Guidelines for valuation and provisioning of non-performing assets and corrigendum Gazette Notification dated July 26, 2000 - SEBI - MFD/CIR/ 8 / 92 /2000

DIVISION CHIEF MUTUAL FUNDS DEPARTMENT MFD/CIR/ 8 / 92 /2000 September 18, 2000 All Mutual Funds Registered with SEBI Unit Trust of India Dear Sirs, Association of Mutual Funds in India (AMFI) made certain recommendations on valuation norms and provisioning of non-performing assets. The recommendations were placed before the Accounting Standards Committee set up by SEBI. The Committee, which also had representation from AMFI, deliberated the issues and has given its report. Enclosed herewith are (i) Guidelines for valuation of securities and (ii) Guidelines for Identification and Provisioning for NPAs. These guidelines are being issued in accordance with the provisions of Regulation 77 of SEBI (Mutual Funds) Regulations, 1996. These guidelines are supplementary to the provisions specified in SEBI regulations. A few modifications in the Regulations wherever required would be made in due course. These guidelines shall be effective from October 1, 2000. 2. A copy of corrigendum published in the gazette notification dated July 26, 2000 is also enclosed. Yours faithfully, P. K. NAGPAL Encl : a/a SECURITIES AND EXCHANGE BOARD OF INDIA MUTUAL FUNDS DEPARTMENT GUIDELINES FOR VALUATION OF SECURITIES FOR MUTUAL FUNDS Mutual funds shall categorise the securities according to the following norms: 1. Traded Securities : When a security (other than Government Securities) is not traded on any stock exchange on a particular valuation day, the value at which it was traded on the selected stock exchange or any other stock exchange, as the case may be, on the earliest previous day may be used provided such date is not more than thirty days prior to valuation date. 2. Thinly Traded Securities : (i) Thinly Traded Equity/Equity Related Securities : When trading in an equity/equity related security (such as convertible debentures, equity warrants, etc.) in a month is less than ₹ 5 lacs or the total volume is less than 50,000 shares, it shall be considered as a thinly traded security and valued accordingly. Where a stock exchange identifies the thinly traded securities by applying the above parameters for the preceding calendar month and publishes/provides the required information along with the daily quotations, the same can be used by the mutual funds. If the share is not listed on the stock exchanges which provide such information, then it will be obligatory on the part of the mutual fund to make its own analysis in line with the above criteria to check whether such securities are thinly traded which would then be valued accordingly. In case trading in an equity security is suspended upto 30 days, then the last traded price would be considered for valuation of that security. If an equity security is suspended for more than 30 days, then the Asset Management Company/Trustees will decide the valuation norms to be followed and such norms would be documented and recorded. (ii) Thinly Traded Debt Securities: A debt security (other than Government Securities) that has a trading volume of less than ₹ 5 crores in the previous calendar month shall be considered as a thinly traded security based upon information provided by the relevant stock exchange on the volume of debt securities traded. A thinly traded debt security as defined above would be valued as per the norms set for non-traded debt security. 3. Non Traded Securities : When a security (other than Government Securities) is not traded on any stock exchange for a period of thirty days prior to the valuation date (instead of the existing provision of 60 days), the scrip must be treated as a non traded security. VALUATION OF NON-TRADED / THINLY TRADED SECURITIES Non traded/ thinly traded securities shall be valued in good faith by the asset management company on the basis of the valuation principles laid down below : (i) Non-traded / thinly traded equity securities: (a) Based on the latest available Balance Sheet, net worth shall be calculated as follows : (b) Net Worth per share = [share capital+ reserves (excluding revaluation reserves) Misc. expenditure and Debit Balance in P L A/c] Divided by No. of Paid up Shares. (c) Average capitalisation rate (P/E ratio) for the industry based upon either BSE or NSE data (which should be followed consistently and changes, if any noted with proper justification thereof) shall be taken and discounted by 75% i.e. only 25% of the Industry average P/E shall be taken as capitalisation rate (P/E ratio). Earnings per share of the latest audited annual accounts will be considered for this purpose. (d) The value as per the net worth value per share and the capital earning value calculated as above shall be averaged and further discounted by 10% for ill-liquidity so as to arrive at the fair value per share. (e) In case the EPS is negative, EPS value for that year shall be taken as zero for arriving at capitalised earning. (f) In case where the latest balance sheet of the company is