Over the past year, the corporate world has been rocked by bankruptcies and a huge liquidity crisis. This includes one of the country’s largest airline suspending operations, Rs 10 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 a few very large NBFCs have been up to.
NBFCs and housing finance companies (HFCs) together constitute 19.2% 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 a majority of its funding from commercial banks and mutual funds. So something that was not doable directly by the banks, is being done through NBFCs as a vehicle.
Source: REDD Report
To add to the inherent instability, what is of greater concern is the malpractices as highlighted in the case of DHFL, wherein the company was accused of being a vehicle to divert funds.
The company used a new structure called ‘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 loan. 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 Rs 1 crore. Company A, B and C have Rs 1 crore in capital and Rs 1 crore in cash each and are owned by X – thus are the related party for the NBFC XYZ.
Also read: Fear of Contagion Looms Over Financial Sector After DHFL’s Payment Default
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 three 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 Rs 3 crore invested.
4. The company A, B and C now have Rs 1 crore of capital and Rs 1 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 are due, another box of companies will be created to fund the loan repayment of companies A, B and C, 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 of 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 Rs 137 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.
This article was first published on Moneylife.