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Basics of Factoring in India

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

– 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:

 

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

-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?

-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

-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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Factoring Law Amendments backed by Standing Committee

-Megha Mittal 

[finserv@vinodkothari.com]

In the backdrop of the expanding transaction volumes, and with a view to address the still prevalent delays in payments to sellers, especially MSMEs, the Factoring Regulation (Amendment) Bill, 2020 (‘Amendment Bill’) was introduced in September, 2020, so as to create a broader and deeper liquid market for trade receivables.

The proposed amendments have been reviewed and endorsed by the Standing Committee of Finance chaired by Shri. Jayant Sinha, along with some key recommendations and suggestions to meet the objectives as stated above.  In this article, we discuss the observations and recommendations of the Standing Committee Report  in light of the Amendment Bill.

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Digital Consumer Lending: Need for prudential measures and addressing consumer protection

-Siddarth Goel (finserv@vinodkothari.com)

Introduction

“If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck”

The above phrase is the popular duck test which implies abductive reasoning to identify an unknown subject by observing its habitual characteristics. The idea of using this duck test phraseology is to determine the role and function performed by the digital lending platforms in consumer credit.

Recently the Reserve Bank of India (RBI) has constituted a working group to study how to make access to financial products and services more fair, efficient, and inclusive.[1]  With many news instances lately surrounding the series of unfortunate events on charging of usurious interest rate by certain online lenders and misery surrounding the threats and public shaming of some of the borrowers by these lenders. The RBI issued a caution statement through its press release dated December 23, 2020, against unauthorised digital lending platforms/mobile applications. The RBI reiterated that the legitimate public lending activities can be undertaken by Banks, Non-Banking Financial Companies (NBFCs) registered with RBI, and other entities who are regulated by the State Governments under statutory provisions, such as the money lending acts of the concerned states. The circular further mandates disclosure of banks/NBFCs upfront by the digital lender to customers upfront.

There is no denying the fact that these digital lending platforms have benefits over traditional banks in form of lower transaction costs and credit integration of the unbanked or people not having any recourse to traditional bank lending. Further, there are some self-regulatory initiatives from the digital lending industry itself.[2] However, there is a regulatory tradeoff in the lender’s interest and over-regulation to protect consumers when dealing with large digital lending service providers. A recent judgment by the Bombay High Court ruled that:

“The demand of outstanding loan amount from the person who was in default in payment of loan amount, during the course of employment as a duty, at any stretch of imagination cannot be said to be any intention to aid or to instigate or to abet the deceased to commit the suicide,”[3]

This pronouncement of the court is not under criticism here and is right in its all sense given the facts of the case being dealt with. The fact there needs to be a recovery process in place and fair terms to be followed by banks/NBFCs and especially by the digital lending platforms while dealing with customers. There is a need to achieve a middle ground on prudential regulation of these digital lending platforms and addressing consumer protection issues emanating from such online lending. The regulator’s job is not only to oversee the prudential regulation of the financial products and services being offered to the consumers but has to protect the interest of customers attached to such products and services. It is argued through this paper that there is a need to put in place a better governing system for digital lending platforms to address the systemic as well as consumer protection concerns. Therefore, the onus of consumer protection is on the regulator (RBI) since the current legislative framework or guidelines do not provide adequate consumer protection, especially in digital consumer credit lending.

Global Regulatory Approaches

US

The Office of the Comptroller of the Currency (OCC) has laid a Special Purpose National Bank (SPNV) charters for fintech companies.[4] The OCC charter begins reviewing applications, whereby SPNV are held to the same rigorous standards of safety and soundness, fair access, and fair treatment of customers that apply to all national banks and federal savings associations.

The SPNV that engages in federal consumer financial law, i.e. in provides ‘financial products and services to the consumer’ is regulated by the ‘Consumer Financial Protection Bureau (CFPB)’. The other factors involved in application assessment are business plans that should articulate a clear path and timeline to profitability. While the applicant should have adequate capital and liquidity to support the projected volume. Other relevant considerations considered by OCC are organizers and management with appropriate skills and experience.

