Why the RBI-Kotak Spat Deserves Far More Attention Than It's Getting

The RBI’s recent reply to KMB’s writ petition provides compelling evidence to justify its stance in forcing Kotak to reduce his stake in the bank.

The Reserve Bank of India’s reply to Kotak Mahindra Bank’s writ petition on the regulator’s ownership rules sets the stage for a legal battle that has so far received little media attention.

Responding to the bank’s writ petition, which was filed in December 2018 in the Bombay high court, the central bank last month has put up a robust defence that rebuts the claims of the private sector lender.

Apart from Bloomberg, which was been the only major media agency to disclose the contents of the RBI reply, India’s financial press has failed to give this case the importance it deserves.

Such media conduct regarding the unprecedented case of a bank taking its regulator to court is highly unusual. A closer inspection of the documents filed by the RBI in its reply shows that Kotak Mahindra Bank (KMB) may be overly optimistic in challenging the regulator’s authority to compel the bank’s promoters to reduce their stake.

KMB’s main contention was that the Banking Regulation Act, 1949 (BRA) does not empower the RBI to compel any bank to reduce any individual’s (including a promoter’s) shareholding in a bank.

Also read | Why the RBI Should Have Been Transparent When it Gave Citibank a Rap on its Knuckles

According to KMB, the BRA only permits the RBI to determine a ceiling on voting rights, and where a shareholder is not considered to be fit and proper, to curtail the individual’s voting rights to 5%. The bank claimed that RBI’s earlier directives to dilute promoter shareholding in KMB were restricted to “paid-up capital” and not paid-up voting equity capital. The bank claimed that it was only after KMB’s issue of preference capital that the RBI in a letter dated August 13, 2018 emphasised the dilution of promoter shareholding as a percentage of “paid-up voting equity capital.”

The writ also stated that Section 12 and Section 12-B of the BRA dealt with the issue of ownership of shares and voting rights in a bank, and argued that RBI powers on this issue are only limited by these Sections; any directions given by the regulator go beyond the purview of these sections, and are ultra vires of the BRA. Indeed, KMB’s writ alleged that RBI acting to dilute the promoters’ stake in any bank was “arbitrary, manifestly unreasonable, illegal, without the authority of law, ultra vires and …unconstitutional and bad in law”.

Such a statement by a regulated entity directly undermines the credibility and authority of the RBI as a banking regulator and supervisor.

Disputing KMB’s allegations and defending its actions, the RBI in its reply argued that when RBI gave an “in principle” approval for Kotak Mahindra Finance Ltd. to convert itself into a bank via a letter dated February 7, 2002, Conditions 17 and 18 in the Annexure which KMB had to comply with stated,

“17. As regards interpretations of the clauses/provisions of the ‘in-principle’ approvals the decision by the RBI will be final

18. RBI may impose additional conditions that it deems appropriate…” (para 16 and Annexure “A” in RBI reply)

The RBI states that this letter was not annexed in Kotak’s petition. The central bank’s reply also states that on the issue of reducing promoters stake in KMB, both parties have been in correspondence  since 2004 and while RBI has been consistent in its stand to reduce promoters’ shareholding, KMB till August 2018 had “never seriously contested” it. Nor had KMB challenged the Guidelines/Directions issued by the RBI on this subject from at least 2013.

Defending the usage of paid-up capital in its correspondence with KMB, RBI states that until the BRA was amended in January 2013, sub-section 12(1)(ii) excluded ‘preference shares’ (except those issued before July 1, 1944) from the capital of a bank. Therefore in the correspondence between granting the banking license to KMB in 2003 till the BRA amendment, the discussion regarding dilution in promoter shareholding was within the context of equity shares only.