not available within nine months from the close of the year, unless the accounting year is changed, the shares of such companies shall be valued at zero. (g) In case an individual security accounts for more than 5% of the total assets of the scheme, an independent valuer shall be appointed for the valuation of the said security. (ii)(a) Non Traded /Thinly Traded Debt Securities of Upto 182 Days to Maturity : As the money market securities are valued on the basis of amortization (cost plus accrued interest till the beginning of the day plus the difference between the redemption value and the cost spread uniformly over the remaining maturity period of the instruments) the same process should be adopted for non-traded debt securities with residual maturity of upto 182 days, in the absence of any other standard benchmarks in the market. All other non traded Non Government debt instruments should be valued using the method suggested in (ii)(b) hereof. (ii)(b) Non Traded/ Thinly Traded Debt Securities of Over 182 Days to Maturity. For the purpose of valuation, all Non Traded Debt Securities would be classified into Investment grade and Non Investment grade securities based on their credit ratings. The non-investment grade securities would further be classified as Performing and Non Performing assets All Non Government investment grade debt securities, classified as not traded, shall be valued on yield to maturity basis as described below. All Non Government non investment grade performing debt securities would be valued at a discount of 25% to the face value All Non Government non investment grade non performing debt securities would be valued based on the provisioning norms. The approach in valuation of non traded debt securities is based on the concept of using spreads over the benchmark rate to arrive at the yields for pricing the non traded security. The Yields for pricing the non traded debt security would be arrived at using the process as defined below. Step A A Risk Free Benchmark Yield is built using the government securities (GOI Sec) as the base. GOI Secs are used as the benchmarks as they are traded regularly; free of credit risk; and traded across different maturity spectrums every week. Step B A Matrix of spreads(based on the credit risk) are built for marking up the benchmark yields. The matrix is built based on traded corporate paper on the wholesale debt segment of an appropriate stock exchange and the primary market issuances. The matrix is restricted only to investment grade corporate paper. Step C The yields as calculated above are Marked-up/Marked-down for ill-liquidity risk Step D The Yields so arrived are used to price the portfolio METHODOLOGY A. Construction of Risk Free Benchmark Using Government of India dated securities, the Benchmark shall be constructed as below : Government of India Dated securities will be grouped into the following duration buckets viz., 0.5-1 years, 1-2 years, 2-3 years, 3-4 years, 4-5 years, 5-6 years and 6 years and the volume weighted yield would be computed for each bucket. Accordingly, there will be a benchmark YTM for each duration bucket. The benchmark as calculated above will be set weekly, and in the event of any change in the Reserve Bank of India (RBI) policies affecting interest rates during the week, the benchmark will be reset to reflect any change in the market conditions. Note : The concept of duration over tenor has been chosen in order to capture the reinvestment risk. It is intended to gradually move towards a methodology that incorporates the continuous curve approach for valuation of such securities. However, in view of the current lack of liquidity in the corporate bond markets, a continuous curve approach to valuation would be necessarily based on limited data points, and this would result in out of line valuations. As an interim methodology therefore it is proposed that the Duration Bucket approach be adopted and continuously tracked in order to fine tune the duration buckets on a periodic basis. Over the next few years it is expected that with the deepening of the secondary market trading, it would be possible to make a gradual move from the Duration Bucket approach towards a continuous curve approach. B . Building a Matrix of Spreads for Marking-up the Benchmark Yield Mark up for credit risk over the risk free benchmark YTM as calculated in step A, will be determined using the trades of corporate debentures/bonds of different ratings. All trades on appropriate stock exchange during the fortnight prior to the benchmark date will be used in building the corporate YTM and spread matrices. Initially these matrices will be built only for corporate securities of investment grade. The matrices are dynamic and the spreads will be computed every week. The matrix will be built for all duration buckets for which the benchmark GOI matrix is built to effectively link the corporate matrix with the GOI securities matrix. Accordingly: All traded paper (with minimum traded value of ₹ 1 crore) will be classified by their ratings and grouped