LEGAL FRAMEWORK AS TO THE PROCESS
OF SECURITISATION WITH A SPECIAL FOCUS ON SARFAESI ACT
By
Dr. T Padma LLM., Ph D
kethepadma@gmail.com
I. INTRODUCTION
The
1990s witnessed several financial and economic crises worldwide, crippling the
economies of the affected countries. In most cases, crises in the financial
sector culminate into non-performing Loans (NPL)). A high level of NPAs in the
banking system can severely affect the economy in many ways: Management and
financial resources of the banking system are diverted to resolution of NPA
problems causing an opportunity loss for more productive use of resources. The
banks tend to become risk averse in making new loans, particularly to small and
medium sized companies. Thus, large scale NPAs when left unattended cause
continued economic and financial degradation in the country. This results in a
credit crunch and generally signals adverse investment climate. This explains
why most countries in the grip of systemic financial and economic crisis have
attempted system-wide clean up of NPAs as a part of restructuring of their
banking system. ARCs have been used worldwide, particularly in Asia, to resolve
bad-loan problems, and have had a varying degree of success.
II.
BACKGROUND
The problem of recovery from NPA’s,
in the Indian banking system, was recognized by the Government of India (GOI)
as far back as in 1997. The Narasimhan Committee Report mentioned that an important
aspect of the continuing reform process was to reduce the high level of NPA’s
as a means of banking sector reform. It was expected that with a combination of
policy and institutional development, new NPAs in future could be lower.
However, the problem of a huge backlog of existing NPAs remained. This impinged
severely on banks performance and their profitability. The Report envisaged the
creation of an "Asset Reconstitution Fund" to take the NPAs off the
lender's books at a discount. Unlike in some countries where ARCs have been set
up post financial crises and for the purpose of bailout, in India, the GOI
proactively initiated certain measures to control NPAs. In order to regulate
and control the NPAs and quicken recovery, the GOI set up Debt Recovery
Tribunals and Debt Appellate Tribunals under the "Recovery of Debts Due to
Banks and Financial Institutions Act, 1993". As a corollary to this and to
speed up the process of recovery from NPAs, the SARFAESI Act (Securitization
and Reconstruction of Financial Assets and Enforcement of Security Interest
Act, 2002) was enacted for regulation of securitization and reconstruction of
financial assets and enforcement of security interest by secured creditors,
including Securitization or Reconstruction Companies (SC/RC).
The SARFAESI Act provides for
setting up of Securitisation Companies/ Reconstruction Companies (SC/RC) termed
in popular parlance as ARCs. The Act enables the banks and financial
institutions to realize long term assets, manage problems of liquidity, asset
liability mismatch and improve recovery by exercising powers to take possession
of security, sell them and reduce Non Performing Loans (NPL) by adopting
measures for recovery or reconstruction within the framework of the Act, the
rules framed there under and the guidelines and notifications issued pursuant
thereto, by the Reserve Bank of India (RBI). The SC/RCs acquires NPAs from
banks, financial institutions a by raising funds from Qualified Institutional
Buyers (as defined in the Act) by issue of Security Receipts (as defined in the
Act) representing undivided interest in such financial assets. Like banks,
financial institution, the Act also enables SC/ RC to take possession of
secured assets of the borrowers including right to transfer and realize the
secured assets. SC/RCs act as debt aggregators and are focused in the
resolution of NPAs. Thus SC/RCs take away the distraction of banks by isolating
NPAs from the banking system. This leaves rest of the banking system free to
act in their core area of lending and normal banking business.
III.
LEGAL FRAME WORK
The
banks had to take recourse to the long legal route against the defaulting
borrowers beginning from filing of claims in the courts. A lot of time was usually spent in getting
decrees and execution thereof before the banks could make some recoveries. In
the meantime the promoters could seek the protection of BIFR and could also
dilute the securities available to bank. The debt Recovery Tribunals (DRTs) set
up by the Govt. of India. The Debts Recovery Tribunal have been constituted
under Section 3 of the Recovery of Debts Due to Banks and Financial
Institutions Act, 1993. The original aim of the Debts Recovery Tribunal was to
receive claim applications from Banks and Financial Institutions against their
defaulting borrowers. For this the Debts Recovery Tribunal (Procedure) Rules
1993 were also drafted.
