LEGAL ASPECTS OF NON-PERFORMING
ASSETS
G J BULSARA*
KNOWHOW FOR MANUFACTURE AND TECHNIQUES
PERFORMING ASSETS BY PROCESS OF SECURITISATION
TO
ELIMINATE
NON-
Securitisation
The concept of securitisation has been adopted more recently from the American
financial system and has been described as processing of acquiring financial asset and
packaging the same for investments by several investors. The term ‘securitisation’ has
not been defined as such, but has been used in certain rules, regulations and
notifications. In the recently enacted the Securitisation and Reconstruction of Financial
Assets and Enforcement of Security Interest Act, 2002 (for short “the Securitisation Act”)
the term securitisation has been defined as “acquisition of financial assets by any
securitisation company or reconstruction company from any originator, whether by
raising of funds by such securitisation company or reconstruction company from
qualified institutional buyers by issue of security receipts representing undivided
interests in such financial assets or otherwise”.
The Securitisation Act, 2002
The Securitisation Act has been enacted mainly for tackling the growing menace
non-performing assets by securitisation of assets by sale to ARC, which is to issue of
security receipts to the investor and for enforcement of security interest by banks and
financial institutions. Initially, many were delighted to find that the securitisation
process as a class has come to stay in the Indian legal system, and the problem of the
non-performing assets of banks and financial institution would stand resolved since the
banks and financial institutions would be able to enforce its security interest without
intervention of the courts. The quantum of non performing assets has been growing by
leaps and bounds and has been playing havoc on the Indian financial system since as at
the end of the year 2001 the total amount of outstanding NPAs stood at Rs.83,500/crores. After enactment of the Securitisation Act, 2002 the wilful defaulters cannot now
hide behind long-winded judicial process but at the same time the bank also cannot
recover dues arising out of underwriting commitments obligations and equity finance by
way of share subscriptions, so also the shares acquired by exercise of option for
conversion of loan into equity. The Securitisation Act, 2002 does not also ensure or
guarantee full recovery of the entire outstanding over dues fully.
In the result the
financial health of the banks will not improve because, in absence of adequate assets
not more than 20 percent of NPAs would be recovered by resorting to the provisions of
the Securitisation Act, 2002. The IT Tribunal ruling in case of Vishvapriya Financial
Service and Securities Ltd would jolt development of asset securitisation in autofinance
and housing finance sector.
The company was utilising funds obtained from the
investors for deployment in fixed income security and had guaranteed fixed rate of
return. The contention of the company that it was only agent for the investors and has
evolved only a pay-through structure was not accepted by the tribunal, which held that
the company was liable for the withholding taxes on the payments made to the
investors.
Growth of Banking Practice in India
In the long run from the concept of ancient money lenders, India march forward to
the realm of banking, which has since branched out in the concept of the development
banking, the narrow banking and the universal banking. So also from simple current
and savings bank accounts, the bank finance has extended to
structured finance,
trade finance and export finance and finance for
*
ACS, LL.M., CAIIB.
infrastructure, and the last few years saw emergence of fee based services in form of
merchant bankers, financial advisers and managers to the public issue and private
placement of shares debentures and bonds, syndication of loan facilities, external
borrowings, forex services, treasury management and more recently investment and
portfolio management, e-broking and derivatives, futures and options trading facilities
plus back office services and services in takeover, mergers, acquisitions and
amalgamations, mostly through the bank subsidiaries or associates arms.
