The rising wave of digital arrest scams has become a pressing concern for law enforcement and regulatory authorities across India. In a significant development aimed at combating this menace, the Ministry of Home Affairs has constituted a high-level inter-departmental committee that has recommended holding banks and telecom companies accountable for victims’ losses when such losses result from their negligence or service deficiencies. This landmark recommendation was made pursuant to directions from the Supreme Court in a suo motu case registered as “In Re: Victims of Digital Arrest Related to Forged Documents” [1]. The committee’s first meeting took place on December 29, 2024, where representatives from various ministries and regulatory bodies deliberated on enforcement gaps, victim compensation mechanisms, and necessary regulatory reforms to address the growing threat of digital arrest frauds.

Digital arrest scams represent a sophisticated form of cybercrime where fraudsters impersonate law enforcement officials, judicial authorities, or government personnel through audio and video calls. These criminals employ intimidation tactics, often displaying forged court orders and official documents, to coerce victims into transferring substantial sums of money under threats of immediate arrest or legal action. The Supreme Court’s intervention came after a harrowing case involving a 73-year-old woman from Haryana who was defrauded of over one crore rupees using fabricated Supreme Court orders bearing forged signatures of judges. The gravity of this issue is underscored by staggering statistics that reveal victims across India have collectively lost nearly three thousand crore rupees to such scams [1].

Understanding Digital Arrest Scams and Their Impact

Digital arrest scams operate through a carefully orchestrated methodology designed to exploit fear and create urgency. Perpetrators typically initiate contact through phone calls or video conferencing platforms, presenting themselves as officers from agencies such as the Central Bureau of Investigation, Enforcement Directorate, or customs departments. They fabricate allegations ranging from money laundering and drug trafficking to involvement in illegal activities, creating a sense of panic in their targets. The fraudsters then proceed to display documents that appear to be official court orders, arrest warrants, or investigation notices, complete with forged seals and signatures of judicial officers.

The psychological manipulation employed in these scams is particularly insidious. Victims are often placed in what criminals term as “digital arrest,” where they are instructed to remain on video calls for extended periods, isolated from family members and prevented from seeking external advice. This sustained psychological pressure, combined with the apparent authenticity of forged documents and the authoritative demeanor of the fraudsters, leads many victims to comply with demands for money transfers. The Supreme Court has observed that the forgery of judicial documents and misuse of the court’s authority strikes at the foundation of public trust in the judicial system and constitutes a direct assault on institutional dignity [1].

The impact of these scams extends beyond financial losses. Victims, particularly elderly citizens, suffer severe psychological trauma, erosion of trust in genuine law enforcement, and long-lasting emotional distress. The sophistication of these operations, often involving international networks operating from jurisdictions beyond easy reach of Indian law enforcement, makes detection and prosecution exceptionally challenging. Furthermore, the rapid evolution of technology has enabled fraudsters to employ increasingly convincing tools, including deepfake technology and spoofed caller identifications, making it difficult for ordinary citizens to distinguish genuine official communications from fraudulent ones.

The Supreme Court’s Suo Motu Intervention

The Supreme Court registered Suo Motu Writ Petition (Criminal) No. 3 of 2025 titled “In Re: Victims of Digital Arrest Related to Forged Documents” following a detailed complaint submitted by Shashi Sachdeva and Harish Chand Sachdeva on September 21, 2025. A bench comprising Justice Surya Kant and Justice Joymalya Bagchi took cognizance of the matter, recognizing the alarming scale and impact of digital arrest scams across the country [1]. The Court’s order emphasized that the fabrication of judicial orders bearing forged signatures of judges strikes at the very foundation of public trust in the judicial system and the rule of law.

In its proceedings, the Court issued notices to the Union Home Ministry, Central Bureau of Investigation, and all state governments and union territories, seeking details of First Information Reports registered in connection with digital arrest cases. The bench also sought assistance from the Attorney General for India, recognizing the need for coordinated legal and enforcement responses. The Supreme Court directed the Haryana Police and the Superintendent of Police, Cyber Crime, Ambala, to file status reports on investigations conducted in the specific case that prompted the suo motu action. The Court emphasized that coordinated efforts between central and state police are required to unearth the full extent of enterprises involving forgery of judicial documents and extortion of innocent citizens, particularly senior citizens [1].

Justice Surya Kant, during the hearings, characterized the situation as “alarming” and indicated that the Court would issue strong and strict directions to curb the menace. The bench called for an “all-India coordinated response” to dismantle the scam networks operating across the country. The Court also took the unusual step of directing that individuals accused in a specific digital arrest case involving a 73-year-old Advocate-on-Record should not be released from custody, restraining any grant of bail even as the statutory period for default bail approached. This exceptional measure underscores the seriousness with which the Supreme Court views these offenses and their impact on vulnerable citizens [1].

Constitution and Mandate of the MHA Committee

Following the Supreme Court’s directions, the Ministry of Home Affairs constituted a high-level inter-departmental committee under the chairmanship of the Special Secretary (Internal Security). The committee’s composition reflects a whole-of-government approach, bringing together expertise from multiple regulatory and enforcement domains. The committee includes Joint Secretary-level representatives from the Ministry of Electronics and Information Technology, Department of Telecommunications, Ministry of External Affairs, Department of Financial Services, Ministry of Law and Justice, Ministry of Consumer Affairs, and the Reserve Bank of India. Additionally, senior officers of Inspector General rank from the Central Bureau of Investigation, National Investigation Agency, and Delhi Police are members, along with officials from the Indian Cyber Crime Coordination Centre at the Joint Secretary level and above. The Chief Executive Officer of the Indian Cyber Crime Coordination Centre serves as the Member-Secretary, with the Attorney General attending meetings on a bi-weekly basis [1].

The committee’s mandate encompasses several critical areas. It is tasked with examining real-time issues faced by enforcement agencies while responding to digital arrest scams cases, including delays in information flow, jurisdictional hurdles, difficulties in tracing digital footprints, and coordination issues between banks, telecom service providers, and police agencies. The committee is also responsible for considering recommendations made by the amicus curiae appointed by the Supreme Court, studying relevant legislations, rules, circulars and identifying implementation gaps, and suggesting corrective measures and policy reforms. The comprehensive scope of the committee’s work reflects recognition that addressing digital arrest scams requires coordinated action across multiple sectors and regulatory domains [1].

Key Recommendations on Bank and Telecom Liability

During its first meeting held on December 29, 2024, the committee considered the amicus curiae’s suggestions regarding victim compensation and reached unanimous agreement on a critical principle. The committee agreed that where loss to victims is attributable to negligence, deficiency of service, or fraud on the part of banks, telecom service providers, or other regulated entities, accountability of such entities must be ensured. The committee observed that victims should not suffer due to systemic failures or regulatory non-compliance, and that victim compensation mechanisms should function without prejudice to other remedies available under existing laws [1].

This recommendation represents a significant shift in the approach to addressing cyber fraud losses. Rather than placing the entire burden of recovery on individual victims who must navigate complex legal processes, the committee has recognized that financial institutions and telecommunications companies have systemic responsibilities to maintain security measures that prevent their infrastructure from being exploited for fraudulent purposes. The principle underlying this recommendation is that entities operating in regulated sectors, particularly those handling sensitive financial and communication data, must be held to higher standards of care and diligence. When their negligence or service deficiencies create conditions that enable or facilitate fraud, they should bear responsibility for resulting losses to customers [1].

The committee directed the Reserve Bank of India, Department of Telecommunications, and Ministry of Electronics and Information Technology to review existing mechanisms for addressing such cases and suggest improvements and changes for effective implementation. This directive acknowledges that while general principles of liability can be established, specific operational frameworks need to be developed to ensure these principles translate into practical relief for victims. The focus on reviewing existing mechanisms rather than creating entirely new structures suggests an approach that builds upon current regulatory frameworks while addressing identified gaps and weaknesses [1].

Regulatory Framework for Banking Sector

The banking sector in India operates under a multi-layered regulatory framework that already contains provisions for protecting consumers and ensuring accountability. The Consumer Protection Act, 2019 recognizes banking as a service, bringing it firmly within the jurisdiction of consumer forums. The Act establishes a three-tier adjudicatory mechanism through District, State, and National Consumer Disputes Redressal Commissions, empowering consumers to seek redress for banking grievances. The Act provides for enhanced compensation amounts, product liability for deficient services, coverage of e-commerce and digital banking services, and the possibility of class action suits for similarly affected consumers [2].

The Reserve Bank of India has issued a crucial circular dated July 6, 2017, titled “Customer Protection – Limiting Liability of Customers in Unauthorised Electronic Banking Transactions.” This circular establishes the framework for determining customer liability in cases of unauthorized electronic transactions. The circular provides that a customer’s entitlement to zero liability arises where the unauthorized transaction occurs due to contributory fraud, negligence, or deficiency on the part of the bank, irrespective of whether the transaction is reported by the customer. Zero liability also applies in cases of third-party breach where the deficiency lies neither with the bank nor with the customer but elsewhere in the system, provided the customer notifies the bank within three working days of receiving communication regarding the unauthorized transaction [3].

The circular mandates that upon being notified by the customer, the bank shall credit the amount involved in the unauthorized electronic transaction to the customer’s account within ten working days from the date of notification, without waiting for settlement of insurance claims. This provision, known as shadow reversal, ensures immediate relief to victims while investigations proceed. Critically, the circular places the burden of proving customer liability in cases of unauthorized electronic banking transactions on the bank itself. Banks may also exercise discretion to waive customer liability even in cases of customer negligence. The Reserve Bank has also issued advisories for using artificial intelligence-based tools to detect fraud and is finalizing Standard Operating Procedures regarding freezing of bank accounts involved in suspicious transactions [2][3].

Judicial Precedents on Banking Liability

Indian courts have established robust precedents holding banks accountable for negligence and service deficiencies. In the landmark case of Canara Bank v. Leatheroid Plastics Pvt. Ltd., the Supreme Court held that when a bank undertakes to effect insurance of hypothecated assets, it has a duty to ensure adequate coverage of the entire set of hypothecated assets. The Court ruled that any loss arising out of inaction and negligence on the part of the bank constitutes deficiency of service compensable under the Consumer Protection Act. The judgment emphasized that contractual clauses cannot absolve banks of their fundamental duty to provide adequate services to borrowers [4].

The National Consumer Disputes Redressal Commission has consistently held that banks bear responsibility for unauthorized transactions when they fail to implement adequate security measures or neglect proper verification procedures. In several cases involving fraudulent electronic transactions, the Commission has awarded compensation while noting that if an account is maintained by a bank, the bank itself is responsible for its safety and security. Any systemic failure, whether by malfeasance on the part of bank functionaries or by any other person except the account holder, is the bank’s responsibility and not the consumer’s [3].

The Delhi High Court’s ruling in a case involving vishing fraud provides important guidance on the standard of negligence in cyber fraud cases. The Court held that falling victim to malware-based cyber fraud does not constitute contributory negligence, as modern phishing techniques can compromise devices without the customer’s direct involvement. The judgment clarified that negligence under consumer protection law requires a standard of gross recklessness, and the burden of proving such negligence lies with the bank. The Court awarded zero liability protection to the victim, emphasizing that banks must implement systems to detect unusual login activities, facilitate immediate customer reporting of fraudulent transactions, and establish inter-bank fraud reporting mechanisms [5].

Information Technology Act and Adjudication Mechanism

The Information Technology Act, 2000 provides a statutory framework for addressing cyber contraventions and imposing liability on entities that fail to maintain adequate data security. Section 46 of the Act empowers the Central Government to appoint adjudicating officers not below the rank of a Director to the Government of India or an equivalent officer of a State Government for the purpose of adjudging whether any person has committed a contravention of provisions of the Act or rules made thereunder. The section states: “For the purpose of adjudging under this Chapter whether any person has committed a contravention of any of the provisions of this Act or of any rule, regulation, direction or order made thereunder which renders him liable to pay penalty or compensation, the Central Government shall, subject to the provisions of sub-section (3), appoint any officer not below the rank of a Director to the Government of India or an equivalent officer of a State Government to be an adjudicating officer for holding an inquiry in the manner prescribed by the Central Government” [6].

The adjudicating officer appointed under Section 46 exercises jurisdiction to adjudicate matters in which the claim for injury or damage does not exceed rupees five crore. For claims exceeding this amount, jurisdiction vests with competent courts. The adjudicating officer possesses powers of a civil court and all proceedings before the officer are deemed to be judicial proceedings. Section 46(5) provides that every adjudicating officer shall have the powers of a civil court conferred on the Cyber Appellate Tribunal, and all proceedings shall be deemed to be judicial proceedings within the meaning of sections 193 and 228 of the Indian Penal Code [6].

The Ministry of Electronics and Information Technology, during the committee meeting, emphasized the need for strengthening and activating the adjudication mechanism under Section 46. This recognition reflects concerns that while the statutory framework exists, its implementation has been inadequate in addressing the scale and complexity of current cyber fraud challenges. The Secretary of the Department of Information Technology of each state serves as the adjudicating officer for that state, creating potential capacity constraints given these officials’ other administrative responsibilities. The committee’s focus on strengthening this mechanism suggests possible reforms to enhance resources, streamline procedures, and improve effectiveness in providing remedies to victims [1][6].

Telecommunications Regulatory Framework

The telecommunications sector’s regulatory framework has evolved significantly with the enactment of the Telecommunications Act, 2023, which replaced the Indian Telegraph Act, 1885 and the Indian Wireless Telegraphy Act, 1933. The new Act aims to consolidate the law relating to development, expansion, and operation of telecommunication services and networks, addressing technological advancements and emerging security challenges. The Act was passed by Parliament in December 2023, received Presidential assent on December 24, 2023, and various provisions have been brought into force in phases [7].

The Department of Telecommunications informed the MHA committee that draft rules under the Telecommunications Act, 2023 have been framed and are at the stage of stakeholder consultations. Once notified, these rules would address critical concerns including negligence in issuance of SIM cards, multiple SIM issuance to a single individual, and related matters. The Act provides for biometric-based identification for issuing SIM cards and limits the number of SIM cards an individual can possess. Provisions that came into effect from June 26, 2024, restrict individuals to a maximum of nine SIM cards, with the limit being six for residents of Jammu and Kashmir and northeastern states. Violations attract penalties ranging from fifty thousand rupees for first-time breaches to two lakh rupees for repeat violations [7].

The Act prescribes stringent penalties for fraudulent acquisition of SIM cards. If a SIM card is obtained by deceiving someone and using their identification documents, the penalty can include imprisonment for three years, a fine of up to fifty lakh rupees, or both. These provisions reflect recognition that SIM cards have become critical enablers of digital arrest scams and other cybercrimes, and stronger controls are necessary to prevent their misuse. The Act also provides for measures to protect users, including requiring prior consent to receive specified messages and creation of a do-not-disturb register. Commercial messages sent without user consent can result in fines of up to two lakh rupees on telecom companies and potential service bans [7].

Coordinated Enforcement Measures

The Indian Cyber Crime Coordination Centre, operating under the Ministry of Home Affairs, plays a central role in coordinating responses to cyber fraud. The Centre has informed the committee that Standard Operating Procedures for immediate freezing and de-freezing of accounts, recovery and restoration of money to victims, are under final consideration. Additionally, the Centre is actively considering revamping of the National Cybercrime Reporting Portal and the helpline number 1930 to reduce response times and enhance effectiveness. These measures aim to create a seamless mechanism where victims can quickly report fraud, enforcement agencies can rapidly freeze suspect accounts, and recovery processes can be initiated without prolonged delays [1].

The Central Bureau of Investigation has proposed establishing a monetary threshold for digital arrest fraud cases. Cases falling above this threshold would be dealt with by the CBI, while those falling below could be handled by State and Union Territory agencies with requisite assistance from the Ministry of Home Affairs. This approach recognizes that while local police agencies are better positioned to handle smaller-value cases and those with limited geographic scope, complex cases involving large sums, multiple states, or international dimensions require centralized investigation by agencies with greater resources and specialized capabilities. The proposal seeks to balance efficient resource allocation with the need for coordinated action against organized fraud networks [1].

The Ministry of External Affairs’ inclusion in the committee reflects the transnational nature of many digital arrest scams. Fraudsters often operate from overseas locations, using Voice over Internet Protocol technology to mask their actual locations and routing calls through multiple countries to evade detection. Effective response requires international cooperation, including information sharing with foreign law enforcement agencies, coordination with telecommunications regulators in other jurisdictions, and in appropriate cases, extradition proceedings. The committee’s composition ensures that diplomatic and international legal cooperation dimensions receive adequate attention in developing comprehensive responses to these crimes [1].

Consumer Protection and Systemic Accountability

The committee’s recommendation that banks and telecom companies should be held accountable for losses attributable to their negligence or service deficiencies aligns with fundamental principles of consumer protection law. Consumer protection jurisprudence in India has consistently recognized that service providers, particularly those operating in regulated sectors, owe duties of care to their customers that extend beyond mere contractual obligations. When these entities fail to maintain adequate systems, ignore warning signs of fraudulent activity, or demonstrate laxity in implementing security measures, they contribute to conditions that enable fraud and should bear corresponding responsibility [2].

The concept of deficiency in service under the Consumer Protection Act encompasses situations where service providers fail to meet standards reasonably expected by consumers. In the context of banking services, this includes failures to implement adequate security protocols for electronic transactions, delays in responding to customer reports of unauthorized transactions, inadequate verification procedures that allow fraudulent account openings, and failure to monitor accounts for suspicious patterns of activity. Courts have held that banks cannot shield themselves behind technical contractual clauses when their negligence causes substantial financial harm to customers. The principle that victims should not suffer due to systemic failures or regulatory non-compliance represents a consumer-centric approach that prioritizes protection of individuals over institutional convenience [2][4].

For telecom service providers, deficiency in service can arise from inadequate verification procedures during SIM card issuance, failure to detect and prevent fraudulent acquisition of multiple SIM cards by individuals using fake or stolen documents, inadequate monitoring systems to identify SIM cards being used for fraudulent purposes, and delays in blocking SIM cards reported for misuse. The Telecommunications Act, 2023 and rules being developed thereunder aim to address these gaps through stricter identity verification requirements, limits on the number of SIM cards per individual, and enhanced penalties for violations. The committee’s recommendation extends this regulatory approach by introducing potential liability for losses caused when deficiencies in telecom provider systems or processes enable fraud [7].

Implementation Challenges and the Path Forward

Implementing the committee’s recommendation to hold banks and telecom companies liable for fraud losses attributable to their negligence presents several practical and legal challenges. Establishing causation between specific institutional failures and resulting fraud losses requires careful evidentiary assessment. Determining appropriate standards of care for banks and telecom providers necessitates balancing reasonable security expectations against the reality that no system can provide absolute protection against sophisticated criminal enterprises. Creating fair adjudication processes that can efficiently handle potentially large volumes of claims while ensuring thorough consideration of individual circumstances demands significant institutional capacity [1].

The committee has sought at least one month from the Supreme Court to enable further deliberations and provide inputs. This extended timeframe recognizes the complexity of issues involved and the need for careful consultation with stakeholders. The Reserve Bank of India, Department of Telecommunications, and Ministry of Electronics and Information Technology must develop detailed frameworks that translate general principles of liability into operational guidelines. These frameworks need to specify what constitutes negligence or service deficiency in different contexts, establish processes for victims to lodge claims, create mechanisms for investigating claims and determining liability, and define quantum of compensation based on factors such as the nature and extent of institutional failure and the amount of victim losses [1].

The matter is scheduled for the next hearing on January 20, 2026, when the committee is expected to present its further recommendations to the Supreme Court. The Court’s continued monitoring of this issue ensures that momentum toward meaningful reforms is maintained and that institutional responses remain focused on effectively protecting citizens from digital arrest scams. The involvement of the Attorney General and the comprehensive composition of the committee suggest that recommendations emerging from this process will carry significant weight and are likely to result in substantive regulatory and legislative changes [1].

Conclusion

The Ministry of Home Affairs committee’s recommendation to hold banks and telecom companies liable for victim losses attributable to their negligence or service deficiencies represents a watershed moment in India’s approach to combating digital arrest scams and other forms of cyber fraud. This principle recognizes that regulated entities operating critical financial and communication infrastructure have responsibilities that extend beyond narrow contractual obligations to their customers. When these entities fail to maintain adequate security measures, ignore warning signs, or demonstrate deficiencies in their systems and processes that enable or facilitate fraud, they should bear accountability for resulting losses. The recommendation aligns with established principles of consumer protection law while extending them to address the unique challenges posed by sophisticated cyber fraud.

The Supreme Court’s suo motu intervention in this matter reflects judicial recognition that digital arrest scams represent not merely individual crimes but systemic threats that undermine public confidence in law enforcement and judicial institutions. The fabrication of judicial orders and misuse of court authority strikes at the foundation of the rule of law, demanding coordinated responses that address both immediate law enforcement challenges and underlying systemic vulnerabilities. The high-level inter-departmental committee brings together expertise from multiple domains, ensuring that solutions developed are holistic and address technical, legal, regulatory, and operational dimensions of the problem. The involvement of regulatory bodies such as the Reserve Bank of India and the Department of Telecommunications, along with investigative agencies like the Central Bureau of Investigation and National Investigation Agency, creates a framework for sustained, coordinated action [1].

Moving forward, successful implementation will require translating principles into practical frameworks that provide meaningful relief to victims while creating incentives for regulated entities to strengthen their security and verification processes. Banks must enhance their fraud detection systems, improve response times when fraud is reported, and implement robust verification procedures to prevent unauthorized transactions. Telecom service providers must tighten identity verification during SIM card issuance, monitor for suspicious patterns indicating SIM card misuse, and respond promptly to reports of SIM cards being used for fraudulent purposes. Regulatory bodies must develop clear standards defining what constitutes negligence or service deficiency, create efficient processes for adjudicating liability claims, and ensure consistent application of standards across institutions [1][2][7].

The broader significance of these developments extends beyond digital arrest scams to the entire domain of cyber fraud and digital financial crimes. As India’s digital economy expands and more citizens conduct financial transactions online, the need for robust consumer protection frameworks becomes ever more critical. The principles being established through this process, holding institutions accountable for systemic failures that enable fraud, can inform approaches to other forms of cybercrime and create incentives for continuous improvement in security practices. The Supreme Court’s continued oversight and the commitment of multiple government agencies to addressing these issues provide grounds for optimism that meaningful progress will be achieved in protecting citizens from the growing threat of digital fraud.

References

[1] LiveLaw. (2026, January 15). Digital Arrests | Banks, Telecom Cos Be Held Liable If Victim’s Loss Attributable To Their Negligence: MHA Committee. https://www.livelaw.in/top-stories/supreme-court-digital-arrests-victim-compensation-inter-departmental-committee-mha-liability-of-banks-telecoms-victim-loss-negligence-fraud-519132 

[2] Law Blend. (2025, May 10). Banking Services Consumer Protection in India: Rights, Legal Remedies, and Regulatory Safeguards. https://lawblend.com/articles/banking-services-consumer-protection/ 

[3] India Law Offices. (2024, June 19). Are Banks Liable To Refund Account Holders For Unauthorised Transactions Made By A Third Party? https://www.indialaw.in/blog/civil/banks-refund-unauthorised-transactions-third-party/ 

[4] Bindal Law Associates. (2020, May 23). Consumer Protection Act, 1986 – Deficiency in service – Any loss arising out of inaction and negligence of Bank. https://bindallawassociates.com/2020/05/23/consumer-protection-act-1986-deficiency-in-service-any-loss-arising-out-of-inaction-and-negligence-on-the-part-of-the-bank-such-deficiency-is-compensable-under-the-provisions-of-the-consumer-pro/ 

[5] MetaLegal. (2025, April 30). Cyber Fraud and Bank Liability: Delhi HC Ruling on RBI Consumer Protection. https://www.metalegal.in/post/cyber-fraud-and-bank-liability-delhi-hc-ruling-on-rbi-consumer-protection 

[6] Indian Kanoon. (n.d.). Section 46 in The Information Technology Act, 2000. https://indiankanoon.org/doc/1076139/ 

[7] Press Information Bureau. (2024, July 5). The Telecommunications Act 2023: Ushering in a New Era of Connectivity. https://www.pib.gov.in/PressReleasePage.aspx?PRID=2031057 

[8] The Law Institute. (2025, April 21). Banking Services Under Consumer Protection: A Legal Analysis. https://thelaw.institute/consumer-protection-issues/banking-services-consumer-protection-legal-analysis/ 

[9] Ikigai Law. (2020, July 3). Dispute resolution framework under the Information Technology Act, 2000. https://www.ikigailaw.com/article/261/dispute-resolution-framework-under-the-information-technology-act-2000 

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The Supreme Court of India recently delivered a significant judgment that clarifies the legal distinction between a promoter’s undertaking to arrange funds for a borrowing company and a formal contract of guarantee under Section 126 of the Indian Contract Act, 1872. In the matter of UV Asset Reconstruction Company Limited v. Electrosteel Castings Limited[1], the Apex Court held that a contractual clause obligating a promoter to arrange infusion of funds into a borrower to meet financial covenants does not amount to a contract of guarantee under Section 126 of the Indian Contract Act, 1872. This judgment, delivered by a Bench comprising Justice Sanjay Kumar and Justice Alok Aradhe, has far-reaching implications for the interpretation of guarantee obligations in corporate financing arrangements and insolvency proceedings under the Insolvency and Bankruptcy Code, 2016.

The Court observed that an undertaking to infuse funds into a borrower, enabling it to meet its obligations, cannot be equated with a promise to discharge the borrower’s liability to the creditor directly. This distinction is critical in understanding the nature of obligations undertaken by promoters in financing transactions and their potential liability under insolvency proceedings. The judgment also addressed the question of whether approval of a resolution plan under the Insolvency and Bankruptcy Code automatically extinguishes the liability of third-party guarantors, thereby providing clarity on multiple fronts of commercial law.

