RBI introduces corporate governance norms for Asset Reconstruction Companies

Timothy Lopes | Manager | finserv@vinodkothari.com

The RBI has, on October 11, 2022, issued a circular^[1], amending the extant regulatory framework for Asset Reconstruction Companies (‘ARCs’) and introducing corporate governance norms and other aspects through this circular.

Considering the importance of ARCs, a need was felt to review the extant regulatory framework. Through the Statement on Developmental and Regulatory Policies released along with the Monetary Policy Statement on April 7, 2021, the RBI had set up a committee to “undertake a comprehensive review of the working of ARCs in the financial sector ecosystem and recommend suitable measures for enabling such entities to meet the growing requirements of the financial sector.” The committee, constituted on April 19, 2021^[2], had submitted its report to RBI and the same was placed on the website of RBI on November 02, 2021^[3] and many recommendations have been implemented since. The circular comes pursuant to the recommendations of the said committee.

This circular is in addition to the extant regulatory framework governing ARCs and come into effect immediately or as otherwise indicated specifically therein.

This article aims to summarise and analyse the major amendments brought in through the RBI circular dated October 11, 2022.

Introduction of Corporate Governance norms

Among the changes introduced is the introduction of corporate governance norms for ARCs aimed at enhancing the governance of ARCs. Some of the measures introduced relate to the constitution of committees and their responsibilities in the ARCs, while others relate to the manner of conduct of meetings, chairman of the Board, quorum, etc.

Further, there is a transition period of 6 months for ARCs to comply with these new corporate governance norms (specifically the measures to enhance governance in ARCs and Committees of the Board) as given in para 3 of the Annex to the RBI circular.