Reasons for Growth of NPAs
The development and proliferation in the activities of the bank has led to everincreasing non-performing assets that has mounted to an enormous amount during the
last decade or so. The quantum of NPAs has been calculated and put at different figures
mainly due to absence of proper statistics and the method on the basis adopted for
calculating the percentage of NPAs in relation to either the total assets of the bank or
the amount of loan portfolio or on the basis of the number of the accounts or the size of
the outstanding advances. But till recently little attention was paid to the real reasons as
to why and how non performing assets have appeared in the books of the banks and
also the books of many of the financial institutions. For a large number of years, the
banks have been taking credit in its books, on basis of accrued interest income, even for
the amount of periodic interest that was not actually paid by the borrower. This was
done by raising debit in suspense account and crediting amount equal to the periodic
interest in the loan account of the borrower. After objections from the auditors and
income tax authority the banks changed strategy and started giving additional loans to
the defaulting borrowers for the purpose of making payments to the bank for
adjustment of the overdues, in many cases the due dates of payments were postponed
and even the entire duration of the loan was extended further again and again. As if to
add fire to the fuel, ambitious programme for branch development and extension of
banking services led to new recruitments, transfers, relocation and unhealthy competition
amongst offices of the same bank, but at the same time adequate facilities available for training of the
staff were not expanded. In the anxiety to achieve business targets the rules and procedures for prudent
banking were conveniently forgotten. Even the higher management setup conveniently relaxed the
rules for proper appraisal of the loan proposals, the provisions of standard bank sanction letter, errors in
execution of the loan agreements, deeds of hypothecation and mortgages were more often overlooked
for compliance in the hurry for disbursement and achievement of targets for purposes of building up
record of achievements and reporting.
Off Balance Sheet Transactions (OBS)
The Banks in India are long familiar with off balance sheet finance by way of standby
letters of credit, revolving letters of credit, repurchase agreements, backup line of credit
for issue of commercial paper, note issuance facility, interest rate exchange and swap
and hedging transactions. Some of these OBS transactions are intended to avoid and
circumvent regulatory taxes like payment of deposit insurance premium, cash reserve
requirements and capital adequacy norms, but the securitisation and sale of loan
portfolio and receivables as form of OBS transaction tops the list, so much so that even
the income tax, capital gains tax, sales tax, lease tax and tax on transfer of right to use
the property, as applicable are not paid since the OBS transaction is seldom reflected in
the balance sheet of the bank or the borrower company concerned. Further, the OBS
transactions eliminate funding risk and even the credit risk. In India the banks and
institutions and also the investors and the borrowers were too happy to finance off
balance sheet transactions. Even though assets given on hire purchase basis do appear
in the balance sheet of the company, the future receivables in form of hire charges
payable by the hirer are not shown in the balance sheet of the originator. It is very
happy situation for the originator to sell the future receivables and raise finance and
show surge in the case on the balance sheet and raise the bottom line and also the top
line. Further, for the financing bank, it was much more advantageous as the amounts
paid are shown as investments in PTC and not as the loan transaction. This type of
structures of giving finance by investment in PTC and not as a loan, the financing bank
has easy escape from CRR and SLR requirements.
As the future receivables are
purchased at discounted value and the banks could easily amount of liability under the
Interest Tax Act, 1974 for the period before the interest tax was withdrawn.
The
originator also benefited by securitisation and sale of future receivables on which the
originator need not now pay hire purchase tax. The originator has added advantages
because of sale of receivables, an amount of cash is generated and shown in the balance
sheet even without the removal of any assets. In this way the originator could show
better results, improve balance sheet figures and raise further finance
O Lord forgive them, for they know not what they are doing
The term securitisation was not defined but was used in the year 1994 in the
Maharashtra Government Notification under the Bombay Stamp Act, 1958 dealing with
reduction of stamp duty in respect of “instruments of securitisation of loans or of
assignment of debt with underlying
securities”
Article 25(a) of the Bombay Stamp Act, 1958.
