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Distressed financial assets include NonPerforming Loans (NPLs), restructured loans by banks and the Corporate Debt Restructuring (CDR) forum set up by the RBI, as well as written off accounts. The distressed financial assets are mostly secured by physical assets such as plant and machinery, real estate and current assets. Many distressed financial assets are also backed by personal guarantees of promoters. The implementation of Basel II framework and consolidation of the banking sector will bring Balance Sheet Management, including disposal of NPLs, into sharper focus and build up the motivation on the banks for remedial action.

Role of Asset Reconstruction Companies (‘ARCs’)

ARCs in India are expected to play an important role in the resolution process in the given profile of NPLs and prevalent lending practices (consortium lending) followed by the system.
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• NPL profileLarge and mid-size NPLs, mainly in the industrial sector, account for around 70-80% of total NPLs in the system. Resolution of these assets would largely be through operationalization of these industrial assets over a long timeframe. This requires in-depth skills for operational and financial restructuring, including change of management and interim management.
• Banking landscapeThe Indian banking landscape has traditionally been characterized by consortium / multiple lending with different classes of security. This results in significant inter-creditor issues inhibiting prompt implementation of the most appropriate resolution strategy, causing loss of value to all concerned. Most resolution approaches (under the SARFAESI Act, CDR mechanism, etc.) in India call for the consent of secured lenders representing 75% total debt by value.
• ARC advantageThe intermediation by ARCs in the NPL resolution process becomes critical as ARCs would have debt aggregation capability and capability to build necessary skill-sets which are critical to a successful resolution. ARCs with the ability to aggregate debt of different classes would be in a better position to address inter-creditor issues. The debt aggregation capability would also provide better control / leverage over the creditor in implementing the desired resolution strategy.Further, the SARFAESI Act has provided wide-ranging powers to ARCs for the resolution of NPLs. ARCs have access to all possible routes available to banks for resolution. In view of the nature of NPLs and the relevance for debt aggregation, the ARCs will have to be focused on developing domain expertise in resolution in order to maximize value for sellers and investors, as opposed to an approach of a quick exit through a secondary sale.

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Market development and increasing emphasis on resolution

The Indian model provides for operation of multiple ARCs. This is likely to foster competition leading to pricing and performance benchmarks enabling the market to evolve along sound lines. Thus, the Indian ARC model envisages market forces to consolidate and package lender interests attractively by arranging to fund to an provide exit to the lenders and create value for the investors with focused attention on NPL resolution. The government of India (GoI) and the regulator are actively encouraging this market framework. The tighter provisioning norms and implementation of Basel II norms (as mentioned earlier) will lead to increased flow of NPLs to the market for exit / resolution.

Transfer of Assets to ARCs

The SARFAESI Act provides for the transfer of the financial assets (loans, debentures, etc., but not shares of the borrower, unless the shares are collateralized for the loan) from banks and institutions to ARCs. The acquisition would typically take place by way of assignment of rights title and interest in favour of ARCs on a ‘true sale’ basis. Upon acquisition, the ARCs become the legal and effective owners of financial assets acquired, and step into the place of lenders. The Act also enables acquisition of financial assets through securitization. The assets are acquired by way of setting up of trusts by ARCs. The financial assets are held in such trusts for the beneficial interest of investors. Security Receipts (SRs) issued by trusts of ARCs represent such beneficial interests of investors. ARCs act both as trustees and managers of such trusts.

Resolution empowerments

The Act provides unfettered rights to the lenders acting in a majority (75% by value) to enforce the security interest without judicial intervention. Lenders acting in the majority are empowered to take possession of secured assets after giving 60 days’ notice to the borrower, and after the possession, are entitled to sell, lease or manage the assets for the realization of the dues. These provisions aim to overcome the procedural delays and pave the way for expeditious recovery.

The Act accords the same powers for resolution as are available with the lenders. These are as follows:

1. Restructuring of debts of the borrower
2. Settlement of debts of the borrower
3. Enforcement of security interest as above
4. Change in the business and management of the borrower and
5. Sale or lease of a part of or the whole business

ARC Business Approach

Let us analyse the transaction structure followed by Asset Reconstruction Company (India) Limited (‘ARCIL’)

In accordance with the Act and the RBI guidelines, ARCIL acquires the financial assets of NPL companies on their own balance sheet or through the trust structure by floatation of schemes for raising resources through an issuance of SRs from QIBs. The trust structure for acquisition and resolution of NPLs is the preferred structure by the investors and, in general, in line with international practices.

