EASE OF RECOVERY FOR NBFCS?

–  Ministry of Finance relaxes the criteria for NBFCs to be eligible for enforcing security interest under SARFAESI

-Richa Saraf (richa@vinodkothari.com)

 

The Ministry of Finance has, vide notification[1] dated 24.02.2020 (“Notification”), specified that non- banking financial companies (NBFCs), having assets worth Rs. 100 crore and above, shall be entitled for enforcement of security interest in secured debts of Rs. 50 lakhs and above, as financial institutions for the purposes of the said Act.

BACKGROUND:

RBI has, in its Financial Stability Report (FSR)[2], reported that the gross NPA ratio of the NBFC sector has increased from 6.1% as at end-March 2019 to 6.3% as at end September 2019, and has projected a further increase in NPAs till September 2020. The FSR further states that as at end September 2019, the CRAR of the NBFC sector stood at 19.5% (which is lower than 20% as at end-March 2019).

To ensure quicker recovery of dues and maintenance of liquidity, the Finance Minister had, in the Budget Speech, announced that the limit for NBFCs to be eligible for debt recovery under the SARFAESI is proposed to be reduced from Rs. 500 crores to asset size of Rs. 100 crores or loan size from existing Rs. 1 crore to Rs. 50 lakhs[3]. The Notification has been brought as a fall out of the Budget.

Our budget booklet can be accessed from the link below:

http://vinodkothari.com/wp-content/uploads/2020/02/Budget-Booklet-2020.pdf

ELIGIBILITY FOR INITIATING ACTION UNDER SARFAESI

To determine the test for eligible NBFCs, it is first pertinent to understand the terms used in the Notification.

The Notification provides that NBFCs shall be entitled for enforcement of security interest in “secured debts”. Now, the term “secured debt” has been defined under Section 2(ze) of SARFAESI to mean a debt which is secured by any security interest, and “debt” has been defined under Section 2(ha) as follows:

(ha) “debt” shall have the meaning assigned to it in clause (g) of section 2 of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (51 of 1993) and includes-

(i) unpaid portion of the purchase price of any tangible asset given on hire or financial lease or conditional sale or under any other contract;

(ii) any right, title or interest on any intangible asset or licence or assignment of such intangible asset, which secures the obligation to pay any unpaid portion of the purchase price of such intangible asset or an obligation incurred or credit otherwise extended to enable any borrower to acquire the intangible asset or obtain licence of such asset.

Further, Section 2(g) of the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, provides that the term “debt” means “any liability (inclusive of interest) which is claimed as due from any person by a bank or a financial institution or by a consortium of banks or financial institutions during the course of any business activity undertaken by the bank or the financial institution or the consortium under any law for the time being in force, in cash or otherwise, whether secured or unsecured, or assigned, or whether payable under a decree or order of any civil court or any arbitration award or otherwise or under a mortgage and subsisting on, and legally recoverable on, the date of the application and includes any liability towards debt securities which remains unpaid in full or part after notice of ninety days served upon the borrower by the debenture trustee or any other authority in whose favour security interest is created for the benefit of holders of debt securities.”

Therefore, NBFCs having asset size of Rs. 100 crores and above as per their last audited balance sheet will have the right to proceed under SARFAESI if:

  • The debt (including principal and interest) amounts to Rs. 50 lakhs or more; and
  • The debt is secured by way of security interest[4].

EFFECT OF NOTIFICATION:

An article of Economic Times[5] dated 07.02.2020 states that:

“Not many non-bank lenders are expected to use the SARFAESI Act provisions to recover debt despite the Union budget making this route accessible to more such lenders due to time-consuming administrative hurdles as well as high loan ticket limit.”

As one may understand, SARFAESI is one of the many recourses available to the NBFCs, and with the commencement of the Insolvency and Bankruptcy Code, the NBFCs are either arriving at a compromise with the debtors or expecting recovery through insolvency/ liquidation proceedings of the debtor. The primary reasons are as follows:

  • SARFAESI provisions will apply only when there is a security interest;
  • NBFCs usually provide small ticket loans to a large number of borrowers, but even though their aggregate exposure, on which borrowers have defaulted, is substantially high, they will not able to find recourse under SARFAESI;
  • For using the SARFAESI option, the lender will have to wait for 90 days’ time for the debt to turn NPA. Then there is a mandatory 60 days’ notice before any repossession action and a mandatory 30 days’ time before sale. Also, the debtor may file an appeal before Debt Recovery Tribunal, and the lengthy court procedures further delay the recovery.