chargeable
under
the Schedule I,
Subsequently, SEBI amended the SEBI
(Mutual Funds) Regulations, 1996 and the Seventh Schedule dealing with Restrictions on
Investments by mutual funds and allowed mutual funds to make investments within the
prescribed limits “in the mortgaged-backed securitised debt”. More recently, even the
recognized Stock Exchanges have started listing of the PTC (Pass Through Certificates),
without realizing that the PTC is not a “security” within the meaning of the definition of
the term “Security”, as given in Section 2(h) of the Securities Contracts (Regulation) Act,
1956. Soon thereafter some of the banks and even public financial institutions started
business of securitisation of future receivables. Credit Rating Agencies started assigning
triple-A ratings to the PTCs on basis of feedback and select information supplied at the
instance of the hire-purchase and lease finance companies. Certain State Governments
followed the bandwagon and notified reduction in stamp duty on securitisation
transaction, even though the expression securitisation was nowhere defined in the
relevant Stamp Act provisions as applicable in
the State concerned or in the Indian
Stamp Act, 1899.
Why banks could not prevent loan defaults
The banks are required to give loans under the priority sector lending and complete
requisite quota for each of the segments for the reporting year. In case of agriculture
lending the rural borrowers are often under impression that the disbursement is by way
of grant and there is no need for any repayment. Very often the loan documents are not
properly signed by the particular borrower. The amount and the rates of interest are
higher than what was conveyed to the borrower. Most of the time the borrower has not
benefitted and in absence of higher earnings, the repayments of the bank loan cannot
be made. Even in the urban sector and in towns and cities situation is no better. At
times accounts are opened without proper identification and due introduction. This is
mainly due to procedural lapse and inadequate control mechanism and loosening of
bank supervision. Every type of fraud is committed often with connivance with the staff,
perhaps due to absence of proper reporting and due vigilance. The instruments are
stolen in transit and encashed fraudulently. The remittance of cash, money transfers and
issue of demand drafts often fall to fraudulent practices.
Where the buck stops
All the ills for mounting figure of loan defaults and rising amount of NPAs are
invariably put at the door of the legal system and procedural delays, costs and expenses
involved and the lengthy procedures involved in litigation and execution of decrees
obtained from the court. Even provisions contained in law for corrective action by way
of review and appeal against judgments of the trial courts are branded as causes for
delay in recovery of loan from the defaulting borrower. But the same persons when
aggrieved by order for transfer or non-promotion himself approaches the temple of
justice for redress of his own grievance. The Securitisation Act, 2002 seeks to improve
mechanism available to the secured lender for enforcement of the security interest held
by them, but fails to notice the difference between willful defaulter and the borrower
who is unable to make payments on the due dates due to change in market conditions
and regardless of the intention or the reasons leading to such defaults like change in
government policy, competition from new technology, power shortages. No attempt is
made for inducting fresh finance to tide over the difficulty or for diversification,
upgradation or rehabilitation of the defaulting unit. Implementation issues relating to
management and financing of the business of the company are mostly ignored before
taking drastic step for sale of the units by the lenders.
The potential buyers would turn weary as no one wants to pay for the mortgaged
unit in forced sale anything more than its scrap value. Taking over of the defaulting
company, which has unpaid secured over dues will only go to deter the ARC as also the
potential buyers, who would make payments after borrowing from the banks and
financial institutions as the lenders.
The potential buyers has become weary and can therefore offer only the scrap value,
for purchase by the same management in the name of new promoters, with moneys
raised from the same lender bank, which initiated steps for enforcement of security
against the borrower concerned. Take over of the defaulting unit with large amounts of
overdues would only go to deter the ARC and potential purchaser. It seeks to improve
mechanism available to secured creditors for enforcement of the security available to
them.
Securitisation Versus Securitisation
The Securitisation Act has been enacted for dealing with and solving problem of
NPAs, but look at the manner in which perfectly healthy accounts with AAA ratings are
now being securitised for raising finance that is free from regulatory requirements
prescribed by the Reserve Bank or SEBI. Mostly the hire-purchase and loan receivables
generated by non-banking finance companies, hire purchase finance companies,
housing finance companies and even commercial bank loans receivables are purchased
in the guise of securitisation by an SPV established in the form of a trust, set up by the
non-banking finance company itself, and thereafter receivables are sold to mutual funds
as the Investors by issue of Pass Through Certificates (PTC). By device of issuing PTC,
the SPV merely undertakes to pass on the receivable to the PTC holder, only after and on
condition that the loan receivables are paid by the hirer or the borrower concerned and
received by the non-banking finance company as the originator.
