A

sset Reconstruction Com-

panies (ARCs) are organi-
zational unit created to
manage and recover illiquid NPAs
acquired from banking system.
ARCs act as bad banks by isolating
NPAs from the balance sheets of
banks/FIs and facilitate the later to
concentrate on normal banking
activities. A cross country experi-
ence suggests that ARCs have been
successfully deployed to implement
a comprehensive NPA management
strategy in the aftermath of systemic
banking crisis. In East Asian coun-
tries, Korea, Taiwan, Mexico,
Thailand etc., the Governments
have encouraged transfer of assets
to ARCs through creation of sup-
portive environment. In 1980s,
United States used government
sponsored ARC - Resolution Trust
Corporation (RTC) to overcome
thrift crisis. Governments may also
provide special powers to ARCs that
are not otherwise available to bank-
ing system.
As on February 28, 2005,
Reserve Bank of India has issued
licence to 3 ARCs to be formed in
India viz ASREC (I) Ltd. floated by
Unit Trust of India, Asset Care
Enterprise Ltd. floated by IFCI and
Asset Reconstruction Company (I)
Ltd. (Arcil) floated by ICICI, SBI,
and IDBI.
Asset Reconstruction need for
resolution driven approach
(a) ARC Models
Globally, ARCs follow two
approaches in relation to their func-
tioning:
Resolution Agency
In this model, ARCs acquire and
aggregate NPAs from various
lenders in order to quicken the
process of corporate restructuring.
ARCs act as debt aggregators and
nodal resolution agencies.
Rapid Disposal Agency
The major objective is to acquire
and rapidly liquidate the assets to
investors after appropriate packag-
ing. Focus of ARC is prompt sell-
THE CHARTERED ACCOUNTANT 1522 MAY 2005
NPA Management
- Role of Asset Reconstruction Companies
A high level of NPAs in the banking system can severely affect the
economy in many ways. Management and financial resources of the
banking system are diverted to resolution of NPA causing an opportu-
nity loss for productive use of resources. Large scale NPAs, when left
unattended, cause continued economic and financial degradation.
This results in a credit crunch and generally signals adverse invest-
ment climate. This explains why most countries in the grip of systemic
financial and economic crisis have attempted system-wide clean up of NPAs as a
part of restructuring of their banking system. The role of Asset Reconstruction
Companies in managing these NPAs is discussed in this article.
The author is MD & CEO of Asset Reconstruction Company (India) Limited
He can be reached at [email protected]
BANKING & FINANCE
Rajendra
Kakker
In the Indian context, the
issues arising from NPA
stock are need to be
addressed on a priority
basis. The ARCs, there-
fore, needed to have
focus on expeditious reso-
lution of NPAs in order to
address concerns of the
banking system (either as
a seller or as an investor)
and unlock value in the
NPAs.
down leaving the task of corporate
restructuring to the investors (often
foreign investors).
(b) Critical success factors
In the Indian context, the issues
arising from NPA stock are need to
be addressed on a priority basis.
The ARCs, therefore, need to have
focus on expeditious resolution of
NPAs in order to address concerns
of the banking system (either as a
seller or as an investor) and unlock
value in the NPAs. Further, ARCs
acting primarily as nodal resolution
agencies through effective debt
aggregation are most likely to suc-
ceed in light of the banking land-
scape and lending practices.
In light of the above, following
factors will be critical to the suc-
cess of ARCs in the Indian market:
Ability to aggregate debt
In order to implement a resolution
strategy, ARCs should have demon-
strable ability to acquire and aggre-
gate debt from various lenders as also
stature and competence to resolve
inter-creditor issues effectively.
Ability to attract funding - both
domestic and foreign investors
The other aspect of functioning of
ARCs is their ability to fund the
acquisition. NPA financing is as
such a high-risk business. This is
further compounded by the
absence of market for NPAs and
benchmarks in India. With
expected high variance in success
and failure ratio of assets, sustain-
ability of ARC will be based on its
ability to attract/source funds at
regular intervals. This would
require high degree of structuring
skills. This will be a key differenti-
ating factor for the ARC in the
Indian market.
