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Can CICs invest in AIFs? A Regulatory Paradox

-Anshika Agarwal (finserv@vinodkothari.com)

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

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

What are AIFs (Alternative Investment Funds)?

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

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

What are Core Investment Companies (CICs)?

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

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

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

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

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

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

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

Who are included in Group Companies?

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

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

The Issue with Paragraph 26(a): The paradox

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

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

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

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

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

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

Conclusion

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

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

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

Full Day Workshop on Securitisation,Transfer of Loans and Co-lending

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

– Anshika Agarwal (finserv@vinodkothari.com)

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

Understanding the concept of ‘Outsourcing’

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

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

Regulatory Framework: The RBI’s Perspective

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

Core Management Functions: Non-Negotiable Responsibilities 

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

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

Contractual Engagement for Internal Audit

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

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

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

ICAI Standards: Expertise and Independence in Internal Audits

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

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

The standards indirectly allow for outsourcing when:

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

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

Companies Act, 2013: Flexibility in Internal Audit Assignments

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

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

Conclusion

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

Read our other related resources –

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

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

Credit Information Reporting: Actionables under the New Directions

– Anshika Agarwal (finserv@vinodkothari.com)

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

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:

  1. 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.
  2. The line of credit may be tapped any time, and does not have any major end-use restrictions, except, may be a negative list. 
  3. It may be paid back any time.
  4. 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.
  5. 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

  1. 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.
  2. 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. 
  3. 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:

  1. Receivables discounting: Sellers of goods and services sell individual or multiple receivables to a finance provider at a discount.
  2. 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.
  3. 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.
  4. 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 DistinctionSCF RLOC
Purpose and End-Use RestrictionsIn 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 RepaymentIn 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 RateCredit 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.

Financial Sector Regulator – ‘Rule of Law’ Review

– Aditya Iyer (adityaiyer@vinodkothari.com)

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