Analytical Speaking

VINOD KOTHARI & COMPANY

Asset Reconstruction Companies

Making Good Misuse of the Law

Vinod Kothari
vinod@vinodkothari.com

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Disclaimer:
This write up is intended to initiate academic debate on a pertinent question. It is not intended to be a
professional advice and should not be relied upon for real life facts.
 Asset Reconstruction Companies Making Good Misuse of the Law
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Analytical Speaking

Headline news in financial press on monday [here] carried a seemingly-sensational story

about one of the leading asset reconstruction companies (ARCs) working under stress of
its major shareholders, practices about breaches of law and regulations by the ARCs and
so on. For those several people, including professionals, who would have some
experience of dealing with ARCs, this is hardly surprising, because many would know
that ARCs have been engaged in variety of practices including arm-twisting troubled
companies into accepting loans at steep rates of interest from private lenders, allowing
private lenders to enforce security interests on assets without satisfying the claims of
banks and financial institutions, getting allotment of shares in troubled companies,
forcing change in management in violation of RBI norms on takeover of management,
etc. Many, however, many not know that ARCs have been vested with special legal
powers that need to be deployed in strict compliance with the law, and therefore, many
things that ARCs are doing currently are outright illegal.

In fact, in a larger context, the very institution of ARCs, vested with special powers of
recovery, is as much a misconceived idea as the parent legislation under which the ARCs
are created.

Models of ARCs: Indian model and international models:

While asset reconstruction company may be a typical Indian expression, possibly due to
the heritage of the Narsimham Committee referring to an asset reconstruction fund, the
global model of dealing with non-performing assets is called asset management
companies (AMCs). The first most important point to note is that AMCs are created to
resolve the problem of NPAs that result from a systemic crisis. That is, if a systemic
crisis leaves the banking system infested with bad loans, there has to be a one-time,
central remedy to resolve the problem. AMCs are not envisaged, and intuitively cannot
have been envisaged, to resolve the problem of loans that go bad due to bad lending.

Therefore, most countries brought about AMCs as a one-time measure with a sunset
clause. The classic example is that of the Resolution Trust Corporation of the USA that
acquired assets of savings and loans associations in the 1990s. Closer home, the Danharta
of Malaysia is an example that took over loans that went bad due to the 1997 SE Asian
crisis, and once the loans were resolved, it wound up its affairs.
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Analytical Speaking
Whether one-time or continuing, AMCs in most countries have taken the centralized
AMC model that is, one AMC formed to resolve a systemic crisis.

In India, our unique ARC model has lot of differences from the global models. First,
there has not been any systemic crisis that the ARCs seek to resolve. Most of the bad
loans in India are a product of bad lending they represent what is called the flow
problem, rather than the stock problem. Second and a key difference is that we have not
envisaged a sunset clause for the ARCs the SARFAESI Act envisages ARCs to be an
ongoing business model. Hence, it could not have been a response to a systemic crisis.
On a policy plane, it sounds completely counter-intuitive for an agency armed with
special powers conferred by law to come and rescue a loan that goes bad due to bad
lending. What are the insolvency laws, winding up laws and civil laws on recoveries are
doing, if a special law had to come to resolve every loan that goes bad? Hence, the very
concept of ARCs in India seems to be a paradox. It is easy to attribute the concept of
ARCs to the Narasimham Committee, but the Narsimhan committee had not thought of
profit-seeking companies fitting the bill of ARCs in the country.

That brings us to the third significant difference a single AMC versus multiple ARCs.
In India, over the years, several ARCs have come into existence. In fact, ARC has
become a business model.

Vesting a profit-driven entity with special powers:

From a legal policy perspective, how does not envision a profit-driven, shareholder-
wealth-maximising entity resolving the problem of bad loans? Sure enough, bad loan
resolution is a business model, but such a business model has to fit into the overall
regime of recovery of loans, enforcement of security interests, and so on. It would be
hard to think of entities armed with special powers of the law that buy bad loans and
resolve them. If power corrupts, then a special power would corrupt especially. Sure
enough, there is no equity and justice on the part of a borrower who does not pay a loan,
but then one cannot close eyes to the fact that lenders who foreclose loans quite often
commit excesses. Assets are sold in opaque manner, at prices that do not represent fair
values. Sure enough, one cannot expect a borrower-centric fair deal from an entity that
has to focus on shareholder wealth.
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Analytical Speaking
Trust route: the easy escape route to regulation:
Another very unique feature of the Indian ARC model is that virtually all the NPAs are
bought in the name of trusts, of which the ARC becomes the trustee. This is a simple
device to wish away the regulation of the RBI. RBI regulations require capital adequacy,
NPA treatment and income recognition norms in case of ARCs almost in the same tone
as applicable to NBFCs. However, if the assets are bought in the name of ARCs, other
than the mandatory investment requirement, much of the regulation is not applicable.
This may sound real strange, as the legal privileges of the special powers are presumably
available even where the assets are sitting in the books of the trusts.

In fact, this question whether the powers of the ARCs are exercisable where the assets
are sitting on trust books is a significant question that has not been discussed
adequately in legal forums. In order for exercise of the special powers, the asset must be
an NPA in accordance with the directions of the RBI the directions which are not
applicable in case of trusts. So, the issue is, if the directions are not applicable to trusts,
are the trust assets NPAs are per directions of the RBI?

ARCs traveling much beyond their limited business:

ARCs have a very limited sphere of powers allowed by law their powers are limited by
the SARFAESI Act. Whatever else they do has to be incidental or ancillary to what they
are permitted to do under the law. An ARC is not a normal business entity that can buy
equity shares, takeover management of businesses, engage finance companies to acquire
loans of the defaulting companies, and so on. However, in real world, ARCs are being
run exactly as bania shops.

Sale of assets the opaque way:

Also, the sale of assets by ARCs, in spirit, is no different from the sale of assets by state
finance corporations and others vested with special powers of recovery. Courts have,
over the years, ruled that there is no scope for any lack of transparency in causing a sale
of the borrowers assets, because every single penny realized from the sale goes to the
credit of the borrower. It is also clear in SARFAESI Act that the ARC acts as the trustee
of the borrower in exercising the rights of sale of the property. Hence, any opaqueness in
the sale is completely intolerable in law. There have been numerous instances where
ARCs have sold assets by way of so-called private auctions, and simply served a notice
on the borrower giving credit to the extent of sale proceeds. No account of how much
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Analytical Speaking
was the sale proceed, who was the buyer, who were the competing bidders, how was the
asset sold, how much were the expenses on sale, etc., have been provided to borrowers.
ARCs have gone on record saying they are not obliged to disclose the particulars of the
sale this is completely erroneous.

[The author has written a book titled Securitisation, Asset Reconstruction and
Enforcement of Security Interests, published by Butterworths Lexis-Nexis Wadhwa]