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NBFCs licensed for KYC authentication: Guide to the new RBI privilege for Aadhaar e-KYC Authentication

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-Kanakprabha Jethani (kanak@vinodkothari.com)

Background

On September 13, 2021, the RBI issued a notification[1] (‘RBI Notification’) permitting all NBFCs, Payment System Providers and Payment System Participants to carry out authentication of client’s Aadhaar number using e-KYC facility provided by the Unique Identification Authority of India (UIDAI), subject, of course, to license being granted by MoF. The process involves an application to the RBI, onward submission after screening of the application by the RBI, then a further screening by UIDAI, and final grant of authentication by the MoF,

We discuss below the underlying requirements of the PMLA, Aadhaar Act and regulations thereunder (defined below) and other important preconditions for this new-found authorisation for NBFCs.

Understanding the difference between authentication and verification

As per section 2(c) of the Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016 (‘Aadhaar Act’)[2] “authentication” means the process by which the Aadhaar number along with demographic information or biometric information of an individual is submitted to the Central Identities Data Repository for its verification and such Repository verifies the correctness, or the lack thereof, on the basis of information available with it;

Further, Section 2(pa) defines offline verification as the process of verifying the identity of the Aadhaar number holder without authentication, through such offline modes as may be specified by regulations.

Authentication is a process of authenticity of aadhaar information using the authentication facility provided by the UIDAI. The same may be done in any of the following ways:

  • Use of demographic authentication: The Aadhaar number and demographic information of the customer is obtained and matched with the demographic information of the Aadhaar number holder in the CIDR[3].
  • Using one-time pin based authentication: Aadhaar number of customer is obtained. OTP is sent to the registered mobile number and/ or e-mail address. Aadhaar is authenticated when customer shares OTP and is shared with the same generated by UIDAI
  • Using biometric information: The Aadhaar number and biometric information submitted by the customer are matched with the biometric information stored in the CIDR.

Essentially, aadhaar authentication requires the Regulated Entity (RE) to obtain the aadhaar number of the customer. However, owing to the Supreme Court Verdict on Aadhaar, aadhaar number could be obtained only by banks or specific notified entities. Eventually, the concept of offline verification was introduced by virtue of which verification can be done using XML file or QR code which carries minimum details of the customer. RE is not required to obtain aadhaar number in this case.

Understanding the concept of AUA and KUA

The Aadhaar (Authentication) Regulations, 2016 provide the following definitions:

“Authentication User Agency” or “AUA” means a requesting entity that uses the Yes/ No authentication facility provided by the Authority;  

 “e-KYC User Agency” or “KUA” shall mean a requesting entity which, in addition to being an AUA, uses e-KYC authentication facility provided by the Authority;  

 “e-KYC authentication facility” means a type of authentication facility in which the biometric information and/or OTP and Aadhaar number securely submitted with the consent of the Aadhaar number holder through a requesting entity, is matched against the data available in the CIDR, and the Authority returns a digitally signed response containing e-KYC data along with other technical details related to the authentication transaction; 

 To Summarise:

  • AUA’s rights are limited and it gets only a yes or no as a response of aadhaar authentications, i.e. response to whether the aadhaar is authentic or not.
  • KUA’s rights are comparatively broader. It shall receive eKYC details of the customer upon utilising the authentication facility.

Further, there is a concept of sub-AUA and sub-KUA, which utilise the facility of licensed AUAs or KUAs for aadhaar authentication.

Application for AUA/KUA License

Process

The power of granting permission for use of aadhaar authentication facility by entities other than banks is derived from section 11A of the Prevention of Money Laundering Act, 2002[4] (‘PMLA’). It states-

(1) Every Reporting Entity shall verify the identity of its clients and the beneficial owner, by—

(a) authentication under the Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016 (18 of 2016) if the reporting entity is a banking company; or

(b) offline verification under the Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016 (18 of 2016); or

**

Provided that the Central Government may, if satisfied that a reporting entity other than banking company, complies with such the standards of privacy and security under the Aadhaar (Targeted Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016 (18 of 2016), and it is necessary and expedient to do so, by notification, permit such entity to perform authentication under clause (a):

**

In exercise of powers under the above mentioned provisions, the Ministry of Finance (MoF) issued a notification on May 9, 2019[5], providing the process for permitting entities other than banks for using authentication facilities of the UIDAI. The notification provides for the following process:

  • Step1: Application to be made to the concerned regulator
  • Step 2: Examination of the application by concerned regulator
    • To ensure conditions of section 11A of PMLA and other security and IT related requirements are met
  • Step 3: Examination by UIDAI of applications recommended by the regulator
    • To check standards of privacy and security set out by UIDAI are complied with
    • UIDAI to then send notification to the Department of Revenue, MoF
  • Step 4: Notification as AUA/KUA by MoF
  • Step 5: UIDAI to issue authorisation to use UIDAI’s authentication facility

The Reserve Bank of India, being the financial sector regulator, has issued the notification permitting all NBFCs, Payment System Providers and Payment System Participants to carry out authentication of client’s Aadhaar number using e-KYC facility. The Application form seeks various details about the applicant, including a confirmation that the entity is meeting the standards of complying with the Data Security Regulations 2016 of UIDAI and other related guidance / circular issued by UIDAI from time to time with regard to the privacy and security norms.