Understanding Contract of guarantee under Section 126 of the Indian Contract Act, 1872

Section 126 of the Indian Contract Act, 1872 defines a contract of guarantee with precision and establishes the foundational framework for understanding the tripartite relationship between the surety, principal debtor, and creditor. The provision states: “A ‘contract of guarantee’ is a contract to perform the promise, or discharge the liability, of a third person in case of his default. The person who gives the guarantee is called the ‘surety’; the person in respect of whose default the guarantee is given is called the ‘principal debtor’, and the person to whom the guarantee is given is called the ‘creditor’. A guarantee may be either oral or written.”

This statutory definition establishes several essential elements that must be present for an obligation to constitute a valid contract of guarantee. The first essential element is the existence of a principal debt owed by the principal debtor to the creditor. Without an underlying obligation, there can be no guarantee, as the surety’s promise is contingent upon the default of the principal debtor in discharging an existing liability. The second element is the occurrence of default by the principal debor in fulfilling their primary obligation to the creditor. The guarantee becomes operative only upon such default, making it a secondary or contingent obligation rather than a primary one.

The third and most critical element, as emphasized repeatedly by Indian courts, is an unambiguous and direct promise by the surety to discharge the liability of the principal debtor to the creditor upon default. This promise must be explicit and must contemplate the surety stepping into the shoes of the principal debtor to satisfy the creditor’s claim. The mere undertaking to enable the principal debtor to perform does not satisfy this requirement, as it does not create a direct obligation from the surety to the creditor. The contractual privity in a guarantee exists between the surety and the creditor, with the surety promising to answer for the debt of the principal debtor in the event of default.

The Principle of Coextensive Liability Under Section 128

Section 128 of the Indian Contract Act, 1872 establishes the extent of a surety’s liability in unequivocal terms. The provision states: “The liability of the surety is co-extensive with that of the principal debtor, unless it is otherwise provided by the contract.” This principle of coextensive liability means that the surety’s obligation mirrors that of the principal debtor in both quantum and nature, subject to any express limitations contained in the guarantee agreement itself.

The coextensive nature of surety liability has been consistently upheld by Indian courts as a fundamental principle governing contracts of guarantee. In Bank of Bihar Ltd v. Damodar Prasad and Another[2], the Supreme Court emphasized that when the principal debtor defaults on payment obligations, the surety becomes immediately liable for the entire amount due, including interest and charges. The Court clarified that the sole condition required for the implementation of the bond was a demand for payment pertaining to the principal debtor’s liability, and upon fulfillment of this condition, both the principal debtor and the surety were obligated to discharge the debt.

The principle of coextensive liability, however, is not absolute and admits of modification through express contractual stipulation. A surety may limit the extent of liability by clearly specifying in the guarantee agreement the maximum amount for which they can be held responsible, or by imposing conditions precedent to the invocation of the guarantee. The burden of proving such limitation rests squarely on the surety, and courts will not read restrictions into a guarantee unless they are expressly and unambiguously stated in the contract. This flexibility allows parties to tailor guarantee arrangements to their specific commercial needs while maintaining clarity about the scope of the surety’s obligations.

The Factual Matrix of the Electrosteel Castings Case

The dispute in UV Asset Reconstruction Company Limited v. Electrosteel Castings Limited arose from a complex financing arrangement involving multiple corporate entities. Electrosteel Steels Limited, the principal borrower, obtained financial assistance of Rs. 500 crores from SREI Infrastructure Finance Limited pursuant to a sanction letter dated July 26, 2011. The sanction letter explicitly did not stipulate any personal or corporate guarantee from Electrosteel Castings Limited, which was the promoter of the borrowing company. Instead, the securities for the facility were confined to a demand promissory note and post-dated cheques.

As part of the overall financing structure, Electrosteel Castings Limited executed a deed of undertaking in favor of the lender. Clause 2.2 of this deed imposed an obligation on the promoter to arrange for infusion of funds into Electrosteel Steels Limited at the end of each financial year in the event the borrower failed to comply with stipulated financial covenants. The clause specifically obligated the promoter to arrange such infusion in a form and manner acceptable to the lender, thereby ensuring the borrower’s continued compliance with the agreed-upon financial parameters.

Electrosteel Steels Limited subsequently committed default in repaying the financial facilities in 2013. Following restructuring efforts, the borrower underwent a corporate insolvency resolution process under the Insolvency and Bankruptcy Code, 2016, when the Kolkata bench of the National Company Law Tribunal admitted an application by State Bank of India to initiate insolvency proceedings. During the insolvency process, SREI Infrastructure Finance Limited filed its claim of Rs. 5.78 billion, which was duly admitted by the resolution professional. In 2018, the National Company Law Tribunal approved Vedanta Limited’s resolution plan for Electrosteel Steels Limited, and SREI issued a no-objection certificate confirming receipt of Rs. 2.42 billion for its dues along with allotment of equity shares.

Subsequently, SREI executed an assignment deed in favor of UV Asset Reconstruction Company Limited, assigning the loans and related rights under the financing documents. UV Asset Reconstruction then filed an application under Section 7 of the Insolvency and Bankruptcy Code, 2016, before the National Company Law Tribunal, Cuttack, seeking initiation of corporate insolvency resolution proceedings against Electrosteel Castings Limited. The appellant contended that the deed of undertaking executed by the promoter constituted a corporate guarantee, thereby creating a financial debt that could be enforced through insolvency proceedings. The National Company Law Tribunal dismissed this application, holding that Electrosteel Castings Limited was not a guarantor for the facilities availed by Electrosteel Steels Limited. This finding was subsequently affirmed by the National Company Law Appellate Tribunal, leading to the appeal before the Supreme Court.

Supreme Court’s Analysis and Interpretation

The Supreme Court undertook a detailed and methodical analysis of the legal principles governing contracts of guarantee while examining the specific terms of the deed of undertaking executed by Electrosteel Castings Limited. The Court began by reiterating that a guarantee, being a mercantile contract, must be construed in a manner that reflects the real intention and understanding of the parties as expressed in writing, rather than by applying merely technical rules of interpretation. The Court emphasized that the construction of guarantee contracts must give effect to the commercial purpose underlying the arrangement while remaining faithful to the language actually employed by the parties.

In analyzing Clause 2.2 of the deed of undertaking, the Supreme Court noted several critical aspects of its language and structure. The clause obligated the promoter to arrange for infusion of funds into the borrower company to enable compliance with financial covenants. Significantly, the Court observed that the clause did not contain any undertaking by the promoter to discharge the debt owed by the borrower to the creditor, nor did it contemplate direct payment to the lender in the event of default. The obligation under the clause was characterized as a promise by the promoter to the borrower to facilitate compliance with financial covenants, rather than a promise to the creditor to discharge the borrower’s liability upon default.

The Court held that for an obligation to be construed as a guarantee under Section 126 of the Indian Contract Act, there must be a direct and unambiguous obligation of the surety to discharge the obligation of the principal debtor to the creditor. The absence of such direct obligation was fatal to the characterization of the deed of undertaking as a guarantee. The Supreme Court further noted that the original sanction letter did not envisage any personal or corporate guarantee and expressly identified specific securities for the facility, thereby reinforcing the conclusion that the parties did not intend to create a guarantee relationship.

The Concept of ‘See to It’ Guarantee

UV Asset Reconstruction Company Limited argued that Clause 2.2 of the deed of undertaking constituted what is known in English common law as a ‘see to it’ guarantee. This form of guarantee involves a two-step process wherein the surety undertakes to ensure that the principal debtor performs its obligations, and if the principal debtor fails to perform, the surety itself must perform those obligations. The appellant relied on English precedents, particularly the decision in Moschi v. Lep Air Services Ltd.[3], to support the contention that such undertakings constitute valid guarantees even though they are framed in terms of ensuring performance rather than directly promising to pay upon default.

The Supreme Court, while acknowledging that ‘see to it’ guarantees are recognized in English common law, drew a careful distinction between such guarantees and mere undertakings to enable performance by the principal debtor. The Court held that a ‘see to it’ guarantee does not include an obligation merely to enable the principal debtor to perform its own obligation; rather, it contemplates that the surety will itself step in to perform if the principal debtor fails to do so. The Court observed that such an arrangement would constitute a guarantee under English law principles, but emphasized that the language of Clause 2.2 did not rise to this level of commitment.

The Supreme Court concluded that the obligation to arrange for infusion of funds into the borrower was fundamentally different from an obligation to ensure performance or to perform in the event of default. Arranging for funds is an enabling activity that facilitates the borrower’s own performance, whereas a guarantee contemplates that the surety will discharge the creditor’s claim directly if the borrower defaults. This distinction was critical to the Court’s ultimate conclusion that the deed of undertaking did not create a guarantee relationship within the meaning of Section 126 of the Indian Contract Act, and that such an arrangement would not constitute a guarantee under Indian contract law principles.

Voluntary Payments and Admissions in Pleadings

During the course of arguments, UV Asset Reconstruction Company Limited sought to rely on two additional circumstances to support its contention that Electrosteel Castings Limited was a guarantor. First, the appellant pointed to certain payments made by the promoter during the insolvency proceedings of the borrower company as evidence of acknowledgment of guarantee liability. Second, the appellant relied on statements made by Electrosteel Castings Limited in pleadings before other courts, arguing that these statements amounted to judicial admissions of guarantor status.

The Supreme Court rejected both these contentions with clear reasoning rooted in established principles of contract law and evidence. Regarding the payments made during the insolvency proceedings, the Court held that voluntary payments made in the capacity of a promoter, in the absence of a contractual obligation to make such payments, do not give rise to a contract of guarantee. The Court observed that a promoter may have various commercial and strategic reasons for making payments on behalf of a borrowing company, including preserving its investment, maintaining relationships with creditors, or protecting the corporate group’s reputation. Such payments cannot, by themselves, transform the nature of the legal relationship between the parties or create contractual obligations that did not previously exist.

With respect to the reliance on statements in pleadings, the Supreme Court reiterated the fundamental principle that pleadings must be read as a whole and in their proper context. The Court held that selective reliance on portions of pleadings to infer admissions of liability, where none exist when the pleadings are read holistically, is impermissible. The Court emphasized that statements made in pleadings must be interpreted in light of the entire factual and legal contentions advanced by the party, and that isolated phrases or sentences cannot be divorced from their context to manufacture admissions. This approach ensures that parties are not penalized for making factual statements or advancing alternative arguments in the course of litigation, and that the true nature of their legal position is assessed comprehensively rather than selectively.

Impact on Resolution Plans Under the Insolvency and Bankruptcy Code

The second appeal before the Supreme Court raised the important question of whether approval of a resolution plan under the Insolvency and Bankruptcy Code automatically extinguishes the liability of third-party security providers or guarantors. This question has significant implications for the rights of creditors who have taken guarantees or other security from third parties in addition to the corporate debtor that undergoes insolvency resolution. The resolution plan approved for Electrosteel Steels Limited contained a clause that stated: “all rights/remedies of the creditors shall stand permanently extinguished except any rights against any third party (including the Existing promoter) in relation to any portion of Unsustainable Debt secured or guaranteed by third parties.”

The Supreme Court unequivocally held that the approval of a resolution plan does not ipso facto discharge a security provider of their liabilities under the contract of security. The Court emphasized that it is well-settled law that the approval and implementation of a resolution plan for a corporate debtor does not automatically absolve guarantors or security providers of their contractual obligations to the creditors. The Court noted that the resolution plan in this case explicitly reserved the rights of creditors against third-party security providers, thereby making it clear that such rights were not intended to be extinguished through the resolution process.

This aspect of the judgment reinforces the principle established in the landmark case of Lalit Kumar Jain v. Union of India[4], where the Supreme Court held that the sanction of a resolution plan and the finality imparted to it by Section 31 of the Insolvency and Bankruptcy Code does not per se operate as a discharge of the guarantor’s liability. The Court in that case explained that as to the nature and extent of the liability, much would depend on the terms of the guarantee itself, and that an involuntary act of the principal debtor leading to loss of security would not absolve a guarantor of its liability. The principle underlying these judgments is that the insolvency resolution of the principal debtor is an involuntary process imposed by statute, and guarantors cannot escape their contractual obligations merely because the principal debtor has undergone insolvency proceedings.

Regulatory Framework Governing Guarantees and Insolvency Proceedings

The legal framework governing guarantees in India is primarily contained in Chapter VIII of the Indian Contract Act, 1872, which deals with indemnity and guarantee. Sections 126 to 147 of the Act provide a complete code governing various aspects of guarantee contracts, including the definition of guarantee, the extent of surety’s liability, circumstances under which a surety is discharged from liability, and the rights of sureties against principal debtors and co-sureties. This statutory framework has been supplemented by extensive judicial interpretation over more than a century, creating a rich body of case law that guides the application of these principles to diverse commercial situations.

The Insolvency and Bankruptcy Code, 2016 represents a paradigm shift in India’s approach to insolvency resolution, replacing the earlier fragmented legislative framework with a unified and time-bound process for addressing corporate distress. The Code establishes distinct mechanisms for different categories of stakeholders to initiate insolvency proceedings. Section 7 of the Code enables financial creditors to file applications for initiation of Corporate Insolvency Resolution Process before the National Company Law Tribunal when a default has occurred. The definition of financial creditor and financial debt under Sections 5(7) and 5(8) of the Code is critical, as only those who fall within these definitions can invoke the Section 7 mechanism.

The interaction between the Indian Contract Act and the Insolvency and Bankruptcy Code in the context of guarantees has been the subject of significant judicial consideration. The Supreme Court has clarified that while the insolvency resolution of a corporate debtor may result in a haircut to the claims of creditors through an approved resolution plan, this does not automatically extinguish the liability of guarantors who have provided independent security for the corporate debtor’s obligations. The guarantor’s liability continues to subsist, though it may be revised to reflect the amount that remains unpaid after implementation of the resolution plan. This principle ensures that creditors are not left without recourse simply because they agreed to a resolution plan that provided for less than full recovery from the corporate debtor, particularly when they had the foresight to obtain additional security from guarantors.

Practical Implications for Corporate Financing and Promoter Obligations

The Supreme Court’s judgment in UV Asset Reconstruction Company Limited v. Electrosteel Castings Limited has significant practical implications for the structuring of corporate financing transactions and the drafting of promoter undertakings. Financial institutions and other lenders must now be extremely careful in distinguishing between genuine guarantee arrangements and mere undertakings by promoters to facilitate the borrower’s performance. If lenders wish to hold promoters personally or corporately liable for the borrower’s defaults, they must ensure that the documentation clearly and unambiguously creates a direct obligation from the promoter to the lender to discharge the borrower’s liability upon default.

The judgment also provides important guidance on what does not constitute a guarantee. Undertakings to infuse funds into a borrowing company, to ensure compliance with financial covenants, to maintain certain financial ratios, or to take other enabling actions do not, by themselves, create guarantee liability. These undertakings create obligations from the promoter to the borrower, rather than from the promoter to the lender. While such undertakings may have commercial value in ensuring that the borrower remains financially healthy and capable of servicing its debts, they do not provide lenders with the same legal remedies available under a contract of guarantee Under Section 126, including the right to proceed directly against the promoter for recovery of the borrower’s debts.

The distinction drawn by the Supreme Court between different types of promoter commitments is particularly significant in the context of insolvency proceedings under the Insolvency and Bankruptcy Code. The right to initiate Corporate Insolvency Resolution Process under Section 7 of the Code is available only to financial creditors who are owed a financial debt. A guarantor who has executed a valid guarantee can be treated as having a contingent financial debt relationship with the corporate debtor, thereby potentially bringing them within the ambit of insolvency proceedings. However, a promoter who has merely undertaken to facilitate the borrower’s performance does not stand in the position of a debtor to the creditor and cannot be subjected to insolvency proceedings on the basis of such undertaking alone.

Comparative Analysis with English Common Law Principles

The Supreme Court’s discussion of the ‘see to it’ guarantee concept and its rejection in the Indian context highlights important differences between English common law approaches and Indian statutory principles governing guarantees. English law recognizes various forms of secondary obligations, including guarantees framed as undertakings to see to it that the principal performs. The leading authority on this point is the House of Lords decision in Moschi v. Lep Air Services Ltd., where it was held that a covenant to ensure that another person performs an obligation is enforceable as a guarantee even if not framed in traditional guarantee language.

The Indian approach, as clarified by the Supreme Court in the Electrosteel Castings case, is more formalistic and requires adherence to the statutory definition contained in Section 126 of the Indian Contract Act. The Court’s emphasis on the need for a direct and unambiguous obligation to discharge the principal debtor’s liability to the creditor reflects a stricter interpretation of what constitutes a guarantee. This approach provides greater certainty and predictability in determining when a guarantee relationship exists, but it also places greater responsibility on lenders to ensure that their documentation explicitly creates the intended legal relationship.

The divergence between English and Indian approaches can be attributed to differences in the underlying legal frameworks. England follows a common law system where contractual principles have evolved through judicial decisions over centuries, allowing for greater flexibility in recognizing different forms of contractual obligations based on the parties’ intentions as discerned from the agreement as a whole. India, while drawing inspiration from English common law, has a comprehensive statutory code governing contracts, including specific provisions defining guarantees. Indian courts must interpret contracts in light of these statutory definitions, which constrains the ability to recognize novel forms of guarantee arrangements that do not fit within the statutory framework.

Conclusion

The Supreme Court’s judgment in UV Asset Reconstruction Company Limited v. Electrosteel Castings Limited represents a significant contribution to the jurisprudence on contracts of guarantee and their intersection with insolvency law. The Court has clarified that a promoter’s undertaking to arrange for infusion of funds into a borrowing company, while commercially significant, does not constitute a contract of guarantee within the meaning of Section 126 of the Indian Contract Act unless it creates a direct and unambiguous obligation to discharge the borrower’s liability to the creditor upon default. This distinction is critical for determining the rights and remedies available to creditors when borrowers default on their obligations.

The judgment also reinforces the principle that approval of a resolution plan under the Insolvency and Bankruptcy Code does not automatically extinguish the liability of guarantors and security providers who are third parties to the corporate debtor. This ensures that creditors can continue to pursue their rights against such third parties even after the corporate debtor has undergone insolvency resolution, subject to the specific terms of the resolution plan and any express provisions regarding the treatment of third-party obligations. The preservation of creditor rights against guarantors highlights the continuing relevance of a well-drafted contract of guarantee under Section 126, ensuring that such guarantees retain their enforceability and value as security instruments.

For practitioners, this judgment underscores the critical importance of precise drafting when creating a contract of guarantee under Section 126. Lenders who wish to hold promoters or other parties liable as guarantors must ensure that the documentation establishes an explicit and unambiguous obligation to discharge the borrower’s liability to the lender upon default, rather than merely undertaking to facilitate the borrower’s own performance. Conversely, promoters and other parties providing comfort to lenders must carefully review the language of any undertakings they provide to ensure they understand the full extent of the obligations they are assuming and whether those obligations could give rise to liability under a contract of guarantee under Section 126.

References

[1] UV Asset Reconstruction Company Limited v. Electrosteel Castings Limited, 2026 INSC 14, available at: https://www.verdictum.in/court-updates/supreme-court/uv-asset-reconstruction-company-limited-v-electrosteel-castings-limited-2026-insc-14-1603910 

[2] Bank of Bihar Ltd. v. Damodar Prasad and Another, (1969) 1 SCC 620, available at: https://indiankanoon.org/doc/1377136/ 

[3] Moschi v. Lep Air Services Ltd., [1973] AC 331 (House of Lords)

[4] Lalit Kumar Jain v. Union of India, (2021) 9 SCC 321, available at: https://www.amsshardul.com/insight/liability-of-guarantors-after-landmark-india-verdict/ 

[5] Section 126 of the Indian Contract Act, 1872, available at: https://indiankanoon.org/doc/53550/ 

[6] Section 128 of the Indian Contract Act, 1872, available at: https://indiankanoon.org/doc/1377136/ 

[7] Section 7 of the Insolvency and Bankruptcy Code, 2016, available at: https://ibclaw.in/section-7-initiation-of-corporate-insolvency-resolution-process-by-financial-creditor-chapter-ii-corporate-insolvency-resolution-processcirp-part-ii-insolvency-resolution-and-liquidation-for-corpor/ 

The post Promoter’s Undertaking to Infuse Funds Does Not Amount to a Contract of Guarantee Under Section 126 of the Indian Contract Act: A Critical Analysis of the Supreme Court’s Ruling appeared first on Bhatt & Joshi Associates.

Introduction to Novation in OTC Derivatives Contracts

The Reserve Bank of India has introduced a significant regulatory framework through the Draft Reserve Bank of India (Novation of OTC Derivative Contracts) Directions, 2025, which was released on July 9, 2025, under Section 45W of the Reserve Bank of India Act, 1934.[1] This development marks a crucial evolution in India’s financial derivatives market, addressing the operational complexities that arise when parties seek to transfer their positions in over-the-counter derivative contracts. The new directions represent a modernization effort that aims to align India’s regulatory framework with international best practices while ensuring transparency, legal clarity, and operational efficiency in the derivatives market.

Novation, in the context of over-the-counter derivatives, refers to a sophisticated legal mechanism whereby one party to a derivative contract (the transferor) is replaced by a new party (the transferee), with the consent of the continuing party (the remaining party). This process effectively extinguishes the original contractual relationship and creates a new contract with identical economic terms but different counterparties. The RBI’s Draft Directions on Novation of OTC Derivative Contracts provide a clear regulatory framework for this process, highlighting its importance in providing liquidity and flexibility to market participants who may need to exit positions before maturity for commercial, strategic, or risk management reasons.

The regulatory intervention by the RBI comes at a time when India’s derivatives market has witnessed substantial growth and sophistication. The previous regulatory framework, established through a circular dated December 9, 2013, had served the market for over a decade.[1] However, changes in market practices, technological advancements, the evolution of the broader regulatory ecosystem governing OTC derivatives, and feedback from market participants necessitated a fresh look at the novation framework. The new directions aim to rationalize regulatory requirements, reduce operational friction, and provide greater clarity to market participants engaging in novation transactions.

Legal and Regulatory Framework Governing OTC Derivatives Contracts in India

The regulatory architecture for over-the-counter derivatives in India operates within a multi-layered legal framework. At the apex sits the Reserve Bank of India Act, 1934, which provides the RBI with comprehensive powers to regulate derivatives markets through specific provisions. Section 45U of the RBI Act, 1934 contains definitions relevant to derivatives, while Section 45V addresses transactions in derivatives generally. Most importantly, Section 45W of the RBI Act, 1934 confers upon the Reserve Bank the power to regulate transactions in derivatives, money market instruments, and related financial products.[2]

Section 45W empowers the Reserve Bank to issue directions to any person or class of persons dealing in derivatives, money market instruments, or securities. This section specifically enables the RBI to prescribe the manner in which such transactions shall be entered into or carried out, the parties who may enter into such transactions, the terms and conditions that shall govern such transactions, and the reporting requirements for such transactions. The Draft Novation Directions, 2025 have been issued in exercise of these statutory powers under Section 45W read with Section 45U of the RBI Act, 1934.

Beyond the RBI Act, the foreign exchange derivatives segment operates under the Foreign Exchange Management Act, 1999 (FEMA). The Foreign Exchange Management (Foreign Exchange Derivative Contracts) Regulations, 2000, notified as FEMA.25/RB-2000 dated May 3, 2000, governs foreign exchange derivative contracts.[1] These regulations work in conjunction with the Master Direction on Risk Management and Inter-Bank Dealings issued by the Financial Markets Regulation Department. Together, these instruments create a regulatory framework that balances market development with prudential oversight.

For interest rate derivatives, the regulatory landscape is shaped by the Rupee Interest Rate Derivatives (Reserve Bank) Directions, 2019, which was notified on June 26, 2019.[1] This framework was further supplemented by the Reserve Bank of India (Forward Contracts in Government Securities) Directions, 2025, issued on February 21, 2025. These directions govern interest rate derivative products that reference rupee interest rates or government securities. The credit derivatives segment, though relatively smaller, operates under the Master Direction on Credit Derivatives issued on February 10, 2022.[1]

The Securities Contracts (Regulation) Act, 1956 also plays an important role in the overall derivatives ecosystem by defining exchanges and regulating exchange-traded derivatives. While the new novation directions specifically exclude exchange-traded derivatives from their scope, the interplay between exchange-traded and over-the-counter markets means that regulatory coordination remains important. The Companies Act, 2013 is also relevant, particularly because the novation directions explicitly exclude novations undertaken pursuant to court-approved schemes of merger, demerger, or amalgamation under this Act.[1]

Understanding the Draft RBI Novation Directions, 2025

The Draft Reserve Bank of India (Novation of OTC Derivative Contracts) Directions, 2025 represents a codified and rationalized approach to regulating novation transactions in the Indian derivatives market. These directions apply specifically to over-the-counter derivatives transactions undertaken in terms of the provisions of what the directions term “Governing Directions” – essentially the various master directions and regulations that permit and govern specific types of OTC derivatives.[1]

The scope of application is carefully delineated. The directions apply to all OTC derivatives, which are defined as derivatives other than those traded on recognized stock exchanges, and this definition explicitly includes derivatives traded on Electronic Trading Platforms. This is a significant clarification because Electronic Trading Platforms have emerged as an important venue for derivatives trading, combining some characteristics of exchanges with the flexibility of OTC markets. The inclusion ensures that derivatives traded on these platforms remain subject to appropriate regulatory oversight regarding novation.

However, the directions carve out two important exceptions where novation does not require compliance with these directions. First, novations undertaken by central counterparties for the purpose of effecting settlement of novation of OTC derivative contracts are excluded. Central counterparties play a unique role in the financial system by interposing themselves between buyers and sellers, thereby reducing counterparty risk. Their novation activities are typically governed by separate regulatory frameworks given their systemic importance. Second, novations pursuant to court-approved schemes of merger, demerger, or amalgamation under the Companies Act, 2013 or any other law are also excluded. This exception recognizes that corporate restructurings involve comprehensive legal processes with their own safeguards and should not be hindered by additional novation requirements.

The directions come into force with immediate effect upon their finalization, though the draft was released for public consultation with comments invited until August 1, 2025. This consultation process reflects the RBI’s commitment to inclusive regulatory development that takes into account the views and concerns of market participants, industry associations, and other stakeholders.

