EVOLUTION OF STRESSED ASSET INDUSTRY
As we understand that Non-Preforming Assets (“NPAs”) and stressed assets, by whatever name they are known or called, all are associated with the debt markets having the same meaning with different consequences. Such NPAs or stressed assets are part of our financial system and universally, no lending activity or financial activity is free from risk of creating bad debts/bad assets.
Security As the Legal Comfort
Since risk is intrinsic to the business of lending, creation of security whether prime security or collateral security, including personal guarantee, corporate guarantee, letter of comfort and pledge of securities has not provided desirable solution in preventing creation of stressed assets or in the matter of resolution of stressed assets in the books of lenders, mainly owing to huge size of loans which are defaulted. Therefore, over a period of time several steps, both formal or informal have been taken by Government of India (“GoI”) and Reserve Bank of India (“RBI”) to reduce and manage the menace of NPA to preserve credit worthiness of banks and financial institutions.
Reserve Bank of India Income Recognition and Assets Classification Guidelines
In or about 1991, when Indian economy were opened-up, demand for bank credit increased manifold and consequential financial distress / stressed assets have also been increased.
In line with global prudential norms of accounting, RBI has issued a Circular in the year 1992 regarding guidelines on “Income Recognition and Assets Classification” (“NPA Guidelines”) for the purpose of recognition of NPA in the books of banks and financial institutions and its effective supervision and management at early stage of financial distress.
The NPA Guidelines have been reviewed, revised and updated from time to time by RBI. Under the NPA Guidelines, the accounts of the borrowers are now categorized into Special Mention Accounts (“SMA”) and NPA Accounts depending upon the age of default.
Debts Recovery Tribunals
Soon after the NPA Guidelines were put in place in 1992, the Recovery of Debts and Bankruptcy Act, 1993 (“DRT Act”) was enacted to expedite recovery of bad loans by banks and financial institutions. Under the provisions of the DRT Act, all original applications filed by banks were required to be decided within six months from the date of filing. Despite the effective legal framework put in place for speedy recovery of bad loans through the Debts Recovery Tribunals (“DRTs”) in accordance with the provisions of the DRT Act, the recovery related to stressed assets /bad loans could not be expedited and DRTs have not succeeded in achieving the object. The reasons for the delays in disposal are, inter alia, lack of infrastructure, dearth of expertise of lawyers and presiding officers who are/were not well-versed with the nuances of the banking practice.
SARFAESI ACT
Since recovery measures under the DRT Act have not yielded the desired results despite over a decade of its existence, in order to further strengthen the recovery measures and reduce NPAs, the Securitisation and Reconstruction of Financial Assets and Enforcement Security Interest Act, 2002, (“SARFAESI Act”) was enacted allowing the banks and financial institutions, inter alia, to take possession of the secured assets and sell the same without intervention of the courts /tribunals to recover NPAs as set out in the SARFAESI Act. Unfortunately, implementation of SARFAESI Act faced many initial legal challenges and when implemented, the measures have fallen short in
reducing the NPAs of banks and financial institutions primarily due to lack of buyers in the market and other legal hurdles faced by the banks and financial institution before DRTs, DRATs, High Courts and the Supreme Court. There is no priority for dealing with such cases/appeals by the tribunals and courts. Moreover, in regard to sale of project related assets (in infrastructure projects etc.), lenders faced tough tasks in finding suitable buyers/purchasers. The asset reconstruction companies constituted pursuant to the SARFAESI Act have contributed in reduction of NPAs to some extent by acquiring the stressed assets in the books of banks and financial institutions.
Mechanism of Restructuring of Debt Under RBI Scheme
Prior to enacting the SARFAESI Act, RBI has issued various schemes like Corporate Debt Restructuring (“CDR”) vide Circular dated August 23, 2001 in order to recognize the genuine problem of the causes of NPAs/stress assets and bad market of project assets.
The efforts to resolve stress in financial assets have continued by RBI under various frameworks introduced from time to time which include 5/25 Debt Restructuring Scheme dated July 15, 2014; Strategic Debt Restructuring (“SDR”) vide RBI Circular dated June 08, 2015; and Scheme for Sustainable Structuring of Stressed Assets (“S4A”) dated June 13, 2016 with the spirit that banks and financial institutions be allowed to clean-up their balance sheets and promoters to take all necessary steps to revive the companies by way of selling their non-core assets or personal assets and transfer the management of their companies in favour of new management.
Balance Sheet Clean Up Mechanism Before SARFAESI
By Way Assignment Mechanism
In the late 1990s or early 2000 (period prior to SARFAESI), for the purpose of maintaining the exposure in respect of different sectors of borrowers as per RBI Circulars, the banks and financial institutions were making absolute transfer of their debt (non NPA) from ‘A’ Bank (Assignor) to ‘B’ Bank (Assignee) by way of a deed of assignment along with underlying security interest without amending the financing and security documents, to meet the sector specific exposure requirements . By this process, banks increased their ability to extend finance to various borrowers in a particular sector. In order to facilitate such transactions, various States have amended their respective Stamp Acts and reduced the rate of applicable stamp duty with the cap of Rs 1 lakh or 2 lakh, as the case may be.
By Way Securitization Mechanism
Subsequently, securitization of financial assets (non NPA) with underlying security interest has started before the advent of the SARFAESI ACT. Under the securitization mechanism, financial assets used to be pooled and repackaged into marketable securities. An originator or transferer bank, used to transfer its financial assets in favour of Trust declared by the originator. Under this trust mechanism, a trustee and service providers used to be appointed under the Trust and the transferor bank used to be also appointed as the collecting agent to collect receivables from the respective borrowers and deposit in the bank account maintained by the Trust. Such transfer was treated as the “True Sale” under the Income-tax Act, 1961. The Trust, in turn was required to issue pass through certificates (“PTCs”) (in present parlance the term used is security receipt (SC) under SARFAESI Act). Earlier PTCs were not listed but were transferable.
