Are ARCs being reconstructed now?

For a capitalist market-making of stressed assets, it needs ability to “market-price" the asset and to allow buyers of those assets to turn it around to economic-viability for profit-booking. ARCs are a critical for the market as they allow capital release for lenders whose loan-exposure to stressed companies choke the system and block their ability to lend.

The Indian ARC industry is relatively a small considering the quantum of bad loans that the system sees. The growth of this industry would mean that ARCs come on their own by taking exposure of larger stressed pools and turning them around. This attempt by the domestic ARCs is evident from the data that more and more such firms have been bidding for portfolios of distressed lenders and for large bankrupt accounts.

Yet its challenges abound.

ARCs are under the administrative control of RBI, are regulated by it, and are subject to its audit and inspection. ARCs are required to meet various compliance requirements including around its operational aspects to RBI.

Under RBI guidelines, in force since 2017, ARCs can hold more than 26% equity in a stressed asset, after debt-to-equity conversion, if they meet certain norms. The principles of Sarfaesi regulations provide that ARCs can only be involved in securitisation or asset reconstruction. The Sarfaesi Act does allow lenders to directly auction assets pledged with them to recover their loans.

The Insolvency and Bankruptcy Code, 2016 (IBC), the bankruptcy law of India allows debtors, creditors and the companies themselves, to ask for the particular stressed business to be sold to another set of promoters. The critical philosophy of the IBC was the concept of “creditor in possession and control", rather than “debtor". IBC has a non-obstante clause that has an overriding effect on other laws contrary to it.

Under the IBC, control of the business, shifts to the Committee of Creditors (CoC). A Resolution Professional (RP) is appointed to manage the business of the debtor on behalf of the CoC to preserve value of its assets as a “going concern". However being in its early stages, IBC’s special feature that the resolution process is time-bound, has been challenged across multiple cases; some of them are being debated in various courts.

As per Section 29A of IBC, an ARC can act as a resolution applicant and can submit resolution plan itself or with other investors jointly as a consortium or partnership. The section also mentions that the expression “related party" shall not include a financial entity, regulated by a financial sector regulator, if it is a financial creditor of the corporate debtor and is a related party of the corporate debtor due to the conversion of debt into equity shares or instruments convertible into equity shares, prior to the insolvency commencement date.

ARCs, as a resolution applicant (RA) or partner of bidder group, bring many an advantage to the table. The very first advantage and infact low-hanging fruit is the case of sale under Sarfaesi Act, where the priority of dues of Secured Creditors over other dues is established. ARCs can use part-monetisation of the assets of the corporate debtor, once the resolution plan is approved; it can then pay the lenders from the sale proceeds.

The RBI had rejected the resolution plan submitted by one of the ARCs for acquiring assets of a telecom company, with media reports citing that the plan did not conform to Sarfaesi Act guidelines. The specific ARC’s resolution plan involved the ARC getting 76% stake in the company in the first five years, with the financial creditors getting the rest. It has been published that the regulator has also rejected other insolvency resolution plans submitted by the same ARC in question.

RBI’s primary objection seems that instead of buying debt, an ARC is buying equity in a company. The media reports also state that the lenders see this ARC bid as a viable resolution plan and that the lenders have been asking for the regulatory blessing.

In a number of accounts, as per the resolution plans proposed, ARCs are holding majority of equity and will manage day-to-day affairs of the acquired company. ARCs will also commit to infusion of capital and funds for revival of stressed company. As an entity running the management of the reconstructed company, “will ARC be treated as promoter as per the Companies Act, 2013" which defines promoters as the persons who controls the affairs of the company? Will these ARCs also have to undergo various compliances as per the Companies Act?

Many experts seem to believe that the inclusion of ARCs as resolution applicants under IBC, is not violating any norms and would might benefit from more regulatory clarity, as the regulator had not objected to plans submitted by ARCs in earlier cases.One of the concerns heard in the market is this : is it the worry regarding the telecom spectrum reaching the hands of ultimate acquirer, assuming that the ARC is acting as the intermediary.

Another theory doing the rounds is that the banks actually don’t want ARCs to run non-financial business; will this push-back of ARCs allow them to push for their own bad-bank idea ahead with their principal shareholder (GoI) ?Another chatter is that PE firms don’t want any undue competition and want to look at IBC pool directly for themselves. And that they are exerting various regulatory ideas and the gaps between the IBC norms & execution issues.

But these conjectures apart, it has been good momentum that’s evident in the way the GoI & RBI have shown regulatory speed. The Centre’s push to the Sarfaesi Act is evident from the amendment in December 2019; it helped that, after the registration of security interest with CERSAI, the debts of the secured creditor (banks, FIs, NBFCs, ARCs, etc.) shall be paid in priority over all other debts and all revenue, taxes, etc. payable to the central government or State Government or Local Authority, exception being IBC proceedings. With this, the GoI and RBI had signalled that the provisions of IBC on priority of dues of secured creditors and Section 29A of IBC with that of Sarfaesi Act and applicable to ARCs, to enable ARCs to play a larger role in the resolution of stressed assets in the country.

Restricting ARCs from acquiring control is not rational. If a business has intrinsic value and an ARC wants to hold onto it, regulations shouldn’t come in the way. Unlike banks, ARCs don’t take public deposits, hence there shouldn’t be regulatory concerns to restrict them from acquiring such stressed business. In the backdrop of rising stress in the financial sector and the elongated covid scenario which might add to the stressed pools over next few quarters, the landscape of ARC industry is bound to widen. ARCs in partnership with investors and as Resolution Applicant are bidding for bigger and large distressed companies and financial assets.

It would help the entire IBC process, if RBI clarifies its stand formally whether it would allow ARCs to participate as RAs under the IBC rules and if yes, bring the enabling rules quickly.

Srinath Sridharan is an independent markets commentator.