RBI – Vinod Kothari Consultants

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

November 28, 2024/0 Comments/in Financial Services, NBFCs, RBI /by Vinod Kothari

– Vinod Kothari (vinod@vinodkothari.com)

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

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

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

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

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

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

Regulatory carve outs

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

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

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

Three situations requiring approval

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

Takeover or acquisition of control

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Change in Control:

Change in management

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

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

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

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

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

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

Intra-group transfers

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

Here is an excerpt from the RBI FAQs:

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

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

Corporate Restructuring

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

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

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

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

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

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

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

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

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

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

Omnibus use vs know-its-use: Is Supply Chain Financing a revolving line of credit?

November 15, 2024/0 Comments/in Financial Services, RBI /by Staff

Vinod Kothari and Dayita Kanodia | finserv@vinodkothari.com

There have been recent concerns that the RBI is not happy with NBFCs extending revolving credit facilities; there are also some reports to suggest that the supervisor has shown opposition to supply chain funding.

This write up delves into what could be the objections of the regulator in NBFCs extending revolving lines of credit, and why supply chain funding, if properly structured, is not a revolving credit facility that the regulator may be objecting to. It is a credit facility for sure, like every other credit facility, but it is way different from a revolving credit facility such as a cash credit, overdraft, or a credit card.

What could be the objection to revolving lines of credit by NBFCs ?

One of the traditional functions of a bank is credit creation, which, in essence, is the multiplied availability of money supply in an economy. For example, a bank accepts a demand deposit of Rs 100 from customer X, keeps 10% of the money as cash, and lends Rs 90 to customer Y, X still has a spending power of Rs 100, and Y has a spending power of Rs 90, though the system has a total cash of only Rs 100. The bank does it on the basis that X or similar depositors do not withdraw all their deposits at a time; therefore, the bank may keep liquidity as a part of its demand liabilities, and deploy the rest. It is a different issue that Basel requirements of LCR require banks to keep liquid resources, not necessarily in hard cash.

In another way, banks may create liquidity by granting overdraft or cash credit facilities. That is, customer, customer X who has deposited Rs 100 may be permitted to draw upto Rs 200. As the bank estimates that not every customer who has overdraft sanctions will fully use the same, each such customer has a spending power, without the need to have actual cash.

This is, of course, different from an actual loan, where the money would have moved from the lender to the borrower.

A revolving line of credit is a flexible credit facility that offers borrowers access to a pre-approved amount of funds, which they can draw upon, repay, and redraw as needed.

Credit card is another classic case of a revolving line of credit – the card company creates spending power, equal to the available credit on each card. If, on an average, every card is drawn to the extent of, say, 33%, a card issuer may create spending ability equal to 3X the money the issuer has.

Credit creation has macroeconomic implications; central bankers use expansion of credit and contraction of credit as tools of achieving macroeconomic objectives.

Since NBFCs are not banks, if NBFCs start creating credit, without actual funding, there may be an exception to the central bank’s powers to control credit in the economy.

In case of credit cards, the revolving line of credit is also used as a payment instrument. In essence, the card is used to settle payment obligations – therefore, the one who accepts a payment by use of a credit card is acquiring the right to receive money from the card issuer. The card issuer is, in that sense, making an obligation to pay money represented by the card to anyone accepting the card. Such a privilege can only be given to authorised entities. Banks are, by their very nature, authorised entities for the payment system; NBFCs need specific authorisation.

The key features of a revolving line of credit, which may have the regulator’s disapproval, are as follows:

It is a line of credit and not a funding attached to a specific usage. The grantor of the facility approving any particular drawdown or usage of the line of credit does not arise.
The line of credit may be tapped any time, and does not have any major end-use restrictions, except, may be a negative list.
It may be paid back any time.
Once paid back, it will auto replenish -that is, it will be available for withdrawal again. Even though a revolving facility may have a sunset, but until it lives, it continues to revolve.
Given the fact that there is no specific time for repayment of any particular usage, a revolving facility is considered to be out of order only when it breaches some of the triggers – may be set with respect to the asset-liability cover, or otherwise.

For further details on revolving line of credit – See Lend, Recover, Replenish: A guide to revolving lines of credit

Why is supply chain financing important ?

