Ramesh S Arunachalam
A previous article (PART I) looked at the issue of
regulation/supervision of MIVs using the levels of analysis aspect. In this
article, we look at practical questions that regulators/supervisors would need
to ask at these various levels to ensure minimum regulation/supervision of MIVs
concerned. What is provided here is only a starter’s set[i]
and that caveat needs to be stated up front and clearly.
As noted earlier in PART I, there are four levels of
analysis as shown below and for reasons outlined in PART I, we restrict our
discussion to levels # 1 and 2.
|
Level
|
Relationship (s)
|
|
Level # 1
|
Investor – Fund
|
|
Level # 2
|
Fund – Fund Manager (or Fund – Sub-Advisor)
|
|
Level # 3
|
Fund/Fund Manager – MFI
|
|
Level # 4
|
MFI – Clients
|
OK, let us start with level # 1.
Level # 1: Investor – Fund
At level # 1,
the following questions appear to be relevant:
a. What has the fund promised investors when collecting
their money?
b. Has the fund delivered (at the most basic level) what
it has promised to its investors?
Let us take an example. For instance, a fund may claim
to be an ethical fund like ASN Novib Fund[ii]
and it may have received some tax/other concessions. Investors may also have
invested in the fund became of its ethical tag (and associated tax
breaks) - which basically come from the fund claiming to make certain kinds
of ethical investments and engage in some specified behavior. Taking the
ASN Novib – Triple Jump case, I quote from the ASN Novib Fund annual report
2007 (pages 12, 13 and 14). The report notes that:
“Socially
Ethical Project Regulations: The Socially Ethical Project Regulations [Regeling
Sociaal Ethisch Beleggen], which allows private funds to be used to achieve
development aid goals thanks to tax relief, is a major success. ASN Bank
anticipates that there will continue to be a widespread interest in socially
ethical investments. The market for microfinance institutions which satisfy the
ASN-Novib Fund’s strict criteria is moving apace. There is an increase in
expertise and experience as well as the number of small businesses which are
being reached, and a great deal of growth is still possible. In order to ensure
that an optimum dialogue occurs with the Ministries of Development Cooperation
and of Finance, which determine what tax relief is available, ASN Bank has
assumed the role of chair of the Beraad Sociaal Ethisch Beleggingsfondsen
[Socially Ethical Investment Funds Forum] of the Netherlands Bankers
Association [Nederlandse Vereniging van Banken]” [iii] (Page No. 12 and 13)
It further notes:
“Socially
responsible investment allowance: As of 1 January 2004 additional tax benefits
apply to investments in the ASN-Novib Fund following the latter’s acquisition
of a socially ethical status. First of all a maximum allowance of
EUR 53,421.00 (the amount for 2007) is provided for socially responsible
investments under Box 3. Socially responsible investments include green and
socially ethical investments, amongst others. In this case the savings amount
to 1.2% of capital gains tax on investments of up to EUR 53,421.00. In
addition, a deduction is permitted on any income tax owed, which is equivalent
to 1.3% of the average value of any tax-exempt investment listed in Box 3.
Consequently, the relevant tax benefits can amount to 2.5% (1.2% + 1.3%) of
one’s investment. In the case of partners both allowances represent an amount
as high as EUR 106,842.00 (the amount for 2007). An indexed tax exempt sum
of EUR 54,223.00 has been determined for 2008. The corresponding figure for
partners is EUR 108,446.00.” [iv] (Page No 14)
Likewise, the ASN Novib annual report 2008 notes that:
“Socially
Responsible Investment Regulation: Because of the socio-ethical status of
the ASN Novib Fund, an additional tax benefit applies to investments in the
Fund. Investors in the Fund enjoy a Box 3 exemption of no more than € 54,223
(2008) for socially responsible investments, which include green and
social/ethical investments. The savings for investors amount to 1.2% of capital
gains tax on investments up to € 54,223. In addition, the tax authorities
permit a deduction on any income tax due, which is 1.3% of the average value of
any tax exempt investment listed in Box 3. Consequently, the relevant tax
benefits can amount to 2.5% (1.2%+ 1.3%) of one’s investment. In the case of
‘partners for tax purposes’, both allowances represent an amount as high as €
108,446 (2008). A tax-exempt sum of € 55,145 per person has been indexed for
2009. The corresponding figure for partners is € 110,290.” [v] (Page No. 13)
Now, the regulator needs to be sure that the fund has
indeed behaved ethically and made such investments. Given the information in
Hugh Sinclair’s book and my previous articles[vi],
I am not sure that ASN Novib fund’s investment in LAPO was entirely in
line with its ethical objectives.
