Emerging Landscape for Asset Reconstruction Companies – By Satish Kumar Gupta, Insolvency Professional

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Emerging Landscape for Asset Reconstruction Companies

Opportunities and Challenges

“With increasing stressed assets in the financial eco-system, ARCs strive to face greater challenges to capture these opportunities”

[Satish Kumar Gupta is as a stressed asset specialist with more than 25 years of experience. He was the Resolution Professional for Essar Steel India Ltd, the largest account under IBC, which got successfully resolved recently. He can be reached on satishkg.ip@gmail.com.]

ARCs have been playing an important role in the resolution of stressed assets by adapting their business model and aligning with ongoing ever evolving regulatory changes. ARCs are enhancing their role in stressed assets space by co-investing with various investors by leveraging on the unique advantages available with ARC structure and becoming a source of alternative capital for banks. ARCs are playing critical role as more and more ARCs are bidding for large IBC accounts and distressed NBFCs portfolios. Multiple ARCs are present in IBC bidding or purchase of NPAs which demonstrates active participation on its own and/or on behalf of investors to tap large pool of capital available. However, ARCs face multiple challenges also before it takes quantum jump to tap these opportunities.

Current Scenario

As per recent Financial Stability Report of RBI, the gross and net non-performing asset (GNPA and NNPA) ratios of all SCBs were at levels of 8.5 per cent and 3.0 per cent in March 2020. As per aforesaid report, given the fact that impact of moratorium is still uncertain and evolving, the exact nature of how the same will play out on the quality of banking assets is difficult to ascertain accurately. The stress tests indicate that the GNPA ratio of all SCBs may increase from 8.5 per cent in March 2020 to 12.5 per cent by March 2021 under the baseline scenario. If the macroeconomic environment worsens further, the ratio may escalate to 14.7 per cent under the very severely stressed scenario. Similarly, NBFCs’ Gross NPAs which were at 6.3% of advances as of September 2019 are expected to reach above 9 per cent level as per various reports. NPAs of NBFCs comprising real estate loans, structured loans, etc. are additional pool of assets which are now available to distressed debt investors. The Government and RBI have announced various schemes and measures to reduce stress and NPAs which may not allow NPAs rising to such high levels. Still on account of large number of earlier NPAs, failure or non-fructification of earlier restructuring schemes, contraction in economy, fresh slippages etc., pool of NPAs and stressed assets is expected to increase significantly.

With banks currently sitting on large NPAs and stressed assets against which significant provisions have been made, banks would be able to undertake sale of these assets comfortably. In large assets, banks can undertake consortium sale of stressed assets to ARCs and distressed debt investors for its expeditious resolution. While opportunities are large from banks and NBFCs, ARCs face challenges in raising capital, by way of increased regulatory oversight, transparency and increased participation of SR holders in decision making.

Details of financial assets securitized by ARCs in last four years till June 2019 as per RBI report are as given below:

 

Item

Jun-16

Jun-17

Jun-18

Jun-19

1.

Book Value of assets Acquired

2,37,653

2,62,733

3,30,563

3,88,069

2.

Security Receipts issued by SCs/RCs

79,020

93,918

1,20,308

1,46,409

3.

Security Receipts Subscribed to by:

 

a) Banks

65,119

77,653

95,951

1,01,733

b)SCs/RCs

11,406

14,159

20,165

27,480

c)FIIs

326

326

505

1,735

d)Others (Qualified Institutional Buyers)

2,170

1,779

3,686

15,521

4.

Amount of Security Receipts completely redeemed

7,200

7,355

8,830

12,906

5.

Security Receipts Outstanding

64,117

78,312

98,118

1,14,615

Source: Quarterly statements submitted by ARCs

Difference of SRs of Rs 18,888 crore, though not explained in aforesaid RBI report, may be attributed to SRs written-off or loss assets/ zeroizing them after completion maximum resolution period of 5/8 years. Data regarding break-up of outstanding SRs held by banks, SCs/RCs, FIIs, NBFCs and QIB is not available.