Supply chains have become extremely important as manufacturing has moved to aggregation. Any large manufacturing operation today is, indeed, a substantial extent of assembly and aggregation of the components made at different places by different suppliers. Thereby, the dependence of a business on upstream vendors has increased. In the same vein, the ability of a business to enable supplies to the end user with minimum time has become very important. All these factors make effective supply chain management a very important function for most businesses.

Meaning of SCF

SCF, also known as channel finance or reverse factoring, is a financial arrangement that helps companies optimize their working capital and improve the efficiency of their supply chain operations. It involves the use of financial instruments and techniques to facilitate the smooth flow of funds between buyers, suppliers, and financial institutions.

The Global Supply Chain Finance Forum defines Supply Chain Finance as,

“the use of financing and risk mitigation practices and techniques to optimize the management of the working capital and liquidity invested in supply chain processes and transactions. SCF is typically applied to open account trade and is triggered by supply chain events. Visibility of underlying trade flows by the finance provider(s) is a necessary component of such financing arrangements which can be enabled by a technology platform.

In a SCF arrangement, the buyer procures goods or services from a supplier and receives an invoice for the transaction. The supplier receives upfront payment based on the invoice amount, improving their cash flow. This arrangement provides the buyer with the flexibility to settle the payment by the invoice’s due date, optimizing working capital for both parties.

Importance of SCF

Working Capital Optimization: Buyers can extend their payment terms, which can free up cash for other investments, while suppliers can access early payments to meet their financial obligations.
Increased chances that the buyer will pay on the due date: Due to the presence of a financial institution, it is more likely that the buyer will pay on the due date.
Improved Supplier Relationship: Due to SCF, the supplier receives early payment while the buyer has the flexibility to pay on the due date. This also improves the buyer-supplier relationship.

Various modes of SCF

The following are some of the SCF product types:

Receivables discounting: Sellers of goods and services sell individual or multiple receivables to a finance provider at a discount.
Factoring: Sellers of goods and services sell their receivables at a discount to a ‘factor’. Typically, the factor becomes responsible for managing the debtor portfolio and collecting the payment of the underlying receivables.
Reverse factoring (Payables finance): It is a buyer-led program within which sellers in the buyer’s supply chain are able to access finance by means of receivables purchase.
Purchase-order finance: Pre-shipment or purchase-order finance is a loan provided by a finance provider to a seller of goods and/or services for the sourcing, manufacture, or conversion of raw materials or semifinished goods into finished goods and/or services, which are then delivered to a buyer.

The Global Supply Chain Finance Market has increased by 7% to USD 2,347bn in the year 2023.

For further details on Supply Chain Finance – see Unlocking Working Capital: An Overview of Supply Chain Finance

Credit with a purpose vs Credit on demand

The key defining features of revolving line of credit will help us to differentiate the same from SCF. In fact, SCF emerged as an alternative to the traditional mode of working capital finance – viz., overdraft or cash credit. SCF reduces the need for revolving facilities for working capital – hence, it is referred to as an alternative working capital financing product.

The table below distinguishes between SCF and RLOC.

Points of Distinction	SCF	RLOC
Purpose and End-Use Restrictions	In SCF, each drawdown is made against a specific purchase or sale transaction. Therefore, it is transactional funding – funding of a specific transaction. In case of purchase financing, it becomes funding for the purpose of enabling a purchase, and in case of sales financing, it becomes a mode of releasing funding locked in a specific sale. Once again, what sales will qualify for funding are clearly defined by the grantor of the facility. Typically, the grantor may approve every specific sale or purchase invoice.	RLOC offers unrestricted use, giving borrowers the flexibility to allocate the funds as needed. In other words, revolving facilities can be used for any spending.
Structure and Repayment	In SCF, each transaction is treated as a unique drawdown, meaning repayment is generally linked to the cash flow generated from the sale or purchase for which the funds were advanced. Further, further disbursal may also be restricted in case the amount pertaining to the earlier facility is overdue.	A revolving credit structure where the borrower can repay and re-borrow funds multiple times during the term of the facility, providing continuous liquidity regardless of specific transactions.
Annualised Percentage Rate	Credit is advanced against a specific invoice with a defined repayment period, APR calculation is possible.	Calculating APR for RLOCs may not be feasible, as the exact dates of repayments and future disbursements are unknown at the time of sanction.

