Credit Guarantees Demand and Regulatory Viability

The impact of Covid-19, and the consequent lock downs, on our society and economy is known to all. While most sectors were impacted, micro, small medium enterprises (MSMEs) sector which is a hub of entrepreneurs and contributing to employment for many, has also been hugely impacted. The pandemic added to the woes of the MSMEs with uncertainty on financial credit, which is key for uninterrupted continuation of the MSME business and which is also marred by inadequate collaterals or guarantees that these MSMEs are able to furnish.

This has caught the interest of several domestic and international groups, including philanthropic organizations, whereby they can contribute to bridge the gap and support these MSMEs or small businesses to avail the much needed credit facilities, by providing the necessary collateral in the form of guarantees.

Why guarantees: MSME sector companies often lack robust security, tangible assets or immovable properties to mortgage or charge in favour of banks/ lenders to obtain loans. Conventional business loans are primarily granted only against securities and guarantees satisfactory to banks/ lenders. At times, even the personal guarantees of the promoters of MSME sector companies are not acceptable to the banks/ lenders owing to limited resources or wealth. Dearth of bankable securities with MSME and their promoters led to them looking out for a viable, acceptable and bankable guarantees from corporates or foundations, which are willing to support, to help MSMEs get their much desired and needed loans and financing.

There are several domestic as well as international corporates and foundations are willing to help support MSME sector companies owing to the vicious circle these companies are in. However, they these domestic and international corporates and foundations look for viable means to provide guarantees, which would enable MSMEs raise the necessary credit facilities, including to Non-Banking Financial Companies (NBFCs) on-lending to MSMEs or small businesses, such that the banks and financial institutions get the necessary comfort and assurance on the repayment of these loans from MSMEs.

Issue in hand: Now, here we are, (i) with MSMEs who must procure guarantees to get loans to continue to be in business and to grow; and (ii) with these domestic as well as international corporates and foundations. Unfortunately, the stumbling block seems to be the question whether the Indian regulatory framework is clear and adequate to enable these international as well as domestic organizations, which are unrelated to the borrowers, to give credit guarantees to Indian entities.

History: Prior to delving into the existing regulatory regime, it would be interesting to know the history of credit guarantees in India. The need for these credit guarantees has always been recognised in India and is not new to the system. In 1960, the Government of India (GOI), in consultation with Reserve Bank of India (RBI), introduced a Credit Guarantee Scheme (CGS). RBI was entrusted with the administration of CGS, as an agent of the central government, under Section 17(11A)(a) of the Reserve Bank of India Act,1934 (RBI Act) and was designated as the credit guarantee organization for guaranteeing the advances granted by banks and other credit institutions to small scale industries. Subsequently in 1971, the RBI also promoted a public limited company called Credit Guarantee Corporation of India Limited. The essential concern was to persuade banks to make credit available to not so creditworthy clients/ customers.

Thereafter, pursuant to the Small Industries Development Bank of India Act, 1989 (SIDBI) (established to act as well as co-ordinate functions of institutions engaged in similar activities), in August, 2000, the Credit Guarantee Fund Trust for Micro and Small Enterprises was set up as a trust by GOI and SIDBI (the principal financial institution for the promotion, financing and development of the MSME sector) to implement the credit guarantee schemes for MSMEs to make available collateral-free credit to the micro and small enterprise sector. There are also certain other credit guarantee trust funds set up by the GOI, for certain identified sectors/ objectives such as skill development loans, education loans, etc. It is evident that a large part of the credit guarantee products currently available in India are being offered by the GOI.

In 2008, in exercise of the power conferred on it under the RBI Act (with the prior approval of the GOI), RBI specified mortgage guarantee companies (MGC(s)) as NBFCs under the provisions of the RBI Act. This was restricted to guarantees in respect of mortgage and that too for guarantees only for repayment of housing loans.

Present Scenario: The question then arises is what about guarantees for loans given in sectors other than housing loans? Would that be permitted without registration from RBI as an NBFC or some other regulator given that RBI has specifically issued guidelines for a mortgage guarantee to be registered as NBFCs? Or given that there is no express prohibition can any entity set up a guarantee company in India?

The answer to these questions will need to be analysed from various perspectives. RBI has defined a “non-banking financial company” to mean a financial institution, which has in turn been eventually defined to include amongst others an entity undertaking the business of ‘financing’, whether by way of making loans or advances or otherwise. With the term “financing”, as used in Section 45-I(c) of the RBI Act, has not been specifically defined in the RBI Act, the said term could have wide implications. A guarantee could be argued to be a financing activity/ financial transaction, given that this is a security for an underlying financial transaction and thereby could be treated as an extension of a financial activity. A guarantee by its very nature entails a right of subrogation which permits the guarantor to step into the shoes of the lender and assume all rights of the lenders vis-à-vis the borrowers. This right is statutorily available under the Indian Contract Act, 1872. With all the defaulted loans becoming the loans of the guarantee company and the guarantee company having to take action to recover them, it would be very difficult to say it is not financing activity. Further, when the loans are assumed by the guarantee company and the outstanding amounts appear as receivables in the books of such guarantee company, there is also a likelihood of such an entity breaching the asset-income test prescribed for NBFC registration.

In the context of grant of guarantees by a foreign entity i.e. an offshore guarantor, the same is governed by the Structured Obligations Paragraph 19 of the Master Directions no. 5/2018-19, Master Direction- External Commercial Borrowings, Trade Credit and Structured Obligations, dated March 26, 2019 (ECB Master Directions). Although, the said Paragraph 19 of the ECB Master Directions permits grant of guarantees by non-residents on behalf of residents, subject to certain terms and conditions specified therein, nonetheless there remains ambiguities owing to a historical limited application of these provisions to a parent- subsidiaries or related parties one -off transactions.

Need of the hour: There is no doubt that our MSME sector needs guarantee for their loans, and there is enough Indian and international interest in providing or extending such guarantees for them. There is lack of regulatory clarity, and ease of facilitation and set-up, which are must for a significant growth of guarantees provisioning. We are hopeful that ambiguities will be soon cleared, which will pave the way for much needed loan access to MSMEs through guarantees that Indian and, or international corporates are offering to provide. We are tracking this space very closely, so do watch out for more.

Authors:

Hardeep Sachdeva, Senior Partner
Priyamvada Shenoy, Partner

Date: July 5, 2021