Governance of MFIs: Time to implement ‘connected lending’ provisions of RBI circular of 2007

Is it appropriate for a company, established to provide access to finance to low-income people, to lend to its promoter and managing director to buy shares in the same company at par value?

Consider yourself as an institutional/retail investor in a micro-lender and you may have bought equity because you believe that microfinance institutions (MFIs) provide access to finance for low-income people and enable them to have a better life. Alternatively, you could be a development finance institution (DFI)/bank that has provided a loan to an NBFC MFI as part of the priority sector obligations and/or other schemes. Or you could be a multi-lateral or bi-lateral institution that seeks to improve the lot of excluded and disadvantaged people in an emerging market through development of the private (financial) sector using institutions like NBFC MFIs. How would you react when you hear that one such NBFC MFI, where you have either invested your hard-earned money or lent priority sector funds, has, in turn, lent to its own founder managing director, a huge sum of money to buy shares in the same MFI and especially, at par value?

Unbelievable but true. Such a transaction did take place at a large Indian NBFC MFIi . The incident first came to light through Professor MS Sriram's paperii , in the Economic and Political Weekly (June 2010), which noted that an NBFC MFI had lent its founder and managing director, a sum of Rs1.636 crore to enable him to buy shares in the same company. From a perusal of the published financial statements of this NBFC MFI, it is clear that an interest-free loan of Rs1.636 crore, was granted by the MFI [which was supposedly predominantly owned by the poor clients through several Mutual Benefit Trusts (MBTs) and also had key institutions as shareholdersiii ] to its then managing director and promoter to buy shares at par value. (Read relevant table below, reproduced from the MFI's audited statements for the year ended March 2007.)

Now, you may wonder whether this is legally permissible from the standpoint of corporate governance. In fact, I had a similar question and did some research on the matter and found that there is a Reserve Bank of India (RBI) circular that talks about this aspect of (not) providing credit facilities to the directorsiv . Specifically, the RBI circular on corporate governance for NBFCs, dated May 2007, notes that,

"In order to obviate conflict of interest in the lending operations of the NBFC, it should not grant any loan, advance or non-fund based facility or any other financial accommodation/facility to: (a) its directors or their relatives; (b) to any firm in which any of its directors is interested as partner, manager, employee or guarantor; (c) any individual in respect of whom any of its directors is a guarantor; (d) any company of which, or the subsidiary or the holding company of which, any of the directors of the NBFC is a director, managing agent, manager, employee or guarantor, or any firm in which he holds substantial interest; and (d) any entity, whether incorporated or not, which uses as a part of its name or in connection with its business, the name of the NBFC or any such word as would show its association with the NBFC."

Likewise, further research led me to believe that the spirit of the Companies Act, 1956 typically prohibits companies from directly buying its own shares and/or indirectly financing its directors to buy the same. In the present case, it must be noted that, the loan grantedv interest-free to the promoter managing director was towards purchase of shares in the same company.


My views apart, as I got deeper into the legal aspects, I got to know a very interesting aspect that the provisions relating to connected lending in the aforementioned RBI circular have been in abeyancevi since 11 July 2007. Likewise, it appears that the concerned MFI also publicly stated (prior to its IPO) that there was nothing illegal in what it had done (in so far as the connected lending was concerned) and further that the provisions of the Companies Act did not apply to private limited companies, which is what the NBFC MFI was when the said (connected lending) transaction took place.

Therefore, it seems prudent to conclude that as per the prevailing lawsvii , the connected lending that occurred at the NBFC MFI may not have been strictly illegal. However, I am not sure whether it is appropriate for a company-established, in the first place, to provide access to finance to low-income and vulnerable people, registered as an NBFC with RBI and using public deposits (by way of accessing priority sector bank loans)-to lend to its promoter and managing director to enable him to buy shares in the same company at par value, without being seen as a "misgoverned" company. This is something that all of us need to take a call on.

In my humble opinion, granting of such a huge interest-free loan to a director in a financial services company that is owned in majority by the poor clients in MBTs and DFIs (together, the MBTs and DFIs held 54% of the shares of the company then), and meant to service these poor clients in the first place, is not at all appropriate from a corporate governance perspective. Without question, this action of providing the loan to a director was certainly not, under any circumstance, in the interest of these shareholders, especially the minority (individual MBTs and/or individual women) shareholders. One can certainly make the argument that such a thing may not have happened if there had been someone on the NBFC's board protecting the interest of the (minority) shareholders. I am sure that whether an institutional/retail investor or a DFI/bank or a multi/bi-lateral agency, you will certainly not approve of such connected lending transactions as examples of good practices in corporate governance. {break}
Now, that is certainly an issue that the RBI, SEBI and Ministry of Company Affairsviii need to seriously ask and answer, and thereafter, amend the relevant circulars/laws accordingly. Some of the key questions that these regulators would need to ask and learn from are mentioned here.

