Winds of change in the stressed assets market

The market for stressed loans in India is undergoing a major shift. The government, the RBI as well as the SEBI have unleashed a series of reforms in what appears to be a well-coordinated strategy to address the NPA (non-performing asset) crisis. State intervention in the form of a new bad bank is being complemented through wider structural reforms to facilitate the development of a vibrant market in stressed assets.

The policy mandarins of North Block deliberated on the management of stressed assets at the Financial Stability and Development Council (FSDC) in early September. By mid-September, the Cabinet approved setting up of the National Asset Reconstruction Company Ltd. (NARCL) to takeover nearly ₹2-lakh crore worth of NPAs from the banking sector.

A week later, the RBI followed through and liberalised its norms on transfer of stressed loans. Banks, NBFCs, and All India Financial Institutions (AIFIs) have now been allowed to use the resolution process under RBI’s June 7, 2019, Circular to sell their stressed loans on cash basis directly to a new set of players including corporates as well as financial sector entities permitted to take on such loan exposures by their respective regulators.

In parallel, SEBI Chairman Ajay Tyagi announced at a recent CII event that the regulator is considering a new sub-category of Alternative Investment Funds (AIFs) for investing in distressed loans from the banks and NBFCs. This reform was originally suggested in 2019 by the RBI Task Force on Development of Secondary Market for Corporate Loans. Given the larger context, this new category of AIFs would possibly be allowed to purchase NPAs directly from banks, NBFCs and AIFIs on cash basis under RBI’s new norms.

These reforms are indeed in the right direction. They should help unlock the capital of banks and financial institutions, enabling them to extend fresh loans to boost the post-pandemic economic recovery. To achieve this larger objective, policymakers should consider the following legal changes to complement these structural reforms.

Suggested changes

First, any financial entity which is allowed to purchase stressed loans from banks and financial institutions should also be given enforcement rights under SARFAESI, which was traditionally enjoyed only by identified banks and financial institutions. Foreign portfolio investors who play a major role in financing to the unbanked sectors in India by investing in unlisted securities should also be permitted similar access (the access at present is only for listed securities). This legal privilege can be restricted to financial investors and need not be extended to strategic investors who are otherwise eligible to purchase distressed debt under the recent changes introduced by RBI.

Secondly, SEBI should permit Category II AIFs to also invest in distressed loans from the banks and financial institutions. Category II AIFs already enjoy pass-through status under the Income Tax Act, 1961. Further, they are already being used as debt funds and have the potential capabilities required for stressed assets funds. Given the nature of their set-up, they can provide a healthy competition to the existing participants in the stressed assets market.

Finally, acquisition of control of a listed company through debt to equity conversion by permitted financial sector entities under the new RBI directions should be exempted from the open offer requirement under the Takeover Code, 2011. Currently, acquisitions under SARFAESI as well as under the Debt Restructuring Schemes of RBI are exempt from such open offer requirements.

The same treatment should be extended to acquisitions by permitted financial sector entities under the new RBI norms. This measure would make it relatively easier for permitted financial sector entities to take control of a highly leveraged distressed listed company, turn it around and subsequently make a profitable exit by selling the business.

The Government, the RBI and SEBI are on the right track in reforming the Indian stressed assets market. The recent structural reforms coupled with the anticipated reforms for ARCs as a sector, if complemented with the legal measures suggested above, could make the market for stressed assets more attractive and lucrative to potential investors, including offshore investors, giving the best possible exit for banks and financial institutions. A vibrant change in this space is hopefully a reality soon.

Veena Sivaramakrishnan is a Partner and Pratik Datta is a Senior Research Fellow at Shardul Amarchand Mangaldas & Co.

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