Kotak Lawsuit: Will It Finally Make RBI Accountable?
Uday Kotak is a cautious and savvy banker with deep and strong connections in the business world.  However, by no stretch, is he an activist. So, why would he drag his regulator to court, especially the Reserve Bank of India (RBI) which has always guarded its ‘independence’ or lack of public accountability very zealously?
 
Kotak’s decision, made after a great deal of deliberation, was the subject of much derision and raised eyebrows in business and official circles. But, for us, the lawsuit is symptomatic of the frustration of all stakeholders with the opaque and, often, capricious RBI. In this case, it is about the frequent changes in promoter holding norms for new private banks.
 
RBI ordered the promoters of Kotak Mahindra Bank (Kotak) and Bandhan Bank to bring down promoter holding to below 20%. In Kotak’s case, there has been back-and-forth on the issue for 10 long years, largely because of the many changes in guidelines and regulations in the interim. Finally, RBI gave an ultimatum to both the Banks and threatened coercive action if they did not comply by 31 December 2018. 
 
Bandhan Bank, a micro-finance company-turned-bank that hit the big time, was asked to dilute its stake, within three years, to 40% (August 2018). After an IPO (initial public offering), the promoter shareholding remains locked in until 2019; but RBI doesn’t care about capital market regulations. Since Bandhan Bank failed to dilute its holding, RBI decided to freeze the pay of a very dynamic promoter, Chandra Shekhar Ghosh, and bar it from opening new branches. Faced with the reputational damage implicit in the action, Bandhan Bank was pressured into desperate dilution. 
 
On 7th January, Bandhan Bank announced the acquisition of Gruh Finance (57.8% held by HDFC), one of the most high-valued housing finance companies in the world. The all-share deal surprised and upset shareholders on both sides causing both the stocks to tank, even though it helped Bandhan Bank move towards compliance with RBI’s rules and brought in a marquee shareholder like HDFC (Housing Development Finance Corporation).
 
Interestingly, HDFC would have liked to get 5% in cash, but Bandhan Bank, which has been strong-armed by the regulator, needs every rupee to focus on expansion. Again, shouldn’t RBI have to explain its rigidity when it already has a cap on voting rights? 
 
Does RBI really have the power to punish banks on the basis of unexplained and ever-changing rules on the acceptable promoter holding? Can a regulator, which has repeatedly failed to catch wrongdoing for over 25 years (from Harshad Mehta to Nirav Modi and Gitanjali), have no accountability for capricious actions against good managements and consequent damage to shareholder value? Isn’t it absurd that two highly successful bankers are being punished by the regulator, despite exemplary performance?
 
The Kotak petition raises many important issues which, if  taken to a logical conclusion, will force some clarity on RBI’s powers, policymaking and supervision and its accountability. 
 
Kotak’s lawsuit against RBI came up for hearing on 17 December 2018 where media headlines focused on the fact that the court had not granted a stay. In fact, RBI was given time to respond by 17th January (it has, since, sought more time to respond and the next hearing is on 12th March) and it also assured the court that it “was a responsible institution and would act accordingly.” Effectively, Kotak is protected from coercive action until March and, possibly, until the issue is resolved. 
 
The Kotak petition, which I have reviewed, makes four compelling points. 
1. RBI’s many changes on promoter shareholding, after it was granted a banking licence in February 2003, ought not be applied retrospectively to it.
 
2. RBI’s regulations are ultra vires of Sections 12, Sec 12(2) and Sec 12(B) of the Banking Regulation Act (BR Act). Kotak argues that the BR Act does not empower RBI to ask any bank to reduce shareholding; the Act only permits it to fix a ceiling on voting rights. Or, if a shareholder is found to be ‘not fit and proper’ [Sec 12-B (8)], to curtail such person’s voting rights to 5%. It further argues that RBI’s general powers under Sec 35-A to issue directions to banks and make delegated legislation, is also circumscribed by the need for these to be in public interest and to protect depositors’ interest. 
 
3. Kotak claims that it has complied with RBI’s direction by reducing its stake to 19.5% (below the mandated 20%) in August 2018 by issuing perpetual non-convertible preference shares (PNCPs). RBI had immediately rejected the move and demanded a reduction in paid-up voting capital to prevent concentration of control.
 
4. Finally, the petition says, compliance would require the Bank to issue fresh equity of Rs1.10 lakh crore, which was “equal to the entire market-capitalisation of State Bank of India.” It calls this ‘manifestly unreasonable’, since it would not only dilute share value but require large placements to foreign institutional investors.
 
