Willful Defaulters and Derivatives Transactions

The Supreme Court was recently confronted with a question as to whether a company that had entered into a derivatives transaction with a bank could be categorized as a “willful defaulter” under the Reserve Bank of India’s Master Circular on Willful Defaulters on account of non-performance of payment obligations. More specifically, the question was whether a bank could be treated as a “lender” in respect of such derivatives transactions. The derivatives were foreign exchange derivatives in which either party could be obligated to make payment to the other depending upon the relative movements of specified currencies over a period of time.

While there were differences of opinion between two High Courts, the Supreme Court in Kotak Mahindra Bank v. Hindustan National Glass & Industries Limited (and related matters) ruled last week that banks could invoke the willful defaulter provision even in case of unfunded transactions such as derivatives and guarantees, and that the said scheme was not confined to funded transactions such as customary lending and borrowing of sums of money.

The appeals arose out of three different cases. In one case, the Calcutta High Court held that the Master Circular applied only to borrowing and lending transactions. Since the transactions in questions were foreign exchange derivatives, it held that there was no borrower and lender and hence the derivatives counterparty (client) could not be treated as a willful defaulter. In the other two cases, the Bombay High Court came to the opposite conclusion. After considering the Master Circular and various other circulars relating to the banking industry, the Court held that counterparties of banks in derivatives transactions will fall within the purview of the Master Circular, and that banks could name them as willful defaulters (so long as they followed principles of natural justice).

On appeal, the Supreme Court was required to interpret the Master Circular. The term “willful default” is defined in the Master Circular with reference to a unit that has “defaulted in meeting its payment/repayment obligations to the lender”. The difficulty arose due to the use of the expressions “payment/repayment obligations” and more specifically the expression “lender”. A literal interpretation would mean that only customary lending and borrowing transactions would be covered. However, the Supreme Court instead adopted a purposive interpretation, keeping in mind the objective of the Master Circular. The Supreme Court’s decision was influenced by the broader objectives of the Master Circular. This is evident from the following extracts from the Supreme Court’s judgment:

34. When we look at the Master Circular, we find that the purpose of the Master Circular is "to put in place a system to disseminate credit information pertaining to willful defaulters for cautioning banks and financial institutions so as to ensure that further bank finance is not made available to them". Hence, the purpose of the Master Circular is to have a system to disseminate credit information pertaining to willful defaulters amongst banks and financial institutions so that no further bank finance is made available to such willful defaulters from such banks and financial institutions. …

35. Keeping in mind the mischief that the Master Circular seeks to remedy and the purpose of the Master Circular, we interpret the words used in the definition of 'willful default' in clause 2.1 of the Master Circular to mean not only a willful default by a unit which has defaulted in meeting its repayment obligations to the lender, but also to mean a unit which has defaulted in meeting its payment obligations to the bank under facilities such as a bank guarantee. …

36. The scheme of Collection and Dissemination of information on cases of willful default of Rs.25 lakhs and above was framed by the RBI in the year1999 when the derivative transactions were not part of the country's economy. … Such derivative transactions may not involve a lender-borrower relationship between the bank and its constituent, but dues by a constituent remaining unpaid to a bank may affect the credit policy and the credit system of the country. Information relating to defaulters of dues under derivative transactions who intend to take additional finance from the bank obviously will come within the meaning of credit information under Section 45A(c)(v) of the 1934 Act. …

Although the companies challenging the banks’ decision to treat them as willful defaulters raised several other issues, the Supreme Court did not set out its views on those. These include issues pertaining to the constitutionality of the Master Circular, which was not directly challenged in these appeals.

Given this interpretation of the Supreme Court, the Master Circular on willful defaults will have wider applicability beyond customary borrowing and lending transactions, and would extend to unfunded transactions as well where the obligor has any kind of payment obligation towards the banks. Among these, the Supreme Court has specifically listed out derivatives transactions as well as guarantees.

