The Indian Stressed Assets and New RBI Framework for ARCs
India has always been a land of investment opportunities. As I am writing this the official data and experts have clearly stated while world may enter into a recession in 2022 2023, India will be the only bright spot. The topic for article is the Indian Stressed Assets and the new Regulatory Framework for Asset Reconstruction Companies (ARC) released by the Reserve Bank of India (RBI).
Lets start with the basics first, what exactly are stressed assets? India Investment Grid a website of Government of India for investment opportunities defines it as Distressed assets are assets that represent the opportunity to purchase operational and good underlying assets, with a potential to turnaround, at attractive valuations. It enables strategic investors to expand capacity in a cost-effective manner.
As per the same website, currently there are 3573 cases of stressed assets on various forums across 27 sectors. Out of the above 928 cases have been fully resolved and 2645 cases are in the process of resolution. How large is the Indian Stressed Asset Market, according to report by Alvarez and Marsel it is USD 150 + Billion. According to the RBI Financial Stability Report, June 2022, Gross NPA of Scheduled Commercial Banks were at 5.9% and Net NPA was at 1.7%. The good news though is both slippages and write off ratios declined post covid but still remains elevated.The write off ratio which is ratio of write off to Gross NPA stood at 20% still. This still means that this market has growth and has potential.
The regulatory journey of Indian Stressed Asset Market began in 1985 with the Sick Industrial Companies (Special Provisions) Act, 1985, then in 1993 came Recovery of Debt dues to Bank and Financial Institutes Act (DRTs), Corporate Debt Restructuring Mechanism (CDR) in 2001, the ground breaking SARFAESI Act, 2002, followed by various schemes in 2014 and 2015. In 2016 Insolvency and Bankruptcy Code (IBC), 2016 and in 2019 Prudential Framework for Resolution of Stressed Assets were introduced. Both of these together subsumed almost all of the frameworks above except for SARFAESI. Deputy Governor of RBI M Rajeshwar Rao in a speech has rightly pointed out that efficient insolvency legislation should be premised on following five pillars:
I.???????????????????It should prioritize going concern status over liquidation.
II.????????????It should force the creditors to come together and work out a resolution plan that tries to preserve the value by looking at the options to keep the company as a going concern.
III.???????????It should ensure a time bound resolution so that value deterioration for the creditors of an insolvent exposure is arrested.
IV.??????????It must provide claw back of questionable transactions that may have contributed to the financial stress of the defaulting borrower.
V.???????????Finally, an effective resolution regime should protect the majority from the minority by forcing a cramdown if the majority decision covers a predefined threshold of approval.
In the same speech he also discussed about fundamentals of 2019 Prudential Framework for Resolution of Stressed Assets, which talks a lot of RBI’s view on stressed asset scenario and its resolution:
I.???????????????????Early recognition and reporting of default in respect of large borrowers by banks, FIs and NBFCs.
II.?????????????????Complete discretion to lenders with regard to design and implementation of resolution plans, subject to the specified timeline and independent credit evaluation.
III.???????????????A system of disincentives in the form of additional provisioning for delay in implementation of resolution plan or initiation of insolvency proceedings.
IV.???????????????Withdrawal of asset classification dispensations on restructuring. Future upgrades to be contingent on a meaningful demonstration of satisfactory performance for a reasonable period.
V.?????????????????For the purpose of restructuring, the definition of ‘financial difficulty’ was aligned with the guidelines issued by the Basel Committee on Banking Supervision; and,
VI.???????????????Signing of inter-creditor agreement (ICA) by all lenders was made mandatory, which will provide for a majority decision making criteria.
A majority of investors in the stressed assets are foreign investors. The following are the preferred ways of investing:
I.?????Direct takeover through Foreign Direct Investment (FDI), External Commercial Borrowings (ECB), IBC.
II.????Foreign Portfolio Investors (FPI) can invest through purchase of Non Convertible Debentures.
III.???Investment in an NBFC through Equity and then NBFC can purchase the asset.
IV.??Subscribe to the units of Alternative Investment Funds (AIF) and then AIF subscribes to the investments.
V.???Through SAFAESI mechanism which involves the Asset Reconstruction Companies and their Trust. Discussed later in this article.
In substance, the turnaround story of stressed assets is a mixed emotion. In my personal opinion, resolutions where tangible assets are underlying have been quite successful for eg power, steel etc. However in the financial services, it required a lot of muscle capital and regulatory support as the money and intangibles were lost completely and there were no tangible assets for recovery or bringing the operations back to the capacity.
This brings me to my second topic for the article, Regulatory Framework for Asset Reconstruction Companies (ARC) released by the Reserve Bank of India.