The key element of a business plan is the proposed applicant’s risk management framework i.e. the ability of the applicant to identify, measure, monitor, and control risks. The business plan should also describe the bank’s proposed internal system of controls to monitor and mitigate risk, including management information systems. There is a need to provide a risk assessment with the business plan. A realistic understanding of risk and there should be management’s assessment of all risks inherent in the proposed business model needs to be shown.

The charter guides that the ongoing capital levels of the applicant should commensurate with risk and complexity as proposed in the activity. There is minimum leverage that an SPNV can undertake and regulatory capital is required for measuring capital levels relative to the applicant’s assets and off-balance sheet exposures.

The scope and purpose of CFPB are very broad and covers:

“scope of coverage” set forth in subsection (a) includes specified activities (e.g., offering or providing: origination, brokerage, or servicing of consumer mortgage loans; payday loans; or private education loans) as well as a means for the CFPB to expand the coverage through specified actions (e.g., a rulemaking to designate “larger market participants”).[5]

CFPB is established through the enactment of Dood-Frank Wall Street Reform and Consumer Protection Act. The primary function of CFPB is to enforce consumer protection laws and supervise regulated entities that provide consumer financial products and services.

“(5)CONSUMER FINANCIAL PRODUCT OR SERVICES  The term “consumer financial product or service” means any financial product or service that is described in one or more categories under—paragraph (15) and is offered or provided for use by consumers primarily for personal, family, or household purposes; or **

“(15)Financial product or service-

(A)In general The term “financial product or service” means—(i)extending credit and servicing loans, including acquiring, purchasing, selling, brokering, or other extensions of credit (other than solely extending commercial credit to a person who originates consumer credit transactions);”

Thus CFPB is well placed as a separate institution to protect consumer interest and covers a wide range of financial products and services including extending credit, servicing, selling, brokering, and others. The regulatory environment has been put in place by the OCC to check the viability of fintech business models and there are adequate consumer protection laws.

EU

EU’s technologically neutral regulatory and supervisory systems intend to capture not only traditional financial services but also innovative business models. The current dealing with the credit agreements is EU directive 2008/48/EC of on credit agreements for consumers (Consumer Credit Directive – ‘Directive’). While the process of harmonising the legislative framework is under process as the report of the commission to the EU parliament raised some serious concerns.[6] The commission report identified that the directive has been partially effective in ensuring high standards of consumer protection. Despite the directive focussing on disclosure of annual percentage rate of charge to the customers, early payment, and credit databases. The report cited that the primary reason for the directive being impractical is because of the exclusion of the consumer credit market from the scope of the directive.

The report recognised the increase and future of consumer credit through digitisation. Further the rigid prescriptions of formats for information disclosure which is viable in pre-contractual stages, i.e. where a contract is to be subsequently entered in a paper format. There is no consumer benefit in an increasingly digital environment, especially in situations where consumers prefer a fast and smooth credit-granting process. The report highlighted the need to review certain provisions of the directive, particularly on the scope and the credit-granting process (including the pre-contractual information and creditworthiness assessment).

China

China has one of the biggest markets for online mico-lending business. The unique partnership of banks and online lending platforms using innovative technologies has been the prime reason for the surge in the market. However, recently the People’s Bank of China (PBOC) and China Banking and Insurance Regulatory Commission (CBIRC) issued draft rules to regulate online mico-lending business. Under the draft rules, there is a requirement for online underwriting consumer loans fintech platform to have a minimum fund contribution of at least 30 % in a loan originated for banks. Further mico-lenders sourcing customer data from e-commerce have to share information with the central bank.

Australia

The main legislation that governs the consumer credit industry is the National Consumer Credit Protection Act (“National Credit Act”) and the National Credit Code. Australian Securities & Investments Commission (ASIC) is Australia’s integrated authority for corporate, markets, financial services, and consumer credit regulator. ASIC is a consumer credit regulator that administers the National Credit Act and regulates businesses engaging in consumer credit activities including banks, credit unions, finance companies, along with others. The ASIC has issued guidelines to obtain licensing for credit activities such as money lenders and financial intermediaries.[7] Credit licensing is needed for three sorts of entities.

  • engage in credit activities as a credit provider or lessor
  • engage in credit activities other than as a credit provider or lessor (e.g. as a credit representative or broker)
  • engage in all credit activities

The applicants of credit licensing are obligated to have adequate financial resources and have to ensure compliance with other supervisory arrangements to engage in credit activates.