As may be observed, 70% of SRs have been subscribed to by banks and accordingly 70% of outstanding SRs may have public money at risk. Latest figures of total financial assets securitized, break-up of SRs outstanding held by ARCs, Banks, FIIs, other QIB as on March 31, 2020 are not available in public domain though as per reports during year 2019-20 significant amounts of SRs have been redeemed.

Regulatory and Operational Issues

ARCs are under administrative control of RBI, are regulated by it and are subject to its audit and inspection. Further, ARCs are required to meet compliance requirements such as submission of quarterly statement on its operations to RBI. Higher regulatory and compliance requirements keep ARCs operational costs high.

In December 2019, RBI issued circular that ARCs shall not acquire financial assets on a bilateral basis from (i) a bank/ financial institution which is the sponsor of the ARC; (ii) a bank/ financial institution which is either a lender to the ARC or a subscriber to the fund, if any, raised by the ARC for its operations; (iii) an entity in the group to which the ARC belongs. However, such ARCs may participate in auctions of the financial assets provided such auctions are conducted in a transparent manner, on arm’s length basis and the prices are determined by market forces. Above shall provide level playing field and will discourage asset acquisition by ARCs on bilateral basis and sale by sellers to captive entities. 

In view of above restriction, in future many of captive/in-house ARCs may find it challenging to continue business on account of sub-optimal operations and may therefore yield space to large ARCs.

Financial Performance and Funding of ARCs

As per regulations, there is 15% ‘invest and hold’ requirement on the part of the ARCs in relation to each class of SR. ARCs cannot transfer this holding, which was Introduced as ‘skin in the game’ as long as class of SR is in existence. ARCs have to raise funds and maintain leverage keeping in account the risks associated with the distressed asset sector and the volatility of their earnings profile. ARCs mainly rely on the following sources of funds:

  1. Equity capital – 100% FDI is permitted in ARC sector;
  2. Bank borrowings or Non-Convertible Debentures;
  3. Principal protected market linked debentures; and
  4. Raising of funds against Fixed Deposits

Above borrowings by ARCs are normally secured by:

  1. charge on receivables;
  2. secured by exclusive pledge of ARCs own SRs held with cover from 1.5-2.0 times; and
  3. backed by an unconditional and irrevocable corporate guarantee issued by holding/parent company

ARCs raise funds by pledging its own invested SRs with its lenders, however, same can lead to breach of RBI regulations in certain situation. If lenders invoke pledge of 15% mandatorily held SRs on ARC defaulting to its lender, ARC may find itself not in compliance with RBI regulations. However, ARCs have been borrowing conservatively and no such situation has arisen so far.

ARCs have been strengthening their balance sheets with infusion of equity and long term borrowings and have reduced reliance on short term commercial papers significantly in last year. Edelweiss ARC with total borrowing of Rs 4375 crore has diversified sources of funding including asset specific borrowing wherein repayments are linked to recoveries of Rs 1,539 crore as on March 31, 2020. To raise capital, one of entities of CDPQ, one of Canada’s fund, has invested funds by convertible instruments in the Edelweiss group and is expected to hold 20% stake in Edelweiss ARC. Additionally, CDPQ has also committed to invest Rs 4,500 crore in distressed assets through SRs and other instruments.

JM Financial Ltd had also infused Rs 183 crore in H1FY2020 by subscribing to the rights offer made by JMF ARC for the issue of Compulsorily Convertible Debentures. ACRE ARC raised capital of Rs 70.77 crore during FY2019 which was largely subscribed to by its existing shareholders. It will be interesting to see resource raising by UVARC for its acquisition of Aircel and Reliance Communications. At present, UVARC, as per details from MCA, has borrowings from banks and one of funds of UTI.

Various funding routes by different ARCs are being used and explored, however, these should stand tests of regulatorily, trust and the Companies Act. ARCs are able to attract lot of funds as is evident from their interest in large IBC accounts and NBFCs bidding of portfolios.