The last bit has a patriotic appeal attached to it, with the submission that Uday Kotak had partnered with, and eventually bought out marquee foreign partners (Goldman Sachs, Ford Credit), and acquired of ING Vysya Bank (with a 44% foreign holding) in order to remain an Indian bank. Kotak points out that its foreign shareholding is already at 47% and a forced dilution will only push majority stake into the hands of foreign investors. 
 
RBI’s Changing Rules
Kotak has raised significant issues that need answers. For instance, on point 1, when RBI granted Kotak a licence in 2001, RBI mandated a minimum capital requirement of 49% for it, since it did not want promoters of new private banks to cobble together money from diverse sources. 
 
In 2005, RBI came up with new rules on ownership and governance of private banks and wanted the changes to apply retrospectively to Kotak. In 2012, it decided that Kotak would need to reduce promoter stake to 20% within 10 years and to 15% in 12 years, in accordance with new bank licensing guidelines issued in 2013. 
 
So far, each communication referred to ‘paid-up capital” which is a key issue in the petition. In 2016, RBI came up with more changes – it issued ‘On tap licensing guidelines’ with different deadlines for dilution of promoter equity. It also issued ‘Ownership Master Directions’ which added to the confusion by saying that conditions applicable to specific licences at the time of issuance would remain valid. 
 
While RBI kept changing the rules, it also repeatedly granted additional time to Kotak to comply with its diktat through eight letters written from February 2008 to 30 January 2017. Each of these referred to a reduction in promoter shareholding as a percentage of ‘paid-up capital’, says Kotak. However, in August 2018, for the first time in 10 years, RBI demanded a reduction in promoter holding as a percentage of ‘paid-up equity voting capital’.  
 
Banking Regulation Act and RBI’s Powers
This brings us to Kotak’s second contention. When it was granted a banking licence, the voting rights of each shareholder were capped at 10%. Following amendments to Section 12(2) of the BR Act, RBI was granted the power to increase voting rights of shareholders from 10% to 26% in a phased manner. Section 12-B, inserted into the BR Act, requires investors to seek specific permission from RBI for any acquisition of shares of 5% or more of the paid-up share capital. 
 
Kotak argues that RBI derives its powers from the BR Act which make its legislative intent very clear: the Act does not restrict or prohibit larger shareholding, but capped voting rights to 26%. Hence, Kotak maintains that RBI’s demands and regulations are untenable for being ultra vires of the BR Act. 
 
Concentration and Control
If the whole purpose of forcing a reduction in promoter holding is to prevent one powerful group from controlling the bank, what does RBI have to say about the fact that all major private banks – HDFC, ICICI and Axis Bank are now majority foreign owned? 
 
Concentration in the hands of disparate institutional investors may seem different from promoter control; but the Kotak petition argues that foreign institutions are guided en masse by only a couple of global proxy advisors (rather than making up their own mind) on corporate resolutions which means that they will end up taking action as a block.  
 
To my mind, this opens up a whole new discussion on the role of proxy advisory firms in India and abroad and one wonders why Uday Kotak did not address this in the corporate governance committee headed by him, where a couple of proxy advisors were the voice of shareholders. Even if one ignores the whole swadeshi pitch, probably aimed at lobbying government, the fact that Indian private banks are majority foreign owned is an issue that needs discussion. 
 
Banking analyst Hemindra Hazari, argues https://thewire.in/banking/kotak-rbi-tussle-also-has-consequences-for-control-of-the-overarching-group that Kotak is the holding company for the entire group and a majority shareholder in Kotak Prime, Kotak Securities, Kotak Capital, Kotak Life Insurance and Kotak Asset Management and owns a 100% shareholding in various subsidiaries. He says, “The structure was devised so as to capture the valuation of all the group companies into KMB (Kotak), which was the sole listed entity in the group” and this personally benefited Uday Kotak. 
 
Mr Hazari, correctly, believes that this structure causes the entire risk of the group to fall on unsecured bank depositors. Uday Kotak himself is getting a ringside view of the risks involved in complex holding structures as he struggles to unravel the Infrastructure Leasing and Financial Services (IL&FS) scandal which is continuing to threaten the financial system. But, again, this can be dealt with through the securities market and insurance regulator and also by demanding listing or separation of group entities. 
 
Implications for RBI
Whichever way one looks at it, the Kotak petition is a lose-lose proposition for RBI, whose power has been challenged for the first time in court (unlike SEBI which is routinely dragged to the Supreme Court over most decisions). 
 
