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 directors^iv . 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 granted^v 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 abeyance^vi 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 laws^vii , 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.

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