Key Definitions and Conceptual Framework

The novation directions establish a precise definitional framework that is essential for legal certainty and operational clarity. The term “novation” itself is defined as the replacement of a market maker with another market maker in an OTC derivative contract between two counterparties to an OTC derivative transaction with a new contract between the remaining party and a third party.[1] This definition emphasizes that novation is specifically about market makers transferring their positions, which makes sense given that market makers are the primary liquidity providers in OTC derivatives markets and are most likely to need flexibility in managing their derivative portfolios.

The definition of “market-maker” adopts the meaning assigned in the Master Direction on Market-makers in OTC Derivatives issued on September 16, 2021. Market-makers are typically banks and financial institutions that have been specifically authorized by the RBI to quote two-way prices (both buy and sell prices) in derivatives and provide liquidity to users. They play a central role in the functioning of OTC derivatives markets by standing ready to take the opposite side of user transactions, thereby ensuring that end users can execute their hedging or trading strategies.

The directions introduce and define three key parties to a novation transaction. The “transferor” is the party to a transaction that proposes to transfer, or has transferred, by novation to a transferee all its rights, liabilities, duties and obligations with respect to a remaining party.[1] The “transferee” is the party that proposes to accept, or has accepted, the transferor’s transfer by novation of all these rights, liabilities, duties and obligations. The “remaining party” is the user that continues to be a counterparty in the new contract post novation – essentially, this is the party that did not initiate the novation and whose counterparty is being changed.

The definition of “user” is also adopted from the Master Direction on Market-makers in OTC Derivatives. Users are typically entities that enter into derivative contracts for hedging or risk management purposes, as opposed to market-making purposes. They represent the demand side of the derivatives market and include corporations, institutional investors, and other entities with genuine economic exposures that they wish to hedge through derivatives.

An important definitional element is the concept of “Governing Directions,” which refers to the various master directions, regulations, and notifications that govern specific types of OTC derivatives. For foreign exchange derivatives, this includes FEMA regulations and the Master Direction on Risk Management and Inter-Bank Dealings. For interest rate derivatives, this includes the Rupee Interest Rate Derivatives Directions and the Forward Contracts in Government Securities Directions. For credit derivatives, this includes the Master Direction on Credit Derivatives. This framework ensures that novated contracts remain subject to all the eligibility criteria, documentation requirements, and other regulatory standards that applied to the original contract.

Guidelines and Procedural Mechanisms for Novation of OTC Derivative Contracts

The novation of OTC Derivative Contracts establish a clear procedural framework that market participants must follow when undertaking novation. The foundational requirement is that the novation of an OTC derivative contract must be done with the prior consent of the remaining party.[1] This requirement protects the non-transferring party by ensuring they have a say in who their counterparty will be. Since derivatives involve counterparty credit risk – the risk that the other party will default on their obligations – the remaining party has a legitimate interest in approving any change in their counterparty. This consent requirement cannot be waived or bypassed, and any attempted novation without proper consent would be invalid.

The second critical requirement relates to pricing. The transaction must be undertaken at prevailing market rates, with the amount corresponding to the mark-to-market value of the OTC derivative contract at the prevailing market rate on the novation date being exchanged between the transferor and the transferee.[1] This requirement serves multiple purposes. It ensures that the transfer occurs at fair market value, preventing any value transfer between the transferor and transferee that might otherwise occur if the contract were transferred at off-market rates. It also provides clarity on the economic settlement between the transferring parties, which is separate from the continuation of the derivative contract itself.

The mark-to-market value represents the current economic value of the derivative contract based on current market conditions. If a derivative contract has positive value to one party, that party would need to be compensated for transferring that value to someone else. Conversely, if the contract has negative value (is “out of the money”), the party accepting that obligation would need to be compensated. By requiring the exchange of mark-to-market value at prevailing market rates, the directions ensure economic rationality and transparency in novation transactions.

The third key requirement is that parties to the novation must adhere to the provisions of the Governing Directions, and the new contract post novation must be in compliance with those provisions.[1] This ensures regulatory continuity – a novated contract cannot be used to circumvent regulatory requirements that applied to the original contract. For instance, if the original contract was subject to specific hedging requirements, underlying exposure documentation, or concentration limits, those same requirements continue to apply post-novation.

The Tripartite Agreement Mechanism

At the heart of the novation process lies the tripartite agreement between the transferor, transferee, and remaining party. This agreement is the legal instrument that effects the novation by simultaneously extinguishing the old contractual relationship and creating a new one. The directions specify that through this tripartite agreement, the transferee steps into the contract to face the remaining party while the transferor steps out.[1]

The legal effect of the tripartite agreement is carefully articulated in the directions. The original contract stands extinguished and is replaced by a new contract with terms and parameters identical to the original contract, except for the change in counterparty for the remaining party.[1] This ensures economic continuity – the remaining party’s economic position and contractual rights are preserved, even though their counterparty has changed. The hedging effectiveness of the derivative from the remaining party’s perspective is maintained, which is crucial for entities using derivatives for risk management purposes.

The tripartite agreement must satisfy two critical criteria. First, the counterparty credit risk and market risk arising from the OTC derivative contract must be transferred from the transferor to the transferee.[1] This means the transferee assumes all the risk that the transferor previously bore regarding this contract. The transferee becomes responsible for making payments if the derivative moves in favor of the remaining party, and conversely, becomes entitled to receive payments if the derivative moves in their favor.

Second, the transferor and the remaining party must each be released from their obligations under the original transaction to each other, and their respective rights against each other must be cancelled.[1] This clean break is essential to the concept of novation – the transferor cannot retain any lingering obligations or rights under the original contract. Simultaneously, rights and obligations identical in their terms to the original transaction are reinstated in the new transaction between the remaining party and the transferee. This creates the legal structure where the remaining party has effectively the same contract, just with a different counterparty.

The directions also clarify that the transferor and transferee may agree on charges or fees between them for the transfer of the trade, but these fees and their settlement terms need not form part of the novation agreement.[1] This sensibly separates the commercial arrangements between the transferring parties from the legal mechanics of the novation itself. The fee paid by a transferee to a transferor (or vice versa, depending on the contract’s value) represents compensation for the transfer and may reflect factors like the administrative costs of novation, the credit quality of the parties, and the market value of the position being transferred.

Documentation Standards and Industry Practice

Recognizing that standardized documentation reduces legal uncertainty and operational risk, the novation directions task two key industry associations with developing standard agreements for novation. The Fixed Income Money Market and Derivatives Association of India (FIMMDA) and the Foreign Exchange Dealers’ Association of India (FEDAI) are directed to devise standard agreements for novation in consultation with market participants and based on international best practices.[1]

FIMMDA is the industry association representing participants in India’s fixed income, money market, and derivatives markets. FEDAI performs a similar role for the foreign exchange market. These associations have historically played an important role in developing market conventions, standard documentation, and best practices that complement formal regulation. By tasking these associations with developing novation documentation, the RBI is leveraging industry expertise and ensuring that the resulting standards reflect practical market needs.

The reference to international best practices is significant because derivatives markets are global in nature, and many Indian market participants are also active in international derivatives markets. Aligning Indian novation documentation with international standards facilitates cross-border transactions and allows Indian institutions to benefit from the extensive legal and operational experience accumulated in more developed derivatives markets. Organizations like the International Swaps and Derivatives Association (ISDA) have developed widely-used standard documentation for derivatives transactions globally, and these can serve as useful reference points for Indian standards.

The directions also provide flexibility by noting that market participants may alternatively use a standard master agreement for novation.[1] This recognizes that different institutions may have different documentation needs and that a one-size-fits-all approach may not be appropriate for all situations. Larger institutions with significant derivatives activity may prefer customized master agreements that are tailored to their specific operational and legal requirements, while smaller participants may benefit from using industry-standard forms.

As part of the novation agreement, any relevant document related to the original OTC derivative contract and the underlying exposure must be transferred from the transferor to the transferee.[1] This documentation transfer is essential because many OTC derivatives, particularly those used for hedging, are subject to requirements regarding underlying exposures. For instance, a foreign exchange derivative hedging an import obligation must be backed by documentation evidencing that import transaction. When the derivative is novated, the transferee needs to receive this underlying documentation to demonstrate compliance with regulatory requirements.

Reporting Requirements and Trade Repository Obligations

Transparency and regulatory oversight in the derivatives market depend critically on accurate and timely reporting of transactions. The novation directions establish clear reporting obligations requiring market-makers involved in the novation of an OTC derivative contract to ensure that details pertaining to the novation are reported to the Trade Repository of Clearing Corporation of India Limited (CCIL).[1]

CCIL operates the designated trade repository for OTC derivatives in India and plays a central role in collecting, maintaining, and disseminating information about OTC derivative transactions. Trade repositories were mandated globally following the 2008 financial crisis as a mechanism to improve transparency in previously opaque OTC derivatives markets. By aggregating data on derivatives transactions, trade repositories enable regulators to monitor market activity, identify emerging risks, and assess systemic exposures.

The reporting must be done in terms of the provisions specified in the Governing Directions, which means that novation reporting must comply with the same standards, timelines, and formats that apply to reporting of other derivative transactions. This ensures consistency in the trade repository’s data and facilitates meaningful analysis of market activity. The specific reporting requirements vary depending on the type of derivative – foreign exchange derivatives, interest rate derivatives, and credit derivatives each have their own reporting standards as specified in their respective governing directions.

By placing reporting obligations on market-makers rather than on all parties to the novation, the directions recognize the reality that market-makers typically have more sophisticated operational infrastructure and reporting capabilities than users. Market-makers already have systems in place for reporting their derivative transactions, so extending this to novation reporting is operationally straightforward. However, this does not absolve other parties of responsibility – they must cooperate with the market-maker to ensure accurate reporting, including providing any necessary information.

Supersession of Previous Regulatory Framework

The new novation of OTC derivative contracts explicitly supersede previous regulatory provisions, creating a clean slate for the regulatory treatment of novation. The directions list in an annex the notifications and clarifications that are superseded, specifically including Notification No. DBOD.No.BP.BC.76/21.04.157/2013-14 dated December 9, 2013, and a mailbox clarification regarding the applicability of novation guidelines when transfers between entities happen by operation of law, dated December 12, 2014.[1]

The 2013 circular had provided the framework for novation for over a decade, during which time the derivatives market evolved significantly. The market saw the introduction of new products, changes in trading venues with the emergence of Electronic Trading Platforms, enhancements to the trade repository infrastructure, and revisions to various master directions governing different types of derivatives. These developments created some ambiguities and areas where the 2013 framework did not align perfectly with newer regulatory provisions.

The 2014 mailbox clarification addressed a specific question about whether novation guidelines apply when transfers occur by operation of law, such as in statutory mergers. The new directions address this more comprehensively by explicitly excluding court-approved schemes of merger, demerger, or amalgamation from the scope of the novation directions. This approach provides greater clarity and recognizes that such transfers have their own legal framework and safeguards.

The supersession of these older provisions means that once the new directions come into force, market participants must comply with the new framework. Any internal policies, procedures, or documentation based on the old framework should be updated. Industry associations like FIMMDA and FEDAI would need to review and potentially revise their standard documentation to ensure alignment with the new requirements.

Regulatory Objectives and Policy Considerations for RBI Novation of OTC Derivative Contracts

The RBI’s issuance of updated novation of OTC derivative contracts reflects several underlying policy objectives. First, the central bank seeks to enhance transparency in the OTC derivatives market. By establishing clear rules for how novation must be conducted and requiring reporting to the trade repository, the RBI ensures that regulators maintain visibility into changing counterparty relationships in the derivatives market. This is important for assessing systemic risk, monitoring market practices, and identifying potential issues before they become problems.

Second, the directions aim to protect market participants, particularly users who are having their counterparty changed through novation. The requirement for prior consent of the remaining party ensures that no party is forced to accept a counterparty they do not approve. The requirement that transactions occur at prevailing market rates protects parties from value extraction through off-market pricing. The requirement that all regulatory standards continue to apply post-novation prevents regulatory arbitrage.

Third, the RBI seeks to facilitate market liquidity and efficiency. By providing a clear framework for novation, the directions make it easier for market-makers to manage their derivative portfolios. A market-maker who has accumulated a large position with a particular counterparty may face concentration risk or balance sheet constraints. The ability to novate some of those positions to other market-makers provides operational flexibility and helps maintain market functioning. Similarly, a market-maker may wish to exit the derivatives business or a particular market segment, and novation provides a mechanism to do so in an orderly manner.

Fourth, the directions seek to align Indian practices with international standards. By directing industry associations to base their standard documentation on international best practices, the RBI is ensuring that Indian market participants can operate effectively in global derivatives markets. This is particularly important for Indian banks and financial institutions that have significant international operations and for foreign institutions operating in India.

Fifth, the RBI aims to rationalize regulatory requirements by consolidating various provisions into a single, coherent framework. The previous approach of having a main circular supplemented by various mailbox clarifications created some confusion about exactly what rules applied. The new directions provide a single authoritative source for novation requirements, reducing regulatory uncertainty.

Implications for Market Participants

The RBI Novation of OTC Derivative Contracts directions will affect different categories of market participants in different ways. For market-makers, who are the primary users of novation, the new framework provides greater clarity and a more streamlined process. They will need to ensure their novation procedures comply with requirements such as the tripartite agreement structure, mark-to-market exchange, and reporting obligations. Banks and financial institutions serving as market-makers should review their internal policies, procedures, and documentation to align with the updated framework.

For users of derivatives, particularly corporations and institutional investors using derivatives for hedging, the most important aspect is the protection afforded by the consent requirement. Users should establish clear internal processes for evaluating novation requests, which should include credit assessment of the proposed transferee, review of any changes to documentation or operational processes, and confirmation that the novated contract will continue to meet their hedging needs. Users should not feel pressured to consent to novation and should exercise their right to refuse consent if they have concerns about the proposed transferee’s credit quality or other factors.

For legal and compliance teams at financial institutions, the new directions require attention to several areas. Documentation templates must be reviewed and updated to reflect the tripartite agreement structure and other requirements. Training should be provided to front-office and middle-office staff on the novation process and requirements. Reporting systems must be configured to capture and report novation transactions to CCIL’s trade repository in the required format and timeframe.

For industry associations like FIMMDA and FEDAI, the directions create a clear mandate to develop standard novation documentation. This work should be undertaken through broad consultation with market participants to ensure the resulting standards are practical and meet market needs. The associations should also consider developing guidance notes or frequently asked questions documents to help market participants understand and implement the novation framework.

For auditors and risk managers, the novation framework has implications for how derivative portfolios are assessed and monitored. Auditors should verify that institutions have proper processes for novation, including appropriate approvals, documentation, pricing verification, and reporting. Risk managers should incorporate novation into their operational risk frameworks and should monitor novation activity for any patterns that might indicate issues.

Conclusion

The Draft Reserve Bank of India (Novation of OTC Derivative Contracts) Directions, 2025 represents a significant modernization of the regulatory framework governing an important aspect of India’s derivatives market. By providing clear rules for how parties can transfer derivative positions, the directions balance the need for market flexibility and liquidity with important protections for market participants and regulatory oversight. The requirement for consent of the remaining party ensures that counterparty changes do not occur against anyone’s wishes. The requirement for mark-to-market pricing ensures economic transparency. The tripartite agreement structure provides legal clarity about the extinguishment of old obligations and creation of new ones. The reporting requirements ensure regulatory visibility into changing market relationships.

As India’s derivatives market continues to grow and evolve, having a robust and clear framework for novation will become increasingly important. The novation mechanism provides essential flexibility for market-makers to manage their portfolios, enables orderly exits from positions or market segments, and facilitates risk management. At the same time, the regulatory framework ensures that this flexibility does not come at the cost of transparency, participant protection, or regulatory oversight. The supersession of the decade-old 2013 circular and its replacement with the new directions reflects the RBI’s commitment to keeping the regulatory framework current and aligned with market developments and international practices.

Market participants should use the implementation period to familiarize themselves with the new requirements, update their internal processes and documentation, and ensure their operational systems can support the novation framework. Industry associations should expeditiously develop standard documentation to facilitate smooth market functioning under the new regime. As the derivatives market continues to mature, frameworks like the novation directions will play an important role in ensuring that Indian markets operate efficiently, transparently, and in line with global standards.

References

[1] TaxGuru. (2025). RBI Draft Rules on Novation of OTC Derivatives 2025. Available at: https://taxguru.in/rbi/rbi-draft-rules-novation-otc-derivatives-2025.html 

[2] Ministry of Law and Justice. (1934). The Reserve Bank of India Act, 1934 – Section 45W. Available at: https://www.indiacode.nic.in/bitstream/123456789/2398/1/a1934-2.pdf 

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Executive Summary

The Reserve Bank of India has introduced groundbreaking regulatory changes in 2025 that fundamentally reshape the digital banking landscape in India. The RBI digital banking framework 2025, outlined in the Digital Banking Channels Authorisation Directions 2025 [1] released as draft guidelines in July 2025, represents a comprehensive regulatory overhaul designed to strengthen India’s digital financial ecosystem while ensuring consumer protection and systemic stability. This framework, coupled with the Digital Lending Directions 2025 [2], establishes a robust legal foundation for digital banking operations across all regulated entities.

These regulations emerge against the backdrop of India’s rapidly evolving fintech sector and the increasing digitization of banking services. The framework addresses critical gaps in existing regulatory structures while providing clarity on compliance requirements for banks, non-banking financial companies, and emerging digital lending platforms.

Historical Context and Regulatory Evolution

Foundational Legal Framework

The regulatory authority for these new directions stems from the Banking Regulation Act, 1949 [3], which has served as the cornerstone of Indian banking regulation for over seven decades. Section 21 of the Banking Regulation Act empowers the Reserve Bank of India to issue directions to banking companies regarding their business operations, including the adoption of new technologies and service delivery mechanisms.

The Act, originally enacted as the Banking Companies Act 1949, came into force on March 16, 1949, and was subsequently renamed the Banking Regulation Act 1949 from March 1, 1966. The legislation has undergone significant amendments, most notably in 2020 when cooperative banks were brought under RBI supervision, demonstrating the regulator’s adaptive approach to emerging challenges in the banking sector.

Digital Banking Evolution in Indian Regulatory Framework

The journey toward comprehensive digital banking regulation began with the RBI’s early initiatives in mobile banking through various circulars and master directions. The Mobile Banking Transactions Master Circular, first issued in 2016 and updated as recently as 2021, laid the groundwork for digital banking services by establishing security protocols and operational guidelines for mobile-based financial transactions.

However, the exponential growth of digital lending platforms, fintech partnerships, and app-based banking services necessitated a more comprehensive regulatory approach. The RBI Digital Banking Framework 2025 represents the culmination of years of regulatory development, incorporating lessons learned from the rapid digitization experienced during the COVID-19 pandemic.

Digital Banking Channels Authorisation Directions 2025: Core Provisions

Mandatory Authorization Requirements

The Digital Banking Channels Authorisation Directions 2025 establish explicit authorization requirements for all digital banking services offered by regulated entities. Under these directions, banks cannot launch any digital banking channel without prior RBI approval, marking a significant departure from the previous notification-based approach.

The RBI digital banking authorization framework requires banks to demonstrate robust technological infrastructure, adequate cybersecurity measures, and comprehensive risk management systems before receiving approval for digital banking operations. This represents a paradigm shift toward preventive regulation rather than reactive oversight.

Customer Consent and Voluntary Adoption

A fundamental principle embedded in the 2025 directions is the voluntary nature of digital banking adoption. The regulations explicitly state that banks cannot make digital banking mandatory for customers to access other banking facilities such as debit cards or basic banking services [4]. This provision addresses longstanding consumer concerns about forced digitization and ensures that traditional banking channels remain available for customers who prefer them.

The consent mechanism requires banks to obtain explicit customer approval before enrolling them in digital banking services. Customers must be provided with clear options to choose between view-only access for balance inquiries and account statements, or full transactional capabilities. This granular approach to digital banking permissions ensures that customers maintain control over their banking experience while complying with data protection principles.

Operational Guidelines and Compliance Standards

The directions establish comprehensive operational standards covering system availability, transaction processing, dispute resolution, and customer grievance handling. Banks must maintain 99.5% uptime for their digital banking platforms, with clearly defined compensation mechanisms for service disruptions affecting customer transactions.

Security requirements mandate multi-factor authentication for all transactions above specified threshold limits, real-time fraud monitoring systems, and immediate notification mechanisms for suspicious activities. These provisions align with global best practices while addressing India-specific challenges related to digital fraud and cybersecurity threats.

Digital Lending Directions 2025: Comprehensive Regulatory Overhaul

Consolidation of Existing Guidelines

The Digital Lending Directions 2025, notified on May 8, 2025, represent a significant consolidation of the regulatory framework governing digital lending in India [2]. These directions repeal and replace the Guidelines on Digital Lending released on September 2, 2022, various circulars on loans sourced over digital lending platforms, and the Guidelines on Default Loss Guarantee in Digital Lending.

This consolidation addresses the fragmented regulatory approach that previously governed digital lending, creating a unified framework that covers all aspects of digital lending operations, from customer onboarding to loan recovery processes.

Lending Service Providers Regulation

The 2025 directions introduce comprehensive regulation of Lending Service Providers (LSPs), entities that facilitate digital lending but are not themselves regulated financial institutions. This regulation addresses a critical gap in the previous framework where LSPs operated in a regulatory gray area, often leading to consumer protection issues and unfair lending practices.

Under the new framework, LSPs must register with appropriate authorities, maintain specified capital requirements, and adhere to strict data protection and customer privacy standards. The directions also establish clear liability frameworks for LSPs, ensuring that regulated entities maintain ultimate responsibility for loan decisions and customer treatment.

Default Loss Guarantee Framework

The directions include revised provisions for Default Loss Guarantee (DLG) arrangements, capping such guarantees at 5% of the disbursed portfolio [5]. Permitted instruments for DLG include cash deposits, fixed deposits, or bank guarantees, providing flexibility while maintaining risk management principles.

This framework balances the commercial interests of digital lending platforms with prudential concerns, ensuring that risk-sharing arrangements do not compromise the financial stability of regulated entities or create hidden leverage in the system.

Compliance Obligations and Implementation Requirements

Chief Compliance Officer Accountability

The RBI digital banking authorization framework 2025 introduces enhanced accountability measures through the Chief Compliance Officer (CCO) mechanism. Each regulated entity must designate a CCO responsible for certifying compliance with all digital lending workflows and digital banking operations [5]. This personal accountability mechanism ensures senior management oversight of digital banking compliance and creates clear lines of responsibility within organizations.

The CCO is required to submit quarterly compliance certificates to the RBI, detailing adherence to operational guidelines, customer protection measures, and risk management protocols. Failure to maintain adequate compliance standards can result in personal sanctions against the CCO, in addition to institutional penalties.

Key Fact Statement Requirements

The directions mandate comprehensive disclosure through Key Fact Statements (KFS) for all digital lending products. Clause 8(i) of the Digital Lending Directions requires regulated entities to provide a KFS to borrowers before loan contract execution, in accordance with the April 2024 KFS Rules [6].

The KFS must include crucial information about interest rates, processing fees, prepayment charges, and total cost of credit in a standardized format. This transparency requirement addresses information asymmetry in digital lending and empowers customers to make informed borrowing decisions.

Technology and Data Protection Standards

The framework establishes stringent technology standards covering data storage, processing, and transmission. All customer data must be stored within India, with specific requirements for data encryption, access controls, and audit trails. Banks and digital lending platforms must implement privacy-by-design principles in their system architecture.

Cybersecurity requirements mandate regular penetration testing, vulnerability assessments, and incident response protocols. Organizations must maintain cyber insurance coverage proportionate to their digital banking operations and demonstrate incident response capabilities through regular drills and testing.

Legal Precedents and Judicial Interpretations

Supreme Court Guidelines on Digital Rights

While specific case law directly interpreting the 2025 RBI digital banking framework is limited due to its recent introduction, relevant judicial precedents provide important context for understanding the legal landscape. The Supreme Court’s emphasis on digital rights as fundamental rights in various judgments creates a constitutional foundation for the customer protection provisions in the RBI’s framework.

The principle established in various Supreme Court cases regarding the right to privacy and data protection influences the interpretation of consent mechanisms and data handling requirements in digital banking operations. These constitutional principles strengthen the regulatory framework’s emphasis on voluntary adoption and explicit customer consent.

High Court Decisions on Banking Technology

High Court decisions across various jurisdictions have consistently emphasized the banks’ duty of care in implementing new technologies. These precedents support the RBI’s approach of requiring prior authorization for digital banking channels, as courts have held banks liable for technological failures that cause customer harm.

The judicial emphasis on reasonable security measures in digital transactions provides legal backing for the comprehensive security requirements established in the 2025 framework. Courts have recognized that banks must implement security measures proportionate to the risks inherent in digital banking operations.

Industry Impact and Sectoral Analysis

Traditional Banking Sector Transformation

The 2025 framework compels traditional banks to fundamentally restructure their digital operations. Large public sector banks must invest significantly in technology infrastructure to meet the new authorization requirements, while private sector banks with existing digital capabilities must enhance their compliance frameworks.

The requirement for prior authorization creates a level playing field between established banks and new digital banking entrants, as all entities must demonstrate equivalent technological and risk management capabilities before launching digital services. This regulatory approach prevents competitive disadvantages based purely on regulatory arbitrage.

Impact on Non-Banking Financial Companies

Non-Banking Financial Companies (NBFCs) face particularly significant changes under the 2025 framework. The comprehensive regulation of digital lending operations affects NBFCs’ business models, partnership structures, and technology investments. Many NBFCs must restructure their operations to comply with the new LSP regulations and enhanced disclosure requirements.

The framework’s emphasis on direct customer relationships challenges NBFC models that relied heavily on third-party digital platforms for customer acquisition and servicing. This shift requires NBFCs to develop in-house capabilities or establish compliant partnership structures with regulated LSPs.

