To align the regulatory framework for non-banking financial companies (NBFCs) with mainstream governance practices, the Reserve Bank of India (RBI) introduced a scale-based regulatory framework for NBFCs in October 2021. This included governance-related requirements.
The framework required NBFCs to put in place board-approved pay and compensation policies "to address issues arising out of excessive risk-taking caused by misaligned compensation packages", with the RBI to issue guidelines later. In April 2022, the RBI issued such compensation guidelines for key managerial personnel (KMP) and senior management of all NBFCs other than base layer and government-owned NBFCs. The guidelines come into effect on 1 April 2023.
Under the guidelines, the board of directors of an NBFC is required to set up a nomination and remuneration committee (NRC) in accordance with section 178 of the Companies Act, 2013. The NRC must consist of at least three non-executive directors, and at least half of such directors must be independent directors. Section 178 also prescribes certain duties and responsibilities of the NRC. Its key function is to oversee the framing, review and implementation of the board-approved compensation policy. The guidelines prescribe that the NRC should coordinate with the risk management committee to achieve "effective alignment between compensation and risks".
The compensation levels of an NBFC must reflect the need for the retention of earnings and the maintenance of adequate capital. The compensation of KMPs and senior management must be reasonable and must adhere to statutory requirements and industry practices. Compensation packages may comprise fixed and variable pay components, ensuring that compensation is proportionate to risk outcomes. The mix of cash, equity and other forms of compensation is to be consistent with incurred risk. The fixed component of compensation may include cash, perquisites that are reimbursable up to a monetary ceiling, contributions towards superannuation and retirement benefits and the monetary equivalent of non-monetary benefits, such as accommodation and cars.
Performance and remuneration criteria for variable pay should be clearly defined at the beginning of the performance measurement period. The variable component of compensation may be in the form of share-linked instruments or a balanced mix of cash and share-linked instruments. The proportion of the variable component of compensation must be comparable with the role and prudent risk-taking profile of KMPs or senior management. The higher the responsibility, the higher should be the proportion of variable pay. The variable component should be variable in spirit as well as in the letter and can be zero, based on performance at an individual, business unit and company-wide level. The variable portion, whether cash or otherwise, may be deferred and paid in tranches on the basis of risk assessments, as decided by the board.
In the event of poor or negative financial performance of the NBFC or a relevant line of business or employee misconduct, the deferred compensation may be subject to malus arrangements that block payment of such remuneration and contractually agreed clawback terms where the employee returns remuneration in predetermined circumstances. NBFCs must identify situations that invoke the malus and clawback provisions. NBFCs may specify a time period during which such provisions apply.
The compensation of KMPs and senior management engaged in financial control, risk management, compliance and internal audit must be commensurate with their roles, and independent of the business areas they oversee. While KMPs and senior management may have a higher proportion of fixed compensation, there should be a reasonable proportion of variable pay to ensure that malus and clawback options are effective. Under the guidelines, KMPs and senior management cannot receive guaranteed bonuses. Joining bonuses for new hires may be offered and will not form part of a fixed or variable portion of compensation.
The guidelines are a move towards healthy governance practices. They provide broad guidance to NBFCs, reflective of the move towards principle-based regulation and a better relationship between NBFCs and the RBI.
Originally published by Law Asia.
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