ARCs will come of age only when the legal process turns highly efficient
The 15:85 structure introduced by Reserve Bank of India (RBI) in August, raising asset reconstruction companies’ (ARC) minimum security receipts (SR) subscription to 15%, for acquisition of non-performing assets (NPAs) from banks, restored parity between NPA acquisition cost and the estimated recovery (see here). As expected, barring few tactical acquisitions by the ARCs for consolidation, the NPA acquisition by ARCs has come to a standstill. Why? The erstwhile 5:95 structure provided capital protection often exceeding 100% to the ARCs from the management fee. Hence, the ARCs could bid aggressively for asset acquisition and realise fair returns with back-ended recovery even when the total recovery fell substantially short of the acquisition cost. Though the resultant losses on SRs impacted the banks, the transactions suited them since those resulted in back-ended provisioning by the banks. Under 15:85 structure, the capital protection to ARCs is limited, and hence ARCs have to seek NPAs at a significant discount to the anticipated recovery, entailing upfront provisioning by the banks.
Overall recoveries from NPAs average around 25% of the secured loans outstanding.
Hence, for 20% return over a 5-year horizon under 15:85 structure, the ARCs tend to quote an average of less than 20% of outstanding loans for NPA acquisition. Based on RBI provisioning norms, such deals require provisioning in excess of normal if the asset has been non-performing for up to two years. This tends to deter the banks from selling early NPAs, and limits the transactions only to the loss assets. But is this happening?
Regulatory hurdle
According to RBI guidelines, the banks are required to sell the NPAs at a (reserve) price, which should not be generally lower than net asset value (NPV) of estimated net realisation from the account. This is not workable since this does not leave any margin for the ARC, barring exceptions. No wonder the banks have not been able to offer even loss assets at reasonable price to the ARCs under 15:85 structure.
Based on identical acquisition cost and 5-year back-ended recovery profile with 15:85 structure, reasonable returns to ARCs require high recovery ratios i.e. ratio of overall recovery to the acquisition cost. For 20% pre-tax internal rate of return (IRR), with management fee (1.5% pa) linked to SR value, the recovery ratio is 148% (see “A” in the figure). With management fee (1.5% pa) linked to recovery, the recovery ratio is 153% (see “B”). For all-cash acquisition, the recovery ratio is 182% (see “C”). It is evident that the 15:85 structure has resulted in fairly-efficient NPA price discovery, though the price discovery in all-cash acquisition is the most efficient. However, the acquisitions are not materializing owing to the regulatory constraint.
In the SR structure, the maximum recovery and hence the distribution is limited to the outstanding dues. Hence, if the stressed account turns around, a limited upside flows to the SR holders if in the portfolio, the recoveries leave surplus after paying for the expenses, management fee, SR redemption and yield if any. The ARCs are allowed to convert a part or whole of debt into, up to 26% of total equity. Such conversion can potentially provide significant upside to the ARC in case of all-cash acquisition. However, such upside tends to be nullified since the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 requires restoration of the management back to the defaulter after turnaround by the ARC.
Efficient legal process - A must for maximizing value
Owing to legislative loopholes, judicial pronouncements, and very tardy legal process, the DRTs, which adjudicate the Recovery of Debts Due to Banks & Financial Institutions (RDDBFI) Act 1993 and SARFAESI matters, take years to dispose of the cases. The recovery by ARCs, therefore, continues to be highly back-ended to which scenarios A to C relate. However, if the recovery is front-ended, ARCs’ returns increase substantially, and for 20% return, recovery ratio is just 122% (see “D”). Thus, banks can expect significantly higher valuations only with front-ended recovery. This, however, requires highly efficient legal process.
Way forward
RBI should withdraw the current NPA pricing methodology, which does not leave margin for the ARCs. The banks should sell the NPAs mandatorily to the highest bidder without reckoning the imprecise reserve price. Loss on sale to the ARCs should be allowed to be written off in three years, for the next five years. This will also catalyze all-cash transactions. ARCs should also be allowed 100% equity through conversion and exercise of pledge of shares if any.
