SECURITISATION – AN OVERVIEW
Introduction to Securitisation
Securitization has emerged globally as an important technique for bundling assets and segregating risks into marketable securities. Securitization can be regarded as an incentive for banks to become more efficient in order to offer the most competitive financial product. The basic purpose of securitisation is to reward the comparative advantage of a bank to originate loans, compared with its ability to service the loans and its ability to bear the risk associated with those loans.
Ιn theory, a loan is a simple transaction where a borrower wants money, and a lender advances it and collects interest on it and this arrangement continues until the loan is repaid by the borrower. In practice, however, it is observed that every fifth borrower is a defaulter which ruins the lenders financials. While in case of secured loans the borrower offers collateral such as real estate or machinery which serves as a security to the lender, authorizing it to seize and sell the asset to recover its money, in the event of default in repayment of loan by the borrower. However, this simple transaction collapses when the seizure of an asset becomes impossible within a reasonable time. Our slow and tardy legal system with endless hearings and appeals keep things in limbo for decades and as a result, there are bad debts across the entire financial system.
Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors. The assets may be anything ranging from credit card receivables, auto loans, equipment leases, hire purchase deals to housing loans and non-performing assets (NPAs).
Securitisation has emerged as an important means of financing in recent times. The process of Securitisation involves the following steps:
First, an entity with loans or other income-producing assets ("Originator") identifies the assets that it wants to remove from its balance sheet.
Second,a special legal entity or Special Purpose Vehicle ("SPV") is created, which usually is established as a Trust and the Originator sells the assets to that SPV. This effectively separates the risk related to the original entities operations from the risk associated with collection.
Third, to raise funds to purchase these assets the SPV issues asset-backed securities ("Asset-backed security is a security whose value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets i.e. illiquid assets") to investors in the capital markets in a private placement or pursuant to a public offering. The SPV uses the proceeds of the sale to pay back the Originator that created, or originated, the underlying assets. The SPV is responsible for "bundling" the underlying assets into a specified pool that will fit the risk preferences and the needs of investors. These securities are structured to provide maximum protection from anticipated losses using credit enhancements like letters of credit or reserve accounts. The securities are also reviewed by the credit rating agencies that conduct extensive analyses of bad-debts experiences, cash flow certainties and rate of default.
Finally, Investors are paid through the money received in the form of loan repayments by those borrowing loans through the Originator. Originators are in turn paid certain service charges by the SPV for the servicing of the loan. The services generally include: mailing monthly statements, collecting payments, and remitting them to the investors, investors reporting, accounting, foreclosure proceedings and the like.
This process leads to the financial asset being taken off the balance sheet of the Originator, thereby relieving pressures of capital adequacy, and provides immediate liquidity to the Originator.
There is no clear regulatory framework for the securitisation market per se. However, securitisations originated by RBI regulated entities like Banks, FIs and NBFCs are governed by guidelines issued by the RBI. Enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 ("SARFAESI Act") enabled securitisation of the non-performing assets ("NPAs") of Banks, which could sell off their NPAs to asset reconstruction companies registered with RBI. The SARFAESI Act laid the framework to the constitution of asset reconstruction companies (ARCs) specialising in securitising distressed assets purchased from banks.
The SARFAESI Act is a significant legislative initiative to address the malaise of mounting NPAs. The Act addresses the interests of secured creditors. Its purpose is to promote the setting up of asset reconstruction/securitisation companies to takeover the NPAs accumulated with the banks and public financial institutions. The Supreme Court, in its judgment in the case of Mardia Chemicals Ltd. and Others vs. Union of India and Others upheld the constitutional validity of SARFAESI Act.
The Act provides three alternative methods for recovery of NPAs, namely: (i) Securitisation; (ii) Asset Reconstruction; and (iii) Enforcement of Security without the intervention of the Court. The main objective behind this Act is to strengthen creditor rights through foreclosure and enforcement of securities by banks and financial institutions. By conferring on lenders the right to seize and sell assets held as collateral in respect of overdue loans, it allows banks and financial institutions to recover their dues promptly without going through a costly and time-consuming legal process.
Salient features of the Act
Incorporation & Registration of Special Purpose Vehicles - The SARFAESI Act proposes to securitise and reconstruct the financial assets through two SPVs viz. Securitisation Company and Reconstruction Company. Securitisation Company and Reconstruction Company ought to be a company incorporated under the Companies Act, 1956 having securitisation and asset reconstruction respectively as main object.
The SARFAESI Act requires compulsory registration of Securitisation Company and Reconstruction Company with the RBI under the SARFAESI Act before commencing its business. Further a minimum financial stability requirement is also provided by requiring Securitisation Company and Reconstruction Company to possess owned fund of not less than Rs.2 crore or up to 15% of the total financial assets acquired or to be acquired.