At a broader level, this decision is one among the line of cases where courts are keen to adopt more purposive reasoning to give effect to traditional legislative provisions as they apply in the context of more modern financial transactions such as derivatives and securitization. In this type of an approach, the courts seem keen to uphold the sanctity of contracts in such type of banking transactions in the interest of the overall banking and credit environment in the country. Other examples of this pro-bank approach that we have previously discussed on this Blog include the Supreme Court’s decision in ICICI Bank Limited v. Official Liquidator of APS Star Industries Ltd. and Rajshree Sugars & Chemical Ltd. v. Axis Bank Ltd.

Liberalisation of FDI from Pakistan

Hitherto, a person resident in Pakistan or an entity incorporated in that country was not allowed to purchase shares or convertible debentures in an Indian company. This was by virtue of Regulation 5 of the Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations, 2000.

By way of a circulardated August 22, 2012, the Reserve Bank fo India (RBI) has partially removed this prohibition. Now, a person who is a citizen of Pakistan or an entity incorporated there may invest in an Indian company under the approval route, i.e. with the prior approval of the Foreign Investment Promotion Board (FIPB). However, investment is not permitted in specific “sectors/activities pertaining to defence, space and atomic energy and second/activities prohibited for foreign investment”.

The blanket ban has given way to a more restricted avenue for investments.

A Review and Analysis of the CDR Mechanism

The out-of-court approach for corporate debt restructuring (CDR) was instituted by the Reserve Bank of India (RBI) over a decade ago. While it has been successful in several cases, there have also been significant shortcomings with the CDR mechanism.

In a recent speech, a Deputy Governor of the RBI undertakes a review of the CDR mechanism. A number of issues are examined in the speech, including –

- reasons for the large numbers of restructurings;

- excessive leveraging by borrowers, coupled with slowdown in the economy;

- lack of transparency in the restructuring process;

- the disproportionate burden assumed by the public sector banks; and

- operation of the moral hazard problem, leading to misuse of the CDR process by borrowers.

These and other issues, including the way forward are considered in the speech.

Although the CDR mechanism, despite its flaws, has helped in turning around companies, any review efforts can only be piecemeal in nature. The absence of a comprehensive and functional law on corporate insolvency in India will continue to be sorely felt.

RBI: Liberalisation in Capital Account Transactions

The Reserve Bank of India has taken measures to liberalise the process with respect to certain types of current account transactions. The measures announced include the following:

- manufacturing and infrastructure companies can avail of external commercial borrowings (ECB) to repay rupee loans towards capital expenditure; this is under the approval route with an overall ceiling of USD 10 billion (RBI circular here); and

- enhancement of the limit of USD 15 billion for FII investment in Government securities by USD 5 billion to USD 20 billion; broad-basing the non-resident investor base in Government securities, by including investors such as  Sovereign Wealth Funds (SWFs), Multilateral agencies, endowment funds, insurance funds, pension funds and foreign Central Banks to be registered with SEBI (RBI circular here).

It remains to be seen how far such measures will help boost economic growth in general and also arrest the slide in the value of the Rupee.

Miscellaneous

1.         Further Liberalization of ECB Policy

Given the ailments afflicting the civil aviation sector in India, the Reserve Bank of India (RBI) has allowedexternal commercial borrowings (ECBs) in that sector even where the end-use of funds is for working capital requirements. This is permissible under the approval route, and is subject to several conditions stipulated by the RBI.

Earlier, the RBI also announcedrelaxations in the ECB regulations governing certain infrastructure sectors such as power and toll roads and highways.

2.         Tax Treaties: Mauritius vs. Singapore

This reportin the Economic Times suggests that Singapore is becoming an increasingly attractive option for investment funds focusing on India, and that the importance of Mauritius is likely to wane in the future. India’s tax treaties with both Singapore and Mauritius provide substantially the same benefits as far as taxation with respect to Indian investments are concerned. While the advantage of Singapore is that it is an established financial centre with substantial presence requirements for investors, Mauritius has a first-mover advantage and the availability of treaty benefits has been tried and tested successfully before the Indian courts, including in the form of the Azadi Bachao Andolan case ([2003] 132 Taxman 373 (SC)).

