Regulatory Framework for Securitization or Reconstruction Companies

Narendra Kumar

03 Dec, 2020

It is generally estimated that up to 75% of the unsuccessful businesses (Company) close down because of an inability to tackle the financial pressure, of either the poor management or an outright mismanagement of the capital lent (for e.g. by using working capital loans to cover long-term finance needs, then facing liquidity pressure), of pressure from the banks who threatens the penalties & legal action, pressure from the private equity partners or the public investors who demands to see increases in dividends or bottom line. & every so often it happens that when exposed to such a baptism of fire, with numerous creditors concurrently demanding payment & several liabilities & obligations outstanding, unable to withstand the incoming demands from virtually every quarter, some businesses & the entrepreneurs eventually crack under stress, & give up. To avoid such an unhappy end, it is helpful to know there are numerous options for the businesses undergoing difficulties & that if you are going through such a term yourself, it isn’t the end of the world. However, at such a high level, it is said knowledge is power, & likewise, ignorance can be fatal. Failure should not be considered final but viewed as the temporary setback, it is a stepping stone to more wonderful future conquest & eventual success. But for this, there are some things in the world of business & finance that must be known, & an Asset Reconstruction Company is one of them.

Overview of an Asset Reconstruction Company (ARC)

The asset reconstruction company’s primary goal is to manage & to make profitable those assets which have been underperforming or become formally classified as NPA’s belonging to the companies who have been not able to generate sufficient timely revenue to service their outstanding obligations. One of the downsides is a potential loss of income that can be suffered in trying to resolve crises in distressed debt where the companies are in danger of bankruptcy/insolvency. Nevertheless, ARC’s when managed properly have a significant possibility of profit if they can relieve the company of financial stress & manage to pass over the acquisition of the assets to another more worthy candidates. ARC’s charge the management fee or commission for their services from the distressed company/individual.

Asset management companies have the responsibility under the SARFESI Act to function as intermediaries between promoter & the trust. They charge a fee for their services & the role is to see that the trust is able to take over such assets or loans at a nominal fee according to the revalued amount, which is subsequently paid to the promoter for the acquisition.

Asset Management Companies in the west perform many of the similar functions ARCs were set up in India to provide. India’s first ARC was the company ARCIL which has been the leader & the pioneer in this field, having established industry standards for the rest of the market to follow.

Asset Reconstruction Company (ARC) in India

In India, a problem of recovery from NPAs was recognized in the year 1997 by the Government of India^[1].  The Narasimhan Committee Report stated that an important aspect of the continuing reform process was to reduce a high level of NPAs as a means of the banking sector reform.  It was expected that with the combination of policy & institutional development, new NPAs in the future could afford to be lower.  Though the huge backlog of existing NPAs continued to hound banking sector & this impinged severely on banks’ performance & any ensuing hopes of their profitability. A Report envisaged the creation of an “Asset Recovery Fund” to take NPAs off the lender’s books at the discount.

Accordingly, Asset Reconstruction Company (Securitization Company / Reconstruction Company) is a company registered under Section 3 of the Securitization & Reconstruction of Financial Assets & Enforcement of Security Interest (SRFAESI) Act, 2002. It is regulated by Reserve Bank of India as a Non-Banking Financial Company

RBI have exempted the ARCs from compliances under the Reserve Bank Act, 1934. ARC functions like an AMC within guidelines issued by RBI.

ARC has been set up to provide the focused approach to the Non-Performing Loans resolution issue by:-

• Isolating Non-Performing Loans (NPLs) from Financial System (FS)
• Freeing financial system to focus on their hardcore activities &
• Facilitating the development of the market for distressed assets.

Functions of Asset Reconstruction Company (ARC)

The ARC performs the following functions:-

Acquisition of the financial assets

• Changes or takeover of Management or Sale or Lease of Business of the Borrower
• Rescheduling of the Debts
• Enforcement of the Security Interest
• Settlement of the dues payable by the borrower

How an Asset Reconstruction Company (ARC) actually works

ARC allocates acquired assets to 1 or more than 1 trusts at the price at which the financial assets that are acquired from the originator.

Asset Reconstruction Companies (ARC) have seen an increase in their client base during the recession, with many companies experiencing financial difficulties & having distressed assets in their possession. The Banks see that many of their loans turn non-performing & require restructuring. ARCs have an opportunity to relieve these companies, resell their assets & make most of them, with trusts they turn to buy them off & bearing the risks concomitant with them.

These ARCs have the obligation to help the companies in times of stress refresh the activities of the non-performing assets. Some companies that haven’t been working for a while will be enabled to continue their operations by the virtue of the transaction made by these companies. The trusts themselves issue Security Receipts to the (QIB) Qualified Institutional. The trusteeship of such trusts shall vest with an ARC. ARC receives the management fee from the trusts. Any upside in between acquired price & realized price will be shared with such beneficiary of the trusts & ARC. Likewise, any downside in between acquired price & realized price will be borne by the beneficiary of trusts.

Benefit to Investors

Many of the leading investment banks in west perform the functions of the asset management, as there is a lot of scope for such business. The Asset Management or the Reconstruction is sometimes performed by specialized companies set up for that end, at other times performed by other miscellaneous financial institutions. The major or key business skill involved here is to be able to spot the right company for acquisition & restructuring.

The usefulness of ARC to the Macro Economy

Distressed Debt & Securitization is the asset instrument of the future. Investors with their detailed knowledge of the market environment & internal & external conditions will be more easily able to spot an undervalued product, acquire it at low cost, work to restoring it to somewhere nearer to its true value & sell it off for a healthy profit. In the process, the whole economy benefits, as a previously non-performing asset is now restored to operationality & functionality. The ARC is an intermediary in this process & justly charges its own fee for overseeing this successfully.

Confidence Booster to Entrepreneurs

That such an option exists itself is a means of boosting the entrepreneur’s confidence, & gives other options than filing for bankruptcy or insolvency in times of stress. The Entrepreneurs know that the distressed debt & assets don’t mean everything is lost, but just due to the ARC’s & other such financial players to turn to, this can be viewed as the temporary setback. Turning to an ARC, 1 has an opportunity to gain some time if not anything else to restore the company’s operations to profitability, or else to close it in a relatively debt-free manner. Institutional buyers & professional investors will increasingly turn to this mode of capital as a means of reactivating potential, trusts have much to gain if they can successfully revamp the company’s operations & restore it to operational normalcy & profitability. Thus, there exists a significant market for this sort of activity, & those who have the requisite skill & know-how in the business of Asset Reconstruction are rewarded with substantial returns on investment.