Sanjam AroraPartner
Prashant KhuranaAssociate
Jatin LalwaniAssociate
Key Developments
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Review of regulatory framework for asset reconstruction companies and asset reconstruction companies as resolution professionals
The asset reconstruction company (ARC) ecosystem and the Insolvency and Bankruptcy Code, 2016 (IBC) were introduced to address India's growing concerns with providing a robust framework for the exit of loss-making businesses and freeing up credit resources with banks to enhance lending activities.
Currently, ARCs are regulated by the Reserve Bank of India (RBI). Their business model hinges on the arbitrage from buying non-performing loans at discount and making substantial recoveries. To this end, their organisation and management can have a cascading effect on the stability of the financial sector.
The RBI has recently, on a review of the regulatory regime governing ARCs, overhauled its regulations in this regard to improve their corporate governance standards. A key change introduced is the permission granted to an ARC with a net owned fund (NOF) of more than INR 1,000 crores to act as a resolution professional under the IBC (subject to other conditions governing professional conduct). This is a logical integration of the ARC business model with the insolvency regime and could enable them to scale their businesses.
Other key highlights of the new regime are:
- Increased NOF Requirements: An ARC is now required to have a minimum NOF of at least INR 300 crores (on an ongoing basis) instead of the extant requirement of INR 100 crores. Existing ARCs can meet these requirements in a staggered manner by the end of FY 2025-26.
- Liberalisation of surplus funds utilisation: Surplus funds of an ARC (up to 10% of NOF) can now be deployed in short-term instruments such as money market mutual funds, certificates of deposit and corporate bonds/commercial papers which have a short-term rating equivalent to the long-term rating of AA- or above. This should help reduce carrying costs for cash on an ARC’s balance sheet and enhance management autonomy for treasury decisions.
- Change in control approvals: The existing regulations required the approval of the RBI where a sponsor was added, removed or substituted owing to transfer of shares. An approval was also required if a sponsor transferred 10% or more of the ARC’s share capital within five years of obtaining the certificate of registration. This approval requirement has now been extended to situations where an issue of new shares (and not just a transfer) yields the same result.
- Board and key managerial personnel guidelines: The chairperson of the board of directors must be an independent director. The Managing Director/Chief Executive Officer/whole time director of the ARC can hold their post continuously for a maximum of 15 years, subject to renewal every five years. Service beyond 15 years is possible only after a three-year cooling off period - the individual cannot be associated with any ARC for this time in any capacity. The individual must also compulsorily retire after attaining the age of 70 years.
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Board committees: The board of directors of an ARC is now required to constitute an Audit Committee and a Nomination and Remuneration Committee (NRC).
- The Audit Committee can comprise only of non-executive directors and an independent director (not being the chairperson of the board or of any other committee) as its chairperson.
- The NRC is to be constituted in accordance with the Companies Act, 2013, i.e., with at least three independent directors, 50% of the committee being comprised of non-executive directors and an independent director (not being the chairperson of the board) as the chairperson.
Existing ARCs have been given a six-month period (ending 10 April 2023) to transition to this structure.
- Enhanced disclosures: ARCs now need to make enhanced annual disclosures relating to (i) summary of financial information for the preceding five years of operations, (ii) returns generated on security receipts issued in the preceding eight years of operations, and (iii) recovery rating track record for preceding eight years of operations.
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Categorisation of Non-Banking Financial Companies
In late October 2021, RBI introduced a layered system of categorisation for Non-Banking Financial Companies (NBFC), to provide a cascading scale of regulatory oversight and compliance requirements depending upon the size, scale and systemic importance of the NBFC to the Indian financial services sector.
Adding to this scale-based categorisation, RBI has now issued a notification that NBFCs that are part of the same group or with common promoters would no longer be evaluated on a standalone basis for regulatory compliance in the middle layer i.e., non-deposit taking NBFCs with asset size of INR 1,000 crore or above. It is noteworthy that categorisation in the middle layer increases the frequency of regulatory reporting on elements such as solvency, non-performing assets, etc. It also increases capital adequacy requirements and places concentration limits on exposure to a single entity/group (by way of loans or investments). Accordingly, where a group has multiple NBFCs which each individually fall below the threshold for being categorised in the middle layer, the combined value of the group’s NBFCs would be used for the categorisation. Groups such as Kotak Mahindra Group, Axis Finance and Credilla Financial services have been categorised in the middle layer. It is likely that many other NBFCs will now be eligible to be categorised in the middle layer.
