India – Banking & Finance Snapshots.

30 January, 2018

 

Invoking SARFAESI Act for an Existing Debt of a Recently Notified NBFC and Simultaneous Conduct of Arbitration and SARFAESI Proceedings

 

In the case of M. D. Frozen Foods Exports Private Limited and Others (‘Appellants’) v. Hero Fincorp Limited (‘Respondent’), the Supreme Court (‘SC’) has, on September 21, 2017, passed a judgement considering whether: (i) arbitration proceedings and proceedings under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘SARFAESI Act’) can be carried along simultaneously; and (ii) a lender can invoke the SARFAESI Act where its application (a) arises after the account became a Non-Performing Asset

(‘NPA’); (b) arises in respect of debts created prior in time to such applicability.

 

In the current case, the Appellants had borrowed monies from the Respondent against the security of certain immovable properties by way of an equitable mortgage on September 30, 2015 and October 21, 2015. The Respondent was notified as a financial institution under Section 2(1)(m) of the SARFAESI Act pursuant to notification dated August 5, 2016 and a notice under Section 13(2) of the SARFAESI Act was issued on November 24, 2016 and February 16, 2017. On July 6, 2016, the account of the Appellants became an NPA within the meaning of Section 2(1) (o) of the SARFAESI Act. On November 16, 2016, the Respondent invoked the arbitration clause contained in the documents it had executed with the Appellants.

 

In case of the first issue, the Court held that the application of the SARFAESI Act will be in addition to and not in derogation of any other laws for the time being in force. It was held that SARFAESI proceedings and arbitration proceedings can go hand in hand, and this issue was clearly answered in favour of such simultaneous proceedings in Transcore v. Union of India & Anr.2 and Mathew Varghese v. M. Amritha Kumar.3 It was further held that SARFAESI proceedings and arbitration proceedings are complimentary to each other, and that it was not a case of election of remedies. 

 

On the second issue, the Court held that the SARFAESI Act applies to all the claims which would be alive at the time when it was brought into force. Similarly, it would be applicable to the Respondent from the date when it was so made applicable to it. Hence, the SARFAESI Act applies to all existing agreements irrespective of the fact whether the lender was a notified ‘financial institution’ on the date of the execution of the agreement with the borrower or not.

 

Directions on Managing Risks and Code of Conduct in Outsourcing of Financial Services by NBFCs

 

The RBI  has, by a notification dated November 9, 2017, released Directions on Managing Risks and Code of Conduct in Outsourcing of Financial Services by Non-Banking Financial Companies (‘NBFC ’) (‘Outsourcing Directions ’) to ensure that outsourcing arrangements by a NBFC  neither diminish its ability to fulfil its obligations to its customers and the RBI , nor impede effective supervision by the RBI . Existing NBFC s have been directed to conduct a selfassessment of their existing outsourcing arrangements and bring these in line with the directions within two months from the date of the circular.

 

The Outsourcing Directions are applicable to material outsourcing arrangements4  with a service provider located in India or elsewhere with respect to financial services and are not applicable to technology-related activities. NBFC s outsourcing financial services would not require prior RBI  approval but would be subject to on-site/ off-site monitoring and inspection/scrutiny by RBI .

 

Some of the salient features of the Outsourcing Directions are set out below: 

 

i. Outsourcing of core management functions is restricted, with an exception for NBFC s in a group/ conglomerate, where these functions may be outsourced within the group, subject to compliance with specific instructions provided in the Outsourcing Directions;

 

ii. NBFC s will be responsible for the actions of their service providers and are required to exercise utmost care and due diligence in relation to the services outsourced;

 

iii. NBFC s outsourcing any financial activities will put in place a comprehensive outsourcing policy approved by its Board in the specified manner; 

 

iv. The relationship with the service provider is required to be defined by way of a written agreement addressing the risks and risk mitigation strategies;

 

v. NBFC s will ensure protection of the security and confidentiality of customer information;

 

vi. NBFC s will require the service providers to develop and establish a robust framework for documenting, maintaining and testing business continuity and recovery procedures;

 

vii. NBFC s will have in place a management structure to monitor and control its outsourcing activities;

 

viii. Each NBFC  is required to constitute a grievance redressal mechanism as per the RBI  directions; and

 

ix. NBFC s can outsource within the group entities by having Board approved policy and entering into service level agreements. However, while doing so, they have to ensure that the customers are aware of the company which is actually offering the product/services.