If Kotak wins—and it has a strong case—it could seriously circumscribe RBI’s powers and make it more accountable than the government could ever have done. Investors will also want to know how this extreme rigidity, backed by punitive action, helps improve its supervision and catch the next IL&FS or NiravModi/Gitanjali in time. Those failures have inflicted far bigger pain on India’s financial system. If RBI wins and forces Kotak to dilute shareholding through needless acquisitions or issue of capital, it would mean an endorsement of capricious changes and no accountability for regulators. 
 
Our sources believe that between now and several postponements, RBI would find a way to get this lawsuit dropped, rather than have a judicial ruling on its powers or even the way in which it keeps changing the rules of the game. After waiting long enough for things to cool down, it is likely to work on an acceptable compromise. 
 
Hopefully, the compromise will benefit all banks. Uday Kotak is too shrewd a businessman to indulge in a protracted war with his regulator. He was pushed into litigation because of the humiliatingly rigid stand of RBI. It will be a pity, though, if this litigation ends through a closed-door compromise without RBI being forced to be more transparent, accountable and predictable. If nothing else, it should be forced to take into account how its changing rules clash with other regulations. 
 
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    COMMENTS

    AAR

    2 years ago

    "Not apply retrospectively" if this clause is applied then no new laws can be enforced on existing players in any field.

    Raul Verma

    2 years ago

    excellent article, clearly spelling out the issues involved!

    Dayananda Kamath

    2 years ago

    It is nothing but trying to be abide by the law in letter than spirit. And splitting hair and interpreting to its advantage. When the licence is given higher promoter share holding is to ensure serious contenders only. Subsequent changes are to ensure that there is no concentration of decision making with the growth of the bank. But in this case instead of dilution they are actually increasing their investment through a different instrument with argument that it is considered as capital for capital adequacy norms. Which are two different issues.
    Hope the court will uphold independence of regulator for a right cause.

    V.Krishnamoorthy

    2 years ago

    Will not DVR type share issue resolve the problem?

    Girish N Kamat

    2 years ago

    RBI is right in this case. If Kotak believed that RBI has no right to prescribe promoters holding then why did he issued preference capital in the first place. Secondly if promoters shareholding is not enforced along with voting rights, anybody can frustrate voting right condition by holding 90 per cent equity shares so that other party can at most have 10 per cent effectively retaining control. Worse they can go for Differential voting rights. And SBI market cap is 2.55 lakh crores and not 1.10 lakh crores. Secondly RBI is right in saying when they asked to dilute to 20 per cent they meant 20 per cent of equity capital since Kotak only had equity share capital then. And for that matter even market cap computation only equity (common) shares are includes not preference share capital. Its more like debt for all practical purposes (excepting tax treatment and payment of dividend in case of inadequate profits). Banks take large deposits from public and operate with high leverage. RBI is within its rights to ensure their ownership does not create systemic risk. Otherwise we would large corporate houses taking control of the banks through this backdoor method and RBI would be helpless spectator.

    REPLY

    Raj Sharma

    In Reply to Girish N Kamat 2 years ago

    Uday was part of banking governance body.why he didn't talk about foreign proxy companies as it was benefitting him.he is typical indian businessman who doesn't want to relinquish control and till recently was sitting going paens of this govt supported note bandi and now is speaking against.totalky opportunistic...he believes he is above law and can manipulate the system,the unfortunate reality of indian business with few exceptions like premji,birla,Tata and others he is greedy

    Ravindra Shetye

    In Reply to Girish N Kamat 2 years ago

    Irrespective of the percentage of holding by the promoter, Regulators should just observe whether the Bank or for that matter any Company follows the rules or not. The limitation on the limited voting rights sufficiently ensures that the Bank/Company does not run in any arbitrary and harmful (to the other shareholders) way. There is already a minimum outside shareholding required (I suppose) for the Company to be listed on stock market so that the minority shareholders interests are reasonably protected. In any case the Kotak Mahindra shareholders are not bothered about Uday Kotak's 40% (or near about) shareholding. They purchased the shares because of Bank's performance. I am one of them for 6-7 years. in fact before this HoHaHa I was not even aware that Uday Kotak owns so many shares.