UK

Financial Conduct Authority (FCA) is the regulator for consumer credit firms in the UK. The primary objective of FCA ensues; a secure and appropriate degree of protection for consumers, protect and enhance the integrity of the UK financial system, promote effective competition in the interest of consumers.[8] The consumer credit firms have to obtain authorisation from FCA before carrying on consumer credit activities. The consumer credit activities include a plethora of credit functions including entering into a credit agreement as a lender, credit broking, debt adjusting, debt collection, debt counselling, credit information companies, debt administration, providing credit references, and others. FCA has been successful in laying down detailed rules for the price cap on high-cost short-term credit.[9] The price total cost cap on high-cost short-term credit (HCSTC loans) including payday loans, the borrowers must never have to pay more in fees and interest than 100% of what they borrowed. Further, there are rules on credit broking that provides brokers from charging fees to customers or requesting payment details unless authorised by FCA.[10] The fee charged from customers is to be reported quarterly and all brokers (including online credit broking) need to make clear that they are advertising as a credit broker and not a lender. There are no fixed capital requirements for the credit firms, however, adequate financial resources need to be maintained and there is a need to have a business plan all the time for authorisation purposes.

Digital lending models and concerns in India

Countries across the globe have taken different approaches to regulate consumer lending and digital lending platforms. They have addressed prudential regulation concerns of these credit institutions along with consumer protection being the top priority under their respective framework and legislations. However, these lending platforms need to be looked at through the current governing regulatory framework from an Indian perspective.

The typical credit intermediation could be performed by way of; peer to peer (P2P) lending model, notary model (bank-based) guaranteed return model, balance sheet model, and others. P2P lending platforms are heavily regulated and hence are not of primary concern herein. Online digital lending platforms engaged in consumer lending are of significance as they affect investor’s and borrowers’ interests and series of legal complexions arise owing to their agency lending models.[11] Therefore careful anatomy of these models is important for investors and consumer protection in India.

Should digital lending be regulated?

Under the current system, only banks, NBFCs, and money lenders can undertake lending activities. The regulated banks and NBFCs also undertake online consumer lending either through their website/platforms or through third-party lending platforms. These unregulated third-party digital lending platforms count on their sophisticated credit underwriting analytics software and engage in consumer lending services. Under the simplest version of the bank-based lending model, the fintech lending platform offers loan matching services but the loan is originated in books of a partnering bank or NBFC. Thus the platform serves as an agent that brings lenders (Financial institutions) and borrowers (customers) together. Therefore RBI has mandated fintech platforms has to abide by certain roles and responsibilities of Direct Selling Agent (DSA) as under Fair Practice Code ‘FPC’ and partner banks/NBFCs have to ensure Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Service (‘outsourcing code’).[12] In the simplest of bank-based models, the banks bear the credit risk of the borrowers and the platform earns their revenues by way of fees and service charges on the transaction. Since banks and NBFCs are prudentially regulated and have to comply with Basel capital norms, there are not real systemic concerns.

However, the situation alters materially when such a third-party lending platform adopts balance sheet lending or guaranteed return models. In the former, the servicer platform retains part of the credit risk on its book and could also give some sort of loss support in form of a guarantee to its originating partner NBFC or bank.[13] While in the latter case it a pure guarantee where the third-party lending platform contractually promises returns on funds lent through their platforms. There is a devil in detailed scrutiny of these business models. We have earlier highlighted the regulatory issues in detail around fintech practices and app-based lending in our write up titled ‘Lender’s piggybacking: NBFCs lending on Fintech platforms’ gurantees’.

From the prudential regulation perspective in hindsight, banks, and NBFCs originating through these third-party lending platforms are not aware of the overall exposure of the platforms to the banking system. Hence there is a presence of counterparty default risk of the platform itself from the perspective of originating banks and NBFCs. In a real sense, there is a kind of tri-party arrangement where funds flow from ‘originator’ (regulated bank/NBFC) to the ‘platform’ (digital service provider) and ultimately to the ‘borrower'(Customer). The unregulated platform assumes the credit risk of the borrower, and the originating bank (or NBFC) assumes the risk of the unregulated lending platform.