A related question arises in this regard:
c.
Is the fund legal in its operations in terms of its
investments? Is it supporting legal organizations/ activities?
The regulator also needs to be sure that the
fund does not invest in activities or organizations (MFIs etc) that are
engaged in and/or support illegal activities. And I think that the definition
of legal should be based on laws in the home (parent) country as well as the
host country.
Again, let us take the case of ASN Novib, which is
classified as an ethical fund and was accorded certain tax benefits in
Netherlands. A key question that arises here is: How appropriate was it for the ASN Novib fund to invest in LAPO
that, according to public domain material, was involved in illegal collection/
intermediation of savings as well as suffered several other weaknesses? Two
specific issues would serve to highlight this better:
A.
Illegal collection/intermediation of savings –
evidence in the public domain
MicroRate's 2007
rating report[vii]
clearly mentions the following:
“’Client savings intermediation without a license and without an
appropriate structure’ as a weakness” (Page No. 1)
"Borrowings are well diversified among a large number of
mainly foreign lenders. Approximately one-third of funding is provided by
client deposits even though as an NGO, LAPO is not licensed to mobilize
savings." (Page No. 5)
"With a cost of only 4%-5%, savings deposits are a much
cheaper source of funding than commercial credits. Recognizing this, LAPO has
strongly pushed savings mobilization. In MicroRate's opinion, this policy bears
a serious risk since as a NGO, LAPO is neither authorized nor adequately
equipped to mobilize savings from the public." (Page No. 5)
"LAPO's present policy using savings deposits to fund its
operations-besides being illegal-exposes its clients to risks of which they are
unaware." (Page No.6)
B. Unusually
high interest rates – evidence in the public domain
And the Planet Finance rating
report[viii]
of 2009 notes that:
"Since the end of October 2009, all clients pay a 2.5% monthly flat interest rate (from 3% before), disbursement and administration fees, and a 2% risk premium (covering clients in case of fire or death). Earlier in 2009 before that change of pricing, LAPO increased the amount of cash collateral requested as compulsory savings prior to loan disbursement, from 10% to 20% of the loan amount (upfront) and from 50 to 100 NGN at each instalment. Compulsory savings earn interest at a rate of 4% per annum (from 6% before). The decrease in interest rates coupled with the increase in the level of cash collateral, resulted in an increase of the average Effective Interest Rate (EIR) for the clients to 125.9% from 114.3% before." (Page No.6)
Likewise, the Planet Finance rating report[ix]
of 2011 notes that:
"LAPO had its pricing certified by Microfinance
Transparency as of December 2010 for its Regular Loan. The average price for a
first-time loan with insurance was estimated at 80%, expressed as a nominal
APR. Since then, the average APR for Regular Loan decreased to around 76%.
However, Microfinance Transparency also noted that as the client remains with
LAPO, the APR can reach between 99% and 144% by the third year (depending on
the loan amount and increase at each cycle) due to the cost of accumulating
weekly savings that cannot be withdrawn." (Page No.7)
Without any doubt, the ratings and other
public domain material also pointed to other serious issues and weaknesses in
the investee (LAPO) apart from its illegal collection and intermediation of
client savings and inordinately high interest rates: a) an illegal loan product
(perhaps) because illegal savings collection was a part of it; b) conflict of
interest in terms of the auditor being related to the CEO and other such
issues; c) high levels of client desertion; d) lack of transparency with regard
to data (which led to MicroRate’s subsequent withdrawal of its rating); and e)
poor governance among other things.
