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Mahak Saxena is a penultimate year student at National Law Institute University, Bhopal and Muskan Saxena is pursuing CA (Final) and CS (Professional)
Introduction
As a financial intermediary, the banking system is unquestionably a crucial sector for running any economy, and any banking sector’s performance is crucial for encouraging investments and boosting economic growth.[1] Over the past decade, the consistent concern has been the declining quality of assets in the Indian banking sector. Non-Performing Assets (NPAs) have become a significant sector in India, with their prominence escalating since 2010. The government took notice of the alarming levels of NPAs in 2015,[2] prompting the introduction of the Insolvency and Bankruptcy Code (IBC) in 2016 to curb this uncontrolled growth.[3]
The institutional framework for NPA recovery in India has exhibited shortcomings, negatively impacting the banking system and causing a contraction in credit growth.[4] The Reserve Bank of India (RBI) has implemented measures to address the NPA issue. Legal interventions such as debt recovery tribunals (DRTs), Lok Adalats, the SARFAESI Act, and the IBC have been introduced for NPA resolution. Additionally, the RBI has undertaken initiatives such as the recapitalization of public sector banks and the establishment of stressed asset management verticals.
In a collaborative effort, the Securities and Exchange Board of India (SEBI) issued a consultation paper on November 28, 2023, titled ‘Changes in the regulatory framework for Special Situation Funds, a subcategory of Category I Alternative Investment Funds’ proposing amendments to existing regulations governing Special Situation funds (SSF). These funds operate within the framework of Alternate Investment Funds (AIF), with a particular emphasis on distressed debt investing. In this article, the author attempts to provide a holistic account of the proposed amendments mentioned in the consultation paper and their possible ramifications on India’s lending market.
SSF- A New Alternative to Boost the NPA Paradigm
SEBI introduced the concept of SSFs as a Category I Alternative Investment Fund through an amendment in the SEBI (Alternative Investment Funds) Regulations, 2012, on January 24, 2022.[5] AIFs are basically investment vehicles that pool funds from high-net-worth and sophisticated investors with elevated risk appetites. In contrast, a Special Situation Fund is essentially a mutual fund scheme designed to exploit opportunities arising from unique or special like financial distress, restructuring, bankruptcy, mergers and acquisitions, or other distinctive events. Given the complexity and risk associated with these strategies, investors in special situation funds are usually sophisticated institutional investors or high-net-worth individuals (HNIs).
Under existing regulations, SSFs encompass, among other things, the securities of investee companies. These companies should have stressed loans available for acquisition according to Clause 58 of the RBI (Transfer of Loan Exposures) Directions, 2021, (Master Directions hereinafter) subject to amendments, or as part of a resolution plan approved under the Insolvency and Bankruptcy Code, 2016. Presently, existing AIFs have the authorization to invest in a company’s securities, comprising Security Receipts (SRs) issued by Asset Reconstruction Companies (ARCs). According to the Master Directions,ARCs are restricted to acquiring stressed loans that have been in default for over 60 days or are categorized as NPAs. In contrast, SSFs have the privilege to acquire all stressed loans and NPAs.[6]
In the past, AIFs were granted permission to act as resolution applicants under the IBC.[7] However, the special provisions extended to SSFs, such as the removal of diversification limits—enabling SSFs to invest more than 25% of their investable fund in a Corporate Debtor[8]—position them as a more appealing choice for becoming resolution applicants compared to other AIF categories.
How was a regulatory gap created for SSFs?
Asset Reconstruction Companies are entities which function as specialized financial institutions, acquiring NPAs from both private and public banks at a discounted rate with the intention of selling them at a higher value. However, their performance has fallen short of anticipated levels. Several factors contribute to this, including the disposal of legacy NPAs by lenders, limitations in fundraising, and challenges related to the scarcity of opportunities for debt aggregation and liquidity in the secondary market for security receipts. [9]
The market structure involves the originating entity acquiring security receipts (SRs) from ARCs, with potential NPA treatment if SRs exceed 10%. To address challenges, ARCs may use AIFs for funding asset accumulation and NPA resolution. SSFs combine ARC benefits and AIF features, enjoying additional exemptions, enhancing support for stressed asset resolution.
ARCs have encountered difficulties in the redemption of Security Receipts. According to the RBI report, a mere two ARCs hold 62% of the total issued SRs. [10] To exacerbate the situation, the RBI has imposed a cap of 25% on the investable funds in an Investee Company directly or through investment in the units of other Alternative Investment.[11] Furthermore, ARCs lack the capability to acquire equity in borrower companies, impeding their restructuring endeavors. This contrasts with SSFs, which have the flexibility to invest in both debt and equity without constraints. Hence, the purpose of introducing SSFs is to employ cash-rich alternative funds as a complementary measure to support ARCs in acquiring stressed assets.