Right To Stay in Control
Under all the above-mentioned mechanisms to resolve the NPAs/ bad debt issues, the companies continued to be under the control of management of the promoters. The lenders were unable to either effectively transfer the management in the hand of new promoters or to sell the secured assets without legal hurdles.
Resolution Plan under IBC
The main object of Insolvency and Bankruptcy Code, 2016 (“IBC”) is to consolidate and amend the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner for maximisation of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders including alteration in the order of priority of payment of Government dues and to establish an Insolvency and Bankruptcy Board of India, and for matters connected therewith or incidental thereto.
To sum up, the aim is to resolve insolvency of a corporate debtor (borrower) by way of inviting the resolution plan from the public who are eligible applicant through the Resolution Professional (RP). The control of a corporate debtor is taken over by RP from promoters and the decision-making process for resolution of assets (whether NPAs or not) is in the hands of the Committee of Creditors (lenders) in accordance with the provisions of IBC. For the purpose of maximization of value of the corporate assets and financial viability of the corporate debtor, the lenders are in a position to take haircut of their outstanding dues without intervention of any third agency. Their decision is treated as the “Commercial Wisdom” and the same cannot be questioned even by the Adjudicating Authority.
National Company Law Tribunals are overburdened to deal with the ever-increasing number of applications filed by both the financial creditors and operational creditors and completion of whole process within stipulated time frame may not be possible with the existing infrastructure – at registry level and no dedicated tribunal members to deal insolvency matters.
Asset Reconstruction Companies (ARCs)
In order to remove various legal hurdles in resolution of default faced by banks and financial institutions as stated above, the ARCs are constituted pursuant to SARFAESI Act, precisely address to various legal hurdles in resolving the bad debts or NPAs as a specialized financial institution. ARCs can either be public or private companies registered with RBI in accordance with the provisions of SARFAESI Act.
The main object of ARCs, inter-alia, is to buy NPAs / bad loans at a discounted price and repackage the same to make them saleable and then sell to the prospective buyer in accordance with the procedure as laid down in SARFAESI Act and guidelines issued by RBI from time to time. With this mechanism the banks and financial institutions are in a position to clean up their NPAs or stressed assets from their balance-sheet and to raise fund to keep credit activities intact.
Securitization of debt is managed through ARCs and regulated in accordance with the provisions of SARFAESI Act and subject to guidelines issued by RBI from time to time.
ARCs are permitted to set up trust and raise fund by issue of security receipts to Qualified Buyers and also to recover the dues from borrowers through either settlement or through DRT / NCLT. ARCs are now permitted to participate as the Resolution Applicants, subject to compliance of Net Owned Fund requirements, in buying the assets under IBC mechanism.
National Assets Reconstruction Company Limited
In order to further strengthen the mechanism of resolving the stressed assets under ARC, National Assets Reconstruction Company Limited (“NARCL”) and Indian Debt Resolution Company Ltd (“IDRCL”) have been incorporated through public /private sector banks (partly in IDRCL) for the purpose of resolution of their stressed assets through these entities. Under NARCL and IDRCL, NARCL purchases the stressed assets of more than Rs.500 crores by way securitization from the lenders through Assets Reconstruction Trust – a Trust declared by NARCL for the consideration of the loan and NARCL also acts as the Trustee.
Generally, the lenders, being assignors are required to transfer their stressed assets on 15: 85 (Cash: Security Receipt Ratio) as the purchase consideration to the Trust. For the purpose of making the payment of purchase consideration, the Trust is required to issue SR to each lenders/assignor (“SR Holders”). Pursuant to the terms and conditions of Trust Deed, the SR Holders can redeem SR as per the provisions of Trust Deed. SR may be listed on Stock Exchange.
IDRCL is appointed by NARCL (acting as the Trustee) to make resolution plan for revival of the assets in its capacity as service provider and maximize the value of the assets for the benefit of the Trust and its beneficiaries (SR Holders).
Government Guarantee
In order to further provide comfort and security to investors, the shortfall in redemption of SRs issued by the Trust of NARCL is guaranteed by the Guarantee issued by GOI to the Trust for limited purpose of meeting the short fall for discharging its obligations to SR Holders in terms of Guarantee. The said guarantee is limited only for 5 years and subject to compliance of stipulated conditions which are as under:-
- Approval of resolution plan by NCLT
- Passing of liquidation order by NCLT
- Implementation of resolution plan under June 7, 2019 RBI Circular
- Settlement of the Assets or its sale or disposal to any eligible party
Future of ARCs
Since lending and default are two sides of one coin, stressed assets are inevitable to be reflected in the books of lenders every year. Sale of stressed assets by lenders to ARCs may still be one of the best possible solutions to resolve stressed assets as all other efforts have not yielded desired results.
The formation of NARCL and IDRCL is a step in the right direction to make securitization and asset reconstruction by ARC mechanism more effective in managing the stressed assets in more professional manner. RBI may also consider providing provisioning benefit to the lenders on transfer of the stressed assets, so that lenders are encouraged to sell such assets at more attractive price on the basis of cash. Further, one time settlement may also be encouraged for resolving the stressed assets with the existing promoters by ARCs as practical as possible.
For any further clarification you may get in touch with Mr. Ishtiaq Ali, Managing Partner at ishtiaq.ali@orbitlaw.co.in and Mr. Damodararao BM. Joint Managing Partner at damodararao@orbitlaw.co.in.
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