Asset reconstruction companies (ARCs) is a type of finance company in India. They were formed as part of steps taken by the Government to clean up the balance sheets of banks and financial institutions and help revive the credit and investment cycle in India. The ARC industry was born out of the Recapitalization and Financial Services Industry Development Act 2002. The Act gave an opportunity to banks, insurance companies, and financial institutions that have been into losses for some time, or are facing temporary capital problems.
Asset Reconstruction Company is a new concept in the Indian financial system. The company has been formed by pooling of non-performing assets (NPAs) of various Banks/Financial Institutions. The ARC has to be incorporated as a non-banking finance company (NBFC). It can be set up by Indian or foreign individuals, companies, corporations, and Public Sector Undertakings.
Objectives of Asset Reconstruction Company
Contents
The major objectives of formation Asset Reconstruction Company are:
- Asset management activity so as to generate cash flows for repayment of debt and interest thereon.
- Ability to bring in operational efficiency and economies of scale in the organization.
- To promote innovation in financial markets.
- To develop new instruments for risk management and credit enhancement techniques.
- Developing securitization market by promoting high-grade financial assets.
- Enhancement of project evaluation, monitoring, and implementation capabilities.
- Developing infrastructure for alternate sources of long-term finance.
Schemes Offered by Asset Reconstruction Company
The schemes offered by various ARCs vary from one Asset Reconstruction Company to another Asset Reconstruction Company and normally include:
1) Securitization and Reconstruction of Financial Assets (SARFAESI Act 2002 / Debts Recovery Tribunals 2000)- Creation of securities backed by non-performing assets (NPAs).
2) Capital Market Linkages- Participating in the capital market either as a lead manager or as an investor through quasi-equity instruments such as convertible warrants, preference shares, etc.
3) Treasury operations- Maximizing return on surplus funds through investments in money markets or bank deposits.
4) Loans against shares- Loans given against pledged shares/convertible warrants/fixed deposits.
5) Cash management services- Payment collections, cash concentration, and investments in the short-term money market.
6) Trade finance- Advancing credit for business transactions to India or global clients of Indian exporters/importers.
7) Borrower Advisory Services (BAS)- To provide advisory on debtor profile, financial analysis of potential borrowers, restructuring of debt, etc.,
8) Asset reconstruction/securitization funds- Formation of funds with participation from banks, financial institutions, and other investors to acquire assets/NPAs at a discount to the bank book value thereof. These assets will then be reconstructed as per SEBI guidelines and sold either as an entire portfolio or as a single asset.
9) Project Advisory Services (PAS)- Advising promoters on project appraisal, structuring of equity/debt capital, and institutional development.
10) Portfolio Management / Portfolio Advisory services- Providing third-party asset management service to banks, financial institutions, and investors in the Indian market using their expertise either in-house or through an outside fund manager. Banks can also manage part of their restructured loan portfolio through ARC / Asset Management Companies / Trusts under RBI guidelines.
11) Security advisory services- Acting as a trustee for issuing debt instruments, a security consultant for corporate clients on issues like debenture trusteeship, dematerialization of securities, etc.
12) Other activities such as providing pure trade finance products e.g., export credit, import credit, finance for the turnaround of loss-making companies, etc.
The number of ARCs in the country has risen sharply over the last few years with nine new entities starting up operations in 2006. With an asset base of Rs.90 billion (December 2008), Asset Reconstruction Company of India Ltd (ARCIL) is India’s largest ARC, followed by Asset Reconstruction Company of India (ARCI). ARCs are regulated by SEBI and their services are available to both Indian and foreign investors/borrowers. Funds managed by ARCs can be used for almost any commercial purpose – real estate purchase/development; machinery acquisition; working capital requirement, etc.,
An ARC typically buys bad loans or non-performing assets (NPAs) from banks at a discount to their book value. The purchase of NPAs by ARCs is governed by the SARFAESI Act, 2002 which provides for debt recovery tribunals (DRTs). Banks are required to carry out due diligence on loan accounts before selling them to an ARC and provide the necessary reports/certificates in this regard. Besides, they should also obtain the borrower’s consent before passing on his account to an ARC. Banks should not release funds to any borrower in anticipation of a sale to an ARC or till the transfer of title in favor of the bank or till actual payment is made by the ARC.
The difference between book value and fair value is called “discount”, which is payable by the borrower after he gets the money from the bank. This discount is negotiated between banks and ARCs, depending on the type of account/loan bought by them. For instance, an ARC will purchase accounts up to Rs 30 lakh at a price not exceeding 65% over outstanding loans. However, for purchases above this amount but below Rs 1 crore, it will pay not less than 50% of the loan outstanding as against the earlier practice of paying 33%. The negotiations are expected to increase because currently there are only two or three ARCs in each region so banks have very little bargaining power.
ARCs have been allowed by SEBI to launch mutual funds with a view to raising more capital for acquiring bad assets from various financial institutions(FIs). They can acquire NPAs from banks that are willing to sell these assets at a discount. An ARC can collect money from investors through mutual funds by issuing units to them. It can then use the money to buy NPAs from banks, which are willing sellers. Banks, in turn, will be able to remove bad assets on their books and increase their profitability through this sale.
