Posts

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

/0 Comments/in , , /by

– Vinod Kothari (vinod@vinodkothari.com)

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

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

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

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

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

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

Regulatory carve outs

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

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

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

Three situations requiring approval

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

  1. Takeover or acquisition of control

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Change in Control:

  1. Change in management

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

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

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

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

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

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

Intra-group transfers

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

Here is an excerpt from the RBI FAQs:

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

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

Corporate Restructuring

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

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

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

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

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

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

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

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

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

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

Changes in P2P Norms: Collapse of the marketplace model?

/0 Comments/in , /by

Vinod Kothari | finserv@vinodkothari.com

Introduction

The RBI’s 16th August 2024 changes in P2P Directions  may have been inspired by its supervisory observations, and comments by some observers and experts, but the likely impact of the changes may be to make this disintermediation model operationally tough to the extent of unviability. 

The key spirit of the amendments is that P2P Platforms (P2PPs) cannot function as virtual alternative deposit-taking entities, promising liquidity, reinvestment and giving tacit assurance of rates of interest. However, to enforce its intent, the regulator has also provided that the lenders’ funds will be called only on “just in time” basis, that is, only when they can be lent within a day. Further, the regulator has put specific stipulation against any secondary market in loans on a P2PP, whereas, for any mode of savings or investment, an exit when needed is a necessary attribute.

Just-in-time availability of lenders:

P2P, like any platform, premises itself on the ability to match the two parties to the bargain. To the borrower, it has to promise funds; and to the lender, it has to promise deployment. Since no borrower may conceivably wait until the P2PP ramps up requisite lenders, the only intuitive solution would be that the P2PP gets lenders, keeping their money in readiness mode, to be deployed when borrowers are available. However, the regulator has now prescribed that, effective 15th November, the funds in lenders’ escrow should not be there for more than 1 day.

It is important to realise, and it seems that this point has escaped attention of the regulator, that funds in lenders’ escrow need to be a state of readiness for 2 reasons: one, at the time of the lender first investing his money; and secondly, as repayments trickle in from the various loans given to borrowers. As a matter of prudent spreading of the risks of a lender, one particular lender’s funds are not lent to a single borrower – on the contrary, the funds are spread, say over 100 or even larger number of borrowers (a process called “mapping”, which has been recognised by the regulator). Thus, each lender would have lent to hundreds of borrowers, and each borrower would have borrowed from hundreds of lenders. Thus, for each such lender, money starts trickling in small bits and pieces every month. If this money is not reinvested into new loans, the lender’s whole purpose, which was to keep money invested and not just to invest it in one cycle of loans, will not be met. Now, between the repayment of the existing loans, and the redeployment into new loans, there may be a time gap, which may be a few days. Under the new regulatory framework, if the money is not redeployed within a day, the money will have to flow back to the lenders.

If the regulator’s expectation is that the P2PP would be making calls on lenders every time there are borrowers, and the lenders will have ready availability of funds to meet such calls, it is quite an impractical expectation. Such a perfect match between cash inflows and cash outflows is aggressively optimistic. In global markets, there are “warehouse financiers” who provide temporary funding to meet these gaps, but that is not the case in India.

In fact, the whole existential idea of P2PPs is disintermediation.

If the Airbnb model will become impractical if the platform starts searching for houses only when an occupier is ready to check-in, the same argument applies with a stronger force in case of loan-connecting platforms. 

It seems the regulator may not have been happy with the redeployment of funds by the P2PP, but that is exactly what a lender would want and need. The lender should be free to choose to reinvest his funds, or retrieve them, to be able to get a slow exit.

Lenders providing exit to lenders

In P2PP, a lender provides loans to borrowers; but can a lender buy existing loans given by other P2PP lenders to borrowers? A priori, there should be no reason why a lender could have given a loan to an unknown borrower, but couldn’t have bought the loan taken by an existing borrower. After all, for existing loans, there is a history of performance as well as seasoning. If existing loans given by a lender are bought by incoming lenders, the process will lead to creation of a so-called “secondary market”, which will allow existing lenders to exit by selling their portfolio of loans to incoming lenders. It is in the public domain that the P2P industry has been making a case for such secondary market. 