While
initially the Debts Recovery Tribunals did perform well and helped the Banks
and Financial Institutions recover substantially large parts of their non
performing assets, or their bad debts as they are commonly known, but their
progress was stunted when it came to large and powerful borrowers. These
borrowers were able to stall the progress in the Debts Recovery Tribunals on
various grounds, primarily on the ground that their claims against the lenders
were pending in the civil courts, and if the Debts Recovery Tribunal were
adjudicate the matter and auction off their properties irreparable damage would
occur to them.
Apart
from the above big lacunae, there were a number of short comings too. The dues
of work men against a company, the State dues, and the dues of other non
secured creditors all got enmeshed before the Debt Recovery Tribunals. As if
these were not sufficient, there was clash of jurisdiction between the Official
Liquidators appointed by the High Courts and the Recovery Officers of the Debts
Recovery Tribunals. The Official Liquidator, an appointee of a superior
authority, took into his possession all the properties, which actually belonged
to secured creditors who before the Debts Recovery Tribunal. The High Courts
have also took umbrage on the activities of the Recovery Officers who away the
entire amounts and paid off to the banks leaving nothing for the other
claimants, including the work men. All these and other issues lead to drastic
amendments to the Recovery of Debts Due to Banks and Financial Institutions Act
by means of an amending notification in the year 2000.
While
the amending notification of 2000 did bring in some amount rationalization in
the jurisdiction of the Debts Recovery Tribunal, yet it was not sufficient to
coax the big borrowers to acquiesce to the jurisdiction of the Debts Recovery
Tribunal easily. The lenders continued to groan under the weight of the Non
Performing Assets. This led to the enactment of one more drastic act titled as
the Securitisation and Reconstruction of Financial Assets and Enforcement of
Security Interests Act, 2002.
The SARFAESI Act, empowered the
lenders to take into their possession the secured assets of their borrowers
just by giving them notices, and without
the need to go through the rigors of a Court procedure. This Act Is having the
overriding power over the other legislation and it shall go in addition to and
not in derogation of certain legislation. Initially this brought in lot of
compliance from borrowers and many a seasoned defaulter coughed up the Bank
dues. However the tougher ones punched whole in the new Act too. This led
Supreme court striking down certain provisions and allowing the borrowers an
adjudicatory forum before their properties could be taken over by the lenders.
IV. PROVISIONS OF SARFAESI ACT
a)
Object of the Act
The
Statement of Objects and Reasons of the Act is to enable and empower the
secured creditors to take possessions of their securities and to deal with them
without the intervention of the court and also alternatively to authorize any
securitization or reconstruction company to acquire financial assets of any
bank or financial institution.
b) Process
of Securitization
Simply
stated, ‘securitization’ is a process by which the ‘originator’s of assets like
loans which are illiquid, are able to transfer such assets to a ‘ special
purpose vehicle’ transaction can be structured with a wide variety or ‘credit
enhancement’ to make the deals attractive for investors. The most important, however, is the
guarantees of credit quality. There are two purposes for securitization. One,
the securitized assets go off the balance sheet of the originator and so the
asset-base is pruned down to that extent, thereby reducing the regulatory
capital requirements to support the assets.
Second the asset portfolio is liquidated, releasing cash, which in turn
reduces the need for demand and time liabilities that are subject to statutory
reserves.
“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 issue of security receipts representing undivided interest in such
financial assets or otherwise [section 2(1)(z)]. “Securitization company” means
any company formed and registered under the Companies Act, 1956 for the purpose
of securitization [Section 2(1)(za)].
Securitization
is the issuance of marketable securities backed not by the expected capacity to
repay of a private corporation of public sector entity, but by the expected
cash flows from specific assets.
c) Non-Performing
Assets
“Non-Performing
Asset” means an asset or account of a borrower, which has been classified by a
bank or financial institution as sub-standard, doubtful or loss asset-
(a) In
case such bank or financial institution is administered or regulated by an
authority or
body established, constituted or appointed by any law for the time being in
force, in accordance with the directions or guidelines relating to assets
classifications issued by such authority or body;
(b) In
any other case, in accordance with the directions or guidelines relating to assets
classifications issued by the Reserve Bank.
