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By Nilesh Chandra and Abhinav Mishra
With the volume of stressed assets in India almost doubling in last five years, Asset Reconstruction Companies (ARCs), which act as intermediaries between the borrower and the lender, have been bestowed with the imperative responsibility to clean-up stressed assets by adopting effective resolution and recovery mechanisms and relieve lenders from the mountainous burden.
Backed strongly by the RBI, ARCs are a creation of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002 more than a decade ago. Despite the RBI’s encouraging measures towards promoting sale of stressed assets by banks to ARCs, the ARC sector is yet to mature in Indian jurisdiction. This can be witnessed from the fact that in the face of stressed assets verging on an alarming figure of close to INR 700 trillion, only 14 functional ARCs on date have a considerably minimal stressed asset portfolio.
This dismal performance of the ARCs can be attributed to a barrage of issues such as stringent legal and regulatory compliances, inadequate capital, restriction on foreign investment, valuation mismatch, huge stamp duty implications on assignment documents and so on; in addition to inadequate regulatory support for effective resolution/recovery of stressed assets and poor average recovery rate (of about 30% over a period of at least 4 to 5 years) due to inter-alia an overburdened adjudication system.
This has also acted as a roadblock to investors from investing in the ARCs and their security receipts (SRs). Under the current regulatory framework, in contrast to the regulatory freedom for ARCs envisaged under the SARFAESI Act, adoption of resolution mechanism by taking over the borrower’s management or initiation of recovery proceedings, sans interference of courts, have been largely defeated. Borrowers, investors and other secured/unsecured creditors have been successful in creating various long lasting legal and regulatory hurdles in the way of the ARCs.
MANAGEMENT FEE ROUTE AND THE IMPACT
To recoup with the adverse impact on their own balance sheets, discouraged ARCs have transitioned towards relying on the ‘management fee’ based model, defeating the prime objective of resolution/recovery of stressed assets. This can clearly be witnessed from the fact that under the previous regulatory regime i.e. the 5:95 structure, ARCs were buying stressed assets at aggressive book value price with a minimal upfront payment of 5 percent; and balance in the form of SRs, to be redeemed from recovery of the stressed assets. On account of the (annual) management fee of 1.5% charged on the ‘asset under management’ (AUM), the ARCs were ensuring the return of around 18-20% over a 4-5 year period with minor upfront investment of 5%, managing only about 25-30% recovery rate of stressed assets. This not only defeated the object of creation of ARCs but adversely affected the lenders as unredeemed SRs, due to recovery shortfall, were written off without any recourse to the ARCs. This led to introduction of a more stringent regime in 2014, whereunder cash commitment of the ARCs was increased from 5% to 15% (i.e. a 15:85 structure) and the management fee was linked with NAV to ensure better price discovery of stressed assets and to keep the ARC’s skin in the game. This regulatory change led to increased upfront investment requirement from ARCs, substantially reduced the return on investment, whereas no measures were taken to improve the resolution or recovery mechanism of the stressed assets on a regulatory front.
Another significant issue being faced by ARCs pertains to levying of stamp duty on the assignment/transfer of stressed assets especially if the same is coupled with power of attorney (POA), transferring all rights title and interest in the security, to facilitate recovery in the event of enforcement, which is largely prevalent in retail loan portfolio. Recently, a stamp reference petition was placed before the Hon’ble Gujarat High Court, regarding applicability of stamp duty on such POA as an independent document and liable to be charged under as conveyance, which is 6-8% of the value of such assets. This judgment was subsequently challenged before the Hon’ble Supreme Court and pending adjudication, which shall be important in terms of determining the payment of stamp duty on pre-2016 transactions, as the recent amendments in the SARFAESI Act and the Indian Stamp Act, 1899, exempts payment of stamp duty on any document executed by any bank or financial institution in favour of ARCs for the purposes of asset reconstruction or securitisation.
POSITIVE FUTURE TRAJECTORY
Despite the hitches faced by ARCs thus far, the current sentiment among the stakeholders is positive on several accounts. Pursuant to the RBI’s September 2016 guidelines, “other banks, non-banking financial companies (NBFCs) and financial institutions (FIs) etc.” shall also be allowed to bid for stressed assets for ‘better price discovery’ – expanding the arena of stressed-asset-resolution for more players.
Significantly, the new framework under the Insolvency and Bankruptcy Code, 2016 (IBC Code), empowers the RBI to carry out financial audits of ARCs, appoint their board of directors, penalize ARCs for non-compliance and regulate their management fee. IBC code further consolidates and amend several connected laws, including significantly the Companies Act, 2013, 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. The IBC Code also mandates registration of security interest with the central registry, which is expected to significantly ease the process of diligence thereon.
In addition, 100% FDI in ARCs (and SRs) and exemption from levying of stamp duty on debt-assignment transactions further add to the increased viability and future potential success of ARCs. Recently, three additional ARCs have been added to the existing portfolio of India’s institutional arsenal for stressed-asset resolution/recovery, and more are set to follow suit as several corporate houses too are gearing up.
In the wake of introduction of IBC, relaxed regulatory measures and a positive market sentiment for ARCs among the relevant stakeholders, it will be interesting to observe whether the dark clouds looming over ARCs finally move and make way for a more effective asset de-stressing/recovery mechanism.
Nilesh Chandra is an associate partner and Abhinav Mishra is an associate at HSA Advocates.