Strengthening the regulatory framework for core investment companies – Commentary

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introduction
Capital stroke for direct and indirect CIC investments
Limit CIC layers within groups

New risk monitoring requirements
Corporate governance and disclosure requirements
Consolidated financial statements
Investment in money market instruments with a maturity of up to one year
Changes in nomenclature
Other changes
Comment

introduction

The concept of Core Investment Company (CIC) was first introduced by the Reserve Bank of India (RBI) in 2010. While at the time, the RBI clarified that companies that invest in stocks other companies, even for the purpose of owning a stake in such a company, should be considered as carrying on the business of a non-bank financial institution, it expressly recognized that this category of non-bank financial institutions should benefit from differential treatment. This led to the introduction of a differentiated framework for CICs – the main points of difference being the substitution of the ratio of equity to risk-weighted assets (as applicable to non-bank financial corporations (NBFCs)) with requirements different capital and exemption from investment and credit concentration rules.

The recent collapse of a top-tier group led by a highly rated CIC has highlighted the relatively light regulatory regime for CICs and demonstrated the need to strengthen it, particularly to tackle issues around:

  • leverage ;
  • complexity of group structures;
  • governance; and
  • a lack of rigorous regulatory control.

In this context, the RBI set up a working group – chaired by Tapan Ray, former secretary of the Ministry of Social Affairs – to review the regulatory and control framework of CICs. On August 13, 2020, after reviewing the recommendations of the working group, the RBI amended the regulatory regime for CICs via a circular. Some of the main changes introduced are described below.

Capital stroke for direct and indirect CIC investments

The capital requirement that currently applies to all systemically important CICs (NDSI CICs) ensures that the adjusted net worth of these companies is at least equal to 30% of their cumulative risk-weighted assets in their balance sheet and the risk-adjusted value of the balance sheet items. Another key requirement that NDSI CICs must adhere to is leverage ratio (i.e. ensuring that their external liabilities do not exceed two and a half times their adjusted net worth).

In order to face the risk of over-indebtedness of several CICs within the same group, the RBI has introduced the obligation for CICs to deduct, from their own funds, the amount equal to any direct or indirect capital contribution made by one CIC to another, to the extent that this amount exceeds 10% of the equity of the investing CIC, for the calculation of its adjusted net worth. Any such reduction will automatically affect the calculation of the aforementioned capital requirement and leverage ratio. Insofar as investments prior to this circular result in cumulative investments made by a CIC in other CICs exceeding 10% of the funds held, the RBI has introduced a “glide path” which will apply until March 31. 2023.

While the rationale for the change is clear, it raises the following concerns:

  • The method of arriving at an “indirect” investment by one CIC in another for the purposes of the capital stroke is not fully articulated and may require further clarification. For example, if a CIC invests a certain amount in a non-CIC which in turn holds shares in a CIC, it is not clear whether such an investment would automatically be interpreted as an indirect investment in a CIC or if it should be interpreted thus only where there is a demonstrable back-to-back investment of the same funds in the declining CIC.
  • The universal application of the capital stroke, regardless of whether the investing CIC made the investment in the declining CIC using borrowed funds or equity or internal provisions, seems incongruous given that the rationale for the introduction of the provision was to prevent leverage at several levels – a situation which may not occur in the case of investments made from the proceeds of equity or internal provisions of the investor CIC.

Limit CIC layers within groups

In order to respond to the complexity of group structures and the existence of several CICs within the same group, the circular limits to two the number of layers of CICs that can constitute a group (including the parent CIC), which regardless of the extent of the direct relationship or the indirect ownership or control exercised by one CIC over the other. If a CIC invests directly or indirectly in equities in another CIC, it will be considered a layer for the investing CIC. Although this restriction applies from the date of the circular, existing entities have until March 31, 2023 to reorganize their group structures and adhere to this requirement.

While the task force’s recommendation to include a layering cap provision was inspired by the Companies Act 2013 and, in particular, the Companies (Restriction on Number of Layers) Rules 2017, the meaning and scope of a “Layer” as articulated in the circular (ie any direct or indirect investment from one CIC in another) is very different from the Companies Act 2013, which limits layers to subsidiaries. Also, the exact methodology for calculating the number of layers in a widespread group with multiple CICs is not fully articulated and a clarification from the regulator (via FAQ posting or otherwise) would be helpful in this regard.