Curbing unregulated lending

In the balance sheet and guaranteed return models, an undercapitalized entity takes credit risk. In the balance sheet model, the lending platform is directly taking the credit risk and may or may not have to get itself registered as NBFC with RBI. The registration requirement as an NBFC emanates if the financial assets and financial income of the platform is more than 50 % of its total asset and income of such business (‘principal business criteria’ see footnote 12). While in the guaranteed return model there is a form of synthetic lending and there is absolutely no legal requirement for the lending platform to get themselves registered as NBFC. The online lending platform in the guaranteed return model serves as a loan facilitator from origination to credit absorption. There is a regulatory arbitrage in this activity. Since technically this activity is not covered under the “financial activity” and the spread earned in not “financial income” therefore there is no requirement for these entities to get registered as NBFCs.[14]

Any sort of guarantee or loss support provided by the third-party lending platform to its partner bank/NBFC is a synthetic exposure. In synthetic lending, the digital lending platform is taking a risk on the underlying borrower without actually taking direct credit risk. Additionally, there are financial reporting issues and conflict of interest or misalignment of incentives, i.e. the entities do not have to abide by IND AS and can show these guarantees as contingent liabilities. On the contrary, they charge heavy interest rates from customers to earn a higher spread. Hence synthetic lending provides all the incentives for these third-party lending platforms to enter into risky lending which leads to the generation of sub-prime assets. The originating banks and NBFCs have to abide by minimum capital requirements and other regulatory norms. Hence the sub-prime generation of consumer credit loans is supplemented by heavy returns offered to the banks. It is argued that the guaranteed returns function as a Credit Default Swap ‘CDS’ which is not regulated as CDS. Thus the online lending platform escapes the regulatory purview and it is shown in the latter part this leads to poor credit discipline in consumer lending and consumer protection is often put on the back burner.

From the prudential regulation perspective restricting banks/NBFCs from undertaking any sort of guaranteed return or loss support protection, can curb the underlying emergence of systemic risk from counterparty default. While a legal stipulation to the effect that NBFCs/Banks lending through the third-party unregulated platform, to strictly lend independently i.e. on a non-risk sharing basis of the credit risk. Counterintuitively, the unregulated online lending platforms have to seek registration as an NBFC if they want to have direct exposure to the underlying borrower, subject to fulfillment of ‘principal business criteria’.[15] Such a governing framework will reduce the incentives for banks and NBFCs to exploit excessive risk-taking through this regulatory arbitrage opportunity.

Ensuring Fairness and Consumer Protection

There are serious concerns of fair dealing and consumer protection aspects that have arisen lately from digital online lending platforms. The loans outsourced by Banks and NBFCs over digital lending platforms have to adhere to the FPC and Outsourcing code.

The fairness in a loan transaction calls for transparent disclosure to the borrower all information about fees/charges payable for processing the loan application, disbursed, pre-payment options and charges, the penalty for delayed repayments, and such other information at the time of disbursal of the loan. Such information should also be displayed on the website of the banks for all categories of loan products. It may be mentioned that levying such charges subsequently without disclosing the same to the borrower is an unfair practice.[16]

Such a legal requirement gives rise to the age-old question of consumer law, yet the most debatable aspect. That mere disclosure to the borrower of the loan terms in an agreement even though the customer did not understand the underlying obligations is a fair contract (?) It is argued that let alone the disclosures of obligations in digital lending transactions, customers are not even aware of their remedies. Under the current RBI regulatory framework, they have the remedy to approach grievance redressal authorities of the originating bank/NBFC or may approach the banking ombudsman. However, things become even more peculiar in cases where loans are being sourced or processed through third-party digital platforms. The customers in the majority of the cases are unaware of the fact that the ultimate originator of the loan is a bank/NBFC. The only remedy for such a customer is to seek refuge under the Consumer Protection Act 2019 by way of proving the loan agreement is the one as ‘unfair contract’.

