Wednesday, November 23, 2016

Regulation of invoice discounting start-ups: Is RBI proposing a disproportionate regulation?

[The following guest post is contributed by Srinivas Medisetty, who is presently working as a legal counsel in Ola (ANI Technologies Private Limited) advising on the regulatory and litigation aspects of the company. Views expressed are personal.]

The Securities and Exchange Board of India (“SEBI”) as the capital market regulator rightly stepped in to regulate crowd funding through investment in securities, whether equity, debt or fund based. The Reserve Bank of India (“RBI”) being the money market regulator, anticipating a disruption in the financial sector, has evinced interest (through a consultation paper issued in April this year) to regulate the on-line platforms engaged in peer-to-peer (“P2P”) lending which is also a form of crowd funding.

The RBI steps in to regulate the P2P lending platforms treating them akin to non-banking finance companies (“NBFCs”), very well recognizing the business of financial intermediation. However, it is not yet objectively supported by any legal considerations, apart from the likelihood that these platforms may rapidly grow, resulting in high value transactions and thereby being disruptive.

The question of whether the operations of the P2P lending platforms (that are pure play intermediaries with minimal overlap of financial functions) may be regulated like NBFCs, as the RBI presently intends to do, is difficult to be answered in the affirmative. For instance, some of the startups functioning in this space act as invoice discounting market places, where investors may invest in the invoices of cash strapped small and medium enterprises (“SMEs), which are raised against blue chip companies, but remain unpaid. The investor invests at a discounted value of the invoice and achieves returns when the blue chip company finally pays the outstanding dues. The platform only acts as an intermediary, which enables an investor and an SME meet over its platform. All other ancillary services such as the credit worthiness check, legal or accountancy services are provided though separate entities (assuming that the platform has entered into separate agreements with such entities) which are already regulated through statutes such as Credit Information Companies (Regulation) Act 2005, the Companies Act 2013 or the respective bodies governing professionals such as lawyers and chartered accountants.

The following are certain noteworthy points in the consultation paper:

1.         P2P lending “can be defined as the use of an online platform that matches lenders with borrowers in order to provide unsecured loans”. By this definition, asset backed loans against accounts receivables cannot be treated as P2P lending. Further, defining the usage of on-line platforms as P2P lending is itself misconstrued. The platform is merely a facilitator and the actual lending happens between the participants of the platform i.e. the borrower and the investor.

2.         Fixing the Interest rate – the consultation paper highlights the risk that the platform may fix interest rates.  An intermediary should ideally not transgress its function. If the online platform fixes the interest rate to be paid by the borrower, the regulators may attribute such functions to be financial. A majority of startups in this space do not determine the discount rate and it is market driven. However, the regulator may be interested in understanding how the market driven discount rate is determined by the platform.

3.         The platforms provide the service of collecting loan repayments and carrying out preliminary assessment of the borrower’s creditworthiness. The platforms do the credit scoring and make a profit from arrangement fees and not from the spread between lending and deposit rates, as is the case with normal financial intermediation. This a clear differentiation between financial intermediary and an intermediary providing services in accordance with the Information Technology Act 2000, and the intermediaries guidelines.[1]

4.         The issues regarding the need for regulating the platform are as follows:

(a)            the financial services made available through the platform, are provided by credit information/banking/accountancy firms or the legal services provided by law firms, which are already regulated under various statutes. The electronic platform, which brings these regulated institutions and the platform-participants together, need not be separately regulated;

(b)            as no cash transactions are contemplated, there is no scope for un-accounted transactions;

(c)            disproportionate regulation of the platform may trickle to the investor and deter them from investing thereby affecting the working capital requirements of MSME’s; and

(d)            even if any unregulated P2P platform adopts an unhealthy practice it would be an anti-competitive practice which the other participants can address to the Competition Commission of India within the present competitive ecosystem.

This ensures that the end users of the platform stay benefitted without disproportionate regulatory interference.

