Registration of Security Interest and Rights of Secured Creditors under IBC
– Sikha Bansal, Partner & Neha Malu, Senior Executive | resolution@vinodkothari.com
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CERSAI beyond SARFAESI – The multi-faceted effects of security interest registration
– Sikha Bansal and Anirudh Grover | finserv@vinodkothari.com
Introduction
The rights of secured creditors are spread across various laws: common law, Companies Act, Insolvency and Bankruptcy Code (IBC) and the SARFAESI Act. In equal measure, the preconditions which are requisite to assert these rights are also spread over those very laws.
It is lamentable that the security interest registration regime in India is fragmented, without any obvious sense of purpose or direction. This was discussed in our previous article Fragmented Framework for Perfection of Security Interest[1].
Read more →The sale of season: Holding period requirements for assignments and securitisation
– Team Finserv | finserv@vinodkothari.com
Any sale or assignment or transfer, including securitisation, of loans is subject to a minimum seasoning with the originator. Under the extant regulatory provisions, such requirement is referred to as ‘Minimum Holding Period’ (MHP), which means the minimum period for which the originator should have held the loan exposures before the same is transferred to the transferee or Special Purpose Entity (SPE), as the case may be. This serves several purposes: that the loan was not originated for sale, the originator has had some equity in the loans, and that there is a benefit of hindsight of performance.
MHP requirements have always been a part of the regulations in India. However, on December 5, 2022, the Reserve Bank of India (RBI) made certain amendments to the Master Direction – Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021[1] (‘TLE Directions’) as well as the Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021[2] (‘SSA Directions’). Among the other changes, there was a change in the MHP provisions; this change may have a significant impact on future transactions.
This write-up intends to clarify the position with respect to the computation of MHP for different types of loans under TLE Directions as well as SSA Directions.
Read more →Memorandum of Entry for equitable mortgages: A Mortgage by Conduct?
– Neha Sinha, Assistant Legal Advisor | Shraddha Shivani, Executive | corplaw@vinodkothari.com
Mortgage is a transfer of an interest in a specific immovable property for the purpose of securing the payment of money advanced or to be advanced by way of loan, an existing or future debt or the performance of an agreement, which may give rise to a pecuniary liability.
Section 58(f) of the Transfer of Property Act, 1882 (“TP Act”) provides, among other modes, for the creation of mortgage by deposit of title deeds, widely known as equitable mortgage. Applicable to the notified towns under this provision, when a person delivers to a creditor or his agent documents of title deeds to immoveable property, with an intent to create security, then the transaction is called mortgage by deposit of title deeds.
Legally there is no document needed to create an equitable mortgage. In fact, if there is a document, it will be mortgage by instrument and not mortgage by conduct, and hence, will cease to be an equitable mortgage. The Supreme Court expounded in Rachpal Mahraj v. Bhagwandas Daruka and others[1]–
“…when the debtor deposits with the creditor the title deeds of his property with intent to create a security, the law implies a contract between the parties to create a mortgage, and no registered instrument is required under section 59 as in other forms of mortgage.”
However, in practice, a memorandum accompanies the deposit of title deeds. The lender may execute a Memorandum of Entry (“MoE”) which records the delivery of title documents for the creation of mortgage by the mortgagor to the lender. The purpose of the MoE is most intuitive – the title deeds are valuable documents, and lie with the lender or a trustee for the lender. The MoE serves as a matter of record that the borrower placed these documents of his own free will with the intention to create a charge on his property with the lender/trustee, as also serves as a safeguard if the borrower were to play mischief claiming those very title deeds having been lost.
The borrower may also give an undertaking known as Memorandum of Deposit of Title Deed (“MoDT”) which states that the borrower, at his own free will, has deposited his property’s title document with the lender in order to secure a loan by creating a mortgage.
Read more →Tax dues subservient to dues of secured creditors under SARFAESI Act and RDDB Act
Neha Sinha, Executive, Vinod Kothari & Company
corplaw@vinodkothari.com
Introduction
SARFAESI Act and RDDB Act are specific laws for recovery of debts. Both these laws provide that the secured creditors can claim priority for the realisation of dues. On the other hand, State and Central tax authorities can also enforce the payment of tax dues under tax statutes, which often create a statutory first charge in favour of the authorities. This may give rise to situations wherein the secured creditors are competing with the tax authorities in respect of payment of dues. Such competing claims have to be resolved in case of insolvency/deficiency.