When
a borrower who is under a liability to pay to secured creditor, makes any
default in repayment of secured debt or any installment thereof, the account of
borrower is classified as non-performing asset (NPA). NPAs constitute a real economic cost to the
nation because they reflect the application of scarce capital and credit funds
to unproductive uses. The money locked up in NPAs are not available for
productive use and to the extent that banks seek to make provisions for NPAs or
write them off, it is a charge on their profits. High level of NPAs impact adversely on the
financial strength of banks who in the present era of globalization, are
required to conform to stringent International Standards. The public at large
is also adversely affected because bank’s main source of funds are deposits
placed by public continued growth in NPA portfolio threatens the repayment
capacity of the banks and erode the confidence reposed by them in the banks.
d) Asset
Reconstruction Companies
Reconstruction
company means a company incorporated under provisions of Companies Act, 1956
for purpose of assets reconstruction.
The
problem of non-performing loans created due to systematic banking crisis world
over has become acute. Focused measures to help the banking systems to realize
its NPAs has resulted into creation of specialized bodies called asset
management companies which in India have been named asset reconstruction
companies (‘ARCs’). The buying of
impaired assets from banks or financial institutions by ARCs will make their
balance sheets cleaner and they will be able to use their time, energy and funds for development of their business. ARCs
may be able to mix up their assets, both good and bad, in such a manner to make
them saleable.
The
main objective of asset reconstruction company (‘ARC’) is to act as agent for
any, bank or financial institution for the purpose of recovering their dues
from the taken over by banks, or fees or charges, to act as manager of the
borrowers asset taken over by banks, or financial institution, to act as the
receiver or properties of any bank or financial institution and to carry on
such ancillary or incidental business with the prior approval of Reserve Bank
of India wherever necessary. If an ARC
carries on any business other than the business of asset reconstruction or
securitization or the business mentioned above, it shall cease to carry on any
such business within one year of doing such other business.
All
the ARCs who have obtained certificate or registration from Reserve Bank to
carry on the business of asset reconstruction are public institution as defined
under Section 4A of the Companies Act, 1956. This is a special status conferred
by the Act on ARCs.
e) Enforcement of Security Interest under the Act (Sec. 13)
Section
13 of the Securitization Act provides for the enforcement of Security interest
by a secured creditor straight away without intervention of the court, on
default in repayment of installments, and non compliance with the notice of 60
days after the declaration of the loan as a non-performing asset. It must, however, be remembered that the
classification of assets as non performing is not on the mere whims and fancies
of the financial institutions. The
Reserve Bank of India has a detailed policy providing guidelines or prudential
norms in that regard.
The
Secured Creditor has been defined to mean 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
securitization company or reconstruction company or any other trustee holding
securities on behalf of a bank or financial institution, in whose favour
security interest is created for due repayment by any borrower of any financial
assistance.
The
secured creditor has two options. It can either transfer the assets to a
securitization or reconstruction company or exercise the powers under the Act.
Section
13(4) of the Act empowers the recourse to one more of the following measures,
after giving proper notice, for the recovery of the secured debts, namely:
(i)
Take possession of the secured assets of
the borrower including the right to
transfer
by way of lease, assignment or sale for realizing the secured asset;
(ii)
Take over the management of the secured
assets of the borrower including
the right to transfer by way of lease, assignment or
sale and realize the secured asset;
(iii)
Appoint any person (hereafter referred
to as the manager), to manage the
secured assets the possession of which has been
taken over by the secured creditor.
(iv)
Require at any time by notice in
writing, any person who has acquired any
of
the secured assets from the borrower and from whom any money is due or may
become due to the borrower, to pay the secured creditor, so much of the money
as is sufficient to pay the secured debt.
In
cases of joint financing under consortium or multiple lending arrangement if
75% of the secured creditors in the value agree to initiate recovery action the
same is binding on all secured creditors.
In
case of a company under liquidation, the amount realized from the sale of the
secured assets are to be distributed in accordance with the provisions of
Section 529A of the Companies Act, 1956.
