LEGAL FRAMEWORK AS TO THE PROCESS OF SECURITISATION WITH A SPECIAL FOCUS ON SARFAESI ACT
By KPC RAO.,
LLB., FCS., FICWA
Practising Company Secretary
kpcrao.india@gmail.com
I. INTRODUCTION
The 1990s witnessed several financial and economic crises worldwide, crippling the economies of the affected countries. In most cases, crises in the financial sector culminate into non-performing Loans (NPL)). A high level of NPAs in the banking system can severely affect the economy in many ways: Management and financial resources of the banking system are diverted to resolution of NPA problems causing an opportunity loss for more productive use of resources. The banks tend to become risk averse in making new loans, particularly to small and medium sized companies. Thus, large scale NPAs when left unattended cause continued economic and financial degradation in the country. This results in a credit crunch and generally signals adverse investment climate. This explains why most countries in the grip of systemic financial and economic crisis have attempted system-wide clean up of NPAs as a part of restructuring of their banking system. ARCs have been used worldwide, particularly in Asia, to resolve bad-loan problems, and have had a varying degree of success.
II. BACKGROUND
The problem of recovery from NPA’s, in the Indian banking system, was recognized by the Government of India (GOI) as far back as in 1997. The Narasimhan Committee Report mentioned that an important aspect of the continuing reform process was to reduce the high level of NPA’s as a means of banking sector reform. It was expected that with a combination of policy and institutional development, new NPAs in future could be lower. However, the problem of a huge backlog of existing NPAs remained. This impinged severely on banks performance and their profitability. The Report envisaged the creation of an "Asset Reconstitution Fund" to take the NPAs off the lender's books at a discount. Unlike in some countries where ARCs have been set up post financial crises and for the purpose of bailout, in India, the GOI proactively initiated certain measures to control NPAs. In order to regulate and control the NPAs and quicken recovery, the GOI set up Debt Recovery Tribunals and Debt Appellate Tribunals under the "Recovery of Debts Due to Banks and Financial Institutions Act, 1993". As a corollary to this and to speed up the process of recovery from NPAs, the SARFAESI Act (Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002) was enacted for regulation of securitization and reconstruction of financial assets and enforcement of security interest by secured creditors, including Securitization or Reconstruction Companies (SC/RC).
The SARFAESI Act provides for setting up of Securitisation Companies/ Reconstruction Companies (SC/RC) termed in popular parlance as ARCs. The Act enables the banks and financial institutions to realize long term assets, manage problems of liquidity, asset liability mismatch and improve recovery by exercising powers to take possession of security, sell them and reduce Non Performing Loans (NPL) by adopting measures for recovery or reconstruction within the framework of the Act, the rules framed there under and the guidelines and notifications issued pursuant thereto, by the Reserve Bank of India (RBI). The SC/RCs acquires NPAs from banks, financial institutions a by raising funds from Qualified Institutional Buyers (as defined in the Act) by issue of Security Receipts (as defined in the Act) representing undivided interest in such financial assets. Like banks, financial institution, the Act also enables SC/ RC to take possession of secured assets of the borrowers including right to transfer and realize the secured assets. SC/RCs act as debt aggregators and are focused in the resolution of NPAs. Thus SC/RCs take away the distraction of banks by isolating NPAs from the banking system. This leaves rest of the banking system free to act in their core area of lending and normal banking business.
III. LEGAL FRAME WORK
The banks had to take recourse to the long legal route against the defaulting borrowers beginning from filing of claims in the courts. A lot of time was usually spent in getting decrees and execution thereof before the banks could make some recoveries. In the meantime the promoters could seek the protection of BIFR and could also dilute the securities available to bank. The debt Recovery Tribunals (DRTs) set up by the Govt. of India. The Debts Recovery Tribunal have been constituted under Section 3 of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993. The original aim of the Debts Recovery Tribunal was to receive claim applications from Banks and Financial Institutions against their defaulting borrowers. For this the Debts Recovery Tribunal (Procedure) Rules 1993 were also drafted.