To facilitate Special Situation Funds in acquiring stressed loans, their inclusion in the annex of RBI Master Directions is necessary. This inclusion mandates a framework comprising a clear definition of special situation assets, eligibility criteria, minimum holding duration, and mechanisms for monitoring and supervision. The consultation paper discussed these requirements and the introduced amendments.
Modifications in the Definition
The existing definition of SSF states that it includes securities of investee companies whose stressed loans are “available for acquisition” as per Clause 58 of the RBI Master Directions. The proposed amendment suggests replacing the phrase “available for acquisition” with “are acquired.” This change is motivated by the fact that the visibility of stressed loans for acquisition only occurs once lenders agree to a resolution plan submitted by the borrower. However, the proposed wording assumes that stressed loans will become visible to SSFs at a later point, potentially restricting their flexibility, especially in ongoing resolutions where early participation is crucial.
Eligibility Criteria for Investors
The RBI also intends to modify the AIF regulations, indicating that SSFs must refrain from investing in or obtaining a special situation asset if any of its investors is disqualified under Section 29A of the IBC concerning that particular asset. However, the proposal lacks clarification on whether the assessment for disqualification under Section 29A of the IBC should also be conducted for the transferee’s investors.
Initially, SSFs, acquiring distressed loans under RBI Master Directions, were mandated to follow identical due diligence criteria as prescribed for investors in ARCs. However, due to distinct regulatory structures, SSFs now require a more comprehensive due diligence process, given their involvement in transactions with stressed loans not entirely aligned with the ARC framework.
Investment in Related Entities
Presently, SSFs are prohibited from making investments in associated entities. In this context, an associate refers to an entity in which a director, trustee, or partner of the AIF holds more than fifteen percent of its paid-up equity share capital or partnership interest, either individually or collectively. The was incorporated to address the apprehension of potential round-tripping of funds, particularly concerning SSFs acquiring stressed loans from their associated entities.
Nevertheless, the existing definition seems limited in adequately addressing the issue of round-trapping. The Companies Act of 2013 presents a broader definition of ‘related party’ compared to the AIF regulations’ definition of an associate. Hence, it is proposed to incorporate a similar reference for Special Situation Funds to enhance clarity and effectiveness in addressing the concern of round-trapping.
Restrictions on sale of loans after lock in period
According to SEBI’s circular dated January 27, stressed loans obtained by SSFs under clause 58 of the master directions are subject to a six-month lock-in period. However, this duration is deemed inadequate to alleviate concerns related to round-tripping and ensuring credit discipline. Consequently, it is suggested that SSFs be obligated to exclusively sell or transfer stressed loans to entities listed in the annex of RBI master directions, even after the lapse of the initial six-month period.
Monitoring Mechanism
To guarantee the effective implementation and compliance with regulations, a suggestion has been made to empower the RBI to directly request information from SSFs regarding particulars of issued units and investors, any subsequent alterations in unit holdings, resolution strategies, recoveries achieved, and the establishment of a dedicated supervisory framework.
A brief glimpse into the stressed assets scenario of comparable jurisdictions
There have been several experiments of Asset Management Companies dealing with NPA resolution in other countries. Some of the successful ones include, Securum of Sweden which was set up in 1992 and wound up in 1997, and which succeeded in recovering close to 86 per cent of the amount involved.[12] In other advanced economies like South Korea, Malaysia, and Indonesia, entities like the Korean Asset Management Company, Danaharta, and the Indonesian Bank Restructuring Agency were set up in response to the East Asian crisis.[13]
Coming to the status quo, although banks experienced a relatively resilient asset quality during the initial phase of the COVID-19 pandemic, there was a growing apprehension about the emerging pressure, signaling a potential rise in non-performing loans (NPLs).[14] Indications of deterioration in asset quality were observed as early as Q2 2022, and the heightened probability of a recession is anticipated to amplify these risks. The ECB has emphasized the importance of vigilance and prudence, and this caution is expected to influence supervision in 2023.[15] In addressing the NPL issue, the European Banking Authority (EBA) released its final draft Implementing Technical Standards (ITS) on NPL transaction data templates in December 2022, following a public consultation the previous year. However, industry stakeholders have raised concerns about the lack of specific enforceability or reporting requirements outlined in the ITS.
