Non Performing Assets – Legal Paradigm

PART ONE

Dr. Nandimath Omprakash V.,

Professor in Law,
National Law School of India University,
Bangalore-560 072
Email – ovnandimath@nls.ac.in
Contents

PART ONE
Understanding NPAs and its implication
SICA & DRT
PART TWO
concept of ‘securitization; and
SARFAESI – an overview
PART THREE
SARFAESI – legal framework
Non performing assets – what are they?

• A loan asset, which has ceased to generate any

income for a bank whether in the form of an asset or
interest
• Master Circular of July 2010 (DBOD. No. BP. BC.
21/21.04.048/2010-11) – defines a NPA
• An asset, including a leased asset, becomes non
performing when it ceases to generate income for the
bank
• NPA is a loan or advance where
– Interest and/or installment of principal remain overdue for
a period of more than 90 days in respect of a term loan
– The account remains ‘out of order’, in respect of an
OD/cash credit
– The bill remains overdue for a period of more than 90
days in case of bills purchased and discounted
– The installment of principal or interest thereon remains
overdue for two crop seasons for short duration crops
– The installment of principal or interest thereon remains
overdue for one crop season for long duration crops
 – The amount of liquidity facility remains outstanding for
more than 90 days, in respect of a securitization
transaction undertaken in terms of guidelines on
securitization dated February 1, 2006
– In respect of derivative transactions, the overdue
receivables representing positive mark-to-market value
of derivative contract, if these remain unpaid for period of
90 days from the specified due date for payment
• Banks should, classify an account as NPA only if the
interest due and charged during any quarter is not
serviced fully within 90 days from the end of the quarter
Categorization of NPAs
1. Substandard assets
1. The NPA which has remained so for a period of 12 months or
less
2. Doubtful assets
1. The NPA which has remained as substandard for a period of
12 months
3. Loss assets
1. A loss asset is one where loss has been identified by the bank
or internal or external auditors or RBI inspection, but the
amount has not been written-off fully
2. Such an asset is considered uncollectable and of such little
value that its continuance as a bankable asset is not
warranted although there may be some salvage or recovery
value
Mandate to account on receipt basis

• Internationally income from NPA is not recognized on

accrual basis
• But booked as income only when it is actually received
• Therefore, banks should not charge and take to income
account interest on any NPA
How NPA would impact

• Bound to create an adverse repercussion for the

economy of the country
• Interest income of banks will fall
• Banks profitability is affected adversely
• Return on investment is reduced
• The cost of capital will go up
• Asset and liability mismatch will widen
• It limits recycling of the funds
Remedying NPAs

• 1981 – Tiwari Committee

– Examined the means of recovering NPAs;
– Recommended for setting up of ‘special tribunals’ to
expedite the recovery process
• 1991 – Narsimhan Committee
– Reemphasized few of recommendations of Tiwari
Committee
– Called for the definition of NPA
– Setting up of Debt Recovery Tribunal
– Creation of Asset Reconstruction Fund
• 1999 – Andhiyarjuna Committee
– Submitted four reports for
1. On Debt Recovery Tribunals
2. Amendment to Sec. 28 of the Indian Contract Act;
3. Taking possession and sale of securities without
intervention of courts by Banks and Financial
Institutions
4. Special law for securitization
Development of regulatory regime

• The FIRST PHASE

• the Sick Industrial Companies (Special Provisions) Act,
1985
– Based on the recommendations of Tiwari Committee
(basically to deal with Industrial Sickness);
– The enactment inter alia
• Established Board for Industrial and Financial
Reconstruction (BIFR); and
• Appellate Authority for Industrial and Financial
Reconstruction (AAIFR).
• The SECOND PHASE
• The Recovery of Debts due to Banks & Financial
Institutions (RDDBFI) Act, 1993
– Special Debt Recovery Tribunals were established
– Summary proceedings to help banks and FIs to realize
their debts
– Effective and speedy recovery of bad loans
• The THIRD PHASE
• The Securitization and Reconstruction of Financial
Assets and Enforcement of Security Interest Act, 2002
– Stressed the need for overall change in the legal system
to address the issue of NPAs
– Empowering the banks and FIs to take possession of
securities and sell them without the intervention of the
courts; and
– Without allowing the borrowers to take shelter under the
provisions of SICA/BIFR
SARFAESI Act, 2002
Background

