NBFC Due Diligence

Due diligence is a key process for thoroughly examining an entity’s legal, financial, and commercial aspects.

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Overview

Given that NBFC due diligence is a time-consuming and detail-oriented process, its significance cannot be overstated. A poor investment decision can have serious consequences for both the investor and the broader economy. As such, it is highly recommended to seek the assistance of a seasoned professional with years of experience and a keen attention to detail. Due diligence is not a task that can be handled by just one type of professional; it requires a diverse team with expertise in various fields, such as lawyers, Chartered Accountants, Company Secretaries, and others. Each area of evaluation requires specialized knowledge and skills, making a multidisciplinary team the ideal choice for conducting thorough due diligence.

Why is Due Diligence Important for NBFCs?

Due diligence in the case of an NBFC is going through all the available information about its workings and this is important for certain very important reasons:

  • Ensuring Compliance: It assists in ascertaining if the NBFC is in compliance with the various policies of the Reserve Bank of India. For example, whether it has maintained prescribed external capital and its assets are managed as required, among others. This refers to doing things by the book.
  • Understanding the Overview of the Financial Position: It is similar to the way one repeatedly says, ‘go for a health check-up’. This is because in a rational analysis of balance sheets, a cash flow and so forth, one is able to discern the true extent of stability and profitability of any given NBFC.
  • Sensing Potential Risks at An Early Stage: Due diligence is like turning on the spotlight to see underlying issues. Some of these risks can be associated with lending, the state of the economy or the efficiency of the NBFC’s business operations. These are early warning signs, which if sensed very well, will prevent any major surprises later.
  • Making Solid investment Choices:Where the investors are concerned, due diligence is a way to compel the managers themselves to ensure the business into which they invest is sound. It raises the assurance that this institution will not disappoint before any drastic decisions are made.

What are the aspects of NBFC Due Diligence?

NBFC due diligence evaluates the NBFC’s business activities and determines its assets and liabilities from a commercial perspective. Investors considering an investment in an NBFC typically carry out this process to ensure that their investment is secure and directed toward a financially viable entity.

Each NBFC due diligence exercise is carried out under the following key areas.

NBFC Secretarial Due Diligence

Secretarial due diligence for a NBFC is a process of evaluating the company’s corporate governance, legal documentation, and compliance with regulatory and statutory requirements from a company secretarial perspective. It involves reviewing the company’s internal records and corporate structure to ensure that it adheres to all legal and regulatory standards.

Key aspects of NBFC secretarial due diligence include:

  1. Incorporation and Constitutional Documents:
    • Verifying the NBFC’s certificate of incorporation, memorandum of association, articles of association, and other constitutional documents to ensure compliance with applicable laws.
  2. Corporate Governance and Board Composition:
    • Assessing the structure and functioning of the board of directors, including the appointment and removal of directors, board meetings, and decision-making processes.
    • Reviewing the roles and responsibilities of key management personnel and confirming adherence to governance best practices.
  3. Shareholding and Ownership Structure:
    • Examining the company’s shareholding pattern to ensure transparency and compliance with regulatory requirements, such as disclosures to shareholders and the regulatory authorities.
    • Ensuring that any changes in the ownership structure are properly documented and reported.
  4. Statutory Registers and Records:
    • Ensuring that the company maintains and updates statutory registers as required by the Companies Act and other applicable laws. This includes registers of members, directors, share transfers, and meetings.
    • Reviewing the company’s compliance with filing requirements for annual returns, financial statements, and other regulatory filings.
  5. Regulatory Filings and Compliance:
    • Verifying that the NBFC has complied with the filing requirements under the relevant statutes, including filings with the Reserve Bank of India (RBI), the Ministry of Corporate Affairs (MCA), and other authorities.
    • Reviewing compliance with annual financial statements, disclosures, and other statutory submissions.
  6. Contracts and Agreements:
    • Scrutinizing major contracts, shareholder agreements, and related-party transactions for compliance with applicable laws and internal governance policies.
    • Ensuring that any material agreements are properly executed and authorized.
  7. Litigation and Legal Compliance:
    • Identifying any legal proceedings, disputes, or claims involving the company that may affect its operations or governance.
    • Identifying any legal proceedings, disputes, or claims involving the company that may affect its operations or governance.
  8. Changes in Constitution and Resolutions:
    • Verifying that any changes in the constitution of the company (e.g., amendments to the articles of association) are properly authorized and documented through board and shareholder resolutions.
  9. Regulatory Approvals:
    • Ensuring that the NBFC has obtained all necessary approvals, licenses, and permits required for its operations, particularly from regulatory bodies like the RBI.
  10. Risk Management and Compliance Culture:
    • Assessing the company’s approach to internal controls, risk management, and overall compliance culture to ensure robust systems are in place for managing regulatory and governance risks.

