Due Diligence Process

Introduction

Due Diligence is the very FIRST step in the process of MSME Lending. This ensures that the prospective borrower is genuine

• Conducted on transaction participants (borrower) and on the transaction itself. 
• Includes the review of credit and financial history, character, professional experience and reputation. 
• Includes the review of all matters that may affect the likelihood of timely repayment, such as information about the goods and services being financed and related contracts, and may include review of financial projections. 
• The level or amount of due diligence required to conclude that: i) the facts represented in the documents collected for the transaction appear to be true; and ii) the entities and people participating in the transaction are who they claim to be. 
• With the increased availability of data from several sources, including GSTN, Income Tax, Credit Bureaus, Fraud Registry, etc., it is now possible to do most of the due diligence online and appraise the MSME loan proposals expeditiously. 
• RBI recommends that banks should have access to such surrogate data for speedier and robust credit underwriting standards.

To Sum Up…

The process of thoroughly investigating the borrower before lending, called due diligence, is a must when lending to any borrower & more so in case of MSME / EEGs given the peculiarities.

1. Banks have access to a lot of information about MSMEs and their operations, financial transactions, credit history and so on. Banks can also go through their own records as well as information available in a variety of external sources to ascertain the actual repayment capability and intentions of the borrower before making the decision to lend.
2. Banks can also check whether the information available corroborates the details provided by the borrower to detect any signs of fraud/ anomalies in the financial statements or money laundering.
3. Banks need to collect independent information and market intelligence on the potential borrowers from the public domain on their track record, involvement in legal disputes, raids conducted on their businesses, if any, strictures passed against them by Government agencies, validation of submitted information/data from other sources like the ROC, gleaning from the defaulters list of RBI/other Government agencies, etc., which could be used as an input by the sanctioning authority. 
4. Banks shall keep the record of such pre-sanction checks as part of the sanction documentation.

Available Sources of Information

• Internal Sources (ETB-Past track, personal credit history of promoters)
• External Databases (CRILC, CIBIL, ROC, CERSAI etc)
• Documents submitted by the client (Annual report/Bank statements/GST)
• Market Feedback

Internal sources

In the case of an existing borrower, the primary source of internal information is the past conduct of the loan accounts of the borrower. Banks should also consider the performance record of the personal and loan accounts of the promoters or directors.

BORROWER

• Repayment history
• Interest Servicing delays
• Documentation incomplete
• Security creation-delays

PROMOTERS

• CIBIL Scores-Delays or defaults in EMI payments on loans
• Inward Cheque returns from personal accounts due to inadequate balance
• Frequent use of unsecured personal loans

GST Returns

GST returns are subject to stringent inspection by the GST authorities and there are stiff penalties for misstatement. Therefore, a GST return can be taken to be an authentic statement of facts with respect to sales, purchases and GST paid. A GST return :

• Helps validate the borrower’s business performance
• Serves as confirmation of identity and business continuity validation
• Reveals important business details useful to the bank

Therefore, a borrower’s GST return is an extremely critical document when conducting due diligence of an MSME.

A borrower’s GST return contains the following information:

• Name, address and GST registration number of the borrower
• List and classification of goods supplied or sold by the borrower
• Gross sales, Gross purchases (from within or outside the state)
• Freight and installation costs incurred
• Sales returns
• GST paid
• Any interest and penalty paid

Pre-Sanction Inspection

• Visiting the office and factory premises as well as the properties mortgaged with the bank as a collateral security is essential & should be stipulated as a pre-sanction or pre-disbursement condition for all the borrowers.
• While regular inspection of a borrower's unit /factory is an integral part of the ‘Post sanction’ monitoring process; inspection at pre sanction stage itself can prevent booking of a bad asset.
• Unit inspection ensures that the business of the prospective borrower is being run in a satisfactory manner and in line with that stated by the borrower. 
• Experienced bankers have the knack of measuring and ascertaining the level of activity (whether it commensurate with that as given in the financials), the level of stocks, orders in hand, licenses available, products being manufactured, presence of obsolete stock or unused machinery , taxes and statutory dues paid etc. 
•  The information gathered from employees on the conversation during factory/godown inspection can be of early warning signals.
• An independent visit of the collateral properties is also essential at the pre sanction stage to validate the address/location, nature of the property, the demarcation, area and the estimated valuation. Demarcation & identification is crucial in case of vacant plots. In case of residential properties; availability of free passage /entrance is verified. 

