Is there a redeeming arc to the ARC business?
Why is the RBI not pleased with governance standards of ARCs?
Reconstruction devoid of integrity — whether of a nation, economy, or a mere asset class — is but a facade, destined to crumble under the weight of its own deception. Amidst varied hues of national sentiment, I shall leave it to the pundits to ramble on the subject of ‘reconstruction of nations’, while I stick to the topic of ‘reconstruction of bad debt’.
According to the Reserve Bank of India (RBI), governance standards of Asset Reconstruction Companies (ARCs) are no standards at all. Before we delve into what’s plaguing ARCs, let’s quickly explain what they are for the benefit of the uninitiated.
What is an ARC and how do they work?
An ARC is a specialised financial institution that buys Non-Performing Assets (NPAs) from lenders so that the latter can clean up their balance sheets. Basically, they are in the business of buying bad loans from banks, thereby enabling loan originators to focus on their core function of lending.
An ARC is registered under the Companies Act and with the RBI under Section 3 of the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
ARCs typically buy bad loans from lenders at a discount and try to turn a profit by recovering a larger amount. The ARC framework is designed to help borrowers revive their business to the extent possible — the intent is to preserve the productive asset generated out of the loan.
There use several measures for resolution of bad debt such as:
Rescheduling of payment of debt
Sale or lease of borrower’s business
Enforcement of security interest (Possession and Sale of Assets)
One-Time Settlement
Taking over operational control, among other things
However, the malaise of the sector lies not in the scarcity of resourcefulness, but in the perversion of the resourcefulness that exists — utilised not for genuine recovery, but to circumvent and exploit loopholes.
A perusal of the score card of ARCs during the last two decades1 throws up a mixed bag. There seem to be more missed opportunities and less than optimal performance by ARCs in fulfilling the principal mandates under the SARFAESI Act.
-Shri Swaminathan J, Deputy Governor, Reserve Bank of India
What’s bedeviling ARCs?
RBI has lately observed that a few entities find new ways of achieving their designs — whether it is to allow backdoor entry to defaulting promoters or use ARCs as conduits for evergreening of loans.
ARCs also need to be conscious of their conduct vis-à-vis the distressed borrowers. Even a single incident of misconduct can potentially snowball into a controversy which the sector should guard against.
-Shri M. Rajeshwar Rao, Deputy Governor, Reserve Bank of India
ARCs — a vehicle for entry of ‘tainted promoters’
The alleged modus operandi is such:
An ARC acquires the majority/entire debt of a defaulting company from banks at a significant discount during auctions.
It acquires at least 66% of the debt to become the primary debtholder as per the Insolvency and Bankruptcy Code (IBC) to gain substantial control over the resolution process of the distressed company to subvert it to defaulting promoters.
Section 29A of the IBC was specifically meant to keep out such promoters. However, often, entities meet this requirement by merely obtaining a declaration signed by the perspective buyer without undertaking any independent verification
Even outside the framework of corporate insolvency, ARCs tend to engage in covert practices where they sell the assets of defaulting borrowers using the powers granted under the SARFAESI. These sales are purportedly conducted discreetly and may involve transferring assets to entities associated with the company's promoter
In essence, this frees the promoters from debt obligations and facilitates their reacquisition of assets.
The evergreening illusion
Some ARCs, while enjoying the full benefits of the special position granted to them under the Act and the regulations, have been found to be using innovative ways to structure transactions in a manner to circumvent regulations. During the course of our onsite examinations, we have come across instances where ARCs have been used or allowed themselves to be used, if I may say so, as a conduit to evergreen distressed assets.
- Shri Swaminathan J, Deputy Governor, Reserve Bank of India
Another pressing issue is the practice of evergreening loans. Recently, the RBI took action against ECL Finance Ltd and Edelweiss Asset Reconstruction Company Limited (EARCL) for using the latter's platform to evergreen the former's stressed exposures.
The two entities were allegedly acting in concert through a series of structured transactions allegedly designed to mask the true financial health of ECL's loan portfolio. By using EARCL and connected AIFs, ECL could make it appear as if its stressed loans were being resolved when they were simply being rolled over or refinanced. This practice prevents the loans from being classified as non-performing, thereby avoiding the necessary provisions and write-offs.
The way forward?
Sound and robust governance provides a strong foundation for ARCs to build a sustainable business model. In this context, governance transcends mere regulatory compliance; it embodies a philosophy of accountability, transparency, and ethical conduct. In the realm of distressed assets, where conflicts of interest loom large and fiduciary duties are tested, effective governance can instill confidence in the processes adopted by ARCs.
I’d like to reiterate certain critical conditions that must form the bedrock of governance, as highlighted by the RBI governor in a recent speech:
A Diverse and Independent Board: Effective oversight by a diverse and independent board is crucial.
Robust Risk Management Framework: This framework is essential for identifying, assessing, and mitigating risks inherent in the portfolio of distressed assets.
Transparency: There must be clear disclosure of information regarding operations, decision-making processes, and accounting practices.
Conflict of Interest Management: Effective safeguards and robust policies are needed to identify, disclose, and manage conflicts of interest in a fair and transparent manner.
Comprehensive Code of Conduct: This should outline ethical principles, professional integrity, and accountability.
That’s all from me for this week. I’d love to know your thoughts!