Contributed by Pratyanik Chakraborty

Introduction

The Non-Performing Assets in India Inc., after the global pandemic hit the economy- is turning into a new crisis.  India has had a debt problem for a while. An increase in bad debt necessitates a corresponding increase in provisioning- resulting in a greater capital allocation within the financial system. This phenomenon leads to a contraction in credit availability, hence impeding economic growth. To address this issue, banks and financial institutions were initially granted permission to exclusively transfer their distressed loans solely to Asset Reconstruction Companies (“ARCs”).

The primary objective of asset reconstruction is not solely focused on the realisation of non-performing loans but also on the ” reconstruction process,” which involves attempting to revive non-performing loans or borrowers and transform them into performing ones. This commonly results in identifying a single entity, i.e. ARCs, which has become a conventional practice.

Similarly, in case of insolvency resolution, ARCs are given due recognition as resolution applicants under the Insolvency and Bankruptcy Code, 2016 (“IBC”). However, the current treatment of ARCs under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act 2002 (“SARFESI Act”) is far from smooth.

The existing distressed debt market was too muddy and at the same time, too narrowed down.  To address these issues in the distressed debt market- the Securities Exchange Board of India (“SEBI”) introduced the concept of Special Situation Funds (“SSFs”). In this work, we shall be delving into an explorative finding on why, at the current moment, SSF provides a wonderful opportunity in the distressed debt market in India- not just through private debt acquisition but also through a resolution of distressed assets under IBC; while comparing the new SSF regime under SEBI rules and IBC with the mistful ARC regime under the SARFESI Act and IBC.

Special Situation Funds Defined

As the name suggests, these kinds of funds are for special situations. SEBI, in its 2022 amendment to Alternative Investment Fund (“AIF”) regulations, defines an SSF as a Category 1 AIF that aligns its investments with special situation assets based on its investment objectives and can serve as a resolution applicant under the IBC.

The same regulation, Securities and Exchange Board of India (Alternative Investment Funds) (Amendment) Regulations, 2022 (“2022 AIF Amendment”), also defines any “special situation asset” through an inclusive definition. It includes stressed loans available for acquisition either under specific directives from the Reserve Bank of India (“RBI”) or as part of a resolution plan approved under the IBC. Additionally, it encompasses securities receipts that have been issued by ARCs duly registered with the RBI.

It can be inferred that SEBI’s definition gives a huge opportunity for the distressed debt market, apart from creating a new entity under the IBC for being a Resolution Applicant (“RA”). Further, we shall discuss the Indian distressed debt market— the current scenario and how SSFs can bring any changes.

Discussing the Distressed Debt Market in India

The Narasimhan Committee recommendations led to the creation of Debt Recovery Tribunals. This essentially created India’s first structured market for financially unstable assets. Various NPA mitigation strategies were also taken. These methods included loan rescheduling, corporate debt restructuring, and facilitating recovery by utilising ARCs. Earlier, AIFs were not allowed to invest in debt directly; they had to go through listed securities such as bonds or debentures. SSF provided the first-time opportunity to invest directly in debt and acquire debt from the distressed debt market (now, through rules “corporate debt market development funds”, AIFs are also allowed to invest in debt).

Globally, special circumstances funds, which profit from buying distressed debt, have $131.8 billion in liquid cash reserve. This sum is up over 40% from five years ago and 150% from a decade ago. According to the Institutional Investor, distressed funds during the Global Financial Crisis and the Dot Com disaster outperformed other private debt funds and funds from earlier time periods. 2008 distressed funds had a median net internal rate of return of 15%. HFRI Distressed Index rose over 100% in the five years after 2000 after the Dot Com crash. The distressed debt market, especially the private debt route- provides a wonderful opportunity for return to investors. Thus, having an AIF, i.e., an SSF, can contribute significantly to this ecosystem. So SSFs will only add further to the development of a robust distress debt investment ecosystem alongside ARCs- where ARCs have been the only player per se. But where SSF becomes a boon, as compared to ARC- is when it comes to the resolution of insolvency, which we will be discussing in furtherance.

ARC: To be RA or Not be RA?

Through the 2018 amendment to the IBC, Section 29A was introduced, which otherwise provided a four-layer of ineligibility for an RA, but the aforementioned provision stipulated that ARCs registered under the SARFAESI Act may qualify as RA, provided that they are not affiliated with the Corporate Debtor. But at the same time, Section 10 of the SARFESI Act states that ARCs are prohibited from initiating or conducting any business activities except those explicitly authorised by statute or RBI regulations. This created a problem, and the Delhi High Court had to intervene in the case of UV Asset Reconstruction Company v Union of India (2022 SCC Online del 4289). It is evident that Section 29A of the IBC and Section 10(2) of the SARFAESI Act are in direct conflict with one another. The question that arises is: which prevails?

Given Section 10 of the SARFAESI Act, the NCLT initially denied M/s Invent Assets Securitisation & Reconstruction Private Limited from being a resolution applicant, given Section 10 of the SARFAESI Act. But the NCLAT, taking the king clause enshrined in Section 238 of IBC into consideration, rules IBC shall have an overriding effect over the SARFAESI Act in the Puissant Towers India (P) Ltd. v Neueon Towers Ltd (2023 SCC OnLine NCLAT 300) (“Puissant Towers”).