The amended Directions have inserted a clause in reg 6 (1) to say: “NBFC-P2P shall not utilize funds of a lender for replacement of any other lender(s)”. This clause may either be interpreted to mean that there is an absolute bar on secondary marekt in P2P loans. Or, there may be another interpretation: that the right of using the funds of a lender to buying existing lenders shall not be available to the P2PP. However, if that is something that the incoming lender himself wants, that is the exercise of a prudent discretion by the incoming lender, and there should be nothing wrong with that. If it is the first interpretation that the regulator has, then putting a bar on secondary market is most undesirable, given the nature of P2P investing. Exit opportunity is needed for almost every mode of investment. But it becomes critical inthe case of P2P investing, because of the granular spreading of the loans discussed above. Therefore, every lenders’ loans trickle back over a long period, and if the lender has chosen to reinvest the repayments, the period becomes infinite. If at any stage the lender needs to exit, he will have to wait for months and months for the loans to repay. Since need for exit may arise due to exigencies which cannot wait, the slow and protracted exit is unlikely to serve the needs of the lender. As a result, it is only such lenders, and only for a very small part of their lendable portfolios, who can afford to invest in P2PPs, making it a leisurely investing game of one who is flush with money. The whole idea of P2PPs is to take them to a modest lender, so that he may lend at affordable rates to a modest borrower. The idea of reducing cost of lending by a lending marketplace can only be met if the platforms become more and more inclusive on either end. Putting a bar on the secondary market will make it exclusive, rather than inclusive.

See P2P India Report 2023 here

Revamped Fraud Risk Management Directions: Governance structure, natural justice, early warning system as key requirements

/0 Comments/in , , /by

– Team Finserv | finserv@vinodkothari.com

Loader Loading…
EAD Logo Taking too long?

Reload Reload document
| Open Open in new tab

Download as PDF [957.10 KB]

Reporting of Fraud – Resource Centre
Watch our Shastratha this Friday on 26th July, 2024 through: https://youtube.com/live/rSMHiRVD2eE?feature=share

Other Related Articles:

  1. Classification of fraud and reporting – Vinod Kothari Consultants
  2. FAQs on Fraud Reporting
  3. Practical Guide to Fraud Reporting

Is half-truth a lie: Hidden Costs in zero-interest loans

/0 Comments/in /by

-Chirag Agarwal & Archisman Bhattacharjee I finserv@vinodkothari.com

In the realm of personal finance, the attraction of borrowing money without incurring interest charges is an enticing prospect. Zero percent interest rate loans, often advertised as promotional offers by retail financing companies, credit card companies, retailers, and financial institutions, have garnered significant attention in recent years. But what exactly are these loans? Are they really zero-interest loans? No one would believe that the lender is getting zero income on the loans. And if the lender is indeed getting some income, even if not from the borrower, that income is not completely disconnected with the loan. Therefore, are there fair disclosure requirements that may require the lender to disclose his yield on the so-called zero interest loans?

Zero percent financing refers to a loan where no interest is applied, either throughout its duration or for a set period.

One form of zero percent interest rate loans is known as merchant subvention. In this model, the seller or manufacturer of the product assumes responsibility for paying the interest to the lender. This arrangement allows the merchant to effectively market and sell the product, attracting more customers to  the merchant’s  business. Meanwhile, the customer gets the perceived  “feel good” benefit of obtaining the product at a zero percent interest rate. If happiness is all about feeling good and not necessarily being good, it is  a mutually beneficial situation for the buyer, seller and the lender.

Another form of zero percent loan may be where lenders load additional charges in some form other than interest, and pretend to provide an interest-free loan. These could comprise of of a one-time high processing fees, or similar other charges, which disguise the  interest component . This practice, we understand,  is deceptive and is against the concept of fair lending. Hence, if the lender is charging interest in form of the so-called “other charges”,  and claims to be providing interest-free loan, that is a case of lie. However, in this article, we are not dealing with a lie – we are dealing with a half-truth. .

And what is that half truth? , If the lender is making his target yield by way of third party cashflows, such as merchant subvention, product discount, etc., is it fair for the lender to demonstrate that he is lending free of interest? .