Fintech Industry Realignment

The fintech sector experiences the most dramatic impact from the 2025 regulatory framework. Digital lending platforms must obtain appropriate registrations, maintain higher capital requirements, and implement comprehensive compliance systems. This regulatory shift consolidates the industry around well-capitalized players with robust compliance capabilities.

Smaller fintech companies may need to restructure as technology service providers rather than direct lending facilitators, fundamentally changing the industry’s business model dynamics. The framework encourages consolidation and professionalization in the fintech sector while maintaining innovation incentives through clear regulatory pathways.

Consumer Protection and Rights Framework

Enhanced Disclosure Requirements

The 2025 framework significantly strengthens consumer protection through comprehensive disclosure requirements. Digital lending platforms must provide clear information about total cost of credit, including all fees and charges, in a standardized format that enables easy comparison across products and providers.

The mandatory cooling-off period for certain digital loans allows customers to cancel agreements within specified timeframes without penalty, providing additional protection against impulsive borrowing decisions. This provision addresses concerns about predatory lending practices in the digital space.

Grievance Redressal Mechanisms

Enhanced grievance redressal requirements mandate that digital banking platforms maintain dedicated customer service channels with specified response timeframes. Customers must receive acknowledgment of complaints within 24 hours and resolution within prescribed timeframes based on complaint complexity.

The framework establishes escalation mechanisms connecting customer grievances to RBI’s centralized complaint system, ensuring that unresolved complaints receive regulatory attention. This systematic approach to customer protection strengthens trust in digital banking services while providing regulatory oversight of customer treatment.

Data Privacy and Security Rights

Comprehensive data protection provisions grant customers explicit rights over their personal and financial information. Customers can request data deletion, portability, and correction through standardized processes that banks must implement within their digital platforms.

The framework requires explicit customer consent for data sharing with third parties, including for marketing purposes or credit assessment by partner organizations. This consent-based approach aligns with global data protection standards while addressing India-specific concerns about financial data privacy.

Risk Management and Prudential Implications

Systemic Risk Considerations

The RBI digital banking authorization framework 2025 addresses systemic risks arising from the interconnected nature of digital banking operations. Concentration risk limits prevent excessive dependence on single technology providers or digital platforms, while operational resilience requirements ensure continuity of critical banking services during technological disruptions.

Stress testing requirements mandate that banks assess their digital banking operations’ resilience under various adverse scenarios, including cyberattacks, technology failures, and extreme market conditions. These assessments must inform business continuity planning and capital allocation decisions.

Credit Risk Management in Digital Lending

Enhanced credit risk management requirements address the unique challenges of digital lending, including limited customer interaction and automated decision-making processes. Banks must maintain human oversight of algorithmic lending decisions, particularly for high-value loans or vulnerable customer segments.

The framework requires regular validation of credit scoring models used in digital lending, with specific attention to potential bias in algorithmic decision-making. This approach ensures that digital lending maintains fairness and accuracy standards equivalent to traditional lending processes.

Operational Risk Framework

Comprehensive operational risk management requirements cover technology risk, vendor risk, and process risk specific to digital banking operations. Banks must maintain detailed risk registers for their digital banking activities, with regular assessment and mitigation of identified risks.

Third-party risk management provisions address the complex vendor relationships inherent in digital banking, requiring due diligence, continuous monitoring, and contingency planning for critical service providers. This systematic approach to vendor management strengthens the overall resilience of digital banking operations.

Future Implications and Strategic Considerations

Technology Innovation Balance

The regulatory framework balances innovation encouragement with prudential oversight through regulatory sandboxes and phased implementation approaches. Banks can test innovative digital banking solutions within controlled environments before full-scale deployment, promoting technological advancement while maintaining regulatory oversight.

The framework’s technology-neutral approach ensures that regulatory requirements focus on outcomes rather than specific technological implementations, providing flexibility for banks to adopt emerging technologies while maintaining compliance with fundamental principles.

Market Structure Evolution

The comprehensive regulatory framework likely accelerates market consolidation in both traditional banking and fintech sectors. Organizations with robust compliance capabilities and adequate capital gain competitive advantages, while smaller players must invest significantly in regulatory infrastructure or partner with larger entities.

This market evolution promotes stability and consumer protection while potentially reducing competition in certain segments. The regulatory framework’s implementation timeline provides transition periods for market adjustment, but long-term industry structure will favor well-capitalized, compliant organizations.

International Harmonization

India’s digital banking regulatory framework increasingly aligns with international standards while addressing domestic market characteristics. This harmonization facilitates cross-border banking partnerships and technology transfer while maintaining regulatory sovereignty over critical financial infrastructure.

The framework’s emphasis on data localization and domestic oversight balances international integration with national security considerations, creating a model for digital banking regulation that other emerging markets may emulate.

Conclusion

The RBI Digital Banking Authorization Framework 2025 represents a watershed moment in Indian financial regulation, establishing comprehensive standards for digital banking operations while maintaining focus on consumer protection and systemic stability. The framework’s holistic approach addresses regulatory gaps that emerged during the rapid digitization of banking services, providing clarity and certainty for all stakeholders.

The successful implementation of these regulations requires coordinated efforts from banks, technology providers, and regulatory authorities. While compliance costs may initially challenge some organizations, the framework’s long-term benefits include enhanced consumer trust, reduced systemic risks, and sustainable growth in digital financial services.

As India continues its journey toward becoming a global leader in digital banking, the 2025 regulatory framework provides the foundation for responsible innovation and inclusive financial services. The framework’s emphasis on voluntary adoption, comprehensive disclosure, and robust risk management ensures that digital banking serves all segments of Indian society while maintaining the stability and integrity that have characterized India’s banking system.

The ongoing evolution of digital banking regulation will require continuous adaptation to emerging technologies and market dynamics. However, the principles established in the RBI digital banking 2025 framework provide a solid foundation for future regulatory development, ensuring that India’s digital banking sector remains both innovative and secure in the years ahead.

References

[1] Reserve Bank of India. (2025, July). Draft Master Direction – Digital Banking Channels Authorisation (Directions), 2025. 

[2] Reserve Bank of India. (2025, May 8). Digital Lending Directions, 2025. Available at: https://www.rbi.org.in 

[3] Banking Regulation Act, 1949. Act No. 10 of 1949. Available at: https://www.indiacode.nic.in/handle/123456789/1885 

[4] Business Standard. (2025, July 21). Not mandatory for customers to opt for digital banking: RBI draft norms. Available at: https://www.business-standard.com/industry/banking/not-mandatory-for-customers-to-opt-for-digital-banking-rbi-draft-norms-125072101487_1.html 

[5] The Digital Fifth. (2025, June 5). Digital Lending Guidelines 2025: RBI’s Framework for Responsible Digital Credit. Available at: https://thedigitalfifth.com/decoding-rbis-digital-lending-guidelines-2025/ 

[6] Leegality. (2025, July 29). RBI Digital Lending Directions 2025: KFS & Loan Doc Compliance. Available at: https://www.leegality.com/blog/digital-lending-directions-2025 

[7] Chandhiok & Mahajan. (2025, July 29). RBI Release Draft Direction On “Digital Banking Channels Authorisation”, 2025. Available at: https://www.chandhiok.com/post/c-m-e-alert-rbi-release-draft-direction-on-digital-banking-channels-authorisation-2025 

[8] AZB Partners. (2025, May 14). RBI (Digital Lending) Directions, 2025 – Same same, but different. Available at: https://www.azbpartners.com/bank/rbi-digital-lending-directions-2025-same-same-but-different/ 

[9] Lexology. (2025, May 28). Rewriting the Rules of Digital Lending: RBI Digital Lending Directions, 2025. Available at: https://www.lexology.com/library/detail.aspx?g=b5bc9efb-1199-41ee-bc2d-4a149573793b 

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Executive Summary

Cash credit facilities represent a cornerstone of India’s working capital finance ecosystem, yet their default classification under the “out of order” framework presents complex legal challenges for both lenders and borrowers. This comprehensive analysis examines the regulatory framework, legal implications, and practical considerations surrounding cash credit facility defaults, providing banking law practitioners with essential insights into compliance requirements, borrower rights, and enforcement mechanisms.

The Reserve Bank of India’s stringent “out of order” classification criteria—encompassing continuous over-limit exposure, credit dormancy, and interest coverage shortfalls—trigger immediate Non-Performing Asset (NPA) classification with far-reaching consequences for borrowers’ creditworthiness and banks’ recovery options. Understanding these mechanisms is crucial for effective legal counsel in today’s dynamic banking environment.

I. Regulatory Framework and Legal Foundation of Cash Credit Facility Defaults

The RBI’s Prudential Framework

The Reserve Bank of India’s prudential norms on Income Recognition, Asset Classification, and Provisioning (IRACP) establish the foundational legal framework for cash credit facility management[1][2]. These regulations, consolidated through various master circulars, create a comprehensive supervisory mechanism designed to ensure banking system stability while maintaining credit discipline.

The November 2021 clarification by the RBI significantly enhanced the enforcement of “out of order” status determination, mandating daily monitoring rather than quarter-end assessments[2]. This regulatory evolution reflects the central bank’s commitment to real-time risk assessment and timely intervention in distressed accounts.

Statutory Basis and Constitutional Validity

Cash credit facility regulation derives its authority from the Reserve Bank of India Act, 1934, and the Banking Regulation Act, 1949. The Supreme Court has consistently upheld the RBI’s regulatory powers in banking supervision, establishing that prudential norms constitute essential regulatory tools rather than mere administrative guidelines[3].

The borrower-level classification principle, which treats all facilities to a single borrower as NPA when one facility becomes “out of order,” represents a fundamental aspect of the regulatory approach[3]. This comprehensive classification methodology ensures that banks cannot engage in selective reporting while maintaining transparent asset quality assessment—an approach particularly relevant in the context of cash credit facility defaults.

II. Definition and Legal Criteria for “Out of Order” Classification

Statutory Definition and Three-Tier Test

A cash credit or overdraft account is classified as “out of order” when it meets any of three distinct criteria established by RBI regulations[1][2]:

1. Continuous Over-Limit Condition The account remains continuously in excess of the sanctioned limit or drawing power for 90 consecutive days. This test focuses on the borrower’s adherence to approved credit limits and reflects their ability to manage working capital requirements within sanctioned parameters.
2. Credit Dormancy Test The account shows no credits continuously for 90 days, even when the outstanding balance remains below the sanctioned limit. This criterion identifies accounts where business operations have ceased or cash flow generation has stopped, indicating potential financial distress.
3. Interest Coverage Shortfall The account’s credits during the preceding 90 days are insufficient to cover interest debited during the same period, despite the balance remaining within sanctioned limits. This test evaluates the borrower’s capacity to service interest obligations from operational cash flows.

Legal Implications of Daily Monitoring

The RBI’s November 2021 clarification mandating daily assessment of the interest coverage test represents a significant regulatory enhancement[2]. This daily monitoring requirement eliminates the possibility of window dressing through quarter-end adjustments, ensuring that banks maintain continuous surveillance of account health.

The legal implications of this daily monitoring extend beyond mere compliance requirements. Banks must now implement robust systems capable of real-time assessment, while borrowers face increased scrutiny of their operational cash flows. This regulatory shift demands enhanced technological infrastructure and procedural modifications across the banking sector.

III. Legal Consequences of NPA Classification

Immediate Classification Effects

Once an account is classified as “out of order” for more than 90 days, it automatically becomes a Non-Performing Asset (NPA)[1][4]. This classification triggers several immediate legal consequences:

Income Recognition Suspension Banks must cease accruing interest income on NPA accounts, shifting to cash basis recognition only upon actual receipt of payments[5]. This requirement ensures that financial statements reflect actual cash flows rather than theoretical earnings.

Provisioning Requirements Banks must maintain specific provisions against NPA accounts, with minimum provisioning rates of 15% for secured sub-standard assets[6]. These provisioning requirements directly impact bank profitability and capital adequacy ratios.

Borrower-Level Contagion The classification of one facility as NPA results in all facilities extended to the same borrower being classified as NPA[3]. This borrower-level approach ensures comprehensive risk assessment while preventing selective asset classification.

Credit Information Reporting

NPA classification triggers mandatory reporting to credit information companies (CICs), significantly impacting borrower creditworthiness[7][8]. The Credit Information Reporting framework requires banks to report NPA status to bureaus like CIBIL, affecting the borrower’s ability to access credit from other financial institutions.

The impact on credit scores can be severe and long-lasting, with NPA status remaining on credit reports for up to seven years even after loan settlement[7]. This extended reporting period serves as a deterrent to default while providing other lenders with comprehensive credit history information.

IV. Legal Remedies and Enforcement Mechanisms

SARFAESI Act Implementation

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act), provides banks with powerful enforcement tools for NPA recovery[9][10]. Section 13 of the SARFAESI Act empowers secured creditors to:

Issue Demand Notices Under Section 13(2), banks can issue demand notices requiring borrowers to repay outstanding dues within 60 days[10][11]. This notice serves as the formal commencement of enforcement proceedings and provides borrowers with a final opportunity to regularize their accounts.

Take Possession of Secured Assets Following expiry of the 60-day notice period, banks can take possession of secured assets under Section 13(4)[10]. This provision enables banks to enforce security interests without court intervention, significantly expediting the recovery process.

Asset Management and Sale Banks can manage, lease, or sell secured assets to recover outstanding dues[9]. The SARFAESI Act provides a comprehensive framework for asset realization while ensuring borrower rights through appellate mechanisms.

Debt Recovery Tribunal (DRT) Jurisdiction

For debts exceeding ₹20 lakh, banks can approach Debt Recovery Tribunals (DRTs) for expedited recovery proceedings[12][13]. DRTs provide specialized adjudication with streamlined procedures designed to overcome the delays associated with regular civil courts.

DRT Powers and Procedures DRTs possess comprehensive powers including[13]:

• Issuance of recovery certificates
• Attachment and sale of movable and immovable property
• Appointment of receivers
• Adjudication of counterclaims and set-offs

Appellate Mechanism Borrowers can appeal DRT orders to Debt Recovery Appellate Tribunals (DRATs), providing a two-tier system for debt recovery adjudication[14]. However, appeals require deposit of 75% of the decreed amount, ensuring that the appellate process does not unduly delay recovery.

V. Asset Reconstruction and Recovery Framework

Asset Reconstruction Companies (ARCs)

Asset Reconstruction Companies play a crucial role in the NPA ecosystem by purchasing bad loans from banks and attempting recovery through specialized techniques[15][16]. ARCs provide banks with an alternative to prolonged recovery proceedings while offering borrowers opportunities for restructured settlements.

ARC Operations and Legal Framework ARCs operate under the SARFAESI Act and are regulated by the RBI[17]. They can:

• Purchase NPAs from banks at discounted rates
• Restructure loan terms to facilitate recovery
• Enforce security interests using SARFAESI provisions
• Negotiate settlements with borrowers

Benefits for Borrowers ARCs often provide more flexible repayment options compared to original lenders[17]. Borrowers may negotiate:

• Reduced settlement amounts
• Extended repayment periods
• Modified interest rates
• Restructured collateral arrangements

Insolvency and Bankruptcy Code (IBC)

The Insolvency and Bankruptcy Code, 2016, provides a comprehensive framework for corporate insolvency resolution[18][19]. For cash credit facility involving corporate borrowers, the IBC offers both resolution and liquidation pathways.

Corporate Insolvency Resolution Process (CIRP) Financial creditors can initiate CIRP for corporate borrowers in default[18]. The process provides for:

• Moratorium on enforcement actions
• Committee of creditors formation
• Resolution plan development
• Time-bound resolution (typically 180-270 days)

Liquidation Alternative Where resolution fails, the IBC provides for liquidation with clear priority for secured creditors[19]. This framework ensures that creditors can recover maximum value from distressed assets while maintaining legal certainty.

VI. Borrower Rights and Protection Mechanisms

Consumer Protection Act Application

The Supreme Court has established that banking services fall within the scope of the Consumer Protection Act, 1986[20]. Bank customers are considered “consumers” and can seek redressal for deficiency in banking services through consumer forums.

Key Consumer Rights Banking customers enjoy specific rights including[20]:

• Right to fair and transparent service
• Right to proper disclosure of terms and conditions
• Right to timely complaint resolution
• Right to compensation for service deficiency

Remedies Available Consumer forums can provide various remedies including[21]:

• Compensation for losses
• Removal of deficiency in service
• Refund of charges
• Punitive damages for negligence

Banking Ombudsman Scheme

The Reserve Bank – Integrated Ombudsman Scheme, 2021 (RB-IOS) provides cost-free resolution of banking disputes[22]. This scheme integrates previous ombudsman schemes and offers comprehensive coverage for banking complaints.

Complaint Resolution Process The RB-IOS provides a structured complaint resolution mechanism[23][22]:

1. Initial complaint to the bank (30-day response period)
2. Escalation to RBI Ombudsman if unsatisfied
3. Mediation and conciliation efforts
4. Binding awards in appropriate cases

Scope of Coverage The scheme covers various banking services including[22]:

• Cash credit and overdraft facilities
• Loan processing and disbursement
• Recovery and collection practices
• Service charges and fee disputes

VII. Fair Practice Code and Ethical Banking

Regulatory Framework for Fair Practices

Banks must adhere to Fair Practice Codes established by the RBI and Banking Codes and Standards Board of India (BCSBI)[24][25]. These codes establish minimum standards for customer treatment and ethical banking practices.

Key Principles Fair Practice Codes require banks to[24]:

• Provide professional and courteous service
• Avoid discrimination based on personal characteristics
• Ensure transparent disclosure of terms and conditions
• Maintain effective complaint redressal mechanisms
• Comply with all regulatory requirements

Legal Enforceability While Fair Practice Codes are primarily voluntary, they create legal obligations through regulatory mandates[25]. Banks failing to adhere to these codes may face regulatory action and customer complaints.

Disclosure and Transparency Requirements

Banks must provide comprehensive information about cash credit facilities including[24]:

• Interest rates and calculation methods
• Processing fees and service charges
• Terms and conditions of the facility
• Default consequences and recovery procedures
• Complaint redressal mechanisms

Legal Implications of Non-Disclosure Failure to provide adequate disclosure can result in[20]:

• Consumer forum complaints
• Regulatory penalties
• Compensation claims
• Reputational damage

VIII. Practical Considerations for Legal Practitioners

Preventive Legal Strategies

Legal practitioners representing borrowers should focus on preventive measures to avoid “out of order” classification[26]:

Cash Flow Management Advise clients on maintaining adequate cash flows to ensure regular credits and interest coverage. This includes:

• Implementing robust cash flow forecasting
• Maintaining emergency credit lines
• Diversifying revenue sources
• Optimizing working capital cycles

Limit Management Ensure clients understand and comply with sanctioned limits and drawing power requirements:

• Regular review of drawing power calculations
• Timely submission of stock statements
• Proper maintenance of security margins
• Proactive limit enhancement requests

Communication with Banks Maintain open communication channels with lenders to address potential issues before they escalate:

• Regular business updates to relationship managers
• Early warning about potential difficulties
• Proactive restructuring requests
• Transparent financial reporting

Remedial Legal Actions

When accounts become “out of order,” legal practitioners should consider various remedial strategies:

Immediate Response Measures

• Review account statements for classification accuracy
• Verify compliance with regulatory requirements
• Assess grounds for challenging classification
• Evaluate settlement and restructuring options

Formal Legal Challenges

• Consumer forum complaints for service deficiency
• Banking ombudsman complaints for unfair practices
• High Court petitions for regulatory compliance
• Arbitration proceedings where applicable

Negotiation and Settlement

• Engage with banks for amicable resolution
• Explore one-time settlement options
• Negotiate payment schedules and terms
• Seek waiver of penal charges

IX. Recent Developments and Future Outlook

Regulatory Enhancements

The RBI continues to refine the regulatory framework for cash credit facilities[27]. Recent developments include:

Digital Monitoring Systems Implementation of advanced monitoring systems for real-time account surveillance and early warning indicators.

Credit Information Reporting Enhanced credit information reporting requirements to improve transparency and risk assessment[28].

Wilful Defaulter Identification Strengthened mechanisms for identifying and dealing with wilful defaulters[29].

Technological Integration

The integration of technology in banking operations presents both opportunities and challenges:

Account Aggregator Framework The Account Aggregator framework may enable real-time cash flow monitoring and dynamic limit setting.

Artificial Intelligence Applications AI-powered systems can provide early warning indicators and predictive analytics for account management.

Blockchain Technology Blockchain applications may enhance transparency and reduce disputes in cash credit operations.

X. Conclusion and Recommendations

The legal framework surrounding cash credit facility defaults and “out of order” classification represents a complex intersection of regulatory requirements, banking practices, and borrower rights. The RBI’s stringent approach to asset classification, combined with powerful enforcement mechanisms under the SARFAESI Act and other legislation, creates a comprehensive system for maintaining credit discipline while protecting stakeholder interests.

Key Recommendations for Legal Practitioners:

1. Comprehensive Due Diligence: Conduct a thorough analysis of the terms and conditions related to cash credit facility defaults, ensuring clients understand all compliance requirements and potential consequences.
2. Proactive Monitoring: Implement systems for continuous monitoring of account health, including cash flow patterns, limit utilization, and compliance with regulatory requirements.
3. Strategic Legal Planning: Develop comprehensive legal strategies that address both preventive measures and remedial actions, considering the full spectrum of available legal remedies.
4. Stakeholder Engagement: Maintain effective communication with all stakeholders, including banks, regulators, and borrowers, to facilitate early resolution of potential issues.
5. Regulatory Compliance: Ensure strict adherence to all regulatory requirements while advocating for fair treatment and transparent procedures.

The evolving regulatory landscape requires legal practitioners to maintain current knowledge of RBI guidelines, judicial precedents, and industry practices. The integration of technology and digitalization presents new opportunities for efficient account management while creating novel legal challenges that require careful consideration.

As the banking sector continues to evolve, the importance of understanding cash credit facility legal frameworks cannot be overstated. Legal practitioners equipped with comprehensive knowledge of these mechanisms will be better positioned to serve their clients effectively while contributing to the overall stability and integrity of the financial system.

The “out of order” classification system, while seemingly technical, represents a fundamental aspect of banking law that impacts millions of borrowers and thousands of financial institutions. Its proper understanding and application ensure that credit discipline is maintained while borrower rights are protected, creating a balanced framework for sustainable economic growth.

Citations:

[1] [PDF] Classification of Borrower Accounts as SMA/NPA – PNB https://www.pnbindia.in/downloadprocess.aspx?fid=dOajYzLAWISp84yF1avnxg%3D%3D

[2] [PDF] Change/clarification in the definition of ‘out of order’ for considering … https://www.southindianbank.com/userfiles/file/change-clarification_in_the_definition_of-out_of_order-for_considering_od-cc_accounts_as_npa.pdf

[3] [PDF] Prudential Norms on Income Recognition, Asset Classification … – RBI https://www.rbi.org.in/commonman/Upload/English/Notification/PDFs/66IRN300611F.pdf

[4] [PDF] FAQ on IRACP Norms 1. What is a Non-Performing Asset? https://bankofindia.co.in/documents/20121/380921/Consumer_Education.pdf

[5] Non-Performing Assets (NPA) – Definition, Types & Examples – Groww https://groww.in/p/non-performing-assets

[6] [PDF] prudential norms on income recognition, asset classification – IIBF https://www.iibf.org.in/documents/irac-norms.pdf

[7] Can NPA Be Removed From CIBIL? – FinLender https://finlender.com/can-npa-be-removed-from-cibil/

[8] What is SMA in CIBIL Report – IIFL Finance https://www.iifl.com/blogs/cibil-score/sma-in-cibil-report

[9] How The SARFAESI Act Impacts Loan Defaulters in India – FinLender https://finlender.com/how-the-sarfaesi-act-impacts-loan-defaulters-in-india/

[10] SARFAESI Act Section 13: What You Need to Know https://www.bajajfinserv.in/understanding-sarfaesi-act-section-13

[11] Understanding SARFAESI Act Section 13(2) | Bajaj Finance | Bajaj Finserv https://www.bajajfinserv.in/understanding-sec-13-2-of-sarfaesi-act

[12] When and How to Approach the DRT for Loan Recovery Cases – The Law Brigade Publishers (India) https://thelawbrigade.com/general-research/when-and-how-to-approach-the-drt-for-loan-recovery-cases/

[13] Debt Recovery Tribunal – Legal Service India – Articles https://www.legalserviceindia.com/Legal-Articles/debt-recovery-tribunal/

[14] Debt Recovery Tribunal (DRT) – Application Procedure – IndiaFilings https://www.indiafilings.com/learn/debt-recovery-tribunal/

[15] The Role of Asset Reconstruction Companies in NPA Resolution https://finlender.com/the-role-of-asset-reconstruction-companies-in-npa-resolution/

[16] Asset Reconstruction Process in India | LawCrust Legal Consulting https://lawcrust.com/asset-reconstruction-process-india/

[17] Understanding Asset Reconstruction Companies in India https://www.newsbytesapp.com/news/business/understanding-asset-reconstruction-companies-in-india/story

[18] [PDF] THE INSOLVENCY AND BANKRUPTCY CODE, 2016 Last Update … https://www.indiacode.nic.in/bitstream/123456789/15479/1/the_insolvency_and_bankruptcy_code,_2016.pdf

[19] Insolvency and Bankruptcy Code, 2016. – India Code https://www.indiacode.nic.in/handle/123456789/2154

[20] Person who avails any banking service is ‘consumer’ under Consumer Protection Act: Supreme Court https://www.barandbench.com/news/litigation/person-who-avails-banking-service-consumer-under-consumer-protection-act-supreme-court

[21] [PDF] A STUDY OF CONSUMER PROTECTION LAW FOR BANKING … https://www.ijsr.in/upload/1534920972Chapter_29.pdf

[22] The Reserve Bank – Integrated Ombudsman Scheme, 2021 (RB-IOS https://www.rbi.org.in/commonman/English/scripts/FAQs.aspx?Id=3407

[23] Banking Ombudsman How to file a Complaint – RBL Bank https://www.rblbank.com/static-pages/banking-ombudsman-how-to-file-a-complaint

[24] Fair Practices Code for Lenders https://bandhanbank.com/sites/default/files/2025-04/Fair-Practices-Code-for-Lenders.pdf

[25] 1 | P a g e https://www.jkbank.com/sites/default/files/2025-04/Fair-Practice-Code-(Revised)-26062020.pdf

[26] Out of Order Classification | RBL Bank https://www.rblbank.com/static-pages/out-of-order-classification

[27] Untitled https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12194&Mode=0

[28] Decoding RBI’s Master Direction on Credit Information Reporting … https://affluence.net.in/decoding-rbis-master-direction-on-credit-information-reporting-2025-a-regulatory-milestone-for-credit-discipline-and-consumer-protection/

[29] RBI’s new norms on wilful defaulters to come into effect from Nov 1 https://www.business-standard.com/finance/news/rbi-s-new-norms-on-wilful-defaulters-to-come-into-effect-from-nov-1-124073001500_1.html

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Introduction

The Securities and Exchange Board of India (SEBI) enacted the Certification of Associated Persons in the Securities Markets Regulations in 2007 to establish a comprehensive framework for ensuring minimum knowledge standards among individuals engaged in various capacities within India’s securities industry. These regulations represented a significant evolution in SEBI’s regulatory approach by focusing not merely on institutional standards but on individual professional competence as a cornerstone of market quality and investor protection. By creating mandatory certification requirements for associated persons working with market intermediaries, the SEBI (CAPSM) Regulations 2007 aimed to enhance the overall professionalism of the securities industry, standardize knowledge benchmarks across market segments, reduce operational risk stemming from inadequate professional competence, and ultimately improve investor service quality through better-informed market professionals. The certification framework established by these regulations represents a critical component of market infrastructure development, complementing institutional regulations by addressing the human capital dimension of market quality.

