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Provisions on Asset Reconstruction and Enforcement of Security Interests
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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
Corporate insolvency by Vinod Kothari
Nature of ARCs Originator (s) owning NPLs Transfers at fair value debentures Securitisation Reconstruction company Other means QIBs 5 Corporate insolvency by Vinod Kothari .
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.Who can form ARCs ARCs do not need to be government-sponsored. since most ARCs do incur losses Corporate insolvency by Vinod Kothari 6 .
as in case of RTC.Process of acquisition of assets Acquisition of assets by ARCs to be by transfer Provision to issue debentures . 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 7 Corporate insolvency by Vinod Kothari .
powers under sec 15 applicable to ARCs also – – compulsory change in directors or officers sec 15 (4) .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. debt could be the original debt or debt of the ARC Corporate insolvency by Vinod Kothari 8 .secured creditor on realisation of “his debt” to restore management.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 .
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: – – 9 Corporate insolvency by Vinod Kothari .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.
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 10 Corporate insolvency by Vinod Kothari .
not for sale of financial assets Sale is a crucial provision . notification etc transfer of mortgages may further complicate sale Sale of NPLs by the ARC: – – – – 11 Corporate insolvency by Vinod Kothari .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. 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.in most countries.
affecting profits. banks may have to write losses.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. capital adequacy Retention of subordinated interest by banks may be ideal solution 12 Corporate insolvency by Vinod Kothari .
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 13 Corporate insolvency by Vinod Kothari .SARC (RBI) Directions RBI has promulgated SARC Guidelines and Directions vide a 23rd April 2003 notification Policy-making: SARCs must make policies w.t – – – – – – – acquisition of financial assets change in management or takeovers: guidelines to be issued by RBI.r.
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. Security receipts to be offered and be transferable to only QIBss Disclosures for issuance of security receipts laid down: – – initial disclosures quarterly disclosures Corporate insolvency by Vinod Kothari 14 . Appropriately SARC must acquire assets and hold them as trustees. There is no transfer between the SARC and the trust.
this is not applicable in case of assets held in the name of trusts: – therefore. the trust could be said to be subsidiary of the 15 Corporate insolvency by Vinod Kothari . if the SARC continues to hold any residual interest in the trust or a first loss piece. However.Capital adequacy requirements 15% capital adequacy ratio laid down for SARCs Para para 2. the requirement of capital adequacy is rendered nugatory.
whichever is earlier On rescheduling or renegotiation. assets acquired for reconstruction to be treated as standard: – planning period is a period of 12 months or until reconstruction plan is made.Asset classification by SARCs During planning period. 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 Corporate insolvency by Vinod Kothari 16 .
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 17 Corporate insolvency by Vinod Kothari .Disclosures on the balance sheet Names of transferring banks.
Equivalent to 100% provisioning for the retained interest Corporate insolvency by Vinod Kothari 18 . this guideline proscribes any CLOs of performing assets Sale should qualify for off-balance sheet treatment.Directions to banks Only NPAs can be sold to SARCs – literally interpreted. Deferred sale proceeds not allowed. 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. Only it cannot be booked into profit immediately. But banks may share the surplus: – – the surplus is nothing but non-contingent consideration.
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. the same shall be used to meet deficits on other assets.Directions to banks . unconditional undertaking to pay has no meaning 19 Corporate insolvency by Vinod Kothari .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..
Provisions of SARFAESI Act on Enforcement of Security Interests .
hypothecation.a security interest not being a mortgage. Generally.by itself. Sec 100 of TP Act . does not mean anything but security interest.obviously meaning those created for security Mortgage .all charges except a pledge Charge .sec. Any interest in property defeasible or destructible on repayment of a debt .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) . including mortgage.sec 58 of TP Act is limited to immovable property.right title and interest of any kind whatsoever. and not assignment by way of transfer 21 Corporate insolvency by Vinod Kothari .Bond Worth Limited (1980) Ch Assignment . conferring any right to a lender to sell property on default Hypothecation . assignment right title or interest .assignment by way of security. 2 (1) (n) . charge.