Eligibility

The most crucial aspect of eligibility for availing AUA/KUA license is the capability of meeting the standards of privacy and security set out by UIDAI. The requirement for meeting the said standards arises from section 4(4) of the Aadhaar Act[6], which states-

(4) An entity may be allowed to perform authentication, if the Authority is satisfied that the requesting entity is—

(a) compliant with such standards of privacy and security as may be specified by regulations; and

(b) (i) permitted to offer authentication services under the provisions of any other law made by Parliament; or

(ii) seeking authentication for such purpose, as the Central Government in consultation with the Authority, and in the interest of State, may prescribe.

 Additionally, the Aadhaar (Authentication) Regulations, 2016[7] provide for the eligibility criteria for appointment as AUA/KUA. As per the said regulations, the following requirements must be met by the applicant:

  • Backend infrastructure, such as servers, databases etc. of the entity, required specifically for the purpose of Aadhaar authentication, should be located within the territory of India.

  • Entity should have IT Infrastructure owned or outsourced capable of carrying out minimum 1 Lakh Authentication transactions per month.

  • Organisation should have a prescribed Data Privacy policy to protect beneficiary privacy.

  • Organisation should have adopted data security requirements as per the IT Act 2000.

Understanding standards of privacy and security

The regulations surrounding data protection and privacy issued by the UIDAI are:

  • Aadhaar (Data Security) Regulations, 2016
  • Aadhaar (Sharing of Information) Regulations, 2016
  • Miscellaneous circulars issued by the UIDAI from time to time

Major requirements under the said regulations are as follows:

  • Applicant to adopt an information security policy outlining information security framework of the applicant developed in line with applicable guidelines issued by UIDAI;
  • Applicant to designate an officer as Chief Information Security Officer (CISO) for ensuring compliance with information security policy and other security-related programmes and initiatives of UIDAI
  • Operations of applicant to be audited by information systems auditor
  • Applicant to ensure that biometric information is not stored, except for buffer during authentication;
  • Applicant to ensure identity information is not shared with anyone else except with prior approval

Conclusion

Pursuant to the said notification, the NBFCs or Payment System Providers or Payment System Participants shall be eligible to make application with the RBI, subject to compliance with the privacy and security norms issued by UIDAI. The notification is a much-awaited relaxation for the eligible non-banking entities to undertake Aadhaar authentication of their customers. However, the criteria for granting approval have not been laid down specifically and may be based on the evaluation conducted by the RBI along with UIDAI. For those who receive the approval, this would be an addition to the modes in which CDD of a customer can be conducted.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12161&Mode=0

[2] https://uidai.gov.in/images/targeted_delivery_of_financial_and_other_subsidies_benefits_and_services_13072016.pdf

[3] Central Identities Data Repository (CIDR) means a centralised database containing all Aadhaar numbers issued to Aadhaar number holders along with the corresponding demographic information and biometric information of such individuals and other information related thereto

[4] https://www.indiacode.nic.in/bitstream/123456789/2036/1/A2003-15.pdf

[5] https://dor.gov.in/sites/default/files/circular%20dated%2009.05.2019%20of%20PMLA.pdf

[6] https://uidai.gov.in/images/news/Amendment_Act_2019.pdf

[7] Refer Schedule A to Aadhaar (Authentication) Regulations, 2016 (Page 19)- https://uidai.gov.in//images/resource/CompendiumMay2020Updated.pdf

 

Related articles:

Rationalisation of KYC- Measures for relief or technical advancement?

An all-embracing guide to identity verification through CKYCR

 

Workshop on Effective Regulatory interface: Preparing and handling  RBI’s NBFC inspections

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De-novo Master Directions on PPIs

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I. Introduction

The Reserve Bank of India (RBI) on August 27, 2021, issued the Master Directions on Prepaid Payment Instruments[1] (‘Master Directions’) repealing the Master Directions on Issuance and Operation of Prepaid Payment Instruments[2] (‘Erstwhile Master Directions’) with immediate effect. These Master Directions have been issued keeping in mind the recent updates to the Erstwhile Master Directions.

In this write-up we aim to cover the major regulatory changes brought about by the Master Directions.

II. Overview of key changes

1.  Classification of PPIs instruments

The Erstwhile Master Directions classified PPIs into three categories namely closed ended PPIs which could be issued by anyone and required no RBI approval, semi-closed PPIs and open ended PPIs which could be issued only by Banks. The new Master Directions have also classified PPIs in three categories i.e. Closed-ended PPI, Small PPIs and Full-KYC PPIs. However, since closed-ended PPIs are not a part of the payment and settlement system, they are not regulated by the RBI. A brief snapshot of the nature of the other two types of PPIs is presented below:

Basis Small PPI Full KYC PPIs
With cash loading facility Without cash loading facility
Issuer Banks and non-banks after obtaining minimum details of PPI holder (mobile number verified with OTP; self-declaration of name and unique identity/identification number of any OVD) Banks and non-banks after completing KYC of holder
Identification Process Verification of mobile number through an OTP

Self-declaration of name and unique identify number of any OVD as recognized in KYC Master Directions

 Video-based Customer Identification Process
Nature of PPI Reloadable and can be issued in electronic form.

 

Electronic payment transactions have been divided into two categories- transactions that do not require physical PPIs and those which require. Hence, even cards could be issued.

 Reloadable and can be issued in card or electronic form.

 

Loading/Reloading shall be from a bank account / credit card / full-KYC PPI.

 

 Reloadable and can be issued in electronic form.

