LEGAL ASPECTS OF NON-PERFORMING ASSETS
G J BULSARA*
KNOWHOW FOR MANUFACTURE AND TECHNIQUES TO ELIMINATE NON-PERFORMING ASSETS BY PROCESS OF SECURITISATION
Securitisation
The concept of securitisation has been adopted more recently from the American financial system and has been described as processing of acquiring financial asset and packaging the same for investments by several investors. The term ‘securitisation’ has not been defined as such, but has been used in certain rules, regulations and notifications. In the recently enacted the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (for short “the Securitisation Act”) the term securitisation has been defined as “acquisition of financial assets by any securitisation company or reconstruction company from any originator, whether by raising of funds by such securitisation company or reconstruction company from qualified institutional buyers by issue of security receipts representing undivided interests in such financial assets or otherwise”.
The Securitisation Act, 2002
The Securitisation Act has been enacted mainly for tackling the growing menace non-performing assets by securitisation of assets by sale to ARC, which is to issue of security receipts to the investor and for enforcement of security interest by banks and financial institutions. Initially, many were delighted to find that the securitisation process as a class has come to stay in the Indian legal system, and the problem of the non-performing assets of banks and financial institution would stand resolved since the banks and financial institutions would be able to enforce its security interest without intervention of the courts. The quantum of non performing assets has been growing by leaps and bounds and has been playing havoc on the Indian financial system since as at the end of the year 2001 the total amount of outstanding NPAs stood at Rs.83,500/- crores. After enactment of the Securitisation Act, 2002 the wilful defaulters cannot now hide behind long-winded judicial process but at the same time the bank also cannot recover dues arising out of underwriting commitments obligations and equity finance by way of share subscriptions, so also the shares acquired by exercise of option for conversion of loan into equity. The Securitisation Act, 2002 does not also ensure or guarantee full recovery of the entire outstanding over dues fully. In the result the financial health of the banks will not improve because, in absence of adequate assets not more than 20 percent of NPAs would be recovered by resorting to the provisions of the Securitisation Act, 2002. The IT Tribunal ruling in case of Vishvapriya Financial Service and Securities Ltd would jolt development of asset securitisation in autofinance and housing finance sector. The company was utilising funds obtained from the investors for deployment in fixed income security and had guaranteed fixed rate of return. The contention of the company that it was only agent for the investors and has evolved only a pay-through structure was not accepted by the tribunal, which held that the company was liable for the withholding taxes on the payments made to the investors.
Growth of Banking Practice in India
In the long run from the concept of ancient money lenders, India march forward to the realm of banking, which has since branched out in the concept of the development banking, the narrow banking and the universal banking. So also from simple current and savings bank accounts, the bank finance has extended to structured finance, trade finance and export finance and finance for
*ACS, LL.M., CAIIB.
infrastructure, and the last few years saw emergence of fee based services in form of merchant bankers, financial advisers and managers to the public issue and private placement of shares debentures and bonds, syndication of loan facilities, external borrowings, forex services, treasury management and more recently investment and portfolio management, e-broking and derivatives, futures and options trading facilities plus back office services and services in takeover, mergers, acquisitions and amalgamations, mostly through the bank subsidiaries or associates arms.
Reasons for Growth of NPAs
The development and proliferation in the activities of the bank has led to ever-increasing non-performing assets that has mounted to an enormous amount during the last decade or so. The quantum of NPAs has been calculated and put at different figures mainly due to absence of proper statistics and the method on the basis adopted for calculating the percentage of NPAs in relation to either the total assets of the bank or the amount of loan portfolio or on the basis of the number of the accounts or the size of the outstanding advances. But till recently little attention was paid to the real reasons as to why and how non performing assets have appeared in the books of the banks and also the books of many of the financial institutions. For a large number of years, the banks have been taking credit in its books, on basis of accrued interest income, even for the amount of periodic interest that was not actually paid by the borrower. This was done by raising debit in suspense account and crediting amount equal to the periodic interest in the loan account of the borrower. After objections from the auditors and income tax authority the banks changed strategy and started giving additional loans to the defaulting borrowers for the purpose of making payments to the bank for adjustment of the overdues, in many cases the due dates of payments were postponed and even the entire duration of the loan was extended further again and again. As if to add fire to the fuel, ambitious programme for branch development and extension of banking services led to new recruitments, transfers, relocation and unhealthy competition amongst offices of the same bank, but at the same time adequate facilities available for training of the staff were not expanded. In the anxiety to achieve business targets the rules and procedures for prudent banking were conveniently forgotten. Even the higher management setup conveniently relaxed the rules for proper appraisal of the loan proposals, the provisions of standard bank sanction letter, errors in execution of the loan agreements, deeds of hypothecation and mortgages were more often overlooked for compliance in the hurry for disbursement and achievement of targets for purposes of building up record of achievements and reporting.
