Indian banking sector is highly regulated.

The major challenges faced by the Indian banks are

emerging threats from the shadow banking. The institutions such as the Non-Banking
Financial Companies (NBFCs), Nidhi companies, are coming under the purview of shadow
banking as these institutions are functioning almost like the banks but they are not banks by
nature. The shadow banking sector is lightly regulated as a result often they are able to
provide higher return to the depositors than the banks.
However such light regulation can also prove to be a detriment to the interests of the Nidhi
companies with respect to regulatory framework. Unlike traditional banks and other financial
instituions, Nidhi companies fall under a separate category and are goverened by the
Companies Act, 2013 and the Nidhi Rules, 2014. Both these legisations are more concerned
about compliance function and general restrictions rather than any set procedure for strictly
penalizing or offering grievance redressal in case of breach of any functions. This lighter
regulatory framework leaves room for potential explaoitation and fraud, as there is a very
limited scope for comprehensive monitoring and control.
Due to such informal nature and limited regulatory oversight, Nidhi companies may become
susceptible to fraudulent practices. Instances of misappropriation of funds, siphoning off
money lead to more scams being reported in this sector. Such activities result in financial
losses for depositors and damage the reputation of Nidhi companies as a whole. Couple with
such risks is the limited protection that is available to depositors and investors. In the event
of Nidhi company’s failure or default, the deposit insurance mechanism provided by entitites
like the Deposit Insurance and Credit Guarantee Corporation (DIGC) does not cove rthe
Nidhi deposits. The absence of a safety net puts the hard-earned savings of the depositors at a
risk.

Nidhi companies primarily raise their funds through member deposits and by lending only to
its members as provided for in Rule 15(1) of Nidhi Rules, 2014 1. However, this gives rise to
a very limited resource pool as the companies cannot accept deposits from the public.
Insufficient liquidity and inadequate risk management practices can pose a severe threat to
the sustainiblity of such entitites.

1
It must be admitted that the recent few failures referred to above are a salutary signal and
there is an imperative need to regulate, supervise and exercise disciplinary control over the
Nidhis, but without stifling them.2

Transparency and disclosure practices in Nidhi companies can be inadequate making it

challenging for the stakeholders to assess the company’s financial health and risks associated
with it’s operations. To accomplish the objectives of transparency & investor friendliness in
corporate environment of the country, the Central Government has recently amended the
provisions related to NIDHI under the Companies Act and the Rules (effective from
15.08.2019)
The amended provisions of the Companies Act (Section 406) and Nidhi rules (as amended
w.e.f. 15.08.2019) require that the Nidhi companies have to apply to the Central government
for updation of their status/ declaration as Nidhi Company in Form NDH-4.

Upto 1996, 192 companies have been declared as Nidhis, It so happens today in the
Department the number of companies who have applied for registration under Section 620A
of the Companies Act so as to be classified as Nidhis is said to be 93 and there are
unspecified number of such companies claiming to be working on nidhi lines but have not
applied for declaration as nidhis. In respect of those companies who have applied for
classification as Nidhis, while declaration under Section 620A is pending, the RBI has in
consultation with DCA issued instructions permitting such companies, subject to certain
conditions similar to those applicable to companies declared as Nidhis, to accept deposits,
treating them as mutual benefit companies. Hence on the one hand while earlier, only those
companies registered as Nidhis under Section 620A were entitled to exemption from the
restrictions of the RBI, subsequently the DCA identified such other companies on the ground
that they were potential Nidhi companies by their activity, and the RBI in consultation with
DCA permitted such other companies going by the name of Mutual Benefit companies, but
not declared as Nidhis by DCA, also eligible for treatment similar to Nidhis, which seems
anomalous.

2
At present there is no ceiling on the mobilisation of deposits which Nidhis can receive. Any
financial institution must have capital of its own to face losses arising out of the exigencies of
business, if any, so as to avoid the destabilising effect on the interest of the depositors. In the
case of Nidhis the magnitude of credit risk faced by them is much lower than other financial
institutions; they are not allowed to advertise for raising public deposits and they are dealing
only with members.
When sanctioning loans against property offered as security the Nidhis generally get an
equitable mortgage, registered or unregistered, or merely a letter from the loanee depositing
the title deeds with the Nidhi. When the loan is not repaid the Nidhi resorts to legal action
incurring heavy expenditure and it takes years before they can bring the property for sale.
Consequently the liquidity of the Nidhi is affected, sometimes seriously.
No regulation and supervision can be effective without commensurate penalties for
defaults/violations of guidelines/regulations. Nidhis being incorporated with the sole object
of serving lower and middle strata of society, it is imperative that penalties should be
provided for defaults/violations/non-compliance committed by people in charge of
management of such companies. Certain violations which defeat the very object of such
companies should be visited with punishment including imprisonment.

Puraswalkam Santhatha Sanga Nidhi Ltd. ... vs Reserve Bank Of India

Of Others on 29 October, 1996
At any rate, the apprehension of the Reserve Bank of India, that if the nidhi
companies are not controlled, in time, there is every likelihood of such nidhi
companies being equated to the unincorporated bodies who are soliciting deposits by
offering attractive rates of interest and incentives. The Reserve Bank of India had
sufficient materials for entertaining such an apprehension on the basis of the study
undertaken by them, as disclosed in the counter-affidavit.
In K. Varadan And Ors. vs The Ambattur Saswatha Nidhi15, the petitioners collectively
holding in excess of 10% of the issued capital of the Ambattur Saswatha Nidhi Limited
aggrieved on account of certain acts of mismanagement and asking for appointment of an
independent director for better management of the affairs of the company. The representative
of the petitioners has complained of the acts of mismanagement in the affairs of the
Company as the Company has been lending monies, on the security of properties in and
around Ambathur, to persons without any credit worthiness and adequate securities in
violation of Clause 2 of the object clause of Memorandum of Association, resulting in
delayed repayment of loans availed by the borrowers. The respondents misappropriated the
funds of the Company by writing off the loans extended to the friends and relatives of the
directors. The respondents have abused their fiduciary position and failed to perform their
fiduciary responsibilities and duties of protecting the interests of the Company.
The observations of Khalid J. in Reserve Bank of India v. Peerless General Finance and
Investment Co. Ltd11 ..."[I] share my ……….. the mushroom growth of financial companies
all over the country. Such companies have proliferated. The victims of the schemes that are
attractively put forward in public media, are mostly middle class and lower middle class
people. Instances are legion where such needy people have been reduced penniless because
of the fraud played by such financial vultures. It is necessary for the authorities to evolve
fool-proof schemes to see that fraud is not allowed to be played upon persons who are not
conversant with the practice of such financial enterprises who pose themselves as benefactors
of people."