 

2 Transcore v. Union of India & Anr, (2008) 1 SCC 125.

3 Mathew Varghese v. M. Amritha Kumar, (2014) 5 SCC 610.

4 The Outsourcing Directions define ‘material outsourcing arrangements’ as those, which if disrupted, have the potential to significantly impact business operations, reputation, profitability or customer service. Further, ‘outsourcing’ has been defined as the NBFC’s use of a third party (either an affiliated entity within a corporate group or an entity that is external to the corporate group) to perform activities on a continuing basis that would normally be undertaken by the NBFC itself, now or in the future.

 

For further information, please contact:

 

Zia Mody, Partner, AZB & Partners

zia.mody@azbpartners.com

 22 July, 2015

 

• The RBI had, by a circular dated August 21, 2014, set out certain conditions for NBFCs having an asset size of ¤1 billion and above, lending against collateral of shares, including maintenance of a loan to value (‘LTV’) ratio of 50%; acceptance of Group 1 securities for loans of a value ex- ceeding ¤5,00,000 and reporting of the pledge of securities to the stock exchanges. The RBI has on April 10, 2015, clarified that the requirements under the circular dated August 21, 2014 are not applicable to unlisted shares and has issued further clarifications with regards to the conditions prescribed under the circular dated August 21, 2014, which are set out as follows:

 

1. the LTV ratio of 50% is to be maintained at all times and in case of a shortfall in the LTV (from 50%) occurring on account of movement in share prices, such shortfall is required to be made good within seven working days; 
2. the condition for acceptance of only Group 1 securities for loans of value exceed- ing ¤5,00,000 is applicable only where the lending is done for investments in the capital market; and
3. the reporting to the stock exchange is to be done on a quarterly basis.

 

• The RBI has by way of its circular dated April 1, 2015 formulated a scheme for setting up of banking units by banks within International Financial Services Centres (‘IFSC’) (such scheme, the ‘IFSC Scheme’). The IFSC Scheme provides specific conditions for Indian banks and foreign banks already having a presence in India to set up such ‘IFSC Banking Units’ (‘IBUs’). In terms of the IFSC Scheme, each eligible bank is permitted to establish only one IBU in each IFSC, with a specific permission from the RBI. In case of foreign banks, an additional permission from the home country regulator of such foreign bank will also be required. The parent bank is required to provide a minimum capital of US$20 million or equivalent in any foreign currency (along with a letter of comfort for providing financial assistance to such foreign banks as and when required). The IBU’s are exempt from liabilities pertaining to both cash reserve ratio and statu- tory liquidity ratio requirements. Further, conditions regarding raising of resources, permis- sible activities, prudential regulations, maintenance of accounts and reporting requirements have also been prescribed.

 

• The RBI has, by a circular dated June 8, 2015, introduced the strategic debt restructuring scheme (‘SDR Scheme’), by way of which banks may convert loans due to equity shares. In terms of this circular, lenders forming a Joint Lenders’ Forum (‘JLF’) must incorporate in the condi- tions to the restructured loan, an option to convert the entire loan (including unpaid interest), or part of such loan, into shares in the borrowing company. This option may be exercised by the banks in an event where the borrower is unable to achieve the viability milestones and/or ad- here to critical conditions stipulated in the restructuring package. Further, the exercise of such option should be supported by necessary authorisations from the borrower, as required under law, to enable the lenders to exercise the said option effectively.

 

The RBI has further clarified that the provisions of the SDR Scheme will also be applicable to accounts that have been restructured before the date of the circular, provided that the neces- sary enabling clauses are included in the agreement between the lender bank/s and borrower. The invocation of the SDR Scheme will not be treated as restructuring for the purpose of asset classification and provisioning norms. The objective of invoking the SDR Scheme is to permit the lenders to collectively hold 51% or more of the equity shares issued by the borrower. How- ever, the equity holding by individual banks will continue to be subject to the statutory limit on shareholding by banks prescribed under the Banking Regulation Act, 1949 i.e. 30%. Further, the RBI has stated that the lenders should divest their holdings in the company as soon as possible. On divestment of banks’ holding in favour of a new promoter, the asset classification of the ac- count may be upgraded, subject to certain conditions relating to provisioning. Further, at the time of such divestment, the banks may refinance the existing debt of the borrower considering the changed risk profile of the borrower, without treating the exercise as restructuring, subject to certain conditions.