It is important to note that in SCF like in case of a RLOC, there can be a sanctioned credit limit within which the drawdowns can be made. However, the setting of a credit limit is common for any credit facility. However, in SCF unlike RLOC, the drawdown would depend upon the availability of an invoice pertaining to a specific sale or a purchase, of goods or services which are either approved by qualifying criteria, or are approved specifically by the facility provider.

RBI’s Concerns About Evergreening

The RBI has raised concerns about the practice of “evergreening” in financial arrangements, particularly when it comes to credit facilities such as RLOCs. Evergreening occurs when additional funds are borrowed to pay off existing debt, creating a cycle of borrowing without actual repayment, often concealing the true creditworthiness or financial health of the borrower. This practice poses systemic risks, as it may lead to artificially inflated financial statements and delayed recognition of bad debts.

Why RBI’s Concerns Do Not Apply to Supply Chain Financing:
The structural design of SCF mitigates the risk of evergreening. Since each drawdown in SCF is linked to a specific, commercial transaction, further financing is typically contingent on the timely settlement of previous advances. If a borrower fails to repay a previous drawdown on schedule, additional financing for new transactions is withheld, preventing the borrower from obtaining funds solely to meet previous obligations. This transaction-based financing model ensures transparency and aligns with RBI’s efforts to curb evergreening practices, as each drawdown must have a legitimate underlying trade transaction.

RLOC and Evergreening Risks:
In contrast, an RLOC does not impose restrictions on the use of funds or require them to be linked to specific transactions. Borrowers may potentially use an RLOC to repay prior debts, thus getting their line of credit reinstated and then further borrowing.

Regulatory Updates | October 2024

November 8, 2024/0 Comments/in Corporate Laws, Financial Services, RBI, SEBI, UPDATES /by Staff

Regulatory-Updates-for-the-month-of-October-2024 Download

Financial Sector Regulator – ‘Rule of Law’ Review

November 7, 2024/0 Comments/in Financial Services, NBFCs, RBI /by Team Finserv

– Aditya Iyer (adityaiyer@vinodkothari.com)

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RBEye: Red-eyed RBI wants lenders to revisit interest rate policies

October 30, 2024/0 Comments/in Financial Services, NBFCs, RBI /by Staff

-Vinod Kothari (vinod@vinodkothari.com)

Against the backdrop the action against 4 specific lender, RBI now expects all NBFCs to appraise their boards of the action taken by the regulator, and in specific terms, have the interest rate policy examined with respect to, at least, the following, in “unambiguous terms”:

The Board of each NBFC shall adopt an interest rate model taking into account relevant factors such as cost of funds, margin and risk premium and determine the rate of interest to be charged for loans and advances
The rate of interest must be annualised rate so that the borrower is aware of the exact rates that would be charged to the account.

Usually, it is believed that if a penal or disciplinary action is taken against some, it is in relation to aberrations by the respective entities. While others need to sit up and take notice it is but natural, but it is a bit different this time – the regulator itself is expecting that all NBFCs need to sensitise their boards on the action taken. The action taken by the RBI is hardly a surprise and therefore, all boards of all NBFCs know it for sure – however, what is not known is what was the background for the action taken. Generic expressions such as “fair, reasonable and transparent pricing, especially for small value loans” have been used in the press release, but these have always been there and have always been the abstractions that everyone talks about, and tried to walk. But what boards of every NBFC will need to know is the nature of the aberrations. Other than just expressing concerns and sending alert signals, NBFCs may need to do self introspection and course correction, for which they would have expected granular observations, as in the case of gold lending vide circular dated September 30, 2024.

It may be the expectation of the regulator that interest rate models, based on which the actual setting of interest rates by business is done, are not vague or subjective, and leave room for opportunistic pricing. For example, the risk premium on loan is imposed on the price: this should be a reflection of the expected loss models. There may be loan acquisition costs and servicing costs – which may be either fixed, variable or semi variable. These may be translated into a mark-up based on appropriate pricing models. The most important component of loan pricing, of course, is the cost of capital – including the cost of equity, which may be priced on the basis of actual (in case of equity, expected) costs of each of the sources of capital. In essence, there is entity-wide or product-wide pricing, such as cost of capital and servicing, and loan-specific pricing, such as cost of acquisition and credit risk premium.

