Accounting Articles for Students

Non-Banking Finance Companies

by Ahmed Faraz | Published on 5/12/2006

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There are different types of institutions involved in financial services. These include commercial banks, development financial institutions (DFIs) and non-banking finance companies (NBFCs). Unlike DFIs e.g. ADBP and PICIC, that have a specified objective at priority besides efficient business conduct, NBFCs are formed purely with the commercial objectives. NBFCs provide range of financial services to their clients. Types of services that fall under the domain of non-banking finance services include the following;

1. Investment Finance Services

2. Investment Advisory Services

3. Asset Management Services

4. Venture Capital Services

5. Leasing Services

6. Housing Finance Services

7. Discounting Services

8. Any other form of business activities which the Federal Government may, by notification in the official gazette, specify from time to time

Incorporation of NBFC

1. To conduct any one or more type of non-banking business, prior permission of the SECP (the Commission) is required.

2. If the Commission grants permission to form an NBFC, the promoters of NBFC shall get the NBFC incorporated under the Companies Ordinance 1984 as a public company.

3. After incorporation under the Companies Ordinance 1984, the directors shall make separate application to the Commission for the grant of license for carrying on each type of business along with a nonrefundable fee of Rs. 100,000 for each such license.

4. The license granted by the Commission to NBFC would be valid for one year and each license shall be renewable annually on the payment of a fee of Rs.25,000.

5. The company must have separate tiers of minimum equity in respect of each type of service it want to indulge in:

   • Investment finance services - 300 million

   • Investment advisory services - 30 million

   • Asset management services - 30 million   

   • Venture capital investment - 5 million

   • Leasing - 200 million

   • Housing finance services - 100 million

   • Discounting services - 200 million

6. In non-banking services, there by default vest more fiduciary duties over the company’s management, hence the Commission before granting such license ensures that the board of directors comprises personnel with adequate qualification, expertise and integrity e.g. have no record of corruption, insolvency or default.

Powers of the Commission in Regulating NBFCs

Section 282A – 282M were inserted in the Companies Ordinance 1984 in November 2002 that gave the Commission following powers in regulating NBFCs:

1. Prior approval of the Commission is required to incorporate an NBFC.

2. After incorporation, NBFC needs license from the Commission to conduct any type of business.

3. The Commission may issue directions to any such company or may cancel any prior instructions.

4. The Commission is empowered to remove any director, chief executive, chairman or any officer from the office of the company for a period upto 3 years.

5. The Commission is also empowered to supersede the Board of Director of the company upto 3 years if board was found lacking fiduciary behaviour.

6. The Commission may require the company to furnish any particulars within the time specified by it.

7. The Commission may order a special audit to be conducted to the affairs of the business of the company.

8. The Commission may cause an inquiry or inspection to be made by any person appointed by the Commission for this purpose.

9. The Commission may impose penalty for contravention or noncompliance of any of its directions or rules or upon any false statement made by the company.

Now we take a look at each type of service that an NBFC could undertake.

Investment Finance Company (IFC)

Investment Finance Company is also known as investment bank or merchant bank. In Pakistan, there are many banks operating in this field as either full fledge merchant bank like Atlas Bank, Escorts Bank, First Dawood Bank, Jahangir Sidiqqui Bank, and some others carrying such services as ‘wing operations’ beside their main operations. This includes many commercial banks and even DFIs like IDBP that besides being a Development Financial Institution is also a scheduled bank and is also serving as a merchant bank. However these hybrid institutions are operating under their respective regulations i.e. Prudential Regulations. Following services have been specified in the NBFC Rules that an IFC usually undertakes, but not limits to this:

Money Market Activities

1. Issuing certificates of deposit or short-term commercial papers

2. Trading money market instruments (short term securities including gilts)

3. Act as a broker

Capital Market Activities

1. Trade in listed securities both shares and bonds

2. Provide professional analysis of securities to both institutional and individual investor

3. Underwrite stock and shares, TFCs and other obligations

4. Manage portfolios of stocks and shares

5. Manage pension funds of different enterprises (defined contribution plans for clients)

Project Financing Activities

1. Underwrite public issue of securities

2. Guarantees loans and obligations

3. Open letter of credit for their corporate clients for imports

Corporate Finance Services

1. Act as adviser and financial agent for companies in obtaining suitable credit from appropriate source with minimum cost

2. Assist companies in private placement of debt and equity securities

3. Advise companies in merger and acquisition

4. Prepare feasibility, market or industry studies for companies

5. Act as custodian for securities held by its clients

Investment Companies & Investment Advisory Services

To understand investment advisory service and investment companies, it is important to understand mutual fund. So it would be more helpful to read the appendix ‘A’ first.