Also read | Kotak-RBI Tussle Also Has Consequences for Control of the Overarching Group

Furthermore, according to the RBI, prior to the BRA amendment, KMB made repeated requests for extension of time to comply with the required reduction in promoter shareholding and provided assurances to the RBI of complying with the mutually agreed timelines. The dialogue between the regulator and KMB to dilute promoter shareholding was only within the context of paid-up equity capital, as KMB till August 2018 had no other class of shares. Hence the correspondence between the RBI and KMB prior to the issue of preference capital meant that the reference to “paid-up capital’ was ‘paid up voting capital’.

After the amendments to the BRA in 2013, the RBI issued ‘Guidelines for Licensing of New Banks in the Private Sector’ on February 22, 2013 and the ‘Master Direction on Ownership in Private Banks’ on May 12, 2016. The latter stated that for all existing banks, the promoter shareholding would be the same as permitted in the February 22, 2013 guideline (“@ For all existing banks, the permitted promoter/promoter group shareholding will be in line with what has been permitted in the February 22, 2013 guidelines on licensing of universal banks viz. 15 per cent.”) which stipulated that the dilution of shareholding shall be in respect of “paid-up voting equity capital.”

2(D) (v) The shareholding by NOFHC [Non-operative Financial Holding Company] shall be brought down to 20 per cent of the paid-up voting equity capital of the bank within a period of 10 years, and to 15 per cent within 12 years from the date of commencement of business of the bank.

Therefore the RBI argues that in its correspondence with KMB on the issue of dilution of promoters’ shareholding it was correct in referring to KMB’s equity capital as paid-up capital prior to the bank’s issue of preference capital.

On the issue of the applicability Section 12, BRA, the RBI addresses (para 144-150 in reply) KMB’s argument that the impugned reduction communication and the 2018 RBI letter run contrary to both the letter and spirit of Section 12 and 12-B of the BRA. KMB interprets those sections as pertaining only to the goal of ‘ensuring that control of banking companies is in the hands of fit and proper persons’, and as having nothing to do with the regulation of banks’ capital, and shareholding and voting rights of shareholders generally.

According to the RBI, the concerned section sufficiently empowers the RBI to regulate the extent of voting rights of any individual shareholder in a bank and does not dilute the regulator’s authority, while Section 35-A, BRA gives RBI wide powers to issue directions to any bank in the public interest or in the interest of banking policy. Hence the RBI believes these sections give the RBI the required powers to issue directions to KMB to dilute the promoter shareholding.

Also read | RBI vs Kotak: How a Ten-Year-Long Rope Finally Ran Out

The correspondence in RBI’s reply contains an interesting anecdote on how KMB attempted to reduce promoter shareholding by removing the classification of promoter for Anand Mahindra (AM).

The RBI had informed KMB that it had to bring down the promoter holding to 49% by June 30, 2009.

On June 3, 2009, KMB informed the RBI that the bank’s board of directors had resolved that AM was no longer a promoter on account of his significant dilution since 2003, and he was not a person acting in concert with the other promoters; hence the promoter holding as on June 3, 2009 was 48.53%.

However, the RBI responded in a letter dated November 9, 2009 that for AM to be classified as a non-promoter, the bank would have to stop using the word ‘Mahindra’ in its name.

Realising that the RBI was unwilling to grant its request, KMB in a letter dated February 2, 2010 to the RBI stated that the bank will bring down the promoters’ holding (including that of AM) to below 49% within a period of one year.

As on September 30, 2010, Anuradha Mahindra held 14.54 mn shares and 1.98% of KMB. Finally on October 29, 2010, the promoter shareholding (including that of AM) was brought down to 48.99%. It is pertinent to note that KMB had originally assured the RBI that the 49% promoter holding would be achieved by June 2007; finally it was achieved more than three years later, without any form of regulatory censure.

To date, in the media, coverage on the KMB-RBI spat has largely weighed in on the side of KMB and Uday Kotak in particular.

The RBI’s reply to KMB’s writ provides compelling evidence to justify its stance in forcing Kotak to reduce his stake in KMB, and stakeholders will now have to await the Bombay high court’s decision on this critical issue.

Hemindra Hazari is an independent market analyst.