After Puissant Towers, RBI released its Review of Regulatory Framework for ARCs. This notification allows ARCs to perform RA activities that were previously not mentioned in the SARFAESI Act. The notification has seven conditions. The conditions also included certain onerous elements. This Regulatory Framework Review by RBI puts the debate over ARCs as RA- back at square one, raising the question of whether they have a blanket power to be RA under IBC or whether the SARFAESI Act’s conditional approval regime applies.

But it is a settled position of law when it comes to applying the king clause of Section 238 of IBC, which is repeatedly reiterated in judgments such as Pr. Commissioner of Income Tax v Monnet Ispat and Energy Ltd. (2018 SCC Online SC 3465) and Jag Mohan Bajaj vs. Shivam Fragrances Pvt. Ltd (2018 SCC OnLine NCLAT 413) that Section 238 of the IBC possesses the capacity to override any other legislation that is inconsistent and/or contradictory to the IBC and RBI’s review of regulatory framework shall not be any different.

However, one may argue that Section 29A of the IBC authorises ARCs to be RAs. The RBI notification merely facilitates this process, allowing it to meet its regulatory duties- supplementing Section 29A of IBC. The question that arises here is whether Section 29A of the IBC can be put to conditional approval through the RBI review of the regulatory framework pursuant to the king clause enshrined into Section 238 of IBC, or the blanket approval u/s 29A of IBC can not be put to conditional approval.  Thus, it makes the water muddier rather than decluttering the myst. Essentially questioning the validity of the RBI notification. Here, SSF comes as a boon!

SSF: The Win-Win?

Foreign investors must use one of four routes to invest in non-performing loans: foreign portfolio investment (“FPI”), AIF, external commercial borrowings (“ECB”) or ARC. These routes have distinct restrictions. FPIs and AIFs were previously prohibited from investing directly in loans; instead, they could only invest in debt securities like bonds and debentures, which comprise a small portion of India’s secondary debt market. ECB investments have rigorous all-in-cost limits, which inhibits distressed debt investors’ commercial activity.

The problem with ARCs has already been discussed at length in this piece. Because of the persistence of black clouds in ARCs’ status as RA- the SSFs come to the rescue. The 2022 AIF Amendment clearly mentions, under regulation 19I(3), that the SSFs “may act as a resolution applicant under the Insolvency and Bankruptcy Code, 2016.” Additionally, SSF, being a Category I AIF, has certain privileges, such as not having an investment limit. Moreover, SSFs can convert debt into equity without restrictions. This differs from ARCs, where conversions are restricted and may not be accessible for a few ARCs. Simultaneously the SSF may fully oversee a company’s management, improving the restructuring process.

Although SSF has several advantages for the smooth running of the de-distressing process of distressed enterprises, there are also a few reasonable concerns. As Desai et al. suggest, the pre-condition requiring credit ratings for investee company securities poses challenges for SSFs seeking to invest in unlisted debt securities. Firstly, unlisted debt securities generally lack initial credit ratings. Secondly, the investee company may encounter difficulties obtaining a credit rating later, further complicating the investment process.

Further, As per clause 58 of RBI (Transfer of Loan Exposures) Directions, 2021(“Master Direction”)- any entity authorised to acquire “loan exposures by its statutory or regulatory framework” must be individually authorised by its regulatory or legal framework to assume loan liabilities, and thereafter included in the RBI’s Annex. Therefore, it is crucial for SSFs to be listed in the Annex of Master Directions, as RBI is the primary authority governing the sale and purchase of stressed loans in India. SEBI has received communication from RBI regarding certain requirements that need to be considered for the SSF framework. This is to include the SFFs in the list, as mentioned in a recent SEBI consultation paper (“SSF Consultation Paper”). The said requirements are not brought into the scope of this study apart from one, “eligibility of investors in SSFs in terms of Section 29A of Insolvency and Bankruptcy Code, 2016.” The SSF Consultation Paper addresses the issue by acknowledging that ARCs have the ability to offer security receipts to investors based on the distressed asset in question. However, it notes that the ARCs are mandated to do continuous and initial due diligence on the same. A similar due diligence is also prescribed for the SSFs under Chapter 6 of the Master Circular for AIFs. But it has to be considered that the SSFs, being AIF- have a comparatively wider spectrum of investors than ARCs. Thus, to avoid regulatory arbitrage, the SSF Consultation Paper proposes a greater level of due diligence that must be considered. Furthermore, the safeguards that are there for Banks and/or ARCs under the SARFAESI Act will not apply to the SSFs, nor will they get any benefits under the securities laws. Although even when these are considered, as long as the ARCs’ conundrum under the SARFAESI Act and IBC don’t declutter, SSF shall remain the only saviour.

Conclusion

It is pertinent to note that SSFs offer a dual-layered set of benefits. Firstly, they present a novel avenue for the resolution of enterprises facing economic distress. Secondly, they provide an alternative route for investment opportunities within the distressed debt market. Notwithstanding the enticing nature of these benefits, it must be acknowledged that the SSF regime presently bears a reduced compliance burden and/or exhibits a superior level of efficiency compared to the prevailing regimes, particularly regarding distressed debt investment. However, unless and until it is duly listed in the Annex of the Reserve Bank of India’s Master Direction, the benefits in question cannot substantially impact. Overall, SSFs are a promising new development in the Indian distressed debt market and have the potential to play a significant role in resolving distressed enterprises.