DHFL and Reliance Capital Used the ‘Box System’ to Avoid Disclosure, says REDD Report
Over the past one year, the corporate world has been rocked by bankruptcies and huge liquidity crisis. This includes one of the country’s largest airline suspending operations, Rs10 lakh crore of bad loans, the disintegration of the Infrastructure Leasing & Financial Services (IL&FS) group and the Anil Ambani group and rapid demise of Dewan Housing and Finance Corp Ltd (DHFL). This had badly shaken the confidence in non-banking finance companies (NBFCs). How bad is the situation? A just released report by Risk Event-Driven and Distressed Intelligence (REDD) throws some light on the shenanigans of few very large NBFCs have been up to.
 
NBFCs & housing finance companies (HFCs) together constitute 19.20% of total credit extended by the Indian financial system. Typically, the NBFC sector services borrowers deemed too risky for commercial banks. However, there is an inherent flaw in the system; the NBFC sector gets majority of its funding from commercial banks and mutual funds. So something that was not doable directly by the banks, the same is being done through NBFCs as a vehicle.
 
(Source: REDD Report)
 
To add to inherent instability, what is of greater concern is the malpractices as highlighted in the case DHFL, wherein the company was accused of being a vehicle to divert funds. The company used a new structure called as ‘box companies’, says REDD, to evade reporting of funds given to related entities. Using, the box system these companies have found an alternative way to rollover or ever-greening of loans. This is how the Box system works-
 
1. Say X owns an NBFC XYZ and wants to source funds from it. But the NBFC cannot give funds to X without disclosing the same as a related party transaction.
 
2. So X promotes three other companies- A, B and C, each with a capital of Rs1 crore. Company A, B and C have Rs1 crore in capital and Rs1 crore in cash each and are owned by X; thus are the related party for the NBFC XYZ.
 
3. Now, Company A buys 50% of company B and 50% of company C from X. The same is repeated by company B and company C. The end result of this is that, all the 3 companies A, B and C are now owned by each other and X has no ownership of any of these companies and has received back his initial Rs3 crore invested.
 
4. The company A, B and C now have Rs1 crore of capital and Rs1 crore in investments each.
 
5.  Now company A, B and C approach the NBFC XYZ for a loan. XYZ does not have to report these loans as related party transactions, as none of these companies is owned by X. But, in reality the real beneficiary of these companies is still X.
 
6. This way X has extracted money from the NBFC XYZ without having the NBFC to report the same. 
 
7. Next time, when these loans falls due, another box of companies will be created to fund the companies A, B and C loan repayment; thus effectively rolling over the loans.
 
 
Take the case of DHFL, on which a report by Cobrapost highlighted how the company using the box system avoided reporting to the exchanges on the sale of a 9.97% stake in the company. The companies forming the box in this case were Hemisphere, Galaxy and Silicon. The three box companies owned 31.1 million shares in DHFL as of March 2018.
 
All through the year, they sold the stock, disposing four million shares by the end of June and by September; their holdings had come down by another 7.65 million shares and did not appear in the register by March 2019.
 
 
REDD points out that Reliance Capital and its two affiliates, Reliance Home Finance and Reliance Commercial Finance, have engaged in similar kind of funding through box companies. The report indicates that the amount of loan outstanding to these box companies totals around Rs137 billion. REDD also provides details of three box structures of the Reliance ADAG.
 
 
 
 
 
The report further points out that, apart from using the box structure for pulling out funds for themselves by the promoters, some NBFCs may be using the same structure to ever-green the loans of each other.
 
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    COMMENTS

    Abc

    1 month ago

    Can Anyone Please Explain the DHFL box structure(Graphic)?

    Simply I understand that 3 companies collectively owned 9.97% of DHFL and had owned stakes in each other and then offloaded their investments to outsiders without DHFL having to report it as a stake sale.

    What do the curved legend entries signify in the graphic?
    (35.7% in Hemisphere,13.1% in galaxy and 28.7% in silicon)

    Why don't the inter company stakes of the 3 companies along with their stakes in DHFL not add up to 100% as per the graphic?

