Asset Reconstruction Company
Asset Reconstruction Company Executive Summary Purpose and Scope The Year long Project aimed at examining the Asset Reconstruction Company with respect to: • NPA problem in India • Asset Reconstruction Companies (ARCs) – their meaning, models, global experience and the scene in India • The perspective of bankers, ARCs and consultants on the Indian structure and • The ways and models to form a successful ARC
Methodology The information gathered is based on both primary as well secondary researches. Secondary research involved net-based research and library research, while primary research involved personal meetings. Conclusion As the thrust of the second phase of reform is on improvement in the organisational efficiency of banks, the critical area in the improvement of profitability of banks is the reduction of NPAs.
As stated earlier, apart from internal factors such as weak credit appraisal, non-compliance and willful default, there are several external factors such as preponderance of certain traditional industries in the credit portfolio of certain banks, majority of which are suffering from serious inherent operational problems, natural calamities, policy and technological changes which increase the incidence of sickness, labour problems and raw materials and other factors which are out the control of banks.
While banks cannot be blamed for advances becoming non- performing due to external factors, there is an urgent need that the banks address the problems arising out of internal factors and this may call for organisational restructuring of banks, a change in the approach of banks towards legal action which is generally the last step and not the first step, no sooner the account becomes bad and a clear thrust on improving the skills of officials for proper assessment of credit proposal, risk factor and repayment possibilities.
Though there are problems in effecting recoveries and write offs and in compromise settlements, it is of utmost importance that necessary changes are brought about in the related legislations for making recovery process more smooth and less time consuming and also create other alternative channels/agencies for recovery of debt/ reduction of non-performing advances. As the Lok Adalat have proved a very good agency for quick justice and recovery of smaller loans, their use could go a long way as a supplement to the efforts of recovery by the DRTs.
The setting up of Asset Reconstruction Company can also play a vital role in reduction of NPAs and thereby provide necessary liquidity to banks through securitisation of banks loan assets. Government and other authorities could also devise policies having a bearing on the industrial sector, agriculture and trade with a long-term perspective to avoid sickness in the industry and adverse impact on borrowers because of sudden shift in the policy.
Reduction of NPAs in banking should be treated as a national priority item to make the Indian banking system more strong, resilient and geared to meet the challenges of globalisation TABLE OF CONTENTS |Sr No |Title |Page No. |1 |Introduction to NPAs problem in India |06 | |2 |Various Measures for Reducing NPAs |09 | |3 |Introduction to Asset Reconstruction Company |14 | |4 |Different Models of ARCs |19 | |5 |ARCs – The Indian Scenario |23 | |6 |SARFAESI Act, 2002 |26 | |7 |ARCs Formed in India |37 | |8 |Taxation, Legal and Other Issues in Asset Reconstruction |41 | |9 |Various Stakeholders Views |48 | Introduction to the NPA problem in India “If you default on a Rs 5 lakh loan to a bank you have a problem; if you default on a Rs 500 crore loan to a bank, the bank has a serious problem.
But if the defaults to the entire banking industry are over Rs 50,000 crore it is the economy which has a problem. ” It’s a known fact that the banks and financial institutions in India face the problem of swelling non-performing assets (NPAs) and the issue is becoming more and more unmanageable. Undoubtedly the world economy has slowed down, recession was at its peak, globally stock markets had tumbled and business itself was getting hard to do. The Indian economy has been much affected due to high fiscal deficit, poor infrastructure facilities, sticky legal system, cutting of exposures to emerging markets by FIIs, etc. Further, international rating agencies like, Standard & Poor had lowered India’s credit rating to sub-investment grade.
Such negative aspects have often outweighed positives such as increasing forex reserves and a manageable inflation rate. Under such a situation, it goes without saying that banks are no exception and are bound to face the heat of a global downturn. Quantum of NPAs As per the RBI report on Progress and Trends of Banking in India, 2003 – 2004, the NPA situation in the country as on 31st March 2004 was as follows: (Rs. in Crores) |Nature of Banks |Gross Advances |Gross NPAs |Net Advances |Net NPAs | |Public Sector Banks |509,368 |59,507 |480,681 |27,958 | |Old Private Sector |44,057 4,850 |42,286 |3,005 | |Banks | | | | | |New Private Sector |76,901 |6,822 |74,187 |3,663 | |Banks | | | | | |Foreign Banks in |50,631 |2,726 |48,705 |920 | |India | | | | | |Select All-India FI |Not available |Not available |1,33,754 |11,754 | |Total |680,958 |73,904 |779,613 |47,300 | So gross NPAs are > 10 % of gross advances & Net NPA are on an average are 5% Why NPAs have become an issue for banks and financial institutions in India? To start with, performance in terms of profitability is a benchmark for any business enterprise including the banking industry.
However, increasing NPAs have a direct impact on banks profitability as legally banks are not allowed to book income on such accounts and at the same time banks are forced to make provision on such assets as per the Reserve Bank of India (RBI) guidelines. Also, with increasing deposits made by the public in the banking system, the banking industry cannot afford defaults by borrowers since NPAs affects the repayment capacity of banks. Further, Reserve Bank of India (RBI) successfully creates excess liquidity in the system through various rate cuts and banks fail to utilize this benefit to its advantage due to the fear of burgeoning non-performing assets. Measures for Reduction of NPAs The RBI / Government of India have been constantly goading the banks to ake steps for arresting the incidence of fresh NPAs and have also been creating legal and regulatory environment to facilitate the recovery of existing NPAs of banks. The more significant measures undertaken are as follows: – Compromise Settlement Schemes Banks are free to design and implement their own policies for recovery and write-off incorporating compromise and negotiated settlements with the approval of their Boards, particularly for old and unresolved cases falling under the NPA category. The policy framework suggested by RBI provides for setting up of independent Settlement Advisory Committees headed by a retired Judge of the High Court to scrutinize recommend compromise proposals.