“2(46) “unfair contract” means a contract between a manufacturer or trader or service provider on one hand, and a consumer on the other, having such terms which cause significant change in the rights of such consumer, including the following, namely:— (i) requiring manifestly excessive security deposits to be given by a consumer for the performance of contractual obligations; or (ii) imposing any penalty on the consumer, for the breach of contract thereof which is wholly disproportionate to the loss occurred due to such breach to the other party to the contract; or (iii) refusing to accept early repayment of debts on payment of applicable penalty; or (iv) entitling a party to the contract to terminate such contract unilaterally, without reasonable cause; or (v) permitting or has the effect of permitting one party to assign the contract to the detriment of the other party who is a consumer, without his consent; or (vi) imposing on the consumer any unreasonable charge, obligation or condition which puts such consumer to disadvantage;

It is pertinent to note that neither the scope of consumer financial agreements is regulated in India, nor are the third-party digital lending platforms required to obtain authorisation from RBI. There are instances of high-interest rates and exorbitant fees charged by the online consumer lending platforms which are unfair and detrimental to customers’ interests. The current legislative framework provides that the NBFCs shall furnish a copy of the loan agreement as understood by the borrower along with a copy of each of all enclosures quoted in the loan agreement to all the borrowers at the time of sanction/disbursement of loans.[17] However, like the persisting problem in the EU 2008/48/EC directive, even FPC is not well placed to govern digital lending agreements and disclosures. Taking a queue from the problems recognised by the EU parliamentary committee report. There is no consumer benefit in an increasingly digital environment, especially in situations where there are fast and smooth credit-granting processes. The pre-contractual information on the disclosure of annualised interest rate and capping of the total cost to a customer in consumer credit loans is central to consumer protection.

The UK legislation has been pro-active in addressing the underlying unfair contractual concerns, by fixation of maximum daily interest rates and maximum default fees with an overall cost cap of 100% that could be charged in short-term high-interest rates loan agreements. It is argued that in this Laissez-faire world the financial services business models which are based on imposing an unreasonable charge, obligations that could put consumers to disadvantage should anyways be curbed. Therefore a legal certainty in this regard would save vulnerable customers to seek the consumer court’s remedy in case of usurious and unfair lending.

The master circular on loan and advances provide for disclosure of the details of recovery agency firms/companies to the borrower by the originating bank/NBFC.[18] Further, there is a requirement for such recovery agent to disclose to the borrower about the antecedents of the bank/NBFC they are recovering for.  However, this condition is barely even followed or adhered to and the vulnerable consumers are exposed to all sorts of threats and forceful tactics. As one could appreciate in jurisdictions of the US, UK, Australia discussed above, consumer lending and ancillary services are under the purview of concerned regulators. From the customer protection perspective, at least some sort of authorization or registration requirement with the RBI to keep the check and balances system in place is important for consumer protection. The loan recovery business is sensitive hence there is a need for a proper guiding framework and/or registration requirement of the agents acting as recovery agents on behalf of banks/NBFCs. The mere registration requirement and revocation of same in case of unprofessional activities will serve as a stick to check their consumer dealing practices.

The financial services intermediaries (other than Banks/NBFCs) providing services like credit broking, debt adjusting, debt collection, debt counselling, credit information, debt administration, credit referencing to be licensed by the regulator. The banks/NBFCs dealing with the licensed market intermediaries would go much farther in the successful implementation of FPC and addressing consumer protection concerns from the current system.

Conclusion

From the perspective of sound financial markets and fair consumer practices, it is always prudent to allow only those entities in credit lending businesses that are best placed to bear the credit risk and losses emanating from them. Thus, there is a dearth of a comprehensive legislative framework in consumer lending from origination to debt collection and its administration including the business of providing credit references through digital lending platforms. There may not be a material foreseeable requirement for regulating digital lending platforms completely. However, there is a need to curb synthetic lending by third-party digital lending platforms. Since a risk-taking entity without adequate capitalization will tend to get into generating risky assets with high returns. The off-balance sheet guarantee commitments of these entities force them to be aggressive towards their customers to sustain their businesses. This write-up has explored various regulatory approaches, where jurisdictions like the US and UK, and Australia being the good comparable in addressing consumer protection concerns emanating from online digital lending platforms. Henceforth, a well-framed consumer protection system especially in financial products and services would go much farther in the development and integration of credit through digital lending platforms in the economy.