 

Electronic payment transactions have been divided into two categories- transactions that do not require physical PPIs and those which require. Hence, even cards could be issued.
Maximum amount that can be loaded In a month: INR 10,000

In a year: INR 120,000

 No maximum limits
Maximum outstanding amount at any point of time INR 10,000 INR 200,000
Limit on debit during a month INR 10,000 per month No limit No limit
Usage of funds For purchase of goods and services only.

Cash withdrawal or fund transfer not permitted

 

 Transfer to source or bank account of PPI holder, other PPIs, debit or credit card permitted subject to:

 

Pre-registered benefit – maximum INR 200,000 per month per beneficiary

 

Other cases – maximum INR 10,000
Cash Withdrawal Not permitted Permitted subject to limits:

 

INR 2000 per transaction and

INR 10,000 per month
Conversion To be converted into full-KYC PPIs within a period of 24 months from the date of issue of the PPI. Small PPI with cash loading can be converted into Small PPI without cash loading, if desired by the PPI holder. Not applicable
Restriction on issuance to a single person Cannot be issued to same person using the same mobile number and same minimum details more than once. No such restriction No such restriction
Closure Funds transferred back to source or Holders bank account after complying with KYC norms

 

 Funds transferred to pre-designated bank account or

 

PPIs of the same issuer

 

The concept of ‘Small PPI’ and ‘Full-KYC PPI’ cannot be said to be a new introduction, rather, it is more of a merger of the existing variety of semi closed PPIs in Small PPI and the open ended PPI to Full KYC PPI. However, an important change that has been inserted is the recognition of non-bank PPI issuers to issue Full KYC PPI, who were earlier not allowed to issue open ended PPIs.

2. Validity of Registration

Earlier, the Certificate of Authorisation was valid for five years unless otherwise specified and was subject to review including cancellation of the same. However, under the Master Directions, the authorisation is granted for perpetuity (even for existing authorisation which becomes due for renewal) subject to compliance with the following conditions:

  1. Full compliance with the terms and conditions subject to which authorisation was granted;
  2. Fulfilment of entry norms such as capital, net worth requirements, etc.;
  3. No major regulatory or supervisory concerns related to operations, as observed during onsite and / or offsite monitoring;
  4. Efficacy of customer grievance redressal mechanism;
  5. No adverse reports from other departments of RBI / regulators / statutory bodies, etc.

Also, the concept of ‘cooling period’ was introduced in December 2020[3], for effective utilisation of regulatory resources. PPI issuer whose CoA is revoked or not-renewed for any reason; or CoA is voluntarily surrendered for any reason; or application for authorisation has been rejected by RBI; or new entities that are set-up by promoters involved in any of the above categories; will have a one year cooling period. During the said cooling period, entities shall be prohibited from submission of applications for operating any payment system under the PSS Act.

3. Cross border transactions in Indian denomination

The Erstwhile Master Directions provided that Cross Border Transactions in INR denominated PPIS was allowed only by way of KYC compliant semi-closed and open PPIs which met the conditions specified therein. However, under the Master Directions, such issuances have been permitted only in the form of Full-KYC PPI and other conditions as prescribed earlier have not been altered.

4. Maintenance of Current Account

Apart from maintaining an escrow account with a scheduled commercial bank, non-bank PPI issuer that is a member of the Centralised Payment Systems operated by RBI i.e. non-bank issuers as covered under Master Directions on Access Criteria for Payment Systems[4] which have been allowed to access Real Time Gross Settlement (RTGS) System and National Electronic Fund Transfer (NEFT) Systems and any other such systems as provided by RBI, shall also be required to maintain a current account with the RBI.

Transfer from and to such current account is permitted to be credited or debited from the escrow account maintained by the PPIs.

5. Ensuring additional safety norms

  • To ensure safety and security, PPIs issuers are now required to put in place a Two Factor Authentication (2FA) in place for all wallet transactions involving debit to wallet transactions including cash withdrawals. However, it is not mandatory in case of PPI-MTS and gift PPIs.
  • The Erstwhile Master Directions required PPI issuers to put in place a mechanism to send alerts to the PPI holder regarding debit/credit transactions, balance available /remaining in the PPI. In addition to the same, the Master Directions now require issuers to send alerts to the holder even in case of offline transactions. The issuer may send a common alert for all transactions as soon as the issuer receives such information. Separate alerts for each transaction shall not be required.

6. Miscellaneous

  • In case of co-branding, additionally it has been specified that the co-branding partner can also be a Government department / ministry.
  • The Erstwhile Master Directions provided banks and non-banks a period of 45 days to apply to the Department of Payment and Settlement Systems (DPSS) after obtaining the clearance under the Payment and Settlement Systems Act, 2007. The same has now been reduced to 30 days from obtaining such clearance.
  • In addition to the satisfactory system audit report and net worth certificate, RBI also requires issuers to submit a due diligence report for granting final Certificate of Authorisation (CoA).
  • Transfer of funds back to source account in case of Gift PPIs has been allowed after receiving the consent of the PPI holder.
  • To improve customer protection and grievance redressal, the Master Directions have provided customers of non-bank PPI issuers to have recourse to the Ombudsman Scheme for Digital Transactions.

7. Effect on existing issuers

The timeline for complying with the minimum positive net-worth of 15 crores by non-bank PPI issuers has been extended and shall now be met with by September 30, 2021 instead of March 31, 2020. Non-bank issuers shall submit the provisional balance sheet indicating the positive net-worth and CA certificate to the RBI on or before October 30, 2021, failing which they may not be permitted to carry on their business.