Checklist - Prepare a checklist and keep it handy prior to proceeding on inspection.

Report - A detailed Inspection Report in the prescribed format needs to be prepared and form the part of the Sanction/Recommending Note

Highlight - Any adverse observation or irregularities seen at the time of visit need to be highlighted to the Sanctioning Authority.

Bank Statement Analysis

Bank Statements

• A very critical source of information is the Borrower's Bank statement. But before analyzing the same, the bank must verify the genuineness of the bank statement submitted.
• If banks are aware of the early warning signs of otherwise hidden liquidity pressures that are building up, they can protect themselves from bad exposures.
• An analysis of the bank statement can reveal & validate:

1. The reported revenues and cash collection
2. The key suppliers and customers matches with that reported
3. Any suspicious transactions, high value transaction or fraudulent ones
4. Any unusual pattern or trends in credit /debit entries
5. Concern areas such as cheque returns, penal charges levied, instances of overdues or over drawings
6. Liquidity concerns in case of sudden reduction in credit summations
7. LC Devolvement
8. Inter-party /related party transactions

Potential Red Flags

CREDIT SUMMATIONS NOT IN LINE WITH REPORTED REVENUES:

1. More than revenues: Underreporting or infusion/disbursement
2. Less than revenues (deviation>15%): Possibility of diversion of funds

When the bank statement accounts for less than the reported sales, it indicates that all sales are not routed through the account. This could simply be because some sales are directly settled in cash. However, it may also indicate that part of the sales are going through the borrower’s account in another bank, which would violate the terms of sanction. 

Credit summation for a given period should ideally be equal to the value of receivables at the start of the period plus sales during the year less outstanding receivables at the end of the period.

Significant or prolonged decline in credit summations can be treated as a warning sign.

SUSPICIOUS OR HIGH VALUE TRANSACTIONS NOT IN LINE WITH BUSINESS

1. Large transactions with related parties
2. High value transfer to another bank OR Frequent withdrawal of amount of Rs 49000

CHEQUE RETURNS DUE TO INSUFFICIENT FUNDS

1. Increasing trend in cheque returns due to insufficient funds could signal liquidity issues
2. A returned cheque on a borrower’s account could be due to a temporary liquidity mismatch, technical reasons or occasionally as a result of some operational slippages or calculation errors at the borrower’s end. Cheque returns >3 every quarter may be investigated.

Credit Report

Credit Information Company (CIC)

Credit Information Company (CIC) is an independent third-party agency that collects financial data of individuals pertaining to their loans, credit cards and other related information and shares with its members, who generally happen to be banks and other financial institutions. The nature of the services provided by CICs entails them to be a key part of the decision-making process of the banks & NBFCs in their lending activities. Hence the credit information provided needs to be accurate and trustworthy.  Therefore all the CICs in India are licensed by Reserve Bank of India (RBI) and are governed by the provisions under Credit Information Companies Regulation Act (CIC Act), 2005 and other RBI regulations and guidelines.

The RBI has authorized companies which have registered under the ‘The Credit Information Companies (Regulation) Act, 2005’ to provide a credit rating or a credit score based on past performances reported by various member banks and credit institutions. Credit Information Bureau India Ltd (CIBIL™) is India's premier credit information bureau. 

Other than Transunion CIBIL, the other CIC operating in India are:

• Equifax Credit Information Services Private Limited.
• Experian Credit Information Company of India Private Limited.

CRIF High Mark Credit Information Services Private Limited.

Transunion (Erstwhile CIBIL)

Established in 2000, TransUnion CIBIL Limited (formerly known as Credit Information Bureau (India) Limited) is India’s first Credit Information Company. Initially set up by SBI.

TransUnion is one of four credit bureaus operating in India and is part of TransUnion, an American multinational group. In 2016, Transunion acquired 92.1% stake in CIBIL to become Transunion CIBIL. In 2017, Bank of India sold its 5% share in the company for TransUnion CIBIL. 