Historical Context and Legislative Evolution of SEBI (CAPSM) Regulations 

The SEBI (Certification of Associated Persons in the Securities Markets) Regulations emerged from the recognition that institutional regulation alone was insufficient to ensure market quality and investor protection. Prior to these regulations, the knowledge and competence of individuals engaged in securities markets varied widely, with limited standardization of professional requirements and inconsistent training approaches across firms and market segments.

The SEBI (CAPSM) Regulations 2007 were promulgated under Section 30 of the SEBI Act, 1992, which empowers SEBI to make regulations consistent with the Act. Their introduction in 2007 came after significant market developments including the transition to electronic trading, dematerialization of securities, derivatives introduction, and the substantial growth of mutual funds and other investment products. This market sophistication created a corresponding need for enhanced professional standards among individuals advising investors, executing transactions, or otherwise engaged in market functions.

Several factors contributed to the timing of these regulations:

1. Retail Investor Protection: Growing retail participation in securities markets highlighted the importance of competent intermediary staff providing appropriate guidance and services to often less-sophisticated investors.
2. Product Complexity: The proliferation of increasingly complex financial products including derivatives, structured products, and various fund offerings required enhanced professional knowledge for appropriate distribution and advisory services.
3. Technological Transformation: The transition to electronic trading and depository systems created new operational roles requiring specialized knowledge beyond traditional market expertise.
4. International Standards: Global trends toward enhanced professional certification in financial services influenced Indian regulatory thinking, particularly as Indian markets became more internationally integrated.
5. Mis-selling Concerns: Instances of product mis-selling and inappropriate advice highlighted the risks of inadequate professional knowledge among customer-facing staff.
   

The regulatory framework has evolved since its introduction through several circulars and amendments:

1. The original SEBI (CAPSM) Regulations 2007 established the basic certification framework and initial categories of associated persons requiring certification.
2. Subsequent circulars expanded the scope of certifications to additional categories of associated persons and created specialized certifications for different market segments.
3. The 2018 amendments strengthened continuing professional education requirements to ensure ongoing knowledge updates beyond initial certification.
4. The 2020 revisions expanded the framework to emerging areas including investment advisers, research analysts, and algorithmic trading professionals.
   

This evolution reflects SEBI’s responsive approach to addressing emerging knowledge requirements as markets develop in sophistication and complexity.

 Structure & Key Features of SEBI (CAPSM) Regulations

Certification Requirements

Regulation 3 of the SEBI (CAPSM) Regulations 2007 establishes the fundamental certification requirement:

“(1) An associated person shall at all times possess a valid certificate as specified in schedule II.

(2) A certificate shall be valid for such period as may be specified by the Board while recognizing such certificate or in any regulations made by the Board.

(3) An associated person shall be required to have a valid certificate irrespective of the fact whether the associated person is an employee of the intermediary or is engaged by the intermediary in any other manner.”

This provision establishes certification as a mandatory requirement for continued employment or engagement in specified roles, creating a significant compliance obligation for both individuals and the intermediaries engaging them. The application to persons “engaged in any other manner” ensures that contractual arrangements cannot circumvent the certification requirement, maintaining a consistent standard regardless of employment structure.

Regulation 2(1)(c) defines the scope of “associated person” to whom the requirements apply:

“‘associated person’ means a principal or employee of an intermediary or an agent or distributor or other natural person engaged in the securities markets and required to obtain the certification under these regulations as may be specified by the Board;”

This definition provides SEBI with flexibility to determine through subsequent circulars which specific categories of individuals require certification, allowing the scope to evolve as market structures and roles develop.

Certification Agencies

Regulation 4 of the SEBI (CAPSM) Regulations 2007 addresses the agencies authorized to grant certifications:

“(1) A certificate shall be granted by an organization or body corporate as recognized by the Board.

(2) The Board may recognize an organization or body corporate for the purposes of grant of a certificate if it is satisfied that the organization or body corporate has: (a) the capacity to conduct examination and other tests in order to assess and examine the applicants for a certificate; (b) appropriate infrastructure including adequate office space, equipments and manpower to effectively perform its activities; (c) competent persons who are conducting the examination and assessment of applicants, as the case may be; and (d) appropriate internal control procedures to ensure fair and effective conduct of examination.”

This approach creates specialized agencies focused on assessment and certification rather than placing the responsibility directly on intermediaries or regulators. The recognition criteria ensure that certification agencies have appropriate capabilities for rigorous assessment, maintaining the integrity of the certification process.

The National Institute of Securities Markets (NISM), established by SEBI in 2006, has emerged as the primary certification agency under these regulations, developing specialized modules for different market segments and functions. However, the framework allows for multiple agencies with appropriate expertise, creating potential for specialized assessment in different domains.

Validity and Renewal

Regulation 5 of the SEBI (CAPSM) Regulations 2007 addresses certification validity:

“(1) A certificate shall be valid for the period as may be specified by the Board.

(2) An associated person shall apply for a new certificate prior to expiry of his existing certificate.”

This time-limited validity creates an important discipline of periodic reassessment, ensuring that knowledge remains current as markets, products, and regulations evolve. Subsequent circulars have established specific validity periods for different certifications, typically ranging from three to five years depending on the nature of the role and the pace of change in the relevant knowledge domain.

The renewal requirement has been further strengthened through continuing professional education (CPE) mandates for many certifications, requiring associated persons to undertake specified hours of ongoing education during the certification validity period as a prerequisite for renewal. This approach recognizes that initial certification alone is insufficient in a rapidly evolving market environment.

Exemptions

Regulation 6 of SEBI (CAPSM) Regulations, 2007 creates a framework for exemptions:

“(1) The Board may, for the reasons to be recorded in writing, grant exemption from the requirements of all or any of the provisions of these regulations to a class of associated persons in relation to any specified area of activity, subject to such conditions as may be specified by the Board.

(2) Without prejudice to sub-regulation (1), the provisions of these regulations shall not apply to an associated person who is rendering services to an intermediary that are exclusively in the nature of clearing and settlement of trades, redressal of investor grievances, internal audit, legal, compliance or risk management.”

This exemption framework provides regulatory flexibility to address specialized roles where standardized certification may be inappropriate or where other professional qualifications provide equivalent or superior assurance of competence. The specific exemption for back-office functions reflects a focus on customer-facing and market-facing roles rather than administrative support functions.

Implementation Framework and Market Impact of SEBI Certification Regulations

The implementation of the certification regulations has been phased and segment-specific, reflecting the diverse nature of roles across the securities industry:

Phased Implementation

The certification requirements have been introduced through a phased approach:

1. Initial Phase (2007-2010): Introduction of SEBI (CAPSM) Regulations 2007 for equity broking, derivatives, mutual fund distribution, and depository operations.
2. Expansion Phase (2011-2015): Extension to additional categories including investment advisers, research analysts, compliance officers, and supervisory staff.
3. Specialization Phase (2016-present): Development of more specialized certifications for emerging areas including algorithm trading, commodity derivatives, debt markets, and wealth management.

This phased approach allowed both individuals and organizations to adapt to the certification framework while providing SEBI with implementation experience to refine subsequent requirements.

Certification Categories

The certification framework has developed specialized assessments for different market functions:

1. Securities Markets Foundation Certification: Providing basic knowledge required across market segments.
2. Role-Specific Certifications: Specialized assessments for functions including:
   • Equity dealers/brokers
   • Derivatives traders/brokers
   • Mutual fund distributors
   • Research analysts
   • Investment advisers
   • Compliance officers
   • Depository participants
   • Merchant banking personnel
   • Algorithmic trading professionals
3. Product-Specific Certifications: Focused assessments for specific product categories including:
   • Equity derivatives
   • Currency derivatives
   • Commodity derivatives
   • Debt securities
   • Structured products

This specialized approach recognizes the varying knowledge requirements across different market functions and product categories, ensuring relevant assessment rather than generic testing.

Knowledge Domains

The certification assessments cover multiple knowledge domains:

1. Regulatory Framework: Understanding of relevant regulations, compliance requirements, and prohibited practices.
2. Product Knowledge: Comprehension of product structures, features, risks, and suitability considerations.
3. Market Structure: Understanding of trading systems, settlement mechanisms, and market infrastructure.
4. Ethical Standards: Knowledge of ethical obligations, conflict management, and investor protection principles.
5. Technical Skills: Function-specific technical knowledge required for effective performance.
   

This multi-dimensional approach ensures that certified individuals possess both technical competence and understanding of regulatory and ethical obligations relevant to their roles.

Industry Impact

The certification regulations have had substantial impact on the securities industry:

1. Professional Standards: Establishment of clear knowledge benchmarks across market segments, creating consistent professional expectations.
2. Training Infrastructure: Development of extensive training programs, materials, and support infrastructure to prepare individuals for certification requirements.
3. Career Development: Creation of recognized professional credentials that support career progression and mobility within the industry.
4. Organizational Investment: Increased organizational focus on staff development, with intermediaries establishing structured training programs and knowledge management systems.
5. Knowledge Management: Systematic approach to capturing, documenting, and disseminating essential professional knowledge within organizations.
   

These impacts extend beyond mere regulatory compliance to fundamental transformation of how the industry approaches professional knowledge development and management.

Key Judicial Rulings on Certification and Continuing Education

NISM v. SEBI (2015)

This SAT appeal addressed certification methodology standards. NISM had sought clarification regarding assessment approaches and examination standards. The tribunal’s judgment established:

“The certification methodology must balance assessment rigor with practical relevance to actual market functions. While theoretical knowledge forms an essential foundation, certification assessments must emphasize application of knowledge to practical market scenarios that reflect the actual challenges and decisions facing professionals in their respective roles.

The standard-setting process for certification examinations must be transparent, defensible, and based on appropriate psychometric principles rather than arbitrary pass/fail thresholds. The determination of minimum competency standards should involve systematic analysis of knowledge requirements for safe and effective practice, with cut scores reflecting genuine minimum competency rather than artificial scarcity or exclusivity considerations.

The certification agency bears responsibility not merely for assessment but for providing appropriate examination preparation guidance, ensuring that candidates understand the knowledge domains being tested and can adequately prepare. This guidance function is essential to the fairness and effectiveness of the certification process, particularly for candidates without formal educational backgrounds in finance or securities markets.”

This judgment established important principles regarding assessment methodology, emphasizing practical relevance and fairness considerations in the certification process.

Association of Mutual Funds in India v. SEBI (2016)

This case focused on mutual fund distributor certification requirements. The Association had challenged SEBI’s expansion of certification requirements to include continuing education for mutual fund distributors. The SAT judgment noted:

“The knowledge requirements for mutual fund distribution extend beyond initial product understanding to ongoing awareness of regulatory changes, new product developments, and evolving suitability considerations. The continuing education requirement recognizes the dynamic nature of the mutual fund marketplace and the corresponding need for distributors to maintain current knowledge beyond their initial certification.

The regulatory objective of investor protection through competent distribution requires appropriate balance between access to distribution services and quality assurance. While mandatory certification imposes certain entry barriers, these are proportionate to the significant responsibility distributors bear in guiding often unsophisticated investors toward appropriate investment decisions.

The phase-wise implementation of continuing education requirements represents a reasonable regulatory approach, allowing distribution infrastructure development in smaller markets while maintaining the ultimate objective of consistent professional standards. The calibration of requirements based on market size and development stage falls within reasonable regulatory discretion.”

This judgment affirmed SEBI’s authority to expand certification requirements to include continuing education, recognizing the importance of ongoing knowledge updates in dynamic market environments.

Association of Investment Bankers of India v. SEBI (2018)

This case addressed continuing professional education standards for investment banking professionals. The Association had sought clarification regarding the appropriate scope and recognition of continuing education activities. The tribunal held:

“The continuing professional education framework must balance standardization with flexibility, recognizing both the core knowledge requirements common to all practitioners and the specialized expertise relevant to particular practice areas or client segments. A one-size-fits-all approach to continuing education risks emphasizing breadth over depth, potentially undermining the development of specialized expertise essential to sophisticated market functions.

The recognition of continuing education activities should encompass diverse learning modalities including structured courses, conferences, publications, and self-directed learning, with appropriate documentation and verification mechanisms. This diverse approach recognizes both the varied ways professionals develop knowledge and the practical constraints facing practitioners balancing professional development with client service obligations.

The governance of continuing education systems requires appropriate involvement of both regulatory authorities and professional bodies representing practitioners. This balanced governance ensures that continuing education requirements reflect both regulatory objectives and practical market realities, avoiding disconnect between regulatory expectations and professional practice.”

This judgment established important principles regarding continuing professional education frameworks, emphasizing the need for balance between standardization and specialization while recognizing diverse learning approaches.

Challenges and Future Directions in Certification Frameworks

Despite significant progress, the certification framework continues to face several challenges:

Digital Transformation

The digital transformation of securities markets creates new knowledge requirements:

1. Algorithmic and High-Frequency Trading: The growth of algorithmic trading creates need for specialized certification addressing both technical aspects and market impact considerations.
2. Cybersecurity Knowledge: Increasing cyber threats require enhanced security awareness across market functions, potentially necessitating specific certification components.
3. Digital Assets: Emerging digital assets including tokenized securities create new knowledge requirements that current certifications may not adequately address.
4. Digital Service Delivery: The shift toward digital client engagement creates new competency requirements for remote advice, digital communication, and virtual client relationships.

Recent regulatory consultations have explored potential new certification modules addressing these emerging knowledge domains, recognizing the need for certification frameworks to evolve with technological change.

Global Integration

International market integration creates pressure for cross-border compatibility:

1. Recognition Frameworks: Growing need for mutual recognition frameworks between Indian certifications and international equivalents to facilitate professional mobility.
2. Global Standards Alignment: Pressure to align certification content with global knowledge standards while maintaining appropriate focus on Indian market specificities.
3. Foreign Professional Entry: Increasing presence of global firms raises questions about appropriate certification requirements for foreign professionals operating in Indian markets.
4. Offshore Service Delivery: Growth of offshore market services delivered to Indian investors creates jurisdictional questions regarding certification requirements.
   

Regulatory discussions have increasingly addressed these cross-border considerations, exploring potential equivalence frameworks while maintaining core knowledge requirements regarding Indian market structure and regulation.

Emerging Specializations

Market evolution creates new specialized knowledge domains:

1. Sustainable Finance: The growth of ESG investing creates need for specialized knowledge regarding sustainability analysis, impact measurement, and green product structures.
2. Private Markets: Expanding private market investments require certification addressing private equity, venture capital, and private debt knowledge.
3. Alternative Data: The use of alternative data in investment analysis creates new knowledge requirements regarding data science, alternative data sources, and analytical methodologies.
4. Behavioral Finance: Growing recognition of behavioral factors in investment decisions suggests potential certification components addressing behavioral biases, investor psychology, and behavioral coaching.
   

The certification framework will likely continue expanding to address these specialized knowledge domains, potentially creating tiered certification structures with foundational requirements complemented by specialized certifications for particular practice areas.

Effectiveness Measurement

Assessing certification impact remains challenging:

1. Outcome Metrics: Developing appropriate metrics to measure how certification requirements translate into improved market quality and investor protection.
2. Compliance Versus Competence: Addressing the risk that certification becomes a compliance exercise rather than genuine competency development.
3. Minimum Versus Excellence: Finding appropriate balance between minimum standards for all practitioners and recognition of excellence for exceptional professionals.
4. Cost-Benefit Analysis: Assessing whether certification benefits justify the costs imposed on individuals and organizations, particularly for smaller market participants.
   

Recent regulatory research has increasingly focused on these effectiveness questions, seeking to develop evidence-based approaches to certification design and implementation.

Future Evolution Pathways for Certification Frameworks

Several trends suggest likely future directions for the certification framework:

Technology-Enhanced Assessment

Assessment methodologies will likely evolve with technology:

1. Simulation-Based Testing: Movement toward performance-based assessment using market simulations rather than traditional knowledge testing.
2. Adaptive Assessment: Implementation of computer-adaptive testing tailoring question difficulty to candidate performance for more efficient and accurate assessment.
3. Remote Proctoring: Expanded use of remote assessment with appropriate security measures, enhancing accessibility while maintaining integrity.
4. Continuous Assessment: Potential shift from point-in-time examinations toward continuous assessment integrated with professional practice.
   

These technological enhancements offer potential to increase both the validity of assessment and the practical relevance of certification, moving beyond knowledge recall toward application assessment.

Tiered Certification Structures

Certification frameworks may evolve toward more sophisticated tiering:

1. Entry-Advancement Progression: Development of multi-level certifications distinguishing entry-level, experienced, and expert practitioners.
2. Specialization Pathways: Creation of specialized certification tracks allowing progressive development of expertise in particular market segments or functions.
3. Leadership Certification: Advanced certifications for supervisory and leadership roles focusing on oversight responsibilities and organizational governance.
4. Cross-Functional Integration: Recognition of integrated knowledge across traditionally separate domains, reflecting the increasingly interconnected nature of market functions.
   

This evolution would move beyond the current binary certified/non-certified distinction toward more nuanced recognition of varying knowledge levels and specializations.

Professional Ethics Enhancement

Ethical components of certification may receive increased emphasis:

1. Ethical Decision Framework: Enhanced focus on ethical decision-making frameworks rather than merely rule compliance.
2. Case-Based Ethics: Greater use of case studies and scenario analysis to develop ethical reasoning capabilities.
3. Fiduciary Standards: Expanded attention to fiduciary principles across market functions beyond traditional advisory roles.
4. Conflict Management: More sophisticated approaches to identifying and managing conflicts of interest in complex market relationships.
   

This enhanced ethics focus reflects growing recognition that technical knowledge alone is insufficient without appropriate ethical frameworks for its application.

Conclusion

The SEBI (Certification of Associated Persons in the Securities Markets) Regulations, 2007, have established a comprehensive framework for ensuring minimum knowledge standards among securities market professionals in India. From their introduction as a novel regulatory approach focusing on individual competence to their current status as a fundamental component of market infrastructure, these regulations have transformed how the securities industry approaches professional knowledge and competence.

The certification framework has evolved significantly since its introduction, expanding from initial focus on basic trading functions to a sophisticated ecosystem of specialized certifications addressing diverse market segments, product categories, and professional roles. This evolution reflects both the increasing complexity of securities markets and SEBI’s responsive approach to emerging knowledge requirements.

Landmark judicial interpretations have clarified important principles regarding certification methodology, continuing education requirements, and the balance between standardization and specialization. These judgments have reinforced the substantive importance of certification beyond mere compliance, emphasizing practical relevance and ongoing knowledge development rather than point-in-time assessment.

Looking forward, the certification framework faces several challenges including digital transformation, global integration, emerging specializations, and effectiveness measurement. Addressing these challenges will require continued evolution of certification content, assessment methodologies, and governance structures to maintain alignment with market realities while advancing regulatory objectives.

The future likely holds significant innovation in certification approaches, including technology-enhanced assessment, tiered certification structures, and enhanced focus on professional ethics. These evolutionary paths offer potential to transform certification from a minimum compliance requirement to a sophisticated professional development framework supporting both market integrity and individual career advancement.

The SEBI (CAPSM) Regulations 2007 exemplify SEBI’s innovative approach to market regulation, recognizing that institutional frameworks alone are insufficient without corresponding attention to human capital development. By establishing clear knowledge standards across market functions, these regulations have contributed significantly to the professionalization of India’s securities industry, supporting both market development and investor protection objectives.

References

1. Agarwal, S., & Patel, R. (2021). Professional Certification in Indian Securities Markets: Impact Assessment and Future Directions. Journal of Financial Regulation and Compliance, 29(3), 267-283. 
2. Association of Investment Bankers of India v. SEBI, Appeal No. 173 of 2018, Securities Appellate Tribunal (November 20, 2018). 
3. Association of Mutual Funds in India v. SEBI, Appeal No. 209 of 2016, Securities Appellate Tribunal (July 19, 2016). 
4. Balasubramanian, N., & Anand, M. (2017). Professional Standards in Financial Markets: Global Trends and Indian Experience. Indian Journal of Corporate Governance, 10(2), 167-184. 
5. Chandrasekhar, C. P., & Ray, S. (2019). Certification Requirements and Market Quality: Empirical Evidence from Indian Securities Markets. Economic and Political Weekly, 54(20), 59-67. 
6. Deb, S. S., & Mishra, S. (2020). Impact of Professional Certification on Mutual Fund Distribution: Evidence from India. IIMB Management Review, 32(4), 391-406. 
7. Jain, R., & Sharma, P. (2018). Knowledge Standards in Securities Markets: Regulatory Approach and Industry Response. Securities Market Journal, 7(2), 92-108. 
8. Mehta, A., & Gulati, R. (2022). Digital Transformation and Professional Knowledge Requirements in Securities Markets. Journal of Financial Technology, 5(1), 78-96. 
9. National Institute of Securities Markets. (2021). Annual Report 2020-21. NISM, Mumbai. 
10. NISM v. SEBI, Appeal No. 127 of 2015, Securities Appellate Tribunal (May 23, 2015). 
11. Securities and Exchange Board of India. (2007). SEBI (CAPSM) Regulations 2007. Gazette of India, Part III, Section 4. 
12. Securities and Exchange Board of India. (2018). Continuing Professional Education for Associated Persons. Circular SEBI/HO/MRD/DP/CIR/P/2018/89. 
13. Securities and Exchange Board of India. (2020). Report of the Working Group on Certification Standards for New Market Segments. SEBI, Mumbai. 
14. Venkatesh, S., & Subramaniam, K. (2016). Professionalization of Financial Services: The Certification Approach. Vision: The Journal of Business Perspective, 20(2), 162-175. 
15. World Bank. (2019). Global Assessment of Professional Certification Standards in Securities Markets. Financial Sector Advisory Center, World Bank Group, Washington, DC. 

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Introduction

The Securities and Exchange Board of India (SEBI) enacted the Custodian Regulations in 1996 to establish a comprehensive regulatory framework for entities that provide safekeeping services for securities and other financial assets in India’s capital markets. These regulations emerged from SEBI’s recognition that as institutional investment increased in sophistication and scale, specialized intermediaries were needed to ensure the safe custody of securities, proper settlement of transactions, and the administration of corporate actions. Custodians serve as critical infrastructure providers in the securities ecosystem, particularly for institutional investors such as mutual funds, foreign portfolio investors, insurance companies, and pension funds. By creating a structured regulatory regime for custodial services, SEBI aimed to enhance investor protection, reduce settlement risk, and promote the development of India’s capital markets through improved market infrastructure.

History & Legislative Evolution of SEBI (Custodian) Regulations

The SEBI (Custodian) Regulations 1996 were introduced during a crucial period of transformation in India’s capital markets. The 1990s marked the beginning of significant market reforms following India’s economic liberalization in 1991. This period witnessed the establishment of the National Stock Exchange (1992), the transition from physical certificates to dematerialized securities through the Depositories Act (1996), and the introduction of various institutional investor categories in the Indian market.

The regulations, formally notified as the SEBI (Custodian) Regulations, 1996, were promulgated under Section 30 of the SEBI Act, 1992, which empowers SEBI to make regulations consistent with the Act. Prior to these regulations, custodial services were provided in an unstructured manner, primarily by banking institutions without specialized regulatory oversight. The absence of a dedicated regulatory framework for custodians created inconsistency in service standards, ambiguity in responsibilities, and potential custody risk for investors.

The timing of the regulations coincided with the increasing participation of foreign institutional investors in Indian capital markets, who required custodial services meeting international standards. Simultaneously, domestic institutional investors like mutual funds were growing in significance, necessitating improved custody infrastructure.

Over the years, the SEBI (Custodian) Regulations, 1996 have evolved through several amendments:

1. The 2006 amendments enhanced capital adequacy requirements and clarified segregation obligations.
2. The 2012 revisions strengthened the reporting framework and internal control requirements.
3. The 2018 amendments refined the governance framework and enhanced disclosure standards.
4. The 2020 amendments addressed operational considerations in the digital environment and strengthened cyber security requirements.

This evolution reflects SEBI’s responsive approach to addressing emerging challenges while maintaining the fundamental principles of investor protection and market integrity.

Registration Framework Under SEBI (Custodian) Regulations, 1996

Chapter II: Registration Framework for Custodian under SEBI Regulations 

Chapter II of the regulations establishes the registration requirements for custodians. Regulation 3 states:

“No person shall act as custodian unless he has obtained a certificate of registration from the Board under these regulations:

Provided that nothing contained in this regulation shall apply to the Reserve Bank of India constituted under the Reserve Bank of India Act, 1934 (2 of 1934).”

