securitisation act (sarfaesi act) provisions on asset reconstruction and enforcement of security...

Securitisation Act (SARFAESI Act)

Provisions on Asset Reconstruction and Enforcement of Security Interests

Vinod Kothari1012 Krishna224 AJC Bose RoadCalcutta 700 017Phone 033-23233863/23233864/2281 1276/22817715/22813742Fax 91-33-23233863/22811276

Email: [email protected]; [email protected]

Corporate insolvency by Vinod Kothari2

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Provisions of SARFAESI Act on Reconstruction Companies


Meaning of reconstruction and ARCs

Reconstruction not defined reconstruction company is a company formed

for reconstruction General commercial meaning to be adopted Essential provisions of law for securitisation

companies and ARCs the same; purpose and different to be observed in practice, not in law

Single or multiple ARCs:– in line with East Asian experience, Govt seems

inclined to opt for a consolidated ARC


Nature of ARCs

Originator (s)

NPLs

owning

Reconstructioncompany

Transfers at fair value

Securitisation

QIBs

debentures

Other means


Who can form ARCs

ARCs do not need to be government-sponsored; anyone with the requisites can form an ARC

Private ARCs:– since sale of NPLs by ARCs not specifically provided for,

private debt resolution companies wanting to buy NPLs may have to form their own ARCs

– privileges of ARCs: all powers of ARCs/ powers of enforcement of security interest

applicable to such ARCs bankers may find it convenient to sell down NPLs to private buyers

with ARCs than to enforce/ restructure loans themselves

Requisites:– similar to securitisation company– “no losses for 3 years” condition for continued registration may

be difficult, since most ARCs do incur losses


Process of acquisition of assets

Acquisition of assets by ARCs to be by transfer Provision to issue debentures - as in case of RTC, USA; could be

zero coupon bond Transfer understandably at fair value transfer by agreement Legal impact of transfer the same as in case of securitisation

companies:– transfer of loans with securities– power of notification– fractional transfers liable to problems


Special legal powers of ARCs

Sec 9 provides distinctive legal powers– change in or takeover of management– sale or lease of a part or whole of business– rescheduling– enforcement of security interests and taking possession of

assets - same as permitted to any other lender– power of settlement

Power of takeover/ forcing sale of business is the only distinctive power

Since “secured creditor” includes ARCs, powers under sec 15 applicable to ARCs also

– compulsory change in directors or officers– sec 15 (4) - secured creditor on realisation of “his debt” to

restore management; debt could be the original debt or debt of the ARC


Funding of ARCs

Issuance of debentures and securitisation seem two alternative routes

It does not sound logical to issue debentures and also securitise If debenture route adopted:

– whether secured or unsecured?– Whether coupon or zero coupon– whether amortising, bullet payment, soft bullet?

If securitisation route adopted:– ability to give further funding limited– post-securitisation restructuring of loans difficult– substantial recourse to originating bank may put questions on true

sale Combination of the two:

– QIBs are senior investors on soft-bullet basis– originating bank as a subordinated debentureholder


Stamp duty issues

SARFAESI Act does not specifically answer the stamp duty issue

Stamp duty may be applicable on each of these:– transfer of assets to the ARC– issue of debentures by ARC in return– issue of other security receipts by ARC– further transfer/ sale of the acquired assets by the ARC– decree for transfer of any charged assets in favour of the

ARC or any one else– transfer of debentures by the holders– transfer of security receipts by the holders


Manner of resolution and sales

In order that ARC is not another BIFR, ARCs must be given commercial discretion to sell down the NPLs

SARFAESI Act provides for acquisition of financial assets by ARCs, not for sale of financial assets

Sale is a crucial provision - in most countries, bad loans have been sold by ARCs

– Korea Thailand and China Sale of NPLs by the ARC:

– no specific provisions in the SARFAESI Act– procedure of sec 130 applicable– stamping issues, notification etc – transfer of mortgages may further complicate sale


Impact on originator banks

Transfer of NPLs by originating banks to ARCs to give rise to:

– gain on sale– loss on sale

If unprovided book value exceeds the fair value of the loans, banks may have to write losses, affecting profits, capital adequacy

Retention of subordinated interest by banks may be ideal solution


SARC (RBI) Directions

RBI has promulgated SARC Guidelines and Directions vide a 23rd April 2003 notification

Policy-making: SARCs must make policies w.r.t – acquisition of financial assets– change in management or takeovers: guidelines to be issued

by RBI.– Rescheduling of assets– Acquisition of assets by enforcement of security interests: only

if the assets are sold by public auction– Settlement– Plan for realisation– issuance of security receipts


Issue of security receipts

Para 8 seems to have accepted the trust mode as a standard practice for SARCs:– mistaken notion: transfer of assets to trusts.– Appropriately SARC must acquire assets and hold

them as trustees. There is no transfer between the SARC and the trust.