It collects and maintains credit-related information of individuals and corporations, including loans and credit cards. These records are submitted by member institutions to the credit bureau on a periodic basis. The information is then used by the bureau to create credit reports and issue credit scores. CIBIL is a database of credit information.  The credit bureau does not make any lending decisions. It only provides data to banks and other financial institutions, who use it to filter applications for loans and credit cards.

Credit score is seen as a direct indicator of your credit health. The number of loans and types of loan accounts, outstanding debt, and length of credit history also play a major role in determining your score. If you maintain a good track record backed by a solid credit score, lenders will be very comfortable lending to you.

A credit rating agency provides an opinion relating to future debt repayments by borrowers. A credit bureau provides information on past debt repayments by borrowers.

Transunion CIBIL Report

• The report will indicate instances in which the borrower has defaulted on any loan in the past. Default is treated as a negative sign.
• Banks should also look out for settled accounts. These are cases where the borrower has settled some accounts by making part payments while the remaining amount has been written off.
• The report indicates the ‘days past due’, which is the number of days by which the payment was delayed. If this increases from month to month, it indicates that the borrower is having increasing cash-flow problems.
• In addition to the scores, another interesting detail revealed through the CIBIL report is the number of queries made by lenders for credit applications. A high number of queries in the recent past indicates that the promoter is looking at availing credit from multiple sources.

CIBIL scores are assigned on a scale of 900:

• A score higher than 750 indicates an excellent record of meeting all financial commitments.
• A score above 650 indicates a good record with occasional strain like issues in settlement of credit card dues.
• A score below 550 indicates strained finance, delays in meeting the repayment obligations, etc.

High level of past-dues and level of borrowing, high proportion of unsecured borrowing and steep growth in borrowing indicate liquidity strain and higher propensity to default.

CRILC

• The Central Repository of Information on Large Credits (CRILC) has been created by the RBI for the purpose of preventive monitoring of large loans from banks. The list includes non-performing assets as well as performing accounts that are showing incipient signs of stress.
• CRILC captures information on borrowers with aggregate exposure, both fund and non-fund based, of ₹5 crore or above. 
• Set up by RBI  in 2014 to collect, store, and disseminate credit data to banks.
• Through analysis of the CRILC report, banks can find out about:
• The borrowers’ current position in other banks ( SMA Status, Exposure levels)
• The borrowers’ asset classification (Standard or substandard)
• Any stress in the borrowers’ accounts
• Current accounts maintained with other banks
• Moved to Default & Moved Out of Default status
• All banks should take utmost care about data accuracy and integrity while submitting the data on large credit to RBI, failing which penal action, as per provisions of the Banking Regulation Act, 1949 could be invoked.

CRILC

Performing but showing signs of stress

• SMA-0 - Account overdue for 1-30 days & account showing signs of stress
• SMA-1 - Account overdue for 31-60days & account showing signs of stress
• SMA-2 - Account overdue for 61-90 days & account showing signs of stress

Special Mention Account (SMA) is an account which is exhibiting signs of incipient stress resulting in the borrower defaulting in timely servicing of her debt obligations, though the account has not yet been classified as NPA. Early recognition of such accounts enables banks to initiate timely remedial actions to prevent their potential slippages into NPAs.

CRILC also shows whether the borrower has been  classified as ‘Non Cooperative”, “Red Flagged” or “Fraud” by any bank.

RBI Defaulter’s List

• Banks share information on all defaulters of ₹1 crore and above with the RBI every six months. They also share information on wilful defaults (where the borrower had the capacity to repay but did not) every quarter of Rs 25 lacs and above. The RBI compiles this information into the RBI Defaulters List and the RBI Wilful Defaulters List.
• The RBI lists include information about the amount of exposure, present status and reasons for default. 
• The RBI Defaulters Lists may be up to six months old. However, the RBI has recently instructed banks to send information about defaulters and wilful defaulters to Credit Information Companies (CICs) like CIBIL on a monthly basis. Therefore, banks may refer to CICs as the comprehensive source of information on wilful defaulters in the future.
• If the borrower is an individual and is a director in any company, the information shared also contains their Director Identification Number (DIN). Banks should scan the Defaulters Lists to see if any of the following are listed as defaulters or wilful defaulters:

1. The borrower
2. The Director/Partners/Proprietor of the borrowing entity
3. The guaranteeing company or individuals

CERSAI 

Central Registry of Securitisation Asset Reconstruction and Security Interest (CERSAI) is a central online security interest registry of India. CERSAI was set up in 2011 under Section 20 of the SARFAESI Act, 2002. The company is licensed under Section 25 of the Companies Act 1956.