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Prudential norms for corporate/NBFC lending by banks – use of proxy credit reports
Under existing norms, banks may use the credit rating of a company/NBFC reported on a debt of similar profile (tenure, interest, etc.), when accounting for the debt in their own books – without having to conduct an independent rating analysis on the facility extended by the bank. However, ratings from reporting agencies often exclude lender details for purportedly similar loans (owing to privacy considerations of the borrower), obscuring a complete analysis of similarity of the loan’s profile.
To avoid under-pricing risks, the RBI has now tweaked prudential norms, requiring banks to either (i) conduct independent rating analysis, or (ii) ensure that the proxy reports provide lender details. In all other cases, banks need to account for such lending as ‘unrated’ exposure in their books – requiring higher capital provisioning for such loans. These changes may have the effect of tightening capital requirements for banks that are lending to corporates and NBFCs.
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Discontinuation of regulatory regime for unlisted Infrastructure Investment Trusts
The Securities and Exchange Board of India (SEBI) introduced key amendments in the previous quarter to the SEBI (Infrastructure Investment Trusts) Regulations, which have taken effect from 1 January 2023. The amendments appear to discontinue the regulatory framework for unlisted Infrastructure Investment Terms (InvITs). While there is little clarity on how existing unlisted InvITs will be treated, there is speculation that SEBI has undertaken this step with the intent to discontinue tax benefits for unlisted InvITs, which are closely held and whose assets would otherwise have been structured in the ordinary course (without the consequent tax benefits). Though the change has limited impact given the relatively few privately held InvITs, it has rekindled the debate on regulatory certainty and its impact on investment decisions.
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Liberalisation of other forms of capital issuance for insurance companies
In December 2022, the Insurance Regulatory and Development Authority (IRDAI) issued new regulations - the IRDAI (Other Forms of Capital) Regulations, 2022. The new regulations do away with the requirement of IRDAI approval for issuance of preference share capital (i.e. a share carrying a preferential right to dividend relative to equity shares) or coupon-carrying subordinate debt instruments, by an insurer. Key highlights of the new regulations are as follows:
- Eligible investor: Both domestic and foreign investors may invest in such securities, subject to conditions that apply in the ordinary course under exchange control regulations (e.g., pricing/valuation rules).
- Issuance limits: An increased limit for quantum of issuances for these instruments is now provided. The new limit stands at the lower of – (i) 50% of aggregate of paid-up equity share capital and securities premium; and (ii) 50% of net worth of the insurer. The limit prescribed under the older regulations was 25% of the total of paid-up equity share capital and securities premium, and the total issuance not exceeding 50% of the net worth of insurer at any point.
- Return on investment: The preferential dividend on preference shares or coupon on debt instruments can be paid in the ordinary course, so long as the insurer is profitable and maintains a solvency ratio of 150%. Solvency ratio is the ratio of an insurer’s assets to its liabilities and reflects the insurer’s ability to have enough liquid assets on its balance sheet to be able to pay out any policy change.
While certain other procedural requirements also apply to the issuances, the changes open up an alternative avenue for insurance companies to raise capital. This is significant given that the IRDAI requires insurers to adhere to strict capital conservation norms – which may have been the reason for most Indian insurance companies not issuing preference shares so far.
In the preceding quarter, several granular changes have also been introduced in the insurance sector that have a direct impact on business models and availability of innovative products in the sector. For instance, IRDAI liberalised its sandbox regulations to permit demand-based testing of innovative products as against allowing such tests for specified periods earlier.
Looking at the next quarter, it would be interesting to see how proposals such as the Insurance Act (Amendment) Bill (currently with the government) take shape. Also, the quarter kicked off with SEBI proposing (in January 2023) significant amendments to the ‘offer for sale (OFS) through stock exchanges’ route for listed companies. The recent changes expand the OFS route to non-promoter shareholders of listed entities with market capitalisation of INR 1,000 crore or above (for a period of six months prior to OFS opening), subject to a minimum offer size of INR 25 crore. This is noteworthy because earlier the OFS route was only available to promoters and promoter group entities of listed companies, who used it as a preferred method for offloading partial stakes to meet regulatory minimum public shareholding norms (often breached during M&A transactions). The changes would now permit institutional investors in mid-large listed entities to achieve relatively quick sales of their holdings through stock exchanges, providing an effective alternative for exiting residual holdings or complying with regulatory requirements, compared to negotiated off-market transfers.