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• ARCIL sets up a trust (the Trust) for the purpose of acquiring NPLs on the books of the bank (Financial Assets)
• The Financial Assets would be acquired at fair value based on assessment of realizable amount and time to resolution
• The Trust raises resources through formulation of schemes by issuing Security Receipts (‘SRs’) to the eligible investors (QIBs) under the Act, and such monies received from QIBs are utilized towards payment of purchase consideration for the Financial Assets to the sellers
• The Trust is the legal owner of the Financial Assets and the SR holders are beneficial owners of the same – SRs represents undivided right, title and interest in the Trust Fund, including the initial contributions received by the Trustee for the Financial Assets proposed to be acquired
• ARCIL acts as a Trustee and the asset manager of the SPV trusts to leverage empowerments fully to ARCs under the Act for resolution – the SR holders have no recourse against ARCIL

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Case study (for illustration purpose only):

PNB had an NPL account of a textile industry aggregating INR 100 crores. The account was classified under the ‘doubtful’ category for a period of more than 1 year but less than 3 years. The value of the assets, mortgaged by the borrower as a security against the loan borrowed, had decreased substantially whereby the asset cover was only 50% of the outstanding amount. As per RBI’s provisioning norms, THE BANK had provided for 100% of the advance not covered by realizable security, i.e. 50 crores and 30% of the balance amount, i.e. 15 crores.

The NPL account was serving no financial purpose for THE BANK; in fact, it was adding to the cost of THE BANK as a result of its maintenance and was pulling down the capital adequacy ratio due to higher risk weight. THE BANK decided to sell the account to an ARC at an agreed value of INR 30 crores. Although, it may look as if THE BANK lost Rs. 20 crores from the sale of the account to the ARC (i.e. selling the asset for only Rs. 30 crores against the realisable security of Rs. 50 crores), THE BANK benefited from the deal as follows:

1. Early exit:With every passing year, the value of realizable security mortgaged with THE BANK was diminishing. Earlier exit from the asset at least provided the bank with an immediate cash flow of Rs. 30 crores.
2. Legal wrangles:Had the bank, initiated action under SARFAESI Act against the borrowers and tried to take over the financial assets of the borrower, it would have incurred additional legal costs. Also, the borrower might have filed a complaint against the Debt Recovery Tribunal (‘DRT’) and prolonged any benefit that the bank was expecting to derive from the legal action.
3. Extracting maximum true value:Assuming, the bank would have taken control of the asset under SARFAESI in a smooth manner, it may have sold the assets on a strip-sale basis and would not have realized the true value of the assets. Deriving maximum value from the stressed assets requires specific skill sets in order to restructure the assets, turn around the industry and sell it as a going concern, debt aggregation, etc.
4. Concentration on main business:Initiating legal action against the borrower, valuing the assets, auctioning them off requires management bandwidth. As a result, the Management would not able to focus 100% on their core competence: Banking.
5. Reduction of maintenance cost:Sell off the distressed loan account reduces expenditure on NPA maintenance of PNB and releases resources for core operations. An estimated cost of carrying and holding NPA in books of the banks is nearly 7.25 %.
6. Utilisation of funds:PNB can now immediately start utilizing the funds received from the sale of assets for lending and other productive purposes.

Conclusion

The distribution of stressed assets in the system follows the 80-20 rule whereby 20% by a number of borrowers are responsible for 80% of a value of impaired assets and vice versa. The large impaired assets comprise industrial assets having good restructuring potential.

In value terms, more than 60% of the impaired assets are amenable to be restructured or sold as going concerns.

The seed of success of managing the impaired assets in any economy lies in the speed of recycling these assets and their realization into cash. In achieving this objective, it is important that an attempt should be made to discern incipient difficulties in an asset brewing at an early stage and to make attempts and transfer it to ARCs at that stage itself. This will ensure a much higher realization and a better chance for business turn-around and resolution. Strong and vibrant ARCs specialising in an acquisition and turning around the distressed assets has a key role to play in the economy.

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