Given this, it is clear that ASN Novib’s investment in
LAPO (via Triple Jump) was supporting illegal activities on the ground. And
irrespective of whatever retrospective action is/was taken, the regulator/
supervisor must have a method to determine (in the future especially), whether
or not investments being made by MIVs are legal. Otherwise MIVs will claim to
be making ethical investments while actually doing things to the contrary.
Another question appears important at this level (level # 1).
d.
Is the fund tapping legal sources of money?
Regulators
must be clear that the contributions by investors are indeed from legal sources
and this is especially difficult, especially when web based and related
mechanisms are used. But this is an important question indeed and it is dealt
with in a separate article.
Ok, let us now move on to level # 2
Level # 2: Fund – Fund Manager (or Fund –
Sub-Advisor)
The following questions appear relevant here (at level # 2):
e. Is the fund taking adequate steps to protect its
investors?
f. Does the fund have minimum standards/systems to ensure
that investments made by the fund manager are in line with what has been
promised by the fund to its investors?
g. Does the fund have sufficient supervisory mechanisms
to ensure that the fund manager (sub-advisor) safeguards the interests of the
fund and its investors?
h. Does the fund have independent access to information
about the investees in which the fund manager (sub-advisor) proposes to invest
and/or has invested?
Again, let us take the ASN Novib case. The ASN Novib
Fund annual report[x] of
2007 notes that:
“LAPO, Nigeria:
In February the ASN-Novib Fund approved a loan of EUR 1 million to LAPO in
Nigeria. LAPO is the second microfinance institution in Africa to which the ANF
has provided a loan. Various studies have revealed that Nigeria is one of the
poorest countries in the world. For more than 30 years Nigeria has been rocked
by unrest and military regimes, with the result that the country has barely
developed. The majority of the people have had to rely on income from their own
small-scale activities which lend themselves exceedingly well to micro-funding.
Although micro-credit is still in its infancy in Nigeria, with a loan portfolio
of USD 7.5 million and 84,000 customers LAPO is the absolute epitome of
micro-lending in that country. LAPO has made the leap from receiving a loan
from the Oxfam Novib fund for less developed organisations to one from the
ASN-Novib Fund for more mature organisations. LAPO services the poorest
population groups in Nigeria. LAPO’s internal surveys of its customers have
revealed that their circumstances have improved by 80% compared with the
situation prevailing before they had received a loan from it. In conclusion
LAPO is actively involved in the development of Nigeria’s national regulations
governing microfinance institutions, which will provide legal protection for
any savings which poor people hold with such organizations”. (Page No. 8 and 9)
This statement about LAPO in the ASN Novib Fund annual
report of 2007 runs counter to available public domain information. Clearly,
LAPO was involved with illegal collection and intermediation of client savings
apart from having several other weaknesses. Yet, the ASN Novib Fund called LAPO
as the ‘absolute epitome of
micro-lending’. This clearly shows that the ASN Novib Fund lacked the systems
needed to safe guard the interests of its investors as well as gauge/collect
‘objectively correct’ information pertaining to investments made by the fund
manager. The fund perhaps took at face value, the information that was provided
by the fund manager and assumed it to be ‘correct’ and hence, did not do
its own checks with regard to the reliability/validity of information. The fund
needs to revisit these aspects for its own good as well as that of its
investors.
And herein
lies an important lesson for all stakeholders including MIVs (and/or
investors) who use fund managers/sub-advisors:
Lesson # 1: Irrespective of any
circumstances, it is the paramount duty of funds to actively supervise their
fund managers/sub-advisors (so as to
safeguard their own and investor funds).
And the regulator needs to ensure that such effective and timely supervision
of the fund manager (sub-advisor) by the fund happens on the ground in a
continuous manner.
From a regulatory standpoint, this is indeed a serious
issue because when a fund makes
investments through fund managers/sub-advisors, it does so (for and) on behalf
of its investors. And therefore, the regulator must be sure that the fund has a
strong mechanism/method (system) to ensure that the investments made (by the
fund manager/sub-advisor) have been done with required care and are in
the best interests of the investor. The mechanism could range from mere
inspection (by the fund) of a fund manager/sub-advisors’ due diligence
records to even actual due diligence (on a random basis) of the investees
covered. And specially, the regulator also needs to be sure that funds INDEED have
the requisite systems and processes to do this in real time. Therefore, it
would be useful for the regulator/supervisor to randomly and selectively test
the strength of internal control and other such systems at the level of the
fund, fund managers and sub-advisors.
