Governing NBFCs - Part 1

Introduction:

1. What is a Non-Banking Financial Company (NBFC)?

A Non-Banking Financial Company (NBFC) has been defined under section 45 I(f) of the RBI Act, 1934. as per this "NBFC is a company registered under the Companies Act, and is engaged in the business of:

- loans and advances, 

- acquisition of shares/ stocks/ bonds/ debentures/ securities issued by Government or local authority or other marketable securities of a like nature, 

- leasing, 

- hire-purchase, 

- insurance business, 

- chit business 

but does not include any institution whose principal business is that of agriculture activity, industrial activity, purchase or sale of any goods (other than securities) or providing any services and sale/ purchase/ construction of immovable property. 

A non-banking institution which is a company and has principal business of receiving deposits under any scheme or arrangement in one lump sum or in installments by way of contributions or in any other manner, is also a non-banking financial company (Residuary non-banking company).

In short, NBFC is a financial Institution that is into Lending or Investment or collecting monies under any scheme or arrangement but does not include any institutions which carry on its principal business as agriculture activity, industrial activity, trading and purchase or sale of immovable properties. A company that carries on the business of accepting deposits as its principal business is also a NBFC.

1.1 As an NBFC then only it can undertake activities of investing. Now, if it does the same business under the form of a partnership firm, then his registration and compliance all are now gone, This is 100% legal way to work as NBFC. Even the registrar of firms do not stop anyone from doing so,

2. Principal Business Test or 50-50 Test

When a company’s financial assets > 50 per cent of the total assets and 

income from financial assets > 50 per cent of the gross income (not net income)

A Company which fulfills both these criteria can be registered as NBFC by RBI.

Now, based upon this can we say that a Company seeks to register itself with RBI as an NBFC, if during the previous FY it fulfills the 50-50 test?

To answer this question, first of all we need to determine whether such a company intends to carry on the business of NBFC. If the intention of the company is to stick to its existing line of business, then mere fulfilment of the principal business test in one financial year will not change the nature of the entity. 

Further, What happens if the Company takes NBFC registration, in the second year it fails to satisfy the principal business test and again in the third year it attains the criteria? Does that mean the Company will obtain CoR in the first year, surrender in the second and again obtain in the third year?

No. There can be temporary fluctuations in the business that cannot change the nature of the business. If the intention of the Company is to carry on the business of NBFC, it can continue to hold COR in the second year as well.

But yes, if in the further years, there remains a trend that the NBFC is having more portion of its income from other business and not from lending or investing, then it may opt to surrender the same permanently. 

3. Can NBFC give loans to its directors?

On the face of it, YES, NBFC can.give loans to its directors.

But if we go in depth, then the answer to this question would find its way as to how the NBFC is operating. Basically section 185 provides that a Company can not give loans to its directors. But there is an exemption also given to those companies which are into lending business. So, in general we can say YES... NBFC can give loans to its directors..

But, it has to mind the conditions as prescribed under section 185, which is that the Company in its ordinary course of its business provides the loans (or gives guarantees or securities for the due repayment of any loan) and 

in respect of such loans an interest is charged at a rate not less than the rate of prevailing yield of one year, three years, five years or ten years Government security closest to the tenor of the loan. 

So, only those NBFCs can give loans to directors which are into lending plus it does not provide the loans for free, it charges a good amount of interest and as per the prevailing yield rate. Other NBFCs can not.

Further, RBI has vide a circular dated 19th April, 2022 (DOR.CRE.REC.No.25/ 03.10.001/2022-23) has prescribed some Regulatory Restrictions on Loans and Advances to the directors and senior officers of the NBFCs-

For Middle Layer and Upper Layer NBFC-

As per this, an NBFC can grant loans and advances equal to 50 Million INR and above to directors and other persons only after the Board or Committee has duly sanctioned the same.

Now, here in these provisions, other persons means 

a) relatives of directors;

b) any firm in which any of their directors or their relatives is interested as a partner, manager, employee or guarantor;

c) any company in which any of their directors, or their relatives is interested as a major shareholder, director, manager, employee or guarantor.