Currently, mutual fund houses such as UTI and Birla Sun Life offer such funds where an investor can park his/her money for a fixed period. The return would depend on the performance of the underlying assets, i.e., loans or NPAs bought by ARCs with the help of those funds. These schemes also generate revenue for ARCs which would not have been possible if they had to depend on bank funding alone.
Till date, no Indian institution has entered into any such arrangement for purchasing NPAs from foreign Banks/FIs under the SARFAESI Act 2002 (India does not allow the purchase of NPAs by FIs from abroad). It may, therefore, be premature to say something about the success or otherwise of such transactions when they are proposed. However, given that our economy is driven majorly by domestic demand it would seem likely that loans acquired abroad may be of less importance. Even if acquired, the final decision to pay or default would remain with the borrower (i.e., Indian party)..
The Government is reportedly considering allowing asset reconstruction companies (ARCs) to acquire non-performing assets (NPAs) in foreign countries. Such a move could help both Indian borrowers and FIs, as well as Indian ARCs that are facing a fund crunch because banks are not willing to sell their NPAs at reasonable prices. This would be in line with the SEBI regulations which allow ARCs to raise money by issuing units of various categories of funds including those invested in debt instruments/assets or loans receivable from lenders other than banks.
Credit guarantee corporation (CGC) has recently introduced the facility for partial risk guarantee up to 70% of loan amount subject to a maximum limit of USD 3million per borrower provided the borrowing company is registered in India. Lower risk of credit to foreign borrowers can be further minimized by appropriate documentation of the deal and standard contract clauses, which would provide comfort to Indian lenders/FIs besides ensuring high recovery ratio.
The proposal has found favor with some ARCs already operating in India which are finding it difficult to raise funds for buying NPAs from banks that are willing to sell their stressed accounts on reasonable terms. They also see this as an opportunity for tapping into global markets.. However, they suggest that more clarity is needed on modalities before bilateral deals involving the purchase of NPA accounts start becoming a reality. This clarification should come from RBI because the proposed arrangement will be governed by the rules applicable both under the SARFAESI Act and the FDI policy.
The RBI can also seek clarification from SEBI on issues such as whether ARCs would be allowed to sell these assets in foreign countries when they grow in value or when opportunities arise in the future, or if Indian law alone will apply to any sale within India. This is important because many NPA accounts are unlinked to specific projects – thus they may not necessarily have a long-term value proposition attached to them.
It would seem that though bilaterally negotiated deals between Indian banks and overseas borrowers/FIs may help Indian borrowers, it will be difficult for ARCs with limited ability to service stress outside of India without adequate investment back into the country. Also, irrespective of the quantum of money mobilized by ARCs through these bilateral deals, it would be difficult to deal with the entire stock of bad loans.
Another important consideration is that even balanced/un-discriminating bilateral deals may affect Indian FIs’ profitability adversely due to the relatively high risk involved in such transactions. For instance, an FI lending against specific assets or projects could end up having the security held by another FI/bank overseas resulting in a serious threat to its financial interests if there is a default on account of either party.
The procedure followed by Asset Reconstruction Company
Asset reconstruction companies (ARCs) are essentially specialized financial institutions created to acquire and manage bad assets. They target the entire spectrum of stressed accounts ranging from lower-rated ‘watch list’ accounts to higher-rated ‘special mention accounts’ or even unrated stressed assets. Asset reconstruction companies use different strategies for credit recovery which include asset sales with recourse, bulk portfolio purchases through auctions as well as individual account purchases by making a substantial equity investment linked with an agreement for profit share.
ARCs are typically capitalized by asset reconstruction professionals who have the ability to recover credit over a longer time frame. The company acquires these non-performing assets at discounted prices and then employs strategies to improve their cash flows, realize value through strategic sales/disposals or operational improvements which translate into superior returns for investors. Generally, an ARC has 60% equity participation from its management shareholders supported by around 8-14% debt component raised domestically as well as foreign borrowings. The promoters of ARCs are generally experienced financiers with extensive knowledge of stressed sectors through their past work exposures in the banking sector.
These companies purchase stressed accounts representing impaired loans that are not considered standard or fully performing by traditional banks or other lending institutions. This acquisition of non-performing assets (NPAs) is done with the intent to create a new business model that will aid in recovering some or all of the money owed.
Usually, ARCs purchase portfolios of NPA accounts by making an upfront payment and providing funds for asset improvement over time. The key to success in this type of business is having credit managers who can analyze historical data and develop strategies that work toward reducing losses and recovering payments.
ARCs provide working capital loans to acquire these non-performing assets, usually through their own treasury divisions. They also sell enough securities on the market to generate cash flow from interest gained, ensuring profitability for investors. Sometimes they even maintain ownership of about 40% of the overall portfolio.