Understanding the mechanism of merchant subvention

It is a well-established practice among dealers or manufacturers to offer subventions or discounts on products to customers availing loans from financial institutions. In such instances, banks/NBFCs, leverage their volumes and vendor relationships to secure favourable terms. Here, it becomes imperative that these benefits are passed on to customers without altering the applicable rate of interest (RoI) of the product. Furthermore, the actual discount is not provided by the bank/NBFC, but by the merchant as a part of the merchant’s customer acquisition strategy. As a regulated entity, the lender is expected to ensure full and transparent disclosure of these benefits to customers

Hence, the lender showing the loan as 0% is essentially passing the discount or benefits   provided by the merchant to the lender. It cannot be contended that the lender would have bought the product or service but for the purpose of the loan. In fact, the lender is not the actual purchaser; the lender is simply aiding or pushing the sales of the merchant by offering credit. It is the credit facility that triggers the purchase; it is the purchase that triggers the discount. Hence, there is a clear nexus between the grant of the merchant’s benefits to the lender.

Quite often, the issue is – will the customer be able to get the same discount, subvention or benefits if the customer was to make a direct purchase from the vendor? The answer will mostly be negative. The lender has a relationship with the vendor, whereby the lender gives volumes as well as regular business. But no lender will obviously do a loan without a threshold rate of return. There is absolutely nothing wrong in saying that the interest charged to the customer is zero, but at the same time, to not make basic disclosure about the extent of discount or benefits that the lender gets from the merchant will be a case of half truth.

The following is a diagrammatic illustration of how the concept of merchant subvention works

The concept of annualised percentage rate (APR) has also been introduced to enhance transparency and reduce information asymmetry on financial products being offered by different regulated entities, thereby empowering borrowers to make informed financial decisions. Accordingly, discussion on what is APR and how merchant subvention should be disclosed holds precedence.

Definition of APR

In India, as per Key Facts Statement (KFS) for Loans & Advances the term APR ”is the annual cost of credit to the borrower which includes interest rate and all other charges associated with the credit facility”. The said circular covers retail loans, MSME term loans, digital loans, MFI loans, and all loans extended by banks to individuals. Our FAQs on the said circular can be read here.

Further, as per Para 2(a)(iii) of the Display of information by banks APR allows customers to compare the costs associated with borrowing across products and/ or lenders. Further, through the circular dated September 17, 2013 the RBI emphasised that it is important to ensure that the borrowers are fully aware of associated benefits, with emphasis on indiscriminately passing on such benefits without altering the Rate of Interest (RoI). To address this, the RBI directed that when discounts are provided on product prices, the loan amount sanctioned should reflect the discounted price, rather than adjusting the RoI to incorporate the benefit.

The Consumer Credit (Disclosure of Information) Regulations 2010, which is a UK regulation defines the term APR as “annual percentage rate of charge for credit xx…. and the total charge for credit rules”. Further, as per the regulation, APR helps the borrowers compare different offers.

The Truth in Lending (Regulation Z) defines APR  in the case of closed-end credit as a “measure of the cost of credit, expressed as a yearly rate, that relates the amount and timing of value received by the consumer to the amount and timing of payments made”.

Components of APR

       I.            India

In accordance with the definition as provided under the Key Facts Statement (KFS) for Loans & Advances APR includes the following:

  1. Rate of interest
  2. Associated charges
  1. Processing fee
  2. Valuation fee
  3. Other non-contingent charges

c. Third-party service provider fees/charges (if collected by lender on behalf of third-party)

  1. Insurance charges
  2. Legal charges
  3. Other charges of similar nature

However, excluding contingent charges like penal charges, foreclosure charges, etc.

The intent is to have simple transparent, and comparable (STC) terms of the loan communicated to the customer upfront and hence, an illustrative example for the computation is provided. The illustration includes all charges that the RE levies.

     II.            United Kingdom

In accordance with the definition provided, APR refers to the annual percentage rate of charge for credit along with the total charge for credit as provided under credit rule  As per FCA handbook, the total charge for credit, applicable to an existing or potential loan agreement, encompasses the “comprehensive cost” incurred by the borrower.

“Comprehensive cost” includes all pertinent expenses such as interest, commissions, taxes, and any other associated fees that are obligatory for the borrower to be paid in conjunction with the loan agreement.

The FCA handbook further specifies that the total cost of credit includes fees to credit brokers, account maintenance expenses, payment method costs, and ancillary service fees. However, the total cost of credit to the borrower must not take account of any discount, reward (including ‘cash back’) or other benefit to which the borrower might be entitled, whether such an entitlement is subject to conditions or otherwise.

