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.