Credibility of the
sponsors
Credibility of sponsors
assumes significant
importance in order to
effectively deal with
moral hazard related
issues, which are likely
to arise particularly in
this business where
industry and its regula-
tory framework is
evolving. Sponsors
background, experi-
ence and strength in
terms of their (i) track
record - bankers, either as sellers or
investors, will be sensitive in deal-
ing with ARCs; (ii) ability to aggre-
gate debt and arrange for funds as
discussed above; (iii) ability to
establish best industry practices
transparency, disclosures and
super-ordinate objective of value
maximization at systemic level;
(iv) ability to adopt and benchmark
internal processes to global stan-
dards - (e.g. KAMCO Korea,
Danaharta Malaysia); and (v)
ability to attract best skill sets - res-
olution and structuring skills will
be the nucleus around which ARC
model will be built, act as a com-
petitive advantage for one player
vis--vis other players.
ARCs the Indian Scenario
Though India has not witnessed the
level of systemic economic and
financial crisis witnessed by Asian
countries, the Government of India
(GOI) proactively initiated mea-
sures in order to address the NPAs
levels (both stock and flow)
and quicken recovery from NPAs
through enactment of the
Securitisation and Reconstruction
of Financial Assets (FAs) and
Enforcement of Security Interest
(SARFAESI) Act, 2002., (the
Act). The Act paves the way for
setting up ARCs and their empow-
erment. Reserve Bank of India
(RBI) has also issued detailed
guidelines and prudential norms
for functioning of ARCs.
Unlike in other countries
where ARCs are government spon-
sored or government has direct par-
ticipation (including the funding
support) in operations of ARCs, in
India, the Government has minimal
participation in the Non-Perfor-
ming Loan (NPL) resolution
process. The Indian ARC model
envisages market forces to consoli-
date and attractively package
lender interests, arrange funding
for providing clean exit to seller
banks and lend focused attention
for NPL resolution. In line with the
above objective, ARCs in India
have been set up as non-govern-
ment vehicles with the support
from the banking system rather
than debt aggregation and funding
support under a government
owned/supported model. Further,
the Indian model envisages setting
up of multiple ARCs and funding to
be arranged by ARCs on their own.
THE CHARTERED ACCOUNTANT 1523 MAY 2005
BANKING & FINANCE
Why SARFAESI Act?
The Debt Recovery Tribunal Act,
1993 enables the banks /Financial
Institutions (banks/FIs) to file an
application in the DRT towards
recovery of amount from the
lenders. There are several addi-
tional provisions in SARFAESI
Act, which are as under: -
Registration and regulation of
Securitization Companies /
Reconstruction Companies
(SC/RCs) by the RBI
Facilitating securitisation of the
FAs of banks/FIs with or without
the benefit of underlying securities
Facilitating easy transferability
of FAs by the banks/FIs.
Issue of debentures or bonds or
any other security in the nature
of a debenture by SC/RCs
towards acquisition of FAs by
banks/FIs.
Empowering SC/RCs to raise
funds by issue of security
receipts (SRs) to qualified insti-
tutional buyers
Facilitating reconstruction of
FAs acquired by exercising
powers of enforcement of secu-
rities or change of management
or other powers which are pro-
posed to be conferred on the
banks / FIs
Empowering banks / FIs to take
possession of securities given
for financial assistance and sell
or lease the same or take over
management in the event of
default.
Why ARCs in India?
(a) NPA Size merits a prompt
response
The reported gross level of NPAs in
the Indian banking system is pegged
at about Rs. 90,000 crore represent-
ing about 9% of gross advances. The
net NPAs are at about 5% of total
advances. The estimates of some
agencies indicate the gross NPA
level to be about Rs. 130,000 crore.
A year-on-year analysis shows that
while net NPAs have been decreas-
ing, the gross NPAs have remain
steady, indicating high level of pro-
visioning but limited progress on
recoveries by banking system. It
also indicates the Provide and
Hold approach by the banks. This
slow progress is largely attributable
to the following factors:
NPA profile
Large and mid-size NPAs, mainly
in industrial sector, account for
more then 50% of total NPAs of the
system. Resolution of these assets
would largely be through operation
of industrial assets over an extended
timeframe. This requires in- depth
skills for operational and financial
restructuring either with the same
promoters or change in hand.