Investment Companies And Investment Advisory Services

In simple words, investment company is a company that raises capital to invest it into the securities of other companies. It does not indulge in any production activities itself nor it provides, say, any physical service. Instead it specializes in developing and managing profitable investment portfolios. Investment companies should not be confused with investment finance companies that are also called merchant bank or investment banks.

An investment company must appoint an investment advisor, that is itself a company, to manage its investment portfolios. Investment advisor acts as a management company of the investment company. NBFC may obtain a license to act as an investment advisor to manage its own close-end funds. An investment advisor by definition is a public company that manages close-ended fund of its own unit trust (fund) or of another investment company. Consideration of service for an investment advisor is the management fee it gets. This fee remains a fixed percentage of monthly average of net fair value of assets it managed. Thus more is the value of assets – more the fee it would get. For illustration, we can discuss Arif Habib Investments (AHI) as an investment advisor which is currently maintaining three such close-end funds namely, Pakistan Capital Market Fund, Pakistan Premier Fund and Pakistan Strategic Allocation Fund. Details can be explored at www. Arifhabib.com.pk.

Investment advisory appears a relatively less understood topic because of its two possible structures. NBFC Rules contain provisions for the both of the following structures without any separate classification that makes it little confusing for the reader. Investment advisory services can be classified into the following two structures:

Structure 1:
Investment Advisor
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Trustee	Close-ended Scheme or Fund

Structure 1

In first structure, NBFC is shown as an investment advisor managing its own unit trust fund. Other players are trustee and the fund. A trustee is a company appointed to act as trustee through a trust deed (an agreement to safeguard the interest of scattered unit holders). This could be a bank, merchant bank (investment finance company) or a central depository company (CDC) that could be appointed as a trustee. AHI has CDC as a trustee for all of its close-end funds. Trustees are appointed to safeguard the interests of unit holders who have no such rights as available to shareholders. Trustees are appointed through a written trust deed that narrates rights and obligation of both the company and the trustee.

Third element of first structure is the close-ended scheme through which the NBFC raises funds by issuing certificates to the public. These certificates entitle each certificate holder to receive, on demand, his proportionate share of the net assets of the scheme/fund. Investment advisor uses this fund to develop and manage investment portfolios (assets of the fund). As the market value of such assets increases, value of units does increase.

Structure 2:
Investment Advisor
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Custodian	Investment Co (Any Public Co)

Structure 2

In second structure, NBFC is shown as providing investment advisory service to another company called investment company. Investment company is a separate public company and role of investment company in the whole structure is similar to the fund i.e. it raises the required amount by the issue of shares to the general public. So instead of certificate holders there are shareholders of the investment company having full rights and privileges as endured under the Companies Ordinance 1984 and there remain no need to appoint independent trustee to safeguard the interests of such shareholders.

Instead of trustee, there is a role for custodian. Again a custodian could be a bank, a merchant bank or central depository company but role of custodian is quite limited in contrast to a trustee. A custodian has to just hold securities that investment advisor bought. These investments could even be held in the name of custodian to facilitate transfer. Unlike a trustee, a custodian has not to oversee the acts of investment advisor and there is no such safeguarding role as a trustee has to play. AHI again appointed CDC as its custodian.

Investment company appoints its investment advisor through a written contract. This contract among other things provides that the investment advisor shall bear all expenditure in respect of the secretarial and office space of the company and of professional management including all administrative, accounting and legal services. However fee payable on account of auditor’s fee, custodian fee, brokerage, stamp duty and any other duties or taxes connected with the sale or purchase of securities and taxes on income of the company shall be payable by the investment company.