• SARFAESI Act, 2002 – a third step in the government’s

initiative towards NPA management
• The existing law was found to ineffective
– Sec. 22 of SICA was identified to be an impediment
– The enactment of RDDBFI was felt to be somewhat
ineffective due to
• Lengthy process
• Inadequate infrastructure
Objective of the Act

• To introduce legal framework

– Securitization of financial assets
– Reconstruction of financial assets
– Power to ensure security for realization in the event of
default without intervention of the courts
– Enabling for setting up of Central Registrary for
registration of transactions of securitization,
reconstruction and creation of security interest
Three concepts

SECURITIZATION

RECONSTRUCTION

ENFORCEMENT OF SECURITY INTEREST (without intervention

of court)
The fundamental premise

• That, three is an obligation on the part of the borrowers

to repay loans and if they are unable to repay; then the
securities for the loans are liable to be sold for recovery
of loans
• The provisions of this Act shall have overriding effect,
notwithstanding anything inconsistent in any other law
for the time being in force
What is ‘securitization’?

• A process of pooling and repacking of homogeneous,

liquid financial assets into marketable securities
• It is a structured financial instrument and a means of
raising funds by transfer of assets
• This allows the securitizing organization/bank to get
fund up front, which can be put to more productive use
in the business
• S. 2(1)(z) – “Securitization” means acquisition of
financial assets by any securitization company or
reconstruction company from any originator, whether
by raising of funds by such securitization company or
reconstruction company from qualified institutional
buyers by issuing security receipts representing
undivided interest in such financial assets or otherwise
• S. 2(1)(za) “securitization Company” means any
company formed and registered under Companies Act,
1956 (1 of 1956) for the purpose of securitization
 POST SECURITIZATION
ORIGINATOR SERVICER

HIGH QUALITY RECEIVABLES [EX. HOME

MORTGAGE LOANS, CONSUMER CREDIT
RECEIVABLES ETC.,]
SERVICE FEE
PURCHASE PRICE

SPV
GRANT OF SECURITY

BANKS
FUNDING

BANKS OTHER INVESTORS CREDIT ENHANCEMENT

THIRD PARTY MAY GIVE GURANTEE TO SPV OR THE

ORIGINATOR MAY AGREE TO MAKE SUBORDINATED
LOAN TO SPV
Securitization
Registration of SC/RC

• Sec. 3 – Mandatory Registration with RBI

– Minimum stability requirement
• Owned fund of not less than rupees two crores; or
• Up to 15% of the total financial assets acquired or to
be acquired
• SC sets up SPVs for different schemes by constituting
trusts of which it is a trustee
• SPV holds the assets for the sole and simple benefit of
the investors
• SPVs are submitted to the following qualifications
– It shall not get into any business, other than the business
of holding the assets and realize them;
– It is not allowed to issue liabilities (bankruptcy remote)
– Can’t have any permanent employees and for any
outsources services – it shall obtain an undertaking from
the service provider that the later will not file a petition for
winding up of the SPV for non-payment of the fees
– Rights of the equity holders of the company to resolve for
voluntary winding up is restricted
• Only QIBs (Qualified Institutional Buyers) can only be
intended buyers (Act recognizes only private
placement) – S. 2(1)(u)
Asset Reconstruction
Asset reconstruction of financial assets