3.         Breakout Nations

In the last decade or so, India has enjoyed the branding of an “emerging market” and has also been an integral part of the "BRIC" nations. However, a new book seeks to demystify some of these notions and challenges the continued relevance of these labels and branding. The book, Breakout Nations: In Pursuit of the Next Economic Miracles by Ruchir Sharma, has been reviewed in the Economist, with the following being some extracts from the review:

“EMERGING markets” is a useful term precisely because it is imprecise. Coined for the convenience of investors looking for somewhere exciting to put their money, it covers a bewildering range of economies with little in common, except that they are not too rich, not too poor and not too closed to foreign capital.

The invention of “emerging markets” as an asset class required the invention of experts to manage those assets; experts who could discourse confidently about places as far apart as South Korea and South Africa. It might seem impossible to say anything coherent about such an eclectic mix of places. But in fact emerging markets have shadowed each other surprisingly closely in recent years, as Ruchir Sharma of Morgan Stanley points out in his new book, “Breakout Nations”.

Mr Sharma argues that emerging-market funds have lost sight of local idiosyncrasies in their fixation with global macroeconomic forces. Because of this “macro mania”, funds make “little or no distinction between Poland and Peru, India and Indonesia”, which he suggests further synchronises these markets. Emerging markets may have little in common except the funds created to invest in them, but that in itself creates a powerful affinity between them. The term “emerging markets” has helped to create the world it named.

The review concludes with the following observations:

Mr Sharma does not believe the shared success of emerging economies can continue. Some countries will break out from the pack, others will disappoint. The very concept of emerging markets may lose its appeal, he writes, as investors discover they need to distinguish between them: “These economies are now too big to be lumped into one marginal class, and are better understood as individual nations.” …

Dormant NBFCs under RBI scanner

There are numerous NBFCs who have obtained registration from the RBI, parked their funds in fixed deposits with commercial banks but have not commenced NBFC activities for several years thereafter. In view of the recent difficulty in getting NBFC registrations as well as to get the benefit of lower net owned funds (NOF) requirements (in case the NBFC was registered pre-1999), acquiring such inactive/ dormant NBFCs had almost become the norm for entities wishing to enter the financial services' space in India.

The RBI has by way of a recent notification attempted to plug this loophole. The regulator has clarified that it issues a Certificate of Registration (CoR) for the specific purpose of conducting NBFI activities. Investments in fixed deposits cannot be treated as financial assets and receipt of interest income on fixed deposits with banks cannot be treated as income from financial assets as these are not covered under the activities mentioned in the definition of “financial Institution” in Section 45I(c) of the RBI Act 1934. Besides, bank deposits constitute near money and can be used only for temporary parking of idle funds, and/or in the above cases, till commencement of NBFI business. The RBI has directed that a NBFC which is in receipt of a CoR from the Bank must necessarily commence NBFC business within 6 months of obtaining CoR. If the business of NBFC is not commenced by the company within such a  period, the CoR will stand withdrawn automatically. Further, there can be no change in ownership of the NBFC prior to commencement of business and regularization of its CoR.

I am starting a blog tracking developments in laws/ regulations relating to NBFCs. Please follow and needless to mention, I am happy to receive comments/ feedback on practical experiences readers have had with the regulator.

Secondary Market Purchases by Foreign Venture Capital Investors

The Reserve Bank of India (RBI) has issued a circular that expands the scope of investments that foreign venture capital investors (FVCIs) can make in Indian companies. Hitherto, FVCI investments were permitted either through initial public offerings or through private placements. Under the new regime, FVCIs may acquire shares in the secondary markets from existing shareholders. The operative portion of the RBI circular reads as follows:

It has now been decided, to allow FVCIs to invest in the eligible securities (equity, equity linked instruments, debt, debt instruments, debentures of an [Indian Venture Capital Undertaking] or [Venture Capital Fund (VCF)], units of schemes / funds set up by  a VCF) by way of private arrangement / purchase from a third party also, subject to terms and conditions as stipulated in Schedule 6 of Notification No. FEMA 20 / 2000 -RB dated May 3, 2000 as amended from time to time. It is also being clarified that SEBI registered FVCIs would also be allowed to invest in securities on a recognized stock exchange subject to the provisions of the SEBI (FVCI) Regulations, 2000, as amended from time to time, as well as the terms and conditions stipulated therein.