Revised guidelines issued by RBI for compromise settlement of Non-performing Assets (NPAs) of public sector banks provide for the compromise settlement of chronic NPAs up to Rs. 10 crore covering NPAs which have become doubtful or loss as on 31st March, 2000 with outstanding balance of Rs 10 crore and below on the cut off dates as on 31st March 2000, which have subsequently become doubtful or loss. These guidelines also cover cases on which the banks have initiated action under the Securitisation Act 2002 and also cases pending before Courts/DRTs/BIFR, subject to consent decree being obtained from the Courts/DRTs/BIFR. However, cases of willful default, fraud and malfeasance will not be covered. Settlement Formula –amount and cut off date NPA’s classified as Doubtful or Loss as on 31st March 2000.
The minimum amount that should be recovered would be 100% of the outstanding balance in the account as on the date of transfer to the protested bills account or the amount outstanding as on the date which the account was categorized as doubtful NPA’s, whichever happened earlier, as the case maybe. NPA’s classified as Sub-standard as on 31st March 2000 which became doubtful or loss subsequently: The minimum amount that should be recovered would be 100% of the outstanding balance in the account as on the date on which the account was categorized as doubtful NPAs, whichever happened earlier, as the case maybe, plus interest at existing Prime Lending Rate from 1st April 2000 till the date of final payment. Payment
The Amount of settlement arrived at in both the above cases, should preferably be paid in one lump sum. In cases where the borrowers are unable to pay the entire amount in one lump sum, at least 25% of the amount of settlement is required to be paid up front and the balance amount of 75%, is recovered in installments within a period of one year together with interest at the existing Prime Lending Rate from the date of settlement up to the date of final payment. Measures for faster legal process Lok Adalats Lok Adalat institutions help banks to settle disputes involving accounts in “doubtful” and “loss” category, with outstanding balance of Rs. lakh for compromise settlement under Lok Adalats. Debt Recovery Tribunals have now been empowered to organize Lok Adalats to decide on cases of NPAs of Rs. 10 lakhs and above. The public sector banks had recovered Rs. 40. 38 crore as on September 30, 2001, through the forum of Lok Adalat. The progress through this channel is expected to pick up in the coming years particularly looking at the recent initiatives taken by some of the public sector banks and DRTs in Mumbai. Debt Recovery Tribunals The Recovery of Debts due to Banks and Financial Institutions (amendment) Act, passed in March 2000 has helped in strengthening the functioning of DRTs. Provisions for placement of more than one Recovery Officer, o Power to attach defendant’s property/assets before judgment, o Penal provisions for disobedience of Tribunal’s order or for breach of any terms of the order and appointment of receiver with powers of realization, management, protection and preservation of property are expected to provide necessary teeth to the DRTs and speed up the recovery of NPAs in the times to come. There are 22 DRTs set up at major centres in the country with Appellate Tribunals located in five centres viz. Allahabad, Mumbai, Delhi, Calcutta and Chennai. However, DRTs have been plagued by lack of judges and legislative loopholes. Consequently, only 23,393 out of 57,000 cases lodged have been settled and 4. 36 per cent of litigated amounts recovered. Passage of the Securitisation Act, 2002
Under this Act promulgated on June 21, 2002 if a corporate borrower defaults on its loans for 180 days, banks will be able to issue a notice to the borrower and if money is not paid within the next 60 days banks can take possession of the security offered by the borrower at the time of availing of the loan and sell the same to realize the dues. The Act also provides that no court can interfere in the matter and issue stay orders, which could help the defaulting borrowers. In short, the Act takes the judicial system out of the loan recovery process and by stipulating definite number of days for definite action, ensures the whole process of recovery would be quite swift. The right to take possession of the security was there earlier under the transfer of securities act but only for mortgage securities and not for every type of security. The Act enlarges this right and includes all types of securities like mortgage, fixed and floating charge, hypothecation etc. hough liens and pledge are not covered. Asset Reconstruction Company Asset reconstruction means acquisition by any securitization company or reconstruction Company, of any right or interest of any bank or financial institution in any financial assistance, for the purpose of realization of such financial assistance. The company, which undertakes such assets declared as Non-performing by the Lending Institution, is referred to as Asset Reconstruction Company. Corporate Debt Restructuring (CDR) Corporate Debt Restructuring mechanism has been institutionalised in 2001 to provide a timely and transparent system for restructuring of the corporate debts of Rs. 0 crore and above with the banks and financial institutions. The CDR process would also enable viable corporate entities to restructure their dues outside the existing legal framework and reduce the incidence of fresh NPAs. The CDR structure has been headquartered in IDBI, Mumbai and a Standing Forum and Core Group for administering the mechanism had already been put in place. The experiment however has not taken off at the desired pace. As announced by the Hon’ble Finance Minister in the Union Budget 2002-03, RBI has set up a high level Group under the Chairmanship of Shri. Vepa Kamesam, Deputy Governor, RBI to review the implementation procedures of CDR mechanism and to make it more effective.
The Group will review the operation of the CDR Scheme, identify the operational difficulties, if any, in the smooth implementation of the scheme and suggest measures to make the operation of the scheme more efficient. Credit Information Bureau Institutionalisation of information sharing arrangements through the newly formed Credit Information Bureau of India Ltd. (CIBIL) is under way. RBI is considering the recommendations of the S. R. Iyer Group (Chairman of CIBIL) to operationalise the scheme of information dissemination on defaults to the financial system. The main recommendations of the Group include dissemination of information relating to suit-filed accounts regardless of the amount claimed in the suit or amount of credit granted by a credit institution as also such irregular accounts where the borrower has given consent for disclosure.
This is expected to prevent those who take advantage of lack of system of information sharing amongst lending institutions to borrow large amounts against same assets and property, which had in no small measure contributed to the incremental NPAs of banks. Proposed guidelines on willful defaults/diversion of funds RBI is examining the recommendation of Kohli Group on willful defaulters. It is working out a proper definition covering such classes of defaulters so that credit denials to this group of borrowers can be made effective and criminal prosecution can be made demonstrative against willful defaulters. . Asset Reconstruction Company What is an Asset Reconstruction Company?
