1. UNIVERSAL LEGAL
ATTORNEYS AT LAW
Sector Focus
MICRO-FINANCE
Micro- Finance Vol.1, January 2010
This first issue dedicated to the Micro- Finance sector deals with
“COMPARISON OF LEGAL STRUCTURES AND FOREIGN INVESTMENT IN THE MICROFINANCE SECTOR”
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2. COMPARISON OF LEGAL STRUCTURES AND FOREIGN INVESTMENT IN THE
MICROFINANCE SECTOR
In the last half a decade, the microfinance sector has attracted drones of investors, more so due to
it’s resilience against the recession and consistent assurance of return of repayment. The last two
years alone witnessed an infusion of over USD 230 million equity capital into the sector, in India1.
Nevertheless, regulatory compliances continue to be relentless and structuring investment routes
continue to be a hurdle both for the investors and investees alike.
MFIs can broadly be classified into two important factions:
Banking channels: Examples are such as NABARD, Small Industries Development Bank of
India (SIDBI), commercial banks, regional rural banks, etc.
Non- banking channels: Examples are such as non-banking finance companies, section 25
companies, trusts, societies, co-operatives etc.
Presently, the banking channels dominate the microfinance sector. However, non- banking channels
have begun to gain prominence and enjoy a rough 75% of the market share compared to their
banking channel cousins.2 In order to accept FDI, the MFI investees will have to clear their first
hurdle- to organize themselves under the Indian Companies Act.
Microfinance activities fall squarely within the definition of the activities of a non- banking financial
institution (NBFI) as defined by the Reserve Bank of India Act, 1934. The Act defines a NBFI as any
company, corporation or cooperative society that carries on a list of specified activities such as
financing, insurance business, chits, lending, receiving deposits, etc.
Companies in order to carry on these activities are required to be registered with the RBI as Non-
banking financial companies (NBFCs). Registration is usually an elaborate process as the
government has its scruples before registering a company as an NBFC. Setting up an NBFC that is
suitable for inward bound FDI, is a huge put- off for MFI- investees due to the cumbersome
capitalization requirements involved (refer table below).
In order to defer the applicability of the provisions pertaining to an NBFC the MFIs seek to register as
a not- for profit under Section 25 of the Companies Act. These companies are specifically exempted
from being registered or treated as an NBFC if
They do not accept public deposits and
They provide credit not exceeding Rs. 50,000 for a business enterprise and Rs. 1,25,000 for
meeting the cost of a dwelling unit to any poor person
However, section 25 companies do not provide an attractive source of investment for the investors
due to the prohibition on dividend distribution. So, though the corporate structure affords advantages
of corporate governance, transparency as compared to the unorganized structures such as trust or
societies, the hurdle of securing capital for the NBFC continues to persist. In a bid to evade these
difficulties, unorganized MFIs have opted to transform into NBFCs either by
acquiring shell NBFCs or
by forming a mutual benefit trust.
The first route of acquiring an NBFC is as straightforward as it sounds. The acquiring MFI- trust or
society will customarily execute a share subscription or a share purchase agreement with the NBFC
and its shareholders. In a mutual benefit trust (MBT) the existing MFI would give a one- time grant/
loan to its customers who would re- invest the return on the grant into the corpus of the SPV i.e., the
MBT. The MBT would then invest the corpus into the NBFC and the voting right of the SPV would vest
with the MFI. The grants, though being a small amount per customer, by reason of the fact that it is
distributed to a large clientele would suffice to meet the capitalization requirements of an NBFC.
Foreign investment through debt is strictly prohibited in NBFCs engaged in microfinance. However,
section 25 companies, co-operatives, trusts and societies may be permitted to raise debt within the
prescribed limits under the Master Circular3. Given below is a comparison of the various legal
structures.
1
The Role of Private Equity: Fueling the growth of microfinance- Microfinance Insights Vol 13 July/ Aug 2009
2
Microfinance India- State of the sector report: 2008 by N. Srinivasan
3
Master Circular No. 07/2009-10

3. COMPARISON OF LEGAL STRUCTURES4
Institutional Societies Trusts Section 25 Non-Banking Finance
Variable Companies Companies
Capitalization None None None Rs.200 lakhs
Capital None None None 12% (including both Tier I
Adequacy and Tier II capital). Tier II
capital shall not exceed
100% of Tier I capital
ECB Permitted Permitted Permitted Not permitted per the
master circular 5
Grants and Permitted Permitted and Permitted Permitted but not exempt
Subsidized and grants exempt from and exempt from tax if grant is domestic.
Loans exempt from tax if used for from tax if
tax if used charitable grant is
for charitable purposes. domestic.
purposes.
Foreign grants require approval under the Foreign Contribution Regulation Act,
1976
Foreign None None Permitted. Permitted upto 100% with
Direct No dividend limitations on activities
Investment distribution specified in the master
circular of the RBI subject to
minimum capitalization
norms.
Capital None None No Permitted with strict
Markets restriction, reporting requirements
No dividend
distribution
Depending If registered, Compliance Reporting to Registrar of
Disclosure on the home to the with Companies and RBI as per
state of the Registrar on provisions of their requirements.
society, to an annual Company law Reporting to Registrar of
the Registrar basis in the and reporting Companies largely annual,
of Societies form of annual to the but reporting to RBI has
on an annual accounts Registrar of varying periodicity for
basis in the statement Companies different requirements.
form of on annual Disclosures on maintenance
annual basis – of statutory liquidity, details
accounts essentially of public deposits,
statement accounts, information on opening/
shareholding closing of branch offices for
pattern and collection of deposits, details
board of net owned funds, asset-
membership. liability management,
income recognition and asset
classification.
4
Existing Legal and Regulatory Framework for the Microfinance Institutions in India: Challenges and Implications,
M-Cril Sa-Dhan Microfinance Resource Centre , edition 2006
5
Master Circular No. 07/2009-10

4. SHOWCASE OF KEY MFI TRANSACTIONS
Key Co – Investment Transactions over the last 2 years
Investment MFI Investors Amount
Date (USD)
millions)
Mar - 09 Bharatiya Aavishkaar Goodwell, 10
Samrudhi Lok Capital, SIDBI
Nov - 08 Ujjivan Sequoia, Lok, Unitus & 19
Others
May - 07 Share Microfin Legatum, Aavishkaar 8
Goodwell
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