This appears to be aimed at deepening the markets by providing greater avenues for investments in the growth sectors, a theme that is also highlighted in some of the proposals in the Budget announced last week (such as expansion of external commercial borrowings in the infrastructure sector, allowing qualified foreign institutional investors to invest in the bond markets, etc.).

Outbound FDI and M&A

The Reserve Bank of India has published a paper/address titled “Outward Indian FDI – Recent Trends & Emerging Issues” that examines various regulatory aspects of outbound FDI by Indian companies. It considers various business aspects and comments upon regulatory issues and concerns.

The latest issue of The Economist also looks at outbound M&A from India, and analyzes the level of success that Indian outbound deals have achieved. While some deals have indeed been profitable, others may not have achieved the expected success for several reasons, including the global financial crisis that emerged at the peak of the Indian outbound M&A boom. Part of the issues identified relate to complexity in Indian corporate structures, and possible regulatory obstacles. For example, the article notes:

But to do more jumbo deals in a tougher world, Indian firms need to tackle a glaring area of weakness. This is their complex structures, which mean cash flows are spread thinly, and their dislike of issuing equity for fear of diluting their controlling shareholders. Both factors combined make it hard to marshal resources without resorting to risky levels of debt.

Nevertheless, it appears that the deal-flow on outbound Indian M&As have continued even into 2012 although the sizes of the deals have dropped in comparison with those witnessed during the boom.

Regulating the Pay of Bankers in the Private Sector

Last week, the Reserve Bank of India (RBI) issued compensation guidelines for implementation by private sector and foreign banks that become operational from the financial year 2012-2013. This approach is consistent with the trend that corporate governance norms in the banking sector tend to be more controlled than in other industry sectors. Apart from the fact that the pay of CEOs and wholetime directors requires the prior regulatory approval, the compensation guidelines set out detailed principles to be deployed in order for these banks to determine senior bankers’ pay.

The guidelines place emphasis on board’s oversight regarding compensation design and operation. For example, banks must constitute a remuneration committee consisting of independent directors that frames, reviews and implements the compensation policy. The guidelines also stipulate operational matters in sufficient detail, including the distribution between fixed component and variable component of the compensation. It encourages deferral arrangements in compensations so as to eliminate short-termism in the senior management’s approach. Other mechanisms, which received significant attention following the onset of the financial crisis, such as clawback arrangements are also required to be implemented. Reliance is also placed on greater disclosure of compensation arrangements, both at a quantitative level as well as qualitative level. While the guidelines stop short of imposing quantitative limits on pay, they set out stringent requirements that banks will have to comply with starting the next financial year.

On a related note, the Economist has a different take on the politics and economics of executive compensation generally, and bankers more specifically.

QFI Route Operational

Following the decision of the Government of India to permit qualified foreign investors (QFIs) to invest in the Indian stock markets, SEBI and RBI yesterday issued detailed guidelines (here and here) to operationalise the investment mechanism.

SEBI has introduced a number of checks and balances to prevent misuse of this route. For example, significant KYC obligations have been imposed on the depository participants. Moreover, the QFIs are required to provide details regarding their beneficial ownership to prevent anonymity in trading. In the context of foreign institutional investors (FIIs), SEBI has in the past sought to ascertain details of beneficial ownership of shares, but not always with success. It remains to be seen whether SEBI will be faced with a similar situation with respect to QFIs. Further, QFIs cannot issue offshore derivative instruments such as participatory notes. All these are intended to ensure close scrutiny of investments such that significant inflows or outflows do not cause undue volatility in the Indian stock markets thereby affecting investors in general.