 

[1] Reserve Bank of India – Press Releases (rbi.org.in), dated January 13, 2020

[2] Digital lending Association of India, Code of Conduct available at https://www.dlai.in/dlai-code-of-conduct/

[3] Rohit Nalawade Vs. State of Maharashtra High Court of Bombay Criminal Application (APL) NO. 1052 OF 2018 < https://images.assettype.com/barandbench/2021-01/cf03e52e-fedd-4a34-baf6-25dbb55dbf29/Rohit_Nalawade_v__State_of_Maharashtra___Anr.pdf>

[4] https://www.occ.gov/topics/supervision-and-examination/responsible-innovation/comments/pub-special-purpose-nat-bank-charters-fintech.pdf

[5]  12 USC 5514(a); Pay day loans are the short term, high interest bearing loans that are generally due on the consumer’s next payday after the loan is taken.

[6] EU, ‘Report from the Commission to the European Parliament and the Council: on the implementation of Directive 2008/48/EC on credit agreement for consumers’, dated November, 05, 2020, available at < https://ec.europa.eu/transparency/regdoc/rep/1/2020/EN/COM-2020-963-F1-EN-MAIN-PART-1.PDF>

[7] https://asic.gov.au/for-finance-professionals/credit-licensees/applying-for-and-managing-your-credit-licence/faqs-getting-a-credit-licence/

[8] FCA guide to consumer credit firms, available at < https://www.fca.org.uk/publication/finalised-guidance/consumer-credit-being-regulated-guide.pdf>

[9] FCA, ‘Detailed rules for price cap on high-cost short-term credit’, available at < https://www.fca.org.uk/publication/policy/ps14-16.pdf>

[10] FCA, Credit Broking and fees, available at < https://www.fca.org.uk/publication/policy/ps14-18.pdf>

[11] Bank of International Settlements ‘FinTech Credit : Market structure, business models and financial stability implications’, 22 May 2017, FSB Report

[12] See our write up on ‘ Extension of FPC on lending through digital platforms’ , available at < http://vinodkothari.com/2020/06/extension-of-fpc-on-lending-through-digital-platforms/>

[13] Where the unregulated platform assumes the complete credit risk of the borrower there is no interlinkage with the partner bank and NBFC. The only issue that arises is from the registration requirement as NBFC which we have discussed in the next section. Also see our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[14] The qualifying criteria to register as an NBFC has been discussed in our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[15] see our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[16] Para 2.5.2, RBI Guidelines on Fair Practices Code for Lender

[17] Para 29 of the guidelines on Fair Practices Code, Master Direction on systemically/non-systemically important NBFCs.

[18] Para 2.6, Master Circular on ‘Loans and Advances – Statutory and Other Restrictions’ dated July 01, 2015;

 

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One-stop guide for all Regulatory Sandbox Frameworks – Vinod Kothari Consultants

 

Banking exposure to open the current account by the banks

-Siddarth Goel (finserv@vinodkothari.com)

Background

Declaration from current account customers

The RBI issued a circular dated August 06, 2020, whereby the regulator instructed all scheduled commercial banks and payments banks shall not open a current account for customers who have availed credit facilities in form of cash credit (CC)/overdraft (OD) from the banking system. The motive behind the circular being that all the transactions of borrowers should be routed through the CC/OD account.

The genesis of this circular was in RBI circular dated May 15, 2004, where banks were advised that at the time of opening of current accounts for their customers, they have to insist on a declaration form by the account-holder to the effect that he is not enjoying any credit facility with any other bank or obtain a declaration giving particulars of credit facilities enjoyed by such customer. The move was in essence to secure the overall credit discipline in banking so that there is no diversion of funds by the borrowers to the detriment of the banking system. Post-May 15, 2004, a clarification notification was issued by the regulator dated August 04, 2004, stipulating that in case there is no response obtained concerning NOC after waiting a minimum period of a fortnight, the banks may open current accounts of the customers.

Thus there was an obligation on banks to scrupulously ensure that their branches do not open current accounts of entities that enjoy credit facilities (fund based or non-fund based) from the banking system without specifically obtaining a No-Objection Certificate (NOC) from the lending bank(s). Further, the non-adherence by banks as per the circular is to be perceived as abetting the siphoning of funds and such violations which are either reported to RBI or noticed during the regulator inspection would make the concerned banks liable for penalty under Banking Regulation Act.