While initially the Debts Recovery Tribunals did perform well and helped the Banks and Financial Institutions recover substantially large parts of their non performing assets, or their bad debts as they are commonly known, but their progress was stunted when it came to large and powerful borrowers. These borrowers were able to stall the progress in the Debts Recovery Tribunals on various grounds, primarily on the ground that their claims against the lenders were pending in the civil courts, and if the Debts Recovery Tribunal were adjudicate the matter and auction off their properties irreparable damage would occur to them.
Apart from the above big lacunae, there were a number of short comings too. The dues of work men against a company, the State dues, and the dues of other non secured creditors all got enmeshed before the Debt Recovery Tribunals. As if these were not sufficient, there was clash of jurisdiction between the Official Liquidators appointed by the High Courts and the Recovery Officers of the Debts Recovery Tribunals. The Official Liquidator, an appointee of a superior authority, took into his possession all the properties, which actually belonged to secured creditors who before the Debts Recovery Tribunal. The High Courts have also took umbrage on the activities of the Recovery Officers who away the entire amounts and paid off to the banks leaving nothing for the other claimants, including the work men. All these and other issues lead to drastic amendments to the Recovery of Debts Due to Banks and Financial Institutions Act by means of an amending notification in the year 2000.
While the amending notification of 2000 did bring in some amount rationalization in the jurisdiction of the Debts Recovery Tribunal, yet it was not sufficient to coax the big borrowers to acquiesce to the jurisdiction of the Debts Recovery Tribunal easily. The lenders continued to groan under the weight of the Non Performing Assets. This led to the enactment of one more drastic act titled as the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002.
The SARFAESI Act, empowered the lenders to take into their possession the secured assets of their borrowers just by giving them notices, and without the need to go through the rigors of a Court procedure. This Act Is having the overriding power over the other legislation and it shall go in addition to and not in derogation of certain legislation. Initially this brought in lot of compliance from borrowers and many a seasoned defaulter coughed up the Bank dues. However the tougher ones punched whole in the new Act too. This led Supreme court striking down certain provisions and allowing the borrowers an adjudicatory forum before their properties could be taken over by the lenders.
IV. PROVISIONS OF SARFAESI ACT
a) Object of the Act
The Statement of Objects and Reasons of the Act is to enable and empower the secured creditors to take possessions of their securities and to deal with them without the intervention of the court and also alternatively to authorize any securitization or reconstruction company to acquire financial assets of any bank or financial institution.
b) Process of Securitization
Simply stated, ‘securitization’ is a process by which the ‘originator’s of assets like loans which are illiquid, are able to transfer such assets to a ‘ special purpose vehicle’ transaction can be structured with a wide variety or ‘ credit enhancement’ to make the deals attractive for investors. The most important, however, is the guarantees of credit quality. There are two purposes for securitization. One, the securitized assets go off the balance sheet of the originator and so the asset-base is pruned down to that extent, thereby reducing the regulatory capital requirements to support the assets. Second the asset portfolio is liquidated, releasing cash, which in turn reduces the need for demand and time liabilities that are subject to statutory reserves.
“Securitization” means acquisition of financial assets by any securitization company or reconstruction company from any originator, whether by raising of funds by such securitization company or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interest in such financial assets or otherwise [section 2(1)(z)]. “Securitization company” means any company formed and registered under the Companies Act, 1956 for the purpose of securitization [Section 2(1)(za)].
Securitization is the issuance of marketable securities backed not by the expected capacity to repay of a private corporation of public sector entity, but by the expected cash flows from specific assets.
c) Non-Performing Assets
“Non-Performing Asset” means an asset or account of a borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset-
(a) In case such bank or financial institution is administered or regulated by an
authority or body established, constituted or appointed by any law for the time being in force, in accordance with the directions or guidelines relating to assets classifications issued by such authority or body;
(b) In any other case, in accordance with the directions or guidelines relating to
assets classifications issued by the Reserve Bank.