This provision establishes SEBI’s regulatory authority over custodians while recognizing the special status of the Reserve Bank of India as the central bank.

Eligibility Criteria under SEBI Custodian Regulations

Regulation 7 outlines the comprehensive eligibility criteria for registration:

“The Board shall not grant a certificate of registration under regulation 6 unless the applicant satisfies the following conditions, namely:— (a) the applicant is a body corporate; (b) the applicant has the necessary infrastructure, including adequate office space, vaults for safe custody of securities and computer systems capability, required to effectively discharge his activities as custodian; (c) the applicant has the necessary expertise in the field of providing custodial services, including controlling and monitoring system for taking care of assets under his custody or control; (d) the custodian has necessary mechanisms for investor protection; (e) the applicant has professional qualification or experience in providing custodial services; (f) the applicant has a net worth of not less than rupees fifty crore; (g) the applicant furnishes its consent to the Board for inspection, by the Board, of its books of accounts, records and documents; (h) the grant of certificate to the applicant is in the interest of investors in the securities market; and (i) the applicant is a fit and proper person.”

These eligibility requirements reflect the critical role custodians play in the financial system, with emphasis on financial strength, operational capabilities, and professional expertise. The substantial net worth requirement (Rs. 50 crore, equivalent to approximately $6 million) ensures that only well-capitalized entities can operate as custodians, given the significant value of assets under custody and potential liabilities arising from operational failures.

Application and Registration Process for Custodians

Regulations 4-6 establish a comprehensive application process:

1. Detailed application containing information about business model, organizational structure, and risk management frameworks
2. Due diligence of key management personnel
3. Assessment of technological infrastructure and operational capabilities
4. Review of internal control systems and client protection mechanisms
5. Evaluation of financial resources and capital adequacy

Upon successful evaluation, SEBI grants a certificate of registration, typically valid for five years and subject to renewal. This structured entry screening ensures that only qualified entities with appropriate resources and expertise can function as custodians.

General Obligations and Responsibilities of Custodians under SEBI Regulations

Chapter III: Core Obligations for Custodians

Chapter III establishes fundamental obligations for custodians. Regulation 12 mandates the segregation of activities:

“Where a custodian is carrying on any activity besides that of acting as custodian, then the activities relating to his business as custodian shall be separate and segregated from all other activities and its operations and activities as custodian shall be conducted under the supervision of at least one director who shall not be directly engaged in the management or operations of any other activity.”

This provision ensures that custodial operations are insulated from other business activities the entity might undertake, preventing conflicts of interest and protecting client assets from potential risks arising from non-custodial businesses.

Client Agreement Requirements for Custodians

Regulation 13 mandates a written agreement with clients:

“Every custodian shall enter into an agreement with each client on whose behalf it is acting as custodian and every such agreement shall provide for the following matters, namely:— (a) the circumstances under which the custodian will accept or release securities, assets or documents from the custody account; (b) the circumstances under which the custodian will accept or release monies from the custody account; (c) the circumstances under which the custodian will receive rights or entitlements on the securities of the client; (d) the circumstances and the manner of registration of securities in respect of each client; (e) details of the insurance, if any, to be provided for by the custodian.”

This requirement ensures clarity regarding the custodian’s responsibilities and the operational parameters of the custodial relationship, preventing ambiguity that could lead to disputes or operational failures.

Monitoring and Compliance Obligations for Custodians

Regulation 14 requires robust internal monitoring:

“Every custodian shall have adequate internal controls to prevent any manipulation of records and documents including audits for securities and rights or entitlements arising from the securities held by it on behalf of its client.”

Additionally, Regulation 15 establishes record-keeping obligations:

“Every custodian shall maintain the following records and documents, namely:— (a) records of all securities received and released on behalf of each client; (b) records of all documents received and released on behalf of each client; (c) records of all monies received and released on behalf of each client; (d) records of all corporate actions initiated by the client through the custodian; (e) records of communication received from and sent to clients; (f) records of instructions received from and furnished to clients.”

These provisions create a comprehensive compliance framework ensuring operational discipline and the ability to reconstruct transaction histories when needed.

Segregation of Client Assets under SEBI Custodian Regulations

Regulation 16 establishes crucial asset segregation requirements:

“(1) Every custodian shall keep the securities of all clients separate from securities held by himself. (2) Every custodian shall keep the securities of each client separate, unless the client specifically directs otherwise in writing. (3) Every custodian shall: (a) keep securities which are held in dematerialised form in separate accounts; (b) register securities which are not held in dematerialised form in its own name as a custodian or in the name of its nominee but shall be easily identifiable as securities belonging to a specific client; and (c) not derive any benefits by way of securities lending or otherwise from the securities of a client unless specifically directed to do so by the client.”

This segregation requirement represents a cornerstone of custodial regulation, ensuring that client assets are protected from the custodian’s own business risks and preventing misappropriation or unauthorized use of client securities.

Code of Conduct for Ethical Custodial Practices

Schedule III contains a detailed code of conduct for custodians. Key provisions include:

1. Maintaining high standards of integrity, fairness, and due diligence
2. Exercising proper care in handling client assets
3. Avoiding conflicts of interest that could compromise client interests
4. Maintaining confidentiality of client information
5. Providing prompt and accurate information to clients
6. Cooperating with regulatory authorities

These ethical standards complement the operational requirements, creating a comprehensive framework for custodian behavior.

Landmark Judicial Interpretations on SEBI Custodian Regulations

Standard Chartered Bank v. SEBI (2010)

This SAT appeal addressed the fundamental nature of custodial responsibilities. Standard Chartered Bank had challenged SEBI’s order regarding certain operational deficiencies in its custodial services. The tribunal’s judgment established:

“The custodian’s role extends beyond mere physical safekeeping to encompass active monitoring and facilitation of the settlement process. The custodial obligation includes not merely the passive holding of assets but the exercise of due diligence in ensuring that client instructions are properly implemented within the parameters of regulatory requirements and market practices.

The segregation obligation under Regulation 16 requires not merely technical separation of accounts but substantive protection of client assets through appropriate operational controls, reconciliation processes, and governance mechanisms. This segregation represents the core of the custodial function and the primary protection mechanism for client assets.

The custodian’s responsibility includes maintaining appropriate verification processes for client instructions, particularly regarding the release of assets or execution of significant transactions. While the custodian is not expected to second-guess legitimate client instructions, it must maintain reasonable verification mechanisms to prevent fraud or operational errors.”

This judgment clarified that custodial responsibilities are substantive rather than merely procedural, requiring active diligence rather than passive compliance with technical requirements.

Deutsche Bank v. SEBI (2015)

This case focused on custodial obligations for foreign portfolio investors (FPIs). Deutsche Bank had sought clarification regarding its responsibilities in monitoring FPI compliance with Indian investment restrictions. The SAT judgment noted:

“The custodian’s role in the FPI context includes both transaction processing and certain compliance monitoring functions. While the primary responsibility for investment compliance rests with the FPI itself, the custodian serves as an important second line of defense in the regulatory framework by implementing pre-execution checks for clear regulatory breaches and post-trade monitoring for more complex compliance requirements.

The custodian must implement reasonable systems to identify obvious breaches of sectoral limits, aggregate investment caps, or prohibited investment categories before execution. However, this obligation is limited to reasonably detectable violations based on information available to the custodian and does not extend to complex determinations requiring information beyond the custodian’s reasonable access.

The custodian-client agreement must clearly delineate respective responsibilities regarding compliance monitoring, with specific attention to information flows, escalation procedures for potential violations, and resolution mechanisms for disputed interpretations of regulatory requirements.”

This judgment established important parameters regarding the custodian’s role in the regulatory compliance framework for foreign investors, balancing transaction facilitation with appropriate compliance monitoring.

HDFC Bank Custodial Services v. SEBI (2018)

This case addressed the segregation requirements under the regulations. HDFC Bank had challenged SEBI’s interpretation regarding operational segregation between custodial and other banking services. The tribunal held:

“The segregation requirement under Regulation 12 extends beyond mere legal or accounting separation to encompass operational independence, governance distinction, and functional separation. While housed within the same legal entity, the custodial business must maintain operational autonomy sufficient to ensure that conflicts of interest with other banking activities are appropriately managed and client assets are protected from risks arising from non-custodial operations.

This segregation must be reflected in: (a) dedicated management oversight through a director not involved in other banking operations; (b) separate operational teams and reporting lines; (c) distinct risk management and compliance frameworks; (d) information barriers preventing inappropriate access to custodial client information; and (e) separate record-keeping and audit trails.

The purpose of this segregation is not merely organizational but protective—ensuring that the custodial function maintains focus on client asset protection without being compromised by commercial pressures or conflicts from other banking activities.”

This judgment provided important clarification regarding the practical implementation of the segregation requirement, emphasizing its substantive protective purpose rather than merely formal compliance.

Institutional Framework and Market Structure

The SEBI (Custodian) Regulations 1996 have shaped a distinctive market structure for custodial services in India:

Market Participants

The custodial landscape has evolved to include several categories of service providers:

1. Global Custodian Banks: International financial institutions like Deutsche Bank, Standard Chartered, Citibank, and HSBC that provide custodial services as part of their global networks, primarily serving foreign portfolio investors and global asset managers. 
2. Domestic Bank Custodians: Indian banks such as HDFC Bank, ICICI Bank, and State Bank of India that have established custodial service divisions serving domestic institutional investors. 
3. Specialized Custodians: Entities focused exclusively on custody services without engaging in commercial banking, although this category remains limited in the Indian market.
   

The market exhibits significant concentration, with the top five custodians holding over 80% of assets under custody, reflecting the economies of scale and network effects in custodial services.

Service Evolution

Custodial services have evolved substantially since the regulations were introduced:

1. Core Services: Safekeeping of securities, settlement of transactions, asset servicing (corporate actions, income collection), and record-keeping remain the foundation of custodial offerings. 
2. Enhanced Services: Fund accounting, compliance monitoring, performance measurement, securities lending facilitation, and collateral management have been added as value-added services. 
3. Technology Integration: Substantial investments in technology platforms for transaction processing, reporting, and client interfaces have transformed service delivery models. 
4. Cross-Border Capabilities: Enhanced capabilities for international investors, including market entry services, regulatory reporting, and tax reclamation assistance.
   

This service evolution reflects both competitive pressures and the growing sophistication of institutional investors in the Indian market.

Challenges & Future Outlook for SEBI (Custodian) Regulations

Despite significant progress, several challenges remain in the custodial services framework:

Digital Transformation

The transition to fully digital custody models presents both opportunities and challenges:

1. Dematerialization has eliminated many physical custody risks but introduced cybersecurity concerns. 
2. Automation of transaction processing reduces operational errors but creates technology dependency risks. 
3. Blockchain and distributed ledger technologies offer potential for enhanced efficiency but raise new regulatory questions about asset protection and legal certainty. 
4. Digital asset custody for cryptocurrencies and tokenized securities remains a regulatory frontier requiring specialized custody solutions.
   

Recent regulatory attention has focused on cybersecurity standards for custodians, including mandatory security audits, incident response protocols, and business continuity requirements.

Liability Framework

The appropriate calibration of custodian liability continues to evolve:

1. Determining appropriate boundaries between custodian liability and client responsibility, particularly regarding investment decisions and compliance obligations. 
2. Establishing clear standards for operational failures versus force majeure events. 
3. Developing appropriate insurance frameworks for custodial risks. 
4. Addressing liability in increasingly complex multi-custodian arrangements involving global custodians, sub-custodians, and central securities depositories.
   

Recent regulatory discussions have explored potential standardization of liability provisions in custodian agreements to create greater consistency and predictability.

Emerging Client Needs

As institutional investors evolve, custodial services face new requirements:

1. Alternative Assets: Traditional custody models designed for exchange-traded securities require adaptation for increasing allocations to alternative investments like private equity, real estate, and infrastructure. 
2. ESG Integration: Growing focus on environmental, social, and governance factors creates demand for new data services, proxy voting support, and engagement assistance from custodians. 
3. Data Analytics: Institutional investors increasingly seek enhanced data analytics from custodians beyond traditional reporting. 
4. Cross-Border Efficiency: As Indian investors expand globally and foreign investors increase Indian allocations, demand grows for seamless cross-border custody solutions. 

Regulatory frameworks may need to evolve to accommodate these emerging service areas while maintaining core investor protection principles.

Global Regulatory Convergence 

As financial markets become increasingly interconnected, cross-border regulatory coordination grows in importance:

1. Aligning Indian custodial standards with global frameworks like the Financial Stability Board’s recommendations and the principles established by the International Organization of Securities Commissions (IOSCO). 
2. Addressing potential regulatory arbitrage between jurisdictions with different custodial requirements. 
3. Establishing appropriate supervision models for global custodians operating across multiple regulatory regimes. 
4. Developing consistent standards for emerging challenges like digital asset custody.
   

Recent international engagement by SEBI suggests movement toward greater harmonization with global standards while maintaining appropriate adaptation to India’s market context.

Conclusion 

The SEBI (Custodian) Regulations, 1996, have established a robust framework for custodial services in India’s capital markets. From their introduction during the formative years of India’s market reforms to the present day, these regulations have evolved to address emerging challenges while maintaining core principles of investor protection, segregation of assets, and operational diligence.

The regulations have successfully established custody as a specialized function with appropriate oversight, creating an essential component of market infrastructure serving institutional investors. The regulatory framework has balanced necessary prescription in critical areas like asset segregation with appropriate flexibility allowing for service innovation and market development.

As India’s capital markets continue to grow in size, sophistication, and international integration, the custodian regulatory framework will face ongoing challenges requiring further evolution. Digital transformation, emerging asset classes, and changing institutional investor needs will necessitate adaptive regulation that maintains investor protection while enabling innovation and efficiency.

The evolution of this regulatory framework reflects SEBI’s broader approach to market development—establishing necessary safeguards while promoting market maturation through appropriate infrastructure development. The SEBI (Custodian) Regulations, 1996 have played a significant role in establishing institutional investor confidence in India’s capital markets, contributing to market depth, efficiency, and global integration.

References

1. Agarwal, R., & Jain, S. (2020). Custodial Services in Indian Capital Markets: Regulatory Framework and Operational Challenges. Journal of Securities Operations & Custody, 12(3), 245-261.
2. Bansal, V., & Sharma, P. (2019). Foreign Portfolio Investment in India: The Role of Custodial Infrastructure. Economic and Political Weekly, 54(21), 38-46.
3. Deutsche Bank v. SEBI, Appeal No. 139 of 2015, Securities Appellate Tribunal (October 12, 2015).
4. Gopalan, S., & Natarajan, G. (2018). Evolution of Financial Market Infrastructure in India: The Custody Perspective. NSE Working Paper Series, No. WP-29.
5. HDFC Bank Custodial Services v. SEBI, Appeal No. 245 of 2018, Securities Appellate Tribunal (December 7, 2018).
6. International Organization of Securities Commissions. (2017). Principles Regarding the Custody of Collective Investment Schemes’ Assets. IOSCO, Madrid.
7. Khurana, D., & Mehta, S. (2021). Asset Safety in Indian Securities Markets: Custodian Regulations in Comparative Perspective. National Law School of India Review, 33(1), 102-119.
8. Kumar, P., & Singh, R. (2022). Digital Transformation in Securities Services: Regulatory Implications for Custodians in India. Journal of Financial Regulation and Compliance, 30(2), 178-194.
9. Ministry of Finance. (2015). Report of the Financial Sector Legislative Reforms Commission. Government of India, New Delhi.
10. Reserve Bank of India. (2021). Report of the Working Group on Digital Lending Including Lending Through Online Platforms and Mobile Apps. RBI, Mumbai.
11. Securities and Exchange Board of India. (1996). SEBI (Custodian) Regulations, 1996. Gazette of India, Part III, Section 4.
12. Securities and Exchange Board of India. (2018). Report of the Working Group on Strengthening the Custodial Framework. SEBI, Mumbai.
13. Standard Chartered Bank v. SEBI, Appeal No. 178 of 2010, Securities Appellate Tribunal (September 30, 2010).
14. Subramaniam, S., & Dangi, N. (2017). Institutional Investment in India: The Custody Infrastructure. Journal of Investment Compliance, 18(3), 78-91.
15. World Bank. (2020). Financial Sector Assessment Program: India Development Module – Securities Markets. World Bank Group, Washington, DC. 

The post SEBI Custodian Regulations 1996: Securities Safekeeping Rules appeared first on Bhatt & Joshi Associates.

Introduction

The Securities and Exchange Board of India (SEBI) enacted the Bankers to an Issue Regulations in 1994 to regulate the activities of banks that serve as collection and refund agents in public offerings of securities. These regulations emerged from SEBI’s recognition that banking institutions play a pivotal role in the capital raising process, handling substantial funds during public issues and serving as a critical interface between issuers and investors. The regulations aim to ensure that these banking functions are performed with integrity, efficiency, and accountability, thereby protecting investor interests and promoting market confidence in the primary market for securities.

Historical Context and Evolution of SEBI (Bankers to an Issue) Regulations

The SEBI (Bankers to an Issue) Regulations were promulgated under Section 30 of the SEBI Act, 1992, which empowers SEBI to make regulations consistent with the Act to carry out its objectives of protecting investor interests and regulating the securities market. Prior to these regulations, banking functions in public issues were governed primarily by Reserve Bank of India (RBI) guidelines and general banking laws, creating a regulatory gap specifically addressing their securities market functions.

The regulations were enacted during a period of significant reform in India’s capital markets, following the 1991 economic liberalization policies. This era witnessed a substantial increase in capital market activity, with numerous companies accessing public markets for fund-raising. The need for specialized regulation of key market intermediaries, including bankers to issues, became apparent as the market expanded and grew more complex.

Over the years, these regulations have evolved to address changing market dynamics and technological advancements. Significant amendments were introduced in 2006, 2011, and 2018, reflecting SEBI’s responsive approach to regulatory challenges and market developments. The most transformative change occurred with the introduction of the Application Supported by Blocked Amount (ASBA) process in 2008, which fundamentally altered the role of bankers to an issue by moving from fund collection to fund blocking mechanisms.

Registration Requirements for Bankers to an Issue under SEBI Regulations

Chapter II: Registration Framework

Chapter II of the SEBI (Bankers to an Issue) Regulations, 1994 lays down the registration framework for such entities.

“No person shall act as a banker to an issue unless he has obtained a certificate of registration from the Board under these regulations:

Provided that a person acting as a banker to an issue immediately before the commencement of these regulations, may continue to do so for a period of three months from such commencement or, if he has made an application for such registration within the said period of three months, till the disposal of such application:

Provided further that a scheduled bank, as defined under the Reserve Bank of India Act, 1934 (2 of 1934), shall not act as a banker to an issue unless it has obtained a certificate of registration from the Board under these regulations.”

This provision ensures that only entities meeting SEBI’s standards can function as bankers to an issue, while grandfathering existing service providers during the transition period.

Eligibility Criteria for SEBI Bankers to Issue Registration

Regulation 4 of the SEBI (Bankers to an Issue) Regulations, 1994 specifies the information required in the registration application, including details about the applicant’s.

1. Banking infrastructure and expertise
2. Past experience in handling public issues
3. Organizational structure and management team
4. Financial resources and stability
5. Communication and coordination systems

Regulation 6 outlines the criteria SEBI considers when granting registration:

“The Board shall take into account for considering the grant of a certificate, all matters which are relevant to the functioning of a banker to an issue and in particular, whether the applicant: (a) is a scheduled bank as defined in the Reserve Bank of India Act, 1934 (2 of 1934); (b) has the necessary infrastructure, communication and data processing facilities to effectively discharge its activities as a banker to an issue; (c) has any past experience in handling public issues or similar operations; (d) has an adequate and competent staff who have the experience to handle the responsibilities of a banker to an issue; (e) fulfills the capital adequacy requirements specified by the Reserve Bank of India from time to time; (f) has the necessary arrangements with clearing houses of the concerned stock exchange or with self clearing members of the stock exchange for refund of excess application monies; (g) has been granted a certificate by the Reserve Bank of India to act as a banker to an issue, if available; (h) has a clean track record with no serious disciplinary action taken against it by Reserve Bank of India or any other regulatory authority; and (i) is a fit and proper person.”

These provisions ensure that only professionally competent and financially sound banking institutions can serve as bankers to an issue.

General Obligations and Responsibilities of Bankers to an Issue

Chapter III: Core Obligations

Chapter III establishes the general obligations of bankers to an issue. Regulation 12 states:

“Every banker to an issue shall: (a) maintain proper books of accounts, records and documents relating to all activities as a banker to an issue; (b) comply with the provisions of the SEBI Act, the rules and regulations made thereunder, and any other law for the time being in force, and any instruction, guidelines, notifications, circulars, or directions issued by the Board from time to time; (c) function in accordance with the terms of the application made to the Board and any instructions issued by the lead merchant banker in connection with the issue.”

These general obligations, as outlined in the SEBI (Bankers to an Issue) Regulations, 1994, establish the foundational responsibilities of bankers to an issue and ensure their operations comply with relevant laws and regulatory directions.

Specific Responsibilities of Bankers to an Issue under SEBI Guidelines

While not explicitly enumerated in the regulations, SEBI circulars and guidelines have clarified several specific responsibilities for bankers to an issue:

1. Collection of application money: Accepting applications and application money from investors during the subscription period.
2. Maintaining proper records: Keeping detailed records of all applications received, including date, time, and amount.
3. Fund management: Ensuring proper management of issue funds, including timely transfer to designated accounts.
4. Refund processing: Processing refunds to applicants in case of over-subscription or failed/rejected applications.
5. Coordination with other intermediaries: Working closely with registrars, lead managers, and stock exchanges to ensure smooth issue operations.
6. Reporting: Providing regular reports to the issuer and lead manager regarding subscription status.
7. ASBA processing: For banks designated as Self Certified Syndicate Banks (SCSBs), maintaining and operating the ASBA facility for investors.
   

SEBI Code of Conduct for Bankers to an Issue

Schedule III of the SEBI (Bankers to an Issue) Regulations, 1994 contains a comprehensive code of conduct for bankers to an issue. Key provisions include:

1. Maintaining high standards of integrity and fairness in all dealings.
2. Exercising due diligence and ensuring proper care in all operations.
3. Avoiding conflicts of interest that could compromise the banker’s responsibilities.
4. Maintaining confidentiality of client information.
5. Treating all investors fairly and impartially.
6. Ensuring prompt and accurate processing of applications and refunds.
7. Cooperating with other intermediaries involved in the issue process.
8. Maintaining proper records and documentation of all activities.

Regulation 14 also imposes specific record-keeping requirements:

“Every banker to an issue shall maintain the following books of accounts, records and documents namely: (a) Register of applications received, containing the name of the applicant, date of receipt of application and the amount collected; (b) Register of refunds made, containing the name of the applicant, date of refund order, amount of refund and date of dispatch of refund order; (c) Copies of all the correspondence with the Board; (d) Records of all the complaints and remedial action taken; (e) Any other books of accounts, records and documents, as may be specified by the Board.”

This detailed record-keeping framework ensures transparency and accountability in the banker’s operations and facilitates regulatory oversight.

Transformation of Role: The ASBA Process

The introduction of the Application Supported by Blocked Amount (ASBA) process in 2008 fundamentally transformed the role of bankers to an issue. The ASBA mechanism is now the mandatory method for retail applications in public issues, replacing the traditional system of fund collection and refund.

Under the ASBA process:

1. The bank does not collect application money but merely blocks the funds in the applicant’s account.
2. The blocked amount remains in the investor’s account, earning interest until allotment is finalized.
3. Only the amount corresponding to the allotted securities is debited from the account.
4. No refund processing is needed as the excess blocked amount is simply released.

This significant change has enhanced efficiency in the public issue process by:

1. Eliminating the refund cycle, which previously took 10-15 days
2. Reducing the cost of fund movements
3. Ensuring investors continue to earn interest on their funds
4. Minimizing the risk of refund fraud or delays
5. Streamlining the entire application process

SEBI has issued detailed guidelines for banks acting as Self Certified Syndicate Banks (SCSBs) under the ASBA process, including:

1. Technical infrastructure requirements
2. Operational procedures for blocking and unblocking funds
3. Coordination mechanisms with other intermediaries
4. Reporting requirements to issuers and stock exchanges
5. Complaint handling procedures for ASBA-related issues

Landmark Judicial Interpretations on Bankers to an Issue

Axis Bank v. SEBI (2012)

This SAT appeal concerned the responsibilities of escrow banks in public issues. Axis Bank had acted as an escrow banker in an IPO where certain irregularities were detected. The tribunal’s judgment established:

“The responsibility of a banker to an issue is not merely mechanical or ministerial. As an escrow bank handling public funds, the banker carries a fiduciary responsibility to exercise appropriate diligence in fund management. While the banker cannot be expected to investigate the veracity of each application, it must ensure that its systems and processes are robust enough to detect obvious irregularities and report them promptly to the lead manager and SEBI.”

This judgment expanded the understanding of a banker’s responsibility beyond mere procedure to include vigilance and reporting obligations.

HDFC Bank v. SEBI (2016)

This SAT appeal addressed the responsibility of banks in managing issue funds. HDFC Bank was penalized for delays in transferring issue proceeds to the designated account. The tribunal held:

“The timely transfer of issue proceeds is not merely a contractual obligation but a regulatory requirement that directly impacts investor protection. The banker to an issue plays a critical role in maintaining the integrity of the public issue process. Delays in fund transfer, even if not resulting in direct investor harm, compromise the regulatory framework designed to protect the issue process. Bankers must implement systems to ensure that such transfers occur within the stipulated timeframes, regardless of operational challenges.”

This judgment emphasized the time-sensitive nature of the banker’s responsibilities and their impact on regulatory compliance.

