Asset Reconstruction Companies – Making Good Misuse of the Law

Headline news in financial press today [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.

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.

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 borrower’s 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 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.