Asset reconstruction means acquisition by any securitization company or reconstruction company, of any right or interest of any bank or financial institution in any financial assistance, for the purpose of realization of such financial assistance. The company, which undertakes such assets declared as Non-performing by the Lending Institution, is referred to as Asset Reconstruction Company. In other words, asset reconstruction companies (ARCs) are really debt collectors, given sweeping powers, which were so far exercised by debt recovery tribunals and civil courts and were not available to the debt recovery department of the lenders themselves. Objectives of an ARC
An ARC is formed to accomplish the following objectives: • To buy out troubled loans from banks and make special efforts at recovering value from the assets, if necessary by special legislation, with special powers for recovery Restructuring of weak banks to divest the bad loan portfolio – essential for a comprehensive restructuring strategy of weak banks Need for an ARC In the normal course, banks and financial institutions themselves handle the job of recovery for most of their lending, but in this process they are finally saddled with a left over portion of sticky debts representing willful dodgers and sunset industries. This is because no credit institution, on account of inherent risks in lending, can have 100% recovery performance.
The left over or unrecovered credit represents difficult cases, which warrant special and concerted action. When such overdue credit outstanding grows large in volume, the banks and financial institutions are unable to divert attention from their core business substantially to this time-consuming job requiring concerted and continuous efforts. These can therefore be outsourced to specialised agencies i. e. Asset Reconstruction Companies, who have built-in professional expertise in this task, and who handle recovery as their core business. Handling recovery of chronic cases and willful dodgers is the normal function of these companies and they are adequately geared and equipped for this job.
In this respect the ARCs handle the function of recycling to productive and beneficial use of assets that otherwise threaten to turn as scrap or waste. In the first place Banks & FIs assign or transfer all their rights with reference to specific debts including their security rights on the collateral held by them as cover to the ARC. The ARC thus steps into the shoes of the banker and attends to recovery of the outstanding through manifold methods and devices. Stock Problem and Flow Problem The problem of non-performing loans is both a stock and a flow problem. The stock problem refers to the accumulated volumes of NPAs with banks, or the overhang of bad loans, while the flow problem is the incremental bad loans.
Stock solutions tend to be necessarily, where banking distress is systemic and often include the liquidation of unviable banks, disposal and management of impaired assets and the restructuring of viable banks. While flow solutions are more successful when banking distress is limited, i. e. non-systemic and the official safety net is either limited or the supervisory authority is willing to intervene in those institutions whose capital base is further deteriorating. Approaches to Resolution of NPAs These are essentially two approaches to resolving the problem of bad loans: 1. Creditor–led Approach 2. ARC Approach Creditor-led / Bank-led Approach
Bank-led approach means each bank tries to restructure or recover its own assets and the government simply either provides more capital to the banks or provides fiscal or other incentives to write off bad loans and backs up the recovery efforts with appropriate security enforcement legislation. As any problem is best resolved by the one who created it, logically, it might seem that the problem loan is better handled by the bank itself. Banks with the loan files and some institutional knowledge of the borrower should be better placed to resolve NPAs than centralized ARCs. This approach may also provide better incentives for banks to maximize the recovery value of bad debt and avoid future losses by improving loan approval and monitoring procedures. Another advantage would be that these banks could provide new loans in the context of debt restructuring.
However, individual bank-led approach to resolving NPAs has several problems, particularly where the problem loans are the result of a crisis. Fearing the risk of further loans going bad, banks shun lending, which deepens crisis. In most cases, in the name of restructuring, borrowers take more loans and therefore, more amounts become non-performing. The ARC Approach The approach to resolving the problem by dedicating one or more specialized unit(s) is known as the ARC Approach. This approach is based on the premise that NPAs created by a systemic crisis cannot be treated at par with those accumulated due to bad lending practices, and therefore, a focused attention, backed by appropriate legislation, is required to resolve the problem.
If banks were burdened with resolving problem loans, they will not be able to attend to the need to create new loans, which will further deepen the crisis. Banks having provisioning requirements will also face threat of capital erosion and will shun new asset creation is important to take the country out of crisis. ARCs with their expertise in loan resolution should maximize recovery value while minimizing costs. Evidence suggests that the use of asset reconstruction or management companies or distinct loan workout units have played an important role in systemic difficulties in the banking sector and could be considered as a part of best practice.
Advantages of a centralized public ARC Disadvantages O Banks have informational advantages over ARCs as they have collected information on their borrowers. O Leaving loans in banks may provide better incentives for recovery—and for avoiding future losses by improving loan approval and monitoring procedures. O Banks can provide additional financing which may be necessary in the restructuring process. O If assets transferred to the ARCs are not actively managed, the existence of an ARC may lead to a general deterioration of payment discipline and further deterioration of asset values. Different Models of ARCs Models of ARCs 1. Based on ownership 2. Based on multiplicity
Based on Ownership Different countries have tried different models of ownership of ARCs. The different models are • Asset workout departments or units of banks: A separate unit or department within the bank is only as good as the bank as a whole, especially from the viewpoint of legal powers, interests of the shareholding groups, etc. Therefore, in most countries, this has only been the last choice. • Bank subsidiaries and Bank affiliated companies: This model has been used in several countries like Australia and several continental European countries. In China as well, the Big Four banks have set up their own ARCs, subsequently which have been privatized.
There are certain advantages associated with this model like: ? Use of in-house experience and knowledge about the NPAs, ? Maintenance of important banking relationships, ? Strengthening of expertise the resolution of bank NPAs, and ? Establishment of new business relationships with new investors involved in asset workouts. Another very important consideration is that a bank-based ARC is likely to have more operational flexibility than a government entity. This flexibility can be particularly valuable in retaining qualified personnel and in structuring transactions. • Private companies: Private companies, though with substantial shareholding of banks have been used in Thailand.
In India also, the model used is one of private ARCs. Such a company enjoys all the advantages of the centralized ARC. Centralizing asset management and disposition facilitates asset packaging and marketing and ensures consistency and transparency within the ARC. Also, the risk of different bank-based ARCs competing to drive down sale values should be reduced. The greater the number of institutions, the more extensive the debtor interrelationships and the more similar the assets, so greater will be the need for government coordination and oversight. Based on Multiplicity: Yet another issue in modeling ARCs is: whether to have a single ARC, or to allow as many ARCs as the market demands.