A similar situation arose in the case of Jalgaon Janta Sahakari v. Joint Commissioner of Sales.[1] The Division Bench of the Bombay High Court decided on the issue of the conflict between SARFAESI Act and RDDB Act, and State tax statutes, in respect of priority of claims. The primary that arose in this case was whether State tax authorities can claim priority, by virtue of first charge created under State tax statutes, over a secured creditor for liquidation of their respective dues.
Chapter IV-A of the SARFAESI deals with registration of charges by secured creditors and. Pursuant to section 26D therein, a secured creditor who has not registered the charge loses his right to enforce the security under SARFAESI. Section 26E, which has a non-obstante clause, accords priority to the secured creditor who has registered the charge in the CERSAI, over “all other debts and all revenue, taxes, cesses and other rates payable to the Central Government or State Government or local authority.” Similarly, section 31B of the RDDB Act gives states that “notwithstanding anything contained in any other law….rights of secured creditors shall have priority and shall be paid in priority over all other debts and Government dues including revenues, taxes, cesses and rates due to the Central Government, State Government or local authority.” Pertinently, the aforesaid provisions in both Acts have a non-obstante clause, having the effect of overriding any other law inconsistent with it.
In the instant case, by virtue of relevant State tax statutes, a first charge was created in favour of State tax authorities. This brings forth the conflict as to who shall have priority in terms of payment- that State tax authorities with first charge or the secured creditors with the registration of charge in CERSAI?
Mortgage on movable property – whether another lucrative option for lenders?
– Sikha Bansal, Partner & Shraddha Shivani, Executive | corplaw@vinodkothari.com
Introduction
Pledge[1], hypothecation, mortgage – these are all forms of security interest[2], albeit with different features. Although the common objective of any form of security interest is to create a right in rem[3] (rather than in personam[4]) in favour of the lender, the effectiveness of the security interest would depend on the extent of overarching rights created by such security interest in favour of the lender. In another article[5], we have drawn a quick snapshot of the characteristics of each form of security interest. For instance, in hypothecation, the lender does not have any right of possession or any beneficial interest in the property, and the lender’s rights are limited to cause a sale on default; on the other hand, a mortgage (depending upon the type) may have far better rights – including the right to have the title, beneficial interest, etc. In fact, as we discuss elaborately in this article, a mortgage has several motivations for the lender.
However, a conventional notion around mortgages has been that the concept of ‘mortgage’ is only applicable to immovable property. This common view arises in view of explicit provisions under the Transfer of Property Act, 1882 (‘TP Act’). On the other hand, there are no written/codified provisions on mortgage of movable property. It is not that the Courts have not discussed and debated on the same. There have been ample opportunities before the Courts (as this article highlights), wherein Courts have upheld mortgages of movable properties as well. As such, it cannot be said that there has not been any decisive jurisprudence around the subject, however, the recent ruling of Supreme Court in PTC India Financial Services Limited v. Venkateshwar Kari and Another strongly revives the discussion and reinforces the argument that ‘mortgage of movables’ is perfectly possible, although not exactly in terms of the Contract Act; however, under common law principles of equity and natural justice. In fact, in his book Securitisation, Asset Reconstruction and Enforcement of Security Interests, Vinod Kothari, has discussed about ‘chattel mortgages’.
Here, it is important to understand the relevance of this discussion. As we discuss below, a mortgage is seen as the strongest form of security interest – a pledge or a hypothecation create much lesser rights in favour of the secured lender. Hence, from a lender’s perspective, it is always beneficial to have ‘better’ rights in terms of beneficial interest and control. Also, mortgages can be of various kinds (as discussed below), hence, the parties may have the flexibility to structure and opt for a suitable form of security interest.
