Securitisation Act

(SARFAESI Act)
Provisions on Asset Reconstruction and Enforcement of Security Interests

Vinod Kothari
1012 Krishna 224 AJC Bose Road Calcutta 700 017 Phone 033-23233863/23233864/2281 1276/22817715/22813742 Fax 91-33-23233863/22811276 Email: vinod@vinodkothari.com; vinodk@vsnl.com

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All rights reserved with Vinod Kothari.

The presentation is to be used only for the purpose of the training course/meeting/class for which it is intended and any use of any part of it, other than for distribution at such training course/meeting/class is unauthorized. No rights of any kind have been transferred in soft copy of the presentation, meant only for the purpose of printing. The soft copy should be purged immediately after printing. No copying or distribution of this presentation in any form is allowed except with the express permission of the author.

Corporate insolvency by Vinod Kothari

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

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Nature of ARCs
Originator (s)

owning
NPLs

Transfers at fair value debentures

Securitisation Reconstruction company

Other means

QIBs

Corporate insolvency by Vinod Kothari

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
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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

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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

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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? ability to give further funding limited post-securitisation restructuring of loans difficult substantial recourse to originating bank may put questions on true sale QIBs are senior investors on soft-bullet basis originating bank as a subordinated debentureholder

If securitisation route adopted:

Combination of the two:

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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

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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

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

Sale of NPLs by the ARC:

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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

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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

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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

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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

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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
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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

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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
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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

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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

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Ingredients of a charge

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

In Cossletts case, a right of a contractee to sell contractors 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

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Financial assistance

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

intends to include originated loans, not acquired loans

purchased debentures cannot be included obviously, lead to a financial assistance only when principal debtor defaults

debentures or bonds subscribed

guarantees given or letter of credit established

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

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Secured creditor - sec 2 (1) (zd)

Bank financial institution:

Includes power to notify financial companies

unsecured debentures do not seem to be covered (last line of definition) secured debentures - rights exercisable by trustees

"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

In case of debentures:

debenture trustee appointed by any bank or financial institution:

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 securitisation company and reconstruction company any other trustee holding securities on behalf of a bank assistance; 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

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

provider of security

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
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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?

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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
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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, bankers lien u/s 171 unpaid sellers lien u/s 47 of Sale of Goods Act generic rights under Contracts law applicable

pledge

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

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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 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: bankers 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?

Requisites for action u/s 13:

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

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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

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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

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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
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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

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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

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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) borrowers 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

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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

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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 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

Financing of the secured asset confusing:

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

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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
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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

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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

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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)
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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)

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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
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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 borrowers 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.

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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) DRT proceedings direct action under this law this law should be resorted only as a remedy of last resort? A debatable issue

Can a view be taken that of the two alternate remedies:

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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