If the company is being wound up after the commencement of this Act, the
secured creditor of such company, who opts to realize its security instead of
relinquishing its security and proving its debts under proviso to sub-section
(1) of Section 529 of the Companies Act, may retain the sale proceeds of its
secured assets after depositing the workmen’s dues with the liquidator in
accordance with the provisions of Section 529A of that Act.
Where
dues of the secured creditor are not fully satisfied with the sale proceeds of
the secured assets, the secured creditor may file an application in the form
and manner as may be prescribed to the Debts Recovery Tribunal having
jurisdiction or a competent court, as the case may be, for recovery of the
balance amount from the borrower.
Secured
creditor is entitled to proceed against the guarantors or sell the pledged
assets without first taking any of the measures specified above in relation to
the secured assets under this Act.
f) Manner
and effect of takeover of Management (Sec. 15)
Section
15 of the Securitization Act provides for the manner and effect of takeover of
management. When the management of
business of a borrower is taken over by a secured creditor it can appoint as many
persons as it thinks fit to be the directors, where the borrower is a company,
or the administrators of the business of the borrower, in any other case after
due publication of notice as prescribed.
Where
the management of the business of a borrower, being a company as defined in the
Companies Act, 1956 (1 of 1956), is taken over by the secured creditor, then,
notwithstanding anything contained in the said Act or in the memorandum or
articles of association of such borrower:
- (i) It shall be lawful for the shareholders of such company or any other person to nominate or appoint any person to be director of the Company,
- (ii) No resolution passed at any meeting or the shareholders or such company shall be given effect to unless approved by the secured creditor;
- (iii) No proceeding for the winding up of such company or for the appointment of a receiver in respect thereof shall lie in any court, except with the consent of the secured creditor;
- (iv) Where the management of the business of a borrower had been taken over by the secured creditor, the secured creditor shall, on realization of his debt in full, restore the management of the business of the borrower to him.
g) Non-Applicability
of the Act
The
provisions of this Act shall not apply to-
(a)
A lien on any goods, money or security
given by or under the Indian Contract Act, 1872 or the Sale of Goods Act, 1930
or any other law for the time being in force;
(b)
A pledge of movables within the meaning
of Section 172 of the Indian Contract
Act, 1872:
(c)
Creation of any security in any aircraft
as defined in clause (1) of Section 2 of
the Aircraft Act, 1934;
(d)
Creation of security interest in any
vessel as defined in clause (55) of Section 3 of the Merchant Shipping Act, 1958;
(e)
Any conditional sale, hire-purchase or
lease or any other contract in which no security interest has been crated;
(f)
Any rights of unpaid seller under Section 47
of the Sale or Goods, 1930;
(g)
Any properties not liable to attachment
(excluding the properties specifically charged with the debt recoverable under
this Act) or sale under the first proviso to Sub-section (1) of section 60 of
the Code of Civil Procedure, 1908;
(h)
Any security interest for securing
repayment of any financial asset not exceeding
one lakh rupees:
(i)
Any security interest crated in
agricultural land;
(j)
Any case in which the amount due is less
than twenty per cent of the principal
amount and interest thereon.
h) Over-riding
effect of the Act (Sec 35 & 37)
The
provisions of this Act shall have effect, notwithstanding anything inconsistent
therewith contained in any other law for the time being in force or any
instrument having effect by virtue of any such law (section 35). In accordance
with Section 37, the provisions of this Act or the rules made there under shall
be in addition to and not in derogation of the Companies Act, 1956, the
Securities Contracts (Regulation) Act, 1956, the Securities and Exchange Board
of India Act, 1992, the Recovery of Debts Due to banks and Financial
institutions Act, 1993 or any other law for the time being in force.
The
Combined affect of Sections 35 and 37 is that in cases of any conflict with
these Acts or any other Act, then the SARFAESI Act, 2002 shall have the over
riding effect over such Act or Acts.
Therefore the provisions of the SARFAESI Act, 2002 have the binding
power and cannot be put on hold because of conflict with any other legislation.
