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

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

– Vinod Kothari (vinod@vinodkothari.com)

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

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

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

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

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

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

Regulatory carve outs

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

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

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

Three situations requiring approval

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

Takeover or acquisition of control

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Change in Control:

Change in management

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

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

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

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

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

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

Intra-group transfers

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

Here is an excerpt from the RBI FAQs:

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

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

Corporate Restructuring

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

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

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

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

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

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

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

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

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

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

Securitisation of MSME receivables in India

November 27, 2024/0 Comments/in Financial Services, Securitisation /by Team Finserv

Vinod Kothari l finserv@vinodkothari.com

Financing needs of MSMEs in India: Working capital constitutes a major part of SMEs’ funding requirements

There are considerable gaps in funding for SMEs: In India, the total addressable demand for external credit is estimated to be USD 173 billion^[1] while the overall supply of finance from formal sources is estimated to be USD 441 trillion. The Expert Committee on Micro, Small and Medium Enterprises, constituted by Reserve Bank of India in December, 2018 has estimated the overall gap in India to be USD 238 – 298 billion^[2].

Traditional sources of funding are working capital facilities with banks; however, given their unorganised nature, lack of formal financial statements, etc., many SMEs find it difficult to have formal lines of credit from banks.

The marketplace is trying alternative sources of working capital for SME. The avenues tried based on the different components of the working capital:
Accounts receivables	Inventory
Trade Receivables Discounting System (TREDS) Factoring/ supply chain financing	Credit period for accounts payable, funded by way of reverse factoring/ supply chain financing

Trade Receivables Discounting System (TReDS/TREDS)

TREDS is almost India’s own innovation, though it was inspired by Mexico’s NAFIN Cadenas Productivas Program. TREDS as a mechanism for discounting and unitisation of trade receivables was launched in 2014. Currently, there are 4 of them – RXIL, M3, InvoiceMart and C2FO Factoring Solutions Private Limited. The first one is the largest.

Limited number of funding participants. However, given that there are quite a limited number of funding participants in the TREDS ecosystem currently (as informed by some of the participants in the TREDS platform(s), only 5-6 banks are currently actively bidding), there is very little competitive bidding for invoices currently. The cost of funding, we were given to understand, is about 0.25% – 0.40% higher than bank finance, if the buyer happens to be a BBB rated entity.

Figure: Trend in TREDS over 3 years^[3]

Supply chain financing

Supply chain financing is growing, as present-day trade needs to move fast; working capital availability is key to achieving turnover with low spreads, to service the ultimate consumer affordably and efficiently. Supply chain finance is a key mode of financing for upstream procurements as well as downstream supplies by an entity with a good credit standing, say Anchor. Usually, the financing is done by setting a limit based on the Anchor’s credit standing, with a bank or NBFC. Both banks and NBFCs are active in the space. Financing may be done by discounting of supply bills, either accepted by the Anchor as due for payment, or drawn by the Anchor on the dealers/ customers of the Anchor.

Most supply chain financing programs work on first loss guarantee by the Anchor. For the downstream supplies, Anchor usually has to provide a first loss guarantee support, to the extent of 5% to 10% of the pool of receivables funded by a lender under the facility.

Factoring

Factoring law, intended to encourage factoring, has not lived to its purpose due to regulatory overtone. The Factoring Regulation Act was enacted to facilitate and encourage factoring; however, its regulatory stance has served to stifle factoring. Only a handful of NBFCs are currently registered as factors, while banks are not required to register^[4]. As a result, the volume of factoring in India is trivial, as compared to global jurisdictions.

Potential for securitisation of SME receivables

Direct securitisation by SMEs is not feasible. There are 2 ways in which securitisation of MSME receivables can take place: securitisation of trade receivables by SME itself; and secondly, receivables are funded by intermediaries (banks, NBFCs), aggregated by intermediaries, and securitised by them.

Securitisation by SMEs directly is not feasible, as volumes are not sufficient. Plus, it requires direct access to investors, which is unviable. Hence, the discussion below focuses on securitisation of receivables funded by intermediaries.

Intermediated securitisation is the way the world does it. However, regulations in India have scuttled the possibility. Acquisition of receivables by intermediaries (either on their balance sheet, or in the balance sheets of trade finance conduits) is quite common world-over^[5]. However, this activity has not picked up in India, for several reasons:

There is a bar on securitisation of revolving credit facilities in the RBI SSA Directions. Naturally, a trade receivable funding program has to be structured as a revolving facility, to allow the SME continued and assured access to working capital. Issuance of asset backed commercial paper is also barred under the same Directions.
Regulated financial lenders cannot do a securitisation transaction outside of SSA Directions. If unregulated entities (not regulated by the RBI, say, a conduit vehicle) does a securitisation outside of SSA Directions, no regulated lender can invest in such a transaction, as any investment so made will be a full charge against regulatory capital.

As a result, securitisation of trade receivables is currently a near impossibility under the regulatory regime.

Will trade receivables securitisation help?