Banking landscape
Indian banking landscape has tradi-
tionally been characterized by con-
sortium / multiple lending with dif-
ferent classes of security. This
results in significant inter-creditor
issues inhibiting prompt implemen-
tation of most appropriate resolu-
tion strategy causing loss of value to
all concerned. Most resolution
approaches (under the SARFAESI
Act, Corporate Debt Restructuring
(CDR) mechanism etc.) in India
call for debt aggregation of mini-
mum 75% of secured debt.
(b) ARCs bring effective
intermediation in the NPA
resolution process
To resolve NPAs, debt aggregation
capability and necessary skill sets
for resolution are critical. ARCs
with ability to aggregate debt of
different classes are in a better posi-
tion to address inter-creditor issues.
The debt aggregation capability
provides better leverage in imple-
menting resolution strategy.
Further, The Act has provided
wide-ranging powers to ARCs for
resolution of NPAs. ARCs have
access to all possible routes avail-
able to banks/FIs for resolution as
also access to additional empower-
ments viz. step-in rights and
change in management, sale or
lease of business [section 9(a)
& 9(b) of the Act].
Thus, ARCs with focus
and domain expertise in reso-
lution and the statutory / regu-
latory empowerments for res-
olution are in a better position
to implement timely resolu-
tion strategy thereby enhanc-
ing the value from recoveries.
THE CHARTERED ACCOUNTANT 1524 MAY 2005
BANKING & FINANCE
Advantage to banks / FIs from
sale of NPAs
Sale of the FAs to ARCs enables
the banks to take off NPAs from
their books. Subsequent to the
sale of NPAs no known liability
devolves on the banks / FIs. The
sale can provide for sharing of
upside upon eventual realization
by the ARC thereby continuing
their association in the realiza-
tion of NPAs.
Sale of NPA would also release
capital and reduce expenditure
on NPA maintenance and release
resources for core operations.
Sellers have an opportunity to
invest, as Qualified Institutional
Buyers (QIBs), in Security
Receipts (SRs) issued by ARCs
for acquisition of NPAs thereby
continuing to participate in the
upside.
RBI guidelines to Banks /FIs on
sale of FAs to SC/RCs
FAs which can be sold to
SC/RCs
- NPAs and
- Standard Asset if 75% by
value of the asset is classified
as NPA in other banks / FIs
Valuation of financial asset to be
based on the estimated realiz-
able value
Banks/ FIs may receive
cash/bonds/debentures as sale
consideration or invest in SRs /
Pass-through Certificates issued
by SC/RCs
Investment in SRs should be cat-
egorized as non-SLR investment
Sale price < net book value
- The shortfall should be deb-
ited to the profit and loss
account of that year.
Sale price > net book value
- The excess provi-
sion will not be
reversed but will be utilized to
meet the shortfall/loss for trans-
ferring further FAs to ARCs.
Investment in the SRs issued by
SC/RCs in respect of the FAs
sold by the Banks/FIs should be
recognized at the lower of:
- the redemption value of the
SRs and
- the NBV of the financial
asset.
Agreement may be entered with
SC/RCs for sharing of upside
AARCs and CDR mechanism
CDR and ARCs are two pronged
strategy to address the NPA resolu-
tion. Co-existence of CDR and
ARCs is a mutually beneficial asso-
ciation. CDR typically focuses on
restructuring of viable businesses at
early stages of distress while ARCs
would focus on cases involving
multi-pronged workouts involving
sale of businesses and assets of the
borrower company without any
restriction on size of the debt.
In a multiple ARCs model, it
would be necessary to avoid frag-
mentation of debt, particularly in
respect of large and medium sized
NPAs. ARCs should focus on those
cases where they are better posi-
tioned to aggregate debt. This will
facil-
itate resolution process - a win-
win approach for all.
Acquisition and Management of
NPAs by ARCs
In accordance with the Act and RBI
guidelines, ARCs can acquire the
FAs of NPA companies on their own
balance sheet or through the trust
structure by floatation of schemes
for raising resources through
issuance of Security Receipts (SRs)
from QIBs. The trust structure for
acquisition and resolution of NPAs
is preferred structure by the
investors and in generally in line
with the international practices.
