The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 or SARFAESI Act, 2002 allows banks and financial institutions to auction properties (residential and commercial) when borrowers fail to repay their loans. The Act aims at speedy recovery of defaulting loans and to reduce the mounting levels of Non-performing Assets of banks and financial institutions.
As stated in the Act, it has “enabled banks and FIs to realise long-term assets, manage problems of liquidity, asset-liability mismatches and improve recovery by taking possession of securities, sell them and reduce non performing assets (NPAs) by adopting measures for recovery or reconstruction.”
The SARFAESI Act, 2002 has been largely perceived as facilitating asset recovery and reconstruction. The Act has been passed based on the recommendations of Narasimham Committee I and II and Andhyarujina Committee constituted by the Central Government for the purpose of examining banking sector reforms and to consider the need for changes in the legal system in respect of these areas. The provisions of the Act would enable the banks and financial institutions to realize long-term assets, manage problems of liquidity and asset liability mismatches and to improve recovery by exercising powers to take possession of securities, sell them and reduce non-performing assets by adopting measures for recovery or reconstruction.
Provisions of the SARFAESI Act, 2002
The Act has made provisions for registration and regulation of securitization companies or reconstruction companies by the RBI, facilitate securitization of financial assets of banks, empower SCs/ARCs (Securitisation Companies and Asset Restructuring Companies) to raise funds by issuing security receipts to qualified institutional buyers (QIBs), empowering banks and FIs to take possession of securities given for financial assistance and sell or lease the same to take over management in the event of default.
The Act provides three alternative methods for recovery of NPAs, namely:
- Securitization: It means issue of security by raising of receipts or funds by SCs/ARCs. A securitization company or reconstruction company may raise funds from the QIBs by forming schemes for acquiring financial assets. The SC/ARC shall keep and maintain separate and distinct accounts in respect of each such scheme for every financial asset acquired, out of investments made by a QIB and ensure that realizations of such financial asset is held and applied towards redemption of investments and payment of returns assured on such investments under the relevant scheme.
- Asset Reconstruction: The SCs/ARCs for the purpose of asset reconstruction should provide for any one or more of the following measures:
• the proper management of the business of the borrower, by change in, or take over of, the management of the business of the borrower
• the sale or lease of a part or whole of the business of the borrower
• rescheduling of payment of debts payable by the borrower
• enforcement of security interest in accordance with the provisions of this Act
• settlement of dues payable by the borrower
• taking possession of secured assets in accordance with the provisions of this Act.
- Exemption from registration of security receipt: The Act also provides, notwithstanding anything contained in the Registration Act, 1908, for enforcement of security without Court intervention: (a) any security receipt issued by the SC or ARC, as the case may be, under section 7 of the Act, and not creating, declaring, assigning, limiting or extinguishing any right, title or interest to or in immovable property except in so far as it entitles the holder of the security receipt to an undivided interest afforded by a registered instrument; or (b) any transfer of security receipts, shall not require compulsory registration.
The Guidelines for SCs/ARCs registered with the RBI are:
- act as an agent for any bank or FI for the purpose of recovering their dues from the borrower on payment of such fees or charges
- act as a manager between the parties, without raising a financial liability for itself;
- act as receiver if appointed by any court or tribunal.
Apart from above functions any SC/ARC cannot commence or carryout other business without the prior approval of RBI.
The Securitization Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003
The Reserve Bank of India issued guidelines and directions relating to registration, measures of ARCs, functions of the company, prudential norms, acquisition of financial assets and related matters under the powers conferred by the SARFAESI Act, 2002.
Defining NPAs: Non-performing Asset (NPA) means an asset for which:
- Interest or principal (or instalment) is overdue for a period of 180 days or more from the date of acquisition or the due date as per contract between the borrower and the originator, whichever is later;
- interest or principal (or instalment) is overdue for a period of 180 days or more from the date fixed for receipt thereof in the plan formulated for realization of the assets
- interest or principal (or instalment) is overdue on expiry of the planning period, where no plan is formulated for realization of the
- any other receivable, if it is overdue for a period of 180 days or more in the books of the SC or ARC.
Provided that the Board of Directors of a SC or ARC may, on default by the borrower, classify an asset as a NPA even earlier than the period mentioned above.
- Every SC or ARC shall apply for registration and obtain a certificate of registration from the RBI as provided in SARFAESI Act;
- A Securitization Company or Reconstruction Company, which has obtained a certificate of registration issued by RBI can undertake both securitization and asset reconstruction activities;
- Any entity not registered with RBI under SARFAESI Act may conduct the business of securitization or asset reconstruction outside the purview of the Act.
Net worth of Securitization Company or Reconstruction Company: Net worth is aggregate of paid up equity capital, paid up preference capital, reserves and surplus excluding revaluation reserve, as reduced by debit balance on P&L account, miscellaneous expenditure (to the extent not written off ), intangible assets, diminution in value of investments/short provision against NPA and further reduced by shares acquired in SC/ARC and deductions due to auditor qualifications. This is also called Owned Fund. Every Securitization Company or Reconstruction Company seeking the RBI’s registration under SARFAESI Act, shall have a minimum Owned Fund of Rs 20 mn.
Permissible Business: A Securitization Company or Reconstruction Company shall commence/undertake only the securitization and asset reconstruction activities and the functions provided for in Section 10 of the SARFAESI Act. It cannot raise deposits.
Some broad guidelines pertaining to Asset Reconstruction are as follows:
- Acquisition of Financial Assets: With the approval of its Board of Directors, every SC/ARC is required to frame, a ‘Financial Asset Acquisition Policy’, within 90 days of grant of Certificate of Registration, clearly laying down policies and guidelines which define the; norms, type, profile and procedure for acquisition of assets,
- valuation procedure for assets having realizable value, which could be reasonably estimated and independently valued;
- plan for realization of asset acquired for reconstruction
The Board has powers to approve policy changes and delegate powers to committee for taking decisions on policy/proposals on asset acquisition.