Moreover as per the provisions of Section 34 of SARFAESI Act, 2002, no civil
court shall have any jurisdiction to entertain any suit or proceeding in
respect of any matter which a Debts Recovery Tribunal or the Appellate Tribunal
is empowered by or under this Act (i.e. SARFAESI Act, 2002) to determine and no
injunction shall be granted by any court or any other authority in respect of
any action taken or to be taken in pursuance of any power conferred by or under
this Act or under the Recovery of Debts Due to banks and Financial Institutions
Act, 1993. Therefore it shall not be
possible to get any injunction from any Court of Law. In line with the SARFAESI
Act, 2002 Indian parliament has amended following legislations:
1.
The Companies Act, 1956: The definition
of Public Financial Institution under Section 4A has been altered and it now
includes securitization company or reconstruction Company.
2.
The Securities Contract (Regulation)
Act, 1956: Section 2 has been amended to include the definition of Security
Deposit as defined in 2 (kg) of SARFAESI Act, 2002.
3.
The Sick Industrial Companies (Special
Provisions) Act, 1985 has been amended to the extent it provides that after the
commencement of SARFAESI Act, 2002 and if the financial assets have been
acquired by securitization or reconstruction company, no reference shall be
made to BIFR. Moreover, after the commencement of SARFAESI Act, 1956 and if the
reference is pending, then the reference shall abate, if 75% of the Secured
Creditors have taken measures to recover their Secured Debts.
i) Applicability
of Limitation Act (Sec. 36)
Limitation
Act, 1963 is applicable to the claims made under this Act, Accordingly, no
secured creditor shall be entitled to
take all or any of the measures under Sub-section (4) of Section 13, unless his
claim in respect of the financial asset is made within the period of limitation
prescribed under the Limitation Act, 1963.
V. RBI GUIDELINES
The
Reserve Bank of India considered it necessary to issue the guidelines and
directions to Securitization companies or Reconstruction Companies in the
public interest and for the purpose of enabling the Reserve bank to regulate
the financial system to the advantage of the country and to prevent the affairs
of any Securitization Company or Reconstruction company form being conducted in
a manner detrimental to the interest of investors or in any manner prejudicial
to the interest of such Securitization Company or Reconstruction Company.
Accordingly,
the Reserve Bank of India has issued guidelines to every Securitization Company
or Reconstruction Company namely the Securitization Companies and
Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003.
relating to registration, owned fund, permissible business, operational
structure for giving effect to the business of securitization and asset
reconstruction, deployment of surplus fund, internal control system, prudential
norms, disclosure requirement etc. acquisition of financial assets and matters
related thereto.
The
provisions of these guidelines and directions shall apply to Securitization
Companies of Reconstruction Companies registered with the Reserve Bank of India
under section 3 of the Securitization and Reconstruction of Financial Assets
and Enforcement of Security Interest Act, 2002.
VI.
RIGHT
TO APPEAL
Section
17 of the Securitization Act provides that any borrower or any other person
aggrieved by the action of the secured creditors can file an appeal to the
concerned Debt Recovery Tribunal (DRT)
Such
appeal can also be filed by any person aggrieved by the action of the secured
creditor without being required to deposit any amount with the DRT. Such provisions will take care of any third
party interest in the secured assets which need to be considered before sale of
securities. Any person aggrieved by the order of DRT, may prefer an appeal to
the Appellate Tribunal within thirty days from the date of receipt of the order
of Debt Recovery Tribunal.
VII.
CONSTITUTIONAL
VALIDITY
The
securitization Act, 2002 was challenged in various courts on grounds that it
was loaded heavily in favour of lenders, giving little chance to the borrowers
to explain their views once recovery process in initiated under the
legislation., A notable case that has come up before the Apex court was Mardia
Chemicals in its plea against notice served by ICICI Bank. In Mardia Chemicals Ltd. V. UOI,[1] it
was urged by the petitioner that
(i)
There was no occasion to enact such a
draconian legislation to find a shortcut to realize non-performing assets
(‘NPAs’) without their ascertainment when there already existed the Recovery of
Debts Due to Banks and Financial Institutions Act, 1993 (‘ Recovery of Debt
Act’) for doing so;
(ii) No provision had been made to take into
account lenders liability;
(iii)
That the mechanism for recovery under
Section 13 does not provide for an adjudicatory forum of inter se disputes
between lender and borrower; and
(iv)
That the appeal provisions were illusory because the appeal would be maintainable after
possession of the property or management of the property was taken over or the
property sold and the appeal is not entertainable unless 75 per cent of the
amount claimed is deposited with the Debts Recovery Tribunal (‘DRT’)
The
Supreme Court held that though some of the provisions of the Act 2002 be a bit
harsh for some of the borrowers but on those grounds the impugned provisions of
the Act cannot be said to unconstitutional
in the view of the fact that the objective of the Act is to achieve
speedier recovery of the dues declared as NPAs and better availability of
capital liquidity and resources to help in growth of economy of the country and
welfare of the people in general which would sub-serve the public interest.