Centralized ARCs have been used by all those countries, which have floated ARCs with government support and provided special legal powers to the ARCs. The approach in India is one of several ARCs. But there are certain risks associated with such a model. If too many ARCs come up, an ARC might just be a bank look-alike. Worse still, since the price at which the bad loans will be sold is only a paper price (represented by a bond or debenture), the ARCs will start competing on the price they offer for the bad loans, leading to artificially inflated value of bad loans. The risk with too many ARCs is that at least some of the will become as bad as the loans they buy.
ARC Models: Based on Resolution Approach: ARCs can adopt several approaches to resolve the loans they buy. A rapid sale approach implies that the ARC tries to sell its own assets soon after acquiring them. A workout approach or corporate restructuring approach implies that the ARC tries to nurse the loan back to health by actively restructuring either the loan or the business of the borrower. The ARC might either force the borrower to sell non-core assets, or merge, or dispose off a part of its undertaking, etc. More often than not, no single approach can be associated with any ARC, as all of them will take a suitable approach based on the case.
However, there have been international studies on the success of the two approaches mentioned above. Daniela Klingebiel in ‘The use of Asset Management Companies in the Resolution of Banking Crises: Cross-Country Experience’ says that ‘The results of the analysis of the seven cases can be summarized as follows: Two out of three corporate restructuring ARCs did not achieve their narrow goals of expediting corporate restructuring. These experiences suggest that ARCs are rarely good tools to accelerate corporate restructuring. Only the Swedish ARC successfully managed its portfolio, acting in some instances as lead agent in the restructuring process. It was helped by some special ircumstances, however: the assets acquired were mostly real estate related, not manufacturing that are harder to restructure, and were a small fraction of the banking system which made it easier for the ARC to maintain its independence from political pressures and to sell assets back to the private sector. Rapid asset disposition vehicles fared somewhat better with two out of four agencies, namely Spain and the US, achieving their objectives. The successful experiences suggest that ARCs can be effectively used, but only for the purpose of asset disposition including resolving insolvent and unviable financial institutions. ‘She further says that disposition agencies have worked better than restructuring agencies.
However, this success of disposition agencies is due to factors like easily liquefiable real estate assets, mostly professional management, political independence, a skilled resource base, appropriate funding, adequate bankruptcy and foreclosure laws, good information and management systems, and transparency in operations and processes. In the Philippines and Mexico, the success of the ARCs was doomed from the start as governments transferred a large amount of loans politically motivated loans and / or fraudulent assets to the ARCs which are difficult to be resolved or to be sold off by a government agency. Both of these agencies did not succeed in achieving their narrow objective of asset disposition, thus delaying the realignment of asset prices. Asset Reconstruction Companies –The Indian Scenario Development of ARCs in India
The idea of Asset Reconstruction first surfaced in the Narasimhan Committee Reports. Earlier, the Committee had suggested the creation of an Assets Reconstruction Fund (ARF) to take the non- performing assets off banks’ books at a discount. Recapitalisation through infusion of capital was another approach and was used in the case of some banks. However, since this was a costly and a time-consuming option it was not sustainable. The problem, however, remained and further consideration was given to revisiting the concept of an ARF. The Second Narasimhan Committee Report recommended that the core NPAs of the banks would be transferred to a new entity (an ARC) which, in turn, would issue NPA swap bonds at the realisable alue arrived at after due assessment. The basic elements of this approach consisted the following assumptions: – The Reserve Bank of India in early 2001 has suggested a maximum life span of seven years for asset reconstruction companies (ARCs) and a minimum Rs. 100-crore initial paid-up capital. The suggestion placed the authorised capital of ARCs at Rs. 500 crore. In a draft scheme prepared as a run-up to the constitution of ARCs, the RBI had proposed that the entities would function as private sector companies with 49 per cent holding subscribed by public sector banks and financial institutions, while the remaining 51 per cent would be offered to the public.
It also suggested that the ARCs, which are to be set up for tackling the problem of non-performing assets (NPAs) in the banking sector, should be restricted to only the past bad debt of the banks. Thus, the companies would not be allowed to nibble at the fresh NPAs added by banks on an ongoing basis after the constitution of the ARC. The RBI further suggested that the realisable value of the NPAs should be a fair discounted value arrived at through a consensus between the valuers acting on behalf of the banks and the ARC. The ARCs should be managed by a board of directors consisting of professionals from various fields such as banking, finance, law, engineering and valuation experts. The issue of NPAs is closely related to the state of legal framework.
The legal framework sets standards of behaviour for market participants, details about rights and responsibilities of transacting parties, assures that completed transactions are legally binding and provides regulators with the backing to enforce standards and ensure compliance and adherence to law. Financial institutions was felt too cumbersome and time consuming and there was persistent demand for provision of powers to the banks/FIs for summary take over of securities with the power to sell the same in satisfaction of the dues. To consider all these matters Government in the year 1999 appointed the Andhyarujina Committee under Chairmanship of T R Andhyarujina, senior Supreme Court advocates and former Solicitor General of India. Among its many recommendation some important recommendation were • To confer larger powers on the DRTs • Need for expert personnel of the DRTs Clarification of conflicts of jurisdiction experienced between the working of the Winding Up Court under the Companies Act and the jurisdiction of the BIFR under SICA, 1985 • Regulations for a uniform procedure to be adopted by all the tribunals in the country • Right of private sale of movable and immovable property to banks and financial institutions for speedy recovery as have been conferred upon land development banks and state finance corporations • A new law incorporating power of sale without intervention of the court in cases where the lenders are banks and financial institutions with proper safeguards. The committee enclosed a draft of a model Bill titled “Securitisation Bill 2000” The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 Need The pressing factors that urged the need for the SARFAESI are: 1. First concern is the impact of the burden of ballooning Non-performing Assets on the health of the financial sector, reported to be at Rs. 82, 846 crores as on 31st March, 2002. 2. Urgent need for legal reforms to keep pace with the changing industrial and financial scenario of the times.
