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The release of the Master Directions on Non-Banking Financial Company – Peer to Peer Lending Platform (Reserve Bank) Directions, 2017 (“ Master Directions ”) was a  decision anticipated since April 2016 when the Reserve Bank of India (“ RBI ”) issued a Consultation Paper on Peer to Peer (“ P2P ”) lending (“ Consultation Paper ”). The Consultation Paper contained various arguments against and in favour of regulating the P2P lending sector. Thereafter, on August 24, 2017, as a precursor to the ultimate regulations, the RBI issued a gazette notification classifying entities providing the ‘business of a peer to peer lending platform’ as a Non-Banking Financial Company (“ NBFC ”). The Notification assumes significance since the classification of a P2P lending platform as an NBFC brings such a platform within the RBI’s regulatory ambit. The broad points under the Consultation Paper have now been crystallised under the Master Directions released by the RBI on October 04, 2017.

The key points of the Master Directions are discussed in a question-answer format, dealing with the major compliance and operational issues pertaining to the P2P lending platform.

1. What is the business of a P2P lending platform according to the RBI?

According to the RBI, a P2P lending platform is

• A company (incorporated under the Companies Act, 1956/2013)

• Which is an intermediary

• Providing the services of loan facilitation

• Via online medium or otherwise

• To persons who have entered into an arrangement with it to lend or to avail of the loan facilitation services

A platform fulfilling the above criteria is classified as an NBFC P2P.

2. Are there any registration requirements for an NBFC P2P?

The RBI has introduced a registration mechanism for all entities (whether currently existing or proposed to be incorporated) to operate as an NBFC P2P. An important precondition for seeking registration is having a Net Owned Fund (“ NOF ”) of not less INR two crores. The NOF is calculated in the following manner:

NOF = (A – B) – C

where

A = Paid up equity capital + Free reserves + Balance in share premium account + Capital reserves (representing surplus arising out of asset sale excluding revaluation of assets)

B = Accumulated loss + book value of intangible assets

C = Investments in shares of other NBFCs and in shares, debentures of subsidiaries and group companies greater than 10% of (A-B).

Additionally, an NBFC P2P must maintain a leverage ratio not exceeding 2 at all times during the course of its operations. The leverage ratio is defined as the ratio of the total outside liabilities and the owned funds (A+B) of the NBFC P2P. Thus, the total outside liabilities must not be more than twice the owned funds of the NBFC P2P.

Apart from certain documentary filings and declarations required from its directors, the NBFC P2P is also required to submit a plan for the implementation, or proof of implementation, of a robust and secure information technology (“ IT ”) system, presumably to ensure the safety of sensitive data such as the credit information of participants. Further, it must also submit a viable business plan after approval by the board of directors (“ Board ”) of the NBFC P2P.

Scrutiny by the RBI and In-Principle approval

After scrutinising the application forwarded by new entities, the RBI may grant an in-principle approval, subject to additional conditions. The in-principle approval will be valid for twelve months from the date of its grant. Within this period, the NBFC P2P is required to ensure complete compliance with the Master Directions, including the setting up of the IT systems, and report the same to the RBI. This is pertinent in light of the fact that the business of the NBFC P2P is primarily technology driven and therefore, the IT system must be capable of handling business growth and provide protection against unauthorized access. An NBFC P2P can only commence operations upon receiving a Certificate of Registration (“ CoR ”) from the RBI.

Existing Entities

To ensure continuity of business, the RBI has allowed existing NBFC P2P entities to continue their functions subject to procuring a CoR within three months from the date of the Master Directions, i.e., by January 03, 2018. Prior to such date, all existing NBFC P2Ps must apply for registration with the RBI and continue their business until their application for a CoR is rejected.

Comments: The requirement of a minimum NOF and a leverage ratio not exceeding 2 presumably ensures that the NBFC P2P is likely to remain sustainable. Further, the leverage ratio would render the NBFC P2P incapable of borrowing indiscriminately so as to function within the leverage ratio. However, some existing NBFC P2Ps may find it difficult to generate the minimum NOF within the mandated three month period. Raising finances for scaling up the operations may also be hindered since debt financing would have to be considered with the leverage ratio in check.

Further, a three month period for existing entities to comply with, or draw out strategies to comply with the significant requirements of these Master Directions may also prove to be a clog in their regular operations; it remains to be seen how the RBI would consider these issues once the three month period expires.

3. What are the general obligations of an NBFC P2P?

An NBFC P2P is required to undertake the following activities to facilitate the lending process on its platform:

• Undertake a due diligence of the participants on its platform

• Undertake the credit assessment and risk profiling of borrowers on the platform, and disclose the same to prospective lenders

• Documentation, including loan agreement, consents, etc.