Off Balance Sheet Transactions (OBS)
The Banks in India are long familiar with off balance sheet finance by way of standby letters of credit, revolving letters of credit, repurchase agreements, backup line of credit for issue of commercial paper, note issuance facility, interest rate exchange and swap and hedging transactions. Some of these OBS transactions are intended to avoid and circumvent regulatory taxes like payment of deposit insurance premium, cash reserve requirements and capital adequacy norms, but the securitisation and sale of loan portfolio and receivables as form of OBS transaction tops the list, so much so that even the income tax, capital gains tax, sales tax, lease tax and tax on transfer of right to use the property, as applicable are not paid since the OBS transaction is seldom reflected in the balance sheet of the bank or the borrower company concerned. Further, the OBS transactions eliminate funding risk and even the credit risk. In India the banks and institutions and also the investors and the borrowers were too happy to finance off balance sheet transactions. Even though assets given on hire purchase basis do appear in the balance sheet of the company, the future receivables in form of hire charges payable by the hirer are not shown in the balance sheet of the originator. It is very happy situation for the originator to sell the future receivables and raise finance and show surge in the case on the balance sheet and raise the bottom line and also the top line. Further, for the financing bank, it was much more advantageous as the amounts paid are shown as investments in PTC and not as the loan transaction. This type of structures of giving finance by investment in PTC and not as a loan, the financing bank has easy escape from CRR and SLR requirements. As the future receivables are purchased at discounted value and the banks could easily amount of liability under the Interest Tax Act, 1974 for the period before the interest tax was withdrawn. The originator also benefited by securitisation and sale of future receivables on which the originator need not now pay hire purchase tax. The originator has added advantages because of sale of receivables, an amount of cash is generated and shown in the balance sheet even without the removal of any assets. In this way the originator could show better results, improve balance sheet figures and raise further finance
O Lord forgive them, for they know not what they are doing
The term securitisation was not defined but was used in the year 1994 in the Maharashtra Government Notification under the Bombay Stamp Act, 1958 dealing with reduction of stamp duty in respect of “instruments of securitisation of loans or of assignment of debt with underlying securities” chargeable under the Schedule I, Article 25(a) of the Bombay Stamp Act, 1958. Subsequently, SEBI amended the SEBI (Mutual Funds) Regulations, 1996 and the Seventh Schedule dealing with Restrictions on Investments by mutual funds and allowed mutual funds to make investments within the prescribed limits “in the mortgaged-backed securitised debt”. More recently, even the recognized Stock Exchanges have started listing of the PTC (Pass Through Certificates), without realizing that the PTC is not a “security” within the meaning of the definition of the term “Security”, as given in Section 2(h) of the Securities Contracts (Regulation) Act, 1956. Soon thereafter some of the banks and even public financial institutions started business of securitisation of future receivables. Credit Rating Agencies started assigning triple-A ratings to the PTCs on basis of feedback and select information supplied at the instance of the hire-purchase and lease finance companies. Certain State Governments followed the bandwagon and notified reduction in stamp duty on securitisation transaction, even though the expression securitisation was nowhere defined in the relevant Stamp Act provisions as applicable in the State concerned or in the Indian Stamp Act, 1899.
Why banks could not prevent loan defaults
The banks are required to give loans under the priority sector lending and complete requisite quota for each of the segments for the reporting year. In case of agriculture lending the rural borrowers are often under impression that the disbursement is by way of grant and there is no need for any repayment. Very often the loan documents are not properly signed by the particular borrower. The amount and the rates of interest are higher than what was conveyed to the borrower. Most of the time the borrower has not benefitted and in absence of higher earnings, the repayments of the bank loan cannot be made. Even in the urban sector and in towns and cities situation is no better. At times accounts are opened without proper identification and due introduction. This is mainly due to procedural lapse and inadequate control mechanism and loosening of bank supervision. Every type of fraud is committed often with connivance with the staff, perhaps due to absence of proper reporting and due vigilance. The instruments are stolen in transit and encashed fraudulently. The remittance of cash, money transfers and issue of demand drafts often fall to fraudulent practices.