- Change or take over of Management/ Sale or Lease of Business of the Borrower: No SC/ARC can takeover/ change the management of business of the borrower or sale/lease part/whole of the borrower’s business until the RBI issues necessary guidelines in this behalf.
- Rescheduling of Debt/ Settlement of dues payable by borrower: A policy for rescheduling the debt of borrowers should be framed laying the broad parameters and with the approval of the Board of Directors. The proposals should to be in line with the acceptable business plan, projected earnings/ cash flows of the borrower, but without affecting the asset liability management of the SC/ARC or commitments given to investors. Similarly, there should be a policy for settlement of dues with borrowers.
- Enforcement of Security Interest: For the sale of secured asset as specified under the SARFAESI Act, a SC/ARC may itself acquire the secured assets, either for its own use or for resale, only if the sale is conducted through a public auction.
- Realization Plan: Within the planning period a realization plan should be formulated providing for one or more of the measures including settlement/rescheduling of the debts payable by borrower, enforcement of security interest, or change/takeover of management or sale/lease of a part or entire business. The plan should clearly define the steps for reconstruction of asset within a specified time, which should not exceed five years from the date of acquisition.
Broad guidelines with regards to Securitization are as follows:
- Issue of security receipts: A SC/ARC can set up trust(s), for issuing security receipts to QIBs, as specified under SARFAESI Act. The company shall transfer the assets to the trust at a price at which the assets were acquired from the originator. The trusteeship remains with the company and a policy is formulated for issue of security receipts.
- Deployment of funds: The company can sponsor or partner a JV for another SC/ARC through investment in equity capital. The surplus available can be deployed in G-Sec or deposits in SCBs.
- Asset Classification: The assets of SC/ARC should be classified as Standard or NPAs. The company shall also make provisions for NPAs.
Issues under the SARFAESI Act, 2002
Right of Title
A securitization receipt (SR) gives its holder a right of title or interest in the financial assets included in securitization. This definition holds good for securitization structures where the securities issued are referred to as ‘Pass through Securities’. The same definition is not legally inadequate in case of ‘Pay through Securities’ with different tranches.
Thin Investor Base
The SARFAESI Act has been structured to enable security receipts (SR) to be issued and held by Qualified Institutional Buyers (QIBs). It does not include NBFC or other bodies unless specified by the Central Government as a financial institution (FI). For expanding the market for SR, there is a need for increasing the investor base. In order to deepen the market for SR there is a need to include more buyer categories.
Demand for securities is restricted to short tenor papers and highest ratings. Also, it has remained restricted to senior tranches carrying highest ratings, while the junior tranches are retained by the originators as unrated pieces. This can be attributed to the underdeveloped nature of the Indian market and poor awareness as regards the process of securitization.
Risk Management in Securitization
The various risks involved in securitization are given below:
- Credit Risk: The risk of non-payment of principal and/or interest to investors can be at two levels: SPV and the underlying assets. Since the SPV is normally structured to have no other activity apart from the asset pool sold by the originator, the credit risk principally lies with the underlying asset pool. A careful analysis of the underlying credit quality of the obligors and the correlation between the obligors needs to be carried out to ascertain the probability of default of the asset pool. A well diversified asset portfolio can significantly reduce the simultaneous occurrence of default.
- Sovereign Risk: In case of cross-border securitization transactions where the assets and investors belong to different countries, there is a risk to the investor in the form of non-payment or imposition of additional taxes on the income repatriation. This risk can be mitigated by having a foreign guarantor or by structuring the SPV in an offshore location or have an neutral country of jurisdiction
- Collateral deterioration Risk: Sometimes the collateral against which credit is sanctioned to the obligor may undergo a severe deterioration. When this coincides with a default by the obligor then there is a severe risk of non-payment to the investors. A recent example of this is the sub-prime crisis in the US which is explained in detail in the following sections.
- Legal Risk: Securitization transactions hinge on a very important principle of “bankruptcy remoteness” of the SPV from the sponsor. Structuring the asset transfer and the legal structure of the SPV are key points that determine if the SPV can uphold its right over the underlying assets, if the obligor declare bankruptcy or undergoes liquidation.
- Prepayment Risk: Payments made in excess of the scheduled principal payments are called prepayments. Prepayments occur due to a change in the macro-economic or competitive industry situation. For example in case of residential mortgages, when interest rates go down, individuals may prefer to refinance their fixed rate mortgage at lower interest rates. Competitors offering better terms could also be a reason for prepayment. In a declining interest rate regime prepayment poses an interest rate risk to the investors as they have to reinvest the proceedings at a lower interest rate. This problem is more severe in case of investors holding long term bonds. This can be mitigated by structuring the tranches such that prepayments are used to pay off the principal and interest of short-term bonds.
- Servicer Performance Risk: The servicer performs important tasks of collecting principal and interest, keeping a tab on delinquency, maintains statistics of payment, disseminating the same to investors and other administrative tasks. The failure of the servicer in carrying out its function can seriously affect payments to the investors.
- Swap Counterparty Risk: Some securitization transactions are so structured wherein the floating rate payments of obligors are converted into fixed payments using swaps. Failure on the part of the swap counterparty can affect the stability of cash flows of the investors.
- Financial Guarantor Risk: Sometime external credit protection in the form of insurance or guarantee is provided by an external agency. Guarantor failure can adversely impact the stability of cash flows to the investors.