Another question is relevant at this juncture:
i.
Does the fund manager have minimum standards of
governance, management and systems to ensure that investments made are in line
with what has been promised by to the investors?
Take for example, what Hugh Sinclair notes in his book[xi]:
“The Calvert document was largely copied and pasted
from the ASN Novib document. The same myths about the smoothly operating IT
system, the same low interest rates, even large chunks of text explaining the
political environment of Nigeria, were simply lifted from ASN Novib’s document
into the Calvert proposal—even though they was known, without doubt, to be
false. The author was even thoughtful enough to copy some spelling mistakes. In
the discussion of interest rates the word “flat” had been removed, obscuring
this questionable practice from Calvert, although it had been mentioned in the
original document presented to ASN-Novib. In another bizarre twist, at one
point the document referred to LAPO as “PRIDE,” which was another MFI that
Triple Jump had lent to in Africa that also charged high interest rates to the
poor, and in which Calvert had also coincidentally invested in. A
copy-and-paste error I suspect, albeit one that no one had detected. (Page No. 116 and 117)
The author of the document was none other than Inge,
the same girl who prepared the ASN-Novib document and who had recently left on
maternity leave. She and I had discussed LAPO at length, including the high
interest rates charged to the poor. She was entirely aware of the reality at
LAPO—we had explicitly discussed the second mission to Nigeria. How could she
have written this proposal, knowing that it misrepresented LAPO’s operations?
Inge’s relative lack of interest in microfinance certainly did not suggest to
me that she would deliberately fabricate evidence—she had nothing to gain, and
given the controversy surrounding LAPO, surely such inconsistencies would be
detected….I drew up a third column in the sheet that I had prepared for Oxfam
Novib and filled in the information presented to Calvert. In most cases the
same fabrications, or errors, that had been presented to ASN-Novib were also
presented to Calvert. This was potentially serious, and there was no defense of
this was the best information we had
available at the time, as there had been with ASN-Novib. (Page No. 117)
Unfortunately an almost identical
document, containing the same material “inaccuracies,” was presented to Calvert
Foundation for a loan to LAPO some nine months later (October 8th, to be
precise). By this point full information about LAPO was known by all involved,
and yet this information was entirely absent from the appraisal sent to
Calvert, making many of the same claims, indeed, copied and pasted from the
original Oxfam Novib/ANF document which you sent me. Given that this was done
with full knowledge of the real situation at LAPO, indeed, after the biggest
and most expensive intervention ever under taken by TJAS to resolve these
matters, the document presented an undeniably inaccurate picture of the
company. This is a much more serious situation than the original document, as I
am sure you appreciate. We can no longer claim ‘negligence’, or ‘inadequate
information at the time.’” (Page
No. 119)
Clearly, if true, the
above does not auger well for the kind of governance, management and systems
prevalent with fund managers like Triple Jump.
And herein lies another
important lesson for the regulator:
Lesson # 2: Irrespective of the circumstances, regulators must ensure
that fund managers (sub-advisors) adhere to prescribed minimum standards of
governance, management and systems.
While the tendency of the micro-finance industry is to prefer voluntary codes (or self-regulation), regulators must
ensure that ‘uniform’ codes exist and that these codes are ‘consistently’
implemented on the ground. Readers may be well versed with the problems associated
with such (well-intentioned) voluntary codes. More often than not, such codes do
not get implemented as past experience has shown in the case of retail MFIs,
especially in India. Therefore, even if voluntary codes are to be used for fund
managers (or even for the funds themselves), it would be important to have some
regulatory oversight (in real time) into the actual implementation of these
voluntary codes.