    Thanks in advance for any answers

    sachchidanand

    2 months ago

    Box System must STOP forthwith..SEBI & RBI must issue Guidelines to NBFC's to plug loopholes in the system..

    Veeresh

    2 months ago

    Box or khoka companies came into their own in the years of huge PPP entities and more. Airport privatisation was just one example. https://www.moneylife.in/article/khoka-companiesempty-corporates-make-no-noise/22300.html

    REPLY

    SURAJIT SOM

    In Reply to Veeresh 2 months ago

    Let somebody google " top tax rates" in different countries. In UK -before Thatcher-it was 83%. In US, it was 94 % in 1944 , India it used to be 97.75% !!!! The thing is bad law devours good law. Honestly , how many individuals will be willing to pay 97.75% of the income ? Why not 100% , by the way ? So tax avoidance is encouraged and then it becomes more and more entrenched. Now US President is suspected of dodging taxes for decades !!! Make-believe laws are framed by some govt servants and then passed be venal politicians. When these absurd and often contradictory laws are enforced , they generate grotesque outcomes( think of narcotic laws). The same politicians spend trillions of dollar for wars in the name of "democracy", "national self interests" -US for example-and kill millions of people all over the world. Chanakya once invited a foreign dignitary to his house. The foreigner was astonished to see the powerful minister was living almost in a hut . When asked why, Chanakya replied when " when rulers live palaces, people become poor". Look at Donald Trump , Africa, yes India, etc. I am no way condoning the loot by people like mama-bhanja but let us not miss the other side of the coin.

    Vijay Parekh

    2 months ago

    Well. This is a systemic failure. These are possible only and only when regularity authorities becomes hand and gloves. Audits etc is just a eyewash. Everyone is interested in giving funny suggestions and get fat fees. Why no action so far far big defaults by adag group. Nothing would change.
    A good eye opener article.

    Ajeya S

    2 months ago

    Good article, keep up the good work . . .

    Mohan Krishnan

    3 months ago

    If you have investible surplus then invest in Govt Schemes, Sovereign Bonds or Bond Funds and Nifty or Sensex funds. This way you can cut out incompetent fund managers. But return of Capital with decent return will be assured.
    However if you get caught by a broker you will be taken to the cleaners in the guise of higher return. You become your own enemy.

    SURAJIT SOM

    3 months ago

    The naked truth that comes out is that with bad or corrupt promoters , investors have little chance. Regulations, regulators,auditors etc are of no use. Mostly, they are hand-in-glove. It is frightening that in IL&FS, DHFL ,..top MF, DII, FII HNIs, ...were involved and not only "rookie retail investors". In this, India is no exception, though the degree may vary in other countries. The losers are millions of sincere investors. Also corporate India . All of them are not bad. We have people like Premji of Wipro. On one hand savers are trying desperately to find return -at least-that can beat inflation . On the other hand ,good promoters are unable to get money from the market by bad sentiment created by companies like IL&FS, DHFL , ADAG group etc. Just think of the euphoria when ADAG floated Reliance Power IPO in Jan,2008. What did the investors get ?

    REPLY

    SUDHAKAR OJHA

    In Reply to SURAJIT SOM 3 months ago

    In adequate control on corporate governance by regulators.

    SUDHAKAR OJHA

    In Reply to SURAJIT SOM 3 months ago

    I have for a long time being saying that mutual funds are a systemic risk. Proved correct now.

    SURAJIT SOM

    In Reply to SUDHAKAR OJHA 3 months ago

    Can you suggest where a saver can put his money ? FD ? Or stop saving altogether ? Thar's what has happened in rich countries.

    SUDHAKAR OJHA

    In Reply to SURAJIT SOM 3 months ago

    Equity funds are safer than debt funds. Equity is safety than equity funds but we need to know how to select and give long time. So nothing is totally Safe.

    SUDHAKAR OJHA

    In Reply to SUDHAKAR OJHA 3 months ago

    Sorry for typos.
    I was saved by adhering strictly to MoneyLife Advisories.

    SUDHAKAR OJHA

    In Reply to SURAJIT SOM 3 months ago

    O was saved strictly sticking to Advisory from Monochrome foundation

    SUDHAKAR OJHA

    3 months ago

    With aforesight and intent ! No thought on creditworthiness of the new box cos that have no business !