Here again let me start with the basic, what is an ARC? ARCs are specialized asset managers that acquire debts from original lenders, securitize them and help recover the debts. Asset Reconstruction means acquisition of an interest of any bank or financial institution in loans, debentures, bonds, guarantees or any other credit facility extended by banks to realize dues and securitize. This happens through creation of a Trust which purchases assets with the help of investors (can be other than ARC as well) and issues Security Receipts in return which are marketable.
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As per RBI, ARCs play a vital role in the management of distressed financial assets of banks and financial institutions.? The best part of ARC business as per me is 100% FDI is allowed in this business, and the interest required by an ARC in trust is only 15% or 2.5% of the total SRs issued, whichever is higher, of each class of SRs issued by them under each scheme on an ongoing basis till the redemption of all the SRs issued under such scheme.. The other part is ARC Trust has been accorded pass through status and accordingly there is no taxation at Trust Level.
As part of the?Statement on Developmental and Regulatory Policies?released along with the?Monetary Policy Statement on April 7, 2021, the Reserve Bank of India had set up a Committee to undertake a comprehensive review of the working of ARCs and recommend suitable measures for enabling them to function in a more transparent and efficient manner, accordingly the RBI vide notification RBI/2022-23/128 dated October 11, 2022 released Review of Regulatory Framework for Asset Reconstruction Companies. These guidelines have been divided into two section:
Section I: Corporate Governance Framework
Section II: Other Measures
Salient features of these regulations are:
Section I:
A. The Chairman of the Board will be an Independent Director.
?B.?Tenure of MD/ CEO or WTD shall not be for a period of more than five years at a time and the individual shall be eligible for re-appointment. However, the post of the MD/ CEO or WTD shall not be held by the same incumbent for more than fifteen years continuously. Thereafter, the individual shall be eligible for re-appointment as MD/ CEO or WTD in the same ARC, if considered necessary and desirable by the Board, after a minimum gap of three years, subject to meeting other conditions. During this three-year cooling period, the individual shall not be appointed or associated with the ARC in any capacity, either directly or indirectly. The ARCs shall put in place appropriate measures to ensure succession planning.
?C.?No person shall continue as MD/ CEO or WTD beyond the age of 70 years. Within the overall limit of 70 years, as part of their internal policy, ARCs’ Boards are free to prescribe a lower retirement age.
?D.?Performance of MD/ CEO and WTD shall be reviewed by Board annually, revised Fit and Proper criterias.
?E.?Constitution of a strong Audit Committee and Nomination and Remuneration Committee of the Board.
?F.?ARCs shall mandatorily obtain recovery rating of the SRs from CRAs and disclose the assumptions and rationale behind such rating to SR holders. ARCs shall retain a CRA for at least 6 rating cycles (of half year each). If a CRA is changed mid-way through these 6 rating cycles, the ARC shall disclose the reason for such change.
?G. Following enhanced disclosures to be incorporated in the offer document:
?I.?????????????Summary of financial information of the ARC for last 5 years or since commencement of business of the ARC, whichever is shorter.
II.????????????Track record of returns generated for all Security Receipt (SR) investors on the schemes floated in the last 8 years.
III.???????????Track record of recovery rating migration and engagement with rating agency of schemes floated in the last 8 years.
Section II:
?A.?Constitution of Independent Advsiory Committee (IAC) which shall guide the Board on the investment proposals.
?B.?Any management fee/ incentives charged towards the asset reconstruction or securitization activity shall come only from the recovery effected from the underlying financial assets, quantitative cap on Management Fees.
?C.?Net Owned Fund of the ARC to be increased from INR 100 Crores to INR 200 Crores by March 31, 2024 and INR 300 Crores by March 31, 2026.
?D. Surplus Funds can now be deployed in variety of instruments subject to certain limits.
?E. ARCs shall now?invest in the SRs at a minimum of either 15% of the transferors’ investment in the SRs or 2.5% of the total SRs issued, whichever is higher, of each class of SRs issued by them under each scheme on an ongoing basis till the redemption of all the SRs issued under such scheme. This was flat 15% earlier.
One major amendment that I wanted to highlight separately is that ARCs having Net Owned Fund of INR 1000 Crores or more can now become Resolution Applicant under IBC. This is again path breaking. For years practically, Banks were avoiding the IBC route directly by selling their stressed assets to ARCs and the asset was taken into IBC. Due to this haste selling, efficient price recovery was not possible as banks rushed to sell the assets to avoid the IBC legal and timeline issues. With the official entry of ARCs in this space, though slowly the IBC may gain momentum again.
Overall these new guidelines shall bring enhanced level of transparency and value in the distressed asset sector.
The views expressed in this article are my own and does not constitute views of my Firm.
All views/ opinions are personal Vice President at Bajaj Finserv Limited || CA, CS|| Ex- PwC|| AIR CA INTER
2 年?? Harsh S Swadia
PE - IndiaRF(Bain Capital - Piramal Alternatives)
2 年Well-articulated!