III. Conclusion

In this write-up we have aimed to cover the gist of changes introduced in the Master Directions as compared to the Erstwhile Master Directions. The changes made in the regulatory framework for the PPIs have created a level playing field for banks and non-banks, especially, with respect to issuance of full KYC PPIs. Comparatively, the new directions are way more liberal than the earlier one, which only indicates how bullish the regulator must be with respect to PPIs.

 

[1] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12156#MD

[2] https://www.rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=11142

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12001&Mode=0

[4] MD51170116C65788DE8A564165B74D5FECE0626A73.PDF (rbi.org.in)

RBI eases norms on loans and advances to directors and its related entities

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Payal Agarwal, Executive, Vinod Kothari & Company ( payal@vinodkothari.com )

RBI has recently, vide its notification dated 23rd July, 2021 (hereinafter called the “Amendment Notification”), revised the regulatory restrictions on loans and advances given by banks to directors of other banks and the related entities. The Amendment Notification has brought changes under the Master Circular – Loans and Advances – Statutory and Other Restrictions (hereinafter called “Master Circular”). The Amendment Notification provides for increased limits in the loans and advances permissible to be given by banks to certain parties, thereby allowing the banks to take more prudent decisions in lending.

Statutory restrictions

Section 20 of the Banking Regulation Act, 1949 (hereinafter called the “BR Act”) puts complete prohibition on banks from entering into any commitment for granting of loan to or on behalf of any of its directors and specified other parties in which the director is interested. The Master Circular is in furtherance of the same and specifies restrictions and prohibitions as below –

 

*since the same does not fall within the meaning of loans and advances for this Master Circular

Loans and advances without prior approval of Board

The Master Circular further specifies some persons/ entities that can be given loans and advances upto a specified limit without the approval of Board, subject to disclosures in the Board’s Report of the bank.  The Amendment Notification has enhanced the limits for some classes of persons specified.

Serial No. Category of person Existing limits specified under Master Circular Enhanced limits under Amendment Notification
1 Directors of other banks Upto Rs. 25 lacs Upto Rs.  5 crores for personal loans

(Please note that the enhancement is only in respect of personal loans and not otherwise)
2 Firm in which directors of other banks interested as partner/ guarantor Upto Rs. 25 lacs No change
3 Companies in which directors of other banks hold substantial interest/ is a director/ guarantor Upto Rs. 25 lacs No change
4 Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors Upto Rs. 25 lacs Upto Rs. 5 crores
5 Relative(other than spouse) and minor/ dependent children of Chairman/ MD or other directors of other banks Upto Rs. 25 lacs Upto Rs. 5 crores
6 Firm in which such relatives (as specified in 4 or 5 above) are partners/ guarantors Upto Rs. 25 lacs Upto Rs. 5 crores
7 Companies in which relatives (as specified in 4 or 5 above) are interested as director or guarantor or holds substantial interest if he/she is a major shareholder Upto Rs. 25 lacs Upto Rs. 5 crores

Need for such changes

The Master Circular was released on 1st July, 2015, which is more than 5 years from now. Considering the inflation over time, the limits have become kind of vague and ambiguous and required to be revisited. Moreover, the population all over the world is facing hard times due to the Covid-19 outbreak. At this point of time, such relaxation can be looked upon as the need of the hour.

Impact of the phrase ‘Substantial interest’ vs ‘Major shareholder’

The Master Circular uses the term “substantial interest” to generally regulate in the context of lending to companies in which a director is substantially interested.

The relevant places where the term has been used are as below –

Completely prohibited Allowed with conditions
Section 20(1) of the BR Act – for companies in which directors are substantially interested Para 2.2.1.2. of Master Circular – for companies in which directors of other banks are substantially interested – upto  a limit of Rs. 25 lacs without prior approval of Board

 
Para 2.1.2.2. of Master Circular – for companies in which directors are substantially interested Para 2.2.1.4. of Master Circular – for the companies in which the relatives of directors of any bank are substantially interested – upto Rs. 25 lacs without prior approval of Board After amendment, the para stands modified as – for the companies in which the relatives of directors of any bank are major shareholders – upto Rs. 5 crores without prior approval of Board

While the Amendment Notification itself provides for the meaning of “major shareholder”, the meaning of “substantial interest” for the purposes of the Master Circular has to be taken from Section 5(ne) of the BR Act which reads as follows –

  • in relation to a company, means the holding of a beneficial interest by an individual or his spouse or minor child, whether singly or taken together, in the shares thereof, the amount paid up on which exceeds five lakhs of rupees or ten percent of the paid-up capital of the company, whichever is less;
  • in relation to a firm, means the beneficial interest held therein by an individual or his spouse or minor child, whether singly or taken together, which represents more than ten per cent of the total capital subscribed by all the partners of the said firm;

The above definition provides for a maximum limit of shareholding as Rs. 5 lacs, exceeding which a company falls into the list of a company in which director is substantially interested. The net effect is that a lot of companies fall into the radar of this provision and therefore, ineligible to take loans or advances from banks.

However, the Amendment Notification provides an explanation to the meaning of “major shareholder” as –

“The term “major shareholder” shall mean a person holding 10% or more of the paid-up share capital or five crore rupees in paid-up shares, whichever is less.”

This eases the strict limits because of which several companies may fall outside the periphery of the aforesaid restriction. Having observed the meaning of both the terms it is clear that while ‘substantial interest’ lays down strict limits and therefore, covers several companies under the prohibition list, the term ‘major shareholder’ eases the limit and makes several companies eligible to receive loans and advances from the bank subject to requisite approvals thereby setting a more realistic criteria.

