said definition. Further, on issue of such currency, it must be approved to be a “bank note” as per section 25 of RBI Act through notification in Gazette of India.

Various regulators would also be required to amend their respective regulations to align them in the direction of allowing use of such digital currency as an accepted form of currency.

Key features of CBDC are expected to be as follows:

  • The access to CBDC will be subject to time constraints as decided in the framework regulating the same.
  • CBDC will be designed to provide anonymity in the transaction. However, the extent of anonymity will depend on the decisions of the issuing authority.
  • Two models are under consideration for defining transfer mechanism for CBDC. One is account-based model which will be centralised and other one is value-based model which will be decentralised model. Hybrid variants may also be considered in this regard.
  • Contemplations as to have interest-bearing or non-interest-bearing CBDC are going on. An interest-bearing CBDC would allow value addition whereas non-interest bearing CBDC will operate as cash.

Why should DLT be used in financial systems?

  • Intermediation: Usually, in payment systems, there are layers of intermediation that add to cost of transaction. Through DLT, the transaction will be executed directly between the nodes with no intermediary which would then reduce the transaction costs. Further, in cross-border transactions through intermediaries, authorisations require a lot of time and result in slow down of transaction. This can also be done away through DLT.
  • KYC: Keeping KYC records and maintaining the same requires huge amounts of data to be stored and updated regularly. Various entities undergoing the same KYC processes, collecting the same proofs of identity from the same person for different transactions result in duplication of work. Through a blockchain based KYC record, the same record can be made available to various entities at once, while also ensuring privacy of data as no centralised entity will be involved. Loan appraisal: A blockchain technology can largely reduce the burden of due-diligence of loan applicant as the data of customers’ earlier loan transactions is readily available and their credit standing can be determined through that.
  • Trading: In trading, blockchain based systems can result in real-time settlement of transactions rather than T+2 settlement system as prevailing under the existing stock exchange mechanism. Since all the transactions are properly recorded, it provides an easier way of post-trade regulatory reporting.
  • Land registries and property titles: A robust land registry system can be established through use of blockchain mechanism which will have the complete history of ownership records and other rights relating to the property which would facilitate transfer of property as well as rights related to it.
  • E-stamping: A blockchain based system would ease out the process of updation of records across various authorities involved and would eliminate the need of having a central agency for keeping records of transaction.
  • Financial service providers: They can be benefited by the concept of ‘localisation of data’ due to which their data is protected from cyber-attacks and theft. Our article[4] studies implementation of blockchain technology in financial sector.

What will be the challenges?

  1. For implementation of DLT: Though a wide range of benefits can be reaped out of implementation of DLT in various aspects of financial systems, it has still not been implemented because there are a few hindrances that remain and are expected to continue even further. Some of the challenges that are slowing the pace of transition towards this technology are as follows:
  • Lack of technological equipment to handle volumes of transactions on blockchains and to ensure data security at the same time.
  • Absence of centralised infrastructure or central entity to regulate implementation of DLT in the financial system. Also, the existing regulators lack the expertise to oversee proper implementation.
  • First, a comprehensive regulatory framework needs to be in place that ensures governance in implementation. The framework will need to address concerns like jurisdiction in case of cross border ledgers, point of finality of transactions etc.
  1. For common digital currency: Decisions regarding validation function, settlement, transfer, value-addition etc. are of crucial importance and would require extensive study. Factors that might be hampering issue of such currency are as follows:
    • Having in place a safe and secure blockchain network and robust technology to handle the same will require significant investments.
    • High volumes of transactions may not be supported and might result in delays in processing.
    • In case an interest bearing CBDC is issued, it would pose great threat over the commercial banking system as the investors will be more inclined towards investing in CBDCs instead of bank deposits.
    • This is also likely to increase competition in the market and lower the profitability of commercial banks. Commercial banks may rely on overseas wholesale funding which might result in downturn of such banks in overseas market.
  2. For banning of private cryptocurrencies: A circular issued by the RBI has already banned its regulated entities from dealing in VCs. Many other countries have also banned dealing in VCs. Despite such restrictions, entities continue to deal in VCs because their speculative motives drive the dealing in VCs to a great extent.

Conclusion

The recommendations of the Committee intend to ensure safety of financial systems and simultaneously urge the growth of the system through innovation and technological advances. Rising above the glorious scenes of these recommendations, one realises that achieving this is a far-fetched reality. One needs to accept the fact that India still lacks in technology and systems sufficient to support innovations like blockchain. Various reports have already shown that operation of blockchains consumes huge volumes of energy, which can be the biggest issue for the energy-scarce India. India needs to work in order to strengthen its core before flapping its wings towards such sophisticated innovation.

