Should OCI be included as a part of Tier I capital for financial institutions?

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India has been adopted International Financial Reporting Standards (IFRS) in the form of Indian Accounting Standards (Ind AS) in a phased manner since 2016. Different implementation schedules have been issued by different regulatory authorities for different classes of companies and they are:

  • Ministry of Corporate Affairs –
    • For non-banking non-financial companies – Implementation schedule started from 1st April, 2016
    • For non-banking financial companies – Implementation schedule started from 1st April, 2018
  • Reserve Bank of India –
    • For banking companies – The original scheduled start date was 1st April, 2018, subsequently, it was shifted to 1st April, 2019. However, a recent notification from the RBI has shifted the implementation schedule indefinitely.[1]
  • Insurance Regulatory Development Authority of India –
    • For insurance companies – The implementation schedule starts from 1st April, 2020.

Consequent upon implementation of IFRS, it is logical that the regulatory framework for financial institutions will also require modifications to bring it in line with the provisions requirements under the new standards.

Though the Ind AS already been implemented in the NBFC sector, no modifications in the existing regulations have been made. Consequently, this has led to the creation of several ambiguities; and one such is regarding treatment of the Other Comprehensive Income (OCI), as per Ind AS 109, for the purpose of computing Tier 1 capital.

This write up will solely focus on the issue relating to treatment of OCI for the purpose of Tier 1 capital.

Other Comprehensive Income (OCI)

Before delving further into specifics, let us have a quick recap of the concept of the OCI. The format of income reporting under Ind AS has undergone a significant change. Under Ind AS, the statement of profit or loss gives us Total Comprehensive Income which consists of a) profit or loss for the period and b) OCI. While the first component represents the profit or loss earned by the reporting entity during the financial year, OCI represents unrealized gains or losses from financial assets of the reporting entity.  

The intention of showing OCI in the books of the accounts, is that it protects the gains/losses of companies from oscillation. As the fair values of assets and liabilities fluctuate with the market, parking the unrealized gains in the OCI and not in the P/L account provides stability. In addition to investment and pension plan gains and losses, OCI also captures that the hedging transactions undertaken by the company. By segregating OCI transactions from operating income, a financial statement reader can compare income between years and have more clarity about the sources of income.

While profit or loss earned during the year forms part of the surplus or other reserves in the balance sheet, OCI is shown separately under the Equity segment of the balance sheet.

Capital Risk Adequacy Ratio

Moving on to the meaning of capital risk adequacy ratio (CRAR), it is a measurement of a bank’s available capital expressed as a percentage of a bank’s risk-weighted credit exposures. The CRAR is used to protect creditors and promote the stability and efficiency of financial institutions. This in turn results in providing protection against insolvency. Two types of capital are measured: Tier-I capital, which can absorb losses without a bank being required to cease trading, and Tier-II capital, which can absorb losses in the event of a winding-up and so provides a lesser degree of protection to depositors.

The concept of CRAR comes from the Basel framework laid down by the Basel Committee on Banking Supervision (BCBS), a division of Bank of International Settlement. The latest framework being followed worldwide is Basel III framework.

RBI has also adopted the Basel framework, however, with modifications to suit the economic environment in the country. The CRAR requirements have been made applicable to banks as well as NBFCs, however, the requirements vary. While banks are required to maintain 9% CRAR, NBFCs are required to maintain 15% CRAR.

To understand whether OCI should form part of CRAR, it is important to understand the components of CRAR.

Components of Tier I and II Capital as per RBI Master Directions[2] for NBFCs

For the purpose of this write-up, requirements have been examined only from the point of view of NBFCs, as Ind AS is yet to be implemented for banking companies.

