Powers of trusts formed by Asset Reconstruction Companies under SARFAESI ACT

Nidhi Bothra
nidhibothra@vinodkothari.com

ARC model was adopted in India to provide an alternative and quick mode of resolution of NPLs
to banks and to develop a healthy secondary market in India. ARCs in India are in the principle
business of acquiring and realizing non performing loans (NPLs) and it has not only surged as a
lucrative business but has also become a significant mode of recovery of debts, over the years.
With the takeover route being officially implemented by the Reserve Bank of India (RBI) by the
Guidelines on Change in or Take Over of the Management of the Business of the Borrower by
Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines, 2010
issued on 21st April, 2010, recovery of debt through this mode has become even more significant.

Typically ARCs in India are acquiring financial assets in the name of trusts. ARCs would either,
acquire assets and transfer them to the trusts wherein ARCs would be trustees or would directly
acquire assets in the name of the trusts. This structure of acquiring assets has been used by ARCs
to fall outside the discipline of the Guidelines and Directions issued by RBI in 2003 for
securitization and asset reconstruction companies. The Guidelines ((The Securitisation
Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003) are
applicable to ARCs but do not apply to assets held by it as a trustee as the assets of the trust are
separate from the assets of the trustee. Further the trusts are not required to comply with the
capital adequacy norms that are applicable with respect to the assets acquired by ARCs, thus
facilitating convenient bypass of the regulations by acquiring assets in the name of the trusts.

Trusts are ‘secured creditor’ 

Section 2(zd) of the Sarfaesi Act, defines ‘secured creditor’ as follows –

“secured creditor” means any bank or financial institution or any consortium or group of banks
or financial institutions and includes—
(i) debenture trustee appointed by any bank or financial institution; or
[(ii) securitisation company or reconstruction company, whether acting as such or
managing a trust set up by such securitisation company or reconstruction company for
the securitisation or reconstruction, as the case may be; or]
(iii) any other trustee holding securities on behalf of a bank or financial institution, in
whose favour security interest is created for due repayment by any borrower of any
financial assistance;

From the above definition it is evident that trusts set up by ARCs are secured creditors. However
Sec 2 (za) and Sec 2(v) defining securitization company and reconstruction company
respectively does not extend the meaning to include trusts. So while the trust formed by ARCs to
acquire assets from banks/ FIs is a secured creditor it is not a part of/ recognized as securitization
or reconstruction company.
Applicability of NPA guidelines to trusts 

NPA acquired by ARCs are classified on the basis of Para 12 of The Securitisation Companies
and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003 and are
reproduced below:

12. Asset Classification

(1) Classification
(i) Every Securitisation Company or Reconstruction Company shall, after taking into
account the degree of well-defined credit weaknesses and extent of dependence on
collateral security for realisation, classify the assets into the following categories,
namely:
(a) Standard assets
(b) Non-Performing Assets.
XXX

It is pertinent to note here that this asset classification norm is to be applied by ‘securitization
company or reconstruction company’ which does not include trust within its meaning as already
discussed above. Moreover, Para 2 of the Directions provide that Para 12 of the Directions shall
not be applicable to the trusts set up by ARCs, in which such companies buy non-performing
assets transferred by banks/FIs. Thus assets held by trusts cannot be characterized as NPA under
these guidelines.

While this point was clear in the guidelines issued in 2003, the amendments to these guidelines
issued by RBI on 21st April, 2010 provide further clarity to the issue. In paragraph 12(1)(i) with
regard to the classification of assets as ‘standard assets’ or ‘non performing assets’ that are ‘held
in its own books’ and not in the books of the trust to which ARC is the trustee.

Can trusts settled by ARCs exercise powers under Sarfaesi Act? 

It certainly does not sound apt to be raising such a question as prima facie, the guidelines provide
for ARCs to set up of trusts to acquire assets from the banks/ FIs. In substance these trusts would
not be different from the trustee ARCs but the guidelines have clearly kept the demarcation
between trusts and ARCs. Thus the question arises, whether trusts can exercise powers of
enforcement of security interest under the Sarfaesi Act. Sec 13 of the Act read with Section 2(o)
clearly states that the power to issue a demand notice under that section is available only where
an asset is classified as a non performing asset as per the Directions of the RBI.The relevant
sections are reproduced below to render clarity in this regard:

2.
(o) “non-performing asset” means an asset or account of a borrower, which has been classified
by a bank or financial institution as sub-standard, 1[doubtful or loss asset,—
(a) in case such bank or financial institution is administered or regulated by any authority
or body established, constituted or appointed by any law for the time being in force, in
accordance with the directions or guidelines relating to assets classifications issued by
such authority or body;
 (b) in any other case, in accordance with the directions or guidelines relating to assets
classifications issued by the Reserve Bank;]

13.

(2) Where any borrower, who is under a liability to a secured creditor under a security
agreement, makes any default in repayment of secured debt or any instalment thereof, and his
account in respect of such debt is classified by the secured creditor as non-performing asset,
(emphasis ours) then, the secured creditor may require the borrower by notice in writing to
discharge in full his liabilities to the secured creditor within sixty days from the date of notice
failing which the secured creditor shall be entitled to exercise all or any of the rights under sub-
section (4).
XXX

As is clear from the above, the power to resort to any special measures of sec. 13 is conditional
upon the loan being characterized as non-performing asset, in the books of the secured lender.
We can thus conclude that though trusts fall under the definition of secured creditor, due to the
asset classification norms not being applicable to trusts, trusts cannot exercise enforcement
powers under sec 13 of the Sarfaesi Act.

So the net effect of the above discussion is that:

• The trusts formed by the ARCs to acquire financial assets are distinct from the ARCs and
are not included in the definition of securitization company or reconstruction company in
the Act.
• The assets acquired by the trust are separate from the assets acquired by ARCs.
• The guidelines provide for the convenient bypassing of the regulations by ARCs, by
allowing them to acquire and transfer assets to the trusts or directly acquire assets in the
books of the trusts and not making the capital adequacy norms applicable to trusts. This
meant that the risk exposure taken by the ARCs would not be appropriately disclosed.
The April, 2010 amendment to these guidelines now require the ARCs to also disclose in
its Balance Sheets value of the financial assets in the books of the trusts (Para 15 of the
Guidelines)
• While the trusts are secured creditors, the RBI Guidelines do not provide for the
provision for classification of the assets as NPA that are held by the trusts. Thus though
in substance the trusts are nothing but a part of the ARCs, due to ambiguity in
regulations, trusts cannot exercise the distinctive powers for enforcement of security
interest under the Sarfaesi Act, which is integral to the conduct of business of ARCs.

It may be contended that taking such an interpretation shakes the very foundation of the Sarfaesi
Act, but then, is the Act at all standing on sound foundations? Particularly, is the scheme of
ARCs in India, completely being out of tune with the way similar devices have worked
elsewhere in the world, the question remains whether ARC model is at all based on sound
thinking or policy?