New risk monitoring requirements

The circular requires the parent CIC of a group – or, in the absence of an identifiable parent company, the CIC with the most significant assets – to set up a group risk management committee (GRMC), which must be chaired by an independent director and have at least two independent directors as members. The GRMC is primarily responsible for undertaking risk management at the group level and is accountable to the board of directors. In addition, all CICs with assets exceeding Rs 50 billion must appoint risk managers with clearly defined roles and responsibilities.

CICs must also submit to the board a quarterly variance statement certified by their CEO or CFO indicating deviations in the use of the proceeds of any financing obtained by creditors and investors from the target stated in the request, the letter of approval or the offer document for such financing.

Corporate governance and disclosure requirements

CICs are now subject to the requirements to ensure the suitability and status of their directors that currently apply to systemically important NBFCs, including the requirement to implement a board approved policy in this regard.

The circular also introduces a series of additional disclosure requirements for CICs, including disclosures that must be made on their website and in their annual financial statements. For example, CICs must publish on their website their corporate governance report and the management report covering, among other things:

  • the structure of the industry;
  • developments, risks and concerns for the group; and
  • the adequacy of internal controls.

Consolidated financial statements

In addition to reiterating the obligation for CICs to prepare consolidated financial statements in accordance with the Companies Act 2013, the circular requires CICs to include information on entities that meet the definition of a “group”. According to RBI guidelines but do not need to be consolidated elsewhere. in accordance with legal provisions or applicable accounting standards. In the light of the broad definition of “group companies”(1) under existing guidelines, which include categories such as companies with a common brand, this may require some CICs to obtain and include information on various entities that were not previously covered by their consolidated financial statements. This requirement applies from the date of the circular and the CICs must implement the protocols required for the preparation of their consolidated accounts for the fiscal year ended in 2021.

Investment in money market instruments with a maturity of up to one year

Under CIC general guidelines prior to the amendment, the exceptions for CICs not to engage in other financial activities included investments in money market instruments, including money market mutual funds and mutual funds. liquid investments. The circular now allows CICs to invest in money market instruments, including UCIs that invest in money market instruments and debt securities with a maturity of up to one year. This is a welcome initiative that will provide greater flexibility for CICs to make cash investments from their surplus funds until they are required for deployment for their core business.

Changes in nomenclature

The circular specifies that core investment companies of systemic importance will henceforth be referred to as “CIC” and that exempt CICs will henceforth be referred to as “unregistered CIC”.

Other changes

Circular requires CICs to adhere to guidelines on submitting data to credit reporting companies that apply to systemically important NBFCs and the RBI Circular of March 13, 2020 on implementation Indian accounting standards.

Comment

Overall, the new framework is a welcome initiative and will help improve corporate governance, monitoring and risk management for CICs. However, heightened compliance and disclosure requirements mean that existing CICs, especially those with lean teams, must implement the operational means necessary to comply with the framework on an ongoing basis. It would be useful for the regulator to expressly clarify the few ambiguities mentioned above to help CICs in their efforts to realign group structures and investments to adhere to the circular.

For more information on this topic, please contact Gautam Ganjawala or Lokesh Deshwal at AZB & Partners by phone (+91 22 4072 9999) or by email ([email protected] Where [email protected]). AZB & Partners’ website can be accessed at www.azbpartners.com.

End Notes

(1) “Group companies” means an agreement involving two or more entities related to each other by one of the following relationships:

  • “Parent subsidiary” (defined in terms of Accounting Standard (AS) 21);
  • “Joint venture” (defined under the terms of AS 27);
  • “Associates” (defined according to AS 23);
  • “Promoter-promoter” as provided for in the Securities and Exchange Board of India (Acquisition of Shares and Takeover) Regulations 1997 for listed companies;
  • “Related parties” (defined in terms of AS 18);
  • companies with a common brand name; and
  • companies with equity investments of 20% or more.
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