(a) Was this connected lending by the NBFC MFI to the promoter (also the then managing director) to enable him to buy shares in the same company, a correct practice from a legal perspective? Given that the company was/is a financial institution registered under the Companies Act, 1956 and the RBI NBFC regulations with the primary purpose of lending to low-income people, how does this practice of connected lending to the promoter managing director relate to extant regulations and norms, both in letter and spirit?

(b) Was this correct practice from a shareholder perspective, given that the company was originally established to provide loans to low-income people and there were significant development funds in the company, and as at the time of granting the loan about 54% of the company was together owned by the MBTsix and DFIs?

(c) On what basis did the NBFC authorise this lending to the then promoter managing director? What were the independent and institutional nominee directors doing, even as the board approved this connected lending transaction?

(d) What was the source of funds from which this loan was made to the promoter managing director? This needs to be transparently understood in terms of whether so-called 'priority sector funds' and/or 'soft development funding' was used for providing the loan to the promoter managing director.

(e) Are not the consequent increases in capital and the associated leverage (without any change in the true financial condition of the NBFC)-serious misstatements of the financial condition, in the absolute sense of the word? Irrespective of the quantum of misstatements, is not the practice questionable, from a corporate governancex perspective?

(f) Ceteris paribus, is this connected lending a correct practice of corporate governance, especially in a financial institution?

The issues here  are especially serious because the company is now a listed NBFC MFI and much of the problems related to the 'perverse incentives' in Indian microfinance (to quote Vijay Mahajan's often mentioned phrase) could perhaps have been avoided, had only the instruction contained in the RBI circular been fully implemented on the ground, way back then.

Further, to the best of my knowledge, the various clauses in this well-intentioned RBI circular on corporate governance for NBFCs, and especially those relating to matters of connected lendingxi , have not yet been implemented as on datexii .

Without any doubt, the time is now ripe for all these provisions of the RBI circular to be fully implemented without any further delay so that such occurrences can be prevented forthwith! And last but not the least, I do hope that the Union Ministry of Finance, which is in the process of finalising a bill on microfinance, addresses these critical issues to ensure the orderly development of a vibrant microfinance industry in India that is really for the poor, in every sense of the word.

i The name of the company has been withheld as the idea is not to embarrass a particular MFI, but it can be provided if required!
ii Commercialisation of Microfinance in India: A Discussion of the Emperor's Apparel by Professor MS Sriram, (Economic and Political Weekly, 12 June 2010, Vol XLV No. 24, Page 70).
iii Development Finance Institutions
iv RBI Guidelines on Corporate Governance 2007, kept in abeyance for some reason. The guidelines were not to be practiced until further notice from the RBI.
v It must also be noted that the loan amount was much greater than the total of six months of his (then listed) salary and apparently, this interest-free loan was also not administered through a trust. Likewise, it seems that the shares were also not issued in the name of the trust.
vi In fact, the circular on Corporate Governance (dated 11 July 2007) on the RBI site still contains the following with regard to 'connected lending': "The Bank has received suggestions in the matter with reference to paragraph 2 (vi) of the circular dated 28 May 2007 containing instructions on connected lending. The suggestions are being studied and the instructions contained in paragraph 2 (vi) of the said circular will become operational after final evaluation of the suggestions and modifications, if any considered necessary."
vii The concerned MFI has all along maintained that these provisions of the Companies's Act did not apply to private limited companies, which is what the MFI was in 2006-7.
viii I am not trying to find fault with any stakeholder or the regulators, but rather I am merely highlighting an existing loophole that can perhaps be still misused. I recognise the tough task of implementing regulations and certainly do not wish to undermine the excellent work done by regulators (in many cases and instances) and this is indeed appreciated. At the same time, we also need to continuously learn from crisis and ensure that laws are indeed changed to suit ground level realities.
ix Despite the MBTs holding 47% of the shares, they appear to be weak shareholders and /or minority shareholders.
x It must be mentioned that all things begin small and eventually snowball.

(The writer has over two decades of grassroots and institutional experience in rural finance, MSME development, agriculture and rural livelihood systems, rural/urban development and urban poverty alleviation/governance. He has worked extensively in Asia, Africa, North America and Europe with a wide range of stakeholders, from the private sector and academia to governments.) 

Free Helpline
Legal Credit