The article thus, studies the jurisprudence around mortgage of movable property, and the principles which must be followed in order to effect the same. The article also studies how the PTC India ruling has revived the discussion around mortgage of movables. However, before we do so, it would be extremely important to understand the features of a mortgage and how a mortgage can be used as a superior tool of security interest.
Read more →Broken Pledge? Apex Court reviews the law on pledges
By Vinod Kothari, Managing Partner, Sikha Bansal, Partner and Shraddha Shivani, Executive | corplaw@vinodkothari.com
The Supreme Court ruling in PTC India Financial Services Limited v. Venkateshwar Kari and Another is significant in many ways – not that it categorically rewrites the law of pledges which is settled with 150 years of the statute[1] and even longer history of rulings, but it surely refreshes one of the predicaments of a pledge. Importantly, since most of the pledges of securities currently are in the dematerialised format, it brings out a very important distinction between the meaning of ‘beneficial owner’ under the Depository law, and the right of the pledgee (a.k.a. pawnee or security interest holder) to cause the sale in terms of the rights arising under the pledge. Also, very importantly, the SC dwells upon the essential principle of equity of redemption in pledges and renders void any provision in the pledge agreement which allows the pledgee to make a sale of the pledged article without notice to the pledgor, or to forfeit the pledged article and convert the same as pledgee’s own property. There are also observations in the ruling that seem to give an indefinite time to the pledgee for the sale of the pledged property – this is a point that this article discusses at some length.
Read more →Special Situation Funds: Funds into asset reconstruction business
Aanchal Kaur Nagpal (Assistant Manager) | Parth Ved (Executive)
Introduction
The intent behind asset reconstruction is not merely concerned with realisation of bad loans but also ‘reconstruction’, that is, to try and resurrect bad loans or bad borrowers into good ones. This almost always leads us to one name i.e. Asset Reconstruction Companies (‘ARCs’). Today, financial institutions are eager to sell their non-performing assets to clean-up their books while stressed companies find ways to get access to capital to anchor themselves. The Indian financial sector is known to be laden financial entities struggling to survive with their mammoth stressed assets. The COVID-19 pandemic has only added fuel to the fire. As at September, 2021, GNPA of banks was at INR 4,53,145 crore and that of the top 30 NBFCs, including HFCs stood at around INR 84,000 crore. Out of these loans, In 2019-20, the amount recovered as per cent of the amount involved under IBC was 45.5 per cent, followed by 26.7 per cent for ARCs. While the amount recovered through ARCs as per cent of amount involved was significantly higher in the initial years of their inception, in the recent years, it has dipped below 30 per cent except for a spurt in 2017-18.
Securities and Exchange Board of India (‘SEBI’) on January 24, 2022[1] along with its circular dated January 27, 2022[2], has further widened the NPA market to a specifically dedicated class of AIFs called Special Situation Funds (‘SSFs’), that shall exclusively invest in the distressed asset market. The intent behind the same is to use these cash-filled alternative funds to supplement ARCs in acquiring such stressed assets and aid banks and other financial institutions to release critical money choked up in such assets. AIFs are currently already permitted to invest in security receipts of ARCs and/ or invest in securities of distressed companies, however, SSFs will be additionally permitted to even acquire stressed loans. These SSFs also have been granted additional exemptions/ benefits over and above regular AIFs to facilitate stressed asset resolution.
This article attempts to cover the adoption of the concept of SSF from the global markets, and the characteristics of this peculiar kind of investing. Read more →
Credit Default Swaps (Global and Indian Scenario)
Other ‘I am the best’ presentations can be viewed here
Our other resources on related topics –
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- https://vinodkothari.com/wp-content/uploads/RBIa%CC%82%C2%80%C2%99s-Guidelines-on-Credit-Default-Swaps-for-Corporate-Bonds.pdf
- https://vinodkothari.com/2021/02/rbi-issues-draft-directions-on-credit-derivatives/
- https://vinodkothari.com/isda_new_definition_credit-derivs_impact/
- https://vinodkothari.com/2013/12/secnews-110810/
- https://vinodkothari.com/rbi-new-cds-guidelines-feeble-effort-start-non-starting-product/
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A Guide to Accounting of Collateral and Repossessed Assets
-Financial Services Team ( finserv@vinodkothari.com )
The purpose of reporting in accordance with International Financial Reporting Standards (IFRS) is to provide financial information about the reporting entity that is useful to various stakeholders in making decisions about providing resources to the entity.