The BR Act was enacted about half a century ago when the amount of Rs. 5 lacs would have been substantial, but not at the present length of time. Keeping this in mind, while RBI has substituted the requirement of “substantial interest” to “major shareholder” in one of the clauses, the other clauses and the principal Act are still required to comply with the “substantial interest” criteria, thereby, keeping a lot of companies into the ambit of restricted/ prohibited class of companies in the matter of loans and advances from banks.

Other petty amendments

Deeming interest of relative –

The Amendment Notification has the effect of inserting a new proviso to the extant Master Circular which specifies as below –

“Provided that a relative of a director shall also be deemed to be interested in a company, being the subsidiary or holding company, if he/she is a major shareholder or is in control of the respective holding or subsidiary company.”

This has the effect of including both holding and subsidiary company as well within the meaning of company by providing that a major shareholder of holding company is deemed to be interested in subsidiary company and vice versa.

Explanations to new terms –

The Amendment Notification allows the banks to lend upto Rs. 5 crores to directors of other banks provided the same is taken as personal loans. The meaning of “personal loans” has to be taken from the RBI circular on harmonisation of banking statistics which provides the meaning of personal loans as below –

Personal loans refers to loans given to individuals and consist of (a) consumer credit, (b) education loan, (c) loans given for creation/ enhancement of immovable assets (e.g., housing, etc.), and (d) loans given for investment in financial assets (shares, debentures, etc.).

Other terms used in the Amendment Notification such as “major shareholder” and “control” has also been defined. The meaning of “major shareholder” has already been discussed in the earlier part of this article. The meaning of “control” has been aligned with that under the Companies Act, 2013.

Concluding remarks

Overall, the Amendment Circular is a welcoming move by the financial market regulator. However, as pointed out in this article, several monetary limits under the BR Act have become completely incohesive and therefore, needs revision in the light of the current situation.

 

Dividend restrictions on NBFCs

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– Financial Services Division (finserv@vinodkothari.com)

Background

The Reserve Bank of India (RBI) vide a notification dated 24th June, 2021[1] imposed restrictions on distribution of dividends by non-banking financial companies (‘Notification’). The restrictions cover both systemically important NBFCs as well non-systemically important ones. The guidelines have been issued in line with the draft guidelines for the declaration of dividends by NBFC issued in December 2020.

Restrictions on dividend payout essentially force financial sector entities to plough back a minimal part of their profits, and therefore, result in creation of a profit conservation. Such restrictions are common in case of financial institutions world-over, and are also imbibed as a part of Basel III capital adequacy requirements. Similar restrictions exist in case of banking entities[2]. In case of NBFCs, such restrictions were proposed by the RBI vide Draft Circular on Declaration of Dividend by NBFCs dated December 9, 2020[3].

Dividend Payout Ratio (DP Ratio) is an important policy measure for companies for shareholder wealth maximisation. A conservative dividend distribution policy ensures churning of profits thereby ensuring organic growth of the net worth, and assisted by leverage, a return on shareholders’ funds higher than what the shareholders can fetch on distributed money. On the other hand, aggressive dividend distribution policy entails that profits be returned to the shareholders as there are less business investment opportunities, thus wealth of shareholders be returned. The foregoing arguments does not encompass stictict dividend payout criteria, but a broad policy objective which organisations seek to achieve.

However, in the case of financial institutions like Banks and NBFCs  the motivation of regulators to limit the dividend payout is from the perspective of prudential regulation. The limit on dividend distribution allows regulators to ensure that adequate capital conservation buffers are maintained at all times by the financial institutions.

Most NBFCs follow very conservative dividend policies, and based on publicly available data, the DP Ratios of some of the NBFCs for FY 2019-20 are as follows:

  1. Manappuram- 18.86%
  2. Cholamandalam- 12.78%
  3. Bajaj Finserv- 11.93%
  4. Muthoot Finance- 19.91%
  5. Tata Capital Financial Services- 32.96%
  6. DCM Shriram- 17.19%

Applicability

Who all are covered?

The opening statement of the Notification provides that the Notification is applicable on all NBFCs regulated by RBI. Further, reference is made to the term ‘Applicable NBFCs’  as defined under the respective RBI Master Directions on NBFC-ND-SI and NBFC-ND-NSI. The concept of Applicable NBFC is relevant to determine the applicability of the provisions of the aforesaid RBI Master Directions. Accordingly, it can be understood that, along with the ‘Applicable NBFCs’, the following categories of NBFCs shall be covered under the ambit of the Notification-

  1. Housing Finance Companies (HFCs),
  2. Core Investment Companies (CICs),
  3. Government NBFCs,
  4. Mortgage Guarantee Companies,
  5. Standalone Primary Dealers (SPDs),
  6. NBFC-Peer to Peer Lending Platform (NBFC-P2P)
  7. NBFC- Account Aggregator (NBFC-AA).
  8. NBFC-D (deposit taking NBFCs)
  9. NBFCs-ND (non-deposit taking NBFCs) (both SI and NSI)
  10. NBFC-Factor (both SI and NSI)
  11. NBFC-MFI (both SI and NSI)
  12. NBFC-IFC (both SI and NSI)
  13. IDF-NBFC

However, it is to be noted that For NBFCs that do not accept public funds and do not have any customer interface no limit has been imposed with regards to the dividend payout ratio.