The primary objective of these methodologies should be to expedite the resolution of non-performing loans (NPLs) at a quicker pace than observed since the Global Financial Crisis (GFC), aiming to foster the development of NPL “ecosystems.”[16]
Critical analysis
Proposed reforms recommend a structured investment framework and heightened regulatory oversight for SSFs to unlock capital tied in distressed loans. The suggested redefinition of connected entities, aligning with the ‘related party’ definition in the Companies Act of 2013, may restrict SSFs from investing in a significant portion of the stressed debt market, especially within complex corporate groups. Despite limitations, this is considered necessary to address round-tripping concerns and prevent fund circulation within the same entities.
The proposed reporting requirements could impose substantial compliance costs, potentially impacting profitability and dissuading new entrants. SEBI has the authority to ease monitoring, and tailoring reporting mandates based on individual SSFs’ risk profiles may alleviate the burden, especially for smaller entities. Phased implementation and technological solutions could further reduce SSFs’ costs.
Concerns arise over regulatory imbalances between ARCs and AIFs. A collaborative approach is crucial for effective stressed asset resolution. While SSFs are expected to bring in new capital, a fair regulatory framework is essential to sustain existing ARC models. Restricting SSFs to post-default activities may limit effective financial risk management. Granting access to both investment and non-investment grade debt before default could provide significant advantages. SEBI should pursue SSFs’ recognition as ‘secured creditors’ under SARFAESI for resolving stressed assets.
Conclusion
In the Indian context, there has been a notable decrease of ₹36,671 crores in Gross Non-Performing Assets from the fiscal year ending in 2019 to the fiscal year ending in 2020. The NPA ratio has also witnessed a decline, dropping from 9.1% to 8.2%. This reduction in non-performing assets can be attributed to enhancements in the resolution process which shows how there has been progress due to such efforts. Hence, it is crucial to attend to the issues raised in the discussion to bring clarity to the legal framework overseeing distressed debt. Resolving these concerns will broaden investment prospects, subsequently promoting private investment and cultivating growth in the Indian secondary loan market.
Nevertheless, the SSF regime appears to fulfill the majority of investors’ requirements. It is optimistic that a comparable disintermediated system could be introduced to enable Foreign Portfolio Investors to directly acquire distressed assets. Moreover, a similar framework might be established to permit Alternative Investment Funds and FPIs to acquire standard assets.
[1] CGFS (2018) Structural changes in banking after the crisis, CGFS Papers (No 60), Bank for International Settlements.
[2] Reserve Bank of India (2019), Report of the Expert Committee to Review the Extant Capital Framework of Reserve Bank of India.
[3] Dixit Yadav, Evolution of the Resolution Framework for NPAs in India: A Study of Assets Reconstruction Companies and Bad Bank Proposal, Business Analyst ISSN 0973 – 211X, Vol. 42(1), 141-163.
[4] Das, S. K., & Uppal, K. (2021). NPAs and profitability in Indian banks: An empirical analysis. Future Business Journal, 7(1), 1–9.
[5] Introduction of Special Situation Funds as a sub-category under Category I AIFs, Circular No.: SEBI/HO/IMD-I/DF6/P/CIR/2022/009, 27th January 2022; SEBI (Alternative Investment Funds) (Amendment) Regulations 2022, available at: https://www.sebi.gov.in/legal/regulations/jan-2022/securities-and-exchange-board-of-india-alternative-investment-fundsamendment-regulations-2022_55525.html.
[6] Review of Regulatory Framework for Asset Reconstruction Companies (ARCs), RBI/2022-23/128, October 11, 2022.
[7] Different benches of the National Company Law Tribunals (Kitply Industries and Anr v. IDBI Bank Limited – Guwahati Bench, Punjab National Bank v. M/s Amzen Machines (P) Ltd. – New Delhi Bench) have approved resolution plans submitted by AIFs.
[8] Regulation 19M, Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
[9] Supra note 6.
[10] Reserve Bank of India (2021), ARCs in India: A Study of their Business Operations and Role in NPA Resolution
[11] Regulation 15(1)(c), Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012.
[12] Bergström, C., P. Englund, and P. Thorell (2003), Securum and the Way Out of the Banking Crisis, Summary of a Report commissioned by SNS (Centre for Business and Policy Studies), Stockholm.
[13] Rohit Prasad, Yogesh B. Mathur, Market design principles for the securitisation of non-performing loans, IIMB Management Review, Volume 34, Issue 4, 2022, Pages 392-404, ISSN 0970-3896,https://doi.org/10.1016/j.iimb.2022.12.003.
[14] European Commission (2020), Tackling non-performing loans in the aftermath of the COVID-19 pandemic.
[15] ECB Banking Supervision, 2022: Better safe than sorry: banking supervision in the wake of exogenous shocks (europa.eu).
[16] Oliver Wayman, The Non-Performing Loans Jigsaw: Pieces Starting to Fit? The road ahead for the NPL ecosystem, 2018.
