RBI Guidelines to Securitisation and Asset Reconstruction Companies

By Vinod Kothari

On 23rd , 2003, nearly 11 months after the SARFAESI law came into effect and nearly 1 month after a ridiculous deadline for making application for registration, the RBI brought into force guidelines relating to securitisation and asset reconstruction companies.

Unsurprisingly, the muddling up of securitisation and asset reconstruction activities became all the more evident in the Guidelines as the RBI said the same company could take up both asset reconstruction and securitisation activities - so, one would have securitisation and asset reconstruction companies (SARCs) in the country.

In all, there are 6 notifications or circulars that bring the regulatory framework for SARCs into place. Together, these guidelines define the net worth and capital adequacy requirements for SARCs, provide for NPA recognition and consequent provisioning for the SARCs, and quite significantly, define the norms for transfer of assets by banks to the SARCs.

SARC (Reserve Bank's) Guidelines and Directions:

Under various provisions of the SARFAESI Act, the RBI has issued the 2003 Guidelines and Directions. Precision of language is not a great virtue with lot many draftsman these days, but one is intrigued by the dual words "guidelines" and "directions". Obvious to a layman, directions implies something which is mandatory, while guidelines are a guide to good conduct, but not necessary mandatory. Sec. 12 of the Act empowers the RBI to give directions - guidelines, being merely for guidance or help, does not need a statutory power as such. Thus, the use of the words "guidelines" and "directions" would fox all those who are more careful about words and want to tell those parts of the said Guidelines and Directions which are mandatory from those that are not. For example, Rule 7 which goes into the niceties of operations of an ARC and prescribes biblical rules of good behavior (thou shall be a good boy) is more like a guideline than a direction.

The most curious exception to the scope of the Directions is that most of the operative part of the Directions applies to a direct acquisition of assets by a SARC, but does not apply only if such assets are held as a trustee for a trust. To fall outside the discipline of the Directions, all that the SARC has to do is to settle a trust, be a trustee to such trust, and acquire assets as a trustee. So, the obvious question is: what is it that would motivate a SARC from holding any of the financial assets it acquires directly? So, if everyone will choose the easy way out anyway, what is the relevance of the Directions, if at all?

Another, and even more curious, provision is in para 4 (iii) of the Directions which says: " Any entity not registered with the Bank under Section 3 of the Act may conduct the business of securitisation or asset reconstruction outside the purview of the Act." Section 3 of the parent law clearly puts a bar on a business of securitisation and asset reconstruction without being registered with the RBI. Of course, the words "securitisation" and "asset reconstruction" only relate to certain assets under that law - for instance, they relate to assets of a bank originator. So, quite obviously, the provisions of the Act do not apply if someone were to securitise assets of a non-banking originator. But if the Directions, where the meaning of the words "securitisation" or "asset reconstruction" could not be different from what it is under the Act, say that business of securitisation or asset reconstruction can be carried outside the purview of the Act, it defies the very purpose of the mandatory nature of sec. 3 of the Act. By settled rule, a subordinate instrument cannot travel beyond the parent law: therefore, sec. 3 should remain unaffected by Rule 4 (iii) of the Directions and the latter should be simply read down.

Modes of acquiring assets:

The Directions seem to be suggesting that securitisation transactions will be done by acquiring assets in the name of trusts to be settled by the SARC. In the Book we have discussed at length the nature of a trust - the trust is not an entity; the trustee is. So, it is the SARC which is the entity. The Directions seem to be suggesting that the SARC will first buy the assets and then transfer the same to the trust - this does not literally make sense because the trust is, in fact, nothing but the SARC itself. Instead of first acquiring assets as a beneficial owner, and then declaring trust, the SARC might acquire assets as a trustee in the first place.

The security receipts will be created by the trust (that is, by the trustee, in capacity as trustee). We have also discussed at length in the Book that the word "security receipts" has a flawed definition in the Act and that there is no bar on the SARC from issuing any other type of security as well.

The only new provision relating to security receipts in the Directions is that the transferability of the security receipts is restricted : they can only be transferred to QIBs.

Reconstruction activities:

The Directions also provide, what we have earlier construed to be, rules of good conduct for reconstruction activities. This is Rule 7. This requires formation of various sets of policies by the SARC on issues like acquisition of assets, valuation, disposal, settlement, realisation cycle, etc. This rule essentially lays down various policies, all of which are internally to be framed and implemented. It should not have been necessary for the RBI to put in such basic rules of business in a quasi-legislative instruments: no regulator should make the mistake of substituting corporate governance by such rudimentary rules.

