Tuesday, February 24, 2015

RBI’s New Diktat: Lending to a Subsidiary

[The following post is contributed by Nivedita Shankar, who is a Senior Associate at Vinod Kothari & Company. She can be contacted at nivedita@vinodkothari.com]

The Reserve Bank of India (RBI) on January 7, 2015[1] has modified the Master Circular on Wilful Defaulters (Master Circular) with a view to usher in greater transparency and accountability in the process for identification of wilful defaulters. However, in its zeal to clamp down on the number of wilful defaulters, the RBI has inadvertently or purposefully added further to the woes of doing business in India.

Companies look to expand their businesses by establishing subsidiaries and joint ventures and undertaking expansions through them. These ventures are nothing but off shoots or subsets of the parent companies. The new regulations of the Master Circular, however, now will completely scuttle any effort of parent company to provide financial aid to its subsets. This is because providing borrowed funds to the subsidiaries/ group companies either through fund-based or non-fund based modalities can henceforth be construed to mean ‘diversion of funds’ or more aptly described as “siphoning of funds”.

Meaning of ‘diversion of funds’ or ‘siphoning of funds’

Para 2.2.1 defines ‘diversion of funds’ as follows:

(a)          utilisation of short-term working capital funds for long-term purposes not in conformity with the terms of sanction; 

(b)          deploying borrowed funds for purposes / activities or creation of assets other than those for which the loan was sanctioned;

(c)          transferring funds to the subsidiaries / Group companies or other corporates by whatever modalities;

(d)          routing of funds through any bank other than the lender bank or members of consortium without prior permission of the lender

(e)          investment in other companies by way of acquiring equities / debt instruments without approval of lenders;

(f)           shortfall in deployment of funds vis-à-vis the amounts disbursed / drawn and the difference not being accounted for.

Further, Para 2.2.2 of the Master Circular defines ‘siphoning of funds’ as follows:

Siphoning of funds, referred to at para 2.1(c) above, should be construed to occur if any funds borrowed from banks / FIs are utilised for purposes un-related to the operations of the borrower, to the detriment of the financial health of the entity or of the lender. The decision as to whether a particular instance amounts to siphoning of funds would have to be a judgement of the lenders based on objective facts and circumstances of the case.

As discussed above, any subsidiary being a sub-set of the holding company will of course look up to it for financial aid. However, by leaving the discretion completely on the RBI, the Master Circular has made the provision of financial aid by holding companies a cautionary step. In this regard, one needs to also direct attention to the consequences of diversion of funds, which are listed out in para 2.5 and enumerated below:

1. No additional facilities would be granted by any bank / FI to the listed wilful defaulters. Additionally, the entrepreneurs / promoters of companies where banks / FIs have identified siphoning / diversion of funds, misrepresentation, falsification of accounts and fraudulent transactions would be debarred from institutional finance from the scheduled commercial banks, Development Financial Institutions, Government owned NBFCs, investment institutions etc. for floating new ventures for a period of 5 years from the date the name of the wilful defaulter is published in the list of wilful defaulters by the RBI.

2. Lending banks have been given full authority to initial criminal proceedings against wilfull defaulters, where necessary

3. Banks and FIs have also been advised to adopt a pro-active approach for a change of management of wilfully defaulting unit.

4. The Master Circular also advises inclusion of a covenant in the loan agreements that the borrowing company will not induct a person who is a promoter or director on the Board of a company which has been identified as a wilful defaulter. Where a company already has such a person on board, it will take expeditious steps to remove him.

Thus should the parent company default in its payment to lenders and if in case the lender is of the view that the disbursed funds were diverted for some other purpose than the purported end-use, then the borrower will not be granted additional credit facilities. To worsen matters, the restriction on providing additional credit facilities has been extended to other banks as well. So, once the borrower is declared as a wilful defaulter, not only will the lending bank cease to provide facilities, any other bank will also not grant any credit facilities.


Para 2.2 requires that the banks should keep the track record of the borrower and the decision to declare as wilful defaulter should not be based on isolated transactions. The Master Circular has left it to the lender’s will to view any default as being intentional, deliberate and calculated before classifying it as ‘wilful’. Further, para 2.3 also relaxes the penal measures mentioned in para 2.5 in case of outstanding balance of less than Rs. 25.00 lakhs. However, by allowing very little opportunity to represent since the right to personal hearing by promoter/ whole-time director has also been left to the discretion of the Committee set up by the lender, there is hardly any scope for the borrower/guarantor company to represent its stand or voice its concerns.

With the Companies Act, 2013 making it difficult for companies to enter into related party transactions, the Master Circular has further added to the woes. Not only does the Master Circular cover fund-based transactions, it also contains specific references to a guarantee provided by any group company. There is of course no restriction on providing guarantees to the group company. However, as per para 2.6 of the Master Circular, once invoked, if the guarantees are not honoured, then the group company will be considered as a wilful defaulter. The Master Circular has also made a reference to section 128 of the Indian Contract Act, 1872 to state that banks can proceed against the guarantor without first exhausting all remedies against the borrower. In this regard, one may refer to the provisions of SARFAESI Act, 2002, which was enacted with the intention to help banks to speedily enforce security interest. Even under SARFAESI Act, 2002, the borrower (which also includes a guarantor) has been given the right to represent. However, RBI has completely overlooked the right of any defaulter to explain its stand and has placed sweeping powers in the hands of the lenders.

It is in common knowledge that lenders are concerned about lending to any newly incorporated company since, its ability to repay is questionable. It is under such circumstances, that the parent company steps in as the guarantor. Since, a subsidiary or a joint venture company is nothing but a sub-set of the parent company, it is but obvious that it will look up to the parent company to act as the guarantor. However, the Master Circular will make any lending company think twice before it makes any financial commitment. Possibly, the only good news from the Master Circular is that it is not retrospectively effective. With penal measures such as reporting to SEBI, CIBIL, possibility of change of management, companies may have to exercise due care and caution before entering into lending transactions.

- Nivedita Shankar

1 comment:

vswami said...

OFFHAND (to share):
By any thinking, this is an unsavoury and unwarranted development, this time RBI being its architect.
Two things essentially crop up, having every potential for a fresh spate of controversies and inevitable litigation:
1. Diagonally opposite to what the new government at the centre has mooted and been lately aiming at,: a) To ease doing of business, with simplified norms and procedures; and b) more governance with less government (understood to meaning, mainly ‘interference’/’superimposing’).
2. Ostensibly, the aforesaid welcome change in the direction decided upon by the centre, for betterment, as was not unexpected, has miserably failed to percolate down.

Further, on the flip side, the new diktat is, as ought to be envisaged, most likely to add a new dimension to the long prevailing vexing controversy, remaining unsubstantiated on merits, in regard to tax deductibility of interest expense on borrowing for bailing out 'related' companies in times of distress.
Without clear dissuading steps, in the form of binding diktats from the centre / the concerned ministries, the lately decided-upon- change in direction /policies could only be expected to be thwarted/effectively vetoed , by the bureaucrats below, including the regulatory/semi-regulatory authorities.