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Introduction to Banking and Financial Laws

A course on business laws would be incomplete without providing a basic understanding of the financial sector. The financial sector comprises of several banks and financial institutions, pension funds, insurance companies, banks, consultants and financial advisors. Lawyers play a key advisory role to these participants. Entrepreneurs interact with various participants in the financial sector on a day-to-day basis, e.g. while taking loans, obtaining insurance, making investments, etc. Consultants can provide useful value-addition to businesses and business owners if they have a knack of the working of the financial sector. Goldman Sachs had built a specialized division in the 1980s in US to provide investment advice to entrepreneurs who sold the shares they held in their startups, which became extremely profitable. 

This module discusses different participants in the financial sector to familiarize readers with how their activities are regulated.

The financial sector is crucial to the development of the economy – it facilitates the flow of money to the areas where it is needed. The financial sector includes banks, insurance companies, pension funds, merchant banks (also known as investment banks), non-banking financial companies, etc. For businesses, the financial sector is an important source of capital (both equity and debt) and also provides various intermediary services (such as financial advice and management).

This chapter will introduce you to the overall regulation of the financial sector and how different financial sector entities operate. It will also introduce you to the key issues faced while taking loans.

Part A - Banking sector and types of loans

Regulation of banks

Banks are the primary participants in the financial sector. As per the Banking Regulation Act, 1949 (which governs the functioning of all banks in India), banking is defined as the accepting of deposits from the public for the purpose of lending or investment and withdrawal (by cheque, DD or other methods). Apart from accepting deposits and lending, banks also perform various ancillary activities for individuals and businesses such as collection of cheques, utility payments, dealing in foreign exchange, providing lockers, etc. The functions that a bank is allowed to perform are elaborately described in Section 6 of the Banking Regulation Act. There is an elaborate body of case law which has developed around Section 6 (interested readers may consult a banking law textbook for details on the interpretation of the provision).

An entity which intends to perform banking activity is required to obtain a license from the Reserve Bank of India (RBI), the sectoral regulator for banks. As the regulator for the banking sector the Reserve Bank of India has the authority to issue directions to all banks in India, which emanates from multiple statutes (depending on the subject matter) – Banking Regulation Act and Reserve Bank of India Act (in relation to general matters), the Foreign Exchange Management Act (in relation to foreign exchange), the, Payment and Settlement Systems Act (in relation to payment systems).
NOTE: RBI has previously issued licenses in 1993 (see here) and 2001 (see here). In 2011, it released draft guidelines for licensing of new banks, which are not yet finalized. They are available here.


In the discussion below, we shall discuss the types of credit facilities granted by banks in more detail.

Broad types of credit facilities granted by banks

Businesses take various kinds of loans or credit facilities from banks, some of which are described below:
  • Letter of credit – A letter of credit (LOC) is a facility extended by a bank to a resident in respect of an import transaction. The LOC guarantees payment to the non-resident exporter (by the importer). A sample letter of credit can be accessed on this link.
  • Cash credit/ overdraft facilities – A cash credit or overdraft facility is a short-term credit facility. It is usually extended by banks to current account holders. 
  • Loans - Loans can be extended for various purposes, such as:
i) For working capital – Working capital loans are given for meeting any deficit in the day-to-day operations of the business. There may be periods of time when the business does not have immediate liquid cash, e.g. when the business is required to make immediate payments but the amounts which are already due to it will be received later. A working capital loan is provided so that it can meet this shortfall in liquidity.

ii) For purchase of specific business equipment (e.g. a tractor, a machine, etc.). Loans can also be provided by for importing the equipment from another country.

iii) For a specific project, e.g. for building infrastructure such as a road, a port or a highway. Loans for specific projects fall within the ambit of ‘Project Finance’ (a major practice area for law firms) and are typically arranged once a project is awarded by the relevant governmental or other statutory body to a private entity for constructing the relevant project.

iv) For a specific business transaction – e.g. for an acquisition. In India, taking loans from banks for acquisition of shares of a company is not permitted. However, loans can be taken from NBFCs or group companies for the purpose of acquisition, subject to compliance with applicable legal provisions in each case.