NBFC Legal Due Diligence

Legal due diligence for a NBFC is a comprehensive process that involves examining the legal aspects of the company’s operations, contracts, compliance, and potential legal risks. The goal is to assess the legal standing, identify any liabilities or risks, and ensure the NBFC complies with all relevant laws and regulations. Legal due diligence helps investors, stakeholders, and regulators make informed decisions by providing a clear picture of the company’s legal health.

Key Areas of NBFC Legal Due Diligence:

  1. Corporate Structure
    • Legal Structure: Evaluate whether the NBFC is operating under the correct business structure, such as a private or public limited company, and if it meets regulatory requirements for such entities.
  2. Licensing and Regulatory Compliance
    • RBI Registration: Ensure the NBFC is registered with the Reserve Bank of India (RBI) as required, and is compliant with all RBI regulations and guidelines governing NBFCs.
    • Other Licensing Requirements: Verify that the NBFC has obtained all necessary licenses and approvals from regulatory bodies to operate in its specific domain, such as the Securities and Exchange Board of India (SEBI), or state regulatory authorities.
    • Regulatory Filings: Review the company’s compliance with statutory filing requirements, including annual returns, financial statements, and any disclosures mandated by the RBI, Ministry of Corporate Affairs (MCA), or other relevant authorities.
  3. Contracts and Agreements
    • Material Contracts: Review key contracts and agreements, such as loan agreements, partnership contracts, service agreements, and related-party transactions, to assess compliance with legal requirements.
    • Third-Party Agreements: Examine any third-party contracts, ensuring that terms, conditions, and obligations are properly defined, and the NBFC is legally protected from risks in its partnerships.
    • Loan Agreements: Analyze the loan documents to determine the terms and conditions of credit facilities, interest rates, and any clauses that could expose the company to risks.
  4. Litigation and Legal Disputes
    • Pending Litigation: Identify any ongoing or past legal disputes involving the NBFC. Evaluate the potential risks and impact of these legal cases on the company’s operations, reputation, or financial position.
    • Pending Litigation: Identify any ongoing or past legal disputes involving the NBFC. Evaluate the potential risks and impact of these legal cases on the company’s operations, reputation, or financial position.
  5. Regulatory Violations and Penalties
    • Past Penalties: Investigate any previous penalties, fines, or sanctions imposed on the NBFC by regulatory authorities, including the RBI, SEBI, or tax authorities. Assess the implications of these violations and whether the company has taken corrective actions.
    • Compliance Gaps: Identify any areas where the NBFC may have failed to comply with regulatory requirements, including corporate governance practices, financial reporting, and risk management.
  6. Intellectual Property (IP) and Assets
    • IP Rights: Check whether the NBFC holds any intellectual property, such as trademarks, patents, or copyrights, and verify that these assets are properly protected and registered.
    • Asset Ownership: Confirm the legal ownership of the company’s assets, including physical properties, equipment, and intellectual property, and ensure that no encumbrances or claims exist on these assets.
  7. Employment and Labor Compliance
    • Employment Contracts: Review employment agreements with key executives, employees, and contractors to ensure compliance with labor laws and to identify any potential employment disputes or liabilities.
    • Employee Benefits and Pensions: Evaluate the company’s compliance with employee benefit programs, pension plans, and statutory payments to employees, such as provident fund and gratuity.
    • Labor Disputes: Investigate any ongoing or potential labor disputes, including union-related matters or employment lawsuits.
  8. Risk Management and Legal Protections
    • Insurance Coverage: Ensure that the NBFC has adequate insurance coverage to protect against legal risks, including liability, property damage, and employee-related risks.
    • Legal Risk Management: Evaluate the company’s internal legal risk management processes, including how it addresses legal risks in lending, compliance, and operational practices.
  9. Corporate Governance and Board Practices
    • Board Composition: Review the composition and functioning of the board of directors, ensuring that the board operates in compliance with corporate governance norms.
    • Director and Officer Liability: Check for any instances of director or officer misconduct, mismanagement, or breaches of fiduciary duties.
    • Governance Policies: Assess whether the NBFC has implemented proper governance frameworks, including internal policies on conflicts of interest, transparency, and decision-making.
  10. Other Legal Considerations
    • Anti-Money Laundering (AML) Compliance: Verify that the NBFC complies with anti-money laundering regulations and has implemented necessary policies and procedures to detect and prevent financial crimes.
    • Data Protection and Privacy Laws: Assess the NBFC’s compliance with data protection and privacy laws, especially if it handles sensitive customer information.
    • NBFC’s adherence to various policies that govern its operations, risk management, compliance, and corporate governance.

