The conundrum of NBFC loans secured against Unlisted Shares

The Reserve Bank of India (“RBI”) through its notification dated April 10, 2015 (“RBI Notification”) amended the Non-Banking Financial (Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007 whereby it mandated that all Non-Banking Financial Institutions (“NBFC”) (having an asset size of 100 crores or above) to maintain an LTV (Loan to Value) ratio of 50 per cent (fifty per cent) at all times. In other words, NBFCs are prohibited from granting a loan worth more than 50 per cent (fifty percent) of the value of the assets against which the loan is being granted. One class of security which is sometimes provided by the borrowers is a pledge of shares. Where any such pledge is taken as a security, the NBFCs are required to report to stock exchanges, on a quarterly basis, the details of the shares pledged in their favour by the borrowers for availing loans.

The RBI also released a clarification dated April 10, 2015 stating that these guidelines do not apply to unlisted shares.

The legal framework surrounding NBFCs offering loans against unlisted shares presents a nuanced picture. While the Banking Regulation Act, 1949 empowers banks to grant such loans subject to specific restrictions, there's an absence of explicit legislation governing this practice for the NBFCs.

This distinction underscores a critical gap in regulatory oversight concerning the NBFCs and the use of unlisted securities as collateral.  This situation leads to ambiguity regarding whether an NBFC has the authority to issue loans against unlisted shares. Therefore, in this article, we aim to explore the feasibility of obtaining a loan from an NBFC using shares of an unlisted company as collateral.

We did notice that there have been some instances where NBFCs have granted loans to borrowers against unlisted shares. One such instance is when PTC India Financial Services Limited (an NBFC registered with the RBI) granted a loan to NSL Nagapatnam Power and Infratech Limited upon pledging 31,80,678 shares of NSL Energy Ventures Private Limited. Similarly, IFCI Limited, another RBI-registered NBFC, has recurrently offered loans to borrowers against shares of unlisted companies. However, it is not very common for NBFCs to go down the pledge route, especially, in relation to the unlisted companies. There are certain risks involved. In the next section, we have highlighted some of the risks that the NBFCs face and how such risks could be mitigated by the NBFCs:

1. Clear title of securities – Prior to accepting unlisted securities as collateral from any borrower, the lender must first ensure that the securities have a clear and free title. This entails verifying whether the borrower holds undisputed ownership of the securities being pledged and confirming that all the compliances were undertaken for acquiring them as per the applicable law, and verifying that there are no ongoing disputes related to their ownership. Further, the lender needs to ensure that the securities are free of any prior claims or liens or any other type of encumbrances. This includes verifying that there are no existing debts or legal restrictions on the borrower's ability to sell or pledge the securities.

2. Share valuation from an independent valuer as these are unlisted securities – The shares of a private company carry a great risk against the recovery of a disputed loan amount as no ready value of these shares is available due to these stocks not being listed on any stock exchange. Further, the valuation of these shares may not be accurate as the same is determined based on the data/ information provided by the company. Therefore, it is of pertinent importance that the NBFC gets a valuation of the pledged securities determined by an independent valuer to get a fair and correct market value. This requirement might be subject to the general lending policy of the NBFC. NBFCs must also assess their potential for conversion into cash if the need arises. Since unlisted shares lack the transparency and liquidity of their listed counterparts, a rigorous evaluation becomes imperative to ascertain their true worth as collateral.

3. Restrictive terms in transaction documents governing pledged securities – Securities of any private limited company are governed by the terms outlined in either its articles of association or the shareholders’ agreement executed between the company and its shareholders. One such restrictive clause could involve preventing the transfer of pledged securities to any competitor of the company or the pledge of shares may not be allowed without the prior written approval of the shareholders. Additionally, another common restriction could be a lock-in period, during which the shares of the company are locked in for a specific duration. Lenders must exercise caution regarding these limitations and reassess whether taking the shares of such a company as a pledge is advisable. If such a decision is made, it's crucial to ensure that any existing restrictions are set to expire in the near future. Furthermore, any additional restrictions imposed should necessitate consent from the lender. This approach helps mitigate risks and ensures that the lender retains the necessary flexibility in managing its investments.

4. Credit appraisal - When it comes to extending loans secured by unlisted shares, NBFCs must tread carefully and employ meticulous due diligence processes. This includes conducting comprehensive credit appraisals to evaluate critical risk factors which includes assessing the financial stability of the borrower, and scrutinizing their financial history, current financial standing, and repayment capabilities. By conducting a comprehensive risk assessment, NBFCs can better gauge the probability of default and devise strategies to mitigate potential losses. By diligently conducting thorough credit appraisals and due diligence, NBFCs can mitigate risks and make well-informed lending decisions.

In conclusion, while there appears to be no legal barrier for NBFCs to offer loans against unlisted shares, it's a practice fraught with risks such as the illiquid nature of securities, restrictions of transfer, unstable valuations and the lack of transparency. Considering the risks associated with the transaction, the practice seems uncommon in the market. However, conducting a thorough verification encompassing a title check of share ownership, credit appraisals, independent valuation of the pledged securities, and a careful scrutiny of the material documents of the borrower which is essential to mitigate potential defaults, could open up a viable option for private company and other entities holding shares of private companies in raising funds and could also open up an investment sector for the NBFCs.

About the authors: Neeraj Vyas is a Partner and Abhishek Malhotra is an Associate at Saga Legal.

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