The present legal structure in the country enables criminals and law dodgers to take protection under its too lenient and cumbersome provisions, and to delay or defeat punitive action against them. This prevents effecting positive remedial measures without undue delay 3. Piling up of large overload of cases with DRTs & Law Courts resulting in slower processing in the Debt Recovery Tribunals (DRTs) and the courts 4. An urgent need to take tougher measures to reign in the exploding problem of Non-performing Assets especially for tackling willful defaulters, who have learnt to perfect the art of defaulting/dodging repayment with a habitual recurrence Objective
The object clause of the Act describes the legal measure as “An Act to regulate securitisation and reconstruction of financial assets and enforcement of security interest and for matters connected therewith or incidental thereto”. The Act allows setting up of ARC/SC companies to be registered with and regulated by RBI. Under the Act identical powers and functions are prescribed for both types of companies, Securitisation Companies and Asset Reconstruction Companies. Scope The Act deals with three distinct actions in respect of financial assets held by banks and FIs: 1. Securitisation of financial assets 2. Setting up of asset reconstruction companies and 3. Enforcement of security interest
These three actions are in fact not seen as distinct, but inter-connected. Securitisation as a co-function helps ARC/SC companies to operate with minimum capital under a sort of self-generated source of funding, while enforcement of security interest helps ARC/SC companies to take possession, to securitise and later to realise the financial assets, more quickly and easily without approaching DRTs or Law Courts. Definitions under the act: Asset reconstruction: Acquisition by any ARC / SC of any right or interest of any bank or financial institution in any financial assistance for the purpose of realisation of such financial assistance Financial Asset Means debt or receivables and includes A claim to any debt or receivables or part thereof, whether secured or unsecured; or • Any debt or receivables secured by, mortgage of, or charge on, immovable property; or • A mortgage, charge, hypothecation or pledge of movable property; or • Any right or interest in the security, whether full or part underlying such debt or receivables; or • Any beneficial interest in property, whether movable or immovable, or in such debt, receivables, whether such interest is existing, future, accruing, conditional or contingent; or • Any financial assistance Financial Assistance Any loan or advance granted or any debentures or bonds subscribed or any guarantees given or letters of credit established or any other credit facility extended by any bank or financial institution Borrower ? Person who has been granted financial assistance ? Person who has given any guarantee or created any mortgage or pledge as security for the financial assistance granted ? Person who becomes borrower of a ARC / SC consequent upon acquisition by it of any rights or interest of any bank or financial institution Default
Non-payment of any principal debt or interest thereon or any other amount payable by a borrower to any secured creditor consequent upon which the account of such borrower is classified as non-performing asset in the books of account of the secured creditor. There should be “default” by the “borrower”(as defined in the Act) for the process under the Act to be initiated. Default implies failure to repay plus as a consequent classification of the borrower’s account as a non-performing asset. Thus if the account of the borrower is not transferred as NPA, action under the Act is not possible even if there is default. Obligor A person liable to the originator, whether under a contract or otherwise, to pay a financial asset or to discharge any obligation in respect of a financial asset, whether existing, future, conditional or contingent and includes the borrower Originator
The owner of a financial asset, which is acquired by a Securitisation company or reconstruction company for the purpose of Securitisation or asset reconstruction. Property • Immovable property • Movable property • Any debt or any right to receive payment of money, whether secured or unsecured • Receivables, whether existing or future • Intangible assets, being know-how, patent, copyright, trade mark, license, franchise or Qualified Institutional Buyer QIBs include: • A Financial Institution • Insurance company • Bank • State financial corporation • State industrial development corporation • Trustee or any asset management company making investment on behalf of mutual fund or provident fund or gratuity fund or pension fund • A registered foreign institutional investor or Any other body corporate as may be specified by SEBI Reconstruction Company Means a company formed and registered under the Companies Act, 1956 for the purpose of asset reconstruction Scheme A scheme inviting subscription to security receipts proposed to be issued by a ARC / SC under that scheme Securitisation Acquisition of financial assets by any ARC / SC from any originator, whether by raising of funds by such ARC / SC from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise. Securitisation Company Means any company formed and registered under the Companies Act, 1956 for the purpose of securitisation.
It thus rule out such companies registered under the Indian Trusts Act and engaging exclusively in the function of Securitisation of assets. There is no bar on Securitisation through non-corporate Special Purpose Vehicles (SPVs) outside the law, but such entities cannot exercise powers under this Act. The Act therefore may be considered as not to be legislating on “Securitisation” as such but on this function to be exercised specifically by ARC companies for asset reconstruction of NPAs of banks/FIs exclusively. As per this definition ‘Securitisation’ implies acquisition of the financial asset by the ARC/SC from the bank or financial institution (referred as originator).
