Saturday, July 30, 2011

Misuse of Asset Reconstruction Company

Are Indian asset reconstruction companies really under stress, or simply happy to misuse the law?

Vinod Kothari
Asset reconstruction companies in India are very different from the global model and they have been operating contrary to the purpose they are meant to fulfil

The top headline in a financial newspaper on Monday reported a seemingly-sensational matter of leading asset reconstruction companies operating under pressure of its major shareholders (all of them major banks) and consequent breach of laws and regulations by these companies.

But for those people, many of them professionals, who have had some experience of dealing with these asset reconstruction companies (ARCs), the issues are hardly surprising. For, these people know how ARCs arm-twist troubled companies into accepting loans at steep interest rates from private lenders; how they even allowing the private lenders to enforce security interest on assets without satisfying claims of banks and financial institutions; how they get allotment of shares in troubled companies; and force changes in management in violation of Reserve Bank of India (RBI) norms on the takeover of management, and so on.

However, many not know that the ARCs are vested with special legal powers that need to be deployed in strict compliance with the law and, therefore, many things that ARCs are doing are outright illegal.

In fact, in a larger context, the very institution of ARCs, vested with special powers of recovery, is as much a misconceived idea as the parent legislation under which the ARCs were created.

In India they are ARCs, but globally AMCs

While the term 'asset reconstruction company' may be a typical Indian expression, possibly from the heritage of the Narasimham Committee that referred to an 'asset reconstruction fund', in the global model of dealing with non-performing assets (NPAs) it is called an asset management company (AMC).

The first and most important point to note is that AMCs are created to resolve the problem of NPAs that result from a systemic crisis. That is, if a systemic crisis leaves the banking system infested with bad loans, there has to be a one-time, central remedy to resolve the problem. AMCs are not envisaged, and intuitively could not have been envisaged, to resolve the problem of loans that go bad due to bad lending.

Therefore, most countries brought about AMCs as a one-time measure with a sunset clause. The classic example is the Resolution Trust Corporation in the United States which acquired assets of savings and loans associations in the 1990s. Closer home, Danharta in Malaysia took over loans that went bad in the 1997 Southeast Asian crisis, and once the loans were resolved, it wound up its affairs.

Whether one-time or continuing, AMCs in most countries have taken the centralised AMC model; that is, one AMC formed to resolve a systemic crisis.

In India, our unique ARC model has a lot of differences from the global model.

First, there has not been any systemic crisis that ARCs have had to resolve. Most of the bad loans in India are a product of bad lending; they represent what is called the flow problem, rather than the stock problem.

Second, and also a key difference, is that we have not envisaged a sunset clause for ARCs. The SARFAESI Act envisages ARCs to be an ongoing business model. Hence, it could not have been a response to a systemic crisis. On a policy plane, it sounds completely counter-intuitive for an agency armed with special powers conferred by the law to rescue a loan that goes bad due to bad lending. What are insolvency laws, winding up laws and civil laws on recoveries meant for, if another special law is going to be used to resolve every loan that goes bad? (SARFAESI Act is short for the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002.)

Hence, the very concept of ARCs in India seems to be a paradox. It is easy to attribute the concept of ARCs to the Narasimham Committee; but the Narasimham Committee had not thought of profit-seeking companies fitting the bill of ARCs in the country.

That brings us to the third significant difference - a single AMC versus multiple ARCs. In India, over the years, several ARCs have come into existence. In fact, ARC has become a business model.

Vesting special powers with a profit-driven entity

From a legal policy perspective, how does one envision a profit-driven, shareholder-wealth-maximising entity resolving the problem of bad loans?

Sure enough, bad loan resolution is a business model, but such a business model has to fit into the overall regime of the recovery of loans, enforcement of security interests, and so on. It would be hard to think of entities having special powers that buy bad loans and resolve them. If power corrupts, then special powers can corrupt specially.

Of course, there is no equity and justice for a borrower who does not pay a loan; but then one cannot close one's eyes to the fact that lenders who foreclose loans often commit excesses.

While one cannot expect a borrower-centric fair deal from an entity that has to focus on shareholder wealth, the sale of assets is not transparent and is far too commonly done at prices that do not represent fair values.

Trust route: Easy escape from regulations

Another very unique feature of the Indian ARC model is that virtually all NPAs are bought in the name of trusts, of which the ARC becomes the trustee. This is a simple device to wish away RBI regulation. For, the regulations require capital adequacy, NPA treatment and income recognition norms in case of ARCs almost in the same tone as is applicable to NBFCs. However, if assets are bought in the name of ARCs, other than the mandatory investment requirement, much of the regulation is not applicable. This may sound strange, but the legal privileges of the special powers are presumably available even where the assets are sitting in the books of the trusts.

In fact, the question whether the powers of ARCs are exercisable where the assets are sitting on trust books, is a significant matter that has not been discussed adequately at legal forums. For the exercise of the special powers the asset must be an NPA, in accordance with the directions of the RBI, which directions are not applicable in the case of trusts. So, the issue is, if the directions are not applicable to trusts, do the trust's assets become NPAs as per directions of the RBI?

Going beyond business that is allowed by law

ARCs have very limited powers under the law; powers limited by the SARFAESI Act. Whatever else they do has to be incidental or ancillary to what they are permitted to do under the law. An ARC is not a normal business entity that can buy equity shares, takeover management of businesses, engage finance companies to acquire loans of defaulting companies, and so on. However, in the real world, ARCs are being run like bania shops (small neighbourhood stores).

Sale of assets not transparent

Also, the sale of assets conducted by ARCs-in spirit-is no different from the sale of assets by state finance corporations or others vested with similar special powers of recovery.

Courts have, over the years, ruled that there exists no scope for obscurity on the sale of a borrower's assets, as every single penny realised from the sale goes to the credit of the borrower.

It is also clear in the SARFAESI Act that the ARC acts as trustee of the borrower, in the exercise of rights of sale of property. Hence, any opaqueness in the sale process is intolerable in law. There have been numerous instances where ARCs have sold assets through so-called private auctions, and simply served a notice on the borrower, giving credit to the extent of sale proceeds. In these cases, no account of the sale proceeds, description of the buyer or competing bidders, information on how the asset was sold or expenses on the sale have been provided to borrowers. Worse, ARCs are on record saying that they are not obliged to disclose the particulars of the sale, but this is completely erroneous.

(The writer is a chartered accountant, trainer and author. He is an expert in such specialised areas of finance as securitisation, asset-based finance, credit derivatives, accounting for derivatives and financial instruments and microfinance. He has written a book titled "Securitisation, Asset Reconstruction and Enforcement of Security Interests", published by Butterworths Lexis-Nexis Wadhwa. He can be contacted at Visit his financial services website at

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