CRAR comprises of two parts – Tier I capital and Tier II capital. Each of the two have been defined in the Master Directions issued by the RBI, in the following manner:

(xxxii) “Tier I Capital” means owned fund as reduced by investment in shares of other non-banking financial companies and in shares, debentures, bonds, outstanding loans and advances including hire purchase and lease finance made to and deposits with subsidiaries and companies in the same group exceeding, in the aggregate, ten percent of the owned fund; and perpetual debt instruments issued by a non-deposit taking non-banking financial company in each year to the extent it does not exceed 15% of the aggregate Tier I Capital of such companies as on March 31 of the previous accounting year;

The term “owned funds” have been defined as:

“owned fund” means paid up equity capital, preference shares which are 9 compulsorily convertible into equity, free reserves, balance in share premium account and capital reserves representing surplus arising out of sale proceeds of asset, excluding reserves created by revaluation of asset, as reduced by accumulated loss balance, book value of intangible assets and deferred revenue expenditure, if any;

Tier II capital has been defined as:

(xxxiii) “Tier II capital” includes the following:

  • preference shares other than those which are compulsorily convertible into equity;
  • revaluation reserves at discounted rate of fifty five percent;
  • General provisions (including that for Standard Assets) and loss reserves to the extent these are not attributable to actual diminution in value or identifiable potential loss in any specific asset and are available to meet unexpected losses, to the extent of one and one fourth percent of risk weighted assets;
  • hybrid debt capital instruments;
  • subordinated debt; and
  • perpetual debt instruments issued by a non-deposit taking non-banking financial company which is in excess of what qualifies for Tier I Capital, to the extent the aggregate does not exceed Tier I capital.

The above definitions of Tier I and II capital do not talk about OCI. However, the Directions were prepared before the implementation of Ind AS 109 and no clarity on the subject has come from RBI post implementation of Ind AS 109.

Therefore, for determining whether OCI should be made a part of Tier I or Tier II capital, we can draw reference from Basel III framework.

Components of Tier I capital as per Basel III framework [3]

As per Para 52 of the framework, the Tier I capital consists of:

Common Equity Tier 1 capital consists of the sum of the following elements:

  • Common shares issued by the bank that meet the criteria for classification as common shares for regulatory purposes (or the equivalent for non-joint stock companies);
  • Stock surplus (share premium) resulting from the issue of instruments included Common Equity Tier 1;
  • Retained earnings;
  • Accumulated other comprehensive income and other disclosed reserves;
  • Common shares issued by consolidated subsidiaries of the bank and held by third parties (ie minority interest) that meet the criteria for inclusion in Common Equity Tier 1 capital. See section 4 for the relevant criteria; and
  • Regulatory adjustments applied in the calculation of Common Equity Tier 1

Retained earnings and other comprehensive income include interim profit or loss. National authorities may consider appropriate audit, verification or review procedures. Dividends are removed from Common Equity Tier 1 in accordance with applicable accounting standards. The treatment of minority interest and the regulatory adjustments applied in the calculation of Common Equity Tier 1 are addressed in separate sections.

The Basel III norms clearly states that accumulated other comprehensive income forms a part of the Tier I capital.

It is very interesting to note that RBI had also adopted Basel III framework on July 1, 2015, however, the framework adopted and introduced is silent on the treatment of the OCI, unlike the original Basel III framework. The reason for the omission of the concept of OCI is that the framework was adopted in India way before Ind AS implementation and under the erstwhile IGAAP, there was no concept of OCI or booking of unrealized gains or losses in the books of accounts.

It is well understood that due to the very recent implementation of IndAS 109, the guidelines have not been revised in line with the IndAS. However, going by the spirit of Basel III regulation, this leaves us very little doubt what the treatment of OCI for the purpose of CRAR computation should be. Therefore, one can safely conclude that the OCI should form part of Tier I capital, unless, anything contrary is issued by the RBI subsequently.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11506&Mode=0

[2] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/45MD01092016B52D6E12D49F411DB63F67F2344A4E09.PDF0

[3] https://www.bis.org/publ/bcbs189.pdf

Guidelines for Review of Loans and Investments by the Audit Committee

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Team Vinod Kothari & Company
corplaw@vinodkothari.com

Background

 

Securities and Exchange Board of India (Listing Obligations and Disclosure Requirement) Regulations, 2015 (‘Listing Regulations’) as well as Companies Act, 2013 (‘Act, 2013’) specify the role of the audit committee and mandates the audit committee to mandatorily review certain matters. Among the matters to be reviewed by the audit committee, section 177 of the Act, 2013 provides for review of inter-corporate loans and investments. Additionally, under Regulation 18 read with Schedule II and Regulation 24 of the Listing Regulations, the audit committee shall review the utilization of the loans/advances given to subsidiaries which exceed a certain threshold and shall also review the financial statements of its unlisted subsidiary.