To satisfy the objective of IFRS/Ind AS reporting, to a large extent, based on estimates, judgements and models rather than exact depictions. In other words, the use of reasonable estimates is an essential part of the preparation of financial statements and does not undermine their reliability.
Understanding Collateral
Collateral is one or more assets that a borrower offers to a lender as security for a loan, with the intent that if the borrower defaults in making the promised loan payments, the lender has the right to seize the collateral, sell the same and realise the amounts due. Since collateral offers a security to the lender should the borrower default, loans that are secured by collateral typically carry lower interest rates than unsecured loans.
Needless to say, secured lending forms a very important segment of the world of finance.
Although the legal rights that flow from collateral are typically specified in the loan agreement, law in some jurisdictions might specify particular overriding rights, obligations, restrictions, etc. In some cases, at the commencement of the loan, collateral is physically transferred from the borrower to the lender. These security interests are called possessory security interests – a pledge is an example of a possessory security interest. There are other types of security interests which are non-possessory, which are known as hypothecation, lien or charge in different jurisdictions. A mortgage in English and Indian law has a different connotation – it creates a property right in favour of the lender to secure the loan; hence, it results into transfer of specific title[1].
Irrespective of the form of collateral, it is clear that collateral is merely security interest, and not property interest. While covenants of security documentation may differ, the most common security document allows the lender to sell or cause the sale of the collateral upon default of the borrower.
Accounting of Collateral
Secured Loans:
When a financial institution (FI) extends a secured facility, it recognises loan as its asset, as the benefits accruing to the entity would be on account of loan provided. The security would only act as backstop measure in case the performance of the loan deteriorates. Further, the entity’s interest lies in the loan not in the charged asset.
However, this does not imply that security on a loan would go unnoticed while accounting for the loan asset. Collateral and other credit risk mitigants are important factors in an entity’s estimate of Expected credit losses (ECL).
Consequently, IFRS 7 Financial Instruments: Disclosures specifies that an entity must disclose information that enables users of its financial statements to evaluate the nature and extent of risks arising from financial instruments to which the entity is exposed at the end of the reporting period and how those risks have been managed by the entity (paragraphs 31 and 32). When relevant, an entity’s risk management disclosure would include its policies and procedures for taking collateral and for monitoring the continuing effectiveness of collateral in mitigating counterparty credit risk. Paragraph 35K of IFRS 7 requires information that will enable users of financial statements to understand the effect of collateral and other credit enhancements on the amount of expected credit losses.
The Division III of Schedule III to the Companies Act, 2013 prescribes a separate disclosure for secured and unsecured advances. Further the impairment loss allowance for both asset categories is also presented along with the specific asset .
In short, disclosure of the collateral and credit enhancements is an important disclosure. The existence of the collateral itself may not change the carrying value of the loan, but it may have repercussions on the value of the ECL, as also, in case of fair-valued loans, on the risk-adjusted value by impacting the credit spread that is deployed as a part of the discounting rate.
Collateral and SPPI test
Simply payment of principal and interest (SPPI) test is one of the two tests that are required to be passed for a financial asset to be classified either as subsequently measured at Amortised Cost or at FVOCI. The test says that the contractual cash flows from the asset, on specified dates, should comprise only of principal payments and interest payments on the principal amount outstanding.
Paragraph BC4.206(b) of the Basis for Conclusions on IFRS 9 explains the IASB’s view that financial assets can still meeting the SPPI test, i.e., the contractual cash flows may consist solely payments of principal and interest, even though they are collateralised by assets. . Consequently, in performing the SPPI test an entity disregards the possibility that the collateral might be foreclosed in the future unless the entity acquired the instrument with the intention of controlling the collateral.