    Apurva

    3 months ago

    Good explanation. But could not understand the holes in our accounting policies / laws / auditors role. In any case X owns all three box companies even though indirect one which can be easily understood by looking at share holding pattern of these companies so what does auditors varify during internal / statutaory audits? And why does our company law / corporate laws allow such manipulation?

    I believe money life should take some initiative to find out the cause for such manipulation and role of involved agencies. You people are voice of minority investors, so please do something for robust financial reporting and audit standard.

    Regards

    Savitha KL

    3 months ago

    Why SEBI does not unearth this, why market regulators sleep

    PM

    3 months ago

    Excellent Article! Could you clarify whether DHFL lent any money to any promoter entities? That was part of Cobrapost's allegations but was denied vehemently by the company and the independent audit report.

    Subhash Chand Garg

    3 months ago

    This is the actual modus operandi of all private sector companies hailed by media for solutions of all the problems of India

    RBI issues new circular on resolution of stressed assets
    The Reserve Bank on Friday issued a revised framework for resolution of stressed assets by banks after the Supreme Court in April struck down the apex bank's earlier circular which mandated that the resolution process begin immediately on the day after default of loans worth over Rs 2,000 crore.
     
    According to the new circular, the lenders can commence resolution process for a stressed asset within 30 days of default.
     
    "All lenders must put in place Board-approved policies for resolution of stressed assets, including the timelines for resolution," the circular read.
     
    "Since default with any lender is a lagging indicator of financial stress faced by the borrower, it is expected that the lenders initiate the process of implementing a resolution plan (RP) even before a default."
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
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    COMMENTS

    RAMESH VORA

    2 months ago

    Irrespective of legality of transfer of funds to DHFL and various entities, end use of funds is important. Any misuse or manipulation of funds by these various companies must be deeply scrutinized and it has to be recovered immediately.

    DHFL Demise Highlights Funding Risk at Indian NBFCs: Fitch
    Liquidity problems at Dewan Housing Finance Corporation Ltd (DHFL) and its reported failure this week to pay coupons highlight the funding challenges faced by India's non-banking finance sector, Fitch Ratings says.
     
    "Issues in the non-banking financial companies (NBFCs) were already known to the market but DHFL became a focus point after the failure of Infrastructure Leasing & Financial Services Ltd (IL&FS) in September 2018," the ratings agency says, adding, "This also contributed to a sector-wide liquidity squeeze as investors became more risk averse. Indian NBFCs' liquidity is sensitive to market sentiment as their business models rely on short-term wholesale funding, which can dry up fast if market sentiment turns negative. Funding models of housing finance companies and NBFC loan companies, which have become increasingly reliant on short-term funding to fund longer-term assets, have been particularly affected by the liquidity squeeze."
     
    According to the ratings agency, the liquidity pressures in NBFCs are in stark contrast to the banking sector, which has not faced significant liquidity pressure or deposit withdrawals, despite asset-quality and capital adequacy weaknesses.
     
    The sector pressures have led India's top NBFCs to explore other sources of funding and to start positioning themselves to tap the US dollar bond market. "We expect Indian NBFIs to become more regular issuers in the offshore bond market as they seek to diversify their funding sources. If prudently managed, this should be credit positive as funding profiles are strengthened," Fitch says.
     
    The funding squeeze has contributed to higher funding costs and a slowdown in loan growth for India's NBFC sector. NBFCs are an important channel for extending credit to the wider economy, given their extensive distribution networks, which are often more far-reaching across rural India than those of banks. The sector's role as a credit-provider became outsized as the Indian banking system was forced to deal with its weak asset quality. 
     
    Banks, particularly public sector banks (PSBs), were undercapitalised and had limited capacity to lend more. NBFCs now account for nearly 20% of credit to the economy compared with about 15% five years ago.
     
    Indian NBFCs fast loan growth in an environment of relatively benign interest rates was increasingly funded by short-term funding, in particular, commercial paper issued to the mutual fund sector. The banking system also is an important source of funding for NBFCs, driven in part by the regulatory push for banks to provide 'priority lending', with NBFCs being an important conduit for this.
     