A. The proposals for credit facilities of an amount less than 50 Million INR to these borrowers can be sanctioned by the appropriate authority in the NBFC under powers vested in such authority, but the matter should be reported to the Board.

This appropriate authority can be any such person who is leading the disbursal team in the NBFC. Also in this case, it requires a reporting sort of to the Board. Although periodicity has not been specified for these reports, then we may assume immediate reporting as and when the loan application gets sanctioned. 

Also, from the good governance point of view, we may report to the Board before the disbursement of loan and not after the disbursement.

B. It clarified further, that a director or her relatives shall be deemed to be interested in a company, being the subsidiary or holding company, if she is a major shareholder (holding 10% or more of the paid-up share capital or five crore rupees in paid-up shares, whichever is lower) or is in control of the respective holding or subsidiary company.

C. It was provided further that the director who is directly or indirectly concerned or interested in any proposal should disclose the nature of her interest to the Board when any such proposal is discussed. 

She should recuse herself from the meeting unless her presence is required by the other directors for the purpose of eliciting information and the director so required to be present shall not vote on any such proposal.

Points for discussion here in this particular provisions are:

a) in Para C, it has not been clarified to which sort of proposal they are talking about, is it for loans and advances or in general?

But actually this is for loans and advances only, we just see in the above mentioned provisions that an NBFC can grant loans and advances to directors and other persons more than 50 Million only after approval from the Board or Committee. Within the limits no approval required, Then in case of direct or indirect interest (or even concern) in the proposal, of any director, should be informed to the Board (not Committee).

Further, if the interested director can avoid the meeting at which such lending is proposed then well and good. However, if the meeting is not avoidable, then it should avoid voting on such a proposal.

For Middle Layer and Upper Layer NBFC-

Loans and advances to Senior Officers of the NBFC

For this rule, Senior officer means personnel of the Company who are members of its core management team excluding Board of Directors comprising all members of management one level below the executive directors, including the functional heads [as per section 178 of Companies Act]

Following two rules are required to be adhered with while granting loans and advances to senior officers:

i) Loans and advances sanctioned to senior officers of the NBFC shall be reported to the Board. (and not committee)

ii) No senior officer or any Committee comprising, inter alia, a senior officer as member, shall, while exercising powers of sanction of any credit facility, sanction any credit facility to a relative of that senior officer. Such a facility shall be sanctioned by the next higher sanctioning authority under the delegation of powers.

Here again, the method of reporting is not specified, Further, a very interesting provision came. Let us say there is Mr. X, who is senior officer in the Company and also incharge of that credit facility process (division) of the NBFC. Now, if he wishes to obtain the loans for himself or say to his relative, then he can freely go as per the extant guidelines. Even, he is still free to go if he is the member of that committee from which they require any prior approval as per this new RBI circular. But NO, for lending for himself or his relative, hisself approval is not required. Such loans or advances shall be sanctioned by the next higher officer in the hierarchy.  

For Base Layer NBFC-

For base layer NBFC, RBI has specified common provisions for lending to the directors, senior officers and related persons unlike what they have mentioned for Middle and Upper Layer.

As per this NBFCs shall have a Board approved policy on grant of loans to directors, senior officers and relatives of directors and to entities where directors or their relatives have major shareholding (holding 10% or more of the paid-up share capital or five crore rupees in paid-up shares, whichever is lower). 

This Board approved policy shall include a threshold beyond which loans to above mentioned persons shall be reported to the Board. 

So basically for a Base layer NBFC, the Board can once approve a clear separate policy on loans and advances to directors, officers and relatives etc. with a clear limit of amount mentioned therein. This policy is separate from its lending policy.

 

The loans beyond the threshold still can be given in case of Base Layer, it is not being restricted but only one additional compliance is being added here is that in the case of loans and advances sanctioned beyond the threshold then reporting shall be done to the Board.

Further, the Base Layer NBFCs shall disclose in their Annual Financial Statement, aggregate amount of such sanctioned loans and advances as per the prescribed format.

Points for discussion here in this particular provisions are:

a) How the reporting should be done to the board, what details should be given, the reporting frequency etc. What actions the Board will take upon receiving these information, whether to take note of the same in the Board meeting or not? 