The regulatory requirements are summarised in the table below –

Particulars	Provision	Comments/ remarks
Measures to enhance governance of ARCs
Chairman of the Board	The Chair of the Board shall be an independent director. In the absence of the Chair of the Board, meetings of the Board shall be chaired by an independent director.	The Chairman of the Board shall mandatorily be an independent director.
Quorum for meetings	The quorum for the Board meetings shall be one-third of the total strength of the Board or three directors, whichever is higher. Further, at least half of the directors attending the meetings of the Board shall be independent directors.	The quorum cannot be met unless half of the directors attending are independent directors. This requirement seems to be counterproductive. In case there are 7 directors attending the meeting of which 3 are IDs, one of the non-ID directors would have to excuse himself from attending the meeting in order to comply with this requirement, which does not seem to serve any purpose.
Tenure of Managing Director (MD)/ Chief Executive Officer (CEO) and Whole -time Directors (WTDs)	Tenure of MD/ CEO or WTD shall not be for a period of more than five years at a time and the individual shall be eligible for re-appointment.	The MD/CEO or WTD can serve for a tenure of 5 years at a time and can be re-appointed subject to serving a maximum of 15 years.
Maximum tenure of MD/CEO/ WTDs	The post of the MD/ CEO or WTD shall not be held by the same incumbent for more than fifteen years continuously.	The maximum a MD/CEO or WTD can serve is 15 years continuously, post which the post must be mandatorily vacated and a new MD/CEO or WTD must be appointed.
Cooling off period and re-appointment as MD/ CEO/ WTD	The individual shall be eligible for re-appointment as MD/ CEO or WTD in the same ARC, if considered necessary and desirable by the Board, after a minimum gap of three years, subject to meeting other conditions. During this three-year cooling period, the individual shall not be appointed or associated with the ARC in any capacity, either directly or indirectly.	In case the same MD/CEO or WTD is considered to be re-appointed, there must be a mandatory 3 year cooling off period, during which he cannot be appointed or associated with the ARC in any capacity, directly or indirectly.
Appropriate succession planning measures	The ARCs shall put in place appropriate measures to ensure succession planning.	Self explanatory
Age of the MD/ CEO and WTDs	No person shall continue as MD/ CEO or WTD beyond the age of 70 years. Within the overall limit of 70 years, as part of their internal policy, ARCs’ Boards are free to prescribe a lower retirement age.	Self explanatory
Performance Review	The performance of MD/ CEO and WTD shall be reviewed by the Board annually.	Self explanatory
Committees of the Board
Constitution of Committees	The following committees must be constituted by ARCs – Audit Committee Nomination and Remuneration Committee	The requirement for committee constitution is new. An audit committee and nomination and remuneration committee would have to be constituted by the ARC in line with these guidelines.
Composition of the Audit Committee	ARCs shall constitute an Audit Committee of the Board, which shall comprise of non-executive directors only. The Chair of the Board shall not be a member of the Audit Committee.	Similar to the chairman of the Board, the chairman of the Audit Committee must be an ID. Further, the chairman of the Board cannot be a member of the Audit Committee. Thus, the chairman of the Audit Committee and the Board must be distinct IDs.
Meetings of the Audit Committee	The Audit Committee shall meet at least once in a quarter with a quorum of three members. The meetings of the Audit Committee shall be chaired by an independent director who shall not chair any other committee of the Board.	The chairman of the Audit Committee cannot be the chairman for any other board committee.
Expertise/ qualifications of Audit Committee members	Each of the members of the Audit Committee should have the ability to understand the financial statements as well as the notes/ reports attached thereto and at least one member should have requisite professional expertise/ qualification in financial accounting or financial management.	Self explanatory
Powers, functions, duties of the Audit Committee	The Audit Committee shall have the same powers, functions and duties as laid down in Section 177 of the Companies Act, 2013.   In addition, the Audit Committee shall periodically review and assess the effectiveness of internal control systems, especially with respect to the asset acquisition procedures and asset reconstruction measures followed by the ARC and matters related thereto.   The Audit Committee shall also ensure that accounting of management fee/ incentives/ expenses is in compliance with the applicable regulations.	In addition to the powers, duties and functions laid down in section 177 of the Companies Act, 2013 and the periodic review of internal controls, the Audit Committee is also responsible for ensuring that the accounting of management fees/ incentives/ expenses do not deviate from and are in compliance with the applicable regulations.
Nomination and Remuneration Committee	ARCs shall constitute a Nomination and Remuneration Committee of the Board, which shall have the same powers, functions and duties as laid down in Section 178 of the Companies Act, 2013. In addition, the Committee shall ensure ‘fit and proper’ status of proposed/ existing directors and sponsors.	The NRC must ensure the fit & proper status of proposed/ existing directors as well as the sponsors of the ARC.

Further, other changes introduced include obtaining prior approval of RBI in case of any change in the sponsor/s of the ARC due to fresh issue of shares (Note – the extant regulations require ARCs to obtain prior approval of RBI for change in shareholding on account of transfer[4] of shares). Additionally a fit & proper criteria has been introduced wherein a declaration and undertaking and a deed of covenant would have to be executed by the directors of the ARC. This is discussed in more detail below.

Another change brought in by the RBI circular relates to enhanced disclosures in the offer document by ARCs giving details of the financial information for the past 5 years, track record of returns generated for all SRs, etc. Furthermore, it is now mandatory for ARCs to obtain recovery ratings of SRs from CRAs.

Fit & proper criteria for directors & CEO

In order for the ARCs to undertake due diligence to determine the suitability, fit & proper criteria of the appointed/ existing directors and MD/ CEO, the RBI circular requires ARCs to obtain necessary information and declaration from the appointed/ existing directors and MD/ CEO in the format enclosed in Appendix I[5] to the RBI circular. The Nomination and Remuneration Committee constituted by the ARC has the responsibility to scrutinise the declarations for this purpose.

This declaration in the prescribed format is required to be obtained on an annual basis as on March 31 of each year. In case there is any change in the items in para 3 (Proceedings, if any, against the Director/ MD/ CEO) and para 4 (Any other explanation/ information considered relevant for judging the Director/ MD/ CEO, fit and proper) of Appendix I, the same must be communicated to the Department of Regulation of the RBI for its consideration.