 

The SDR Scheme also provides guidelines for determination of the conversion price of eq- uity. The pricing formula under SDR Scheme has been exempted from the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 subject to certain conditions set out therein. Further, the lenders acquiring shareholding in the borrower on account of conversion of debt into equity under the SDR Scheme will also be exempted from obligations under the SEBI (Sub- stantial Acquisition of Shares and Takeovers) Regulations, 2011.

 

• The Repo in Corporate Debt Securities (Reserve Bank) Directions, 2015 specify the enti- ties that are eligible to enter into ready forward contracts in corporate debt securities. The RBI has, by way of its circular dated May 14, 2015 permitted NBFCs registered with the RBI including government companies adhering to prudential norms prescribed for NBFCs by the RBI, to un- dertake ready forward contracts in corporate debt securities.

 

• The RBI has, by its circular dated May 14, 2015, amended the Infrastructure Debt Fund-Non- Banking Financial Companies (Reserve Bank) Directions, 2011 (‘Directions’) in order to allow entry of IDF-NBFCs into sectors where there is no presence of an authority constituted for the development of infrastructure (‘Project Authority’). The amendments to the Directions are:

 

1. Investment: In addition to IDF-NBFCs being permitted to invest in Public Private Partnership (‘PPP’) and post commercial operations date (‘COD’) infrastructure projects, they may invest in non-PPP projects and PPP projects, in sectors with- out a Project Authority, provided they are post COD infrastructure projects having completed at least one year of satisfactory commercial operation.
2. Risk Weight: For the purpose of computing capital adequacy, bonds of IDF-NBFCs and all assets of Infrastructure Finance Companies, covering PPP and post COD in- frastructure projects in existence over a year of commercial operations have been assigned a risk weight of 50%. For non-PPP projects the investment will be risk- weighted as per the extant regulations in the Systemically Important Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Re- serve Bank) Directions, 2015.
3. Credit Concentration Norms: The extant credit concentration norms will contin- ue to apply to all assets covering PPP and COD infrastructure projects in existence over a year of commercial operation. For non-PPP projects and PPP projects in sectors without a Project Authority, the credit concentration norms as applicable to Infrastructure Finance Companies, defined under the Systemically Important Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Pruden- tial Norms (Reserve Bank) Directions, 2015 will apply.

 

• RBI has, by its circular dated April 30, 2015, dispensed with the requirement of prior ap- proval from the RBI for Non Banking Financial Companies (‘NBFCs’) to distribute mutual fund products. This circular also dispenses with the minimum eligibility criteria for NBFCs to under- take distribution of mutual funds i.e. those prescribed by an earlier circular, such as minimum new owned funds, minimum net profits, percentage of non performing assets etc.

 

The revised guidelines, that supersede the earlier circular, stipulate that NBFCs that wish to distribute mutual funds, must, inter-alia:

 

1. comply with the SEBI (Mutual Funds) Regulations, 1996 and code of conduct thereunder;
2. should not have any ‘linkage’ either direct or indirect between the provisions of financial services offered by the NBFC to its customers and distribution of the mu- tual fund products;
3. participation by the NBFC’s customers to the mutual funds products should be on a voluntary basis;
4. only act as an agent to the customers. The purchase of units should be at the cus- tomers’ risk and without the NBFC guaranteeing any assured return;
5. should not acquire units of mutual funds from the secondary market for sale to its customers nor should they buy back units from its customers;
6. should have put in place a comprehensive board approved policy regarding un- dertaking mutual funds distribution; and
7. the requisite Know Your Customer guidelines as prescribed by SEBI and the provi- sions of the Prevention of Money Laundering Act, 2002 as amended from time to time should be adhered to.