The Options Saga Continues

A few months ago, we had discussed a change of policy stance by the Government of India in allowing options (such as puts and calls) on shares of Indian companies to foreign investors. While the Government initially specified that the existence of such options would turn the foreign investment into an external commercial borrowing, it was quick to withdraw this stipulation due to the immediate outcry from various quarters. We had remarked at that time: “it remains to be seen whether the Reserve Bank of India (RBI) will also now adopt a more liberal approach to options and modify their prevailing position”. It appears that the RBI has not changed its approach despite the change in policy stance of the Government of India, and continues to raise doubts with respect to transactions where the foreign investor is conferred such options. The contrary signals emanating from different government authorities does give rise to tremendous regulatory uncertainty in structuring investments in India.

QFI Investments in Indian Stock Markets

With a view to creating further depth in the Indian capital markets and attracting greater foreign investment, the Government has provided another avenue for foreign investors to participate in the stock markets. Until now, the portfolio investment route (i.e. buying and selling on the stock exchange) was available only to two types of foreign investors, i.e. foreign institutional investors (FIIs) registered with SEBI and non-resident Indians (NRIs). However, last year, qualified foreign investors (QFIs) were allowed to invest directly in Indian mutual fund schemes.

Now, the Government has announced (through a press release dated January 1, 2012) that QFIs will be permitted to invest directly in the Indian capital markets. The rationale for this decision has been set out as follows:

Foreign Capital inflows to India have significantly grown in importance over the years. These flows have been influenced by strong domestic fundamentals and buoyant yields reflecting robust corporate sector performance.

In the present arrangement relating to foreign portfolio investments, only FIIs/sub-accounts and NRIs are allowed to directly invest in Indian equity market.  In this arrangement, a large number of Qualified Foreign Investors (QFIs), in particular, a large set of diversified individual foreign nationals who are desirous of investing in Indian equity market do not have direct access to Indian equity market. In the absence of availability of direct route, many QFIs find difficulties in investing in Indian equity market.

As a first step in this direction, QFIs have been permitted direct access to Indian Mutual Funds schemes pursuant to the Budget announcement 2011-12. As a next logical step, it has now been decided to allow QFIs to directly invest in Indian equity market in order to widen the class of investors, attract more foreign funds, and reduce market volatility and to deepen the Indian capital market.

Certain checks and balances have been introduced as well. For example, QFIs include only individuals, groups or associations that are resident in a foreign country which complies with requirements of the Financial Action Task Force (FATF) and is a signatory to IOSCO’s multilateral MoU. The QFIs can invest through SEBI registered qualified depository participants (DPs) who must ensure that applicable KYC requirements are met. There are also quantitative investment limits for QFIs, being 5% (individual) and 10% (aggregate) in the paid up share capital of an Indian company.

The Government’s press release appears to be an expression of regulatory intention. The details are to be contained in circulars expected to be issued by SEBI and RBI by January 15, 2012.

This is likely to attract greater foreign investment into the markets as it provides an additional avenue for investors. The current regime for FIIs requires registration with SEBI and compliance with all the requirements under the SEBI FII Regulations, which is often considered onerous. The new proposal appears to rely more on self-regulation through DPs. It remains to be seen whether there would be a gradual migration of FII investment into the QFI route if the latter confers possibilities for regulatory arbitrage. This will become clear only when the operational circulars are issued by SEBI and RBI, and the detailed requirements are known.

This analysis over at VC Circle contains a further discussion of the implications of this move.