These models may be granularly put before the Boards of NBFCs. Boards do not get into pricing, but with the kind of shocks that RBI has given to some lenders, boardrooms rather get into details of pricing being charged.

Another very important factor in pricing are the “extras”, which have become increasingly important over time. These may be fees that NBFCs get from allied services, or subventions from vendors, etc. These constitute part of the returns, but are not shown as cost to the borrower. These may also eventually be a matter of concern.

Vinod Kothari Consultants did a webinar recently on the RBI crackdown – here is the link to the recording of the webinar: https://youtu.be/poy6_HehPgU?feature=shared.

Other related resources:

The Clean up call: RBI Action against Lending practices

October 22, 2024/0 Comments/in Financial Services, Housing finance, NBFCs, RBI, scale based regulations /by Vinod Kothari Consultants

Virtual Webinar | 28^th October 2024 | 6:15 PM.

To watch the webinar, click here.
Click here to register: https://forms.gle/BtiZdmEDrU7Y9Tcb9

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Recent Updates to HFC Directions: What you need to know

October 22, 2024/0 Comments/in Financial Services, Housing finance, NBFCs, RBI /by Staff

-Chirag Agarwal | chirag@vinodkothari.com

On October 10, 2024, RBI updated the Master Direction – Non-Banking Financial Company – Housing Finance (‘HFC Directions’) applicable to HFCs. The HFC Directions were updated to consolidate various circulars that have been issued since its last update on March 21, 2024. A significant change in this edition is the introduction of a new format for the Most Important Terms and Conditions (MITC) following the rollout of the Key Facts Statement (KFS) vide circular no DOR.STR.REC.13/13.03.00/2024-25 dated April 15, 2024.

In this article, we will be discussing the changes introduced by the October 10th update to the HFC Directions.

Clarification regarding MITC and KFS

Previously, Para 85.8 of the HFC Directions mandated that to facilitate a quick, and better understanding of the terms and conditions of the housing loan, a document containing the ‘Most Important Terms and Conditions’ (MITC) must be furnished to the borrower. However, when the KFS circular was first introduced, there was some ambiguity regarding whether both the MITC and KFS would apply to HFCs. This confusion arose because both disclosures contained overlapping information. However, with the recent updates to the HFC Directions on October 10, 2024, clarity has been provided on this matter. The revised regulations clearly state that “the HFCs shall additionally obtain a document containing the other most important terms and conditions (MITC) of such loan (i.e., other than the details included in KFS)”.

Notably, the MITC has now been renamed as Other Most Important Terms and Conditions (‘OMITC’). The OMITC will no longer include disclosures that are already covered in the KFS. The revised format no longer includes an obligation to disclose details of the loan amount, interest rate, type of interest, details of moratorium, date of reset of interest, installment type, loan tenure, the purpose of the loan, fees and other charges, as well as the details of the grievance redressal mechanisms now exclusively appear in the KFS. Further, other substantive aspects have been retained, i.e., details of the security/collateral for the loan, details of the insurance, conditions for disbursement of the loan, repayment of the loans and interest, procedure to be followed for recovery, the date on which annual outstanding balance sheet will be issued, and details of the customer services.

This updated approach simplifies the compliance process for HFCs by clearly defining where specific information should be disclosed. It reduces redundancy and ensures that borrowers can find critical information in a consolidated format without surfing through repetitive disclosures.

Consolidation of Circulars

The following circulars and notifications have been consolidated under the HFC Directions pursuant to the update:

Details of circulars consolidated	Our resources on the topic
Key Facts Statement (KFS) for Loans & Advances	The Key to Loan Transparency: RBI frames KFS norms for all retail and MSME loans
Master Directions on Fraud Risk Management in Non-Banking Financial Companies (NBFCs) (including Housing Finance Companies)	Revamped Fraud Risk Management Directions: Governance structure, natural justice, early warning system as key requirements
Guidance Note on Operational Risk Management and Operational Resilience	Risk Management Function of NBFCs – A Need to Integrate Operational Risk Management & Resilience
Review of Risk Weights for Housing Finance Companies (HFCs)	HFCs: risk weights for undisbursed home loans rationalised
Investments in Alternative Investment Funds (AIFs)	Some relief in RBI stance on lenders’ round tripping investments in AIFs
Frequency of reporting of credit information by Credit Institutions to Credit Information Companies	–

Conclusion

To summarise, the recent updates to the HFC Directions not only consolidate past circulars but also clarify the relationship between the MITC and KFS. HFCs can now navigate their disclosure requirements more effectively, enhancing transparency and making it easier for consumers to understand the terms of their loan.