• The word ‘asset reconstruction company’ is an Indian

equivalent to ‘asset management company’
• Therefore an ARC will perform
– Buy NPAs at a discounted price; and
– Restructuring of bad debts.
• Asset Reconstruction Company (India) Limited [ARCIL]
was the first ARC to be incorporated in India
• Asset Reconstruction means acquisition by any
SC/ARC of any rights or interests of any bank or
financial institution in any financial assistance for the
purpose of realization of such financial assistance [Sec.
2(1)(b)]
• Therefore, asset reconstruction is much broader term
than Securitization
• Act provide some measures for asset reconstruction,
which can be taken up having regard to the guidelines
framed by RBI
– Proper management of the business of the borrower;
– Sale or lease of a part or whole of the business of the
borrower;
– Rescheduling of payment of debts;
– Settlement of dues;
– Enforcement of security interest;
– Taking possession of the secured assets
Enforcement of Security Interest
Steps

• Notice by secured creditor – to the borrower whose

account has been classified as NPA
– 60 days notice;
– On receipt of such notice, borrower can’t transfer the
secured assets without the consent of the secured
creditor.
• Objections by borrower – for the consideration of the
secured creditor – after considering the objections
creditors will covey reasons for not accepting them
• Failure continues – the bank or FI may take recourse to
any of the measures u/s 13(4)
Measures u/s 13(4)

• Take possession of the secured assets including the

right to transfer by way of lease, assignment or sale
• Takeover the management of the business of the
borrower
• Appoint Manager to manage the security
• Ask any debtors of the borrower to pay any sum due to
the borrower
• NOTE – if all the dues with costs and charges and
expenses incurred by the creditor is tendered before
the date fixed for sale of the assets – no further steps
be taken for sale of the property
Right of appeal – Sec. 17

• Any person who is aggrieved by any of the measures

u/s 13(4) may appeal to the DRT within 45 days from
the date on which such measures were undertaken
• Appeal is only entertained – only after 50% of the
amount claimed is deposited by the borrower with DRT
• Mardia Chemicals Ltd., v UOI, JT 2004 (4) SC 308
– Issue No. 1 – whether the provisions u/s 13 & 17,
provide adequate and efficacious mechanism to consider
the objections raised by a borrower against the recovery,
particularly in view of bar to approach the civil court
under Sec. 34 of the Act?
• HELD
– Bank/FI must apply its mind while considering the
objections of the Borrower and should not just
mechanically reject
– The matter is contractual between the two parties and
they are supposed to act in accordance to the terms of
contract
The insertion of Sec. 13(3A)

• Now there is a statutory duty upon the creditor to

consider the objections raised by the borrower and to
communicate the reasons for non acceptance of
borrower’s objections.
• It is now expressed that the borrower has a right to
know the reasons for non-acceptance; but can’t
challenge these reasons unless right to approach DRT
u/s 17 matures
– Issue No. 2 – whether remedy available u/s 17 of the Act
is illusory for the reason it is available post-action u/s
13(4); & the appeal would be entertainable only on
deposit of 75% of the claim raised in the notice of
demand?
• HELD
– Condition of pre-deposit was held to be bad
• As it is imposed while approaching adjudicating authority;
and not in appeal
• There is no determination of the amount due as yet
• The secured assets or its management is already taken
over and under the control of the secured creditor
• It will leave the borrower in a position where it would not be
possible for him to raise any funds to make deposit of 75%
of the undetermined demand
• Such conditions are not alone onerous and oppressive; but
also unreasonable and arbitrary
Conclusions
• SARFAESI has proved to be a strong legislative
initiative; however the issue of NPA is still to be
resolved to the level of satisfaction
• The ‘market’ for securitized NPA is yet to be developed
• Due to unrealistic high book value & low realizable
value – the NPAs acquired by the ARC/SCs can’t be
disposed of (lack of appropriate secondary market)
• No regulatory framework for investment by QIBs
• No specific capital market regulatory framework is in
place to govern the QIB investments (which is essential
for the development of the market)
Thanks very much

• Questions
• Clarifications
• Suggestions for improvements