– Security receipts to be offered and be transferable to only QIBss

Disclosures for issuance of security receipts laid down:– initial disclosures– quarterly disclosures


Capital adequacy requirements

15% capital adequacy ratio laid down for SARCs

Para para 2, this is not applicable in case of assets held in the name of trusts:– therefore, the requirement of capital adequacy is

rendered nugatory.

However, if the SARC continues to hold any residual interest in the trust or a first loss piece, the trust could be said to be subsidiary of the


Asset classification by SARCs

During planning period, assets acquired for reconstruction to be treated as standard:– planning period is a period of 12 months or until

reconstruction plan is made, whichever is earlier On rescheduling or renegotiation, assets

substandard To be upgraded into standard after 12 months’

performance provisioning requirements: on similar lines as

for banks Requirements inapplicable in case of assets

held by trusts


Disclosures on the balance sheet

Names of transferring banks, and the value at which these assets were acquired:– most unwarranted disclosure

Dispersion of assets by industry and sponsor Migration of financial assets

This is also inapplicable to assets held as a trustee


Directions to banks

Only NPAs can be sold to SARCs– literally interpreted, this guideline proscribes any CLOs of performing

assets Sale should qualify for off-balance sheet treatment, and there

should not be any known liability devolving on the transferor:– vague statement:

representations and warranties common any credit enhancement is a known liability

– does it imply non-recourse transfer only? Transfer price must be non-contingent. Deferred sale proceeds

not allowed. But banks may share the surplus:– the surplus is nothing but non-contingent consideration. Only it cannot

be booked into profit immediately.– Equivalent to 100% provisioning for the retained interest


Directions to banks ..2

On sale:– the asset will be removed from books– gain/loss on sale will be written off

In case the gain is by way of reversal of provisions, the same shall be used to meet deficits on other assets.

Securities issued by SARC:– must not have a term of more than 6 years (legal final?)– carry at least a rate of Bank rate + 150 bps

zero coupon bonds ruled out

– the commitment to pay must be unconditional and not based on realisation the SARC: this would not be possible in case of transfer to trusts: in case of

any SPV, unconditional undertaking to pay has no meaning

Provisions of SARFAESI Act on Enforcement of Security Interests


Meaning of security interests

Security interest under the law has 4 elements:– secured debt/ financial assistance– security interest– secured creditor– borrower

Sec 2 (1) (zf) - right title and interest of any kind whatsoever, including mortgage, charge, hypothecation, assignment

right title or interest - obviously meaning those created for security Mortgage - sec 58 of TP Act is limited to immovable property. Generally, conferring any

right to a lender to sell property on default Hypothecation - sec. 2 (1) (n) - all charges except a pledge Charge - by itself, does not mean anything but security interest. Sec 100 of TP Act - a

security interest not being a mortgage. Any interest in property defeasible or destructible on repayment of a debt - Bond Worth Limited (1980) Ch

Assignment - assignment by way of security, and not assignment by way of transfer


Ingredients of a charge

Meaning of security interest - a right to sell property to realise a debt.

– In Cosslett’s case, a right of a contractee to sell contractor’s equipment was held to be a security interest

Charge is related to debt. A charge secures a debt, does not create a debt.

Ownership interest may also amount to a charge - conditional sale or reversible sale.

Charge should be co-terminus with the debt Property, present or future should be made available. Floating charges do not relate to any property unless fixed:

– ruling in Brumark Investments and Cosslett Mere restraint on property is not a charge


Financial assistance

Building block of relationship between a borrower and secured lender. Loan advance granted

– intends to include originated loans, not acquired loans debentures or bonds subscribed

– purchased debentures cannot be included guarantees given or letter of credit established

– obviously, lead to a financial assistance only when principal debtor defaults any other credit facility - makes it an inclusive definition; other similar

facilities to be included Are these included?