The financial results of ARCs for year 2020 have been mixed. Whereas on one hand Edelweiss ARC, the largest ARC in the country, has reported net profit of Rs 301 crore, Phoenix ARC has reported net loss of Rs 5.5 crore (after expensing/providing net loss on account of fair value changes and impairment of financial instruments of Rs 114 crore). Edelweiss ARC’s improved performance was as a result of significant recoveries made from some of large IBC accounts as well as recoveries from a large number of NPA accounts acquired. Results of most of other ARCs are not available as these companies are unlisted.

Financial performance of some of the ARCs which are available in public domain are as follows:                                                                                                                   (Rs in crore)

Particulars

AUM

Net Worth

Total Income

Net Profit/(Loss)

Edelweiss ARC$

43,188

2,036

1,166

301

JM Financial ARC

11,489

1,450

414

42

Phoenix ARC

9,000(est.)

443

183

(5.5)

ARCIL #

11,902

1,945

329

149

UV ARC@

1,044

138

31

2.5

ACRE ARC %

9,353

161

168

41

Reliance ARC *

2,019

211

70

22

$ Covid related impairment on asset quality of ~ Rs 200 crore taken in Q4 2020. As per para 8 of financial results, Impairment Reserve has been created out of Reserves.
# Year 2019 Audited. Year 2020 – N.A.
% Audited Year 2019- From Brickwork Rating Rationale dated November 4, 2019
@ provisional Year 2020– From Brickwork Rating Rationale dated July 13, 2020
*provisional – Year 2020 -From Brickwork Rating Rationale dated April 30, 2020

Parameters of leverage for some of the ARCs, based on publicly available information and rating reports, are as follows:

Particulars

Debt Equity

Debt Service Coverage Ratio

Interest Service Coverage Ratio

Edelweiss ARC

2.15

0.86

1.47

JM Financial ARC

1.77

N.A.

N.A.

Phoenix ARC

1.35

0.12

0.96

ARCIL

0.14

N.A.

N.A.

UVARC

1.15

N.A.

N.A.

ACRE ARC

0.52

N.A.

N.A.

Reliance ARC

0.64

N.A.

N.A.

In order to promote quality and consistent implementation of Ind AS, as well as facilitate comparison and better supervision, RBI has framed regulatory guidance on Ind AS which will apply to ARCs for preparation of their financial statements from the financial year 2019-20 onwards. The guidelines mandate ARCs to put in place board-approved policies that clearly articulate and document their business models and portfolios which will require detailed analysis, application of judgment and detailed documentation to support judgments. These guidelines focus on the need to ensure consistency in the application of the accounting standards in specific areas, including asset classification and provisioning, and provide clarifications on regulatory capital in the light of Ind AS implementation. Above guidance will have significant changes and will require board, audit committees, auditors of ARCs to be well versed with the business policies. One of the provision is that impairment reserve shall not be counted for regulatory capital and will be prohibited to be withdrawn without RBI permission. 

ARCs as Resolution Applicant

As per Section 29A of IBC, an ARC can act as a resolution applicant and can submit resolution plan itself or with other investors jointly as a consortium or partnership. Further, as per Section 29A, expression “related party” shall not include a financial entity, regulated by a financial sector regulator, if it is a financial creditor of the corporate debtor and is a related party of the corporate debtor solely on account of conversion or substitution of debt into equity shares or instruments convertible into equity shares, prior to the insolvency commencement date.  ARC as partner of bidder or Resolution Applicant provides flexibility to investors as:

  1. No further fresh security to be created with assignment of existing debt to ARC;
  2. Restructuring of existing debt into various instruments such as non-convertible debentures, OCDs, equity, etc.;
  3. Low stamp duty on assignment of debt;
  4. Enhanced enforcement rights of ARCs compared to other legal entities;
  5. ARCs can pursue piece-meal sale/monetization of assets of the Corporate Debtor on approval of resolution plan over a period of time and pay lenders from sale proceeds; and
  6. In the event of sale under SARFAESI Act, priority of dues of Secured Creditors over government dues

On ARC taking over controlling interest independently and wherein there is no operating partner, in future ARC as holding platform may be  controlling many businesses through its subsidiaries or through any other structure. As per section 10 of the SARFEASI Act, ARCs business activities are restricted and therefore will have to ensure that business proposed complies with activities permitted under the Act and does not require any prior approval of RBI under section 10(2) of the Act.