Bank Investments in Non-Financial Services Companies

The Reserve Bank of India (RBI) has tightened the control over investment by banks in other companies that do not operate in the financial services sector. The rationale has been set forth in a new set of guidelines issued yesterday:

Banks’ investments in companies which are not subsidiaries are governed by Section 19(2) of the Banking Regulation Act, 1949 (B.R. Act). There is no requirement, at present, for obtaining prior approval of RBI for such investments except in cases where the investee companies are financial services companies. It is, therefore, possible that banks could, directly or indirectly through their holdings in other entities, exercise control on such companies or have significant influence over such companies and thus, engage in activities directly or indirectly not permitted to banks [Section 6(1) of the Act ibid deals with the activities permitted to banks]. This would be against the spirit of the provisions of the Act and is not considered appropriate from prudential perspective.

Consequently, banks are permitted to invest in non-financial services companies only up to 10% of the investee company’s paid up share capital or 10% of the bank’s net worth, whichever is less. Any investment beyond this limit would require the prior approval of the RBI. Through these guidelines, the RBI has effectively narrowed the scope of investment opportunities that banks can otherwise freely undertake under section 19(2) of the Banking Regulation Act, 1949, subject to the overall limit of 30%. By this, the RBI seems to take the position that a bank can potentially control or exercise influence over an investee company with a 10% shareholding, which is an extremely low threshold going by the conventional understanding of “control” or “influence”.

FDI – Transfer of Shares

The Reserve Bank of India (RBI), through a circular issued last week, curtailed its own approval powers involving transfers of shares of Indian companies between residents and non-residents.

Previously, certain specific transactions required the prior approval of the RBI, and these included (i) transfers not compliant with RBI’s pricing norms, (ii) those that required prior approval of the Foreign Investment Promotion Board (FIPB), (iii) where the investee company was in the financial services sector and (iv) where the transfer was within the purview of the SEBI Takeover Regulations.

In the recent circular, the requirement for approval of the RBI in these cases has been done away with so long as the transfer is otherwise in accordance with the FDI policy. Where the pricing is not in accordance with the RBI regulations for transfer, transactions will nevertheless be permitted if the pricing follows the norms of other relevant regulators such as SEBI (for takeovers, public offerings, buybacks, etc.). As regards companies in the financial sector, no prior approval of the RBI is required if no-objection certificates are obtained from the sector regulators.

The effect of the new regime is that it not only liberalizes the procedural requirements for transfers between residents and non-residents making them far easier, but it also cedes RBI’s approval powers on pricing to regulators such as SEBI which also impose pricing norms on specific securities transactions.

Revised Draft Guidelines on Securitisation

The Reserve Bank of India has issued a revised draft of its guidelines on securitisation transactions. This takes into account reform efforts internationally to deal with distorted incentives of originators in downselling financial assets soon after their creation.

The preamble to the revised draft sets forth the rationale:

1.1 Securitisation involves the pooling of assets and the subsequent sale of the cash flows from these asset pools to investors. The securitization market is primarily intended to redistribute the credit risk away from the originators to a wide spectrum of investors who can bear the risk, thus aiding financial stability and to provide an additional source of funding. The recent crisis in the credit markets has called into question the desirability of certain aspects of securitization activity as well as of many elements of the ‘originate to distribute’ business model, because of their possible influence on originators’ incentives and the potential misalignment of interests of the originators and investors. While the securitization framework in India has been reasonably prudent, certain imprudent practices have reportedly developed like origination of loans with the sole intention of immediate securitization and securitization of tranches of project loans even before the total disbursement is complete, thereby passing on the project implementation risk to investors.

1.2 With a view to developing an orderly and healthy securitization market, to ensure greater alignment of the interests of the originators and the investors, as also to encourage the development of the securitization activity in a manner consistent with the aforesaid objectives, several proposals for post-crisis reform are being considered internationally. Central to this is the idea that originators should retain a portion of each securitization originated, as a mechanism to better align incentives and ensure more effective screening of loans. In addition, a minimum period of retention of loans prior to securitization is also considered desirable, to give comfort to the investors regarding the due diligence exercised by the originators. Keeping in view the above objectives and the international work on these accounts, guidelines have been formulated regarding the Minimum Holding Period (MHP) and Minimum Retention Requirement (MRR).

The draft contains all the detailed operational guidelines that are to be complied with to achieve the above policy objectives.