When a borrower who is under a liability to pay to secured creditor, makes any default in repayment of secured debt or any installment thereof, the account of borrower is classified as non-performing asset (NPA). NPAs constitute a real economic cost to the nation because they reflect the application of scarce capital and credit funds to unproductive uses. The money locked up in NPAs are not available for productive use and to the extent that banks seek to make provisions for NPAs or write them off, it is a charge on their profits. High level of NPAs impact adversely on the financial strength of banks who in the present era of globalization, are required to conform to stringent International Standards. The public at large is also adversely affected because bank’s main source of funds are deposits placed by public continued growth in NPA portfolio threatens the repayment capacity of the banks and erode the confidence reposed by them in the banks.
d) Asset Reconstruction Companies:
Reconstruction company means a company incorporated under provisions of Companies Act, 1956 for purpose of assets reconstruction.
The problem of non-performing loans created due to systematic banking crisis world over has become acute. Focused measures to help the banking systems to realize its NPAs has resulted into creation of specialized bodies called asset management companies which in India have been named asset reconstruction companies (‘ARCs’). The buying of impaired assets from banks or financial institutions by ARCs will make their balance sheets cleaner and they will be able to use their time, energy and funds for development of their business. ARCs may be able to mix up their assets, both good and bad, in such a manner to make them saleable.
The main objective of asset reconstruction company (‘ARC’) is to act as agent for any, bank or financial institution for the purpose of recovering their dues from the taken over by banks, or fees or charges, to act as manager of the borrowers asset taken over by banks, or financial institution, to act as the receiver or properties of any bank or financial institution and to carry on such ancillary or incidental business with the prior approval of Reserve Bank of India wherever necessary. If an ARC carries on any business other than the business of asset reconstruction or securitization or the business mentioned above, it shall cease to carry on any such business within one year of doing such other business.
All the ARCs who have obtained certificate or registration from Reserve Bank to carry on the business of asset reconstruction are public institution as defined under Section 4A of the Companies Act, 1956. This is a special status conferred by the Act on ARCs.
e) Enforcement of Security Interest under the Act (Sec. 13):
Section 13 of the Securitization Act provides for the enforcement of Security interest by a secured creditor straight away without intervention of the court, on default in repayment of installments, and non compliance with the notice of 60 days after the declaration of the loan as a non-performing asset. It must, however, be remembered that the classification of assets as non performing is not on the mere whims and fancies of the financial institutions. The Reserve Bank of India has a detailed policy providing guidelines or prudential norms in that regard.
The Secured Creditor has been defined to mean 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 securitization company or reconstruction company 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.
The secured creditor has two options. It can either transfer the assets to a securitization or reconstruction company or exercise the powers under the Act.
Section 13(4) of the Act empowers the recourse to one more of the following measures, after giving proper notice, for the recovery of the secured debts, namely:
(i) Take possession of the secured assets of the borrower including the right to
transfer by way of lease, assignment or sale for realizing the secured asset;
(ii) Take over the management of the secured assets of the borrower including
the right to transfer by way of lease, assignment or sale and realize the secured asset;
(iii) Appoint any person (hereafter referred to as the manager), to manage the
secured assets the possession of which has been taken over by the secured creditor.
(iv) Require at any time by notice in writing, any person who has acquired any
of the secured assets from the borrower and from whom any money is due or may become due to the borrower, to pay the secured creditor, so much of the money as is sufficient to pay the secured debt.
In cases of joint financing under consortium or multiple lending arrangement if 75% of the secured creditors in the value agree to initiate recovery action the same is binding on all secured creditors.
In case of a company under liquidation, the amount realized from the sale of the secured assets are to be distributed in accordance with the provisions of Section 529A of the Companies Act, 1956. If the company is being wound up after the commencement of this Act, the secured creditor of such company, who opts to realize its security instead of relinquishing its security and proving its debts under proviso to sub-section (1) of Section 529 of the Companies Act, may retain the sale proceeds of its secured assets after depositing the workmen’s dues with the liquidator in accordance with the provisions of Section 529A of that Act.