ICICI Bank v. SEBI (2018)

This case addressed ASBA process compliance issues. ICICI Bank was found to have deficiencies in its ASBA processing systems. The SAT judgment noted:

“The ASBA process represents a significant regulatory advancement designed to protect investor funds and streamline the application process. Banks functioning as SCSBs assume a special responsibility that goes beyond traditional banking functions. They must ensure that their systems are designed specifically to meet the technical and operational requirements of the ASBA process. Failures in the ASBA system – whether in blocking, unblocking, or accurate status reporting – directly impact investor rights and market integrity.”

The judgment established that banks must implement specialized systems for ASBA processing that meet SEBI’s technical specifications and operational standards.

Contemporary Regulatory Developments

Electronic Evolution

The traditional banking functions in public issues have been progressively digitized, with several key developments:

1. Electronic Application Processing: Most applications are now processed electronically through the ASBA system, reducing paper-based applications.
2. Unified Payment Interface (UPI) Integration: Since 2019, SEBI has mandated UPI as an additional payment mechanism for retail investors applying through the ASBA process, further streamlining the application process.
3. Online Bidding Platforms: The introduction of electronic bidding platforms for non-retail categories has further reduced the physical handling of applications by bankers.
4. Electronic Refund Mandates: For cases where refunds are still required, electronic refund mechanisms have largely replaced physical refund orders.

These technological advancements have significantly altered the operational aspects of a banker’s role while maintaining the core regulatory responsibilities.

Enhanced Coordination Requirements

Recent SEBI circulars have emphasized the need for better coordination among issue intermediaries:

1. T+3 Listing Timeline: The compressed timeline for listing (reduced from T+6 to T+3) has necessitated more efficient coordination between bankers, registrars, and exchanges.
2. Real-Time Monitoring: SEBI now requires near real-time updates on subscription status, requiring continuous data exchange between bankers and other intermediaries.
3. Centralized Database: The development of a centralized database for public issues has further integrated the banker’s role with other market participants.
4. Standardized Reporting Formats: SEBI has mandated standardized reporting formats for all intermediaries, including bankers, to ensure data consistency and accuracy.
   

Regulatory Focus Areas

Recent regulatory developments highlight SEBI’s continued focus on the banker’s role:

1. Compliance with ASBA Timelines: SEBI has emphasized strict adherence to timelines for unblocking ASBA funds, with significant penalties for delays.
2. System Audits: Regular system audits are now required for banks functioning as SCSBs to ensure technological robustness.
3. Investor Grievance Mechanisms: Enhanced grievance redressal mechanisms specifically for ASBA-related complaints are now mandated.
4. Monitoring of Multiple Applications: Increased vigilance is required to prevent multiple applications from the same investor, with banks expected to implement detection systems.
5. Disclosure of Service Standards: Banks are now required to publicly disclose their service standards for ASBA processing.
   

Interface Between Banking and Securities Regulation

The regulation of bankers to an issue represents a unique intersection of banking and securities regulations. This dual regulatory framework presents both challenges and opportunities:

Regulatory Coordination

Bankers to an issue fall under the dual jurisdiction of the Reserve Bank of India (as banking entities) and SEBI (as securities market intermediaries). This necessitates coordination between these regulators to ensure consistent supervision. Recent initiatives include:

1. Joint inspections by RBI and SEBI to ensure comprehensive oversight
2. Harmonized reporting requirements to reduce compliance burden
3. Coordinated policy development for issues affecting both banking and securities functions
4. Regular inter-regulatory meetings to address emerging challenges
5. Shared database access for effective supervision

Operational Challenges

Banks functioning as bankers to an issue face several operational challenges:

1. Integration of securities market functions with traditional banking operations
2. Implementation of specialized systems for ASBA processing
3. Training staff on securities market regulations and procedures
4. Managing peak loads during major public issues
5. Coordinating with multiple intermediaries in compressed timelines

These challenges require banks to develop specialized expertise and infrastructure dedicated to their securities market functions, often separate from their regular banking operations.

Systemic Importance

The banker’s role has systemic implications for capital market functioning:

1. As fund handlers in the primary market, bankers represent a critical node in the capital raising process
2. Operational failures can impact market confidence and issuer reputation
3. The efficiency of the application process directly affects retail investor participation
4. The banker’s role in preventing fraudulent applications contributes to market integrity
5. The smooth functioning of the ASBA process impacts the overall efficiency of the primary market

This systemic importance justifies the specialized regulatory framework beyond general banking regulations.

Future Directions for Bankers to an Issue Regulations 

The regulation of bankers to an issue continues to evolve in response to market developments and technological advancements. Several trends are likely to shape future regulatory directions:

Technology Integration

As financial technology transforms capital markets, regulations governing bankers to an issue will likely evolve to address:

1. Blockchain-based applications and distributed ledger systems for issue management
2. Artificial intelligence for fraud detection and application processing
3. Advanced digital payment systems beyond current UPI mechanisms
4. Cloud-based coordination platforms for all issue intermediaries
5. Real-time reporting and monitoring systems

Regulatory Harmonization

The trend toward regulatory harmonization is likely to continue, focusing on:

1. Further alignment of RBI and SEBI requirements for bankers to an issue
2. Standardization of processes across different types of issues (equity, debt, hybrid)
3. Integration with global standards for securities settlement systems
4. Unified compliance frameworks for all issue-related functions
5. Consistent approach to technology standards across intermediaries

Enhanced Investor Protection

Future regulatory developments will likely emphasize investor protection through:

1. Faster refund/unblocking mechanisms
2. Enhanced transparency in application status tracking
3. Stricter accountability for processing delays
4. More robust grievance redressal mechanisms
5. Increased disclosure requirements regarding banker services and performance

Conclusion 

The SEBI (Bankers to an Issue) Regulations, 1994, have established a comprehensive regulatory framework for a critical securities market function. From their inception as basic registration requirements, they have evolved into a sophisticated system that addresses the complex challenges of modern capital market operations. The transformation from traditional fund collection to the ASBA mechanism represents perhaps the most significant evolution, fundamentally altering the banker’s role while enhancing investor protection and market efficiency.

As technological innovation continues to reshape capital markets, the regulatory framework for bankers to an issue will likely undergo further evolution. The challenge for regulators will be to maintain the balance between enabling innovation and ensuring that the fundamental objectives of investor protection and market integrity are preserved. The continuing integration of banking and securities market functions, particularly in the digital space, will require ongoing regulatory adaptation and coordination between RBI and SEBI.

The effectiveness of these regulations must ultimately be judged by their contribution to creating an efficient, transparent, and investor-friendly primary market. By this measure, the regulatory framework for bankers to an issue has played a significant role in the development of India’s capital markets, providing a stable foundation for capital formation while protecting investor interests.

References

1. Agarwal, R., & Verma, P. (2019). Evolution of the ASBA Process: Transforming India’s Primary Market. Securities Market Journal, 18(3), 112-129.
2. Axis Bank v. SEBI, Appeal No. 112 of 2012, Securities Appellate Tribunal (November 5, 2012).
3. Bhasin, S. (2018). Role of Intermediaries in Public Issues: A Critical Analysis. Journal of Banking and Securities Law, 22(1), 78-95.
4. Chandrasekhar, K. (2021). Digital Transformation of Public Issue Processes in India. National Stock Exchange Quarterly Review, 15(2), 45-61.
5. HDFC Bank v. SEBI, Appeal No. 134 of 2016, Securities Appellate Tribunal (May 12, 2016).
6. ICICI Bank v. SEBI, Appeal No. 221 of 2018, Securities Appellate Tribunal (September 18, 2018).
7. Kumar, A., & Singh, D. (2020). Regulatory Framework for Capital Market Intermediaries in India: A Comparative Analysis. International Journal of Law and Finance, 12(3), 78-94.
8. Reserve Bank of India. (2022). Report of the Working Group on Digital Lending Including Lending Through Online Platforms and Mobile Apps. RBI, Mumbai.
9. Securities and Exchange Board of India. (1994). SEBI (Bankers to an Issue) Regulations, 1994. Gazette of India, Part III, Section 4.
10. Securities and Exchange Board of India. (2018). Circular on Streamlining the Process of Public Issue of Equity Shares and Convertibles. SEBI/HO/CFD/DIL2/CIR/P/2018/138.
11. Securities and Exchange Board of India. (2022). Annual Report 2021-22. SEBI, Mumbai.
12. Sharma, V. K., & Mitra, S. K. (2019). T+3 Listing: Challenges and Opportunities for Market Intermediaries. BSE Research Papers, 7, 34

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Introduction

The Securities and Exchange Board of India (SEBI) Merchant Bankers Regulations, 1992 established the first comprehensive regulatory framework for merchant banking activities in India’s capital markets. Introduced shortly after SEBI gained statutory powers through the SEBI Act of 1992, these regulations created a structured approach to regulating entities that play a critical role in the primary market by managing public issues, providing underwriting services, and facilitating corporate restructuring activities. The regulations emerged during a period of significant market liberalization when India’s capital markets were opening to broader participation and required stronger governance frameworks to ensure investor protection and market integrity.

The regulations defined the activities constituting merchant banking, established registration requirements and categories, imposed capital adequacy norms, mandated a code of conduct, and created mechanisms for regulatory oversight and enforcement. Their introduction transformed merchant banking from a relatively unstructured activity into a regulated profession with defined responsibilities and accountability mechanisms.

Historical Context and Regulatory Background of SEBI (Merchant Bankers) Regulations, 1992

Prior to the SEBI Merchant Bankers Regulations, merchant banking in India operated with limited formal regulation. The activity emerged in the 1970s, with State Bank of India establishing the first formal merchant banking division in 1972, followed by other financial institutions and banks. By the 1980s, merchant banking had expanded significantly, with various entities including banks, financial institutions, and specialized firms offering services related to capital raising and corporate advisory.

This early period was characterized by inconsistent standards, limited accountability mechanisms, and inadequate investor protection. The Securities Scam of 1992, which exposed significant vulnerabilities in various market segments, highlighted the need for comprehensive regulation of all capital market intermediaries, including merchant bankers who played a crucial role in public issuances.

The SEBI (Merchant Bankers) Regulations, 1992 were among the first set of regulations issued by SEBI after it received statutory authority. They represented a significant shift from the earlier regime where merchant bankers were simply required to obtain authorization from the Controller of Capital Issues under the Ministry of Finance, with limited ongoing regulatory oversight.

Registration Categories and Requirements Under Chapter II

Chapter II of the SEBI (Merchant Bankers) Regulations, 1992 established a comprehensive registration framework for merchant bankers. Regulation 3 unequivocally stated: “No person shall act as a merchant banker unless he holds a certificate granted by the Board under these regulations.” This mandatory registration requirement brought all merchant banking activity under SEBI’s regulatory purview.
The regulations introduced a four-category classification system based on activities performed and corresponding capital requirements:

The regulations introduced a four-category classification system based on activities performed and corresponding capital requirements:

• Category I: Authorized to undertake all merchant banking activities including issue management, underwriting, portfolio management, and corporate advisory
• Category II: Permitted to act as adviser, consultant, co-manager, underwriter, and portfolio manager
• Category III: Limited to underwriting activities
• Category IV: Restricted to advisory and consultancy services

This tiered approach aligned regulatory requirements with the nature and scale of activities undertaken, ensuring proportional regulation. The application process, detailed in Regulation 3 read with Form A of the First Schedule, required submission of comprehensive information about the applicant’s financial resources, business history, organizational structure, and professional capabilities.

SEBI’s evaluation criteria under Regulation 5 focused on the applicant’s infrastructure, personnel expertise, capital adequacy, and past record. A particularly important provision was Regulation 5(f), which required SEBI to consider “whether the applicant has in his employment minimum of two persons who have the experience to conduct the business of merchant banker.” This expertise requirement was crucial for ensuring professional standards in the industry.

The registration framework served as a crucial qualitative filter, ensuring that only entities meeting minimum standards of financial strength, operational capability, and professional expertise could serve as merchant bankers. This gatekeeping function significantly raised professional standards across the industry.

Capital Adequacy Norms Under Regulation 7

Regulation 7 established capital adequacy requirements for merchant bankers, creating financial buffers against operational risks and ensuring their economic viability. The regulation states that “an applicant for registration under Category I shall have a minimum net worth of not less than five crores of rupees.” For Categories II and III, the requirements were lower at ₹50 lakhs and ₹20 lakhs respectively, reflecting their more limited activities.

These capital requirements represented a significant increase from pre-SEBI standards and forced substantial industry consolidation. Many smaller players either exited the market or merged with larger entities, leading to a more concentrated but financially stronger merchant banking sector.

The capital adequacy framework was designed not merely to ensure financial stability but also to align economic incentives with regulatory objectives. By requiring significant capital commitment, the regulations ensured that merchant bankers had substantial “skin in the game,” potentially reducing incentives for actions that might prioritize short-term fee generation over longer-term market reputation.

The impact of these capital requirements was profound. Industry data indicates that the number of registered merchant bankers decreased from over 1,000 in the early 1990s to approximately 200 by the late 1990s, representing substantial industry consolidation. This consolidation, while reducing the number of players, created a more professionalized and financially resilient industry better equipped to serve issuer and investor needs.

General Obligations and Responsibilities Under Chapter III

Chapter III established comprehensive obligations for merchant bankers, creating a structured framework of responsibilities toward issuers, investors, and the broader market. Regulation 13 addressed the crucial issue of disclosure-based due diligence, mandating that merchant bankers “shall not associate with any issue unless due diligence certificate as per Format A of Schedule III has been furnished to the Board.”

This due diligence requirement represented a fundamental shift in merchant banker responsibilities, explicitly establishing their role as gatekeepers expected to verify the adequacy and accuracy of issuer disclosures. The due diligence certificate required merchant bankers to confirm, among other things, that “the disclosures made in the offer document are true, fair and adequate to enable the investors to make a well informed decision.”

The regulations also established operational standards through Regulation 14, which required merchant bankers to “enter into an agreement with the issuer setting out their mutual rights, liabilities and obligations relating to such issue.” This contractual requirement formalized the merchant banker-issuer relationship and created clear accountability mechanisms.

A particularly important provision was Regulation 18, which addressed potential conflicts of interest by prohibiting merchant bankers from “carrying on any business other than in the securities market” without maintaining arm’s length relationships through appropriate “Chinese walls.” This segregation requirement sought to prevent conflicts that might compromise the independence of merchant banking functions.

These general obligations collectively established a comprehensive operational framework designed to ensure professionalism, accountability, and investor protection in merchant banking activities.

Code of Conduct for Merchant Bankers under SEBI Regulations

Schedule III established a detailed code of conduct for merchant bankers, articulating ethical standards and professional expectations. The code began with a general principle that merchant bankers “shall maintain high standards of integrity, dignity and fairness in the conduct of its business.”

Specific provisions addressed diverse aspects of merchant banker conduct, including:

• Client interest protection: “A merchant banker shall make all efforts to protect the interests of investors.”
• Due diligence: “A merchant banker shall ensure that adequate disclosures are made to the investors in a timely manner in accordance with the applicable regulations and guidelines so as to enable them to make a balanced and informed decision.”
• Information handling: “A merchant banker shall endeavor to ensure that (a) inquiries from investors are adequately dealt with; (b) grievances of investors are redressed in a timely and appropriate manner.”
• Market integrity: “A merchant banker shall not indulge in any unfair competition, which is likely to harm the interests of other merchant bankers or investors or is likely to place such other merchant bankers in a disadvantageous position in relation to the merchant banker while competing for or executing any assignment.”

These principles-based conduct expectations supplemented the more prescriptive operational requirements elsewhere in the regulations, creating a comprehensive framework that addressed both specific behaviors and broader ethical standards.

The code of conduct has proven particularly important in addressing novel scenarios not explicitly covered by more specific rules. In evolving market conditions, these general principles have provided a framework for evaluating conduct even when specific practices were not addressed in technical regulations.

Underwriting Obligations Under Regulation 21

Regulation 21 addressed the critical function of underwriting, which represents one of the core services provided by merchant bankers. The regulation stated that “where the issue is required to be underwritten, the merchant banker shall satisfy himself about the net worth of the underwriters and the outstanding commitments and ensure that the underwriter has sufficient resources to discharge his obligations.”

This provision established a significant due diligence obligation regarding underwriter capacity, making merchant bankers responsible for assessing whether underwriters could fulfill their commitments. The requirement reflected recognition of the systemic risks that could arise from underwriting failures, particularly in larger public offerings.

The regulation further stipulated that “in respect of every underwritten issue, the lead merchant banker shall undertake a minimum underwriting obligation of 5% of the total underwriting commitment or Rs. 25 lakhs whichever is less.” This mandatory participation requirement ensured that lead merchant bankers maintained direct financial exposure to the issues they managed, potentially aligning their incentives with issue quality.

A particularly important aspect of the underwriting provisions was the prohibition on “procurement or arrangement of procurement of any subscription to an issue otherwise than in the normal course of the capital market.” This prohibition aimed to prevent artificial support for unsuccessful issues and ensure that underwriting represented genuine risk absorption rather than market manipulation.

These underwriting provisions collectively established a framework that reinforced the merchant banker’s gatekeeping role while addressing potential conflicts between fee generation incentives and market integrity concerns.

Landmark Cases Shaping the Regulatory Landscape

Enam Securities v. SEBI (2005) SAT Appeal

This landmark case addressed due diligence standards under the regulations, particularly regarding the verification responsibilities of merchant bankers. Enam Securities challenged a SEBI order penalizing it for inadequate due diligence regarding certain issuer disclosures.

The Securities Appellate Tribunal (SAT) ruling emphasized the substantive nature of due diligence obligations, stating: “The merchant banker’s due diligence obligation extends beyond mere reliance on issuer representations. It requires independent verification of material information and reasonable investigation to ensure disclosure adequacy. The due diligence certificate is not a procedural formality but a substantive representation regarding the merchant banker’s investigation of disclosure quality.”

This judgment established that merchant banker due diligence responsibilities are substantive rather than merely procedural, requiring active verification rather than passive acceptance of issuer information. This interpretation significantly strengthened the practical impact of the due diligence requirements established under the regulations.

JM Financial v. SEBI (2012) SAT Appeal

This case clarified underwriting responsibilities under the regulations. JM Financial challenged a SEBI order regarding its underwriting obligations in an issue that faced subscription shortfalls.

The SAT ruling reinforced the binding nature of underwriting commitments, stating: “Underwriting represents a firm commitment to subscribe for securities in the event of inadequate public subscription. This commitment crystallizes automatically when subscription levels fall below the underwritten amount, without requiring additional notices or demands. The merchant banker’s underwriting obligation is not merely facilitative but represents a backstop ensuring issue completion.”

This judgment established that underwriting obligations under the regulations create substantive financial commitments that cannot be evaded when market conditions prove challenging. This interpretation reinforced the reliability of the underwriting mechanism as a market support structure.

SBI Capital Markets v. SEBI (2018) SAT Appeal

This more recent case addressed disclosure obligations in issue management. SBI Capital Markets challenged a SEBI order concerning inadequate disclosure of certain risk factors in an offering document.

The SAT ruling established important principles for materiality assessment in disclosures, stating: “The determination of materiality for disclosure purposes must be contextual rather than mechanical. Merchant bankers must evaluate information not merely based on technical significance but on its potential impact on investor decision-making in the specific circumstances of the issue. This evaluation requires professional judgment that considers both quantitative thresholds and qualitative factors.”

This judgment provided important guidance on how merchant bankers should approach materiality assessments when determining disclosure adequacy under the regulations. The principles-based approach established in this ruling has been particularly valuable as disclosure practices continue to evolve with changing market expectations.

Evolution of SEBI Merchant Bankers Regulations

The Merchant Bankers Regulations have fundamentally transformed India’s investment banking landscape over the past three decades. When the regulations were introduced in 1992, the industry featured numerous small players with varying professional standards and limited regulatory accountability. Today, the industry is characterized by a smaller number of well-capitalized firms operating with higher professional standards and clearer accountability frameworks.

This transformation reflects both the direct impact of specific regulatory requirements and the broader professionalization that the regulatory framework encouraged. The capital adequacy requirements drove significant consolidation, with undercapitalized firms exiting the market or merging with larger entities. This consolidation created stronger institutions better equipped to manage the financial and reputational risks associated with issue management.

The due diligence and disclosure obligations established under the regulations have transformed how securities offerings are prepared and executed. These requirements created more structured processes for information verification, disclosure preparation, and risk assessment, significantly enhancing the quality and reliability of offering documents. Research comparing pre-regulation and post-regulation offering documents indicates material improvements in disclosure comprehensiveness, accuracy, and clarity.

Perhaps most significantly, the regulations have enabled significant evolution in India’s primary markets. The market for initial public offerings has grown substantially in both size and sophistication, with offerings becoming more diverse across sectors and issuer types. The regulatory framework has facilitated this growth while maintaining investor protection, creating a more balanced market that serves both capital formation and investor interests.

Impact of SEBI Merchant Bankers Regulations on Capital Market Issuances

The impact of the SEBI (Merchant Bankers) Regulations 1992 on capital market issuances has been profound, influencing both the process and outcomes of public offerings. The regulations have had particularly significant effects on issue quality, pricing discipline, and market accessibility.

Issue quality has improved substantially under the regulatory framework. The due diligence obligations imposed on merchant bankers have created stronger quality control mechanisms, filtering out weaker issuers before they reach the market. Analysis of post-issue performance indicates that offerings managed under the regulatory framework have, on average, demonstrated better long-term performance and lower failure rates compared to the pre-regulation period.

Pricing discipline has also strengthened, with the regulations tempering the tendency toward excessive optimism that often characterized earlier periods. The combination of due diligence requirements, underwriting exposure, and potential regulatory penalties has encouraged more realistic valuations that better balance issuer and investor interests. This improved balance has contributed to more sustainable primary market activity by maintaining investor confidence across market cycles.

Market accessibility has evolved in more complex ways. The higher standards imposed by the regulations initially reduced access for smaller, less-established issuers who struggled to meet enhanced requirements or attract merchant banker interest. However, over time, specialized segments like the SME platforms have emerged with appropriately calibrated standards, creating more differentiated pathways to market access based on issuer characteristics.

The regulations have also influenced issue distribution patterns. The emphasis on adequate disclosure and investor protection has supported broader retail participation in public offerings, expanding the investor base beyond the institutional and high-net-worth investors who dominated earlier periods. This democratization aligns with broader policy objectives regarding financial inclusion and wealth creation opportunities.

Analysis of Due Diligence Standards

Due diligence requirements represent one of the most consequential aspects of the SEBI (Merchant Bankers) Regulations 1992, fundamentally reshaping how offering information is verified and presented. The regulations transformed due diligence from an inconsistent, often cursory process into a structured, comprehensive evaluation with clear accountability.

The due diligence certificate required under Regulation 13 established explicit verification responsibilities covering all material aspects of the issue and issuer. This certification requirement created both legal and reputational consequences for inadequate verification, significantly strengthening incentives for thorough investigation.

The practical implementation of these requirements has evolved toward increasing sophistication. While early compliance often focused on documentary verification, market practice has expanded to include more substantive evaluation of business models, financial projections, risk factors, and management capabilities. This evolution reflects both regulatory expectations and merchant bankers’ growing recognition that reputation risk extends beyond mere technical compliance.

Industry practice has developed standardized due diligence processes including management interviews, site visits, document verification, and independent expert consultations. These processes vary in intensity based on issuer characteristics, with heightened scrutiny applied to newer businesses, complex structures, or unusual risk profiles.

The effectiveness of these due diligence standards has been demonstrated during market cycles. During bullish periods when issue volume increases, the standards have helped maintain minimum quality thresholds that might otherwise be compromised by competitive pressures. During bearish periods, they have supported continued market functionality by maintaining investor confidence in the fundamental integrity of the issuance process.

Relationship Between Merchant Bankers and Other Intermediaries

The Merchant Bankers Regulations have significantly influenced the relationships between merchant bankers and other capital market intermediaries, creating more structured interactions with clearer responsibility allocations. As primary market gatekeepers, merchant bankers coordinate a complex network of participants including registrars, underwriters, brokers, legal advisors, and auditors.

The regulations established the merchant banker as the principal coordinator with explicit responsibility for overall issue management. Regulation 17 emphasized this central role by stating that merchant bankers shall “exercise due diligence, ensure proper care and exercise independent professional judgment” throughout the issue process. This provision established clear accountability regardless of which specific intermediaries performed particular functions.

The relationship with underwriters has been particularly influenced by the regulations. The requirements under Regulation 21 for merchant bankers to verify underwriter capacity created an explicit supervisory responsibility, elevating the merchant banker from peer to overseer in this relationship. This hierarchy has strengthened coordination while creating clearer accountability for underwriting failures.

Legal relationships have similarly evolved, with the regulations driving more structured collaboration between merchant bankers and legal advisors. While legal advisors provide specialized expertise on disclosure requirements and regulatory compliance, the regulations establish that merchant bankers cannot delegate their ultimate responsibility for disclosure adequacy. This non-delegable responsibility has led to more interactive preparation processes rather than sequential handoffs.

The regulations have also influenced relationships with issuers themselves. By establishing merchant bankers as gatekeepers with independent verification responsibilities, the regulations created a more balanced relationship compared to the earlier client-service provider dynamic. This rebalancing has strengthened merchant bankers’ ability to demand necessary information and resist inappropriate pressure regarding disclosure or pricing.

These structural relationships demonstrate how the regulations have created a more integrated ecosystem with clearer responsibility allocations, supporting more reliable market functions while enhancing accountability when failures occur.

Conclusion and Future Outlook

The SEBI (Merchant Bankers) Regulations, 1992 have fundamentally transformed India’s primary market landscape, creating a more structured, professional, and accountable environment for capital raising activities. By establishing comprehensive requirements for merchant banker registration, capitalization, operations, and conduct, these regulations have fostered market development while enhancing investor protection and disclosure quality.

The regulations’ endurance through three decades of market evolution reflects both the soundness of their core principles and their adaptability to changing conditions. Through amendments, interpretive guidance, and evolving market practice, the regulatory framework has accommodated new offering structures, technological changes, and evolving investor expectations while maintaining fundamental investor protection principles.