On certain occasions, a company may intend to raise finance from public capital markets (e.g. by issuing shares or debentures), but since the process is time-consuming, it may obtain a loan of similar amount from banks or financial institutions, which can be repaid once the company has completed the public issue. Such a loan is called a ‘bridge loan’.

v) Syndicate loans - When the loan amount is large, businesses often opt for syndicate loans. In a syndicate loan, multiple banks assume the position of lenders through the same loan agreement. For example, a loan of INR 200 crores by the following banks (lending together), which is for the same purpose and governed under the legal document would be considered a syndicate loan:
Bank Loan Amount (in INR crores)
SBI 20
HDFC Bank 60
Punjab National Bank 30
Standard Chartered 50
Total 200
The portion contributed by each bank in the loan is known as its ‘participation’. Since the outlay by individual banks can be quite substantial, syndicate loan documents have elaborate procedures for banks to exit by selling their ‘participation’ in the loan to another loan. Failure by a bank to provide a credit facility as per the agreement amounts to a ‘default by the lender’, which entitles the borrower to obtain a similar facility for another bank (unless the existing banks wish to increase their participation) in the loan.

Syndicate loan agreements are often drafted on the basis of a standardised format –Asia Pacific Loan Market Association (APLMA) format is one example. (The APLMA was founded in 1998 by seven founding member banks, which included leading banks such as Bank of Tokyo-Mitsubishi, ABN Amro, Citigroup, BNP Paribas, Barclays Capital and Societe Generale).Such formats are prepared in light of the interest and experiences of lenders (and borrowers as well) and are therefore useful in protecting lenders against obvious risks. They are frequently updated in light of changing developments and market experiences.

For example, in 2009 an English court held that in case of a breach of a loan agreement, if a bank did not terminate the agreement (and continued performance) without any communication in respect of the breach to the borrower, it had actually elected to affirm or condone the breach and could not subsequently terminate the contract. See Tele2 International Card Company SA and others vs. Post Office Ltd.  [2009] All ER (D) 144 (Jan). As a result, the APLMA amended the relevant clause in the standardized agreement (titled Remedies and Waivers), stating that an affirmation or condonation of a breach would only be effective if it is made in writing.

Part B - Essential Issues in loan agreements

Like equity, debt is an important component of the finances of any business. However, the market for lending to startups is quite small. Since their cash flows are unstable and the venture is fraught with risk, startups do not prefer debt in their early stages. However, many Indian banks are gradually starting to provide loans for Small and Medium Enterprises (SMEs) to benefit from lending to this segment of the market.

Lenders will agree to provide debt if the venture is less risky or they have some assurance that it will be able to service the debt (through interest and other repayments). Usually, lenders insist on security against the property of the company or the personal property of the founders while agreeing to provide a loan. In this part, we shall discuss some of the broad issues that arise while entering into a loan agreement.

While every agreement may have minor modifications, reliance on a standardized format helps in saving on costs incurred on negotiation of every minor detail (as the number of parties is high and individual interests of each lender could differ with respect to particular clauses). In the discussion below, we outline the key issues in loan agreements:

1. Purpose of the loan-

The purpose for which a loan is taken is extremely important – the terms of a long-term loan (e.g. for an infrastructure project) will be extremely different from those of a loan of a short term loan of, say 2 years.

Banks specify restrictions on the manner in which a borrower can use the loan amount (called end uses) – auditing powers of the banks and information covenants as per the documentation provide sufficient rights to monitor the utilization of the loan. Under law, one cannot obtain a loan from a bank for certain end-uses – e.g. for financing an acquisition of shares. Monitoring the utilization of loan proceeds may not be very easy or cost-effective for a lender – most banks insist on an annual certificate from the statutory auditor of the company.

In practice, some businesses are able to violate the provision on end-use, if the bank does not adequately monitor the utilization of the proceeds). However, non-banking financial companies (NBFCs) can lend for such a purpose (subject to certain limits) (see below for a detailed discussion on NBFCs). Further, banks usually insist on more stringent security requirements (see below for a discussion of security), as compared to NBFCs. Hence, businesses may prefer to take certain kinds of loans from NBFCs for strategic and regulatory reasons.

Costs -

Interest rates and any other fees payable on the loan must be understood by the borrower. Often, banks may charge lower interest rates but compensate by charging various categories of fees, the financial impact which must be evaluated before taking the loan. Interest is payable at certain pre-determined dates (e.g. at the end of every quarter). The interest rate can be a fixed rate (e.g. 12.5 percent), or variable (called floating interest rates) – more frequently they are floating. A floating interest rate is pegged to a particular reference rate, such as the base rate of the RBI (or the London Interbank Offered Rate or LIBOR in case of ECB), plus a certain amount of margin called the ‘spread’.

In syndicated loans, the arranger bank, that is, the bank which plays a critical role in bringing together the other participating banks as lenders in the transaction, also charges an additional fee known as the ‘arranger’s fee’.
It is also important to note interest payable on any prepayment or delayed repayment - some banks include a penal interest on prepayment because it an untimely repayment reduces their ability to earn interest on that amount.