Table below compares securitisation with TREDS, supply chain financing and securitisation:

	TREDS	Supply Chain Financing	Securitisation
Consistent availability of funding	While the funding limits are established based on the rating and credit of the buyer, the funding happens on invoice-by-invoice basis. There is no assurance as to either availability or the cost of funding	As limits are assigned for each vendor/ dealer, there is an assured availability at a pre-agreed cost of funding	As limits are assigned for each vendor/ dealer, there is an assured availability at a pre-agreed cost of funding by the intermediary, who, in turn may take receivables to capital markets
Disintermediation	Involves financial intermediaries	Involves financial intermediaries	Involves intermediaries at the inception, but eventually, the intermediaries offload the receivables to capital market
Burden on banks’ balance sheets	Receivables are on the balance sheet of the lender	Receivables are on the balance sheet of the lender	Receivables are off the balance sheet for regulatory capital purposes
Pricing	While pricing is primarily done on the strength of the Anchor, at times, SME gets good pricing based on the liquidity in the banking system	Pricing is done based on the FLDG support provided by the Anchor; hence, priced based on achor’s credit rating	Availability of capital market access, coupled with credit enhancements may bring down the cost of funding

Policymakers need to enable alternative instruments, and leave the choice to the marketplace. The Table above makes a case for securitisation of trade receivables. Such securitisation does not conflict with TREDS; TREDS may continue as an option, leaving the choice to SMEs /lenders the benefit of choice.

Role of credit enhancements in trade receivables securitisation

The potential structure of securitisation of trade receivables, as it commonly works in global jurisdictions, is as follows:

Figure: Structure of Trade Receivable Securitisation

In essence, there are two levels of credit support – one, at the level of each SME (seller), which sells receivables to the Intermediary/conduit. This is typically by way of over-collateralisation or a first loss facility.

Having thus acquired credit enhanced receivables from the SMEs, the intermediary arranges a program-wide credit enhancement. This enhancement essentially becomes a mezzanine support.

The entire program works as a revolving facility, such that the SME sellers continue to sell receivables on an ongoing basis. On the other hand, the securised paper has a fixed maturity, subject to roll-over at the discretion of the paper holders. Hence, there needs to be liquidity support provided to the conduit, typically by a bank.

Providers of credit enhancement:

SIDBI, as credit enhancer for SME funding, may provide the program credit support.
SIDBI, in turn, may be counter-guaranteed by MDBs

Policy/regulatory changes required:

The bar on securitisation of revolving credit facilities, introduced looking at the experience during GFC, needs to be withdrawn. There is an inherent liquidity risk on the part of the intermediary that does securitisation (the risk that early amortisation triggers may cause the facility to wind down, while the committed funding still will have to be continued by the intermediary), but this may be addressed by appropriate capital charge. Note that there is no bar on revolving credit securitisation either in the EU Capital Directions, or in Basel Securitisation Framework.

Likewise, the bar on issuance of asset backed commercial paper needs to be removed. The provider of liquidity facility needs an appropriate capital charge for the maximum value of the facility.

^[1]https://www.ifc.org/content/dam/ifc/doc/mgrt/financing-india-s-msmes-estimation-of-debt-requirement-of-msmes-in-india.pdf

^[2]https://dcmsme.gov.in/Report%20of%20Expert%20Committee%20on%20MSMEs%20-%20The%20U%20K%20Sinha%20Committee%20constitutes%20by%20RBI.pdf

^[3] Source: RBI Statistics on TREDS: https://www.rbi.org.in/Scripts/TREDSStatisticsView.aspx?TREDSid=8, and VKC Analysis

^[4] See blog by Vinod Kothari: https://www.linkedin.com/pulse/factoring-india-fractured-opportunity-vinod-kothari/

^[5]https://www.euromoney.com/article/2cs68xnhl90cxtg3n64n4/treasury/trade-receivables-deals-buck-broader-market-slump

Read our other articles:

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

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

Vinod Kothari and Dayita Kanodia | finserv@vinodkothari.com

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why is supply chain financing important ?

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

Meaning of SCF

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

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

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

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

Importance of SCF

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

Various modes of SCF

The following are some of the SCF product types:

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

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

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

Credit with a purpose vs Credit on demand

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

The table below distinguishes between SCF and RLOC.

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

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

RBI’s Concerns About Evergreening

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

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

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

Regulatory Updates | October 2024

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

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Financial Sector Regulator – ‘Rule of Law’ Review

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

– Aditya Iyer (adityaiyer@vinodkothari.com)

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

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

-Vinod Kothari (vinod@vinodkothari.com)

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

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

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

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

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

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

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

Other related resources:

Recent Updates to HFC Directions: What you need to know

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

-Chirag Agarwal | chirag@vinodkothari.com

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

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

Clarification regarding MITC and KFS

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

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

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

Consolidation of Circulars

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

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

Conclusion

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

Our other resources on the topic are:-

FAQs on Specific Due Diligence of investors & investments of AIFs

October 21, 2024/0 Comments/in Alternative investment Vehicles, Corporate Laws, SEBI /by Team Corplaw

Team Vinod Kothari & Company | corplaw@vinodkothari.com

Refer to our related resources below:

Surging gold loan business sets off RBI alarm

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

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

– Team Finserv (finserv@vinodkothari.com)

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

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

Indian securitisation enters a new phase: Banks originate with a bang

September 30, 2024/0 Comments/in Financial Services, News on Securitization, Securitisation /by Abhirup Ghosh

Abhirup Ghosh | abhirup@vinodkothari.com

The Indian securitisation market has been without banks as originators for nearly 17 years, until HDFC Bank^[1] launched a landmark transaction that may signal their potential return. Prior to the Global Financial Crisis, which raised significant questions about the viability of securitization as a financial product, banks like ICICI Bank were actively involved in the market, with ICICI’s last reported transaction occurring in 2007^[2].

It is notable that erstwhile HDFC Limited, prior to its merger into the Bank, was the largest single originator of home loan securitisations; however, the present transaction is not home loans.

After the GFC, banks shifted from being originators to becoming investors in securitised assets. To meet the priority sector lending targets, banks started investing heavily in the securitisation market, be it in pass-through certificates or through acquisition of loan pools. This was a stark contrast to the situation elsewhere in the world, where the issuances are primarily made by banks.