into 7 duration buckets; for rated securities, the most conservative publicly available rating will be used; For each rating category, average volume weighted yield will be obtained both from trades on the appropriate stock exchange and from the primary market issuances Where there are no secondary trades on the appropriate stock exchange in a particular rating category and no primary market issuances during the fortnight under consideration, then trades on appropriate stock exchange during the 30 day period prior to the benchmark date will be considered for computing the average YTM for such rating category; If the matrix cannot be populated using any or all of the above steps, then credit spreads from trades on appropriate stock exchange of the relevant rating category over the AAA trades will be used to populate the matrix; In each rating category, all outliers will be removed for smoothening the YTM matrix; Spreads will be obtained by deducting the YTM in each duration category from the respective YTM of the GOI securities; In the event of lack of trades in the secondary market and the primary market the gaps in the matrix would be filled by extrapolation. If the spreads cannot be extrapolated for the reason of practicality, the gaps in the matrix will be filled by carrying the spreads from the last matrix. C. Mark-up/Mark-down Yield The Yields calculated would be marked-up/marked down to account for the ill-liquidity risk, promoter background, finance company risk and the issuer class risk. As the level of illiquidity risk would be higher for non rated securities the marking process for rated and non rated securities would be differentiated as follows C(I) Adjustments for Securities rated by external rating agencies The Yields so derived out of the above methodology could be adjusted to account for risk mentioned above. A Discretionary discount/premium of upto +/-50 Basis Points for securities having a duration of upto 2 years and upto +/- 25 Basis Points for securities having duration higher than 2 years will be permitted to be provided for the above mentioned types of risks. The rationale for the above discount structure is to take cognizance of the differential interest rate risk of the securities. This structure will be reviewed periodically. C (II) Adjustments for Internally Rated Securities To value an un-rated security, the fund manager has to assign an internal credit rating, which will be used for valuation. Since un-rated instruments tend to be more illiquid than rated securities, the yields would be marked up by adding +50 basis point for securities having a duration of upto two years and +25 basis point for securities having duration of higher than two years to account for the illiquidity risk. Valuation of securities with Put/Call Options The option embedded securities would be valued as follows: Securities with call option : The securities with call option shall be valued at the lower of the value as obtained by valuing the security to final maturity and valuing the security to call option. In case there are multiple call options, the lowest value obtained by valuing to the various call dates and valuing to the maturity date is to be taken as the value of the instrument. Securities with Put option The securities with put option shall be valued at the higher of the value as obtained by valuing the security to final maturity and valuing the security to put option In case there are multiple put options, the highest value obtained by valuing to the various put dates and valuing to the maturity date is to be taken as the value of the instruments. Securities with both Put and Call option on the same day The securities with both Put and Call option on the same day would be deemed to mature on the Put/Call day and would be valued accordingly. (ii)(c) Government securities ( not traded for more than 30 days or one which would qualify as a thinly traded security) will be valued at cost plus accrual and amortizing the discount or premium over the like of the security. Illiquid Securities : (a) Aggregate value of illiquid securities of scheme, which are defined as non-traded, thinly traded and unlisted equity shares, shall not exceed 15% of the total assets of the scheme and any illiquid securities held above 15% of the total assets shall be assigned zero value. Provided that in case any scheme has illiquid securities in excess of 15% of total assets as on September 30, 2000 then such a scheme shall within a period of two years bring down the ratio of illiquid securities within the prescribed limit of 15% in the following time frame: (i) all the illiquid securities above 20% of total assets of the scheme shall be assigned zero value on September 30, 2001. (ii) All the illiquid securities above 15% of total assets of the scheme shall be assigned zero value on September 30, 2002. (b) All funds shall disclose as on March 31 and September 30 the scheme-wise total illiquid securities in value and percentage of the net assets while making disclosures of half yearly portfolios to the unitholders. In