Charge should be co-terminus with the debt Property. – In Cosslett’s case. Floating charges do not relate to any property unless fixed: – ruling in Brumark Investments and Cosslett Mere restraint on property is not a charge Corporate insolvency by Vinod Kothari 22 . a right of a contractee to sell contractor’s equipment was held to be a security interest Charge is related to debt. does not create a debt. present or future should be made available.Ingredients of a charge Meaning of security interest .a right to sell property to realise a debt. A charge secures a debt. Ownership interest may also amount to a charge conditional sale or reversible sale.
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 23 Corporate insolvency by Vinod Kothari . not acquired loans purchased debentures cannot be included obviously. Loan advance granted – intends to include originated loans.Financial assistance Building block of relationship between a borrower and secured lender.makes it an inclusive definition. 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 .
debenture trustee appointed by any bank or financial institution.securitisation company or reconstruction company. or .rights exercisable by trustees "secured creditor" means any bank or financial institution or any consortium or group of banks or financial institutions and includes. misnotion.Secured creditor . 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.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 24 Corporate insolvency by Vinod Kothari . 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.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 .
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 .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.after assignment. lender cannot operate against the borrower Corporate insolvency by Vinod Kothari 25 .Borrower Key word is “financial assistance” Any person who has availed of financial assistance guarantor: – – – – guarantee as defined in sec.
as the rights under the law exercisable against secured assets Sec 2 (1) (zc) .Secured asset Meaning is important.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? – – – 26 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 Corporate insolvency by Vinod Kothari .
money or security under Contracts law or Sale of Goods Act: – – – a very confusion clause. public provident fund where financial assistance not exceeding Rs 1 lac where dues are less than 20% of principal and interest agricultural land 27 Corporate insolvency by Vinod Kothari . 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. banker’s lien u/s 171 unpaid seller’s 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. 31 Lien on goods. 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.Exceptions under sec. as essentially. hire purchase or lease or any other contract in which no security interest has been created – exclusion of conditional sale unreasonable. 60 of CPC. LIP. most include personal effects.
69/ 69A of TP Act. Sec. Does not amount to receivership. not right of possession Remedies under this law are not to the exclusion of other rights . do not confer any new rights not implied by the agreement between parties. sec. It is only the interest created which can be enforced.Enforcement of security u/s 13 Sec.e.g. 67 – – – However. by sec 35. 13 overrides sec. decree of Civil Courts borrower.. 67 (a) puts an important distinction between right of foreclosure and right of sale. principles of natural justice applicable 28 Corporate insolvency by Vinod Kothari . A normal charge holder has a right of sale. Rights under sec 13 (1): – – are rights to enforce security interest. the SARFAESI Act overrides all laws in the country. DRT proceedings. 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? Requisites for action u/s 13: – – – – – – – Notice only demands payments. not however.
encumbrances: can be used for stone-walling 29 Corporate insolvency by Vinod Kothari . a Court may order injunction . 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.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.exercise of discretion.
debts barred by limitation cannot be enforced under this law 30 Corporate insolvency by Vinod Kothari .primary right u/s 13 (11) proceeding for balance due under DRTs or competent Court .this envisages payment for secured assets subject fo fixed charge measures u/s 13 (4) limited and cannot be expanded .“as the case may be” implies RDB Act allocation Provisions in case of company under liquidation .for example.sec 13 (7) proceeding against guarantors/ pledged assets . assignment or sale take over the management of the secured assets . 529A of Companies Act to be applicable Limitation Act applicable .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 .sec.No transfer by way of lease. no power to force a sale without taking possession or management recover expenses for action u/s 13 (4) .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 .
Civil law receiverships are for preservation of subject matter. 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.Blade v. 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. this law is for sale Use of reasonable force permitted for possession .Taking possession u/s 13 (4) Purpose of the law is to enforce security interest. Higgs (1861) 10 CBNS 713. the lender is accountable to borrower Lender not allowed to use the asset: all usufructs belong to the borrower Corporate insolvency by Vinod Kothari 31 . rule 1 of CPC difference .
banks may be inclined to avoid difficulties of possession by appointing a manager instead Nature of the functions of a manager .Taking over management of assets Right of taking over management also conditioned by the basic purpose of the law . sale of assets is not permissible u/s 13 (6) without taking over possession or management.security interest However. either of the two is a must As the purpose of possession is to make a sale.asset-specific 32 Corporate insolvency by Vinod Kothari .