In close-end mutual funds, Investment Corporation of Pakistan (ICP) was the fist one to launch its 25 close-end mutual funds, ICP acted as a DFI and now its mutual funds have been taken over by PICIC and some by ABAMCO called lot ‘A’ and lot ‘B’ respectively. For more details please see annexure ‘B’.

Asset Management Company

Management Company (NBFC)
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Trustee	Open-ended Scheme

An NBFC may obtain a licence from the Commission to provide asset management service. An asset management company launches an open-end fund. An open-end fund does not have a fixed pool of money. The fund manager continuously allows investors to join or leave the fund. The fund is set up as a trust, with an independent trustee, who has custody over the assets of the trust. In contrast to close-end fund,

 an open-end fund always has trustee and for this, open-end fund is also called a unit Trust. The portfolio (pool) of investments of the unit trust is (normally) evaluated daily by the fund manager on the basis of prevailing market prices of the securities in the portfolio, this market value of the portfolio is divided by the number of units issued to determine the net asset value (NAV) per unit. An investor can join or leave the fund on the basis of the NAV per unit, however, the fund manager may have a small charge called “load” added to the selling price or deducted from the redemption price of the Units so as to cover distribution costs. Currently Arif Habib Investments is managing three open-end funds namely, Pakistan Stock Market Fund, Pakistan Income Fund and Pakistan Sovereign Fund – Metro Bank.

This structure is similar to the Structure 1 as shown in the investment company and all three elements appearing play the same role as investment advisor, trustee and the fund.

Venture Capital Companies

Venture capitalist is a unique form of financing activity that is undertaken on the belief of high-risk-high-return. Venture capitalists invest in those risky projects or companies (ventures) that have success potential and could promise sufficient return to justify such gamble. In Pakistan, there is no venture capital company till now and commercial banks are to some extent bridging the gap however, in European context 3i, among many others, is the name we must be familiar due to its large scale of successful venture activities.

Venture capitalist not only provides finance but also often provides managerial or technical expertise to venture projects. It usually require equity stake in return or could simply prefer debt finance that is more secure than equity.

There are broadly three legal constituents of venture capital mechanism:

VCC/NBFC
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|	VF
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VI in VP

1. Venture capital company
2. Venture fund
3. Venture investment in venture projects.

Venture capital company (VCC) is the NBFC licensed by the Commission to undertake venture capital activities.

Venture capital fund (VF) is a fund maintained by an NBFC with the minimum amount of 5 million to fulfill the SECP’s requirement of separate tier of equity.

Venture capital investment (VI) means financing of any venture project by a VCC or by venture fund (in case it is also engaged in other services) being managed by an NBFC in venture projects. Venture Projects means a project which is in the start-up phase or undergoing expansion or engaged in a service, manufacturing or production activity based on a new process, service or technology or located in a remote or underdeveloped area of the country and is financed by a venture capital fund or a VCC.

Leasing Services

Leasing service includes the leasing of assets to other companies either on operating lease or finance lease. An NBFC may obtain license to commence leasing services. However an NBFC shall not indulge in the following operations:

1. Hold, deal or trade in real estate except for use of NBFC itself
2. Engage in leasing operations pertaining to
   1. Open land
   2. Buildings other than factory building, warehouses, hospitals, educational institutions, office buildings and residential undertakings of such size as specified in the NBFC Rules
3. Furniture of furnishing of any type, provided the NBFC may lease hard furniture excluding carpets and curtains up to 5% of its lease portfolio
4. Fix the period of lease for less than 3 years in the case of any finance lease agreement except in case of computers and other IT accessories.

Some other institutions, most notably commercial banks, are also carrying leasing business but they don’t need to get any license under NBFC Rules as they are carrying this under their respective regulations.

Discounting Services

Discounting service although not defined in the NBFC Rules but generally involves discounting of invoices and bills of exchange of different parties. This is actually a form of short term finance that an NBFC, if licensed, could provide to its clients. When an NBFC discounts invoices, it releases the amount of invoice to the client after deducting its discount. On the due date, the NBFC collects the amount of invoice directly from the relevant customer. Discounting service may be extended to provide wider factoring services. Any enterprise could thus outsource its sales ledger and recovery function to such NBFC.