Capital adequacy:

A 15% capital adequacy has been prescribed for SARCs on risk-weighted assets. The risk weights are similar to those under the Basle I convention.

SARCs are supposed to deploy their "surplus" funds only in G-secs and bank deposits. "Surplus", of course, is what is not invested in accordance with the scheme of investments. For instance, many revolving securitisation transactions may provide for investment in a particular mode as a part of the scheme of investments itself, which is not a surplus money anway.

It is interesting to note that this requirement also, like most of the operative requirements of the Directions, does not apply in case of acquisition of assets in the name of trusts.

When does a bad apple become bad:

Another curious part of the Directions is its approach to NPA recognition by SARCs. It is a common knowledge that ARCs are really "bad banks" -they represent a bunch of bad assets hived off from the originating banks. By presumption, the assets must have been non-performing (though the Act or the Directions do not limit ARCs to buy bad loans only) from the very start. But they turn into performing assets from the very day they are bought up by the ARC, and remain performing for at least 6 months. It is only after failure of interest and/or principal after 6 months of acquisition that they become non-performing.

Once they become thus non-performing, they will start coming for provisioning requirements. This, coupled with the requirement that the securities of the ARC must be interest-bearing (see later), is a sure prescription that the ARC will soon be having losses on its own balance sheet. By mandatory requirements of the Act, if an ARC does not make profits for 3 consecutive years, it must be disqualified to be an ARC, and therefore, wind up. It would not be surprising, therefore, that the combined effect of the Directions would be to make the whole business of ARCs unviable except for vulture financiers.

Directions to transferring banks:

Importantly, the RBI has also given Directions to banks which contain both a provision for regulatory capital relief, as also issues like recognition of profit/losses, etc.

Para 3 of these Guidelines gives an impression that banks can sell only non-performing loans to SARCs. Once again, the RBI has made the elementary mistake of confusion all securitisation to be all reconstruction or vice versa, since securitisation, as different from asset reconstruction, is done in case of performing assets rather than non-performing assets. But most likely, bankers, who swear by the letter and not spirit of the RBI directives, are unlikely to take these Guidelines only limited to asset reconstruction.

These Guidelines contain certain important clarifications that will help the securitisation market:

• That banks may invest in security receipts or other securities issued by the SARCs, which will be regarded as investments in the hand of the banks.
• That the exposure will be regarded as exposure in the SARC and not the underlying obligors.
• That banks may remove the assets transferred by them to SARCs from their books thus achieving capital relief.

However, the Guidelines also put some extremely impractical limitations on the nature of the securities of the SARCs. Para 5 A (b) says that the securities of the SARC must not have a term exceeding 6 years, must be non-contingent (unconditional undertaking to pay, not related to realisation of the assets by the SARC), and must carry a minimum rate of interest of Bank Rate plus 150 bps. Bankers will take this to mean that zero coupon bonds cannot be issued by the SARC. At the same time, the bond/debenture must not be subordinated, as the condition of an "unconditional undertaking to redeem" cannot be satisfied by a subordinated instrument. Apparently, this requirement is applicable in case of bonds and debentures, but it would be ridiculous to think that what is expressly imposed by the RBI in case of bonds and debentures may be skipped in case of pass-through certificates.

ARCs are not money-banks: they are not financial intermediaries. They are recovery devices. There is no way ARCs can externally fund their acquisitions except by bringing in external investors. Such external investors are unlikely to accept a subordination to the transferring banks, as that does not make commercial sense. Therefore, there is no option but for the originating banks to accept a subordination of their bonds/debentures. Since the RBI guidelines expressly provide that the debentures cannot have a legal final maturity beyond 6 years, and they must be redeemable in cash, the only way would be to take the ARC to bankruptcy after 6 years if the assets have failed to pay off completely by then. And a complete pay off within 6 years will be extremely difficult to expect.

• Have you enrolled for the most popular feature on my website -  our mailing list?
• Any reactions, good or bad - please do post them on our guestbook
• Have any interesting materials or links to suggest - shall be obliged for your contribution - e  -mail me
  
Copyright ...Unless otherwise mentioned, all materials on this site are subject to the sole copyright of Vinod Kothari- their reproduction and use in any form is strictly prohibited. Downloading for personal use (and not circulation) is permitted, provided the credit of such materials to Vinod Kothari is preserved. No permission is required for linking to any of the materials on this site.