    3. Repayment Schedule-

Most loans are repayable on the expiry of a particular term. Repayment may be of a fixed amount (in lumpsum) at the end of a particular period, or it could be in parts. For example, a loan of INR 10 crores carrying interest of 10 percent per annum (interest payable annually) may be repaid at the end of 3 years (without any repayment of the principal being required for the duration of the loan). This is a case of bullet repayment. Alternately, the loan may have an amortization schedule, portions of the principal may be repayable in parts. This will reduce the overall interest burden as compared a case of bullet repayment (since interest is only paid on the principal, and the amount of principal remaining unpaid is reducing with time), but increases aggregate payments in the short term.

While the interest rate is mentioned on a per annum basis for most loans, the frequency of interest payment is relevant (so that the business can plan its cash flows accordingly) – sometimes interest is payable every six months or on a quarterly basis. Any penal interest rates that are payable in case of a pre-payment or delayed repayment should also be borne in mind.

4. Security package and guarantees

The security package for a loan can vary depending on the amount of the loan. Unless it is an unsecured loan (which is extremely unlikely for large amounts), banks and financial institutions are likely to insist on a 100 percent or greater security cover, that is, the value of the security should be at least equal to or greater than that of the loan amount.

A lender is usually interested in taking as much security as possible to ensure that he will be able to realize the value of all pending amounts in case of a default. Businesses may be agreeable to it, as long as it does not interfere with the use of the assets in their day-to-day operations.  For high value transactions, the security documentation can be quite complex.

Typically, lenders insist on one or more of the following as security:
  • a mortgage of land (and any fixed equipment) owned by the business, 
  • hypothecation of all the movable property (in case of a hypothecation, you are allowed to use the property, but if you default in repayment, the bank is allowed to sell the movables and recover outstanding dues from such sale), 
  • pledge of shares held by the promoters in the company and
  • ‘charge’ over any assets that are purchased from the loan
Most institutions will also insist on a personal guarantee from the promoters or of the main holding company in the group (in case the promoter has multiple businesses). They may also require a net-worth certificate from a Chartered Accountant (certifying the individual net-worth of the promoters), in case they are relying on the promoter’s personal guarantee. Guarantees from promoters render the personal assets of the promoters at risk in case there is a default in repayment.

5. Termination and acceleration:

Termination provisions of a loan agreement and the events which can trigger termination rights are extremely important. Every loan agreement stipulates conditions (usually called Events of Default or EODs), occurrence of which gives the right to the lenders to terminate the loan agreement. Failure to make an interest payment can lead to an EOD. In the event of termination, the loan is ‘accelerated’, that is, all pending interest payments and the principal is required payable immediately. Borrowers should carefully understand the circumstances which a lender may call an EOD.

Usually, banks also include ‘cross-default’ clauses in loan agreements – implying that a default under another loan agreement (which is not with the present lender) will give a right to the present lender to terminate and accelerate the present loan. This has the risk that one EOD can accelerate liability under several loans simultaneously and suddenly cause a spike in the payment obligations of the borrower (potentially leading to a ‘winding up’ and liquidation of the borrower’s assets). 

6. Restrictions on use of proceeds-

A lender puts different kinds of restrictions on the business – the essential purpose being that the quality of security or the bank’s rights with respect to the security should not be compromised and that the ownership structure of the business should not change. Typical restrictions imposed to protect these interests are:
  • Prohibition on selling of significant stake in the business, merger or change of control
  • Prohibition from creating any further security over the assets furnished as security for the loan (without the bank’s permission)
  • Change in capital structure, i.e. issuance of further shares
Apart from contractual issues, every loan transaction will involve a number of compliance requirements and regulatory issues, such as obtaining necessary resolutions from the company’s board (and shareholders, where applicable). Stamp duty issues can be quite intricate in loan transactions – the parties to a loan want to minimize the tax paid on the transaction. In case the lender is a foreigner, ECB Regulations will also be attracted.


Sectors in which 100 percent FDI is permitted in NBFCs

(i) Merchant Banking

(ii) Under Writing

(iii) Portfolio Management Services

(iv) Investment Advisory Services

(v) Financial Consultancy

(vi) Stock Broking

(vii) Asset Management

(viii) Venture Capital

(ix) Custodian Services

(x) Factoring

(xi) Credit Rating Agencies

(xii) Leasing & Finance

(xiii) Housing Finance

(xiv) Forex Broking

(xv)  Credit Card Business

(xvi) Money Changing Business

(xvii) Micro Credit

(xviii) Rural Credit


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