 

The intent of audit committee review is to provide an independent view of the strength, objectivity and transparency of long-term investments made by the company and financial exposures taken by the company into other entities. Additionally, the audit committee may also review whether the loans/investments are still serving the purpose that they were intended to achieve, and whether the health/fair value of the loans and investments has substantially been affected over time. The audit committee’s review may also become the basis for strategic decisions on continuing the said financial exposures.

 

In case of subsidiaries, they are a part of the extended enterprise led by the holding entity. The holding entity puts in capital and other resources into subsidiaries. The subsidiaries are engaged in specific activities/verticals based on the business model of the enterprise. The subsidiaries may make further downstream investments and thus, create a network, once again, within the larger group objective of the enterprise. However, the review by the audit committee ensures that the subsidiaries are serving the larger group objective that they were designed to serve.

 

The following is a guideline as to what should be the perspective of the review and the specific areas of concern for such loans and investments which are placed for review/scrutiny before the audit committee; when such review is to be made etc. Further, the perspective and purpose of the audit committee is different while reviewing the loans and investments to its subsidiaries and that given to others.

Relevant provisions of Listing Regulations:

 

Regulation 24(2):

 

“The audit committee of the listed entity shall review the financial statements, in particular, the investments made by the unlisted subsidiary.”

 

Para A of Part C of Schedule II:

 

“The role of the audit committee shall include the following:

…

  1. Scrutiny of inter-corporate loans and investments.

XX

  1. reviewing the utilization of loans and/ or advances from/investment by the holding company in the subsidiary exceeding rupees 100 crore or 10% of the asset size of the subsidiary, whichever is lower including existing loans / advances / investments existing as on the date of coming into force of this provision”

Parallel provisions of Companies Act, 2013:

 

Section 177(4) 

“Every audit committee shall act in accordance with the terms of reference specified in writing by the board which shall, inter alia, include:

…

(v) Scrutiny of inter-corporate loans and investments;

…”

 

Clarification on the terms loans, advances and investment

 

Need to review inter corporate loans and investments by the audit committee:

 

Inter corporate loans and investments made by the company implies a long term financial exposure. Generally speaking, unless the company is into the business of making investments, the inter-corporate investments are not directional investments; they are strategic in nature. Similarly the inter-corporate loans, except in case of companies engaged in the business of lending, are not intended for reaping interest income. Therefore, the review of these long-term financial exposures to be taken by the audit committee is to ensure that these outlays of funds do not lead to long-term resources of the entity being diverted to a purpose which is not congenial or related to the corporate objective. The objective also includes review of the health and integrity of these loans and investments. Where required, disinvestment calls may also have to be taken based on review by the audit committee.

 

While the law requires the audit committee to review the inter-corporate loans and investments, there seems to be no reason for excluding the review of guarantees/ securities provided by the company in connection with the loan.

 

Need to review investments in and made by the unlisted subsidiaries:

 

The holding company invests in the capital of subsidiaries. While the need for reviewing the investment in subsidiaries does not come from the Companies Act, 2013, the Listing Regulations specifically requires the listed holding company to review the investments of its unlisted subsidiaries. The investments made by the subsidiaries are indirect investments of the holding company itself. Where the subsidiaries are listed entity, the investments made are subject to similar review by their audit committee. However, in case of unlisted subsidiaries, there is less likelihood that the subsidiary will have its own audit committee. Irrespective, the audit committee of the holding listed entity is entrusted with the responsibility of monitoring and reviewing the investments made by such subsidiaries. The audit committee of the holding company has to review such investments to understand if there is any diversion from the objectives of the investment. Further, in case of downward investment by the subsidiary, the audit committee shall review whether the larger objective of the holding company is being served.

 

Need to review loans given to unlisted subsidiary

 

The audit committee the holding company is required to review whether the loans granted by it to its subsidiary is being utilized for the approved purpose or not. Any case of diversion of funds has to be brought to the notice of the audit committee since any sort of funding to the subsidiary is always with an intent of expanding or stabilizing the operations of the holding company. Further, the audit committee while reviewing needs to check whether the terms on the loan are reasonably fair and at arm’s length.