Further provisions in case of Middle Layer and Upper Layer NBFCs loans to both senior officers and Directors & Relatives, following additional compliances to be taken care of:

i) NBFCs shall obtain a declaration from the borrower giving details of the relationship of the borrower to their directors/ senior officers for loans and advances aggregating Rupees five crore and above. NBFCs shall recall the loan if it comes to their knowledge that the borrower has given a false declaration.

ii) These guidelines shall be duly brought to the notice of all directors and placed before the NBFC’s Board of Directors.

iii) NBFCs shall disclose in their Annual Financial Statement, aggregate amount of such sanctioned loans and advances as per template provided in the Appendix.

iv) The above norms as mentioned relating to grant of loans and advances will equally apply to awarding of contracts.

Summary:

For Middle layer and Upper Layer, a limit of 5 Cr has been mentioned by RBI itself in case of directors and relatives. Whereas, no limits have been specified for senior officers and also in Base Layer NBFC no such limit has been specified for all the three (Directors, Relatives and Senior Officers) and it is left in the hands of the NBFCs itself.

Only Board reporting and drawing a policy for lending (Base Layer) has been added in the Compliance basket.

Please note that in case of Middle Layer and Upper Layer NBFCs loans to senior officers Board reporting required is of each and every sanction unlike in case of Base Layer, the Board reporting would arise only in case of lending beyond the threshold.

Points for thought:

1. We have been provided an explanation under the said circular that the term "Loans and Advances" shall not include loans and advances against G-Sec, FDs, Shares and Stocks, LIC, and house loan car loan advances to employees under any general sort of scheme.

Provided that NBFC’s interest/lien is appropriately marked with legal enforceability.

Now, the question comes here that this explanation has been mentioned before the guidelines related to Base Layer NBFC. So, does it mean that the above mentioned definition of loans and advances is applicable only on Middle Layer and Upper Layer and not at the Base Layer.

2. The requirement of having a board approved policy on lending to directors. Senior officers and relatives etc has been specified only for the Base layer NBFCs. So, does it mean that ML and UL are not required to have policy for the same.

The answer is no, they are also required to have a policy on the same. By virtue of point 2.2 of SBR circular which provides that those regulatory revisions applicable to lower layers of NBFCs will automatically be applicable to NBFCs falling under higher layers, unless stated otherwise. 

As we have been not provided any specific exemption for non applicability of policy, we will interpret it as applicable to all layers of NBFCs.

3. Awarding of contracts: It is very interesting to note that through the circular on loans and advances. RBI has successfully added regulatory restrictions on a third type of related party transaction (after loans and advances) that is contracts. Though this is not a new type of compliance, this is very much similar to what is currently applicable on Banks also.

From October 01, 2022, all the Middle layer and Upper Layer NBFCs, can not award any contract, amounting to INR 50 Million and above, to the following parties, unless it has prior approval from the Board or Committee::

- their directors (including the Chairman/ Managing Director) or relatives of directors, 

- any firm in which any of their directors or their relatives is interested as a partner, manager, employee or guarantor.

- any company in which any of their directors, or their relatives is interested as a major shareholder, director, manager, employee or guarantor.

Further, all the Middle layer and Upper Layer NBFCs, who intends to award any contract, to its senior officers , can do so after the same has been reported to the Board (and Not Committee)

Please note for senior officers, no monetary limit has been specified. 

For Base Layer NBFCs, the requirement of approval from the Board or Committee or reporting to the Board (as applicable to ML and UL) is not made applicable to Base layer. Therefore, a BL NBFC can freely award contracts to all those specified persons, Just to have a board approved policy over the same.

Please note that the RBI has not specified the scope of contracts. therefore even a small type of contracts or agreements can get covered under it.    

Format for base layer nbfc for annual reporting 

4. Can NBFC take an unsecured loan from the Director/Company and then grant a loan to another Individual or Company?

Yes, they can. Since this is the principal business of the Company. to grant funds on loan. In fact, only an NBFC can do this. Other type of companies are not allowed to do so.

an audit firm cannot conduct audits of more than four commercial banks, eight NBFCs and eight UCBs in a year