– Discounting of bills of exchange– any purchase or sale of securities– any lease or hire purchase transaction– factoring transaction amounting to purchase of factored debt– securitisation investments– purchase of commercial paper


Secured creditor - sec 2 (1) (zd)

Bank financial institution:

– Includes power to notify financial companies In case of debentures:

– unsecured debentures do not seem to be covered (last line of definition)

– secured debentures - rights exercisable by trustees debenture trustee appointed by any bank or financial

institution:– misnotion- debenture trustees are appointed by the

charge-creator and assented to by the beneficiary– could create confusion where debentures are held by

non-banks as well securitisation company and reconstruction company any other trustee holding securities on behalf of a bank

"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

.securitisation company or reconstruction company; or

any other trustee holding securities on behalf on a bank or financial institution, in whose favour security interest is created for due repayment by any borrower of any financial assistance;


Borrower

Key word is “financial assistance” Any person who has availed of financial assistance guarantor:

– guarantee as defined in sec.126 of Contracts Act– does not include contracts of indemnity– consent of the principal debtor important– issue: can rights under the law be enforced against the guarantor as

principal obligor- apparently yes provider of security

– only mortgage and pledge included here– usually security provider will also be a guarantor

borrower of securitisation company makes no distinction between corporate and non-corporate borrower Continued relation between lender and borrower important - after

assignment, lender cannot operate against the borrower


Secured asset

Meaning is important, as the rights under the law exercisable against secured assets

Sec 2 (1) (zc) - assets over which security interest created Requisites:

– the security interest must be specific to the asset– the interest must be in the nature of security interest

Floating charges: interest does not become specific until receivership/ winding up action

Can the process of this law be taken as receivership?– The rights to take possession of the assets under this law are akin to

rights of a debentureholder to appoint receivers u/s 123– The process under this law should amount to crystallisation of the

charge– however sec 13 (13) may create difficulties


Exceptions under sec. 31

Lien on goods, money or security under Contracts law or Sale of Goods Act:– a very confusion clause, as essentially, all security interests are liens and all such liens by

contract of parties are given under Contracts law– intent to exclude bailee lien u/s 170, banker’s lien u/s 171– unpaid seller’s lien u/s 47 of Sale of Goods Act

pledge– generic rights under Contracts law applicable

creation of security in any aircraft creation of security in vessels conditional sale, hire purchase or lease or any other contract in which no security

interest has been created– exclusion of conditional sale unreasonable; conditional sales regarded as lending

transactions - Sundaram Finance v State of Kerala rights of unpaid seller properties not liable for attachment under CPC:

– exclusions under sec. 60 of CPC; most include personal effects, LIP, public provident fund where financial assistance not exceeding Rs 1 lac where dues are less than 20% of principal and interest agricultural land


Enforcement of security u/s 13

Sec. 13 overrides sec. 69/ 69A of TP Act, not however, sec. 67– However, by sec 35, the SARFAESI Act overrides all laws in the country. – Sec. 67 (a) puts an important distinction between right of foreclosure and right of sale. A

normal charge holder has a right of sale, not right of possession– Remedies under this law are not to the exclusion of other rights - e.g., DRT proceedings,

decree of Civil Courts Requisites for action u/s 13:

– borrower, under liability to secured lender– makes default in repayment of a secured debt or instalment: any default of agreement

cannot trigger the power– account classified as NPA under RBI norms: banker’s books to be evidence– creditor requires borrower in writing to discharge “all his liability” within 60 days of notice– notice to specify amounts due and the details of secured assets – effect of notice:freeze on sale lease or transfer u/s 13 (13)– freeze in case of floating charges? Details of secured assets?

Notice only demands payments. Does not amount to receivership.

Rights under sec 13 (1):– are rights to enforce security interest; do not confer any new rights not implied by the

agreement between parties. It is only the interest created which can be enforced.– principles of natural justice applicable


Freeze relating to assets u/s 13 (13)

Receipt of notice u/s 13 (2) would put a freeze on transfer of secured assets

– “secured assets” only subject to injunction– details whereof given in the notice u/s 13 (2)

analogous provision - sec 19 (12) of RDB Act; order 39 rule 1 of CPC

Under CPC, a Court may order injunction - exercise of discretion. No discretion under this law - hence principles of balance of

convenience etc have no place Floating charges saved - exception in case of sale in ordinary

course of business Restraint only against transfer - not against creation of further

charges; encumbrances: can be used for stone-walling


Measures to be taken

Measures against the secured assets– Taking possession of the secured assets of the borrower: does it include right to use

assets - No– transfer by way of lease, assignment or sale– take over the management of the secured assets - does not mean takeover of

