Foreign investments in ARCs and security receipts

I have commented, several times, that the ARC model in India in unique and has nothing to do with similar models elsewhere in the world, in more senses than one. Special statutory powers have been conferred in India on ARCs, while ARCs in India are profit-driven shareholder companies unlike state-promoted special purpose vehicles in other countries. In India, the ARCs are nothing but a surrogate route to a special situations fund or a distressed debt fund, coupled with special powers of recoveries.

The special powers granted under the SARFAESI Act and under the Sick Industrial Companies Act are drastic, and at least in cases, seem to be exceeding the boundaries of well-settled public policies. For example, one of the provisions of the Sick Industrial Companies Act, recently interpreted by the Bombay High court , says that if any loan taken by a sick company is acquired by an ARC, then the reference of the sick company before the BIFR shall abate. Seemingly, the only purpose of constituting the BIFR is that entities which may be revived are sent to the nursing home and not the crematorium. But if any loan, irrespective of the amount of the loan, taken by such sick company, is acquired by an ARC, and that causes the reference before the BIFR to cede, the very philosophy of the revival of sick companies gets negated.

Same are the provisions in sec 9 of the SARFAESI Act about takeover of management. An ARC that has bought a loan taken by a defaulting borrower has the right to takeover the management of the business of the borrower. Notably, the loan was originally given by a bank, and the bank never had any such right of takeover of management. The ARC that buys the loan from the bank cannot have a better right than that of the bank. The bank had a security interest; security interest cannot imply the right of takeover of business.

There are also issues concerning workers’ interest which have not been properly appreciated: workers’ claims are recognised under SARFAESI proceedings only where the company is in liquidation. Sadly enough, the very repossession of assets by an ARC may leave the borrower with no substratum at all, and therefore, with no option but to go for liquidation. But by this time, as the core assets of the borrower would have been taken away by the secured lender, the question is – where do the workers get paid from?

These are generic concerns about the whole scheme of ARCs , which seem to have been pushed into legislation without a holistic approach to resolution of bankruptcies in the country.

However, the present policy about FDI in ARCs and the security receipts (SRs) issued by the ARCs may also be reviewed.

Currently, non-residents are allowed to invest in capital of ARCs, but FIIs are not allowed. As regards investments in SRs, FIIs are allowed to invest upto 49% of a single tranche of SRs, with a limit of 10% per FII.

As regards ARCs themselves, the 49% cap was perhaps devised to ensure ARCs may end up owning bad loans, and bad loans may (a) pertain to borrowers from sectors where there are current restrictions on foreign investments; and (b) be backed by real estate whereby foreign investors may end up owning immovable properties, which may be against the extant FDI policy.

These concerns may, however, be misplaced. First of all, most ARCs do not invest in bad loans themselves – they do it mostly by issuing SRs in the trust mode. Therefore, as long as there are prudent restrictions on investment in SRs, the restriction on equity capital of ARCs may not be necessary. Secondly, even if an ARC with, say, majority foreign ownership, ends up buying bad loans of a borrower where there are sectoral caps, this does not lead to creation of equity stakes in such sector. The acquisition of an NPL does not mean acquisition of equity or ownership of the business of the borrower. True, ARCs have the power to cause change of management or takeover the management as well, but the so-called takeover of management under SARFSAESI Act is not buyout of a business. The law says that the takeover shall be only for the purpose of realisation of the loans, and once the loans have  been realised, the business will be handed back to the original owners. Takeover of management of business is a rarity – ARCs have caused management change, but have never so far taken over management themselves.

It is to be noted that SRs are essentially in the nature of equity – since the returns on the SRs depend on the money realised on recovery of the underlying loans. Though the RBI’s directions to ARCs put a maximum time frame for realisation of loans acquired by ARCs, practically, the repayment of the SRs depends on the realisation of the underlying loans. Hence, investment in SRs is more like an FDI than ECB. However, it is an FDI into the loans, and not FDI into the business from where the loan emanates – thus, not conflicting with the current FDI policy.

How would investment in SRs help Indian economy? Currently, given the restriction of 49% on investment in SRs, most SRs are being subscribed either by the banks that sell the NPLs themselves, or domestic NBFCs that qualify as “qualified institutional buyers.” Internationally, distressed debt has attracted international investors – this is particularly true for China. SRs in India make more sense than distressed debt in China, as ARCs in India are vested with special powers.

Therefore, there is a strong case for relaxing the limit of 49% in case of SRs. Is this likely to attract lot of money into the country? Given the soaring amount of NPLs and loans undergoing restructuring, the amount of NPLs in India will rise sharply in time to come. This may be the right time to attract international investors.