One final set of questions are very relevant to the
operations of the funds/fund managers and the regulators ought to be interested
in aspects like these:
a. Does the fund/fund manager have appropriate internal
control and independent internal audit systems vital for making prudent
investments?
b. What about the extent and quality of due diligence
prior to investment?
c. What about the extent and quality of monitoring post
investment?
The various problems mentioned by Hugh Sinclair in his
book and analyzed in previous articles[xii],
also appear to represent serious control breakdowns that can be grouped into
categories shown below:
· Lack of
adequate management oversight and accountability, and failure to develop a
strong control culture within the institution, from top to bottom
· Inadequate
recognition and assessment of the risk of certain activities, whether on- or
off-balance sheet and especially in relation to the organization’s strategic
objectives
·
The absence
or failure of key control structures and activities, such as segregation of duties,
due diligence and approvals for strategic investments and other activities,
verifications, reconciliations, and reviews of operating and other performance
and the like
· Inadequate
communication of information between levels of management within the
institution, causing significant opacity and
· Lack of
independent and effective (internal and external) audit programs and monitoring
activities.
To summarise, while all of
the above aspects are important from a regulatory/supervisory standpoint with
regard to MIVs (and fund-managers/sub-advisors), two crucial areas are
important from an internal organization as well as regulatory (external)
standpoint: a) the extent and adequacy
of internal control systems at the fund/fund manager level; and b) the presence
of independent and effective internal audits. Without question, both of these can
provide a good basis for ensuring prudent investment by MIVs in the long
run. And indeed many of the problems mentioned
earlier could have (perhaps) been mitigated (if not completely avoided) if only
the MIVs (concerned) had been required (by regulators) to institute well
functioning and appropriate internal control systems and also ensure effective
independent internal audits of the same. Anyway, while the past provides
good learning, we also need to move forward…and so, each of these critical
aspects are dealt sequentially in a series of articles with some further ideas
on the kinds of specific questions that regulators/supervisors would have to
ask…to ensure the above…
[i] At the outset, let me state that these are not
exhaustive and/or comprehensive by any means. They are intended to be a starter
set only.
[ii] The ASN Novib Fund is also referred to as ASN Novib
and they denote the same entity.
[iii] Source: Quoted from ASN - Novib Fund Annual Report
2007 (http://www.asnbank.nl/blob.asp?id=14214)
[iv] Source: Quoted from ASN - Novib Fund Annual Report
2007 (http://www.asnbank.nl/blob.asp?id=14214)
[v] Source: Quoted from ASN - Novib Fund Annual Report
2008 (http://www.asnbank.nl/blob.asp?id=15900)
[vi] Why not regulate and supervise microfinance investment
vehicles in their country of incorporation?; Triple Jump’s Response to Hugh Sinclair’s Book: Does It
Raise More Questions than Provide Credible Answers?; Why blame the MFIs alone?; Should not microfinance investment vehicles be judged
by the same standards set for retail MFIs?; and Does Sinclair’s Open Challenge (to the Global
Micro-Finance Industry) Make His Claims True?
[vii] Source: Lift Above Poverty Organization (LAPO) Rating Report by MicroRate,
December 2007
[viii] Source: Lift Above Poverty Organization (LAPO) Rating
Report by Planet Rating, December 2009
[ix] Source: Lift Above Poverty Organization (LAPO) Rating
Report by Planet Rating, December 2011
[x] ASN - Novib Fund Annual Report 2007 (http://www.asnbank.nl/blob.asp?id=14214)
[xi] Source: Quoted from Confessions Of A Microfinance Heretic: How Microlending Lost Its Way And
Betrayed the Poor by Hugh Sinclair (http://www.microfinancetransparency.com/)
[xii] Why not regulate and supervise microfinance investment
vehicles in their country of incorporation?; Triple Jump’s Response to Hugh Sinclair’s Book: Does It
Raise More Questions than Provide Credible Answers?; Why blame the MFIs alone?; Should not microfinance investment vehicles be judged
by the same standards set for retail MFIs?; and Does Sinclair’s Open Challenge (to the Global
Micro-Finance Industry) Make His Claims True?
Excellent article !! I totally agree with the points on tax benefits and the investment regulations
ReplyDelete