• Facilitate disbursement and servicing of the loans

• Provide loan recovery services in respect of the loans originating on the platform

The RBI has limited the role of an NBFC to provide only those services specified in the Master Direction and not undertake any other activity.

Comments: The objective behind these provisions appears to be safeguarding the interests of the participants on the platform, particularly the lenders, and ensuring that only genuine, credit worthy borrowers are approved. Although the broad manner in which the RBI has specified these requirements provides leeway to an NBFC P2P to conduct such exercises as it deems fit, some aspects would defintely need greater clarity, particularly in relation to the loan recovery process, which may result in borrowers being subject to harassment from such agents.

4. Which activities are prohibited to be undertaken by an NBFC P2P?

An NBFC P2P:

• Cannot raise deposits (as described under the Companies Act, 2013 and the Reserve Bank of India Act, 1934)

• Cannot lend using its own funds

• Cannot provide or arrange any credit enhancement or credit guarantee

• Cannot facilitate or permit any lending which is backed by a security or collateral linked to its platform

• Cannot hold any funds on its balance sheet, any form of funds, either for the purpose of lending or servicing

• Cannot cross sell any product except for loan specific insurance products

• Cannot allow international flow of funds

In other terms, the primary role of the NBFC P2P is to facilitate the lending of unsecured loans without providing any credit guarantee or enhancement, and without holding any funds meant for the purpose of either disbursement or servicing of the loans, in its own account.

Comments: In line with the RBI’s desire to limit and restrict the role of an NBFC P2P as a mere facilitator, the Master Directions clearly proscribe certain activities in the interest of the participants. This may, however, limit the ability of certain NBFC P2Ps to monetize activities that may have been ancillary, complementary, or even supplementary to the their primary functions.

5. Who can lend on an NBFC P2P platform?

The Master Directions allow any person to lend on an NBFC P2P platform subject to the aggregate exposure of any one lender to all borrowers at any point, capped at INR ten lakhs, and exposure to a single borrower capped at INR fifty thousand.

An NBFC P2P platform is required to furnish details about the borrower, including its personal identity and credit score, and the details of the loan including the amount and the interest, fees, and taxes. However, the Master Directions do not mandate the disclosure of personal identity and contact details of the lender to the borrower.

Additionally, the lender must provide the NBFC P2P an explicit affirmation about the voluntary assumption of risks of transactions undertaken in the NBFC P2P, and specify that there is a likelihood of loss of the entire principle in case of default. This declaration becomes critical for an NBFC P2P to limit any liability upon it owing to a default.

6. Who can borrow on an NBFC P2P platform? What are their obligations?

Any person may obtain a loan subject to the exposure limits as applicable to lenders. The maturity period of any loan obtained by a borrower cannot exceed 36 months. Further, as a condition precedent to the grant of the loan, the borrower is required to provide personal details and its credit score (or information/data required to obtain the credit score) to the NBFC P2P. The borrower must be provided with the details about the lender including the proposed amount and interest rate of the proposed loan.

Comments: These conditions may create an issue amongst the incumbents as a lower exposure limit reduces the possibility of viable returns for certain individuals, including high net worth individuals, from taking advantage of such a platform. However, the RBI may just be exercising caution at this stage and may be assessing the manner in which these regulations are implemented. It is possible that if the RBI feels that the industry can function efficiently without the need for excessive restrictions, these limits may undergo a change. However, as things stand, these limits along with the credit information of the borrowers appears to have been implemented to provide the lenders a sense of comfort and reduce the downside to their loans.

7. What are the general disclosures required by an NBFC P2P on their website?

The RBI has put in place conditions requiring disclosure of important information on the website of an NBFC P2P which include the following:

• Credit score assessment mechanism/methodology and factors considered

• Disclosure on usage/data protection

• Grievance redressal mechanism

• Portfolio performance

• Broad business model

• Fair practice code based on the guidelines within the Master Directions, as approved by the Board of the NBFC P2P

• Policy for handling grievances/complaints, including the details of the contact persons who can be approached for resolution of complaints against the NBFC P2P

Additionally, as mentioned above, the NBFC P2P must also display a caveat on its website stating that the RBI would not be responsible for any incorrect or inaccurate statements on the NBFC P2P, nor would it offer any assurance for repayment of loans.

Comments: These requirements would necessarily increase the compliance costs for an NBFC P2P; yet, at the same time, they would ensure that the business of P2P lending becomes transparent and stakeholders have complete access to basic information from each NBFC P2P. Transparency would also result in greater competition amongst the players, thereby benefitting the industry in general and the participants in particular.