Effective from which financial year?

Effective for declaration of dividend from the profits of the financial year ending March 31, 2022 and onwards.

Which all dividends are covered?

Proposed dividend shall include both dividend on equity shares and compulsorily convertible preference shares. However, other than CCPS, dividends declared on preference shares are not included under the Notification.

Note that the issue of bonus shares is, in essence, capitalisation of profits, and therefore, is not affected by the present requirement.

Computation of dividend payout ratio:

Besides the upfront conditionalities such as capital adequacy ratio, leverage ratio, etc., the stance of the present Notification is limitation on dividend payout ratio. Hence, the meaning of the DP ratio becomes important.

The Notification defines the same as :

‘the ratio between the amount of the dividend payable in a year and the net profit as per the audited financial statements for the financial year for which the dividend is proposed.’

As we discussed elsewhere, the word “dividend” shall be restricted to only equity and CCPS dividend. Hence, dividend on redeemable preference shares shall be excluded.

Also note that the word “profit for the year” refers to profits after tax. There is no question of adding the brought forward profits of earlier years, whether parked in reserves or retained as surplus in the profit and loss account.

In case of companies adopting IndAS, there are always questions on what constitutes distributable profits – whether the gains or losses on fair valuation, taken to P/L are a part of the distributable profits or not. The relevant provisions of the Companies Act, viz., proviso to sec. 123 (1) shall have to be borne in mind.

Eligibility Requirement and Quantum Restrictions

Category Eligibility Requirement Quantum*
NBFCs (including SDPs) meeting prudential requirements ●  Complies with applicable regulatory capital adequacy requirements/leverage restrictions/Adjusted net-worth for each of the last three financial years including the financial year for which the dividend is proposed

○ For SPDs, minimum CRAR of 20% to be maintained for the financial year for which dividend is proposed.

● Net NPA ratio shall be less than 6% in each of the last three years, including as at the close of the financial year for which dividend is proposed to be declared.

○ Calculation of NNPA

● Complies with the provisions of Section 45 IC of the RBI Act/ Section 29 C of the NHB Act, as the case may be, that is to say, has transferred 20% of its net profits to the regulatory reserve fund

● No explicit restrictions placed by the regulator on declaration of dividend

 ●  Type I NBFCs- No limit

●  CICs and SPDs- 60%

●  Other NBFCs- 50%
NBFCs (other than SPDs) not meeting prudential requirements ● Complies with the applicable capital adequacy requirements/ leverage restrictions in the financial year for which dividend is proposed to be paid

● Has net NPA of less than 4% as at the close of the financial year.

 10%

 

 

As regards NBFC-ND-NSI, the applicable regulatory capital requirement, as mentioned in Annex I[4] of the Notification,  seems to suggest that if there is a breach of leverage ratio at any time since 2015, the NBFC is disqualified. This however, does not seem to be the intent of the regulator. The meaning of the aforesaid restriction should be that the provision became applicable from 2015; however, it should not be leading to a conclusion that a dividend distribution will ensure that there is no breach of leverage ratio at any time in the history of the said NBFC. We are of the view that each of the ratios (CRAR or Leverage of Adjusted Net worth, as the case may be) need to be observed ideally at the time of distribution (last three FYs including the year for which dividend is declared), and even conservatively, during the year in question.

*The Notification has prescribed the same limits on quantum for a certain class of NBFCs, however, the draft guidelines had prescribed the limits based on the CRAR or adjusted net-worth of the NBFCs. (Refer Annex I of draft guidelines)

Reporting Requirements

NBFC-D, NBFC-ND-SIs, HFCs & CICs declaring dividend shall report details of dividend declared during the financial year as per the prescribed format within a fortnight after declaration of dividend to the Regional Office of the RBI/Department of Supervision of NHB, as the case may be.

There seems to be a lack of clarity w.r.t. the disclosure requirement for NBFC-MFIs and NBFC-IDFs. Though they are covered under the definition of ‘Applicable NBFCs’ under the RBI Master Directions, however, they are not generally classified as NBFC-ND-SI. Hence, whether the disclosure requirement is applicable to them or not seems to create confusion. In our view, going by prudence, this must be adhered to by such systemically important MFI and IDFs as well.

Accordingly, it can be inferred that the disclosure requirements shall not be applicable to following:

  • Mortgage Guarantee Companies,
  • Standalone Primary Dealers (SPDs),
  • NBFC-Peer to Peer Lending Platform (NBFC-P2P)
  • NBFC- Account Aggregator (NBFC-AA).
  • NBFCs-ND-NSIs

Comparison with the dividend regulations on Banks

Criteria Bank NBFCs
Eligibility Only those banks would be eligible to declare dividends who have a CRAR of at least 9% for preceding two completed financial years and the accounting year for which it proposes to declare dividend and Net NPA less than 7% NBFC-ND-NSI with leverage upto 7 times and NBFC-ND-SI with a CRAR of not less than 15% for last three years (including the FY for which dividend is declared) and Net NPA less than 6% in each of the last three years
In case not meeting eligibility In case any bank does not meet the above CRAR norm, but has a CRAR of at least 9% for the accounting year for which it proposes to declare dividend, it would be eligible to declare dividend provided its Net NPA ratio is less than 5% In case any NBFC does not meet the above eligibility criteria for each of the previous three FY, but meets the capital adequacy for the accounting year, for which it proposes to declare dividend and has a Net NPA ratio of less than 4% at the close of the FY, it shall be allowed to declare dividend, subject to a maximum of 10% on the DP ratio.
Quantum Dividend payout ratio shall not exceed 40 % and shall be as per the prescribed matrix

 

 CIC’s and SPDs shall ensure the maximum dividend payout ratio does not exceed 60%, while the other NBFCs shall not exceed 50% of the DP ratio. For Type I NBFCs there is no limit.
Reporting All banks declaring dividends should report details of dividend declared during the accounting year as per the proforma furnished by RBI NBFC-Ds, NBFC-ND-SIs, HFCs & CICs declaring dividend should report the details of dividend within a fortnight after declaration of dividend to RBI/NHB, as may be applicable.