Establishment of CRILC

The RBI established a Central Repository of Information on Large Credits (CRILC). The CRILC was established in connection to the RBI framework “Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalising Distressed Assets in the Economy“. As under the framework banks were required to furnish credit information to CRILC on all their borrowers having aggregate fund-based and non-fund based exposure of Rs. 5 Crores and above with them. Besides banks were required to furnish current accounts of their customers with outstanding balance (debit or credit) of Rs 1 Crore and above to the CRILC. The reporting under the extant framework was to determine SMA-0 classification, where the principal or interest payment is not overdue for more than 30 days but account showing signs of stress. An increase in the frequency of overdrafts in current accounts is one of the illustrative methods for determining stress.

Reposting of large credits

Post establishment of CRILC, a subsequent guideline on the opening of current accounts by banks was issued by the RBI via circular dated July 02, 2015, dealing with the same subject. To enhance credit discipline, especially for the reduction in NPA level in banks, banks were asked to use the information available in CRILC and not limit their due diligence to seeking NOC. Banks were to verify from the data available in the CRILC database whether the customer is availing of credit facility from another bank.

The chart below highlights the series and events and relevant circulars.

Credit Discipline- August 06, 2020 Circular

As per the circular dated August 06, 2020, issued by the regulator on Opening of Current Accounts by Banks – Need for Discipline (‘Revised Guidelines’), there are two aspects that need to be considered before opening a CC/OD facility or opening the current account of the customer. The Revised Guidelines provides a clear guiding flowchart for banks to follow when the customer approaches a bank for opening of the current account, the same has been categorised into two scenarios which could be considered by the banks to comply with the revised guideline.

Case 1: Customer wants to avail or is already having a credit facility in form of CC/OD

Case 2: Customer wants to open a current account or have an existing current account with the bank

 

Further, there is a requirement on banks to monitor all CC/OD accounts regularly at least quarterly, especially concerning the exposure of the banking system to the borrower. There has been an ambiguity surrounding what would amount to ‘exposure’ under the Revised Guidelines.

‘Exposure to the banking system’ under Revised Guidelines

The Revised Guidelines provides that exposure shall mean the sum of sanctioned ‘fund based and non-fund based credit facilities’. However, there is a regulatory ambiguity, since neither the term used by the RBI has been specifically defined in the Revised Guideline nor elsewhere under any other regulations. There is no straight jacket exclusive definition for determining as to what exposure banks should include determining funded and non-funded credit facilities. Therefore, based on back-tracing of regulatory regime an inclusive list can be of guidance for banks and borrowers especially large borrowers (like NBFCs and HFCs) and other financial institutions and corporates who rely on banking facilities (current account and CC/OD) extensively for their business.

The CRILC may not be the only source for banks while the collection of borrower’s credit information. Other modes could be information by Credit Information Companies (CICs), National E-Governance Services Ltd. (NeSL), etc., and even by obtaining customers’ declaration, if required. However, since the revised guideline stresses on borrowers having exposure more than 5 crores, therefore, information disseminated by the banks to CRILC is a good point to start with and to comply with under the revised guidelines. The circular dated July 02, 2015, draws reference to the Central Repository of Information on Large Credits (CRILC) to collect, store, and disseminate data on all borrowers’ credit exposures. The guideline further provided banks to verify the data available in the CRILC database whether the customer is availing credit facility from another bank. Further even under the Guidelines on “Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders” dated January 30, 2014, provided that credit information shall include all types of exposures as defined under RBI Circular on Exposure Norms.

The RBI Exposure Norms dated July 01, 2015, defines exposure as;

“Exposure shall include credit exposure (funded and non-funded credit limits) and investment exposure (including underwriting and similar commitments). The sanctioned limits or outstandings, whichever are higher, shall be reckoned for arriving at the exposure limit. However, in the case of fully drawn term loans, where there is no scope for re-drawal of any portion of the sanctioned limit, banks may reckon the outstanding as the exposure.”

The banking exposure norms provide for two exposures; namely credit and investment exposures. Further RBI Exposure Norms defines ‘credit exposure’ and ‘Investment Exposure’ as follows;

“2.1.3.3. Credit Exposure

Credit exposure comprises the following elements:

(a) all types of funded and non-funded credit limits.

(b) facilities extended by way of equipment leasing, hire purchase finance and factoring services.

2.1.3.4 Investment Exposure

  1. a) Investment exposure comprises the following elements:

(i) investments in shares and debentures of companies.