Securitisation companies who are registered with RBI cannot make substantial change in the management or location without prior approval of RBI. The expression “substantial change in management” means the change in the management by way of transfer of shares or amalgamation or transfer of the business of the company.
Funding of securitisation - The Securitisation Company or Reconstruction Company may raise the necessary funds, for the acquisition of financial assets, from the QIBs by issuing a security receipt. Security receipt is exempted from compulsory registration under the Registration Act. Security receipts issued by any Securitisation Company or Reconstruction Company are the "securities" within the meaning of Section 2(h)(ic) of the Securities Contracts (Regulation) Act, 1956.
A Scheme of acquisition has to be formulated for every acquisition detailing therein the description of financial assets under acquisition, the quantum of investment, rate of return assured etc. Further separate and distinct accounts have to be maintained in respect of each scheme of acquisition. Realizations made from the financial assets have to be held and applied towards the redemption of investments and payment of assured returns. In the event of non-realization of financial assets, the QIB holding not less than 75% of the total value of the security receipts issued, are entitled to call a meeting of all QIB and pass resolution and every such resolution is binding on the Securitisation Company or Reconstruction Company, as the case may be.
Enforcement of security interest - As discussed already the main objective of the Securitisation Act is to provide for the enforcement of security interest i.e. taking possession of the assets given as security for the loan. The Act empowers the lender, in the event of default by a borrower, to issue demand notice to the defaulting borrower and guarantor, calling upon them to discharge their dues in full within 60 days from the date of the notice. If the borrower fails to comply with the notice, the bank or the financial institution may take recourse to one or more of the following measures:
(i) Take possession of the security;
(ii) Sale or lease or assign the right over the security;
(iii) Appoint Manager to manage the security;
(iv) Ask any debtors of the borrower to pay any sum due to the borrower.
If there are more than one secured creditors, the decision to make provisions of this Act will be made applicable only when 75% of them are agreeable.
Transaction to which the Act is not applicable - The provision of this Act shall not apply to:
- A lien on any goods;
- A pledge on movable property;
- Creation of any security in an Aircraft;
- Creation of any security interest in any vessel;
- Any conditional sale, hire purchase or lease or any other contract in which no security interest is created;
- Any right of unpaid seller under Section 47 of the sale of Goods Act. Any property not liable to attachment;
- Any security interest for repayment of any financial asset not exceeding one lakh rupees;
- Any case in which the amount due is less than 20% of the principal amount and interest thereon.
- Any security interest created on agricultural land.
Offences & Penalties - Following are the offences prescribed under the Securitisation Act:
- Default in filing particulars of transactions relating to asset securitisation, asset reconstruction and creation of security interest.
- Default in filing particulars of modification.
- Default in giving intimation of particulars satisfaction.
- Non-compliance of RBI directives by Securitisation Company and Reconstruction Company.
- Contravention, including attempt to contravene and abetting in contravention, of any of the provisions of the Securitisation Act or any rules made thereunder.
Following are the penalties prescribed in the Securitisation Act:
- For default in filing particulars of transactions mentioned above, every company and every officer of the company or every lender or officer of the lender shall be punished with a fine which may extend to Rs.5000/- for every day during which the default continues.
- For non-compliance of RBI directives every company and every officer of the company shall be punished with a fine which may extend to Rs.5, 00,000/-; and for continuing offence an additional fine of Rs.10,000/- for every day during which the default continues.
- For contravention of any provisions of the Securitisation Act, the punishment is imprisonment for a term which may extend to one year, or with a fine, or with both.
Only a Metropolitan Magistrate or Judicial magistrate of the First Class has powers to take cognizance and try an offence under the Securitisation Act.
On the whole, securitisation in India seems to be accelerating in its development. More and more institutions have started participating in the market and the scope of securitised assets is steadily growing. However, problems still remain. One of the most important of them is legislation which lags behind the hovering securitisation market.
Though, SARFAESI Act helped banks wipe out bad loans however, more legal changes to the Act are needed to enable banks to securitise and sell good loans to free up capital for fresh lending. At present, transfer of property is regulated by a law that is more than a century old. The existing foreclosure laws impede development of securitisation since they make it difficult to transfer property rights in the case of default. Also, since the securitised assets could be in various states, the incidence of stamp duty would be different across states, which is one of the major hurdles in the development of the securitisation market. Tax laws also do not contain any specific provision about securitisation. Securitisation needs to be strongly regulated to ensure lenders do not dilute loan appraisal norms. Therefore, a new legislation is required to address all these issues.