HOW SET UP: The company incorporated with majority shareholding of the Central Government, Public Sector Banks (PSB & BOB) and National Housing Bank for the purpose of operating a Registration System under the provisions of Chapter IV of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. (SARFAESI Act). RBI is all set to take 51% stake  (currently held by the Central Government) in CERSAI.

RATIONALE: In India, before the formation of CERSAI, information on the encumbrance on a property was known only to the borrower and the lender due to a fragmented registration system. As a result, people could obtain multiple loans on the same property. Some people used to take one loan from one bank, which would hold the deed papers. Then they used to take several more loans from other banks using attested copies of the deed, by claiming that they had lost the originals. Some people also used to obtain loans using entirely fake title deeds or by using colour photocopies of the original title deed. Properties with unpaid loans were also being sold without informing the buyers of the existing liability on the property. CERSAI's initial mandate was to maintain a central registry of equitable mortgages, where it contains information on the equitable mortgage taken on a property along with details of the financial institution that has extended the loan as well as details about the borrower. 

It was primarily created to check frauds Involving multiple lending against the security of the same property as well as fraudulent sale of property without disclosing the security interest over such property. The records maintained by the Central Registry are available for search by any lender or any other person desirous of dealing with the property.

• The CERSAI registry platform can be accessed online by financial institutions and the general public for a fee. However, the latter can only access information related to equitable mortgages.
• This allows prospective lenders to check the registry to ensure that the property against which they are extending a loan to a borrower is not encumbered by a pre-existing security interest created by another lender. 
• Even if it is, with details of the previous loan available to them, they can examine if the value of the collateral is sufficient for them to extend another loan, given the existing liability on the property. 
• For the general public, especially for home buyers, it enables them to check the registry's records to ensure that any property they are planning to purchase, is free of any loan/security interest created by a lender.
• Financial institutions must register details of security interests created by them with CERSAI

AMENDMENT W.E.F January 2020

Section 23 Amended:

• Removal of the timeline of 30 days, within which a secured creditor is required to file certain types of SI.
• To provide a right to the Central Government to notify types of transactions which require registration with the CERSAI.

Chapter VIA Introduced

• permission to person or creditor who has obtained an attachment order for attachment of property, to file such orders with the CERSAI and gives priority to the claims of such person or creditor
• disallows any secured creditor from exercising the right of enforcement if the same has not been duly registered with the CERSAI
• gives priority to the dues of secured creditors over all other dues including statutory dues and taxes, after registration with the CERSAI; subject to IBC provisions

CERSAI is acronym for Central Registry of Securitisation Asset Reconstruction and Security Interest 

It is a central online security interest registry of India 

Banks are advised to register their charges immediately  so that they can get priority over other lenders 

Primary created to check frauds- Multiple lending against same property

The penalty clause & timeline for registration is abolished.

CERSAI has also been entrusted with the responsibility of operating and maintaining a Central KYC Record Registry (CKYCRR), which started operating from 2016. This registry is governed under the Prevention of Money Laundering Rules 2005 (Maintenance of Records).

ROC

The Registrar of Companies (ROCs) is an office under the Ministry of Corporate Affairs. At present, 25 ROCs are operating in India across all the major states/UT’s. The ROCs are tasked with the principal duty of registering the incorporation of both the companies and LLPs across states and union territories. The central government preserves administrative control over the Registrar of Companies with the help of Regional Directors. 

Under the Companies Act, 2013 and its rules, numerous forms have to be filed by the company with the Registrar of Companies. 

There are two categories of MCA filings – one is periodical and another is based on events like incorporation, change of situation of registered office, resolutions, the appointment of directors and auditors etc. 

The prefix to the form number provides some kind of meaning about the type of form and the purpose of filing. For example, forms with the prefix INC refer to filings related to incorporation, AOC to annual filing, DIR to directors, MGT to management, ADT to audit, and so on. 