This requirement is similar to the declaration and undertaking obtained from directors of financial entities such as NBFC-ICCs. Also, the directors will be required to execute a deed of covenant in the format specified in Appendix II[6], at the time of their joining the ARC and the same should be preserved and made available as and when called for by RBI.

Settlement of dues payable by borrowers under one time settlement

The extant guidelines for settlement of dues payable by borrowers has been modified by the RBI circular. Earlier, the Board of the ARC was permitted to delegate the powers to a committee for taking decisions on the proposal for settlement of dues.

The modified rules for settlement of dues prescribe that settlement can be done only after examination and recommendation by an Independent Advisory Committee (IAC). The recommendations of the IAC would then be deliberated by the Board including at least 2 IDs and specific detailing is required in the minutes of such meeting.

One important change is that the settlement can only be done after all possible steps to recover dues have been taken and there are no further prospects of recovering the debt. This would mean that settlement of dues with the borrower is a sort of last resort option for the ARC.

Other modifications to the extant guidelines include framing of a Board approved policy for this framework, preferably making the settlement in lump-sum, NPV of the settlement amount not being less than the realisable value, etc.

Increase in the minimum Net Owned Fund (NOF) requirement

The current NOF requirement is Rs. 100 crores, which has now been increased to Rs. 300 crores. New ARCs being set up must mandatorily meet the minimum NOF requirement of Rs. 300 crores. However, existing ARCs have been provided a glide path for meeting the minimum NOF requirement as shown below –

Current minimum NOF	By March 31, 2024	By March 31, 2026
Rs. 100 crore	Rs. 200 crore	Rs. 300 crore

Not meeting the NOF requirement would of course warrant supervisory action. This has been reiterated by RBI in the circular.

Further, the ARCs intending to undertake activities as a Resolution Applicant (RA) under IBC would need a minimum NOF of Rs. 1000 crores.

Investment in SRs issued by ARCs

The present 15-85% structure for investment in SRs has been modified. Now ARCs are required to invest a minimum of –

• either 15% of the transferors’ investment in the SRs, or;
• 2.5% of the total SRs issued,

Whichever is higher, of each class of SRs issued by them under each scheme on an ongoing basis till the redemption of all the SRs issued under such scheme.

This amounts to roughly 87-13% structure as opposed to the earlier 85-15% structure.

Transfer of stressed loans to ARCs

As per para 73 of the Master Direction – Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021[7] (‘TLE Directions’) only those stressed loans which are in default for more than 60 days or classified as NPA were permitted to be transferred to ARCs.

Pursuant to the RBI circular all stressed loans which are in default in the books of the transferors are now permitted to be transferred to ARCs. The TLE Directions are being updated in this regard.

Conclusion

The corporate governance provisions introduced are bound to strengthen the corporate governance of ARCs although some of the provisions seem to place additional burdens on the ARCs with respect to compliance.

With respect to the minimum NOF requirement, some ARCs are of the view that asking ARCs to increase the NOF to Rs. 300 crores is a very stiff target especially for boutique ARCs. Only allowing ARCs with Rs. 1000 crores NOF is a bad idea as there are a lot of mid-corporate IBC cases that do not find buyers. The larger ARCs will only focus on large cases. The smaller ones will still look at mid-corporate IBC cases.

---

^[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12399&Mode=0

^[2] https://rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51443

^[3] https://rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=1188

[4] Any transfer of shares by which the transferee becomes a sponsor; any transfer of shares by which the transferor ceases to be a sponsor; an aggregate transfer of ten percent or more of the total paid up share capital of the ARC by a sponsor during the period of five years commencing from the date of certificate of registration.

[5] https://rbidocs.rbi.org.in/rdocs/content/pdfs/ARCs11102022_APP1.pdf

[6] https://rbidocs.rbi.org.in/rdocs/content/pdfs/ARCs11102022_APP2.pdf

[7] https://rbi.org.in/Scripts/BS_ViewMasDirections.aspx?id=12166