[1] https://dea.gov.in/sites/default/files/Approved%20and%20Signed%20Report%20and%20Bill%20of%20IMC%20on%20VCs%2028%20Feb%202019.pdf

[2] http://vinodkothari.com/2019/06/blockchain-technology-its-applications-in-financial-sector/

http://vinodkothari.com/2019/06/an-introduction-to-smart-contracts-guest-post/

[3] http://vinodkothari.com/wp-content/uploads/2017/08/Bitcoints-India-Report.pdf

[4] http://vinodkothari.com/2019/07/blockchain-based-lending-a-peer-to-peer-approach/

BLOCKCHAIN-BASED LENDING – A PEER-TO-PEER APPROACH

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Ind AS vs Qualifying Criteria for NBFCs-Accounting requirements resulting in regulatory mismatch?

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-Financial Services Division and IFRS Division,  (finserv@vinodkothari.com  ifrs@vinodkothari.com)

The transition of accounting policies for the non-banking financial companies (NBFCs) is on the verge of being completed. As was laid down in the implementation guide issued by the Ministry of Corporate Affairs, the Indian Accounting Standard (Ind AS) was to be implemented in the following manner:

Non-Banking Financial Companies (NBFCs)
Phase I

 

  From 1st April, 2018 (with comparatives for the periods ending on 31st  March, 2018)
·         NBFCs having net worth of rupees five hundred crore or more (whether listed or unlisted)
·         holding, subsidiary, joint venture and associates companies of above NBFC other than those already covered under corporate roadmap shall also apply from said date
Phase II From 1st April, 2019 (with comparatives for the periods ending on 31st March, 2019)
·         NBFCs whose equity and/or debt securities are listed or in the process of listing on any stock exchange in India or outside India and having net worth less than rupees five hundred crore

 
·         NBFCs that are unlisted companies, having net worth of rupees two-hundred and fifty crore  or more but less than rupees five hundred crore
·         holding, subsidiary, joint venture and associate companies of above other than those already covered under the corporate roadmap
· Unlisted NBFCs having net worth below two-hundred and fifty crore shall not apply Ind AS.

· Voluntary adoption of Ind AS is not allowed (allowed only when required as per roadmap)

· Applicable for both Consolidated and Individual Financial Statements

As may be noted, the NBFCs have been classified into three major categories – a) Large NBFCs (those with net worth of ₹ 500 crores or more), b) Mid-sized NBFCs (those with net worth of ₹ 250 crores – ₹ 500 crores) and c) Small NBFCs (unlisted NBFCs with net worth of less than ₹ 250 crores).

The implementation of Ind AS for Large NBFCs has already been completed, and those for Mid-sized NBFCs is in process; the Small NBFCs are anyways not required implementation.

The NBFCs are facing several implementation challenges, more so because the regulatory framework for NBFCs have not undergone any change, despite the same being closely related to accounting framework. Several compliance requirements under the prudential norms are correlated with the financial statements of the NBFCs, however, several principles in Ind AS are contradictory in nature.

One such issue of contradiction relates to determination of qualifying assets for the purpose of NBFC classification. RBI classifies NBFCs into different classes depending on the nature of the business they carry on like Infrastructure Finance Companies, Factoring Companies, Micro Finance Companies and so on. In addition to the principal business criteria which is applicable to all NBFCs, RBI has also laid down special conditions specific to the business carried on by the different classes of NBFCs. For instance, the additional qualifying criteria for NBFC-IFCs are:

(a) a minimum of 75 per cent of its total assets deployed in “infrastructure loans”;

(b) Net owned funds of Rs.300 crore or above;

(c) minimum credit rating ‘A’ or equivalent of CRISIL, FITCH, CARE, ICRA, Brickwork Rating India Pvt. Ltd. (Brickwork) or equivalent rating by any other credit rating agency accredited by RBI;

(d) CRAR of 15 percent (with a minimum Tier I capital of 10 percent)

Similarly, there are conditions laid down for other classes of NBFCs as well. The theme of this article revolves the impact of the Ind AS implementation of the conditions such as these, especially the ones dealing with sectoral deployment of assets or qualifying assets. But before we examine the specific impact of Ind AS on the compliance, let us first understand the implications of the requirement.