There is no
independent obligation or any assurance by the SPV or the Trustees of the SPV to
independently make any payments, unless the regular payment is made on due dates by
the hirer or the loan borrower to the originator. There is absolutely no indemnity or any
guarantee or even an assurance provided to the holder of PTC regarding due and timely
payment of the periodic payments falling due to the PTC holder, as the investor. The
PTCs are not negotiable instruments and are not transferable by endorsement and
delivery.
There is no statutory register of PTC holders and therefore there is no
question of transfer of PTC by execution of duly stamped and registered formal transfer
deed, as in the case of shares and debentures. These are also not approved securities
for the purpose of investments by a banking company, a financial institution or by
public or charitable trust or by LIC, GIC and its subsidiaries. Further, the amounts due
and payable under the PTC cannot be recovered even by the bank or financial institution
as the holder thereof by application made to the Debt Recovery Tribunal. The benefits
available under Section 88 of the Income Tax Act for repayment of housing loans for
construction or acquisition of residential house would no longer be available after the
housing loan portfolio along with the security interest therein stands transferred and
assigned by way of securitisation by the housing finance company.
While adopting
securitisation of mortgage debt as a new tool for financing the banks have failed to
appreciate that MBS is the same instrument as a secured non convertible debentures.
There is no legal basis for securitisation of the mortgage loans and the holder of the
MBS will be unable to enforce the mortgage or to sue for sale of hypothecated movable
assets.
Unfair Advantages
The bandwagon of securitisation concept was readily adopted one after the other by
not number of non banking finance companies, housing finance companies and some of
the banks for their own advantages and benefits, especially because the concerned
regulatory authorities failed to comprehend the precise nature of securitisation
transaction in the context of the financial market in India. Unnecessary and vague
comparisons were made with securitisation transaction in America and with the
practices and procedures followed by Fannie Mae, Freddie Mae and Ginnie Mae in
America for financing of growth of housing finance in that country, without look at the
statutory provisions the federal structures and system of insurance for housing loans
prevailing in USA.
SPV
On its part SPVs are mostly organized as a trust and as such indeed they escape all
the regulatory requirements as applicable to the companies the non-banking finance
companies, the mutual funds and cooperative banks or cooperative societies. When the
trust receives income on behalf of the beneficiary, the provisions of Section 161 of the
Income Tax Act 1961 would be attracted, and as representative assesses the Trustee
would be liable to pay tax in like manner and to the same extent as the beneficiary. The
Income Tax Act imposes the liability to tax on the trustee as the representative assesses
on all income.
Banking Utopia
For the ages the banks have been living in its own utopia and taking for its finance
security by way of hypothecation and mortgage by way of deposit of title deeds. The
banks looked to savings in payment of stamp duties and registration charges and avoid
botheration of investigation of title, but the banks did not realise that hypothecation can
hardly be called a charge on the movable assets of the borrower.
The term
hypothecation has not been defined either in the Indian Contract Act, 1872 nor in the
Transfer of Property Act, 1882. The hypothecation is often loosely described as pledge
without possession, and it creates only a floating charge on the movables whose
possession remains with the borrower, who can use the movables for the purposes of
his business. The courts do not recognise right of the bank either to attach the stocks
or sell them inspite of clauses in the hypothecation agreement executed by the
borrower. The Supreme Court in case of K.L. Johar has held that the hypothecatee has
no right to take over possession of the goods. The bank has to file suit and obtain
orders for sale of the goods by public auction for recovery of the defaulted amount. The
bank will have to bear the loss in case the goods had deteriorated or lost or sold in the
meanwhile by the borrower. Justice Ameer Ali had pointed out that the use of the word
hypothecation should be abandoned. It is equivocal and therefore dangerous word. Mr.