the list of investments, an asterisk mark shall also be given against all such investments which are recognised as illiquid securities. (c) Mutual Funds shall not be allowed to transfer illiquid securities among their schemes w.e.f. October 1, 2000. (d) In respect of closed ended funds, for the purposes of valuation of illiquid securities, the limits of 15% and 20% applicable to open-ended funds should be increased to 20% and 25% respectively. (e) Where a scheme has illiquid securities as at September 30, 2001 not exceeding 15% in the case of an open-ended fund and 20% in the case of closed fund, the concessions of giving time period for reducing the illiquid security to the prescribed limits would not be applicable and at all time the excess over 15% or 20% shall be assigned nil value. SECURITIES AND EXCHANGE BOARD OF INDIA MUTUAL FUNDS DEPARTMENT Guidelines For Identification and Provisioning for Non Performing Assets (Debt Securities) For Mutual Funds: (A) Definition of a Non Performing Asset (NPA) An asset shall be classified as non performing, if the interest and/or principal amount have not been received or remained outstanding for one quarter from the day such income / instalment has fallen due. (B) Effective date for classification and provisioning of NPAs : The definition of NPA may be applied after a quarter past due date of the interest. For e.g. if the due date for interest is 30.06.2000, it will be classified as NPA from 01.10.2000. (C) Treatment of income accrued on the NPA and further accruals After the expiry of the 1st quarter from the date the income has fallen due, there will be no further interest accrual on the asset i.e. if the due date for interest falls on 30.06.2000 and if the interest is not received, accrual will continue till 30.09.2000 after which there will be no further accrual of income. In short, taking the above example, from the beginning of the 2nd quarter there will be no further accrual on income. On classification of the asset as NPA from a quarter past due date of interest, all interest accrued and recognized in the books of accounts of the Fund till the date, should be provided for. For e.g if interest income falls due on 30.06.2000, accrual will continue till 30.09.2000 even if the income as on 30.06.2000 has not been received. Further, no accrual will be done from 01.10.2000 onwards. Full provision will also be made for interest accrued and outstanding as on 30.06.2000. (D) Provision for NPAs Debt Securities. Both secured and unsecured investments once they are recognized as NPAs call for provisioning in the same manner and where these are related to close ended scheme the phasing would be such that to ensure full provisioning prior to the closure of the scheme or the scheduled phasing which ever is earlier. The value of the asset must be provided in the following manner or earlier at the discretion of the fund. Fund will not have discretion to extend the period of provisioning. The provisioning against the principal amount or instalments should be made at the following rates irrespective of whether the principal is due for repayment or not. 10% of the book value of the asset should be provided for after 6 months past due date of interest i.e. 3 months form the date of classification of the asset as NPA. 20% of the book value of the asset should be provided for after 9 months past due date of interest i.e 6 months from the date of classification of the asset as NPA. Another 20% of the book value of the assets should be provided for after 12 months past due date of interest i.e 9 months form the date of classification of the asset as NPA. Another 25% of the book value of the assets should be provided for after 15 months past due date of interest i.e. 12 months from the date of classification of the asset as NPA. The balance 25% of the book value of the asset should be provided for after 18 months past due date of the interest i.e 15 months form the date of classification of the assets as NPA. Book value for the purpose of provisioning for NPAs shall be taken as a value determined as per the prescribed valuation method. This can be explained by an illustration : Let us consider that interest income is due on a half yearly basis and the due date falls on 30.06.2000 and the interest is not received till 1st quarter after due date i.e. 30.09.2000. This provisioning will be done in following phased manner : 10% provision 01.01.2001 6 months past due date of interest i.e 3 months form the date of classification of asset as NPA (01.10.2000) 20% provision 01.04.2001 20% provision 01.07.2001 25% provision 01.10.2001 25% provision 01.01.2002 Thus, 1 1/2; years past the due date of income or 1 1/4; year from the date of classification of the asset as an NPA, the asset will be fully provided for. If any instalment is fallen due, during the period of interest default, the amount of provision should be instalment amount or above provision amount, whichever is higher. (E) Reclassification of assets : Upon reclassification of assets as performing assets : 1. In case a company has fully cleared all the arrears of interest, the interest provisions can be written back in full. 2. The asset will be reclassified as performing on clearance of all interest arrears and if the debt is regularly serviced over the next two quarters. 