SC in Mardia Chemicals 33 Corporate insolvency by Vinod Kothari .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.Injunction against confiscation action An important question is . 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.
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 .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.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.sec. at any time before sale or transfer. 13 (5) borrower’s right to moneys collected by the seller after appropriation .no as implicitly there is a trust between the lender and the borrower. 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 . the borrower may clear his dues and prevent the asset from being sold . adversary title to beneficiary not permitted 34 Corporate insolvency by Vinod Kothari . Present law gives to the borrower a right to pay within 60 days of notice in addition.
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. UP Finance Corporation 78 Comp Cas 1. The following are implicitly still applicable: – – – Attempt must be made for best possible price . SC set important rules of natural justice in repossession.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 35 Corporate insolvency by Vinod Kothari .Rules of natural justice In Mahesh Chandra vs.
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 .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 .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” .lenders having subordinate charges put at par with other lenders 36 If lenders take such action. 529 of Companies Act and insolvency laws [sec.Priorities and pari-passu interests In case of “financing of a financial asset” by more than one lender.contracting it out is against public policy -McMillan and Lockwoord 1992 NZ Court of Appeal Corporate insolvency by Vinod Kothari . Pari passu rule is an important rule of equity . their mutual prioritisation not laid down.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. – – Wrong use . 3/4th sanction in value to be obtained before any or all right u/s 13 (4) is exercised. Rules of sec. 61 of Provincial Insolvency Act] to apply on priorities.
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. therefore. 13 (4).Priorities between fixed and floating charges As a trite law. The most practical view. Will subordinate charge-holders rank equally for voting apparently yes 37 Corporate insolvency by Vinod Kothari . Floating chargeholders cannot be said to be holding a security interest in the asset until the charge crystallised. is chargeholders holding fixed charges on the asset need to take a decision (75% voting) on action under sec.
Appropriately. This law appropriately overrides. 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.Allahabad Bank vCanara Bank (SC) Corporate insolvency by Vinod Kothari .Overriding Preferential claims Provisions relating to preferential claims made applicable only where the company is in liquidation where the company is in liquidation. subject to preferential claims. 529A of the Companies Act also contains a notwithstanding clause 38 Sec 529A . sec 28 (6) of Provincial Insolvency Act saves the rights of the secured creditors.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 . However.
– – Does not bar self-help possession.Enforcement of possession -sec 14 For forcing possession of assets. possession by order of CMM or DM of appropriate jurisdiction may be requested. 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) 39 Corporate insolvency by Vinod Kothari .
13 (4). 13 (4) (b) is only to take over management of assets Sec 15 clearly exceeds sec. Takeover of assets u/s 13 (4) can only lead to sale of assets .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.restoration of management Corporate insolvency by Vinod Kothari 40 . Sec 15 (4) . existing directors shall vacate office creditor-directors shall take over the office/ assets sec 15 (3) overrides the Companies Act.not their running by the lender.Takeover of management Sec. Essential rule of foreclosure versus sale Appointment of directors/ administrator to be appointed by the secured creditors – – – notice in newspapers on publication of notice. 15 talks of takeover of management of business while the power under sec. 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 .
Appeals to DRT Surprisingly. 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.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. 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 . 41 Corporate insolvency by Vinod Kothari .
rights of a secured creditor rank above the claims of the government .Unresolved issues on possession/ sale of assets Claims of the Government .Bank of Bihar v State of Bihar (1971) SC and Sitani Textiles 98 Comp Cas.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? 42 Corporate insolvency by Vinod Kothari . Pennar Paterson .divergent view: – Kerala HC held liquidator ’s involvement required: Titus Daniel 101 Comp Cas 117.(AP) whether involvement of liquidator necessary in case of companies under liquidation .
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