While the notification seems to include a larger chunk of NBFCs under SARFAESI, a significant question that arises here is whether NBFCs will actually utilise the SARFAESI route for recovery?

 

[1] http://egazette.nic.in/WriteReadData/2020/216392.pdf

[2] https://m.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=952

[3] https://www.indiabudget.gov.in/doc/Budget_Speech.pdf

[4] Section 2(zf) “security interest” means right, title or interest of any kind, other than those specified in section 31, upon property created in favour of any secured creditor and includes-

(i) any mortgage, charge, hypothecation, assignment or any right, title or interest of any kind, on tangible asset, retained by the secured creditor as an owner of the property, given on hire or financial lease or conditional sale or under any other contract which secures the obligation to pay any unpaid portion of the purchase price of the asset or an obligation incurred or credit provided to enable the borrower to acquire the tangible asset; or

(ii) such right, title or interest in any intangible asset or assignment or licence of such intangible asset which secures the obligation to pay any unpaid portion of the purchase price of the intangible asset or the obligation incurred or any credit provided to enable the borrower to acquire the intangible asset or licence of intangible asset.

[5] https://economictimes.indiatimes.com/industry/banking/finance/banking/not-many-nbfcs-may-use-sarfaesi-act-to-recover-loan/articleshow/74012648.cms

INSOLVENCY OF FSPS AND THIRD PARTY RIGHTS UNDER SECURITISATION CONTRACTS

-Richa Saraf

(richa@vinodkothari.com)

 

The Insolvency and Bankruptcy Code, 2016 (“Code”) does not, in general, deal with insolvency of financial service providers (“FSPs”), as FSPs are seen to be systemic and complex structures with unique transactions in their kitty. However, the Dewan Housing Finance Corporation Limited (DHFL) collapse led to notification of the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019[1] (“Rules”) under Section 227 of the Code. The Rules applied the law to FSPs, with certain modifications[2]. The Rules, inter alia, with respect to third party assets, stipulates that the moratorium provisions will not apply to such assets or properties in custody or possession of the FSP, including any funds, securities and other assets required to be held in trust for the benefit of third parties. The Rules further state that the Administrator shall take control and custody of such third-party assets or receivables, but only for the limited purpose of dealing with them in the manner as may be notified by the Central Government.

Pending notification of clear rules with regard to third party assets with the FSPs, there were ambiguities, which demanded judicial intervention (see below). However, now, the Central Government has, vide notification dated 30.01.2020[3] (“Notification”), notified the manner in which third party assets in custody or possession of financial service providers (against whom insolvency proceedings have been initiated) has to be dealt with.

THE DHFL ISSUE:

On 30.09.2019, the Hon’ble Bombay High Court passed an ad-interim order, on an application filed by deposit-holders, and injuncted DHFL from making any payments and/or disbursements to any of its unsecured creditors and secured creditors, except in cases where payments made on pro-rata basis to all secured creditors, without the sanction of the Court. Aggrieved by the said order, various banks, including State Bank of India, Bank of Baroda, Union Bank of India, Indian Overseas Bank, Canara Bank, Bank of India, Standard Chartered Bank, filed intervening applications before the High Court seeking modification of the above order to the extent that DHFL is allowed to make payment of amounts due to banks pursuant to securitization and assignment agreements.

Finally, vide order dated 13.11.2019[4], the Bombay High Court allowed DHFL to make payments to banks and NBFCs that have securitisation arrangements with the stressed mortgage financier.

Pursuant to notification dated 18.11.2019[5], DHFL became the first FSP against which the insolvency proceedings were initiated on 02.12.2019,

As the Notification was not issued, the following issues arose in the DHFL case:

  • While DHFL continued to be the servicer of the pool underlying the securitisation transaction, it held that transferring of collections from securitised assets and liquidation of cash collateral by the trustee would be in violation of the NCLT order declaring moratorium, and therefore, refrained from depositing the collections from securitised assets into the respective collection and payout accounts.
  • The accessibility of cash collateral to trustee was, thus, restricted as DHFL informed the trustees that until the Central Government notification related to “dealing with third party assets” is issued, transfer/ appropriation/ enforcement of security or collateral will be in contravention of the Code.

 THE NOTIFICATION:

To secure the rights of banks under securitisation agreements for cases, and put an end to the unwarranted circumstances in future as in case of DHFL, the Central Government issued the Notification, which casts the following obligations on the administrator of the FSP:

Dealing with third party receivables:

  1. Where a FSP is contractually obliged, as on the insolvency commencement date, to act as a servicing or collection agent on behalf of third parties, the administrator is required to prepare a statement of such transactions and respective agency contract.
  2. The administrator is required to continue to discharge the obligations of the FSP as a servicing or collection agent.
  3. The administrator is required to ensure that the receivables collected in respect of securitisation transactions are deposited and maintained in a separate account and are not merged with the funds or other assets of FSP.