Our other resources on the topic are:-

Clearing the fog on applicability of SBR norms

October 17, 2024/0 Comments/in Financial Services, NBFCs, RBI /by Team Finserv

Streamlined Regulatory Framework for CICs and HFCs

– Qasim Saif | AVP | qasim@vinodkothari.com

On October 22, 2021, the RBI introduced the Scale-Based Regulation (SBR) framework for NBFCs through the circular titled “A Revised Regulatory Framework for NBFCs” (‘SBR Circular’)^[1]. This framework applied to all NBFCs, including Core Investment Companies (CICs) and Housing Finance Companies (HFCs), both placed under the Middle Layer or the Upper Layer (and not in the Base layer), as the case may be.

RBI proposes major regulatory restrictions on bank NBFCs and HFCs

October 7, 2024/0 Comments/in Financial Services, Housing finance, NBFCs, RBI /by Vinod Kothari

– Vinod Kothari, finserv@vinodkothari.com

Banking regulation is slated to get into a group-wide regulatory framework, embroiling group entities of banks. According to a draft of the proposed regulation circulated on 4th October, 2024,^[1] (“Draft Proposal”) NBFCs in the bank group, engaged in lending or housing finance shall be treated as Upper Layer entities, and additionally, shall be subject to the restrictions on lending as applicable to banks. The proposed regulations also provide that there shall be no overlap between the business carried by the bank^[2], and that by bank group entities, which, literally, would mean that lending and asset finance business cannot be done by banking group companies, and if the bank has a housing finance subsidiary, housing finance can be done only by the housing finance entity.

Once the draft circular, expected to force banks to do a major group rejig, is finalised, banks will have 2 years time to comply with it. The restrictions are proposed to be put by way of amendments to the 2016 Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016^[3] (‘Master Directions’).

The following are some of the major proposals:

Certain activities can be carried only by subsidiaries, and not by banks departmentally

These include activities listed under paragraphs 13, 14(a), 14(b), 15, 16, 17 and 22 in Chapter – III of the Master Directions viz. mutual fund business, insurance business, pension fund management, investment advisory services, portfolio management services and broking services or other such risk-sharing activities that require ring-fencing. While out of the list aforesaid, mutual fund business and Insurance business with risk participation, pension fund management investment advisory services, portfolio management service, broking services for commodity derivatives segment were there in the 2016 Directions as well, the new inclusion seems to be “risk sharing activities that require ring-fencing”. This expression will obviously require explanation. Formation of a limited liability entity is sometimes recommended for the reason of ring-fencing, that is, ensuring that the business liabilities do not go beyond the investment made by the shareholder. Hence, if the activity carried by the bank is something that is in the nature of risk absorption or risk participation, the same can be done only through separate entities.

No overlap in permitted businesses

The most challenging requirement would be to ensure that in case of multiple regulated entities in the same banking group, only one entity within the group shall be allowed to engage in a specific type of permissible business. There should not be any overlap between loan products extended by the bank and its group entities. Hence, in case the group has an HFC extending housing loans, the same shall not be extended by the banking entity.

Bank lending restrictions apply to group entities as well

There are numerous restrictions on lending by banks^[4], including lending to connected entities, directors’ interested entities, senior officers, etc. To the extent these are not currently applicable to NBFCs and HFCs, these restrictions will now apply to such entities in the banking group.

Further, the Draft Proposal also provides that group entities shall not be deployed for regulatory arbitrage – they cannot do what is not permitted for the bank.