3. In case the company has fully cleared all the arrears of interest, the interest not credited on accrual basis would be credited at the time of receipt. 4. The provision made for the principal amount can be written back in the following manner :- 100% of the asset provided for in the books will be written back at the end of the 2 nd quarter where the provision of principal was made due to the interest defaults only. 50% of the asset provided for in the books will be written back at the end of the 2 nd quarter and 25% after every subsequent quarter where both instalments and interest were in default earlier. 5 An asset is reclassified as 'standard asset' only when both overdue interest and overdue instalments are paid in full and there is satisfactory performance for a subsequent period of 6 months. (F) Receipt of past dues : When the fund has received income/principal amount after their classifications as NPAs ; For the next 2 quarters, income should be recognized on cash basis and thereafter on accrual basis. The asset will be continued to be classified as NPA for these two quarters. During this period of two quarters although the asset is classified as NPA no provision needs to be made for the principal if the same is not due and outstanding If part payment is received towards principal, the asset continues to be classified as NPA and provisions are continued as per the norms set at (D) above. Any excess provision will be written back. (G) Classification of Deep Discount Bonds as NPAs : Investments in Deep Discount Bonds can be classified as NPAs, if any two of the following conditions are satisfied: If the rating of the Bond comes down to grade BB or below. If the company is defaulting in their commitments in respect of other assets, if available. Full Net worth erosion. __Provision should be made as per the norms set at (D) above as soon as the asset is classified as NPA. __Full provision can be made if the rating comes down to grade D (H) Reschedulement of an asset : In case any company defaults either interest or principal amount and the fund has accepted a reschedulement of the schedule of payments, then the following practice may be adhered to : (i) In case it is a first reschedulement and only interest is in default, the status of the asset namely, NPA may be continued and existing provisions should not be written back. This practice should be continued for two quarters of regular servicing of the debt. Thereafter, this be classified as performing asset and the interest provided may be written back. (ii) If the reschedulement is done due to default in interest and principal amount, the asset should be continued as non performing for a period of 4 quarters, even though the asset is continued to be serviced during these 4 quarters regularly. Thereafter, this can be classified as performing asset and all the interest provided till such date should be written back. (iii)If the reschedulement is done for a second/third time or thereafter, the characteristic of NPA should be continued for eight quarters of regular servicing of the debt. The provision should be written back only after it is reclassified as performing asset . (I) Disclosure in the Half Yearly Portfolio Reports : The mutual funds shall make scripwise disclosures of NPAs on half yearly basis along with the half yearly portfolio disclosure. The total amount of provisions made against the NPAs shall be disclosed in addition to the total quantum of NPAs and their proportion of the assets of the mutual fund scheme. In the list of investments an asterisk mark shall be given against such investments which are recognized as NPAs. Where the date of redemption of an investment has lapsed, the amount not redeemed shall be shown as Sundry Debtors and not investment provided that where an investment is redeemable by instalments, that will be shown as an investment until all instalments have become overdue. (J) Effective date for implementation / switchover to the current norms : The above norms shall be implemented by all mutual funds including UTI from 01.10.2000. THE GAZETTE OF INDIA EXTRA ORDINARY PART II SECTION 3 SUB-SECTION (ii) PUBLISHED BY AUTHORITY SECURITIES AND EXCHANGE BOARD OF INDIA NOTIFICATION CORRIGENDUM MUMBAI, THE 26th DAY OF JULY, 2000 SECURITIES AND EXCHANGE BOARD OF INDIA (MUTUAL FUNDS) (SECOND AMENDMENT) REGULATIONS, 2000 S.O. 694(E). In Securities and Exchange Board of India (Mutual Funds) (Second Amendment) Regulations, 2000 published in the Official Gazette, Extra-Ordinary, Part II, Section 3, Subsection (ii), dated 22nd May 2000 vide S.O. No. 484 (E), the following be read as under: In para (4), in sub-clause (a), the words in clause (1A) be read as in clause (1) . F. No. SEBI/LE/ 11694/2000 D.R. MEHTA CHAIRMAN SECURITIES AND EXCHANGE BOARD OF INDIA