Where dues of the secured creditor are not fully satisfied with the sale proceeds of the secured assets, the secured creditor may file an application in the form and manner as may be prescribed to the Debts Recovery Tribunal having jurisdiction or a competent court, as the case may be, for recovery of the balance amount from the borrower.
Secured creditor is entitled to proceed against the guarantors or sell the pledged assets without first taking any of the measures specified above in relation to the secured assets under this Act.
f) Manner and effect of takeover of Management (Sec. 15):
Section 15 of the Securitization Act provides for the manner and effect of takeover of management. When the management of business of a borrower is taken over by a secured creditor it can appoint as many persons as it thinks fit to be the directors, where the borrower is a company, or the administrators of the business of the borrower, in any other case after due publication of notice as prescribed.
Where the management of the business of a borrower, being a company as defined in the Companies Act, 1956 (1 of 1956), is taken over by the secured creditor, then, notwithstanding anything contained in the said Act or in the memorandum or articles of association of such borrower:
(i) It shall be lawful for the shareholders of such company or any other person to nominate or appoint any person to be director of the Company,
(ii) No resolution passed at any meeting or the shareholders or such company shall be given effect to unless approved by the secured creditor;
(iii) No proceeding for the winding up of such company or for the appointment of a receiver in respect thereof shall lie in any court, except with the consent of the secured creditor;
(iv) Where the management of the business of a borrower had been taken over by the secured creditor, the secured creditor shall, on realization of his debt in full, restore the management of the business of the borrower to him.
g) Non-Applicability of the Act
The provisions of this Act shall not apply to-
(a) A lien on any goods, money or security given by or under the Indian Contract Act, 1872 or the Sale of Goods Act, 1930 or any other law for the time being in force;
(b) A pledge of movables within the meaning of Section 172 of the Indian Contract Act, 1872:
(c) Creation of any security in any aircraft as defined in clause (1) of Section 2 of the Aircraft Act, 1934;
(d) Creation of security interest in any vessel as defined in clause (55) of Section 3 of the Merchant Shipping Act, 1958;
(e) Any conditional sale, hire-purchase or lease or any other contract in which no security interest has been crated;
(f) Any rights of unpaid seller under Section 47 of the Sale or Goods, 1930;
(g) Any properties not liable to attachment (excluding the properties specifically charged with the debt recoverable under this Act) or sale under the first proviso to Sub-section (1) of section 60 of the Code of Civil Procedure, 1908;
(h) Any security interest for securing repayment of any financial asset not exceeding one lakh rupees:
(i) Any security interest crated in agricultural land;
(j) Any case in which the amount due is less than twenty per cent of the principal amount and interest thereon.
h) Over-riding effect of the Act (Sec 35 & 37)
The provisions of this Act shall have effect, notwithstanding anything inconsistent therewith contained in any other law for the time being in force or any instrument having effect by virtue of any such law (section 35). In accordance with Section 37, the provisions of this Act or the rules made there under shall be in addition to and not in derogation of the Companies Act, 1956, the Securities Contracts (Regulation) Act, 1956, the Securities and Exchange Board of India Act, 1992, the Recovery of Debts Due to banks and Financial institutions Act, 1993 or any other law for the time being in force.
