– By Sikha Bansal (firstname.lastname@example.org)
This article has also been published in IndiaCorpLaw Blog, the same can be viewed here
A regulatory framework for asset reconstruction companies (ARCs) was introduced in India through the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act). This intended to put in place a system for clearing up non-performing assets (NPAs) from the books of banks and financial institutions. Over a decade later, the Insolvency and Bankruptcy Code, 2016 (IBC) was introduced with the objective of reorganisation and resolution of insolvent entities.
Although the common goal of both these legislation seems to be the cleaning or reconstruction of bad loan portfolios, it is important to understand the difference between the basic premises of these two laws: while the SARFAESI Act deals with ‘recovery’ and is more of a ‘class’ remedy, the IBC is about ‘resolution’ and intended to constitute a collective process. Given a common set of stakeholders involved under both these laws, there remains an obvious possibility of overlaps or inconsistencies.
Recently, the rejection of a resolution plan pertaining to a telecom-sector entity by the Reserve Bank of India (RBI) highlighted an important regulatory or interpretative gap. According to publicly available information, the issue essentially revolves around investment by an ARC in the equity of an insolvent entity. While the IBC has imbibed provisions for submission of ‘resolution plans’ by financial entities (including an ARC), the SARFAESI Act does not explicitly permit ARCs to ‘invest’ in or acquire equity in firms. Further, the SARFAESI Act imposes a ban on ARCs from carrying on any business other than that of asset reconstruction and/or securitisation. This has led to a conundrum as to the periphery within which ARCs can operate.
This post intends to analyse the provisions of the SARFAESI Act and the IBC and consider if there is in fact any gap as such, and whether there is any prejudice to the basic framework of any of the laws applicable to the ARCs, if the ARCs become equityholders under resolution plans.
Whether the SARFAESI Act bars equity infusion by ARCs
Going by the definition of “asset reconstruction company” under section 2(1)(ba) of the SARFAESI Act, an ARC is formed for the purpose of “asset reconstruction” or “reconstruction” or “both”. Here, “asset reconstruction” is the acquisition by an ARC of any right or interest of any bank or financial institution in any financial assistance for the purpose of realisation of such financial assistance, while ‘securitisation’ is the acquisition of financial assets by an ARC from any originator, whether by the ARC raising funds from qualified buyers by issue of security receipts representing undivided interest in such financial assets or otherwise.
Barring these two “businesses”, an ARC would have to obtain RBI approval to commence or carry on any other “business”. However, there are exceptions under clauses (a), (b), and (c) of section 10(1), that is, where the ARC acts as a recovery agent, manager or receiver. Hence, the law is clear that the ARCs are specialised business undertakings, expected to concentrate on acquisition of financial assets, rights, or interests for the purpose of their realisation or reconstruction.
Notably, with the inherent right to carry out the business of asset reconstruction, the ARCs will have to be equipped with incidental rights that would facilitate the business. As such, section 9 of the SARFAESI Act lists out the measures that the ARC can take “for the purpose of asset reconstruction”, which includes the “proper management of the business of the borrower, by change in, or takeover of, the management of the business of the borrower” as well as “conversion of any portion of debt into shares of a borrower company”.
A connected provision is section 15(4) which states that the secured creditor (in this case, an ARC) shall, on realisation of debt in full, “restore the management of the business of the borrower to him”. This aspect was also pointed out by Bankruptcy Law Reform Committee (BLRC) while assessing ARCs as possible tools for insolvency resolution [see, page 10 of the Interim Report of the BLRC (2015)]:
“ . . . But given their powers to resort to several measures (which includes taking over the management and conversion of debt into equity among others) for recovering the value underlying those loans, ARCs can (at least in theory) also help in insolvency resolution of a company. . . It may be noted that an ARC can takeover the management of the borrower only for the purpose of ‘realization of dues’. The management of the company has to be restored back to the borrower after realisation of the dues. Therefore, this mechanism is largely seen as a debt recovery tool and not an insolvency resolution tool (i.e., it does not facilitate rescue in practice).” [emphasis added]
Therefore, the BLRC drew a thin line between ‘realisation’ and ‘rescue’. As the intent and objective of an ARC is to ‘realise the dues’ and reposition the borrower, it would not amount to ‘rescue’ in its truest sense.
However, an important amendment was inserted in the SARFAESI Act by way of the Amendment Act of 2016. A proviso to section 15(4) now provides that “if any secured creditor jointly with other secured creditors or any asset reconstruction company or financial institution or any other assignee has converted part of its debt into shares of a borrower company and thereby acquired controlling interest in the borrower company, such secured creditors shall not be liable to restore the management of the business to such borrower.” [emphasis added} Therefore, there would be no obligation on the ARC to return the business to the borrower where the ARC has already acquired a controlling interest in the entity.
