Asset Reconstruction Companies



The genesis of asset reconstruction business in India owes its origin to enactment of the Securitisation Act (THE SECURITISATION AND RECONSTRUCTION OF FINANCIAL ASSETS AND ENFORCEMENT OF SECURITY INTEREST ACT), 2002 which was enacted by the parliament in December 2002. Prior to promulgation of the Securitisation Act, 2002, banks and financial institutions had no option but to enforce their security interests through the court process, which was extremely time consuming.

After the enactment of SARFAESI Act, many asset reconstruction companies (ARCs) were formed. The Asset Reconstruction Company of India ltd (ARCIL) was the first one to get incorporated. It was promoted by ICICI bank, IDBI bank, and SBI. ARCIL has recently launched retail NPAs resolution initiative through ARMS.

The Securitisation Act principally provides for the following:
· Enforcement of Security Interests by secured creditors;
· Transfer of NPLs to asset reconstruction companies (ARCs), which can then take measures for recovery as prescribed under the Securitisation Act, 2002;
· A legal framework for securitisation of assets.

"ARCs are formed to acquire NPL from banks and financial institutions with the objective of focused management and optimal recovery, thereby relieving banks and financial institutions of the burden of NPL and allowing them to focus on core activities. The word asset reconstruction company is a typical Indian word - the global equivalent of which is asset management companies.

The word ""asset reconstruction"" in India owes its origin to Narsimham Committee I which envisaged the setting up of a central Asset Reconstruction Fund with money contributed by the Central Government, which was to be used by banks to shore up their balance sheets to clean up their non-performing loans. This idea never worked: so Narsimham Committee II thought of ARCs, the likes of which had already been successful in Malaysia, Korea and several other countries in the world.

To keep the tune the same as the original idea of asset reconstruction fund, as also to give an impression that ARCs are not merely concerned with realisation of bad loans but they are going to do ""reconstruction"", e.g. resurrect bad loans into good ones, the word ARC has been used in India.

There are two methods under which NPA is sold to ARCs: 1) Cash Route and 2) Auction wherein Security Receipts are issued by ARC to the Bank

1) Cash Route: Auction of NPA Portfolio is conducted and price determined mutually. ARC pays the amount upfront to the Bank.
2) Security Receipts: ARCs generally make 20% payment upfront and for the balance SR is issued either to the Bank / Investors. As and when, NPA is recovered, ARC distributes the same to the Bank/investors against redemption of SRs held by them

In 2012-13, two third of the Asset purchased by ARCs were through Cash Route. However in 2014, major deals have been done by issuing SRs.

RBI allows a maximum period of 8 years to recover the NPA purchased. If the same is not recovered within 8 years, ARC has to write it off and also ARC would lose out on management fees in that case.

Asset Reconstruction Company (India) Limited (Arcil) is India's first and largest asset reconstruction company, to commence business of resolution of Non-Performing Assets (NPAs) upon acquisition from Indian banks and financial institutions. It is sponsored by prominent banks and financial institutions namely State Bank of India (SBI), IDBI Bank Limited (IDBI), ICICI Bank Limited (ICICI) and Punjab National Bank (PNB). Arcil has its registered office at Mumbai, Maharashtra. Arcil has acquired portfolio from more than 65 banks and financial institutions since inception. Arcil also forayed into reconstruction of retail assets through its division 'Arms' which is currently spread across 17 locations in India.
Arcil was incorporated as a public limited company in 2002 and in pursuance of Section 3 under the Securitisation Act, 2002, it holds a certificate of registration issued by the Reserve Bank of India (RBI) and operates with powers conferred under the Securitisation Act, 2002. As the premier ARC, Arcil played a pioneering role in setting standards for the industry in India. It commenced business by acquiring its first tranche of financial assets on 31stDecember, 2003. Since inception, Arcil has acquired more than Rs. 70,000 crore worth of NPAs from the Indian banking system. In the process, it has also empowered the Indian banking system to grow faster and remain stronger in a challenging economic environment.

Transaction flow in Asset reconstruction industry
The trust acquires NPAs from banks/FIs by formulating different trusts for the financial assets taken over. NPA are acquired from banks/FIs at fair value based on assessment of realisable amount and time to resolution. The maximum life of the trust as prescribed by the regulations is five years .The trust is set up as a pass through entity (PTC) for Income tax purposes.
1) Accordingly, the trusts issues securities (SR) to the investors which are usually QIBs or the seller bank itself. Therefore in case the seller bank is itself buying the SR in the Trusts, its status changes from lender of the loan to that of investor in the SR. SR represent undivided right, title and interest in the trust fund. After acquiring the NPA, the trust becomes the legal owner and the security holders its immediate beneficiaries. The Securitisation Act prescribes that an ARC has to make a minimum of 5% investment in the trust.
2) The Trust redeems the investment to the SR holders out of the money realise from the borrowers. The ARC facilitates the whole working.
The NPAs acquired are held in an asset specific or portfolio trust scheme. In the portfolio approach, due to the small size of the aggregate debt the ARC makes a portfolio of the loan assets from different banks and FIs. Whereas when the size of the aggregate debt of a bank/FI is large, thetrusttakes asset specific approach.