The detailed transaction structure
as adopted by Arcil is depicted
below:
Arcil sets up a trust (The Trust)
for the purpose of acquiring
Non-Performing Assets on the
books of the Bank (Assets).
The Assets would be acquired at
fair value based on assessment
of realizable amount and time to
resolution.
The Trust raises resources through
formulation of schemes by issuing
SRs to the eligible investors under
THE CHARTERED ACCOUNTANT 1525 MAY 2005
C D R
and ARCs are two
pronged strategy to address the NPA resolution. Co-exis-
tence of CDR and ARCs is a mutually beneficial association.
CDR typically focuses on restructuring of viable businesses
at early stages of distress while ARCs would focus on cases
involving multi-pronged workouts involving
sale of businesses and assets of the
borrower company without any
restriction on size of the
debt.
BANKING & FINANCE
SARFAESI (banks/ FIs etc.).
Such monies received from QIBs
are utilized towards payment of
purchase consideration for the
FAs to the sellers.
The Trust is the legal owner of
the Assets and the SR holders are
beneficial owners of the same.
Security Receipt represents
undivided right, title and interest
in the Trust Fund, including the
Initial Trust Fund, the
Contributions received by the
Trustee, the Assets proposed to
be acquired by the Trustee . The
SRs are akin to Pass-through
Certificates (PTCs).
Arcil acts as a trustee and the asset
manager of the Special Purpose
Vehicle (SPV) trusts to fully
leverage empowerments to ARCs
under the SARFAESI for resolu-
tion of the Assets. The SR holders
have no recourse against Arcil.
Key issues for effective
functioning of ARCs
While the framework for effective
functioning of ARCs has been laid
down by the Act and RBI guide-
lines, a few enablers in operating
and regulatory framework would go
a long way in fulfilling the ARCs
expected role. These are as follows:
(a) Accelerating transfer of FAs
to ARCs
It may be noted that NPAs lose
value over time. Therefore the
banking system would stand to
gain if the NPAs are put on recov-
ery path in the early stages either
through ARCs or otherwise. The
experience gained in acquisition of
assets so far indicates a moderate
response to transfer of assets. The
book values of the banks / FIs are
often higher than the price offers
causing delays in decision to trans-
fer or rejection of price offers
(based on realistic estimates of
recovery) requiring immediate
write-offs. In such situations, the
concerned bank/ FI tend to shy
away from transfer.
While there is a general desire
amongst the banks / FIs to clean
their books, the level and the mile-
stones have to be defined by indi-
vidual banks / FIs by recognising
the value erosion in the NPA port-
folio over and above the regulatory
minimum. In this regard, RBIs
recent guidelines on provisioning
of doubtful assets and restriction
on dividend would certainly pro-
vide the guidance to banks and FIs.
(b) Participation of foreign
investors (FIIs) in equity of
ARCs and paper of ARCs
For ARCs to effectively giving
clean exit to seller banks/FIs in
respect of NPAs attracting new
investment is critical. FIls, which
specialize in investing in distressed
debt, would be the key source of
such new funding as the domestic
market does not have necessary
risk appetite for such investment.
However, the guidelines for the
extent of FIIs investment in papers
of ARCs (SRs) as well as route for
their investment are not in place.
Similarly, the equity investment in
ARCs by FIIs is not yet permitted.
(c) Rationalization of Stamp duty
and registration charges on
transfer of FAs to ARCs
Stamp duty on assignment of debt
with underlying security of mov-
able/ immovable property is a State
subject. Each State has different
incidence of stamp duty on such
transactions under their respective
Stamp Act ranging from 4% -14%
of the transaction value. The trans-
fer of FAs of NPAs to ARCs is held
back in many States on account of
high incidence of stamp duty on
such transactions. While the matter
has been taken up with respective
States and many States such as
Maharashtra, Gujarat, Rajasthan,
Chattisgarh, Andhra Pradesh,
Bihar and West Bengal have
reduced stamp duty to a notional
level recognising the nature of
THE CHARTERED ACCOUNTANT 1526 MAY 2005
TRANSACTION STRUCTURE
Banks/FIs
Scheme
Borrower wise
Borrower
Sale of loan assets
Reconstruction thru
Restructuring/Asset
sale/M&A
Redemption of
SRs
Purchase
Consider-
ation
Payment
for Sub-
scription to
SRs
Cash
realization
Investors
Banks/FIs
ARCs/
Trusts
BANKING & FINANCE
SRs
transaction in case of transfer of
assets to ARCs. The governments
of other States would have to cap
the stamp duty for transfer of
assets.