In a number of accounts, as per the resolution plans proposed, ARCs are holding majority of equity and will manage day-to-day affairs of the acquired company. ARC will also commit to infusion of capital and funds for revival of stressed company. For example, based on available details, UVARC will initially hold 76% in the reconstructed company of Aircel as per approved resolution plan. As an entity running management of the reconstructed company, question is will ARC be treated as promoter as per the Companies Act, 2013 which defines promoters as the persons who controls the affairs of the company? Additionally, will ARC be subject to regular compliances as per the Companies Act?

RBI’s Fair Practices Code

By its circular dated July 16, 2020, RBI has advised ARCs to adopt ‘Fair Practices Code’ (FPC) so as to ensure transparency and fairness in their operation. Some of the features of FPC are as follows:

  • Transparency in the process of sale of assets

As per FPC, in order to enhance transparency in the process of sale of secured assets, (i) invitation for participation in auction shall be publicly solicited; the process should enable participation of as many prospective buyers as possible; (ii) terms and conditions of such sale may be decided in wider consultation with investors in the security receipts as per SARFAESI Act 2002; (iii) spirit of Section 29A of Insolvency and Bankruptcy Code, 2016 may be followed in dealing with prospective buyers.

RBI has emphasized on ARC to carry out sale through public auctions, have wider consultation with SR holders for sale rather than sharing of information only. As currently majority of the SRs are subscribed to by banks (70% as per RBI report), RBI considered it imperative to consult majority SR holders prior to finalization of sale. It is understood that sale here will also include any measure on asset reconstruction adopted by ARC under Section 9(1) of the Act.

It may be noted here that as per Section 7(3) of the Act, in the event of non-realization under sub-section (2) of financial assets, the qualified buyers of an ARC, holding SRs of not less than seventy five percent of the total value of the SRs issued under a scheme by such company, shall be entitled to call a meeting of all the qualified buyers and every resolution passed in such in meeting shall be binding on the company.  The qualified buyers shall, at a meeting called under sub-section(3), follow the same procedure, as  nearly as possible as is followed at meetings of the board of directors of the ARCs, as the case maybe.

Thus, SR holders with 75% value have right to call the meeting of all SR holders and pass resolution for taking further action by ARC which shall be binding on ARC but above right at present is only in the event of non-realization of financial assets. As per current practice, ARCs periodically submit status reports to SR holders, have periodic review meetings and share audited financial statements of trusts with SR holders, NAV reports from rating agencies etc. on regular basis.

FPC prescribes wider consultation with SR holders which has very expanse meaning and may delay sometimes actions to be taken.  SR holders objective is maximization of their recovery in minimum period. As per discussion with certain large seller banks, they feel that consultation under FPC will further improve co-ordination amongst seller banks and ARCs and accelerate recoveries. It was also felt that sometimes long time is taken to decide on recovery plan in view of perceived sub-optimal recoveries and assets were held for  a long period in trusts. One of the issue of some of SR holders is that in some cases, recovery gets delayed as ARCs are not able to aggregate debt which is beyond control of ARCs. SR holders feel that they can assist ARC in debt aggregation or ask ARC to proceed with resolution as it is. Thus, by consultation with SR holders and with their involvement, optimal decision can be taken expeditiously which won’t be questioned later by SR holders.

An ARC may have multiple trusts which have acquired financial asset of the same company funded by different investors. A scenario may be imagined wherein ARC has acquired NPA asset for external investor as well as has itself subscribed to 100% SRs. Different investors may have different action plans based on their outstanding, securities, charges, acquisition pricing etc. ARC will have to co-ordinate amongst these investors and manage conflicts to reach consensus on asset reconstruction measure to be taken forward. In IBC situation, therefore, various ARC trusts may vote differently resolutions proposed in Committee of Creditors.