Accounting of Repossessed Assets
Assume the following facts: FI had a loan of Rs 1000 outstanding, which was in default. FI forecloses and repossesses the collateral, say a machinery, which is valued Rs 700 on the date of repossession. FI keeps the machinery pending disposal, and on the reporting date, the machinery is still in stock. Eventually, in the next reporting period, the machinery is sold, say for a net realisation of Rs 600.
Several questions arise – on the date of repossession, can FI remove loan to the extent of Rs 700 and debit it to machinery held for sale? What happens to the loss of Rs 100 on the sale – is it loss related to the loan, or loss related to disposal of machinery?
Questions like this are faced by financial institutions all the time.
Though accounting standards provide ample guidance on taking cognizance of collateral, specifically for credit risk assessment and asset recognition, the clarity is lost at the issue of accounting for repossessed assets. Accounting standards do not provide a clear view on how an asset should be treated when the entity enforces its right to foreclose and repossess the asset, and the asset is pending disposal. If the disposal of the asset has already been done, then the question of any accounting for collateral does not arise, as the collateral has already been disposed off. However, the accounting for the collateral itself, as discussed below, will affect the accounting for the disposal as well.
As regards accounting for the repossession of the collateral, some guidance comes from the Para B5.5.55 of IFRS 9/Ind AS 109 :
“…….Any collateral obtained as a result of foreclosure is not recognised as an asset that is separate from the collateralised financial instrument unless it meets the relevant recognition criteria for an asset in this or other Standards.”
The extract clarifies that mere fact that the asset is repossessed would not make it eligible for being recognised as an asset on the books, as the entity’s interest still lies in recovery loan, the entity would have no interest in the asset if not for dues under the loan.
Further, Para 7 of IAS 16 / Ind AS 16 states that
“The cost of an item of property, plant and equipment shall be recognised as an asset if, and only if:
(a) it is probable that future economic benefits associated with the item will flow to the entity; and
(b) the cost of the item can be measured reliably”
Hence, the FI can capitalise and record only such assets whose future economic benefits would accrure to the financial institution in question, that is, the lender. PPE classification is possible It may also be possible for an entity to hold the asset as an investment property, for disposal. There may be cases where the collateral may consist of shares, securities or other financial assets, or may consist of stock in trade or receivables.
Irrespective of the type of asset, the key question would be – has the lender acquired a property interest in the collateral, so as to have risks and rewards in the same, or the lender has simply acquired possession over the collateral for causing disposal?
Legal rights in case of collateral
The accounting here is impacted by the legal rights in case of collateral. To reiterate, we are stating here generic legal position, and it is possible that collateral documents bring rights of the lender which are differential. Further, the legal rights may vary depending upon the kind of security interest being created on the assets, e.g. a pledge would differ from a mortgage.
In the case of Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd[2] the Supreme Court, while also indicating the very distinction between a pawn and a mortgage, observed that even after a pledge is enforced, the legal title to the goods pledged would not vest in the pawnee. the pawnee has only a special property. A pawnee has no right of foreclosure since he never had absolute ownership at law and his equitable title cannot exceed what is specifically granted by law. The right to property vests in the pledged only so far as is necessary to secure the debt.[3]
Although, pledge has to be differentiated from a mortgage which wholly passes the thing in the property conveyed[4] However, as noted in , Narandas Karsondas vs. S.A Kamtam and Anr[5] it is important to note that the mortgagor does not lose the right of redemption until the sale is complete by registration. In selling the property, the mortgagee is not acting as the agent of the mortgagor but under a different (read: superior) claim. No equity or right in property is created in favour of the purchaser by the contract between the mortgagee and the proposed purchaser.
We have mentioned above that the legal rights of a lender differ (a) based on the law of the jurisdiction, as also consistent practices; (b) legal documentation. For instance, in case of mortgage, the common law provides two different rights of a mortgagee – the decree of sale and the decree of foreclosure [Section 67 of Transfer of Property Act, 1882] Decree of sale implies that the mortgagee may simply cause the sale of the mortgaged property. Decree of foreclosure is foreclosure of the mortgagor’s right of redemption, and the mortgagee, therefore, becoming absolute owner of the property. There are exceptional circumstances when this is possible, for example, in case of a mortgage by conditional sale.