After the purchase of the assets, ARCs employ recovery officers who are experienced in recovering money from bad loans. They have the power to negotiate terms with debtors for voluntary repayment plans, write-off percentages on delinquent accounts and improve credit ratings by paying off high-interest rate loans or late fees. Recovering assets usually involves finding buyers for collateralized assets which can take months or even years if they are not marketable. This is where financing comes into play again as ARCs try to find new sources of cash flow while waiting on buyers to come back with offers.
Although these companies operate with capital from investors, their success is dependent upon whether they generate more cash than they spend; otherwise, they fail. If an ARC spends more than it recovers, then its original investors ultimately experience a loss.
ARCs purchases debt from banks and financial institutions with the intent of recovering credit. They use a variety of strategies to improve cash flows and recover payments. Successful ARCs have been developed in India over the past 10 years as losses from NPAs have increased for banks and financial institutions. Banks have been slow to write off bad debt so they sell it to ARCs at discounted prices where it is hoped that better management will yield positive results. However, most credit managers still face difficulty when attempting to accurately predict risk factor behavior within a portfolio. Therefore procedural guidelines are required before an ARC can purchase assets from an institution or bank which has listed non-performing assets on their balance sheets, such as the credit review process and due diligence.
The Reserve Bank of India (RBI) has established guidelines for identifying bad loans, recognizing losses, and determining if a loan is an NPA. The RBI uses its own internal risk rating methodology that is based on:
- Past record: how well the company has performed in the past with respect to its balance sheet and income statement;
- Prospects: whether there is any indication that future performance will deviate from its track record; 3. Company-specific factors: such as size, growth potential, business mix, etc.;
- Industry conditions: prevailing economic conditions or other relevant aspects affecting external factors which have been taken into consideration for arriving at the final risk rating.
RBI risk ratings range from AAA to D and typically impact whether a bank will provide additional funds as the risk of default increases. If a loan falls within this category, it is considered non-performing and must be reported on the balance sheet. The classification of NPAs into substandard, doubtful, or loss can take place at any point during the term of repayment depending on certain conditions such as delinquency, and whether payments are less than 90 days past due. A loan that has been outstanding for one year after it has become an NPA is classified as ‘doubtful’ while loans that have not been repaid for two years are classified as ‘loss’. Loss accounts do not indicate bankruptcy, however; if a company cannot repay a loan, the bank will declare it as non-performing and may eventually decide to file for bankruptcy on its own.
In an effort to prevent banks from diverting funds away from priority sectors such as agriculture and industry, RBI regulations have been established that prohibit lending institutions from using these funds to restructure NPAs. In short, NPA’s must be restructured by the ARC who purchases them rather than being refinanced within the originating institution. The Indian Banks Association (IBA) has set up a policy framework so that both borrowers and creditors can come together in a process dealing with issues of restructuring or liquidation depending on its financial position. Under IBA rules all lenders must appoint an external management agency with experience in asset reconstruction while the borrower must also appoint a committee with the responsibility of representing their interests.
An ARC is able to purchase NPAs through either cash or credit bid procedures where they may stand as the highest bidder or lowest debtor respectively. The assets are then merged into one entity and managed under an asset management company (AMC) operated by the ARC until all returns can be maximized. If it appears that funds will not exceed managerial expenses, the AMC will file for bankruptcy after five years.
This process is governed by section 45L of the Reserve Bank Act which states borrowers cannot circumvent liquidation proceedings by promising to repay loans at face value later on even though negotiations may have taken place between borrowers and lenders prior to the appointment of an ARC. An example of the latter includes leasing agreements where banks are prohibited from doing so by regulation.
The IBA has provided guidelines for regulatory parameters on parameters such as pre-qualification rating of AMCs by rating agencies, eligibility criteria for companies desiring to act as AMCs, and treatment of employees under different circumstances. The main objective is to protect both borrowers and creditors alike through transparency in procedures, adequate disclosures, and judicial review.
It is important to note that if an ARC is unable to generate positive cash flow after a five-year period they must either liquidate the portfolio or restructure it outside of the auctions process with permission from RBI regulators. An example of this would be when an ARC restructures the asset pool through additions, deletions or substitution which may result in the sale of an asset that was not included within the original portfolio.
If a bank is unable to continue with their ARCs because of negative cash flows, they are required to sell or transfer them and submit a request for approval with RBI regulators. The banking regulator then decides whether or not it is necessary to appoint another ARC and if so, notify all lenders accordingly. If permission is granted, the bank can also decide on which ARC will be allowed to manage defaulted assets under the terms and conditions set by RBI as long as it is deemed as least costly for all creditors.
Conclusion
To sum up, setting appropriate rules and regulations for this potential new business area is critical else it may prove counterproductive for all stakeholders including borrowers who are looking forward to fresh infusions of capital . It must also be kept in mind that existing SEBI regulations permit only Indian ARCs to raise money by issuing units of various categories.
It is important not to allow such unilateral deals in order to avoid all legal complications and issues mentioned above, such as the FI’s risk involved. There must be regulation for any purchase because it can prove beneficial for both sides if done correctly without bringing too much scrutiny down on the buyers and sellers of this debt.
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