Financial and Tax Due Diligence

Financial and tax due diligence for NBFC is an essential process to assess the financial health, stability, and tax compliance of the company. This due diligence focuses on evaluating the financial statements, transactions, tax liabilities, and overall financial practices to ensure accuracy, transparency, and compliance with applicable laws and regulations.

  1. Financial Due Diligence
    • Financial Statements and Accounting Records
      • Review of Financial Statements: Scrutinize the NBFC’s financial statements, including the balance sheet, profit and loss statement, and cash flow statement for the last few years (typically 3-5 years). Ensure that they are accurate, prepared in accordance with Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), and provide a clear picture of the company’s financial health.
      • Audit Reports: Verify if the financial statements have been audited by an independent external auditor and whether the audit reports are unqualified or if there are any concerns raised by the auditors.
      • Consistency and Accuracy: Assess the consistency of financial records, ensuring that the company’s reporting practices are transparent and align with industry standards.
    • Loan Portfolio and Asset Quality
      • Loan Book Evaluation: Evaluate the quality of the NBFC’s loan portfolio by reviewing key metrics such as the Non-Performing Assets (NPA) ratio, loan-to-value ratios, and recovery rates.
      • Provisioning for Bad Loans: Review the provisioning policies for NPAs and assess if adequate provisions have been made as per the regulatory guidelines set by the Reserve Bank of India (RBI).
      • Collateral and Security: Evaluate the quality and adequacy of collateral or security for the loans issued by the NBFC. This helps assess the recovery potential of any defaulted loans.
    • Capital Adequacy and Liquidity
      • Capital Adequacy Ratio (CAR): Assess whether the NBFC maintains an adequate Capital Adequacy Ratio as per RBI’s regulations to ensure financial stability and meet regulatory requirements.
      • Liquidity Ratios: Review the liquidity position by evaluating ratios such as the current ratio and quick ratio to assess whether the company has enough short-term assets to cover liabilities.
      • Financial Leverage: Analyze the company’s debt-to-equity ratio to evaluate its financial leverage and reliance on external debt financing.
    • Profitability and Revenue Generation
      • Revenue Streams: Review the company’s revenue model, including interest income, fee-based income, and any other sources of revenue. Assess the sustainability and diversification of these revenue streams.
      • Profitability Ratios: Analyze profitability ratios such as return on assets (ROA), return on equity (ROE), and net profit margins to evaluate the overall financial performance.
      • Cost Structures: Evaluate the company’s cost structure, including operational expenses, interest expenses, and administrative costs, to assess operational efficiency.
    • Financial Forecasts and Projections
      • Forecast Accuracy: Review the company’s financial projections, comparing them to historical performance. Analyze any assumptions made in the forecasting process to evaluate the reliability of future revenue and expenses.
      • Growth Plans: Assess any plans for expansion or growth, such as new product offerings or entry into new markets, and the potential financial impact.
  2. Tax Due Diligence
    • Tax Compliance and Filings
      • Income Tax Returns: Verify that the NBFC has filed its income tax returns in compliance with the Indian Income Tax Act or applicable laws in the jurisdiction it operates in. Ensure that these returns are filed on time and are accurate.
      • Indirect Tax Compliance: Evaluate the NBFC’s compliance with indirect taxes such as Goods and Services Tax (GST), Service Tax, and other applicable taxes. Ensure that tax filings and payments are current and in compliance with regulatory timelines.
      • Tax Audits and Assessments: Review any tax audit reports or assessments conducted by tax authorities to identify any outstanding tax liabilities, audits, or disputes.
    • Tax Liabilities and Provisions
      • Outstanding Tax Liabilities: Check for any outstanding tax liabilities, including income tax, GST, and any other applicable taxes. Assess whether adequate provisions have been made for these liabilities.
      • Tax Litigation and Disputes: Investigate any ongoing tax litigation or disputes with tax authorities and evaluate their potential impact on the NBFC’s operations and finances.
      • Transfer Pricing Compliance: If the NBFC operates in multiple jurisdictions or has related-party transactions, ensure compliance with transfer pricing regulations to avoid potential tax disputes.
    • Tax Incentives and Benefits
      • Tax Credits: Evaluate if the NBFC has availed any tax credits, incentives, or exemptions available under tax laws. This may include tax benefits related to corporate social responsibility (CSR) activities or other industry-specific tax benefits.
      • Tax Loss Carryforward: Review any accumulated tax losses that may be carried forward to offset future taxable income. Ensure these are accounted for appropriately and comply with tax laws.
    • Capital Gains and Asset Taxation
      • Capital Gains Tax: Assess any capital gains tax implications related to the sale of assets, including investments, real estate, or securities. Ensure that these transactions are properly accounted for in the financial statements.
      • Depreciation Policies: Review the company’s policies on depreciation and capital asset taxation. Ensure that depreciation is correctly calculated and in line with tax regulations.