 

Scope of ‘loans’ to be reviewed by audit committee:

 

The audit committee of the listed entity is required to scrutinize inter-corporate loans availed/ granted by the listed entity. Inter- corporate loans for the purpose of review shall include-

 

  • Inter-corporate guarantees given by the listed entity;
  • Inter-corporate security provided by the listed entity;
  • Loans with terms and conditions substantially at variance with the loans ordinarily provided;
  • Guarantees with terms and conditions substantially at variance with the guarantees usually provided;
  • Loans other than in the ordinary course of business

 

Loans/ guarantees which are granted or security provided in the ordinary course of business or to exempted categories need not be reviewed by the audit committee.

 

Scope of ‘Investments’ to be reviewed by audit committee:

 

Investments as are assets held by an enterprise for earning income by way of dividends, interest, and rentals, for capital appreciation, or for other benefits to the investing enterprise. Assets held as stock-in-trade are not ‘investments’.

 

Investments which shall be reviewed by the audit committee of the listed entity will include strategic investments made with the motive to earn yield or regular investment income. Investing the funds reduces the investible funds of the entity, funds available for business and therefore it is necessary to review the same. Investments should not be restricted to investments in securities only. Investment in the assets/property should also be covered within the ambit. Certain investments, as specified here under, need not be included within the ambit:

 

  • Trade investments made by the listed entity or its unlisted subsidiary;
  • Investments made in the ordinary course of business;
  • Statutory investments made under applicable law;

 

Specific concerns for review by the audit committee:

 

The perspective of the audit committee is different while scrutinizing loans and investments of the listed entity as well as while reviewing the investments made in/by the unlisted subsidiary. For this purpose the following points should be included by the audit committee in its review –

 

1.      Specific concerns for loans to other entities

 

  • Purpose of loan, how does it serve the business interest of the company;
  • Tenure of loan;
  • Where the company has raised any money by issuing any shares/ debentures, does the giving of the loan amount to utilization of issue proceeds for a purpose other than that disclosed in the offer document;
  • Rate of interest appropriate in view of credit risk of investee;
  • Security interest and liquidity;
  • Whether the loan is being serviced or has become impaired;
  • Whether the quality of the borrower has deteriorated;
  • Whether repayment happens as per stated repayment schedule;
  • Whether there exists a scope for premature repayment;
  • Whether there exists any reason to opt for premature repayment;
  • If loan is not to a related party, how and why the transaction emanate;
  • Whether the loan has been extended on reasonably fair terms and conditions and at arm’s length.

2.      Specific concerns for investment in other entities

 

  • Purpose of investment, how does it serve the business interest of the company;
  • Whether there has been any diversion in utilizing the investment of the company from the objects and purposes approved by the audit committee;
  • Whether the subsidiary has made any downstream investment and whether such downstream investment is at par with the objectives of the investment of the company
  • Performance of investment – in terms of yield, returns;
  • Likely performance of the investment in future;
  • Liquidity of the investment;
  • Any reason to seek liquidation/ exit from investment.

  

  1. Specific concerns in case of subsidiaries

 

While many of the above may not be relevant in case of subsidiaries, the following areas of concern shall be looked into by the audit committee in case of loans and investment made:

 

Loans

 

  • Whether the loan is being utilized for the purposes approved by the company;
  • Is there any diversion in the end use of the loan;
  • Covenants of the loan, particularly, with a view to ensure that there are no chances of diversion of funds from the purpose for which they are purportedly intended to be provided.

 

Investment

 

  • Whether there has been any diversion in utilizing the investment of the company from the

objective and purposes approved by the audit committee;

  • Whether the subsidiary has made any downstream investment and whether such downstream investment is at par with the objectives of the investment of the company;
  • Whether the investment made is a fit case for impairment considering the performance of the investee company.

On-going review by audit committee:

 

As per Regulation 24(2), investments of the unlisted subsidiary shall be reviewed by the audit committee of the holding listed entity at the time of review of financial statements of the unlisted subsidiary. Financial statements are prepared annually; therefore, the review shall be done on an annual basis for the investments made by unlisted subsidiaries during the year.

 

Further, as per Clause 9 of Para A, Part C of Schedule II to Listing Regulations the loans/ investments of the listed entity shall be subject to scrutiny by its audit committee before making investment/disbursing loans, to the extent possible or after the same have been made.