Acquisition can be normally by raising funds by Securitisation of financial assets taken over by issue of security receipts. The securities Receipt are backed by a charge on the financial assets and the eventual cash flow to be generated from that asset by sale, lease or by managing such assets. The security receipts are to be offered to the QIB i. e. qualified institutional buyers only and not to the general public. Security agreement An agreement, instrument or any other document or arrangement under which security interest is created in favour of the secured creditor including the creation of mortgage by deposit of title deeds with the secured creditor. Secured Asset Means the property on which security interest is created. Secured Creditor Means Any bank or financial institution or any consortium or group of banks or financial institutions and includes • Debenture trustee appointed by any bank or financial institution; or • ARC / SC; or • Any other trustee holding securities on behalf of a bank or financial institution, in whose favour security interest is created for due repayment by any borrower of any financial assistance; Security Interest Means right, title and interest of any kind whatsoever upon property, created in favour of any secured creditor and includes any mortgage, charge, hypothecation, assignment other than those specified in section 31 Security Receipt
Means a receipt or other security, issued by a ARC / SC to any qualified institutional buyer pursuant to a scheme, evidencing the purchase or acquisition by the holder thereof, of an undivided right, title or interest in the financial asset involved in Securitisation. Thus, a distinct scheme is to be formulated by the ARC/SC for each group of security receipts issued by them to QIBs. Sponsor Means any person holding not less than ten per cent of the paid-up equity capital of a ARC. Setting up ARC/SC & Registration with RBI The subject is dealt with under Chapter II of the Act titled “Regulation of Securitisation and Reconstruction of Financial Assets of Banks and Financial Institutions” The requirements for setting up an ARC are as follows They have to be set up under the Companies Act, 1956 either as ‘Private Limited’ or ‘Public’ Companies • There is no bar under the Act for such companies to be formed as subsidiary company of a bank or financial institution, subject to the condition that the ARC/SC so formed complies with the provisions of the Act • Possessing owned funds of not less than Rs. 2 Crores or 15% of the financial assets to be acquired (maximum) [RBI is vested with powers, under the Act, to stipulate the quantum of capital to be owned by ARC/SC companies within this range] • Duly registered with RBI as an ARC/SC set-up under the Act and meeting the eligibility criteria prescribed. Eligibility criteria for an ARC: The company has not incurred losses in any of the three preceding financial years; • Adequate arrangements for realisation of the financial assets acquired for the purpose of Securitisation or asset reconstruction are made and shall be able to pay periodical returns and redeem on respective due dates on the investments made in the company by the qualified institutional buyers or other persons; • Directors of ARC / SC have adequate professional experience in matters related to finance, Securitisation and reconstruction; • Board of directors of such ARC / SC does not consist of more than half of its total number of directors who are either nominees of any sponsor or associated in any manner with the sponsor or any of its subsidiaries; • Any of its directors has not been convicted of any offence involving moral turpitude; • A sponsor, is not a holding company of the ARC / SC, as the case may be, or, does not otherwise hold any controlling interest in such ARC / SC; • Compliance with prudential norms specified by the Reserve Bank. Procedure for Registration of ARC/SC: • Make an application for registration to the Reserve Bank in such form nd manner as it may specify • The Reserve Bank may, after being satisfied that the conditions specified are fulfilled, grant a certificate of registration, subject to such conditions, which it may consider, fit to impose. Acquisition of rights or interest in financial assets: • By issuing a debenture or bond or any other security in the nature of debenture, for consideration agreed upon between such company and the bank or financial institution, incorporating therein such terms and conditions as may be agreed upon between them; or • By entering an agreement with such bank or financial institution for the transfer of such financial assets to such company on such terms and conditions as may be agreed upon between them. On such acquisition the ARC/SC shall be deemed to be the lender and all the rights of such bank or financial institution shall vest in such company in relation to such financial assets • All contracts, deeds, bonds, agreements, powers-of-attorney, grants of legal representation, permissions, approvals, consents or no-objections under any law or otherwise and other instruments of whatever nature which relate to the said financial asset and which are subsisting or having effect immediately before the acquisition of financial asset and to which the concerned bank or financial institution is a party or which are in favour of such bank or financial institution shall, after the acquisition of the financial assets, be of as full force and effect against or in favour of the ARC / SC, as the case may be, and may be enforced or acted upon as fully and effectively as if, in the place of the said bank or financial institution, ARC / SC, as the case may be, had been a party thereto or as if they had been issued in favour of ARC / SC, as the case may be. Measures for assets reconstruction The proper management of the business of the borrower, by change in, or take over of, the management of the business of the borrower • The Sale or lease of a part or whole of the business of the borrower; • Rescheduling of payment of debts payable by the borrower • Enforcement of security interest in accordance with the provisions of this Act; • Settlement of dues payable by the borrower; • Taking possession of secured assets in accordance with the provisions of this Act. Other functions of ARC / SC ¦ Agent for any bank or financial institution for recovering their dues from the borrower on payment of such fees or charges as may be mutually agreed upon between the parties; ¦ Manager referred to manage the secured assets the possession of which has been taken over by the secured creditor ¦ Receiver if appointed by any court or tribunal Power of Reserve Bank to determine policy and issue directions:
The RBI may determine the policy and give directions to all or any ARC / SC in matters relating to income recognition, accounting standards, making provisions for bad and doubtful debts, capital adequacy based on risk weights for assets and also relating to deployment of funds by the ARC / SC, as the case may be, and such company shall be bound to follow the policy so determined and the directions so issued. Reserve Bank may give directions in particular as to- a) The type of financial asset which can be acquired and procedure for acquisition of such assets and valuation thereof; b) The aggregate value of financial assets which may be acquired by any ARC / SC. Enforcement of Security Interest by a Secured Creditor
Notwithstanding anything contained in section 69 or section 69A of the Transfer of Property Act, 1882, such creditor in accordance with the provisions of this Act may enforce any security interest created in favour of any secured creditor, without the intervention of the court or tribunal. Under the Act, the Secured Creditor has been given certain powers to enforce the security interest created in his favour by a defaulting borrower. However, prior to taking any action under this Act, the creditor has to give a sixty-day notice to the borrower to discharge in full his liabilities. In case the borrower fails to discharge his liability in full within the 60- day period, the secured creditor may take recourse to one or more of the following measures to recover his secured debt, namely
In the case of financing of a financial asset by more than one secured creditors or joint financing of a financial asset by secured creditors, no secured creditor shall be entitled to exercise any or all of the rights conferred on him unless exercise of such right is agreed upon by the secured creditors representing not less than three-fourth in value of the amount outstanding as on a record date and such action shall be binding on all the secured creditors In the case of a company in liquidation, the amount realised from the sale of secured assets shall be distributed in accordance with the provisions of section 529A of the Companies Act, 1956. The ARCs formed so far Only two ARCs have formed so far. However, registration is yet to be granted. The ARCs that have formed are: 1. Asset Reconstruction Company of India Ltd. (ARCIL) 2. Assets Care Enterprise Ltd. (ACE)
Asset Reconstruction Company of India Limited (ARCIL) Type: Restructuring as well as Rapid Disposition Agency Shareholding Pattern: Equity Base: Rs. 10 crore |Institution |Stake % |Amount(Rs. Crores) | |ICICI Bank |24. 5 |2. 45 | |IDBI |24. 5 |2. 45 | |SBI |24. 5 |2. 5 | |HDFC |10. 0 |1. 00 | |HDFC Bank |10. 0 |1. 00 | |Clutch of banks (incl Federal Bank & IDBI Bank) |06. 5 |0. 65 | |Total |100 |10. 00 | Plan of Action: Plans to acquire Rs 20,000 crore worth of assets by the end of fiscal 2004, starting with an Rs 5,000 crore-asset base.