    Girish N Kamat

    In Reply to Ravindra Shetye 2 years ago

    My family is also shareholder but there also he is managing bank as private fiefdom making changes in capital structure to keep his shares rather than what is in the best interest of bank. And his success compared to corporate facing banks is only due to focus on retail banking which is easier business especially in India where its very difficult to enforce contracts especially when corporate borrower can afford well connected lawyer (Essar is just one such case). But just to meet his shareholding norms he was even willing of merge Axis, which fortunately did not materialise. Of course here I am not commenting as shareholder (as we can dispose of shares any time and there are many well run businesses in India earning far superior return on equity to reward shareholders in long run) but as corcerned citizen who want corporate governance to be given attention it deserves. RBI may be conservative when it comes to systemic risk and that is why its not allowing foreign banks to operate here freely and not allowing competition to be created for these retail facing banks allowing them to skim the customer (payments banks have so many restrictions that they are no-starters), but it has possibly best track record amongst global central banks in managing system risk.

    Vijay Shivdasani null

    In Reply to Girish N Kamat 2 years ago

    Vijay Shivdasani
    Not sure about RBI being the "best- in-the-world" in managing. There have been too many failings coming to light.
    One should think about the future of Indian Banking. With India growing as it is into one of the largest economies, it is surely not in India's interests that its banks fall into foreign hands. It needs good promoters with a vision and professional experience, with no history of conflict of interests. I agree if RBI only concentrated and focused on its regulatory functions it would do better, rather than taking coercive actions against promoters and banks with unilateral changes & diktats. So long as shareholders are happy with performance there is little need to press things , make changes ever so often.
    I think Mr Kotak's timing to resort to litigation is impeccable and welcome!

    Raj Sharma

    In Reply to Girish N Kamat 2 years ago

    Kamat is bang on RBI is one of the most efficient central banks and has saved India from many financial disasters..if was left to people like kotak they would skim and run the bank as Mom and pop shop...for better governance and efficiency they better adherento the low of the land and shes this arrogance

    Sucheta Dalal

    In Reply to Raj Sharma 2 years ago

    One has a different perspective on RBI's so-called 'best in the world' reputation on managing systemic risk. The huge increase in NPAs which are being paid by citizens are a fall out of the 2008 situation where money was pumped into all kinds of companies- especially realty and infrastructure and we are now facing a HUGE systemic risk. The seeds were sowed then - successive RBI governors have publicly admitted they did not focus on bad loans. These include the rocks star and predecessor.

    Sucheta Dalal

    In Reply to Girish N Kamat 2 years ago

    strangely your comments are contrary to facts. First RBI has repeatedly failed as a regulator and supervisor. You have ignored that. If you are a shareholder then you should worry about every changing rules and how they hurt investors. Interesting that you pick only on one set of issues.

    suman chakrabarty

    In Reply to Sucheta Dalal 2 years ago

    yes the RBI has failed as a regulator on many occasions as on the instances you have mentioned in the article but they are also a lot of instances where the central bank has protected the Indian economy for which it has never got any praise. Plus nowhere in your article have you mentioned of the implications of people who have considerable shareholding over a firm and thus have a bigger say on matters and if on a future date this controlling stakeholder takes a decision which might not be in the best interest of other shareholders it would be very hard to protest against in irrespective of the future implications to the entire firm , you are one of the greatest business journalists in this country i hope i dont have to mention instances when a company got into serious trouble due to decisions taken by controlling promoter stakeholders.

    Girish N Kamat

    In Reply to Sucheta Dalal 2 years ago

    I am only talking about systemic risk here . We have not seen the failure of banking system like USA (S&L Failure 1980s/1990s/2008 sub prime Crisis) or Europe (country after country the banks were allowed to over leverage them resulting into failure-Iceland was most glaring but Royal Bank of Scotland was no different. Whole European banking system is in mess. And for PCA in India I believe bigger problem is government which have failed to capitalise banks after elevated problems resulting from demo and bothced up GST. I agree with you that economy needs stable policy regime but banking should be managed by professional bankers and not promoters once it reaches certain size given access to depositors money they have and systemic raise they can pose. I would worry about economy as a whole. And I agree with you RBI has done many mistakes as regulator. As a top ranking CA having worked with HUL and L&T and provided IT solutions to the largest Indian companies and HDFC Bank , advised Maharashtra government on financial modelling of Expressway and flyovers, I believe that they should have focussed on promoting corporate bond market (today there is no depth in that market) where market evaluates, prices and monitor risk rather than leaving it to ever greening loans and cash credit by bank management. But in this case they case I believe they are right. As far Kotak Bank holding it was never long term buy given their poor ROE of less than 15 per cent. And also we never thought that he would manage his bank as personal fiefdom (his flirting with Axis bank) But I would never use this forum for such personal grouse. I have high respect for you and the work you are doing. Keep it up.