 

Furthermore, the holding company also reviews the following in case of its unlisted subsidiary, on an on-going basis:

 

  • Whether the subsidiary has sufficient accumulated reserves while considering its performance;
  • Whether the dividend policy of the subsidiary is in line with the larger objectives of the holding company;
  • Whether the subsidiary has large amount of surplus lying in its books so as to enable it to plan a buy back.

 

Format for reporting to the audit committee

 

There is no specific format for reporting the performance / status report to the audit committee for enabling the committee to review the same. However, the same may be reported in the following manner:

 

Sr. No Particulars of investment / loan

 

[Name of the party, date of investment or loan, purpose, tenure, etc.]

 Concerns Amount involved Performance / Update
    Whether Secured or unsecured    
What is the yield
Whether liquid or illiquid
Market price of the securities
Whether there is any potential risk associated with the investment /loan
Servicing / repayment schedule
Any change in the credit rating of the investee company

 

Revised Guidelines on KYC & Anti-Money Laundering Measures for HFCs

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Aadhaar Ordinance – Paving way for use of voluntary Aadhaar by Private Companies

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By Simran Jalan (simran@vinodkothari.com)

Introduction

Supreme Court in the case of Justice K.S. Puttaswamy (Retd.) & Anr. V. Union of India, W.P. (Civil) 494/2012 dated September 26, 2018[1] (‘Aadhaar Verdict’) partially quashed section 57 of the Aadhaar Act, which dealt with use of Aadhaar by private companies or bodies corporate. Pursuant to the Aadhaar verdict, the private entities were not allowed to demand Aadhaar for establishing identity unless the same is pursuant to any law.

Consequently, it was proposed to amend the Aadhaar (Targeted Delivery of Financial and Other subsidies, Benefits and Services) Act, 2016 (‘Aadhaar Act’), Indian Telegraph Act, 1885 and the Prevention of Money Laundering Act, 2002 (‘PML Act’) in line with the Supreme Court directives. In order to ensure that personal data of Aadhaar holder remains protected against any misuse and Aadhaar scheme remains in conformity with the Constitution, the Aadhaar and Other Laws (Amendment) Ordinance, 2019[2] (Ordinance) was passed.

In this write-up we intend to discuss the outcome of the Ordinance.

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Simultaneous Claim by a Beneficiary of Guarantee

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By Richa Saraf (resolution@vinodkothari.com)

Introduction

In a recent case of Dr. Vishnu Kumar Agarwal v. M/s. Piramal Enterprises Ltd.[1] Company Appeal (AT) (Insolvency) No. 346 of 2018, the NCLAT has held that an application for initiation of corporate insolvency resolution process for same very claim/debt is not permissible. Now, consider a situation where Company A (guarantor) has guaranteed the loans given to Company B (principal debtor). When Company B defaulted in payment, the creditor issued a notice to Company A invoking the corporate guarantee, however, even Company A failed to make the payment. If Company A and Company B both are undergoing insolvency proceedings (whether corporate insolvency resolution process or liquidation), can the creditor who has already filed its claim for the entire debt due with the IRP/ Liquidator of Company A, also file its claim with the IRP/ Liquidator of the Company B for the entire debt due? Read more →

Press Release: Central Bank of Nigeria appoints Vinod Kothari Consultants for review and drafting of law on securitisation

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The Central Bank of Nigeria (CBN), apex banking authority of the Nigeria, has appointed Vinod Kothari Consultants Pvt. Ltd. (VKC) for review and drafting their domestic law to govern securitisation transactions. The initiative by the apex authority is a part of their Financial System Strategy 2020.

VKC is expected to facilitate enactment of the legislation and regulatory framework for deployment of Asset Backed Securities in banking and capital markets in Nigeria.

VKC has more than two decades of experience in structured finance in and outside India. Vinod Kothari, Director of the firm, is internationally recognised as a trainer, consultant and author on structured finance. In the past, VKC was appointed by the regulatory authorities of Sri Lanka and South Africa to assist them in drafting their law on securitisation.

Vinod Kothari quoted:

Nigeria is rich in natural resources, and is, therefore, a potential issue of future flows based securities. Additionally, the country is an emerging economic force, and therefore, needs to have world-class infrastructure of financial laws in place. In light of this, it is so heartening to get a chance to contribute to the development of securitisation in Nigeria.