(ii) investment in PSU bonds

(iii) investments in Commercial Papers (CPs).

  1. b) Banks’ / FIs’ investments in debentures/ bonds / security receipts / pass-through certificates (PTCs) issued by an SC / RC as compensation consequent upon sale of financial assets will constitute exposure on the SC / RC. In view of the extraordinary nature of the event, banks / FIs will be allowed, in the initial years, to exceed the prudential exposure ceiling on a case-to-case basis.
  2. c) The investment made by the banks in bonds and debentures of corporates which are guaranteed by a PFI1(as per list given in Annex 1) will be treated as an exposure by the bank on the PFI and not on the corporate.
  3. d) Guarantees issued by the PFI to the bonds of corporates will be treated as an exposure by the PFI to the corporates to the extent of 50 per cent, being a non-fund facility, whereas the exposure of the bank on the PFI guaranteeing the corporate bond will be 100 per cent. The PFI before guaranteeing the bonds/debentures should, however, take into account the overall exposure of the guaranteed unit to the financial system.”

The Revised Guidelines, specifically define exposure in a footnote to the revised guideline stipulating that to arrive at aggregate exposures in the footnote as follows;

“‘Exposure’ for the purpose of these instructions shall mean sum of sanctioned fund based and non-fund based credit facilities”.

Further the RBI in its subsequent FAQs on revised guidelines dated December 14, 2020, guided on what could be included in aggregate exposure.

4. Whether aggregate exposure shall include Day Light Over Draft (DLOD)/ intra-day facilities and irrevocable payment commitments, limits set up for transacting in FX and interest rate derivatives, CPs, etc.

All fund based and non-fund based credit facilities sanctioned by the banks and carried in their Indian books shall be included for the purpose of aggregate exposure.”

Further in FAQ No. 3 in the circular dated December 14, 2020, the RBI clarified that

3. For the purpose of this circular, whether exposure of non-banking financial companies (NBFCs) and other financial institutions like National Housing Bank (NHB) shall be included in computing aggregate exposure of the banking system.

The instructions are applicable to Scheduled Commercial Banks and Payments Banks. Accordingly, the aggregate exposure for the purpose shall include exposures of these banks only”

While the regulator evaded assigning express meaning as to what could be included while determining banking exposure and took an inclusive view. However, from the foregoing, it is amply clear that the credit facilities should include credit exposures (funded and not funded) that have been sanctioned by banks. Therefore, only exposures to banks and payments banks are to be included while calculating exposures, any or all the exposure of a borrower to the other financial institutions like NHB, LIC Housing, SIDBI, NABARD, Mutual funds & other development Banks are neither commercial banks nor payments banks hence are to be excluded. [The list of licensed payments banks by the RBI can be viewed here. ]

CIRLC captures credit information of borrowers having aggregate fund-based and non-fund based exposures of Rs. 5 Crores and above including investment exposures. The banks are required to submit a quarterly return to CIRLC. It is pertinent to note that total investment exposure is to be indicated separately under the head total investment exposure. While there is a need for a detailed breakup on fund-based and non-fund based credit facilities in the CIRLC return. The table below is an indicative list of (funded and non-funded) loans to be submitted from the CIRLC return.

 

Non-Funded credit exposure  Funded credit exposure
Letter of Credit Cash Credit/ Overdraft
Guarantees Working Capital Demand Loan (including CPs)*
Acceptances Inland Bills
Foreign Exchange Contracts Packing Credit
Interest Rate Derivatives (incl FX Interest Rate Derivatives) Export Bills
Term Loan
Credit equivalent of OBS/derivative exposure

*CP to be included in WCDL only if part of working capital sanctioned limit. All other CPs are to be considered as investment exposure.

Therefore, all the investment exposures of banks to the borrower such as investments in corporate bonds, shares, PTCs issued by asset reconstruction companies and securitisation companies, and others are to be excluded while arriving at aggregate fund-based and non-fund based credit facilities as under the Revised Guidelines. Nevertheless, the PTCs issued by NBFCs or HFCs are investment exposure of banks on the underlying loan pools and not on the originator entity. Similarly, exposure of a bank in a co-lending transaction is exposure on the ultimate obligor and not the co-originating partner NBFC.

 

 

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