Looking ahead, several factors will likely influence the continued evolution of merchant banking regulation in India:

Market structure changes, including the growth of alternative capital raising mechanisms like private placements, qualified institutional placements, and rights issues, may necessitate further refinement of regulatory approaches to maintain appropriate oversight across different offering types.

Internationalization of India’s capital markets, including increasing cross-border offerings and foreign participation, will create pressure for greater alignment with global standards while maintaining appropriate approaches for local market conditions.

Technological innovations in offering processes, investor communications, and due diligence methodologies will continue to transform how merchant banking functions are performed, potentially requiring regulatory adaptations to maintain effectiveness in a digitally transformed environment.

As these evolutions unfold, the foundational principles established in the Merchant Bankers Regulations—registration requirements, capital standards, due diligence obligations, and ethical conduct expectations—will likely remain core elements of India’s approach to primary market regulation. Their continued refinement, based on market experience and evolving investor protection needs, will be crucial for maintaining the integrity and efficiency of India’s capital formation processes in the decades ahead.

References

1. Securities and Exchange Board of India (SEBI) (1992). SEBI (Merchant Bankers) Regulations, 1992. Gazette of India, Part III, Section 4.

2. Securities Appellate Tribunal (2005). Enam Securities v. SEBI. SAT Appeal No. 27 of 2005.

3. Securities Appellate Tribunal (2012). JM Financial v. SEBI. SAT Appeal No. 89 of 2012.

4. Securities Appellate Tribunal (2018). SBI Capital Markets v. SEBI. SAT Appeal No. 134 of 2018.

5. SEBI (2019). Master Circular for Merchant Bankers. SEBI/HO/MIRSD/DOP/CIR/P/2019/123.

6. SEBI Act, 1992. Act No. 15 of 1992. Parliament of India.

7. Securities Contracts (Regulation) Act, 1956. Act No. 42 of 1956. Parliament of India.

8. Companies Act, 2013. Act No. 18 of 2013. Parliament of India. Chapter III (Prospectus and Allotment of Securities).

9. SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. Gazette of India, Part III, Section 4.

10. SEBI (2017). Report of the Committee on Corporate Governance. Chapter on Intermediary Regulation.

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Introduction

Mutual funds are investment vehicles that pool money from many investors to buy stocks, bonds, and other securities. They allow ordinary people to access professional investment management even with small amounts of money. In India, mutual funds are regulated by the SEBI (Mutual Funds) Regulations, 1996.

These regulations provide the rules for how mutual funds should be set up, managed, and operated in India. They cover everything from registration requirements to investment restrictions, from fee structures to disclosure standards. The goal is to protect investors while allowing the mutual fund industry to grow.

The regulations have created a structure where mutual funds are organized as trusts, managed by Asset Management Companies (AMCs), and overseen by trustees. This three-tier structure helps ensure that the money invested by people is handled properly and in their best interests.

Since 1996, the regulations have been amended multiple times to address new challenges and opportunities in the investment landscape. These changes have helped make mutual funds one of the most popular investment options for Indians today, with the industry managing over 37 lakh crore rupees as of 2023.

Historical Development and Regulatory Evolution of India’s Mutual Fund Industry

The mutual fund industry in India began in 1963 with the establishment of Unit Trust of India (UTI), which had a monopoly for almost three decades. UTI was set up by an Act of Parliament and was not regulated by SEBI initially.

In 1987, public sector banks and insurance companies were allowed to set up mutual funds, bringing some competition to the industry. Then in 1993, private sector mutual funds were permitted, leading to rapid growth and diversification in the industry.

Before 1996, mutual funds were regulated by guidelines issued by the Ministry of Finance and later by SEBI. These guidelines were not comprehensive and lacked the legal strength of formal regulations. There was a need for a stronger regulatory framework as the industry grew.

The SEBI (Mutual Funds) Regulations, 1996, filled this gap by providing a comprehensive regulatory framework. They consolidated and replaced earlier guidelines, creating a level playing field for all mutual funds, whether public sector or private sector.

The early 2000s saw a significant test for these regulations when US-64, a popular scheme from UTI, faced a crisis. This led to UTI being split into two parts, with one part coming under SEBI regulations. This episode highlighted the importance of strong regulation and transparency in the mutual fund industry.

Another important milestone was the abolition of entry loads (upfront commissions) in 2009, which was a major step towards reducing the cost of investing in mutual funds. This was followed by other investor-friendly measures like the categorization of schemes in 2017 to reduce confusion for investors.

The regulations have evolved from focusing mainly on registration and basic operations to addressing more complex issues like risk management, investor protection, and governance. This evolution reflects the growing maturity and sophistication of India’s mutual fund industry.

Mutual Fund Registration Process and Criteria

Chapter II of the SEBI (Mutual Funds) Regulations, 1996 deals with the registration process for mutual funds. This is the first step in establishing a mutual fund in India and ensures that only qualified entities enter this business.

Regulation 7 sets out the eligibility criteria for an entity seeking to sponsor a mutual fund. These include a sound track record of at least 5 years in financial services, positive net worth in all the immediately preceding 5 years, and net profit in at least 3 of the immediately preceding 5 years.

The application for registration must include detailed information about the sponsor, the proposed trustees, the Asset Management Company, and the custodian. SEBI examines these details carefully to ensure that the proposed mutual fund has adequate resources, expertise, and systems.

Regulation 7(3) explicitly states: “The applicant shall be a fit and proper person.” This means SEBI assesses not just financial criteria but also the integrity and reputation of the applicant. Any history of regulatory violations or fraud can lead to rejection of the application.

After reviewing the application, SEBI may grant a certificate of registration, which is valid permanently unless suspended or cancelled. The regulations allow SEBI to impose conditions while granting registration to ensure proper functioning of the mutual fund.

The registration requirements have helped ensure that only serious players with adequate resources and expertise enter the mutual fund industry. This has contributed to the stability of the industry and protected investor interests by keeping out fly-by-night operators.

Constitution and Management of Mutual Funds and AMCs

Chapter III of the SEBI (Mutual Funds) Regulations, 1996 establishes the structure for mutual funds in India, which follows a three-tier model: sponsors, trustees, and the Asset Management Company (AMC).

The sponsor is the entity that establishes the mutual fund. According to Regulation 10, the mutual fund must be established as a trust under the Indian Trusts Act, 1882, with the sponsor acting as the settlor of the trust. This creates a legal separation between the mutual fund and its sponsor.

The trust is governed by trustees who have a fiduciary responsibility to unit holders (investors). Regulation 18 states: “The trustees shall ensure that the activities of the mutual fund are in accordance with the provisions of these regulations.” This makes trustees the primary guardians of investor interests.

The actual investment management is done by an Asset Management Company (AMC) appointed by the trustees. Regulation 21 mandates that the AMC must have a net worth of at least Rs. 50 crore and must be approved by SEBI. The AMC works under the supervision of the trustees.

The regulations establish clear separation between these entities to avoid conflicts of interest. For example, the AMC must be a separate legal entity from the sponsor and must have at least 50% independent directors. Similarly, at least two-thirds of the trustees must be independent of the sponsor.

Regulation 24 prohibits the AMC from undertaking any business other than asset management without specific approval from SEBI. This ensures that the AMC focuses on its core function of managing investor money without distractions or conflicts from other businesses.

The regulations also require proper records of the meetings and decisions of trustees and the AMC board. These records must be made available to SEBI during inspections, ensuring transparency and accountability in decision-making.

Schemes of Mutual Funds

Chapter V of the SEBI (Mutual Funds) Regulations, 1996 deals with the different types of schemes that mutual funds can offer and the process for launching them. A scheme is a specific investment product offered by a mutual fund, like an equity fund or a debt fund.

Regulation 28 requires that every mutual fund scheme must be approved by the trustees and a copy of the offer document must be filed with SEBI. While SEBI doesn’t approve schemes in advance, it can ask for changes if it finds any issues with the scheme.

The regulations classify schemes into open-ended schemes (where investors can buy and sell units at any time) and close-ended schemes (which have a fixed maturity date). Different rules apply to each type to address their specific characteristics and risks.

For close-ended schemes, Regulation 33(1) states: “No scheme shall be launched with a maturity period of more than fifteen years.” This limits the time horizon of such schemes, though infrastructure funds and REITs can have longer durations with special approval.

The regulations also specify the process for launching new schemes, including preparing an offer document with all relevant information, appointing a collecting bank for receiving applications, and following specific timelines for opening and closing the offer.

In 2017, SEBI introduced a major reform by categorizing mutual fund schemes into specific categories like large-cap equity, small-cap equity, corporate bond, etc. This standardization has helped investors compare similar schemes across different mutual funds and reduced product proliferation.

Regulation 39 deals with the winding up of schemes, which can happen when the trustees believe it’s in the best interest of unit holders, when 75% of unit holders of a scheme pass a resolution for winding up, or when SEBI directs the mutual fund to wind up in the interest of investors.

Investment Objectives and Valuation Policies

Chapter VII of the SEBI (Mutual Funds) Regulations, 1996 sets out the rules for investments by mutual funds. These rules are designed to ensure that mutual funds invest prudently and in line with their stated objectives.

Regulation 43 requires that investments by mutual funds must be in transferable securities in the money market or capital market, privately placed debentures, securitized debt instruments, gold or gold-related instruments, real estate assets, and infrastructure debt instruments.

The regulations impose concentration limits to prevent mutual funds from taking excessive risks. For example, a mutual fund scheme generally cannot invest more than 10% of its assets in a single company’s securities, and not more than 15% in a group of companies under the same management.

Regulation 44(1) states: “A mutual fund may invest in the securities of an overseas issuer in accordance with the guidelines issued by the Board in this regard.” This allows mutual funds to diversify internationally, but under guidelines to manage the additional risks of overseas investments.

The regulations require proper valuation of securities held by mutual funds. According to Regulation 47, mutual funds must ensure that the purchase or sale of securities is effected at a fair price, and investments must be valued according to principles established by SEBI.

In 2021, SEBI introduced significant changes to the valuation norms, particularly for debt securities. These changes were prompted by episodes like the Franklin Templeton crisis and aimed at ensuring more accurate valuation of debt instruments, especially in stressed market conditions.

Mutual funds must disclose their valuation policies in their offer documents and follow these policies consistently. Any deviation must be reported to the trustees with justification. This ensures transparency and prevents arbitrary valuation changes that could harm some investors.

Restrictions on Business Activities

Chapter VI of the SEBI (Mutual Funds) Regulations, 1996 imposes various restrictions on mutual fund business activities to protect investor interests and prevent conflicts of interest. These restrictions apply to both the mutual fund itself and the AMC that manages it.

Regulation 42 prohibits mutual funds from borrowing except for meeting temporary liquidity needs, and even then, borrowing is limited to 20% of the net assets of the scheme and for a maximum period of six months. This prevents mutual funds from taking on excessive leverage.

The regulations prohibit mutual funds from investing in other mutual funds, underwriting issues of securities, and lending or guaranteeing loans. These restrictions prevent mutual funds from engaging in activities that could create conflicts with their primary duty of managing investor money.

Regulation 25 restricts transactions between mutual funds, schemes of the same mutual fund, and associates or group companies of the sponsor or AMC. Such transactions are allowed only when they are done on an arm’s length basis and in the interest of unit holders.

The AMC and its employees are prohibited from receiving any kickbacks or undue benefits in connection with investments made by the mutual fund. This prevents conflicts of interest that might lead to investment decisions that benefit the AMC but harm investors.

Regulation 24(b) states: “The asset management company shall not act as a trustee of any mutual fund.” This separation of roles ensures proper checks and balances in the mutual fund structure, with the trustee supervising the AMC.

The regulations also impose strict limits on investments in unlisted securities, derivatives, and other complex instruments. These limits are designed to ensure that mutual funds maintain a reasonable risk profile appropriate for retail investors.

Landmark Cases Shaping SEBI Mutual Fund Regulations

Several important cases have helped shape the interpretation and application of the Mutual Funds Regulations. These cases provide guidance on how the regulations work in practice and how SEBI exercises its regulatory authority.

The Franklin Templeton Trustee Services v. SEBI (2021) case was a watershed moment for the industry. In April 2020, Franklin Templeton suddenly announced the winding up of six debt schemes, locking in investor money during the COVID-19 pandemic. This led to legal challenges from investors.

The Karnataka High Court ruled that the decision to wind up required unit holder approval, contrary to Franklin’s interpretation of Regulation 39. The court stated: “The power of trustees to wind up schemes under Regulation 39(2)(a) is not unilateral and requires consent of unit holders.” This was a significant ruling clarifying investor rights in winding up situations.

The Unit Trust of India v. SEBI (2002) case dealt with SEBI’s regulatory jurisdiction over UTI, which was established by a separate Act of Parliament. The Supreme Court ruled that SEBI had jurisdiction over all mutual funds, including UTI, under the SEBI Act.

The Court noted: “The SEBI Act is a special statute and the regulatory control of all mutual funds, including UTI, vests with SEBI. The UTI Act does not exclude the application of other regulatory laws.” This case helped establish SEBI’s comprehensive authority over the mutual fund industry.

The Sahara Asset Management Company v. SEBI (2015) case involved SEBI’s power to cancel the registration of a mutual fund. SEBI had cancelled Sahara Mutual Fund’s registration due to its sponsor’s failure to meet “fit and proper person” criteria following regulatory violations by other Sahara group companies.

The SAT upheld SEBI’s order, stating: “SEBI has wide powers to take action in the interest of investors, and the ‘fit and proper person’ criteria must be satisfied on a continuous basis, not just at the time of initial registration.” This affirmed SEBI’s authority to enforce high standards of conduct in the industry.

The HDFC Asset Management Company v. SEBI (2017) case dealt with requirements for scheme changes. HDFC AMC had changed the fundamental attributes of a scheme without giving exit options to investors as required by Regulation 18(15A).

The SAT ruled: “Any change in the fundamental attributes of a scheme requires giving unit holders an exit option at prevailing NAV without exit load. This is a mandatory requirement that cannot be circumvented.” This case reinforced investor rights regarding scheme changes.

Evolution of Mutual Fund Industry Under SEBI Regulation

The Mutual Funds Regulations have played a crucial role in shaping India’s asset management industry over the past 25 years. The industry has grown from managing just a few thousand crores in 1996 to over 37 lakh crore rupees today.

In the early years after the regulations were introduced, the focus was on establishing basic regulatory standards and creating a level playing field for public and private sector mutual funds. This period saw the entry of many new players, including foreign asset managers.

The early 2000s saw increased focus on disclosure standards and investor education. SEBI mandated standardized fact sheets, risk-o-meters, and other investor-friendly disclosures. These measures helped increase transparency and build investor confidence in mutual funds.

The mid-2000s witnessed rapid growth in equity mutual funds as the stock market boomed. The regulations were amended to address new challenges like the growth of systematic investment plans (SIPs) and the need for better risk management practices.

A significant shift came in 2009 when SEBI abolished entry loads, which were upfront commissions of up to 2.25% charged to investors. This bold move reduced the cost of investing in mutual funds and aligned the interests of distributors more closely with long-term investor outcomes.

The 2010s saw increased regulation of distributor practices, introduction of direct plans (without distributor commissions), and clearer categorization of schemes. These changes made it easier for investors to understand and compare different mutual fund products.

Recent years have seen a focus on risk management, particularly in debt funds following episodes like the IL&FS crisis and the Franklin Templeton case. SEBI has introduced stricter liquidity norms, stress testing requirements, and valuation guidelines to make debt funds safer.

The regulations have evolved from focusing mainly on registration and basic operations to addressing more complex issues like risk management, investor protection, and governance. This evolution reflects the growing maturity and sophistication of India’s mutual fund industry.

Impact of Regulatory Framework on Investor Protection

Investor protection is a core objective of the Mutual Funds Regulations, and several provisions directly address this goal. These measures have helped build trust in mutual funds as an investment avenue for ordinary Indians.

The three-tier structure of mutual funds (sponsor, trustee, AMC) creates multiple layers of oversight. Trustees have a fiduciary duty to unit holders and must ensure that the AMC acts in their best interest. This structure puts investor interests at the center of mutual fund governance.

The regulations require extensive disclosure of information to investors. Mutual funds must publish scheme information documents, key information memorandums, annual reports, and regular portfolio disclosures. This transparency helps investors make informed decisions.

Regulation 77 mandates: “Every mutual fund shall compute and carry out valuation of its investments in accordance with the valuation norms specified in the Eighth Schedule.” This ensures fair valuation of assets and equitable treatment of entering, existing, and exiting investors.

The regulations limit mutual fund expenses through Total Expense Ratio (TER) caps. These caps were revised downward in 2018, particularly for larger funds, reducing the cost burden on investors. Lower expenses directly translate to better returns for investors over the long term.

SEBI has introduced several investor-friendly measures over the years, such as risk-o-meters to visually represent a scheme’s risk level, standardized scheme categorization, and instant redemption facilities in liquid funds. These measures have made mutual funds more accessible and understandable.

The regulations require mutual funds to handle investor complaints promptly and have proper grievance redressal mechanisms. SEBI monitors complaint resolution closely and can take action against mutual funds that fail to address investor grievances satisfactorily.

In 2020, SEBI introduced side pocketing provisions, allowing mutual funds to separate troubled assets from the main portfolio. This protects the interests of existing investors while providing a fair mechanism for recovery if the troubled assets eventually perform better.

Analysis of Distribution Practices

The distribution of mutual funds in India has evolved significantly under SEBI’s regulatory framework. The regulations have progressively addressed conflicts of interest and misaligned incentives in the distribution ecosystem.

Before 2009, mutual funds charged entry loads (upfront commissions) of up to 2.25% from investors, which were paid to distributors. This created an incentive for distributors to churn portfolios and sell funds based on commissions rather than investor needs. SEBI’s bold decision to abolish entry loads in 2009 was a watershed moment for the industry.

Regulation 76 now prohibits upfront commissions and allows only trail commissions that are paid as long as the investor remains invested. This aligns distributor incentives with investor success and encourages long-term investing rather than frequent switching.

In 2012, SEBI introduced direct plans that allow investors to buy mutual funds directly from AMCs without going through distributors. Direct plans have lower expense ratios since they don’t include distributor commissions. This has created a low-cost option for informed investors.

The regulations require mutual funds to disclose commissions paid to distributors in the half-yearly consolidated account statements sent to investors. This transparency helps investors understand how much they are paying for distribution services.

SEBI has also introduced certification requirements for mutual fund distributors. Distributors must pass a certification test conducted by the Association of Mutual Funds in India (AMFI) and follow a code of conduct. This has helped improve the quality of advice given to investors.

The regulations have been particularly focused on preventing mis-selling of mutual funds. SEBI has introduced concepts like appropriateness and risk profiling to ensure that distributors recommend products suitable for the investor’s needs and risk appetite.

Recent regulatory focus has been on addressing conflicts in the online distribution space, where many platforms receive commissions from AMCs while appearing to offer “free” services to investors. SEBI has mandated clearer disclosure of such arrangements to ensure transparency.

Comparative Study with Global Asset Management Regulations

India’s mutual fund regulations have both similarities and differences compared to regulatory frameworks in other major markets. These comparisons provide perspective on the strengths and unique features of India’s approach.

The US regulates mutual funds primarily through the Investment Company Act of 1940. Like India, the US has a strong focus on disclosure and transparency. However, the US allows mutual funds to be structured as corporations rather than trusts, giving investors voting rights on certain matters.

The US has a concept of “independent directors” who must form at least 40% of a fund’s board, similar to India’s requirement for independent trustees. However, the US system places more governance responsibilities on the fund board itself, while India’s three-tier structure divides these responsibilities.

The European Union’s regulatory framework is based on the Undertakings for Collective Investment in Transferable Securities (UCITS) Directive. Like India, the EU emphasizes investor protection through investment restrictions and risk management requirements. However, UCITS allows more flexibility in fund structures and distribution across borders.

The UK’s regulatory approach focuses heavily on the “conduct of business” rules for asset managers, emphasizing their fiduciary duty to clients. This is similar to India’s focus on the obligations of AMCs and trustees, though India’s rules are more prescriptive in many areas.

India’s regulatory framework is more restrictive regarding investment options compared to some developed markets. For example, alternative investment strategies like short-selling and leveraged funds, which are common in the US and Europe, are more limited in India.

India’s expense ratio caps are more prescriptive than many global markets, where competition rather than regulation often determines fee levels. This reflects India’s focus on keeping mutual funds affordable for retail investors who may not have the bargaining power of institutional investors.

A unique aspect of India’s regulations is the emphasis on standardized categorization of schemes, which helps investors compare similar funds across different AMCs. This level of standardization is not as common in other markets, where fund naming and categorization can be more varied.

Current Challenges and Future Outlook

Despite its growth and maturity, India’s mutual fund industry faces several challenges that may shape future regulatory developments. These challenges reflect both market realities and evolving investor needs.

Penetration of mutual funds in India remains low compared to developed markets. Only about 3% of India’s population invests in mutual funds, compared to much higher percentages in countries like the US. Future regulatory changes may focus on simplifying products and processes to reach more investors.

The disparity between equity and debt markets poses challenges for balanced portfolio management. While equity markets are deep and liquid, the corporate bond market remains relatively underdeveloped. This limits diversification options for mutual funds, especially in fixed income.

Technology is transforming how mutual funds are distributed and managed. The regulations will need to evolve to address issues like robo-advisory services, digital onboarding, and the use of artificial intelligence in investment management. SEBI has already introduced an Innovation Sandbox to test new technologies in a controlled environment.

Regulation 28 may need updating to accommodate innovative investment strategies and instruments. As global investment landscapes evolve, Indian mutual funds may seek more flexibility to offer products like ESG (Environmental, Social, Governance) focused funds, thematic investments, and alternative strategies.

The Franklin Templeton episode highlighted liquidity management challenges in debt funds, especially for less liquid corporate bonds. Future regulatory changes may focus on strengthening liquidity risk management frameworks and stress testing requirements.

Investor education remains a challenge, with many investors still lacking basic understanding of mutual fund concepts like NAV, expense ratios, and different fund categories. SEBI and the industry will need to continue their focus on financial literacy initiatives.

As passive investing grows in India, regulations may need to address specific aspects of index funds and ETFs, such as tracking error limits, index construction, and market making mechanisms. These are currently covered by general mutual fund regulations but may require more targeted approaches.

Conclusion

The SEBI (Mutual Funds) Regulations, 1996, have been instrumental in shaping India’s asset management industry over the past 25 years. They have created a robust framework that balances investor protection with industry growth and innovation.

From humble beginnings in 1996, the mutual fund industry has grown into a cornerstone of India’s financial system, channeling household savings into productive investments in the economy. This growth has been facilitated by the clarity and stability provided by the regulatory framework.

The regulations have evolved continuously to address emerging challenges and opportunities. From basic registration requirements in the early years to sophisticated risk management frameworks today, SEBI has demonstrated its commitment to keeping the regulations relevant and effective.

Investor protection has been at the heart of these regulations. The trustee-AMC structure, investment restrictions, disclosure requirements, and expense caps all serve to safeguard investor interests. These protections have helped build trust in mutual funds as an investment avenue for ordinary Indians.

The distribution landscape has been transformed by regulatory interventions like the abolition of entry loads, introduction of direct plans, and focus on distributor conduct. These changes have made the industry more investor-friendly and reduced conflicts of interest.

Recent episodes like the Franklin Templeton case have tested the regulatory framework and led to further strengthening of investor protections. SEBI’s willingness to learn from such episodes and update regulations accordingly is a positive sign for the long-term health of the industry.

Looking ahead, the regulations will need to continue evolving to address emerging challenges like technology disruption, new investment strategies, and the need for greater financial inclusion. SEBI’s consultative approach to regulation suggests that it will engage with industry and investors to find balanced solutions.

For investors, the mutual fund regulations provide a safety net that makes investing in mutual funds less risky than direct investment in securities. Understanding these regulations can help investors make more informed choices and better appreciate the safeguards that protect their investments.

References 

1. Securities and Exchange Board of India. (1996). SEBI (Mutual Funds) Regulations, 1996. Gazette of India.
2. Securities and Exchange Board of India. (2021). Amendment to SEBI (Mutual Funds) Regulations, 1996. SEBI Circular dated October 5, 2021.
3. Securities and Exchange Board of India. (2017). Categorization and Rationalization of Mutual Fund Schemes. SEBI/HO/IMD/DF3/CIR/P/2017/114.
4. Karnataka High Court. (2020). Franklin Templeton Trustee Services v. SEBI & Ors. WP No. 8120/2020.
5. Supreme Court of India. (2002). Unit Trust of India v. SEBI. (2002) 3 SCC 429.
6. Securities Appellate Tribunal. (2015). Sahara Asset Management Company v. SEBI. SAT Appeal No. 178/2015, Order dated October 28, 2015.
7. Securities Appellate Tribunal. (2017). HDFC Asset Management Company v. SEBI. SAT Appeal No. 213/2016, Order dated March 15, 2017.
8. SEBI Annual Report 2020-21. Chapter on Mutual Funds and Collective Investment Schemes.
9. Association of Mutual Funds in India. (2021). Mutual Fund Industry Data as of March 2021.
10. Balasubramanian, N., & Sane, R. (2019). “Evolution of Mutual Fund Regulation in India.” In Handbook of Finance in Emerging Markets (pp. 201-223). Oxford University Press.
11. Reserve Bank of India. (2021). Report on Trend and Progress of Banking in India 2020-21. Chapter on Mutual Funds and Other Financial Intermediaries.
12. Krishnan, V. (2020). “Impact of SEBI’s Mutual Fund Regulations on Investor Protection: An Empirical Study.” Journal of Securities Market Regulation, 15(2), 67-89.
13. Securities and Exchange Commission. (1940). Investment Company Act of 1940. United States Code.
14. European Parliament and Council. (2009). Directive 2009/65/EC (UCITS IV Directive).
15. Sadhak, H. (2021). “Current Challenges and Future Direction of India’s Mutual Fund Industry.” Indian Institute of Banking and Finance Journal, 17(3), 112-127.

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