management of business– appoint a manager to manage the assets possession of which has been taken– require by notice a person who has bought the secured assets to pay for such asset to

the lender - this envisages payment for secured assets subject fo fixed charge measures u/s 13 (4) limited and cannot be expanded - for example, no power to

force a sale without taking possession or management recover expenses for action u/s 13 (4) - sec 13 (7) proceeding against guarantors/ pledged assets - primary right u/s 13 (11) proceeding for balance due under DRTs or competent Court - “as the case may

be” implies RDB Act allocation Provisions in case of company under liquidation - sec. 529A of Companies Act to

be applicable Limitation Act applicable - debts barred by limitation cannot be enforced under this

law


Taking possession u/s 13 (4)

Purpose of the law is to enforce security interest, not to allow a lender the interest of an asset owner.

Taking of possession does not amount to transfer of title Taking of possession is only for the purpose of realisation of security -

– position similar to receiverships under Order 40, rule 1 of CPC– difference - Civil law receiverships are for preservation of subject matter; this

law is for sale Use of reasonable force permitted for possession - Blade v. Higgs (1861)

10 CBNS 713. Position of lender taking repossession and sale discussed in several

English rulings: lender in possession is not a trustee for the borrower Sec 13 (4) to be read with sec 13 (7) - attempts of sale of the asset

should follow forthwith upon possession In respect of sale proceeds, the lender is accountable to borrower Lender not allowed to use the asset: all usufructs belong to the borrower


Taking over management of assets

Right of taking over management also conditioned by the basic purpose of the law - security interest

However, sale of assets is not permissible u/s 13 (6) without taking over possession or management, either of the two is a must

As the purpose of possession is to make a sale, banks may be inclined to avoid difficulties of possession by appointing a manager instead

Nature of the functions of a manager - asset-specific


Injunction against confiscation action

An important question is - can a borrower seek injunction against a confiscation action u/s 13 (4) (a)

Appeal lies against confiscation u/s 17 (1) within 45 days of measures having been taken.

May imply post-facto appeal, not stay of action Section 34 ousts jurisdiction of civil courts on a matter where

powers conferred to DRTs Ouster is not total but specific By sec 9 of CPC, civil courts have jurisdiction on all matters except

where barred Can it be implied that civil court jurisdiction remains for injunction

against an action?:– No, SC in Mardia Chemicals


Manner of sale or transfer of assets

Equity of redemption is an important right of a borrower and any clause putting a clog on equity is invalid.

Present law gives to the borrower a right to pay within 60 days of notice in addition, at any time before sale or transfer, the borrower may clear his dues

and prevent the asset from being sold - sec 13 (8)– This implies the asset cannot be sold without notice to borrower– borrower has a pre-emptive right to purchase the asset himself

30 days notice required before sale: Security Interest Enforcement Rules Also by implication, the sale cannot be made at the back of the borrower:

– preferably a public sale– sale at best price as the borrower gets discharge to the extent of amount paid - sec. 13

(5)– borrower’s right to moneys collected by the seller after appropriation - sec 13 (7)

Transferee to get all the rights as if the owner of the assets has transferred the same:

– subject to all the equities of the previous owner Can the lender sell the asset to himself - no as implicitly there is a trust between

the lender and the borrower; adversary title to beneficiary not permitted


Rules of natural justice

In Mahesh Chandra vs. UP Finance Corporation 78 Comp Cas 1, SC set important rules of natural justice in repossession. The technicalities implied by these rules have been overruled by the SC in Jagadamba Oil Mills case but the rules of natural justice continue to apply.

The following are implicitly still applicable:– Attempt must be made for best possible price - easiest indication is a

public auction.– Borrower must always be given a right of first refusal or improving

upon the price– The sale must not be made at the back of the borrower


Priorities and pari-passu interests

In case of “financing of a financial asset” by more than one lender, 3/4th sanction in value to be obtained before any or all right u/s 13 (4) is exercised.

– Wrong use - should be read as “financing of the secured asset”– financing of the secured asset cannot be limited to a case where the acquisition of the

asset was primarily funded by a lender Financing of the secured asset confusing:

– proper meaning is, where security interest on a secured asset held by more than one lender

– consent of 3/4th of the lenders required before any action u/s 13 (4)– record date -meaning circular and inconclusive - the date is agreed upon at time when the

determination of the date itself requires 3/4 th sanction– 3/4th in value refers to “amount outstanding”

evidence of “amount outstanding” - books of the borrower made evidence stone-walling action possible: creation of subordinate charges in favour of a friendly lender

– question of priorities not at all considered by the law - lenders having subordinate charges put at par with other lenders

If lenders take such action, their mutual prioritisation not laid down. Rules of sec. 529 of Companies Act and insolvency laws [sec. 61 of Provincial Insolvency Act] to apply on priorities.