J.C. Shah, former Chief Justice of India has opined that a creditor who has advanced
monies on hypothecation of goods has no property in goods hypothecated and that it
would be misnomer to call him a secured creditor. The now famous case of C.T.
Sentianathan, after going deep through the concept underlying
hypothecation
agreements, it was held that there is no transfer of interest in the goods and the right of
the hypothecatee is only to sue on the debt and proceeds in execution of the
hypothecated goods only, use the goods are in possession and available with the
borrower.
The correct position in the case of hire purchase and vehicle finance is even worse.
The vehicles are registered in the name of the customer, as owner of the vehicle with the
RTO under provisions of the Motor Vehicles Act, 1988 and the finance company is never
registered nor regarded as owner of the vehicle, but mere entry is made to the effect
that the vehicle is acquired under a hire-purchase arrangement. The Supreme Court of
India in the case of Sundaram Finance Ltd. v. the State of Kerala, while dealing with
payment of sales tax under the Travancore Cochin General Sales Tax Act has decided
that the clauses appearing in the hire-purchase agreement for option to take possession
of the vehicle by the financer is only license to seize to facilitate recovery of loan
advanced for purchase of the vehicle. The Hire-Purchase, 1972 was in terms of the
Government Notification dated 31st May, 1973 to come into force from 1st September,
1973, but the said notification was subsequently rescinded by the Government
Notification dated 30th August, 1973. Thereafter, the Hire-Purchase (Amendment) Act
was passed but the amendment has not been brought into force, due to court decisions
as to true nature of the hire-purchase and deferred installment payments transactions.
In addition after the Constitution 46th Amendment Act, 1982 for amendment of Article
366,
the hire purchase transactions as such involve payment of sales tax under the
relevant sales tax law as applicable in the particular state concerned.In the state of
Kerala in terms of the notification under the revenue recovery Act, 1820 the nationalised
banks are entitled to recover their dues by simple requisition to the district collector as
arrears of land revenue.
Adoption of Different Forms of Security Devices
There is no reason to believe that non-banking finance companies, banks and
financial institutions are helpless as against the borrower.
As lenders they are all
equipped with a number of legal remedies and rights for speedy recovery of amounts
due from defaulting borrower. But the banks in general and of their own volition are
either ignorant or not willing to take benefit of provisions of the law or the relevant
legislation for various reasons including defect in the loan documentation signed by the
borrower. For example, the erstwhile IFCI Act, 1948 which established the very first
financial institution in India and the State Financial Corporations Act, 1951 contained
special provisions for speedy recovery of due from the defaulting borrower. The
erstwhile IRBI Act for establishment of the Industrial Reconstruction Bank of India
contained provisions for creation of charge by execution and filing mere declaration into
prescribed format. Such declaration is not required to be registered under Section 17 of
the Indian Registration Act, 1908. This declaration creates
mortgage interests on
immovable property and is deemed to be treated as creation of simple mortgage by the
borrower and accordingly all rights and remedies available to a simple mortgage were
made available to IRBI. Some of the State Governments have passed special legislation
akin to law for revenue recovery for speedy recovery of its dues by the banks as arrears
of land revenue. The provisions of Section 69 of the Transfer of Property Act, 1882
deals with powers and rights for recovery of its dues by the mortgagee by private sale
and
without
intervention
of
the
courts.
Further Section 69A of the Transfer of
Property Act provides for appointment of receivers and management of the property of
the borrower without intervention of the courts.
Nearly 100 year-old enactment the
Code of Civil Procedure, 1908 in the Order 37 Rule 40 provides for summary procedure
for recovery of dues by the bank.The shares, debentures and government securities
dematerialised format can now very easily be pledged by filing necessary details in the
Form No W. with the Depository Participant concerned in accordance with the terms of
the Depositories Act,1996.