ARCIL has identified 32 big accounts to kick-start its operations with total dues of its three major sponsors — the State Bank of India, ICICI Bank and IDBI amounting to Rs 6,230 crore. ARC Board Chief Executive Officer: Mr. Rajendra Kakker Non-executive chairman: Mr N Vaghul Other directors: Mr. Deepak ParekhMr. PP Vora Mr. PN VenkatachalamMr. JJ Irani Mr. Ashok GangulyMr. YH Malegam Consultants Appointed: PriceWaterhouseCoopers and another Chartered Accountant firm for valuation of assets Methodology to be adopted: In the initial stages, when there are no ready investors for the securities issued by the ARC, the model followed would be as depicted in the diagram below Stage I: After taking over the assets, it will bundle the assets like an MF and create asset portfolios. Stage II:
Pass through certificates (PTCs) against these assets will be issued to banks and institutions as there is no qualified institutional buyer (QIB) in the market to buy junk bonds. In other words, the banks and institutions, which at the first stage sell sticky assets to the ARC, will replace them with the PTCs, which will be redeemed by the fourth year. Revenue Model: If the net asset value (NAV) of the PTCs is higher than the face value, the ARC will get 20 per cent share of that and the ARC stakeholders the rest. The ARC will charge a management fee of 1 per cent of the assets managed or a performance related fees whereby the ARC is able to sell assets at higher than the book value of the assets. Assets Care Enterprise Ltd (ACE)
Type: Restructuring as well as Rapid Disposition Agency Shareholding Pattern: Equity Base: Rs. 5 crore |Institution |Stake % |Amount (Rs. Crores) | |IFCI Ltd. |49. 00 |2. 45 | |Punjab National Bank |26. 00 |1. 30 | |Tourism Finance Corporation of India |14. 20 |0. 71 | |Life Insurance Corporation of India |10. 00 |0. 0 | |Madhya Pradesh Consultancy Organisation |00. 80 |0. 04 | | Total |100. 00 |5. 00 | Discussions are on with the leading international distressed assets specialists (including, Goldman Sachs, Solomon Smith Barney, Commonwealth Development Corporation, GE Caps and Merrill Lynch) to join hands with us in efforts to resolve NPL / Stressed Assets. Taxation, Legal and other issues in Asset Reconstruction and Securitisation Tax Issues
The tax incidence would usually depend on how the documents relating to the transaction are structured. The main entities involved in the Securitisation transaction are the Originator, the SPV and the Investors. Taxability of the Originator It would depend on: 1. Whether the Securitisation transaction results in the legal transfer of property in the assets being securitised; and 2. Whether the gain or loss (in the case where there is a transfer of the property) is treated as a business gain or a capital gain by the tax authorities Where there is a legal transfer of property (true sale) in the assets to be securitised Where there is no legal transfer of property in the assets to be securitised ?
The tax authorities may characterize the Securitisation transaction as “a method of financing” on the security of the receivables ? And levy tax on the Originator, on the gains if any, under the head “Profits and Gains of Business” under Section 28(i) of the Act. Sam ? The discount charged by the SPV on the receivables would be allowable as a type of a finance expense and deducted from the net amount received by the Originator, which would be liable to tax as business income. Where the income in the assets has been transferred without a transfer of the property Section 60 of the IT Act ? Where only the receivables in the Securitisation transaction and not the asset are transferred: (e. g. n Securitisation of lease receivables, housing rent or hotel receipts) The income would be deemed to accrue to the asset-owner (Originator) and he would be liable to tax thereon. However, the asset-owner could claim capital allowances on the asset, and ? Where the asset itself is transferred: (e. g. in Securitisation of hire purchase receivables, where the only asset claimed by the asset-owner is the right to receive installments and such asset is transferred) On transfer, the income generated from the receivable would be deemed to have been transferred to the transferee and he would be liable to pay tax on such income. The gain, i. e. he difference between the sum received from the transferee and the value of the asset at which it is outstanding, less any expenses incurred by the asset-owner would be considered as either business profit of the asset-owner or capital gains of the asset-owner, depending on whether the asset being transferred is a non-capital or capital asset. Taxability of the SPV There are three alternative approaches 1. SPV regarded a conduit between the Originator and the ultimate investor ‘Pass through Structure’: In this case, it would receive income flows from the underlying assets and would use the same to service the instruments issued by it. Thus, it would not earn any income nor would it make any profits and would not be liable to pay any tax. 2.
SPV may be regarded as a representative assessee of the investors: The SPV generally acts as the trustee of the investors, and in such cases, relevant provisions of the Act, dealing with the concept of a representative assessee may apply to the SPV. Accordingly, the SPV may be taxed for the income received by it on behalf of the several investors. However, such tax would be revenue-neutral since the tax payable by the SPV cannot exceed the tax payable by the investors on such income. Under certain circumstances, the SPV would be liable to pay tax at the maximum marginal rate applicable to individuals. The Act enables the representative assessee to recover the tax paid by the representative assessee from the person/s on whose behalf such tax is paid. Thus, ultimately, the SPV, which is regarded as a representative assessee, may have no tax incidence. 3.
SPV may be characterized as an independent taxable entity or in case of a ‘Pay through structure’: (Example: Where the SPV re-configures the cash flows received by it by reinvesting them, so as to pay the investors on fixed dates, which do not match with the dates on which the transferred receivables are collected by it) Where the SPV is treated as an independent entity, any income received or deemed to be received by the SPV would be deemed to be its income. The income distributed by the SPV in the form of interest would be deemed to be the expense of the SPV and income in the hands of the investors. Where the payments made by the SPV are towards equity or towards distribution or application of income, such payment would not be a tax-deductible expense for the SPV. The SPV would be liable to pay dividend distribution tax on the dividends paid. Taxability of the Investors 1.