Housing Finance Services

Housing Finance Services means financial services related to development and construction of residential and commercial properties. We may compare its role with House Building Finance Corporation, although it is a DFI rather an NBFC. An NBFC licensed by the Commission to undertake such services may undertake the following activities:

1. Provide long term finance for the purpose of constructing, purchasing or renovating any property

2. Lease and rent on hire purchase basis buildings for residential and commercial purposes

3. Establish and manage housing schemes without engaging in real estate business

4. Carry out surveys and valuations of land the properties

5. Manage public or private sector projects in the housing and urban development sector

6. Financing against existing property by way of mortgage

Repealed Laws

• By the introduction of NBFC (Establishment & Registration) Rules, 2003, following enactments have been repealed:
• Venture Capital Companies and Venture Capital Funds Rules, 2001
• The Leasing Companies (Establishment & Regulation) Rules, 2000
• Asset Management Companies Rules, 1995
• Investment Companies and Investment Advisor Rules, 1971

Every company, already in existence before the issue of such rules, which is engaged in one or more forms of NBFC business shall apply in writing to the Commission for grant of a new license along with a non-refundable processing fee of rupees fifty thousand. Provided that till such time that a new license is issued, the existing licenses or registrations shall be deemed to be valid for the purposes of these rules unless the company fails to apply for license as specified in Rule or the Commission declines to grant such license for reasons to be recorded in writing.

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Appendix - A

Unit Trust or Mutual Fund

Financial markets have always attracted large number of investors, and managing investment portfolios has always remained a specialized activity left with qualified and well experienced personnel. But does it mean that an investor with additional finance with no financial market experience would never be able to enter into the stock market? In absence of unit trusts, the answer is yes. So in simple words, unit trusts (mutual funds in American terminology) enables a layman investor to get direct benefit from financial markets that always promise highest returns but unfortunately with highest risks.

Unit trust can be seen as a company that invests in marketable securities and manages investment portfolios to optimize return while bearing minimum risk. Unit trust collects money from smaller investors and manages diversified investment portfolios to maximize the unit-holders’ wealth. Unit-holders get the direct benefit of any dividend payment or capital appreciation through increase in the unit price which is quoted daily to reflect the fair value of net assets managed by the company.

There are two main types of such funds, open-ended fund and close-ended mutual funds. In case of open-ended fund, the fund manager continuously allows investors to join or leave the fund. The fund is set up as a trust, with an independent trustee, who keeps custody over the assets of the trust. Each share of the trust is called a Unit and the fund itself is called a Unit Trust. The portfolio of investments of the Unit Trust is normally evaluated daily by the fund manager on the basis of prevailing market prices of the securities in the portfolio. This market value of the portfolio is divided by the number of units issued to determine the Net Asset Value (NAV) per unit. An investor can join or leave the fund on the basis of the NAV per unit. However, the Fund Manager may have a small charge called “load” added to the selling price or deducted from the redemption price of the units so as to cover distribution costs.

In contrast, a close-end fund is similar to a listed company with respect to its main finance (share capital) as it issues fixed number of shares. These shares are not redeemable and are traded in the stock exchange like any other listed securities. Value of units of close-end funds is determined by market forces not directly by their NAV, even few investors believe that these are available at 20-30% discount to their NAV. Like listed securities, it is easy to trade close-end shares/units, whereas to acquire units of close-end fund, one has to fill some forms and visit the authorized dealers or designated offices who then issue certificate of ownership.

Open-end fund

1. Issues redeemable units
2. Not necessarily listed
3. Does not conduct general meetings of unit holders
4. No voting rights of unit holders
5. May issue as many units and redeem them at NAV
6. Each time, units are directly acquired from or sold to the company through their authorized offices
7. License of investment advisory is required
8. Units are traded at NAV

Close-end fund

1. Issues irredeemable shares
2. Listed
3. Conducts AGMs
4. Bestow voting rights to shareholders
5. Has fixed pool of money and does not continuously offer shares, however may increase its capital under the Companies Ordinance
6. Shares are acquired from the company on initial public offer and from existing shareholders afterwards
7. License of asset management services is required
8. Shares are trades at market price rather NAV reported by the fund manager

Appendix - B

National Investment Trust Limited was incorporated as an unquoted public limited company in 1962. under normal procedures. The principal activity of the company is to manage unit trust named National Investment Unit Trust (NIT), a close-end mutual fund. NIT is the largest single investor in the KSE with about 3 – 4% of the total market capitalization at KSE.

