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Say you have a surplus and want to invest in a fixed deposit. The choices are nine per cent from State Bank of India (SBI) for a year, eight per cent from ICICI Bank, 11.25 per cent from Hawkins Cookers, 10.25 per cent from Prism Cement, etc. The latter option looks most lucrative, by a good margin. But financial experts wouldn't be too happy with this choice. Reason: In the past, several companies have defaulted in their commitments.
Recently, the government stepped in to make these instruments safer. Its proposal of mandatory insurance cover for deposits raised by companies from individual investors, if implemented, could improve these instruments. The proposed measures form a part of the draft rules in the new Companies Act (Rule 13). "A company may accept deposits from its members by passing a resolution at a general meeting and subject to conditions as may be prescribed in the rules, including credit rating, deposit insurance, depositing 15 per cent of the amount of its deposits maturing during the current and next financial years in a scheduled bank, and so on," read the draft norms.
According to Sai Venkateshwaran, partner and head (accounting advisory services), KPMG India, if this is effected, companies would have to redeem current deposits and raise fresh money, in line with the new norms. "In case of a default, the company holding the deposit will have to refund the entire principal and interest for those who invested less than Rs 20,000. Deposits of more than Rs 20,000 may not be refunded completely, as the Act says only a certain amount, as specified in the deposit contract, will be given back, or at least Rs 20,000," he adds. In other words, public company deposits would henceforth be insured for up to Rs 20,000.
To safeguard investors' interest and stop companies from being over-leveraged, the Act has restricted companies to having outstanding deposits equal to 25 per cent of their share capital and reserves.
The Act also bars companies from promising huge returns and hefty commissions to agents, in excess of the prevailing rates prescribed by the Reserve Bank of India (RBI) for such deposits. The premium paid cannot be recovered from the depositor and the money has to be paid by the company alone. Also, the mandate to maintain a balance in a reserve account would push up costs for companies. It isn't clear whether companies would earn any interest on the reserve account, but it wouldn't be much, even if they do. Simply put, these proposals will make deposits an expensive source of raising funds. This means companies might not offer the supernormal returns they mostly do to lure customers. On the flip side, if companies don't offer rates higher than banks, they may find it difficult to get depositors. As it is, company deposits are not tax-friendly and net returns do not beat inflation. With lower returns, it would make even little sense to invest in these.
However, do not get carried away by the insurance component and mistake company deposits to be safe instruments. Higher interest rates or insurance can't be the only criterion to decide on investing in an instrument. Pay attention to the credit rating given to each issue and the premium offered compared to bank deposits. If a company is ready to pay you three per cent or more than market rates, it involves risk. The trade-off between bank and company deposits might not be much in the long term. Financial planners recommend 20 per cent exposure in company deposits in the overall debt portfolio, and that, too, only in those with high ratings - AAA or AA+.
"Given the insurance element may be introduced, there is no point in the government stressing on credit rating of companies. As long as one is able to recover his investments, why should he check the credit rating?" questions an investment advisor.
Importantly, though RBI has hinted at another round of rate increase, it is expected to cut rates starting mid-2014. If it cuts rates, the rates of company deposits, too, would fall. Conservative investors would be better off with bank deposits.
"The concept of deposit insurance is a worldwide initiative being taken and gaining popularity after the 2008-09 financial crisis. Any insurer, public or private, can cover the deposits," says Ashvin Parekh, managing partner, APAS LLP, and senior expert advisor (global financial services), EY.
According to insurers and officials from the corporate affairs ministry, initially, the Deposit Insurance and Credit Guarantee Corporation (DICGC) would insure company deposits. Insurance companies would slowly be brought in, as changes need to be made to the Insurance Act to incorporate cover for default risks. Currently, the Insurance Regulatory and Development Authority does not allow covering of default risks.
DICGC operates the deposit insurance system. It insures all deposits such as savings, fixed, current, recurring, etc, up to Rs 1 lakh (for both the principal and interest amount). In comparison, the Rs 20,000 limit is small and the government could look at revising it because investment experts say most company deposit holders invest at least Rs 40,000.
"Such covers need an insurance pool to be created, because these can't be specific to companies' financials or credit ratings. Insurance needs to be provided across the board. There are many changes required before we can design such a product," says Amarnath Ananthanarayanan, managing director, Bharti AXA General Insurance.
On defaulting, a company would be levied a hefty penalty of up to 18 per cent a year. Besides, any violating company and each of its officers and other persons who could be in default could be fined Rs 10,000, with an additional fine of Rs 1,000 for every day of contravention for a continuing default.
Before April 30 each year, companies have to put away in a deposit repayment reserve account at least 15 per cent of the deposits maturing during the financial year and the one following that. If implemented, the clause would lower the default risk in company deposits that financial experts warn against.
Under the deposit insurance scheme, companies would have to buy an insurance cover equivalent to the total principal amount and the promised interest component to depositors. The corporate affairs ministry would be initiating action against companies failing to comply with the new rules - Regulations for Acceptance of Deposits by Companies. Companies that do not provide insurance would be levied a penalty of 15 per cent a year.
CORPORATE AFFAIRS MINISTRY PROPOSES:
- To insure deposits worth at least Rs 20,000
- To rate company deposit issues for risk assessment of the instrument
- Companies deposit 15% of deposits maturing in current and next financial year in a bank
- A penalty of up to 15% against companies not complying with the rules
- Total deposit outstanding be equal to 25% of companies' share capital and reserves
- Companies should not promise huge returns, hefty commissions to agents
- Companies should not recover insurance cost from depositors
- A penalty of up to 18% annually on defaulting companies