Therefore, it might appear that ARCs can undertake a permanent equity position in the borrower entity. This however, in view of the author, comes with a rider, as imbibed in the law itself. An ARC is only formed for the purpose of asset reconstruction and securitisation and no other purpose. Any other business can only be undertaken with the prior approval of the RBI. Hence, the author opines that the very act of being in the management of a borrower cannot be in perpetuity: ultimately, the ARC will have to obtain an exit. At the same time, it cannot be said that ARCs are completely debarred from infusing equity in the borrower.
On the question as to how the exit can occur, it is always possible for the ARCs to sell the asset, which again, should be subject to overall provisions of the IBC, the SARFAESI Act as well as directions issued by the RBI. For instance, the ARC will not be able to sell the asset to a person ineligible under section 29A of the IBC: this has become all the more clear from the Fair Practice Code for ARCs issued by RBI (see discussion here). As to the appropriate time or stage for the exit, the ARC may have to take a commercial call on the same: the objective, as is obvious, would be to recoup the investments made by the ARC in acquiring the asset.
Besides the above, note that have explicit provisions for conversion of debt into equity. Earlier, there was a cap of 26% of the total post-converted equity shareholding of an entity upon conversion of debt into equity. However, the RBI removed the same through a notification dated November 23, 2017. The 2017 notification also stated that ARCs shall explore the possibility of preparing a panel of sector-specific management firms or individuals having expertise in running firms or companies which could be considered for managing the companies.
Although the notification deals with conversion of debt to equity, it gives the right to ARCs to acquire equity of companies. Essentially, it should not matter whether the equity is acquired against conversion of debt into equity or directly by infusion of equity into the borrower.
Hence, in the view of the author, there is nothing in the SARFAESI Act that bars an ARC from becoming an equity shareholder of the borrower company, subject to the rider that this cannot be a permanent equity investment, as discussed above.
ARCs as resolution applicant under the IBC
Resolution applicants under the IBC can be any person who individually or jointly with any other person submits a resolution plan. The person, however, should not be a person ineligible under section 29A. The list is, therefore, a negative list: anyone who falls under that list is not entitled to be a resolution applicant.
Here, one should refer to the first proviso to explanation I of section 29A. The same is worded as: “Provided that nothing in clause (iii) of Explanation I shall apply to a resolution applicant where such applicant is a financial entity and is not a related party of the corporate debtor” [emphasis added]. According to explanation II, “financial entity” includes an ARC registered under the SARFAESI Act.
The wordings of the law, as above, are amply clear that an ARC can be a resolution applicant under the IBC. While the opening words of explanation II require such entities to meet such criteria or conditions as the Central Government may notify, so far, however, no such notification or criteria have been issued.
Now, the very task of a resolution applicant is to come up with a resolution plan. The resolution plan, seeking the insolvency resolution of the corporate debtor as a going concern, can contain a variety of measures, including varying kinds of restructuring options and acquisition of shares. Therefore, whether the resolution happens by way of debt or by way of equity should not be a matter of concern. As already established by way of landmark court rulings, the IBC is a complete code in itself, having resolution and revival of insolvent entities as a key objective. However, the resolution plan must not contravene provision of any other law: see section 30(2)(e).
The author has noted above that there is nothing under the SARFAESI which prohibits infusion of equity by an ARC in an entity. Therefore, there is arguably no inconsistency between the provisions of the SARFAESI Act and the IBC and, as such, a plan that provides for equity participation of an ARC cannot be said to be ultra vires the provisions of the SARFAESI Act. This again is subject to the condition of impermanency of such relationship between the ARC and the corporate debtor.
Globally, the framework for asset management companies (AMCs) may follow either a centralised approach or a decentralised approach, and may be either perennial or may be with a sunset clause. See for instance, Danaharta (Malaysia), IBRA (Indonesia) and Thai Asset Management Company (TAMC) were formed with specific sunset dates. However, no sunset dates were specified while formation of AMCs in Japan, Korea and Taiwan.
In the Indian context, the activity of asset reconstruction has been encouraged as a ‘business’ activity, and ARCs have been promoted as a specialised business model, although of course, with required regulatory overview. Therefore, it might be difficult to say that the ARCs should be in the business of asset reconstruction, but with the prohibition that they should not be allowed to acquire equity in the entity. This contention would be more irrational where there already exists right with the ARC to take over the management of the borrower.
From the above discussion, there does not seem to be any bar on ARCs in being equity-participants under resolution plans. The only aspect that needs to be taken care of is that, while ARCs take over the management of a company or the company itself, they shall run the business only until the business is revived which, in turn, is a commercial decision . Thereafter, the ARC must exit. In so far as any requirement for any amendment to the law is concerned, given the perplexity surrounding the issue, it would be better if there is a clarification under the SARFAESI Act or one issued by RBI on the same.