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Divyam Shresth Sinha, is a third-year law student at Jindal Global Law School
Stressed assets are loans that have defaulted and turned into Non-Performing Assets (NPAs). NPAs are defined as term loans with overdue payments for more than 90 days. These stressed assets have posed a potent obstacle in giving credit to the sectors which are crucial for the Indian economy. According to Ministry of Finance, Gross NPAs stand at a whopping Rs. 5,71,515 crores as of 2023. As a result, there is a dire need for injecting capital into financial institutions. To tackle this mounting problem for Indian financial institutions SARFESI Act was introduced in 2002 which established Asset Reconstruction Companies (ARCs) for securitising distressed debts and clearing their balance sheets.
Functioning of ARCs
ARCs buy the NPAs from the banks at a discounted rate. ARCs then sell the security receipts to a qualified buyer which represents undivided financial interest in those assets. Section 2 of SARFAESI clearly stipulates that qualified buyers include a financial institution, insurance company, bank, state financial corporation, state industrial corporation, trustee or ARC. The quintessential purpose for buying NPAs is to cover the amount of debt which is owed to them. For achieving this aim, the ARC can use multiple tactics such as altering the borrower company’s management, changing the debt into shares, restructuring the debts etc.
Earlier, there was an absence of any investment criteria for ARCs so they used to buy the entire NPAs without investing any amount and merely by issuing Security Receipts (SRs). However, a minimum investment requirement of 5% was introduced in 2006. When the stressed assets were under management then the ARCs received a management fee. With only 5% investment the ARC could get the entire fee for management without regard to the fact that the assets were revived or not. Therefore, ARCs did not have sufficient incentive for performing their core function of reviving these stressed assets because they can receive profit by way of management fees. Later the minimum required investment was enhanced to 15% and the management fees began to be charged as a percentage of net asset value to incentivize the ARCs for reviving the assets.
Despite looking as, a novel step ARCs have not performed well in reviving assets over the years due to the challenges that they have not been able to overcome. ARCs often face a price mismatch between the price offered by the bank and the price agreeable to them. As a result, ARCs often have to purchase NPAs at high prices than is agreeable to them. Since they buy at higher prices the burden is shifted to the investor who invests his money in the stressed assets. Even though the risk increases for the investor still the return remains constant. Therefore, investor’s attractiveness of NPAs decreases. In absence of any secondary market for selling NPAs, banks enjoy and exercise a monopoly to charge higher prices. Since ARCs cannot sell the security receipts in any other market the SRs are again bought by some other bank and again sold at a high price. This diabolical cycle continues without any resolution or revival of stressed assets.
Establishment of Special Situation Funds under Alternate Investment Fund
In January 2022, SEBI introduced Special Situation Funds (SSFs) under Category I Alternate Investment Fund as a response to the problems faced by Indian financial ecosystem due to stressed loans. SSFs are defined in Regulation 19I(3) of Chapter III-B of Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 as a type of fund which invests in special situation assets. Stressed Assets include stressed loans available for acquisition in terms of RBI (Transfer of Loan Exposures) Directions, 2021 or as part of a resolution plan approved under Insolvency and Bankruptcy Code 2016, SRs issued by ARC and securities of companies in distress.
Unlike ARCs, SSFs does not face any cap on its investment concentration. Under SSFs, one can invest their entire portfolio in a singular special situation asset. ARCs are restricted to invest in loans which are converted into NPAs but SSFs have the opportunity to invest in debt as well as equity of distressed companies as they are not subject to any diversification norms. In SEBI’s circular dated 27 January 2022, it has been clarified that every scheme of SSF shall have a corpus of at least Rs 100 crores. Moreover, it has been specified that minimum investment would amount to Rs 10 crores. However, investors who are employees or directors of SSF the minimum value of investment would be Rs 25,00,000. The stressed loans that were acquired by SSF in terms of clause 58 of the RBI Master Direction were mandated to undergo a lock-in period of 6 months. A peculiar feature of SSFs is that due diligence requirement is same as ARCs.
Analysing Proposed Changes in regulatory framework of SSFs by SEBI
Certain key changes have been proposed by SEBI in its consultation paper which seeks to regulate SSFs. In Regulation 19 of AIF Regulations, the definition of Special Situation Assets consists of securities of companies whose stressed loans are ‘available for acquisition’ in terms of Clause 58 of the Master Direction – Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021. This term is sought to be replaced by ‘are acquired’ because a stressed loan cannot be considered as ‘available’ under the said directions as they are visible only when there is agreement among lenders with respect to the resolution plan.
SSFs are currently restricted from investing in its ‘associates’ to address the problem of round-tripping of funds. However, it appears to SEBI that the definition is inadequate to tackle the challenge. Therefore, a broader definition is proposed. SEBI seeks to use the definition of ‘related party’ present in Companies Act 2013 for this purpose. However, this change might have unintentional ill-effects. For example, in case of financially distressed conglomerates, SSFs would not be capable to invest in subsidiaries because they would fall under the broad definition of ‘related party’.
It is also proposed to create a closed network of entities to whom SSFs are allowed to sell their loans. In this regard, SEBI intends to permit a set of predetermined entities in the Annex of RBI Master Directions to buy loans from SSFs. Such a regulation would preclude unrestricted circulation of stressed loans.
To prevent regulatory arbitrage, SSFs are mandated to follow the same due diligence requirements as followed by ARCs. The SSF needs to ensure that the transferee and its investors are not disqualified from acquiring an economic interest in a loan under Section 29A of Insolvency and Bankruptcy Code, 2016. This requirement of due diligence is applied not just on SSFs investing in stressed assets but all types of special situation assets.
SEBI has plans to create a system for information sharing and monitoring between RBI and itself which is a welcome step. Moreover, SSFs would be required to share details of issuances, the details of investors, implementation of resolution strategies, recoveries conducted, etc. on the reporting platform which would be designated by RBI.
Conclusion
These changes aim to create a regulatory environment which provides a robust oversight along with ensuring a smooth process of revival of NPAs in the Indian financial landscape. It is pertinent to bring regulatory harmony between ARCs and SSFs. This would ensure that both can function to tap true potential of the debt market. Strategic factors like vast supply of stressed assets and profitable rates of currency can make the Indian debt market an appealing destination for not just Indian but also foreign investors. They see a prospect of higher return on investment in Indian debt market than other stressed assets across the world. Therefore, these regulatory changes are a welcome step for the market.