In spite of the various statutory provisions mentioned above, it is wonder of all
wonderers as to how the banks have been able to build-up mountains of NPAs. Further,
very often the banks are not able to recover amounts due on a simple demand
promissory note or even from the Government under the Government Guarantee. The
blame is thereafter put at the door of defective legal system, procedural delays and on
the judiciary. At times the usual care is not taken just to verify and ensure that the
documents are duly signed by the authorised official of the borrower and that proper
stamp duty and registration charges have been paid as per applicable law prevailing in
the particular city or the State in which the documents have been executed. No doubt
that the attention was concentrated on avoidance of stamp duty and escape from
payment of Income Tax and Interest Tax as applicable.
Ignorance is not always bliss
The banks and financial institutions have been adopting practice of taking
memorandum of hypothecation of movable assets and creation of equitable mortgage
by deposit of title deeds on the immovable assets of the borrower , instead of taking
registered legal mortgage in English form over all the assets of the borrower. The banks
started taking equitable mortgage by deposit of title deeds and hypothecation of
movable assets merely in order to save on stamp duty and botheration for registration
of the mortgage deed with the concerned sub-registrar of assurances under the
provisions of Section 17 of the Indian Registration Act, 1908. The banks did not take
note of the fact that an equitable mortgage can be enforced by filing a money suit in the
court and that receiver of the assets of the borrower can be pointed only with and under
orders of the court of competent jurisdiction. In their anxiety to save on stamp duty and
registration charges the banks have in their own wisdom conveniently overlooked
provisions of Section 69 of the Transfer of Property Act,1882 which gives them right of
private sale without intervention of the court and right for appointment of receiver of its
choice. In short, registered legal mortgage in English form gives to the banks right to
appoint receiver of its own choice and sell the mortgaged property at its own option
without intervention of the courts.
The Deposit Insurance and Guarantee Corporation of India Ltd. guarantees the
repayment of the amounts of account holder upto the sum of rupees one lakh to the
bank depositors, but even after decades of its existence no insurance or guarantee is
made available to the banks against default by the borrower.
Exporters are made
available different types of insurance cover and guarantee for recovery of the dues on
failure of the foreign buyers to make payment of the purchase price of the goods
exported by an exporter in India. The Export Credit and Guarantee Corporation of India
Ltd (ECGC) covers not only the finance risk, but also foreign currency remittance risk
and the political risk in the event of change in the policy and political structure of the
foreign country to which the goods have been exported.
The banks often take personal guarantee even in case of professionally managed
companies from the individual directors, but they are not able to recover anything from
the guarantors, as obligation under the personal guarantee is not secured by mortgage
of assets of the guarantor concerned in favour of the bank.
Finale
Each bank should evolve structured letter of sanction, a detailed loan agreement and
elaborate security documents including deed of pledge of securities, undertakings,
declarations and deeds of registered mortgage deed, deed of further mortgage and
additional charge, as also debenture trust deed, all duly supported by drafts of relevant
resolutions to be passed by the general body meeting and at the meeting of the board
of directors of the borrower company. These documents can be evolved under ages of
the Indian Banks Association or by bodies like the Institute of Bankers in India.
A word for non-performing Banks
The banks concerned must, rather than relying on panel of lawyers at different
centers, have the post of chief legal adviser with the rank of an Executive Director, in full
charge and control of drafting, stamping, registration, execution of security interest
created by the borrower in favour of the lending bank.
Non Recourse Finance
It is high time that the banks must learn the need for non-recourse lending, where
repayments are based and made out of profits generated by the business activity
financed by the bank and not by enforcement of security and sale of assets leading to
the closure of the manufacturing capacity.
The bank should necessarily modify its
approach and disburse finance on basis of projections and viability of the project and
the cash flow generated out of the business activity.