(d) Income-tax treatment of ARCs
The trusts set up by ARCs for
acquisition, management and reso-
lution of NPAs in accordance with
the Act are pass through in nature
similar to mutual funds. It would be
necessary to accord the same treat-
ment for the ARC trusts as to
Mutual Funds having regard to the
similarities in transaction struc-
tures by exempting income and
TDS in the hands of the trust of
ARCs. This would weed out ineffi-
ciency by reducing the transaction
costs for investors.
(e) Accounting Treatment of
ARCs
There are various transactions an
ARC enters into. Many ARCs are
also in the process of obtaining
license from RBI. For standardiza-
tion of accounting treatment and
better comparisons of financial
statements of various ARCs,
accounting standard is required for
ensuring transparency in accounts.
Conclusion
ARCs with statutory/ regulatory
powers are likely to emerge as nodal
resolution agencies co-existing
with CDR mechanism. In the
absence of direct funding support
from the Government, ARCs are
self-help mechanism of the banking
system. The onus is with the banks/
FIs and ARCs to clean up the NPAs.
The banks / FIs have to be proactive
in making realistic provisions based
on assessment of realizations from
NPAs towards their dues. These
practices will also enable banks/ FIs
to move to internationally accepted
norms. ARCs can add value by cut-
ting short the time to resolution as
well as maximizing the recoveries.
This is possible by through debt
aggregation and focused approach
to resolution. The banks/ FIs that
can not sell the assets immediately
to ARCs due to possible balance
sheet concerns should support the
resolution efforts of ARCs.
THE CHARTERED ACCOUNTANT 1527 MAY 2005
It may be noted that NPAs
lose value over time.
Therefore, the banking
system would stand to
gain if the NPAs are put on
recovery path in the early
stages either through
ARCs or otherwise. The
experience gained in
acquisition of assets so far
indicates a moderate
response to transfer of
assets.
BANKING & FINANCE
Sub: Clarification regarding Inclusion of Insurance
Financial Advisory Services under the Insurance
Regulatory & Development Authority Act, 1999,
including Insurance Brokerage in the definition of
Management Consultancy & Other Services
The attention of the members is drawn to the Announcement pub-
lished in the January 2005 issue of the Journal at page 935 as well as
hosted in the website regarding inclusion of Insurance Financial
Advisory Services under the Insurance Regulatory & Development
Authority Act, 1999, including Insurance Brokerage in the definition
of Management Consultancy and Other Services as appearing at
pages 8-10 of Code of Ethics, January 2001 edition.
In this regard, it may be clarified that as per the decision of the
Council, a member is permitted to render Insurance Financial
Advisory Services as prescribed under The Insurance Regulatory
and Development Authority (Insurance Brokers) Regulations, 2002
only in Corporate form. Further, the members are required to comply
with the conditions prescribed by the Insurance Regulatory &
Development Authority and the conditions to be prescribed by The
Institute of Chartered Accountants of India.
It may also be clarified that the members are not permitted to do any
work relating to insurance agency as prescribed under Insurance
Regulatory and Development Authority (Licencing of Insurance
Agents) Regulations, 2000 and Insurance Regulatory and
Development Authority (Licencing of Corporate Agents)
Regulations, 2002, either individually or in partnership/proprietor-
ship form or in corporate form.
The existing position regarding allowing members generally to hold
life insurance agency licence for limited purpose of getting renewal
commission, still hold good as provided in the Appendix (9) to the
Chartered Accountants Regulations, 1988 (2002 edition).
ANNOUNCEMENT