Immediate Actionables

NBFCs, who already have a Dividend Distribution Policy in place, may have to amend the policy in line with the Notification. As per SEBI LODR Regulations, top 1000 listed companies are mandatorily required to have a dividend distribution policy.  Further, NBFCs may also have voluntarily adopted a policy.

The dividend distribution policy includes the following parameters:

  • the circumstances under which the shareholders may or may not expect dividend;
  • the financial parameters that shall be considered while declaring dividend;
  • internal and external factors that shall be considered for declaration of dividend;
  • policy as to how the retained earnings shall be utilized; and
  • parameters that shall be adopted with regard to various classes of shares

The eligibility requirements and limits on quantum of dividend, as provided in the Notification,  may be additional criterias for such NBFCs to declare dividend. In such a case, the existing dividend distribution policy shall be required to be amended in order to include the additional parameters.

It is noteworthy here that, as per regulation 43A of the LODR, if a listed entity proposes to amend its dividend distribution policy, it shall disclose the changes along with the rationale for the same in its annual report and on its website.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12118&Mode=0

[2] https://www.rbi.org.in/scripts/FS_Notification.aspx?Id=2240&fn=2&Mode=0 and other associated circulars

[3] https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50777

[4] https://rbidocs.rbi.org.in/rdocs/content/pdfs/NBFCS24062021_A1.pdf

 

Our related write-ups:

FAQs on Dividend Distribution Policy

Our presentation on dividends – https://vinodkothari.com/2021/09/an-overview-of-the-regulatory-framework-of-dividends/

 

Basics of Factoring in India

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– Megha Mittal, Associate ( mittal@vinodkothari.com )
Factoring as an age-old concept has stood the test of time as it enabled businesses to resolve the cash flow issues, rendered liquidity, facilitated uninterrupted services and cushioned businesses against the lag in the billing cycles. Also the merit of the product lies in the simplicity of the concept which is well understood and accepted. 
The principles of factoring work broadly on the seller selling the receivables of a debtor to a specialised financial intermediary called a factor. The sale of the receivables happens at a discount and transfers the ownership of the receivables to the factor who shall on purchase of receivables, collect the dues from the debtor instead of the seller doing so, enabling the seller to receive upfront funds from the factor. This allows companies to cash in on their sales without having to wait for payments to come in from customers in due course. With the purchase of the receivables the factor enters the shoes of the seller and takes on the liability under the contract.

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Restructuring of restructuring: Post 1st April NPAs may be upgraded as Standard under ResFra 2.0

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– Anita Baid (anita@vinodktohari.com)

Source: FIDC’s letter to RBI dated June 3, 2021 seeking clarification on clause of Resolution framework – 2.0 relating to Individuals and Small Businesses and disclosures in the balance sheet read along with the RBI response via email dated June 7, 2021. Though called a clarification it actually makes a substantive positive change which is a silent realisation that there is substantial deterioration of performance of loans during the second wave of Covid-19.

The Reserve Bank of India (RBI) had proposed two restructuring frameworks on May 05, 2021- one for individuals and small businesses (‘Notification 31’) and the other one for MSMEs (‘Notification 32’). The intent of both frameworks is to allow restructuring of the loan account in distress due to the second wave of Covid-19.

Pursuant to the restructuring of the eligible loan account (under the respective framework) the standard classification of the assets can be retained. However, there are certain disparities between the two notifications in terms of eligibility criteria, process, etc.

One of the major distinctions is the fact that under Notification 31, there is no relaxation provided to borrowers who have slipped into NPA between the period from March 31, 2021 to the date of invocation. Hence, such loan accounts, which have become NPA from 1st April to the invocation date, irrespective of being restructured in compliance with the provisions of  Notification 31 will continue to be classified as NPA. However, whereby the loan account slipped into NPA classification between the date of invocation and implementation of resolution plan, such account can be upgraded to standard classification as on date of implementation of resolution plan. This position is different in case of MSMEs coming under Notification 32, wherein the borrowers who have slipped into NPA between the period from March 31, 2021, till the date of implementation shall be upgraded to standard.

The aforesaid interpretation was coming clear from the language of para 16 of Notification 31, which states as follows-

  1. If a resolution plan is implemented in adherence to the provisions of this circular, the asset classification of borrowers’ accounts classified as Standard may be retained as such upon implementation, whereas the borrowers’ accounts which may have slipped into NPA between invocation and implementation may be upgraded as Standard, as on the date of implementation of the resolution plan.

As per the language, the asset classification can be retained as standard- this would mean the account which was standard as on the date of implementation has to be retained as standard. However, if the same has degraded to sub-standard category, the upgradation as standard is allowed only if it slipped into NPA between invocation and implementation. Hence, it could be inferred that the slippage before the invocation would not get the relief of upgradation upon restructuring.