    Girish N Kamat

    In Reply to Sucheta Dalal 2 years ago

    I am only talking about systemic risk here . We have not seen the failure of banking system like USA (S&L Failure 1980s/1990s/2008 sub prime Crisis) or Europe (country after country the banks were allowed to over leverage them resulting into failure-Iceland was most glaring but Royal Bank of Scotland was no different. Whole European banking system is in mess. And for PCA in India I believe bigger problem is government which have failed to capitalise banks after elevated problems resulting from demo and bothced up GST. I agree with you that economy needs stable policy regime but banking should be managed by professional bankers and not promoters once it reaches certain size given access to depositors money they have and systemic raise they can pose. I would worry about economy as a whole. And I agree with you RBI has done many mistakes as regulator. As a top ranking CA having worked with HUL and L&T and provided IT solutions to the largest Indian companies and HDFC Bank , advised Maharashtra government on financial modelling of Expressway and flyovers, I believe that they should have focussed on promoting corporate bond market (today there is no depth in that market) where market evaluates, prices and monitor risk rather than leaving it to ever greening loans and cash credit by bank management. But in this case they case I believe they are right. As far Kotak Bank holding it was never long term buy given their poor ROE of less than 15 per cent. And also we never thought that he would manage his bank as personal fiefdom (his flirting with Axis bank) But I would never use this forum for such personal grouse. I have high respect for you and the work you are doing. Keep it up.

    Sham

    In Reply to Girish N Kamat 2 years ago

    For a while, all I used to see in the mainstream media was that how innocent Mr.Kotak is and how arrogant and inflexible RBI is. I must say my opinion of Mr.Kotak have changed somewhat after reading this, Hemindra's and other articles and comments by Girish. I find it hard to believe that Kotak used PNCPS loophole, that too without informing RBI beforehand. Agreed that the RBI has not been fair and consistent with the promoter stake issue. The RBI is rightfully aiming at tackling possible future systemic risk. One can find fault with its current approach, but not its intention (assuming that it is truly independent). And further, no approach is without fault and without causing inconvenience, and without creating arbitrage for players. Today, Mr.Kotak may find a way to silence the RBI or make a deal based on political connections. He is certainly cut above the rest of CEOs, but it is not mean he is impeccable. He will need to answer in future when the day of reckoning arrives. It is better that he realizes these risks and restructures his group leave it KMB in a better situation.

    It is never the emperor who realizes that he has no cloth. I hope he sees IL&FS himself and learns from it.

    Girish N Kamat

    In Reply to Sucheta Dalal 2 years ago

    I am only talking about systemic risk here . We have not seen the failure of banking system like USA (S&L Failure 1980s/1990s/2008 sub prime Crisis) or Europe (country after country the banks were allowed to over leverage them resulting into failure-Iceland was most glaring but Royal Bank of Scotland was no different. Whole European banking system is in mess. And for PCA in India I believe bigger problem is government which have failed to capitalise banks after elevated problems resulting from demo and bothced up GST. I agree with you that economy needs stable policy regime but banking should be managed by professional bankers and not promoters once it reaches certain size given access to depositors money they have and systemic raise they can pose. I would worry about economy as a whole. And I agree with you RBI has done many mistakes as regulator. As a top ranking CA having worked with HUL and L&T and provided IT solutions to the largest Indian companies and HDFC Bank , advised Maharashtra government on financial modelling of Expressway and flyovers, I believe that they should have focussed on promoting corporate bond market (today there is no depth in that market) where market evaluates, prices and monitor risk rather than leaving it to ever greening loans and cash credit by bank management. But in this case they case I believe they are right. As far Kotak Bank holding it was never long term buy given their poor ROE of less than 15 per cent. And also we never thought that he would manage his bank as personal fiefdom (his flirting with Axis bank) But I would never use this forum for such personal grouse. I have high respect for you and the work you are doing. Keep it up.

    Girish N Kamat

    In Reply to Sucheta Dalal 2 years ago

    Dont take me wrong. I am top ranking CA having worked HUL and L&T and provided solutions to largest corporates in India including HDFC bank as IT enterpreneur. And yes RBI has and is making lot of mistakes and it looks better like one eyed king in land of blinds. And I consider you as finest financial journalist (unfortunately a race horse which media companies can't use in their buggies). And here my grouse is not against you but Kotak Bank.

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