    Fitch says, "Both of these funding sources for NBFCs have become more risk-averse, which means that the sector is likely to face higher funding costs and a period of deleveraging, although the better-positioned NBFCs should still be able to achieve loan growth. The sector's reliance on short-term funding has reduced since late 2018 and some stronger NBFCs have shifted towards longer-term funding, such as term loans or negotiable certificates of deposit."
     
    "We expect credit growth in India to remain slow, despite this week's interest-rate cut, as most banks are capital-constrained and NBFIs face tighter funding conditions," the ratings agency concluded.
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    User

    COMMENTS

    Ramesh Poapt

    3 months ago

    TO ML: this is most clear case for ML to initiate investor protection efforts.
    when investors invest in AAA securities and within 3-4 months, it is downgraded
    to D, small investors may lose their hard earned savings. unrated/lower rated papers is
    different story. but here (AAA) is ML remains silent for investor protection, it is
    just shocking. though i am sure ML should have a plan for this. pl. take it up soon
    or when the loss is sure.

    REPLY

    Sucheta Dalal

    In Reply to Ramesh Poapt 3 months ago

    Mr Popat, thank you for your comments. Let me clarify a few things. First, Moneylife, the digital magazine has done the maximum writing on DHFL. Some stories are for paid, premium subscribers. But you may want to read all of them.
    Moneylife Foundation, which is a separate, stand alone entity, takes up financial literacy and advocacy. However, we operate with limited resources and expect that those who benefit from the magazine and free seminars will make fewer investment mistakes.
    When you say take up issues, it is not clear what you mean. Moreover, those who invested and lost money should first have a complaint. We have not received a single complaint so far. So we are not sure what we are supposed to jump around about.
    As for regulating Rating Agencies, that is something SEBI alone can do.
    If you have specific thoughts and suggestions do write to [email protected]

    best
    Sucheta

    Mohan Krishnan

    In Reply to Sucheta Dalal 3 months ago

    Dear Madam,
    I am an investor in UTI ultra short term and UTI savings fund and I received 2 emails (one for each) from UTI MF on 7th June (21:43) stating reduction in NAV of abt 1% due to DHFL investment gone sour.
    No mention of apology or poor due diligence especially after IL&FS fiasco.
    Will the AMC compensate this loss from their earnings and high salary and bonuses given to their investment managers.

    Gangadhar Shanagala

    In Reply to Sucheta Dalal 3 months ago

    Ms Sucheta Dalal, Isn't unfair that a rating companies say this? that too now, after the damage is done? Not just DHFL, rating companies have a role in almost every default so far and they go scot free.

    Why can't SEBI or MCA overhaul the way system operates? If a company pays to a rating agency to get rated, I feel the outcome is manipulated in favor of the company. Nothing is "independent analysis" in such arrangement. Most surprising thing is all rating agencies act in cohort - they all simultaneously upgrade the rating and downgrade the rating. Reminds me mass copying - either all pass or all fail.

    Instead, the change that should be brought in the system is that lending banks nominate a rating agencies and rating agencies be held responsible by the bank. For public deposits, the rating agency is to be held responsible by SEBI/MCA. If things go wrong rating agencies need to cough up fines.

    There is a very good system that works in elsewhere in the world. Tos comply with Federal Aviation Administration (FAA) regulations, all companies operating in aerospace manufacturing, repairs and services appoint few of their employees as FAA representatives. These reps need to be certified by FAA on regular intervals. They report to FAA on regular basis and FAA monitors reps' performance related to safety incidents. Guess what, companies buy hefty insurance for its FAA representatives to cover the damages if there be any safety incident.

    Similar system with appropriate variations need to be introduced in India for rating agencies, auditors, etc.. On a side note, this arrangement works also for appointing and monitoring Independent Directors in companies.

    Best regards,
    Gangadhar Shanagala

    Pairs Trader

    In Reply to Gangadhar Shanagala 2 months ago

    If FAA was so independent, how did two 787 maxes crash... For that matter how did Boeing even got the plane certified in the first place... Regulatory capture is what you call it. The problem is there everywhere?

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