Where the SPV is regarded as a pass through entity: Each individual investor would be liable to pay tax on the income earned in proportion to his investment. 2. Where the SPV is characterized as a representative assessee: The SPV is taxed and the tax paid by it is deemed to have been paid by the investors. Thus, the investors would not be liable to pay tax individually and the SPV would be entitled to recover the tax paid by it, from the investors. 3. Where the SPV is characterized as an independent entity: Investors would be taxed on what they would earn, by holding the instruments issued by the SPV or by transferring the same. Withholding Taxes The Concept
A person responsible for making payments, which are chargeable to tax, is required to deduct tax as per the applicable rate and remit the same to the Government of India. In a Securitisation transaction, there would be three situations when the issue of deducting tax in certain circumstances at source would arise. These are: 1. When the transferee/SPV makes payments to the Originator, for transfer of the assets: No requirement of any withholding tax since the SPV pays for the discounted value of the receivables purchased and there is no income element in the nature, which requires deduction of tax at source. If the transaction results in taxable profit or gain, it would be on account of business profit or capital gain, for which the tax would be payable by the Originator. 2.
When the transferee/SPV collects payments from the debtors in relation to the securitised asset: Withholding taxes may be applicable depending on the nature of payments collected from the debtors. The Securitisation transaction does not change the character of the original transaction between the Originator and the debtors and thus any withholding tax applicable to the payment to be made by the debtor to the Originator, under the original transaction would continue to be applicable. 3. When the transferee/SPV makes payments to the investors Withholding tax would be applicable, when such payment is made in the form of interest to the investor. Where the SPV is treated as a mere conduit, it is likely that the payments made by it would not be treated as interest payments and thus not liable to any withholding taxes. Legal Issues
Stamp Duty Stamp duty is different in various Indian states and ranges from a low of 0. 1 per cent of the value of loans transferred in certain states to more than 3 per cent in other states. Most states had stamp duty regimes that were unclear on how exactly a securitised instrument may be classified. In certain circumstances the trust/SPV may also be treated as a non-banking financial company and be subject to the regulations framed by the RBI under the Reserve Bank of India Act, 1948 in this regard. In such a situation, stamp duty may be leviable not only on the assignment of the original pool of loans but also on the securitised instrument.
However, stamp duty on transfer of securitised assets by the lender can be reduced or avoided by careful structuring of the transaction. Insolvency Issues True Sale The principal concern in a securitisation transaction is the legal isolation of the assets securitised from the bankruptcy risks associated with the entities involved. To achieve this, the assets securitised must be legally transferred to the SPV, so that the SPV is not affected in a situation where there are any claims against the Originator. It is thus the key to Securitisation transactions that the SPV and the assets are remote from the risk of bankruptcy/insolvency of the originator.
In order to achieve this, the transfer of the assets to the SPV must be regarded as a “true sale” and not merely as being a transfer for obtaining finance. Where the transaction is not regarded as a true sale, it may be treated as a method of financing or a loan by the SPV, in which case, if the Originator goes bankrupt, the liquidator of the Originator would have rights against the underlying assets. Measurement of the Consideration When consideration is not in cash: (e. g. in the form of securities issued by the SPV) The consideration should be measured at the LOWEST of: a. The fair value of the consideration; b. The net book value of the securitised assets; and . The net realisable value of the securitised assets When the consideration is received partly in cash and partly in kind The non-cash component of the consideration should be measured at the lowest of the a. The fair value of the non-cash component; b. The net book value of the securitised assets as reduced by the cash received; and c. The net realisable value of the securitised assets as reduced by the cash received. What is the fair value? The fair value is the price that would be agreed upon between knowledgeable, willing parties in an arm’s length transaction. Normally we consider the following as fair value: • Quoted market price If quoted market price is not available: an estimate based on the market prices of assets similar to those received as consideration • In case the market prices of similar assets are also not available: an estimate based on generally accepted valuation techniques such as the present value of estimated future cash flows. • The amount received by the SPV on issue of PTCs or other securities should be shown on the liability side of the balance sheet, with appropriate description, keeping in view the nature of securities issued. Disclosures In the financial statements of the Originator • The nature and extent of Securitisation transaction(s), including the financial assets that have been derecognised. • The nature and the amounts of the new interests created, if any. • Basis of determination of fair values, wherever applicable In the financial statements of the SPV • The nature of the Securitisation transaction(s) including, in articular, a description of the rights of the SPV vis-a-vis the Originator whether arising from the Securitisation transaction or a transaction associated therewith. • Basis of determination of fair values, wherever applicable. Perspectives for various stakeholders Bankers’ Perspective Problems for transfer of NPAs to ARCs Valuation of NPAs The biggest roadblock for transfer of the NPAs is their valuation. Clear guidelines on this issue are still awaited. The issues involved are: • How will the valuation be done? • What will be the rate of discount? • How will the NPAs secured by different collaterals be valued? • How will one know the realisable value of the NPAs, when there is a lack of such a market in the country? • Different valuations by different valuers / consultants? In a case of consortium lending, all the lenders may not agree on the valuation • The valuer should have the relevant specialized expertise and also should be of a very good repute for acceptability of the value by all the lenders involved • Issue of transparency in the whole valuation procedure (neither under-valuation for ARC profits nor over-valuation for bankers) Losses for the banks • The reported NPAs of the banks are highly under-provided. In other words, their realisable values will be far below their book values. • Moreover these under-provided NPAs will have to be transferred to the ARCs at a huge discount. This will create a huge hole in the banks’ balance sheet • The loss suffered (difference in book value and transfer value) has to be written off by banks in year of transfer. No amortisation has been allowed for it.
As a result, only those banks which have sufficient profit / reserves to write this loss off will be interested to transfer the NPAs. • Also if the ARC is not able to service the securiti