To summarise, the components of APR as per UK regulations are:

  1. Rate of Interest
  2. Commission and taxes
  3. Fees/Charges payable by borrower to agents
  4. Expenses associated with maintaining loan account
  5. Costs linked with means of payment
  6. Costs associated with ancillary services

Further, the following shall not be considered while computing the APR and hence, will be disclosed separately:

  1. Discounts, cashback incentives;
  2. Contingent charges

  III.            USA

Section 107(a)(1)(A) of the Consumer Credit Protection Act outlines how to calculate the annual percentage rate (APR) for credit facilities other than open-ended ones. The APR is the rate that, when applied to the unpaid balance of the loan, equals the total finance charge spread out over the loan’s term. This means that the APR represents the finance charge stretched over the entire duration of the loan. Finance charges, as defined by the Act, include various fees like interest, service charges, origination fees, credit investigation fees, insurance premiums, and other related charges.

Hence, the components of APR as per USA include:

  1. Rate of interest;
  2. Discounts;
  3. Associated charges
  1. Service fees;
  2. Fees associated with loan origination
  3. Charges for credit investigation or reports

d. Third-party service provider charges (such as insurance charges)

Comparative analysis

Upon examining international practices, it becomes evident that the APR encompasses more than just the rate of return; it also incorporates additional charges, often in the form of finance charges, which are annualised over the tenure of the loan. To summarise and consolidate the various laws discussed above, the following factors are considered in determining the APR:

  1. Rate of Interest;
  2. Service charges;
  3. Fees associated with loan origination;
  4. Charges for credit investigation and reports;
  5. Charges for mandatory credit-related insurances, when not separately disclosed in the Key Facts Statement (KFS);
  6. Expenses related to maintaining the account

However, certain elements which are not included in the calculation of APR:

  1. Contingent charges;
  2. Discounts applied to the interest rate.

While US law suggests factoring in discounts when calculating the APR, the stance established by the RBI is clear that: discounts cannot be incorporated when declaring the APR- as the same would be deceptive and shall not disclose the actual bifurcation of cost. Similarly, the perspective under UK law aligns with this stance to separately disclose the merchant discount and deduct it from the APR.

Regulatory concerns

The RBI addressed regulatory concerns pertaining to zero percent loans facilitated by merchant subvention through its circular dated September 17, 2013. A key focus was ensuring borrowers full awareness of associated benefits, with emphasis on indiscriminately passing on such benefits without altering the Rate of Interest (RoI). To address this, the RBI directed that when discounts are provided on product prices, the loan amount sanctioned should reflect the discounted price, rather than adjusting the RoI to incorporate the benefit.

Disclosure of merchant subvention by lenders

As discussed, the rate of interest is a part of the Annual Percentage Rate (APR), which is a measure used by borrowers to compare similar products from different lenders. If the lender changes the rate of interest, it affects the entire APR, making it difficult for customers to compare different loan products. It is important to understand that whether or not there’s a merchant subvention, the rate of return for the lender remains unchanged, hence the APR irrespective of there being any merchant subvention should also remain unaltered.

The RBI through its circular dated September 17, 2013 notified certain “pernicious” practices being followed by banks regarding merchant subvention, whereunder it had provided a specific way of disclosing the discount, which directed that when discounts are provided on product prices, the loan amount sanctioned should reflect the discounted price, rather than adjusting the RoI to incorporate the benefit. We have aimed to understand the requirement of by RBI via an example below:

Assume a lender offers a loan of Rs. 100,000 for 6 months to someone without charging any interest. However, the lender only gives Rs. 95,000 to the merchant, and the remaining Rs. 5,000 is covered by the merchant i.e., the interest component of the loan is recovered from the merchant. The lender still expects the borrower to repay Rs. 100,000. So, to show the true cost in the APR, the lender should disclose the actual amount lent, which is Rs. 95,000, instead of the full Rs. 100,000. Additionally, the lender should include the interest rate the lender is effectively earning, on Rs 95000.  This transparency helps customers understand exactly what they’re paying, making it easier to compare different loan options and lenders.

The circular as mentioned above was directed specifically for banks, however, NBFCs should also be guided by the same principles. There could be another method of disclosing the discount provided by the merchant. For instance, considering the above scenario, let say, the lender provides a loan of Rs. 1,00,000 and the merchant provides a subvention of Rs. 5,000. In this case, the APR is disclosed considering the subvention received from the merchant. Accordingly, the lender shows the loan to be Rs.1,00,000 and the interest of Rs.5000 is shown as a discount to the borrower, which has been recovered from the merchant. Even though the disclosure is being done for the subvention amount, this method does not depict the actual IRR of the lender.  .