Further, as ARCs have multiple assets from small to large assets to work-on, regular monitoring and consultation by SR holders will ensure all assets acquired irrespective of size will get attention for recovery/resolution.

Compliance with Section 29A of IBC is an effort to harmonize the provisions on sale of assets across various statutes.  IBC in both CIRP and liquidation does not allow persons connected to defaulting borrowers not to bid for assets. In the event promoters or connected persons wants to resolve, they should approach ARCs and take asset reconstruction through other measures available to ARC under Section 9(1) of the Act such as settlement, rescheduling, etc.

  • Outsourcing of activities by ARCs

As per FPC, ARCs intending to outsource any of their activity shall put in place a comprehensive outsourcing policy, approved by the Board, which incorporates, inter alia, criteria for selection of such activities as well as service providers, delegation of authority depending on risks and materiality and systems to monitor and review the operations of these activities/ service providers. ARC shall ensure that outsourcing arrangements neither diminish its ability to fulfil its obligations to customers and the RBI nor impede effective supervision by RBI. The outsourced agency, if owned/controlled by a director of the ARC, the same may be made part of the disclosures specified in the Master Circular of ARCs.

Above provision is in line with earlier direction issued to NBFCs in 2017 on outsourcing activities which required a board approved code of conduct for recovery agents, clear demarcation of resources like premises and personnel in case of sharing of back-office.

Outsourcing may include activities such as running process of sale of assets, raising funds, monitoring, etc. which are carried out by group/associate companies to achieve management, operational and financial synergies. Importantly, it has been clarified further that if any outsourcing agency is owned/controlled by a director of the ARC, suitable disclosures have to be made for greater transparency. ARCs therefore have to carry out dealings with group companies on arms’ length basis on these outsourcing activities.

  • Confidentiality of Information

As per FPC, ARCs shall keep the information, they come to acquire in course of their business, strictly confidential and shall not disclose the same to anyone including other companies in the group except when (i) required by law; (ii) there is duty towards public to reveal information; or (iii) there is borrower’s permission.

In the context of some of the ARCs being part of larger group and as ARCs move towards acquisition of bigger ticket, it is important and imperative that confidentiality of information relating to assets acquired, their businesses, customers, assets, resolution status, etc. is maintained. Some of the information could be price sensitive also. As per provision, information may be shared only if required by law or with borrowers’ permission and may be shared through information memorandum only at the time of sale or bidding.

Above provision is important from the standpoint of many ARCs bidding for retail assets aggressively and information of defaulting borrowers is required to be kept confidential.

Way Forward

In the backdrop of rising stress in the financial sector including NBFCs, increasing participation of distressed debt players in stressed asset market, the landscape of ARC industry is changing. ARCs in partnership with investors and as Resolution Applicant are bidding for bigger and large distressed companies and financial assets, which shows the tremendous potential for growth.

The Central Government’s support to SARFAESI Act is clear from the amendment in December 2019, as per which, after the registration of security interest with CERSAI, the debts of the secured creditor i.e. banks, FIs, NBFCs, ARCs, etc. shall be paid in priority over all other debts and all revenue, taxes, etc. payable to the Central Government or State Government or Local Authority, exception being IBC proceedings.  Therefore, the Central Government and RBI have harmonized the provisions of IBC on priority of dues of secured creditors and Section 29A of IBC with that of SARFAESI Act and applicable to ARCs to enable ARCs to play and enable ARCs to play larger role in the resolution of stressed assets.

The challenge before ARCs will be to maintain transparency in its operations, manage increased participation of SR holders, demonstrate superior resolution skills to capture opportunities available and attract more investment in this sector.

Disclaimer

Please note above article has been written for understanding of the topic and for discussion purpose only and is not a professional advice. No responsibility is assumed by author with regard to use of such article and readers are expected to refer to the relevant existing provisions of the relevant laws and take their own independent advice. Article is largely based on information publicly available.

 

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