8. What are the documents required to be executed for a transaction?

At the minimum, the NBFC P2P is required to ensure the execution of a loan contract detailing the terms of the loan as agreed between the lender and the borrower (subject to the conditions of the Master Directions). Further, all the services provided by the NBFC P2P to each of the participants must also be captured through appropriate agreements. Additionally, the consents required from the borrower for accessing its credit information, the document noting the acceptance of risk from the lender, and a certificate from both borrower and lender confirming the compliance to the exposure limits, must also be sought and maintained by the NBFC P2P.

9. How is a loan required to be disbursed and serviced?

Funds are transferred using an escrow mechanism facilitated by an NBFC P2P using the assistance of a bank. At least two separate escrow accounts are required to be created by the NBFC P2P – one for the receipt of funds for disbursal from the lender, and another for the receipt of funds as servicing of the loan from the borrower. The RBI has proposed a possible method for the assistance of an NBFC P2P in the Master Directions.

Comments: Significantly, an NBFC P2P must not have any direct control over any funds routed through their platform. This increases the legitimacy of platforms and provides a degree of comfort to the participants. However, this would also result in greater compliance costs for entities which do not already conform to this requirement.

10. What are the operational compliances required to be undertaken by an NBFC P2P

The RBI has introduced strict compliance requirements from an NBFC P2P. The following are some critical compliances:

• Board approved policy of operations noting, inter alia, the eligibility criteria of participants; the pricing of services; the rules or methods of matching lenders with borrowers, etc.

• Compulsory membership of all Credit Information Companies (“ CIC ”) and provision of data, including historical data. The NBFC P2P must maintain the credit information pertaining to the borrowers on its platform, and update it on a monthly basis and provide any other documents or information as may be required by the CIC.

• Ensure strict compliance with confidentiality and data security measures, including storage and processing of data pertaining to its activities and participants on hardware (such as servers) located in India. As with numerous companies primarily dealing in the tech space, an NBFC P2P must obtain a Board approved Business Continuity Plan, outlining the strategies and the procedure to follow in case of any adverse situation. Regular IT audits have also been mandated by the RBI to ensure that the reporting of the outcome of the audit is conducted on a regular interval.

• An NBFC P2P is also required to conform to the Master Directions on Information Technology Framework for the NBFC Sector, dated June 08, 2017.

Disclosures

An NBFC P2P must make the following disclosures on a quarterly basis:

• Information on disbursements made and transactions closed in the quarter, including the outstanding amount information at the beginning and at the end of the quarter

• Amounts held in escrow accounts, bifurcated by funds received from lenders and borrowers with details of credits and debits

• Number of complaints received, outstanding and closed, bifurcated by whether the complainant is a lender or borrower

• Leverage ratio with appropriate details of numerator and denominator

Comments: Owing to the sharing of sensitive information like a person’s credit information, the RBI has rightly focussed on ensuring that an NBFC P2P puts in place a secure and reliable network infrastructure, and provides details of the same to the RBI. It also mandates the submission of a business continuity plan, which kicks in during an emergency. An NBFC P2P thus has to plan out and document various issues, policies and documents in order to comply with the Master Directions.

11. Do the Master Directions have implications on mergers and acquisitions (“M&A”) activities pertaining to NBFC P2P?

Yes. In fact, the M&A implications of the Master Directions are quite significant. The Master Directions require a prior approval for all transactions that have the effect of transferring control as well as acquisitions which result in an acquirer (whether individual or group) holding 26% or more of the paid up capital of the NBFC P2P. Further, any change in the management of the NBFC P2P resulting in change in more than 30% of directors, would also require prior approval. Most importantly, from a private equity investment perspective, even a minor change in shareholding that grants an acquirer the right to nominate a director would require a prior approval from the RBI.

In each case, the prior approval must be accompanied by certain disclosures, information, declarations and documents. Thus, it remains to be seen whether these conditions of the RBI would adversely impact the deal timelines or the RBI would be prompt and ensure that M&A activity in the sector remains buoyant, without bureaucratic issues.

Comments: These are possibly one the most important aspects to have been introduced by the RBI, from a long term growth and consolidation perspective. Not only is this likely to impact vanilla acquisitions by private equity players, but it may have a bearing on larger acquisitions such as a complete buyout of the entity. Primarily, the costs of procuring such approvals from the RBI, in terms of time and money, would indicate the viability of inorganic growth through M&A in this sector

This article was submitted by Aditya Singha.