Note, however, that the APR computation in the two approaches will be different. The Table below shows the two APRs:

ParticularsFirst optionSecond option
Cost of the asset100000100000
Less: Discount5000 
Net cashflow of the lender95000100000
Interest on the cashflow for 6 months(IRR computed on monthly intervals)10.30%10%
Amount of interest50005000
Less: Discount -5000
Amount paid by the borrower100000100000

As may be noted from the above computation, the first option, computing the APR on a loan size of Rs 95000 shows the APR as 10.30%, while the second approach makes a simple interest computation for 6 months @ 10%. The second approach shows a lower APR than the actual yield.

Accounting

As per IND AS 109 Effective Interest Rate (EIR) has been defined as “The rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial asset or financial liability to the gross carrying amount of a financial asset or to the amortised cost of a financial liability. When calculating the effective interest rate, an entity shall estimate the expected cash flows by considering all the contractual terms of the financial instrument (for example, prepayment, extension, call and similar options) but shall not consider the expected credit losses. The calculation includes all fees and points paid or received between parties to the contract that are an integral part of the effective interest rate,transaction costs, and all other premiums or discounts”.

The definition states that the calculation of EIR will include fees and points paid or received between the parties to the contract that are an integral part of the effective interest. While in normal course, this should refer to the cashflows emanating from the contract between the lender and the borrower. But in the present case, if only the cash flows between the lender and borrower is considered, it will give an EIR of 0%, indicating that the lender is not earning from the transaction, which is not the true picture. The subvention from the third party is an essential element in the entire scheme of things, it is through this the lender is recovering its income. Therefore, in the present context, a wider meaning should be ascribed to  expression parties to the contract that are an integral part of the effective interest; and subvention received from third parties should also be considered for the purpose of determining the effective interest rate and the gross carrying amount of the loan.

The essence of the accounting definition is that cashflows that are “integral part” of the credit facility are included in EIR computation. While the subvention is paid by a third party and not a party to the contract, but it cannot be contended that the subvention is not an integral part of the loan. Taking such a view would lead to an impracticality showing the loan as having zero EIR.

Conclusion

The lure of zero percent interest rate loans is increasingly being used by vendors and lenders, in the realm of personal finance. However, it is crucial to understand the nuances and implications associated with such loans, particularly those facilitated through merchant subvention arrangements. Regulatory concerns have arisen regarding the transparency and fair disclosure of these loans, particularly in ensuring that the actual cost of credit is accurately represented to consumers. Distorting the interest rate structure compromises transparency and hampers informed decision-making by borrowers.

The components of the APR vary across different jurisdictions but universally include factors such as the rate of interest, associated charges, fees, and expenses related to the loan. However, discounts and contingent charges are typically excluded from the APR calculation. To uphold fair lending practices and ensure transparency, lenders must disclose the true cost of credit, including any merchant subvention arrangements, without altering the APR. This transparency empowers consumers to make informed choices and fosters trust in the financial system. A half truth reminds one of the Mahabharat anecdote of “Ashwatthama is dead”, suppressing whether it was elephant or man.

Workshop on RBI Circular on Regulatory Measures on Consumer Credit by Banks & NBFCs

/0 Comments/in , , , /by

– Vinod Kothari | vinod@vinodkothari.com

Loader Loading…
EAD Logo Taking too long?

Reload Reload document
| Open Open in new tab

Download as PDF [598.02 KB]

Our Resources on the topic:-

  1. RBI raises red flag on increasing personal loan
  2. FAQs on Regulatory measures towards consumer credit and bank credit to NBFCs
  3. Workshop on RBI Circular on Regulatory Measures in Consumer Credit by Banks & NBFCs (YouTube live)

Introducing Financial Services on ONDC: Opportunities & Challenges for Digital Lenders