In case of pledges too, while the general rule as set out in Lallan Prasad vs Rahmat Ali[6] and GTL Textiles vs IFCI Ltd.[7] is that the pledgee only has the right to cause sale.
In case of US practices, it is quite a common practice of mortgage lenders to hold the foreclosed property as Real Estate Owned.
Thus, there can be two situations:
- Case 1 – Lender acquires the asset as means of recovery and does not acquire any risk and reward in the property;
- Case 2 – Lender acquirers the property in the full and final settlement of the loan.
Our analysis of broad principles is as follows:
Acquisition as means of recovery
The lender could repossess the property as a result of the borrower’s default with the intention securing the possession of the collateral. The seeking of possession of the collateral is simply seeking the custody of the collateral. This is preventive – to ensure that the asset or its value is not prejudiced. This is intent when a court, receiver, arbitrator or similar agency seeks control over the collateral. The intent is custodial and not proprietary. The actual sale proceeds of the asset, as and when disposed of by the lender, will go to the credit of the borrower; any amounts received in excess of the mortgage balance will be refunded to the borrower; and any shortfall remains the obligation of the borrower.
The FI may continue to charge interest on the outstanding balance. The lender remains exposed to interest rate risk on the collateral but is not exposed directly to property price risk.
In such cases, there is no question of the loan being set off against the value of the collateral, until the collateral is actually disposed off. While giving the particulars of the collateral, the lender may separately classify collateral in possession of the lender, as distinct from collateral which is in possession of the borrower or third parties. However, the classification of the loan remains unchanged.
Acquisition of proprietary interest in the collateral:
The lender could repossess the property, which in terms of the law or contract, gives the lender absolute rights in the property. The lender may have the right to collect the unrealised amount from the borrower, or the obligation to refund the excess, if any, realised, but the issue is, does the lender acquire proprietary interest in the collateral, and whether the lender now is exposed to the risks and rewards, or the variability in the value of the collateral?
However, FASB has prescribed following guidelines to determine whether the charged asset would replace the loan asset. The FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure[8] provides that “a creditor is considered to have received physical possession of residential real estate property collateralizing a consumer mortgage loan, upon either upon
(1) the creditor obtaining legal title to the residential real estate property upon completion of a foreclosure or
(2) the borrower conveying all interest in the residential real estate property to the creditor to satisfy that loan through completion of a deed in lieu of foreclosure or through a similar legal agreement. “
In line with above, where the entity has acquired complete right over the asset there is no doubt that the loan account is closed, and the entity now hold interest entirely in the repossessed asset. Hence the company shall derecognise the loan asset and recognise the charged asset in their books. Whether the asset will be a real asset, financial asset, stock in trade, receivables, PPE or other investment property, will depend on the asset and the intent of the entity in holding it till disposal.
Accounting for repossession of the collateral:
In the above case, the entity should fair value the collateral on the date of seeking repossession, and to the extent of the fair value, the asset should be debited, crediting the loan. Whether the asset will continue to be subjected to fair valuation, or historical cost valuation, will depend on the applicable accounting standard for the type of asset in question.
any subsequent movement in the value of the collateral will affect the entity, and not the borrower.
Conclusion
Given the current stress in the economy, the rates of default on loans collateralized by all kinds of properties – residential real estate, commercial real estate, vehicles, consumer durables, etc., have zoomed up. There will be substantial collateral calls in time to come, and therefore, the need to have clarity on accounting for collateral is more today than ever before.
This article has tried to fill an apparent gap in literature on accounting for collateral. We will want to develop this article further, with numerical examples, by way of further updates.
[1] Different forms of security interests are discussed at length in Vinod Kothari: Securitisation, Asset Reconstruction and Enforcement of Security Interests. Lexis Nexis publication
[2] Balkrishan Gupta And Ors vs Swadeshi Polytex Ltd
[4] Lallan Prasad vs Rahmat Ali
[5] Narandas Karsondas vs. S.A Kamtam and Anr
[6] Lallan Prasad vs Rahmat Ali
[8] FASB guidance on Reclassification of Residential Real Estate Collateralized Consumer Mortgage Loans upon Foreclosure