The Combined affect of Sections 35 and 37 is that in cases of any conflict with these Acts or any other Act, then the SARFAESI Act, 2002 shall have the over riding effect over such Act or Acts. Therefore the provisions of the SARFAESI Act, 2002 have the binding power and cannot be put on hold because of conflict with any other legislation. Moreover as per the provisions of Section 34 of SARFAESI Act, 2002, no civil court shall have any jurisdiction to entertain any suit or proceeding in respect of any matter which a Debts Recovery Tribunal or the Appellate Tribunal is empowered by or under this Act (i.e. SARFAESI Act, 2002) to determine and no injunction shall be granted by any court or any other authority in respect of any action taken or to be taken in pursuance of any power conferred by or under this Act or under the Recovery of Debts Due to banks and Financial Institutions Act, 1993. Therefore it shall not be possible to get any injunction from any Court of Law. In line with the SARFAESI Act, 2002 Indian parliament has amended following legislations:
1. The Companies Act, 1956: The definition of Public Financial Institution under Section 4A has been altered and it now includes securitization company or reconstruction Company.
2. The Securities Contract (Regulation) Act, 1956: Section 2 has been amended to include the definition of Security Deposit as defined in 2 (kg) of SARFAESI Act, 2002.
3. The Sick Industrial Companies (Special Provisions) Act, 1985 has been amended to the extent it provides that after the commencement of SARFAESI Act, 2002 and if the financial assets have been acquired by securitization or reconstruction company, no reference shall be made to BIFR. Moreover, after the commencement of SARFAESI Act, 1956 and if the reference is pending, then the reference shall abate, if 75% of the Secured Creditors have taken measures to recover their Secured Debts.
i) Applicability of Limitation Act (Sec. 36):
Limitation Act, 1963 is applicable to the claims made under this Act, Accordingly, no secured creditor shall be entitled to take all or any of the measures under Sub-section (4) of Section 13, unless his claim in respect of the financial asset is made within the period of limitation prescribed under the Limitation Act, 1963.
V. RBI GUIDELINES
The Reserve Bank of India considered it necessary to issue the guidelines and directions to Securitization companies or Reconstruction Companies in the public interest and for the purpose of enabling the Reserve bank to regulate the financial system to the advantage of the country and to prevent the affairs of any Securitization Company or Reconstruction company form being conducted in a manner detrimental to the interest of investors or in any manner prejudicial to the interest of such Securitization Company or Reconstruction Company.
Accordingly, the Reserve Bank of India has issued guidelines to every Securitization Company or Reconstruction Company namely the Securitization Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003. relating to registration, owned fund, permissible business, operational structure for giving effect to the business of securitization and asset reconstruction, deployment of surplus fund, internal control system, prudential norms, disclosure requirement etc. acquisition of financial assets and matters related thereto.
The provisions of these guidelines and directions shall apply to Securitization Companies of Reconstruction Companies registered with the Reserve Bank of India under section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.
VI. RIGHT TO APPEAL
Section 17 of the Securitization Act provides that any borrower or any other person aggrieved by the action of the secured creditors can file an appeal to the concerned Debt Recovery Tribunal (DRT)
Such appeal can also be filed by any person aggrieved by the action of the secured creditor without being required to deposit any amount with the DRT. Such provisions will take care of any third party interest in the secured assets which need to be considered before sale of securities. Any person aggrieved by the order of DRT, may prefer an appeal to the Appellate Tribunal within thirty days from the date of receipt of the order of Debt Recovery Tribunal.
VII. CONSTITUTIONAL VALIDITY
The securitization Act, 2002 was challenged in various courts on grounds that it was loaded heavily in favour of lenders, giving little chance to the borrowers to explain their views once recovery process in initiated under the legislation., A notable case that has come up before the Apex court was Mardia Chemicals in its plea against notice served by ICICI Bank. In Mardia Chemicals Ltd. V. UOI,[1] it was urged by the petitioner that
(i) There was no occasion to enact such a draconian legislation to find a shortcut to realize non-performing assets (‘NPAs’) without their ascertainment when there already existed the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (‘ Recovery of Debt Act’) for doing so;
(ii) No provision had been made to take into account lenders liability;
(iii) That the mechanism for recovery under Section 13 does not provide for an adjudicatory forum of inter se disputes between lender and borrower; and
(iv) That the appeal provisions were illusory because the appeal would be maintainable after possession of the property or management of the property was taken over or the property sold and the appeal is not entertainable unless 75 per cent of the amount claimed is deposited with the Debts Recovery Tribunal (‘DRT’)
The Supreme Court held that though some of the provisions of the Act 2002 be a bit harsh for some of the borrowers but on those grounds the impugned provisions of the Act cannot be said to unconstitutional in the view of the fact that the objective of the Act is to achieve speedier recovery of the dues declared as NPAs and better availability of capital liquidity and resources to help in growth of economy of the country and welfare of the people in general which would sub-serve the public interest.