/0 Comments/in , /by

– Shreshtha Barman | finserv@vinodkothari.com

Read more →

AML/ CFT Compliances Expand – RBI Further Amends KYC Master Directions

/0 Comments/in , /by

– Chirag Agarwal | Executive | finserve@vinodkothari.com

Introduction

The Reserve Bank of India (“RBI” or “Regulator”) plays a pivotal role in India meeting its anti-money laundering (AML) and combating financing of terrorism (CFT) obligations as part of its membership with the Financial Actions Task Force (FATF). As the Regulator of the credit sector and payment systems it does so by  ensuring the implementation of robust and up-to-date Know Your Customer (KYC) norms vide its  Master Direction – Know Your Customer (KYC) Direction, 2016 (“KYC Directions”). With a possible FATF evaluation around the corner, on October 17, 2023, the RBI introduced significant amendments to these KYC directives through its notification titled – Amendment to the Master Direction on KYC (“Amendment”), impacting various regulated entities, including Non-Banking Financial Companies (NBFCs).

Read more →

Implementation of Compliance Function by NBFC-ML

/0 Comments/in , , , /by

Eliza Bahrainwala, Executive| eliza@vinodkothari.com

Loader Loading…
EAD Logo Taking too long?

Reload Reload document
| Open Open in new tab

Download as PDF [77.82 KB]

Our related resources on the topic:-

  1. Enhanced Corporate Governance and Compliance Function for larger NBFCs
  2. Compliance Risk Assessment

Our Resource Centre on SBR:

Resources on Scale Based Regulations

Penal charges not a cash-cow for lenders

/1 Comment/in , , /by

RBI issues draft guidelines on fair lending practices for penal charges

– Aanchal Kaur Nagpal, Manager and Dayita Kanodia, Executive | finserv@vinodkothari.com

Introduction

Levying of penal interest/ charges is a punitive measure adopted by lenders on borrowers defaulting in making repayments and/ or breaching any terms and conditions mutually agreed in the loan agreement. The Reserve Bank of India also allows lenders to charge such rates as long as the same are communicated to the borrower and are in accordance with the Board approved policy framed in this behalf.

However, lenders, cashing in on such autonomy and flexibility, have adopted varied practices which are often prejudicial to the borrower. These include charging exorbitant rates, capitalisation of penal charges, charging of penal interest on the loan amount and not the defaulted portion etc.

The RBI, in its Statement on Developmental and Regulatory Policies dated February 08, 2023[1], announced policy measures for introduction of guidelines for regulating the penal charges levied by financial institutions[2]. Pursuant to the same, RBI, on April 12, 2023 has issued a draft circular on Fair Lending Practice – Penal Charges in Loan Accounts (‘Draft Circular’) to persuade lenders to use penal charges for their true compensatory nature and not as a revenue enhancement tool. 

While the Draft Circular comes with good intentions, there are certain provisions that may seem ambiguous and contradictory, and the final guidelines would need to provide sufficient clarity to achieve the desired execution.

Read more →

PML Act and Rules: Recent changes may have new compliance requirements

/1 Comment/in , , , /by

-Team Finserv | finserv@vinodkothari.com

Background

Financial sector entities have to follow PMLA and related rules, including by way of KYC Directions. The Finance Ministry came up with various amendments pertaining to the Prevention of Money-Laundering Act, 2002 (“PML Act”) and the Prevention of Money-Laundering (Maintenance of Records) Rules, 2005 (‘PML Rules’). The amendments pertain to revised thresholds for ascertainment of beneficial ownership (25% to 10%), implementation of group wide policies for compliance with provisions of Chapter IV, expanding the obligations under PMLA to service providers of virtual digital assets, etc.

Effective date and applicability:

The amendment shall be effective from the same date, i.e. March 07, 2023. It may be noted that the Master Direction – Know Your Customer (KYC) Direction, 2016  (‘KYC Directions’) are issued and updated by the regulator based on the amendment in PML Act and PML Rules. However, the Regulated Entities (RE) are required to ensure compliance with the provisions of PML Act and PML Rules, as amended from time to time. Hence, necessary steps must be taken based on the amendments.

Whether applicable to existing or new customers?

Customer Due Diligence (as required under the PML Act and Rules) is required to be undertaken at the time of commencement of a financial transaction or account-based relationship with the customer. Accordingly, necessary steps must be taken by the RE to ensure compliance with the Amendment Rules for all new customers or new financial transactions undertaken with existing customers after March 07, 2023. However, it is also pertinent to note rule 9(12) of the PML Rules which requires reporting entities to exercise continuous due diligence with respect to the business relationship with every clients.

Read more →