Relevance of sectoral deployment of funds/ qualifying assets for NBFCs

The requirement, such as the one discussed above, that is, of having 75% of the total assets deployed in infrastructure loans by the company happens to be a qualifying criteria. IFCs are registered with the understanding that they will operate predominantly to cater the requirements of the infrastructure sector and therefore, their assets should also be deployed in the infrastructure sector. However, once the thresholds are satisfied, the remaining part of the assets can be deployed elsewhere, as per the discretion of the NBFC.

The above requirement, in its simplest form, means to have intentional and substantial amount of the total assets of the NBFC in question to be deployed in the infrastructure area, both, at the time of registration, as well as a regulatory requirement, which has to be met over time. Breaching the same would result in non-fulfilment of the RBI regulations.

Impact of Ind AS on the qualifying criteria

The above requirement might seem simple, however, with the implementation of Ind AS on NBFC, there can be important issues which might result in the breach of the above requirement.

With the overall slogan of “Substance over Form”, and promoting “Fair Value Accounting” and an aim to make the financial statements more transparent and just, Ind AS have been implemented. However, the same fair value accounting can result in a mismatch of regulatory requirement, to such an extent that the repercussion may have a serious impact on the existence of being an NBFC.

As already stated above, once an NBFC satisfies the qualifying criteria, it can deploy the remaining assets anywhere as per its discretion. Let us assume a case, where the remaining assets are deployed in equity instruments of other companies. All this while, under the Indian GAAP, investments in equity shares were recorded in the books of accounts as per their book value, but with the advent of Ind AS, most of these investments are now required to be recorded on fair values. This logic not only applies in case of equity instruments, but in other classes of financial instruments, other than those eligible for classification as per amortised cost method.

The problem arises when the fair value of the financial instruments, other than the NBFC category specific loans like infrastructure loans, exceed the permitted level of diversification (in case of IFC – 25% of the total assets). Such a situation leads to a question whether this will breach the qualifying criteria for the NBFC. A numeric illustration to understand the situation better has been provided below:

Say, an NBFC-IFC, having a total asset size of Rs. 1,000 crores would be required to have 75% of the total assets deployed in infrastructure loans i.e. Rs. 750 crores. The remaining Rs. 250 crores is free for discretionary deployments. Let us assume that the entire Rs. 250 crores have been deployed in other financial assets.

Now, say, after fair valuation of such other financial assets, the value of such assets increases to ₹ 500 crores, this will lead to the following:

Under Indian GAAP Under Ind AS
Amount

(in ₹ crores)

 As per a % of total assets Amount

(in ₹ crores)

 As per a % of total assets
Infrastructure Loans 750 75% 750 60%
Other financial assets 250 25% 500 40%
Total assets 1000 100% 1250 100%

 

Therefore, if one goes by the face of the balance sheet of the NBFC, there is a clear breach as per the Ind AS accounting, as the qualifying asset comes down to 60% as against the required level of 75%. However, is it justified to take such a view?

The above interpretation is counter-intuitive.

It may be noted that the stress is on “deployment” of its assets by an IFC. Merely because the value of the equity has appreciated due to fair valuation, it cannot be argued that the IFC has breached its maximum discretionary investment limits. The deployment was only limited to 25% or so to say that even though the fair value of the exposure has gone up but the real exposure of the NBFC is only to the extent of 25%. Under Ind AS, the fair value of an exposure may vary but the real exposure will remain unchanged.

Taking any other interpretation will be counter-intuitive. If the equity in question appreciates in value, and if the fair value is captured as the value of the asset in the balance sheet, the IFC will be required to increase its exposure on infrastructure loans. But the IFC in question may be already fully invested, and may not have any funding capability to extend any further infrastructure loans. Under circumstances, one cannot argue that the IFC must be forced to disinvest its equities to bring down its investment in equities, particularly as the same had nothing to do with “deployment” of funds.

This is further fortified by Para 10. Accounting of Investments, Chapter V- Prudential Regulations of the Master Direction – Non-Banking Financial Company – Systemically Important Non-Deposit taking Company and Deposit taking Company (Reserve Bank) Directions, 2016 about valuation of equities:

“Quoted current investments for each category shall be valued at cost or market value whichever is lower”.

Hence, the RBI Regulations have been framed keeping in view the historical cost accounting. There is no question of taking into consideration any increase in fair value of investments.

Conclusion

Therefore, it is safe to say that while determining the compliance with qualifying criteria, one must consider real exposures and not fair value of exposures as the same is neither in spirit of the regulations nor seems logical. This will however be tested over time as we are sure the regulator will have its own say in this, however, until anything contrary is issued in this regard, the above notion seems logical.