Pakistan Industrial Credit & Investment Corporation Limited (PICIC) was established in 1957. which shares may be obtained by Being the largest DFI in the country in terms of total assets, the corporation's primary activities encompass term financing for industrial and commercial activities, merchant banking operations, capital market operations, consumer financing and leasing. PICIC is now also engaged in asset management consequent to the acquisition of management rights of ICP mutual funds – Lot ‘B'. The corporation has also recently ventured into the insurance business by forming a new insurance company

Investment Corporation of Pakistan (ICP), a state controlled DFI was established through the ICP Ordinance 1966. The main objective of ICP was to strengthen the capital market in Pakistan by investing in listed equity securities. ICP floated 25 mutual funds (close-ended) and a State Enterprise Mutual Fund (close-ended). ICP performed satisfactorily uptill late eighties when its financial position began to deteriorate. After considering restructuring options in June 2001, the GoP decided to windup ICP. The management rights of 25 mutual funds were sold in two lots as Lot A and Lot B to ABAMCO and PICIP respectively. In 2003, PICIC also acquired the management rights of the SEMF.

Jahangir Siddiqui & Co. Ltd., a listed company, was established in 1991. Starting as a traditional securities firm, JSCL is now acquiring the character of a holding company. With its considerably expanded equity and asset base, the company is embarked upon new initiatives while retaining its status as the flagship company of the Jahangir Siddiqui Group.

Jahangir Siddiqui Investment Bank Limited (JSIBL) commenced commercial operations in September 1993. Currently it is under the control of Jahangir Siddiqui and Company Ltd. (JSCL). JSIBL is involved in merchant bank activities and is after the diversification and growth strategy.

ABAMCO, Incorporated in 1995, is the largest private sector asset management company in Pakistan, registered with the (SECP) as Investment Advisor for closed-ended funds and Asset Management Company for management of open-ended funds. It is a subsidiary of Jahangir Siddiqui & Company Ltd. (JSCL).

Arif Habib Securities Limited (AHSL) is a listed company registered with the SECP as a securities broker under the Brokers Agents Registration Rules, 2001. The Company has one of the largest brokerage operations on the Karachi stock exchange and also offers research and corporate finance services. AHSL was incorporated as a Public Limited Company on November 14, 1994 to continue the securities brokerage business successfully carried on by Mr. Arif Habib since 1989 as a sole proprietor under the name of Arif Habib. AHSL was listed on all the three stock exchange in June 2001. Arif Habib Investments is currently managing several open and close-end mutual funds.

Arif Habib Investment Management Limited (AHIML), a subsidiary of AHSL, incorporated in August 2000, is one of the largest asset management companies in Pakistan to manage open-end mutual fund. AHIML is an associated undertaking of Arif Habib Securities Limited, a leading securities brokerage firm also offering research and corporate finance services.

Atlas Asset Management Limited (AAMCL), sponsored by the Atlas Group of Companies, was incorporated on August 20, 2002. Atlas Group, established in 1962, is one of the well-known business groups of the country with strong presence in manufacturing, finance and trading sectors. Currently AAMCL is acting as the asset management company for an open-end fund but also planning to act as an investment advisor to close-end funds.

First Dawood Investment Bank Limited (FDIB) is a grown up form of earlier Dawood Leasing Company Limited which was in operation since 1995 and converted to FDIB in 2004. FDIB offered other financial services besides just leasing and is actively engage as investment banking and housing finance services.

First International Investment Bank Limited, incorporated in 1990, is a joint venture of the Packages Group, American Express Bank New York and International Finance Corporation, who collectively hold majority of the bank’s equity. Until now, the bank has limited branches in Karachi only however is planning to fell in geographical expansion.

Article courtesy of Accountancy

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