This was a huge demotivation of the lenders who intend to restructure the loan accounts under Notification 31. Consequently, representation was made by the Finance Industry Development Council (FIDC) bringing to the notice of RBI that the restructuring notification for individuals and small businesses omits, though maybe unintentionally, to benefit the customers who may have slipped into NPA between April 1 and May 5 as it refers to invocation date and implementation date.

The eligible loan accounts of individuals and small businesses which were standard as on March 31, 2021 can be restructured under Notification 31 if the restructuring is invoked by September 30, 2021. Further, there is a likelihood that such an account may have slipped into NPA between April 1, 2021 till the date of invocation. Though Notification 32  for MSMEs clearly provides for an upgradation to account which might have slipped into NPA from March 1, 2021 till the implementation, however, similar relief was missing from Notification 31.

The RBI has, however, vide an email communication to the FIDC on June 7, 2021, clarified that the loan accounts that may have slipped into NPA between April 1, 2021 and the date of implementation, on the same lines as mentioned in Notification 32 for MSMEs, can be upgraded as standard assets on implementation of the resolution plan.

This would be a relief for not just the borrower but also the lenders who would not hesitate to restructure eligible and potential loan accounts, even if they have turned into NPA by the time the RBI notifications were issued.

Refer to our article on restructuring:

RBI means to halt second wave of borrower defaults: Announces ResFra 2.0

 

AIF Second Amendment Regulations, 2021 – Regulated Steps towards Liberalised Investment

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-Megha Mittal  (mittal@vinodkothari.com)

Amidst the various concerns addressed in the Board Meeting dated 25th March, 2021,[1] the Securities and Exchange of Board of India (‘SEBI’) extensively dealt with several issues identified with respect to Alternative Investment Funds (‘AIFs’), inter-alia a green signal to AIFs for investing in units of other AIFs; ambiguity regarding the scope of the term ‘start-up’; and the need for a code of conduct laying down guiding principles on accountability of AIFs, their managers and personnel, towards the various stakeholders including investors, investee companies and regulators.

Thus, with a view to target the issues in consideration, the Board proposed that the following amendments be introduced in the SEBI (Alternative Investment Funds) Regulation, 2012 (‘AIF Regulations’/ ‘Principal Regulations’)[2] –

  • provide a framework for Alternative Investment Funds (AIFs) to invest simultaneously in units of other AIFs and directly in securities of investee companies;
  • provide a definition of ‘start-up’ as provided by Government of India and to clarify the criteria for investment by Angel Funds in start-ups
  • prescribe a Code of Conduct for AIFs, key management personnel of AIFs, trustee, trustee company, directors of the trustee company, designated partners or directors of AIFs, as the case may be, Managers of AIFs and their key management personnel and members of Investment Committees and bring clarity in the responsibilities cast on members of Investment Committees; and
  • remove the negative list from the definition of venture capital undertaking.

 The aforesaid proposals, put to the fore in view of the suggestions and requests received from several stakeholder groups like the domestic AIFs, global investors, and the regulatory bodies, have now been notified vide notification dated 5th May, 2021, via the SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2021[3] (‘Amendment Regulations’). A key takeaway from the Amendment Regulations is the flexibility granted w.r.t. indirect investments by AIFs for investment in units of another AIF, however with some riders and possible gaps, as discussed below.

Below we summarise and discuss the amendments introduced vide the Amendment Regulations, and analyse its impact

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Rationalisation of KYC- Measures for relief or technical advancement?

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-Kanakprabha Jethani and Anita Baid (finserv@vinodkothari.com)

Background

Considering the resurgence of the Covid-19 pandemic on the economy, the RBI Governor, on May 5, 2021, announced several measures with a view to infuse liquidity in the economy, avoid another wave of borrower defaults[1] as well as aid in ease of business during the lockdown.

Out of the several measures announced by the Governor, one was to simplify the KYC process, which is the initial step of any lending transaction. Some of the amendments seem to provide immediate relief from compliance requirements and some are intended to encourage carrying out KYC compliances electronically, given the social distancing norms.

In this regard, the RBI has issued the following notifications:

  1. Periodic Updation of KYC – Restrictions on Account Operations for Non-compliance dated May 5, 2021[2]
  2. Amendment to the Master Direction (MD) on KYC dated May 10, 2021[3]

In this article we intend to discuss the prima facie implications of the amendments introduced by the aforesaid notifications. Read more →

FAQs: Appointment of Statutory Auditors

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-Financial Services Divison (finserv@vinodkothari.com)

Last updated- June 11, 2021

The Reserve Bank of India has issued Guidelines for Appointment of Statutory Central Auditors (SCAs)/Statutory Auditors (SAs) of Commercial Banks (excluding RRBs), UCBs and NBFCs (including HFCs) under Section 30(1A) of the Banking Regulation Act, 1949, Section 10(1) of the Banking Companies (Acquisition and Transfer of Undertakings) Act, 1970/1980 and Section 41(1) of SBI Act, 1955; and under provisions of Chapter IIIB of RBI Act, 1934 for NBFCs, on 27th April 2021 (“Guidelines”).

The Guidelines intend to supersede the existing circulars/notification on appointment of statutory auditors by Banks and NBFC. The Guidelines provide necessary instructions for appointment of SCAs/SAs, the number of auditors, their eligibility criteria, tenure and rotation as well as norms for ensuring the independence of auditors.

We have tried to figure out the probable questions arising out of these Guidelines and respond to the same in the form of these FAQs.

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