The Supreme Court observed that the Act provides for a forum and remedies to the borrower to ventilate his grievances against the bank or financial institution, inter alia, with respect to the amount of the demand of the secured debt. After the notice is sent the borrower may explain the reasons why the measures may or may not be taken under Sub-section (4) of Section 13. The creditor must apply its mind to the objections raised in reply to such notice. There must be meaningful consideration by the Court of the objections raised rather than to ritually reject them and to proceed to take drastic measures under Sub-section (4) of Section 13. The court held that such a procedure/mechanism was conducive to the principles of fairness and that such a procedure was also important from the point of view of the economy of the court and would serve the purpose in the growth of a healthy economy. It would serve as guidance to secured debtors in general in conducting their affairs.
The court opined that the ‘fairness doctrine’, cannot be stretched too far, such communication is only for the purposes of the secured debtors knowledge and cannot give an occasion to the secured debtor to resort to any proceeding, which are not permissible under the provisions of the Act. Thus, a secured debtor is not allowed to challenge the reasons communicated or challenge the action likely to be taken by the secured creditor at that point of time unless his right to approach the DRT as provided under section 17 matures on any measure having been taken under Sub-section (4) of Section 13.
Moreover, another safeguard is also available to a secured borrower within the framework of the Act i.e. to approach the DRT under Section 17 though such a right accrues only after measures are taken under Sub-section (1) of Section 13.
The Apex Court, however, found that the requirement of deposit of 75 per cent of the amount claimed before entertaining an appeal (petition) under Section 17 is an oppressive, onerous and arbitrary condition and against all the canons of reasonableness. Held this provision be invalid and ordered that it was liable to be struck down.
CONCLUSION
SARFAESI Act not only helps the banks on fast track to debt recovery but also to improve the quality of their assets. Similarly, the act also helps the non banking finance companies to improve the quality of their assets as well as loans.
Banks have been able to recover over 61% of the bad debts for which proceedings were initiated under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act by 2007-08.[2] Although legal issues have cropped up regarding attaching and selling defaulters' properties, the threat of dispossession has propelled many borrowers to pay up, as the Act allowed banks to attach defaulters' properties after giving 60 days' notice. The Act has been responsible for the bulk of the bad loan recovery, and helping the banks to improve ratio of non-performing assets (NPAs) to total assets.
According to Report on Trend and Progress of Banking in India, 2007-08 released by RBI, among the various channels of recovery available to banks for dealing with bad loans, the SARFAESI Act and the debt recovery tribunals (DRTs) have been the most effective in terms of amount recovered. The amount recovered as percentage of amount involved was the highest under the SARFAESI Act, followed by DRTs.
The Act also enabled the creation of asset reconstruction companies, which helped the banks to clean up their balance sheets. Asset reconstruction companies buy NPAs from banks and specialise in recovery of bad loans either through resolution or selling assets. While the Act helped lift the deadweight of large corporate bad loans from their books, banks have been able to get rid of lakhs of small default cases through Lok Adalats, people's courts established by the government for settlement of disputes through conciliation and compromise.
The Banks have referred as many as 78,366 loan default cases by end march 2010 under SARFAESI Act involving a loan amount of `14, 249 crores. Against this, the Banks managed to recover ` 4,269 crores, representing 30% of the loans.[3]
------------------------------------------------------------------------------------------------------------ [Presented at the National Seminar Conducted by the ICSI at Hyderabad]