Accounting aspect of ARC-
New accounting terminologies and accounting polices emerged from the functioning of ARCs and it is important for us to know how they are dealt in the books of ARCs. Only the most prominent terms have been explained.
A- On the income side-
1) Upside Income-Upside income is the surplus generated over the acquisition cost of the NPA. Its like profit generated from sale of goods. Typically the ARC keeps 20% of upside and the remaining 80% is divided into the SR holders. Therefore the ARC gets the upside income in two capacity, first as anARC and then as SR holder. The former is generally termed as management incentive in upside and the latter is upside income from investment in SR.This income is accounted as and when realisation is made.
2) Interest from funded expenses- At the time of inception of trust, it does not have cash for payment of running expenses such as rating agency fees and due diligence etc.. Therefore ARC funds the expenses and charges interest on it, as mentioned in the offer document (typically 9% to 12%).
3) Interest on SR- As per the offer document some trust guarantees minimum yield to the investors. This interest is accounted on accrual basis where certainty exists with respect to its recovery.
4) Management fees- ARC charges trust for managing the asset. This charge is generally fixed as percentage of assets under management which normally ranges from .5% to 1%. The management fee is generally accounted on a quarterly basis and asset under management is valued by an independent valuation agency.
5) Advisory fees- ARC advices many companies on restructuring of debt and earns advisory fees on the same. This is accounted as per the terms of contract.
B- On the expenses side-
1) Acquisition Expenses- while acquiring the NPAs certain expenses such as legal, Registration and stamp duty, ROC, Valuation and due diligence, etc. are incurred which is accounted as and when incurred.
2) Valuation fees- all the trust are generally valued by an independent agencies on a quarterly basis on the basis of which rating is provided to them
3) SR investment w/off- Amount receivable from trust remaining unrealised over one year ,to the extent considered doubtful of recovery taking into account the rating and Net asset value of the SR , is generally provided for in the P & L account
4) Custodianship fees- the SRs are kept with and custodian like NSDL ,for which custodian fees is being paid by ARC
5) Provision for contingency reserve- Generally ARC appropriates certain percentage of outstanding SRs as a contingency reserve over and above diminution in the value of SR.

A typical example of Asset Sale to ARC by Bank is as under:

Let us assume that Bank X is having a Loan Portfolio that is classified as NPA as on 31.03.2010 aggregating to the tune of INR 8000 Million. (This Portfolio is secured by way of Primary Security to the tune of INR 7000 million).
As on 31.03.2014, Bank X decided to sell this portfolio to ARC - A. As on 31.03.2014, Loan Outstanding shall be INR 8000 Million plus Accrued Interest of INR 5000 Million.

Mutually agreed Value of the Portfolio - INR 6500 Million. ARC A pays the Bank upfront under the CASH ROUTE INR 6500 Million.
Since Portfolio was NPA for more than 3 years, 100% provision was supposed to be made by Bank X. Hence, ideally Bank should have written off INR 8000 Million. However, it decided to sell this asset to ARC A for INR 6500 Million.

Impact on Banks' Financial:

  •   Non Interest Income - INR 6500 Million
  •   Volume of NPA redcued by INR 8000 Million
  •   No write off required for INR 8000 Million leading to inflated profits and higher share price on the exchanges.

If we dig deep, actually Bank has lost INR 6500 million (INR 8000 M + INR 5000 M) - INR 6500 Million. ARC A has acquired the Asset with security of INR 7000 Million for INR 6500 Million).

Resources or Mechanism for Recovery followed by ARC is as under:
1. Settlement with Borrower
2. Restructuring of limits
3. CDR
4. Securitization
5. Liquidation of Assets

It should be noted here that ARC do not have power to infuse funds, however on the other hand Banks selling the Asset to ARC may infuse addition funds by way of adhoc or enhancement in case the vialbility of business is proved and intention of the borrower is clean.

Issues which concerns the industry
The Asset Reconstruction industry is in its nascent stage in India and there are many issues which concerns the industry.  

NPA valuation: The valuation of NPA always has been a contentious issue with many parameters affecting its results. There is always a difference of opinion on recovery period, method of valuation (whether value as going concern or not), and data collection. Bridging the valuation gap will be important for growth of the sector

Flexibility in controlling structure of an ARC: India has taken an approach with ARCs are either owned by the private parties or the bank (i.e. not by the government).But there is restrictions on a controlling stake by a single party in the ARC. A relaxation of this norm would encourage more private entities to have a presence in this sector bringing more depth to this sector. This will bring specialists into the game and the sector will be more competitive and transparent.

Reduction and standardization of registration fee and stamp duty:The duties should be rationalised and simplified to reduce the transaction cost and make the procedure smoother.

Life of trust set up by ARC for asset resolution:the maximum life prescribed by the law for trust is five years. There should be flexibility for extending the life of the trust if resolution is on-going or appears to be likely in the foreseeable future.

Lengthy recovery process:Lengthy legal procedures are well known to everybodydealing with Indian laws.The regulator should frame some laws to speed up the recovery procedure to encourage more churning in the sector.

Accounting policies-:As this sector is relatively new in India; the accounting treatment of important issues differs from company to company. ICAI should come forward and should prescribe some guidance which will bring comparability and transparency to this sector.

Changes Suggested:

  • Transparent Auction Process - There should be a mechanism in place so as to ensure that auction of asset and determination of value by ARC is transparent.
  • Increase in Government Participation - In India, most of the ARCs are independent third party entity. Indian Government should increase participation in ARCs so as to give confidence to the general public and related stakeholders.
  • Fiscal Incentives to banks
  • Pricing Benchmark should be created for Asset Class
  • Global Investors should be encouraged to invest in ARCs and effort should be increased for their participation.

The growth of Asset reconstruction sector is important for the Indian Economy. Some kind of fiscal incentives should be provided to fuel the growth of the industry.Also as total NPA in the Indian banks is reducing the ARCs should look forward towards other avenues of business like, business turnaround management and debt restructuring. There should be mechanism to review to working of ARC which should work upon increasing the transparency in the sector .As more and more private players enter into this sector, this space is really worth watching for.

It is worth mentioning here that India is among few Countries where ARC do not have a "Sunset Clause". In most other Countries, Asset Management Companies came in response to a crisis. Crisis should not be seen as a Permanent / everlasting phenomenah.