Commercial Due Diligence

Commercial due diligence is conducted with a focus on assessing the NBFC as a business entity, examining its financial viability and the stability of its operations. The evaluation considers the NBFC’s position within the broader market, comparing its performance against competitors, analyzing customer relationships, understanding the company’s vision, and evaluating current and projected sales:

  • Comparing the performance of the NBFC with its competitors based on market conditions.
  • Assessing the strength of customer relationships and loyalty with the NBFC.
  • Evaluating the goodwill and reputation of the NBFC in the market.
  • Analyzing the marketing and sales strategies aimed at driving future business growth.
  • Assessing the realistic expectations of the NBFC in meeting its targets and objectives.

FAQ's

A non-banking financial company’s due diligence is a voluntary procedure that helps identify potential risks within the organization.

The major areas of NBFC due diligence are as follows:
– Foreign direct investment (FDI)
– Financial statements of the company
– Human resources
– IPR held by the NBFC
– Certificate of KYC registration and other compliance with the RBI
– Agreements entered into by the company
– Legal disputes, pending and otherwise, in the entity’s name
– Insurance claims of the company
– Tax receipts and other related regulatory compliance requirements

The key advantages of due diligence compliance are as follows:
It identifies accounting and financial inaccuracies and risks.
The diligence process helps prevent fraud and misreporting.
It protects the lenders from credit risks.
The due diligence helps investors and stakeholders make sound decisions.

The list of individuals and entities that are eligible to conduct a non-banking financial company is as follows:
– Chartered Accountants
– Investment bankers
– Financial advisors
– Compliance service providers
– Company secretary (CS)
– Legal professional advisories
– Risk consultants

The documents needed for a non-banking financial company due diligence are as follows:
– The NBFC certificate of registration by the RBI.
– The GST and Permanent Account Number (PAN).
– Tax Deduction Account Number (TAN) registration ID.
– Incorporation documents, including MOA, AOA, company charter, net owned fund certified by a CA, and a registered business office address agreement (lease or rental).
– A resolution of the board of directors.
– Minutes of meetings on important decisions.
– Audited financial statements of auditors
– Net worth of the NBFC certified by a chartered accountant.

The NBFC due diligence compliance is needed during:
– Operational improvement assessment
– Mergers and acquisitions
– Partnership with fintech and digital lenders
– Regular audits are conducted for the detection of fraudulent activities and financial irregularities.
– To improve risk and IT infrastructure.
– To comply with statutory audits by the Indian tax authorities.

A statutory audit is conducted by a certified auditor, and it is legally mandated, whereas an NBFC compliance is conducted to enhance the systems and comply with RBI guidelines and latest innovation alignments.

The RBI mandates that one take around 3 to 6 months. However, a voluntary one can take up to 3 to 6 weeks, depending on the size and departments of the NBFC.


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