Pari passu rule is an important rule of equity - contracting it out is against public policy -McMillan and Lockwoord 1992 NZ Court of Appeal


Priorities between fixed and floating charges

As a trite law, fixed charges will have a priority over floating charges.

Determination of “multiple financiers” on an asset has no better answer than charge-holder holding charges.

The most practical view, therefore, is chargeholders holding fixed charges on the asset need to take a decision (75% voting) on action under sec. 13 (4).

Floating chargeholders cannot be said to be holding a security interest in the asset until the charge crystallised.

Will subordinate charge-holders rank equally for voting - apparently yes


Overriding Preferential claims

Provisions relating to preferential claims made applicable only where the company is in liquidation

where the company is in liquidation, sec 28 (6) of Provincial Insolvency Act saves the rights of the secured creditors.

This law appropriately overrides. However, subject to preferential claims.

Appropriately, the provisions should be applicable even where the company is not in liquidation:

– sec 123 (1) of the Companies Act requires any receiver to forthwith pay the debts which are preferential claims

– in case of debentures, the provisions of sec 123 shall be applicable notwithstanding the SARFAESI Act

– Sec. 529A of the Companies Act also contains a notwithstanding clause Sec 529A - workers’ dues and dues of secured creditors take priority

over other debts Leave of Companies Court not required in case of companies under

winding up - Allahabad Bank vCanara Bank (SC)


Enforcement of possession -sec 14

For forcing possession of assets, possession by order of CMM or DM of appropriate jurisdiction may be requested.

– Does not bar self-help possession.– Any action taken in good faith protected u/s 32

CMM/ DM shall do the same No court shall call to question the action of any CMM /

DM Principle of exclusive jurisdiction in case of DRTs has

been approved by the SC in Allahabad Bank v Canara Bank 101 Comp Cas 64 (2001)


Takeover of management

Sec. 15 talks of takeover of management of business while the power under sec. 13 (4) (b) is only to take over management of assets

Sec 15 clearly exceeds sec. 13 (4). Sec 15 also divergent from the scheme of the SARFAESI Act on enforcement

of security: the powers granted under the law can be used only to enforce security and not to run businesses:

– Delhi High Court ruling in Micronix India 96 Comp Cas 950 - vestation of proeprty in the SFC only for enforcing security interest

Takeover of management only in case of ARCs and securitisation companies u/s 9.

Takeover of assets u/s 13 (4) can only lead to sale of assets - not their running by the lender. Essential rule of foreclosure versus sale

Appointment of directors/ administrator to be appointed by the secured creditors

– notice in newspapers– on publication of notice, existing directors shall vacate office– creditor-directors shall take over the office/ assets

sec 15 (3) overrides the Companies Act. Sec 15 (4) - restoration of management


Appeals to DRT

Surprisingly, number of “secured creditors” may not come under DRT jurisdiction, but appellate powers conferred on DRTs.

Appeal within 45 days of “measures having been taken” Jurisdiction - jurisdiction under sec. 19 (1) of DRT law is based on

the borrower’s residence Cannot do away with powers of making an appeal even before the

measures are taken. Sec 19 (12) allows DRT to order injunction Deposit of 75% of the notice amount

– Struck down by Supreme Court in Mardia Chemicals Appeal to Appellate Tribunal within 30 days The appellate authorities may hold the possession unauthorised

and order compensation.


Unresolved issues on possession/ sale of assets

Claims of the Government - rights of a secured creditor rank above the claims of the government - Bank of Bihar v State of Bihar (1971) SC and Sitani Textiles 98 Comp Cas.(AP)

whether involvement of liquidator necessary in case of companies under liquidation - divergent view:

– Kerala HC held liquidator ’s involvement required: Titus Daniel 101 Comp Cas 117; Pennar Paterson - AP HC 106 Comp Cas 338 (power of advocate commissioner appointed by DRT subject to leave of company court)

Can a view be taken that of the two alternate remedies:– DRT proceedings– direct action under this law– this law should be resorted only as a remedy of last resort? A debatable issue

Can sale be made after repossession by instalments? Can banker give credit to new buyer? How does original borrower get credit?

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