The
Supreme Court observed that the Act provides for a forum and remedies to the
borrower to ventilate his grievances against the bank or financial institution,
inter alia, with respect to the amount of the demand of the secured debt. After the notice is sent the borrower may
explain the reasons why the measures may or may not be taken under Sub-section
(4) of Section 13. The creditor must apply its mind to the objections raised in
reply to such notice. There must be
meaningful consideration by the Court of the objections raised rather than to
ritually reject them and to proceed to take drastic measures under Sub-section
(4) of Section 13. The court held that
such a procedure/mechanism was conducive to the principles of fairness and that
such a procedure was also important from the point of view of the economy of
the court and would serve the purpose in the growth of a healthy economy. It would serve as guidance to secured debtors
in general in conducting their affairs.
The
court opined that the ‘fairness doctrine’, cannot be stretched too far, such
communication is only for the purposes of the secured debtors knowledge and
cannot give an occasion to the secured debtor to resort to any proceeding,
which are not permissible under the provisions of the Act. Thus, a secured
debtor is not allowed to challenge the reasons communicated or challenge the
action likely to be taken by the secured creditor at that point of time unless
his right to approach the DRT as provided under section 17 matures on any
measure having been taken under Sub-section (4) of Section 13.
Moreover,
another safeguard is also available to a secured borrower within the framework
of the Act i.e. to approach the DRT under Section 17 though such a right
accrues only after measures are taken under Sub-section (1) of Section 13.
The
Apex Court, however, found that the requirement of deposit of 75 per cent of
the amount claimed before entertaining an appeal (petition) under Section 17 is
an oppressive, onerous and arbitrary condition and against all the canons of
reasonableness. Held this provision be invalid and ordered that it was liable
to be struck down.
CONCLUSION
SARFAESI Act not only helps the banks on fast track to debt
recovery but also to improve the quality of their assets. Similarly, the act
also helps the non banking finance
companies to improve the quality of their assets as well as loans.
Banks have been able to recover over 61% of the bad debts
for which proceedings were initiated under the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI)
Act by 2007-08.[2]
Although legal issues have cropped up regarding attaching and selling
defaulters' properties, the threat of dispossession has propelled many
borrowers to pay up, as the Act allowed banks to attach defaulters' properties
after giving 60 days' notice. The Act has been responsible for the bulk of the
bad loan recovery, and helping the banks to improve ratio of non-performing
assets (NPAs) to total assets.
According
to Report on Trend and Progress of Banking in India,
2007-08
released by RBI,
among
the various channels of recovery available to banks for dealing with bad loans,
the SARFAESI Act and the debt recovery tribunals (DRTs) have been the most
effective in terms of amount recovered. The amount recovered as percentage of
amount involved was the highest under the SARFAESI Act, followed by DRTs.
The
Act also enabled the creation of asset reconstruction companies, which helped
the banks to clean up their balance sheets. Asset reconstruction companies buy
NPAs from banks and specialise in recovery of bad loans either through
resolution or selling assets. While the Act helped lift the deadweight of large
corporate bad loans from their books, banks have been able to get rid of lakhs
of small default cases through Lok Adalats, people's courts established by the
government for settlement of disputes through conciliation and compromise.
The
Banks have referred as many as 83,942 loan default cases by end march 2008
under SARFAESI Act involving a loan amount of ` 7,263 crores. Against this, the Banks managed to
recover ` 4,429 crores, representing 61% of the loans.[1]
[ Published in Supreme Court Journal
/ Weekly
April-2010, Part – 14]
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Note:
The
Author is a member of A P State Higher Judiciary. The views expressed in this
article are purely personal.
[1] RBI’s Report on Trend and Progress of Banking in
India, 2007-08