Possible checks from MCA Records

• Whether the company has filed the annual returns or not? Investigate the Reasons for delay if any.
• Reconciliation of financials: Cross check/Verify the financials submitted to the bank with that filled in the MCA records
• Reconciliation of charges: Check the index of charges and reconcile the same with the debt profile submitted  by the borrower
• ROC Search Report for verification of charges, details regarding modification & amount and securities
• Director’s details can also be verified / any change in directorship
• Details of the signatories

Market Due Diligence

Market Feedback

• Peers /Competitors
• Suppliers/ Creditors
• Customers/ Debtors
• Bankers
• Employees
• One of the very reliable sources of feedback is that obtained from the peers and those dealing with the company.  
• The list of key suppliers, customers, debtors and creditors can be obtained and information about the borrower can be sought regarding length of relationship and satisfaction levels of dealings, information about the promoters, any family feud etc. Some of these may be the bank’s existing customers also.
• Past credit history of the borrower may be obtained from earlier bankers of the company
• Employees also serve as a good source of feedback especially wrt the promoters.

Third Party Due Diligence

Banks subscribe to many third-party databases that can provide valuable information about borrowers and their promoters.

• Banks may also subscribe to certain databases that scrutinise the legal footprint of companies and their promoters or management. Banks can use these databases to evaluate the immediate legal risks that a borrower might be facing.
• Bank’s can use Rating Analytics to provide a good history of the creditworthiness of a borrower. These databases provide information such as credit rating history, rating reports, key financials and peer comparison
• Banks often subscribe to financial databases such as CMIE Prowess and CapitaLine that provide financial data for listed and unlisted companies. It is important to cross-check the financial data submitted by the promoter with these databases. These databases can also be used by banks to get information on subsidiaries and other companies related to the borrower.

Credit Reports- Several companies provide a single & a comprehensive source of verified corporate information such as Probe 42, Save Risk, Zauba , Owler etc. They contain details such as financials as per ROC, Charges, Directors & their other directorships, rating history, legal cases by & against the company etc. Wherever Probe report is not available, Banks can take help of external agencies for verifying the authenticity of the  Audited Balance Sheets and Bank Statements submitted by the borrower

Caution List Exporters: The RBI maintains a caution list of exporters in the Export Data Processing and Monitoring System (EDPMS). Banks can access the EDPMS on a daily basis. If a company or individual is present on the list, it means that payment for exports made by the company or individual or the company promoted by the individual has not been received even six months after the export was completed. In such cases, banks must exercise caution and ascertain reason for non receipt/delay in receipt of export proceeds.

World Checklist /D&B report can be obtained in case the borrower is an exporter or have other businesses abroad.

Banks must thoroughly scrutinize the name of the borrower & the directors/promoters for blacklisted companies, shell company list, fraud, pending legal cases or scam in the internet and any other available database.

Also, in case of MSMEs, the names of the key suppliers, customers, debtors and creditors should be searched and validated to ensure that the names & dealings are genuine as reported.

Unstructured Market Intelligence

Unstructured data from publicly available sources such as the news and social media can be an important source for banks to carry out due diligence.

• News related to the company, promoter, related or group companies and the industry can be used to assess the company’s future prospects and verify information received from the borrower. (eg: Tax raids, CBI inquiry or any ban on the core activity of the company)
• Social media, such as Facebook and LinkedIn can reveal valuable information about promoters, their contacts in the market and their social standing.
• Employee review /feedback from portals such as Glassdoor can also be a useful source of information (Eg: company paying salaries on time etc). Declining and delayed salary payments could be an indicator of liquidity pressures. A sharp drop in salary bills could be an indicator of many employees leaving, which is a negative sign. A delay in salary payments also affects employee morale, leads to attrition and has implications for business continuity.
• Delays or drop in EPF collections, payment of other statutory dues can also signal stress and  can be obtained from statutory authorities. In the case of sustained delays or defaults, tax authorities have statutory rights to impound the business’s cash flows to collect their dues, which would damage the bank’s exposure. 
• Any indication of stretched market creditors can also signal cash crunch.

Written by: Mrs Sonali Mahajan Bansal