ARCs will come of age only when the legal process turns highly efficient. Hence, for speedy clearance of the backlog of about 45,000 cases in DRTs with defaults exceeding 1.45 lakh crore, the government of India should urgently increase the number of current 33 DRTs and appellate tribunals adequately, and introduce e-governance in all the DRTs and tribunals / courts. The system should be backed by adequate judicial manpower and amendments to RDDBFI and SARFAESI acts, including section 15 of SARFAESI act, to allow permanent management change. The recovery suits must be disposed of within the statutory timelines, and any laxity should invite strict penalty. Adjournments sought by the parties should attract prohibitively high fee so that the defaulters’ cannot adopt delay as a strategy.
The UK bankruptcy code is creditor-friendly, where over 50% of the distressed companies are sold as going concerns and over 40% of the companies are liquidated piecemeal. The liquidation process gets concluded in less than 1½ years and delivers to the lenders, recovery of about 75% with recovery cost of just 15% of the asset value. Overall, 75% of the distressed assets undergo bankruptcy and the balance is restructured, reflecting the lenders’ preference for restructuring viable businesses. Speedy resolutions under UK’s bankruptcy code show that the speed of judgments induces discipline among the borrowers. The government of India needs to appreciate merits of speedy adjudication and take immediate corrective action before it is too late.
(Rajendra M Ganatra is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal)
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arc companies makeing sale of assets without taking the future responsibility like provident fund , excise duty on machinery which also auctioned, service tax liability , vat/cst liability -- how buyer will get rif off these problems
As for the legal system, now that is one sad case. You see we have simply continued with what the British left for us. Innovation is no longer there. We have made some minor changes here and there, otherwise its just another monolithic government machine, where there is no real checks and balances or performance yardstick which you have also mentioned. But due to our legacy issues, we are coming with some serious baggage. Yes, we desperately need to increase no. of court including DRT. But that would mean finding more Judges and POs. Where do you get them ? Or if you do, what about quality ? The disparity between small towns and big cities are known and is a major drawback here. The small town guys are the once primarily interested but as seen recently with UP, english is a serious issue with them. So, when the higher courts are english based and lower are vernacular, recruitment is an issue.
I think our country is too complex to have any major changes if realistically contemplated. Rather, it would have to be small changes. Yes, it would be slow and woefully inadequate but there is no other option. RDDB and SARFEASI has happened. Not quite what expected but its there. It would be like that only because of our social structure and strong regionalism which magnifies the problem.
Its for this I sometimes feel that there is some merit in the totalitarian form of government where things happen once it is decided upon. Whereas we have a mockery of democracy. I once asked a Chinese how they dealt with the mutli culture issue which must be there, the country being larger than India. He explained that once there was an emperor Qin (from which the word Chin has come). He decided that there would be one written and spoken language and simply wiped out all opposition. While it is debatable whether he was great or a monster in view of the age old argument of end justifying the means, it is better than what we have here, where I cannot understand what my next door neighbor is saying!!!
The mention of UK bankruptcy act needs to be taken seriously and Govt of India under the leadership of Shri Narendra Modi should bring some changes to protect the public money from being misused.
Your suggestions are apt for amending certain clauses in the SARFAESI act so that the defaulters do not take for granted the loop holes in the law to their advantage. Strict instructions should be given to the DRTs not to grant stay beyond a point and to deliver quick judgements. Otherwise there are cases in DRTs languishing for more than a decade. To accomplish this suitable measures such as increasing thfe presiding officers in good numbers in DRTS and adding more DRTs should be the immediate agenda for the Central Govt.
Once again congrats for a nice article.Please keep it up.
ARCs is an extended arm. These ARCs as author suggests should be allowed the leeway to function on viable and efficient lines but with accountability to deliver results. From one window of NPA shifting to another window does not render the economy any good.