Bar on investment in Category III AIFs

Banks shall not invest in Cat III AIFs. In case of a bank’s group entities, if the entity is a sponsor of an AIF, it can only hold the minimum investment required as a sponsor [Rs. 1 crore]. Note that earlier in December 2023, the RBI has given a shocker, to curb round tripping of money, prohibiting banks and NBFCs to make investment in such AIFs, which in turn have an investment in borrowers of banks/NBFCs^[5]. Further, prior approval from RBI’s Department of Regulations shall be required before investing 20% or more in the equity capital of any financial services company/ Category I or II AIF either individually or collectively by the bank group

The statutory cap of 30% of investee’s capital to include investments by group companies

It is an important provision of the Banking Regulation Act [Section 19(2)] that restricts a bank from holding more than 30% of the equity capital of an investee. This cap shall now include shares held by group companies as well. In existing practice, NBFCs/lending entities in the group are deployed for holding shares or pledges of more than 30%. In fact, one of the proposed changes speaks about shares held indirectly through “trustee companies” as well, raising a question whether shares held by mutual funds and AIFs will also be aggregated. The answer should be negative, as MF and AIF investments cannot be said to be investments held indirectly by the bank, unless the AIF is majority controlled by the bank.

Capital management to be group-wide

The banking group shall have a group-wide capital management policy, enumerating risks and providing economic capital. Understandably, ICAAP will also have to be monitored on a group-wide basis.

Our comments

Veteran bankers are not surprised by the RBI’s move, though, with expected losses, changes in LCR requirements and lot more in the offing, this seems too much over too short a time. In fact, when the non-operating financial holding company (NOFHC) model was recommended in 2013 by the Parliamentary Standing Committee on Finance, it was laid there that “(T)he general principle is that no financial services entity held by the NOFHC would be allowed to engage in any activity that a bank is permitted to undertake departmentally”. The idea of ring fencing of diverse activities was inspired by the need for controlling contagion, alleviation of regulatory arbitrage, etc. The RBI’s Internal Committee named P K Mohanty Working Group also made similar recommendations.

The proposed changes are clearly aimed at curbing any possibility of regulatory arbitrage. Currently, most foreign banks in India have non-banking finance companies; several Indian banks also have NBFCs which are quite large in size and do things which the bank does. In some cases, such as lending against shares, given the NBFC lending norms being more liberal, NBFCs are used for loans against shares, particularly for funding equity investments by group holding companies. Further, NBFCs are not subject to the statutory limit of 30% of the investee company’s capital, by way of ownership, pledge or mortgage. This liberty will no longer be available.

As regards housing finance entities forming part of banking groups, unless the RBI provides a carve out, there will be need to do major corporate restructuring. There are large home loan portfolios both within banks, as also in bank group HFCs. The bank will either need to spin off the housing finance business, or to consider stake sale in HFCs to bring them out of the “group company” definition.

In short, once the proposed changes are finally coded, the banking sector in the country is headed for some very far reaching restructuring changes.

^[1] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/DRAFTCIRCULAR0410202419AC7BEE698D41F4BF221D39468A9E59.PDF

^[2] There is a list of permissible activities that can be undertaken by the bank, laid down in Master Direction- Reserve Bank of India (Financial Services provided by Banks) Directions, 2016 (Updated as on August 10, 2021)

^[3] 25MD2605164EDAA7B1E214468EBE2D7CC406CA6648.PDF (rbi.org.in)

^[4] Prescribed under Master Circular- Loans and Advances – Statutory and Other Restrictions 95MND246C0F34D0041F6831205AB5D695422.PDF (rbi.org.in)

^[5] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0

Other related resources:

RBI bars lenders’ investments in AIFs investing in their borrowers

Surging gold loan business sets off RBI alarm

October 1, 2024/0 Comments/in Financial Services, NBFCs, RBI /by Team Finserv

Several practices in gold lending pointed by supervisor; 3 months’ time to mend ways

– Team Finserv (finserv@vinodkothari.com)

The Reserve Bank of India (‘RBI’) issued a notification dated September 30, 2024^[1] raising concerns on the irregular practices observed in the grant of loans against pledge of gold ornaments and jewellery.

The RBI’s comprehensive review has unveiled notable deficiencies, including lapses in due diligence process, credit appraisals, ineffective monitoring of loan-to-value (LTV) ratios, a lack of transparency in the auctioning of jewellery upon default and so on. This notification compels all commercial banks, primary co-operative banks, and non-banking financial companies to undertake a meticulous evaluation of their existing gold lending processes and rectify identified gaps or shortcomings.