Dealing with Third Party Assets:

  1. Where the FSP has, as on the insolvency commencement date, in its custody or possession assets owned by third parties, and is under an obligation to return or transfer such assets in accordance with the terms and conditions of the contract, the administrator is required to prepare a statement of such assets and the respective contracts.
  2. Further, the administrator is required to ensure that third party assets are maintained in a separate and distinct manner, capable of identifying them contract-wise, and are not merged with those of FSP.
  3. The administrator is required to return or transfer such assets to the person entitled to receive it in accordance with the terms and conditions of the contract, however, when due to breach of the terms of the contract, the FSP becomes entitled to retain certain assets or dispose of the same, the administrator shall not be required to return such assets.

PRACTICAL OBSERVATIONS:

1.   Appointment of alternate servicer or collection agent:

In securitisation transactions, while the originator of the loan (assignor) is appointed as the servicer or collection agent on behalf of the assignees, the assignees are provided with the sole and unquestionable right to replace the servicer with an alternate servicer, particularly in the case of event of default (insolvency is an event of default in all the cases). In our view, the obligation cast upon the administrator to continue acting as collection agent does not take away/ restrict such right of the assignee in any manner. If the assignees do not avail the option of appointing alternate servicer and is desirous to continue with the services of the FSP, only in such cases, the administrator will act for the FSP. Also, immediately, on termination of the services of the servicer, the servicer is required to transfer to the alternate/ successor servicer, the custody of all loan agreements, underlying documents, electronic payment instruments, cheques including post-dated cheques, drafts, instruments (if any), demand promissory notes, correspondence, records, information and monies held by the servicer with respect to the assets

2.   Operation of collection accounts:

Generally, it is seen that the receivables are first collected and deposited by the servicer in one common account, and thereafter disbursed to the beneficiaries as per the waterfall provided in the assignment agreement. The Notification provides that the administrator will be required to maintain separate collection accounts for each securitisation transaction. The requirement to maintain separate accounts means the administrator, on appointment, will be required to open separate bank accounts for collection of funds received from each assignment, which might result in administrative difficulties.

3.   Commingling of pool of loans:

The Notification provides that the administrator shall prepare a statement of assets and the respective “contracts” and further stipulates that the administrator shall ensure that such assets are maintained in a separate and distinct manner, capable of identifying them “contract-wise”. In securitisation transactions, a pool of loans are transferred to the assignee vide an assignment agreement, the language of the Notification may give rise to a confusion as to whether the term “contract” is used for loan agreement or assignment agreement. In our view, the intent was to distinguish between each securitisation transaction and not individual loans.

4.   Security interest enforced by the administrator on behalf of the assignee:

While the Notification provides that the assets which continue to be in the custody or possession of the FSP as on the insolvency commencement date shall be dealt with in the manner provided in the contract, there may be certain assets which might subsequently come in possession of the FSP/ administrator, the Notification is not clear about the treatment of such assets. We believe that the assets which subsequently come in possession or control of the FSP will also be dealt with in the same manner, i.e. in accordance with the terms and conditions of the respective assignment agreements.

CONCLUDING REMARKS:

While there seems to be some relief to the financial sector, since the Notification delinks the insolvency of one FSP from affecting the other financial entities, there still exists ambiguity so far as the scope of the term “third party” is concerned. Also, there is a need to clarify the manner in which third party assets is to be treated in resolution plans or in case of liquidation.

 

[1] https://ibbi.gov.in//uploads/legalframwork/cb1d53c7fe47f8f22ab36a40f441db2c.pdf

[2] See http://vinodkothari.com/2019/11/fsp-insolvency-rules/

[3] http://egazette.nic.in/WriteReadData/2020/215832.pdf

[4]https://bombayhighcourt.nic.in/generatenewauth.php?auth=cGF0aD0uL2RhdGEvb3JpZ2luYWwvMjAxOS8mZm5hbWU9SUEzMTExOTEzMTExOS5wZGYmc21mbGFnPU4mcmp1ZGRhdGU9JnVwbG9hZGR0PTE0LzExLzIwMTkmc3Bhc3NwaHJhc2U9MzEwMTIwMTcwNzQ1

[5] https://ibbi.gov.in//uploads/legalframwork/902f83c01c5698018a07df94bd519c0f.pdf

 

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