Where the buck stops
All the ills for mounting figure of loan defaults and rising amount of NPAs are invariably put at the door of the legal system and procedural delays, costs and expenses involved and the lengthy procedures involved in litigation and execution of decrees obtained from the court. Even provisions contained in law for corrective action by way of review and appeal against judgments of the trial courts are branded as causes for delay in recovery of loan from the defaulting borrower. But the same persons when aggrieved by order for transfer or non-promotion himself approaches the temple of justice for redress of his own grievance. The Securitisation Act, 2002 seeks to improve mechanism available to the secured lender for enforcement of the security interest held by them, but fails to notice the difference between willful defaulter and the borrower who is unable to make payments on the due dates due to change in market conditions and regardless of the intention or the reasons leading to such defaults like change in government policy, competition from new technology, power shortages. No attempt is made for inducting fresh finance to tide over the difficulty or for diversification, upgradation or rehabilitation of the defaulting unit. Implementation issues relating to management and financing of the business of the company are mostly ignored before taking drastic step for sale of the units by the lenders.
The potential buyers would turn weary as no one wants to pay for the mortgaged unit in forced sale anything more than its scrap value. Taking over of the defaulting company, which has unpaid secured over dues will only go to deter the ARC as also the potential buyers, who would make payments after borrowing from the banks and financial institutions as the lenders.
The potential buyers has become weary and can therefore offer only the scrap value, for purchase by the same management in the name of new promoters, with moneys raised from the same lender bank, which initiated steps for enforcement of security against the borrower concerned. Take over of the defaulting unit with large amounts of overdues would only go to deter the ARC and potential purchaser. It seeks to improve mechanism available to secured creditors for enforcement of the security available to them.
Securitisation Versus Securitisation
The Securitisation Act has been enacted for dealing with and solving problem of NPAs, but look at the manner in which perfectly healthy accounts with AAA ratings are now being securitised for raising finance that is free from regulatory requirements prescribed by the Reserve Bank or SEBI. Mostly the hire-purchase and loan receivables generated by non-banking finance companies, hire purchase finance companies, housing finance companies and even commercial bank loans receivables are purchased in the guise of securitisation by an SPV established in the form of a trust, set up by the non-banking finance company itself, and thereafter receivables are sold to mutual funds as the Investors by issue of Pass Through Certificates (PTC). By device of issuing PTC, the SPV merely undertakes to pass on the receivable to the PTC holder, only after and on condition that the loan receivables are paid by the hirer or the borrower concerned and received by the non-banking finance company as the originator. There is no independent obligation or any assurance by the SPV or the Trustees of the SPV to independently make any payments, unless the regular payment is made on due dates by the hirer or the loan borrower to the originator. There is absolutely no indemnity or any guarantee or even an assurance provided to the holder of PTC regarding due and timely payment of the periodic payments falling due to the PTC holder, as the investor. The PTCs are not negotiable instruments and are not transferable by endorsement and delivery. There is no statutory register of PTC holders and therefore there is no question of transfer of PTC by execution of duly stamped and registered formal transfer deed, as in the case of shares and debentures. These are also not approved securities for the purpose of investments by a banking company, a financial institution or by public or charitable trust or by LIC, GIC and its subsidiaries. Further, the amounts due and payable under the PTC cannot be recovered even by the bank or financial institution as the holder thereof by application made to the Debt Recovery Tribunal. The benefits available under Section 88 of the Income Tax Act for repayment of housing loans for construction or acquisition of residential house would no longer be available after the housing loan portfolio along with the security interest therein stands transferred and assigned by way of securitisation by the housing finance company. While adopting securitisation of mortgage debt as a new tool for financing the banks have failed to appreciate that MBS is the same instrument as a secured non convertible debentures. There is no legal basis for securitisation of the mortgage loans and the holder of the MBS will be unable to enforce the mortgage or to sue for sale of hypothecated movable assets.