5.         The platform facilitates receipt of post-dated cheques from the borrower in the name of the lender as a proxy for repayment of the loan. The P2P platform, in general, also helps in the recovery process and as part of this, follows up for repayments and if need be, employs recovery agents too. Several platforms collect cheques from the borrowers. If the recovery process only involves collection of cheques, then in results in the platform acting in the capacity of an agent of the investor. However, if it also engages recovery personnel or adopts other coercive measures, then any related criminal actions of such recovery will be dealt with by the application of penal laws.

6.         In case of NBFCs involved in accepting deposits and lending, the RBI is clearly interested in regulating the deposits and the lending activity of such NBFCs. As the P2P platforms by themselves are neither engaged in the acceptance of deposits nor lending, the regulation should not overstep the purpose.

As mentioned above, any disproportionate regulation may severely impact the technology-based platforms. The intermediaries may however be guided by prescribing the standards of due diligence which is required to be undertaken before providing access to the participants and the relevant stakeholders on to the platform to avoid any illegal or unscrupulous transactions. The following are certain instances, which may require selective regulation:

1.         The platform is to ensure that during the registration process it shall allow only those investors and SMEs who do not fall within the purview of section 45(s) of the Reserve Bank of India Act 1934 (“RBI Act”). This section intends to regulate certain non-deposit accepting financial institutions or individuals or firms engaged in receiving deposits and lending in any manner. The facilitation exercise should not allow participation by the aforesaid players.

2.         Any regulations around the confidentiality, use and processing of data collected from the participants of the platform and the activity of the platform such as (a) custody of documents; (b) disclosure requirements to the investors about the borrowers and (c) assured returns on investment etc. may streamline the operations of these platforms.

3.         Any further regulation beyond the participation on the platform should only be undertaken under section 45 (JA) of the RBI Act (to regulate the financial system of the country) only after any tangible effect of the P2P lending on the financial system is statistically established.

4.         Any regulation under section 45(L) of the RBI Act, which solely seeks information and statements, may be adhered to. The regulatory intent appears to be only to gauge the exposure of NBFCs (also when P2P platforms are treated as NBFCs) to volatility and the likely impact on the markets. While the information sharing with the regulator may be seemingly harmless, any direction, which may follow, is unknown territory for a P2P platform.

In addition to the above and to put things into perspective, we are directed towards a question whether operating a platform for trading the receivable of an SME is actually unregulated or if the Guidelines for setting up of and operating the Trade Receivables Discounting System (TReDS) are applicable.

These Guidelines are issued by the RBI under section 10(2) read with section 18 of Payment & Settlement Systems Act, 2007. Further, the intent behind regulating a trade receivable discounting system appears to be the fact that the platform is a payment and settlement system and not an NBFC.

Objectively, there is a likelihood of drawing parallels between the mode of operation of these platforms and the applicants under the TReDS scheme. However, the significant difference appears to be the fact that under the model followed by the start-ups, the financier is an individual investor or an institutional investor, whereas under the aforementioned guidelines a conventional bank or NBFC is contemplated to be the party investing in the receivable (invoice). Evidently, the platforms have not opted to be applicants for an in-principle approval under the guidelines. The relationship also depends on the kind of contractual obligations that these platforms have undertaken with each of the platform participants.


There is a strong likelihood that these platforms may be asked to assist in ensuring the compliance with the settlement cycle as prescribed by the RBI as there are payment obligations by an investor to the SME and subsequently between the blue chip company and the investor. If a platform is also facilitating the payment process, it may also be required to keep a track and record of all payments made between the participants and also to coordinate between the banks of the participants.

As the platforms operate currently, the information whether these platforms assist in the settlement process between the participants on the platform, which is usually done through the banking channels of the participants, is not known. If these platforms are is engaged in the same, though they are not applicants under the aforementioned guidelines, any of the successful applicants who themselves stand regulated as a payment and settlement system may also want other similarly functioning entities to also be regulated, thereby requesting the RBI to act to bring such platforms within the regulatory net.

- Srinivas Medisetty

[1] Information Technology (Intermediaries Guidelines) Rules, 2011

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