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Critical Analysis of Securitization In India
1.1 The financial sector in India has witnessed a series of reforms and changes since 1991, that is, the period in which the government ensued upon a policy for larger economic reforms allowing foreign direct and indirect investment in India. The need for the legal framework on securitization can be traced back way from 1991 onwards where various committees recommended to have a law on securitization and enforcement, this was followed by the enactment of the Securitization and Reconstruction of Financial Assets & enforcement of Securities Interest Act, 2002 (‘the Act’) 1. The Act encompasses the areas of: securitization of financial assets; reconstruction of financial assets; recognition to any security interest created for due repayment of a loan as security interest under the Securitization Act, irrespective of its form; banks and financial institutions have the power to enforce the security without intervention of the courts; setting up the Central Registry for registration of the transaction of securitization, reconstruction and creation of security interests.
1.2 Securitisation of financial assets is a financial tool for the lenders to securitise their future cash flows from the secured assets and thus to release their funds blocked in them. The secured assets become a market commodity having financial returns on their realisation. This aspect brings in the much-needed expertise in adept handling in realisation of the secured assets. The Act has made an attempt to streamline the legal impediments of normal civil law procedures to foreclose the mortgaged assets by empowering the enforcement of the secured assets by flexible mechanism provided in the Act. It would be pertinent to inter alia highlight the key features of the Act. The Act makes provision for2 :
Incorporation of Special Purpose Vehicles
Securitisation of Financial Assets.
Funding of securitisation.
Enforcing security interest i.e. taking over the assets given as security for the loan.
Establishment of Central Registry for regulating and registering securitisation transactions.
Offences & Penalties.
1.3 The paper proposes to critically analyse the legal regime within which securitization transactions take place in India. This has been done with the view to assess whether the Act promotes and facilitates securitization transactions in India.
2. The Concept of Securitisation
2.1 Securitization can be explained as a process of accumulating the assets having a fixed income stream into one product and converting then into marketable securities for a subsequent sale to investors. These marketable securities are secured by the assets themselves. Hence, the main aim of a firm/ concern in this exercise of securitization is to obtain access to low cost capital that is otherwise unavailable through conventional means. The asset-backed securitization (ABS) is a derivative product developed in American market using the fine blend of the financial engineering and legal expertise. The product gained market acceptability in a very short time and its volumes have touched hundreds of trillion dollars in the US market3 .
2.2 The US market is one of the biggest markets for securitization transactions. It has a reasonably matured legal system supporting the transaction. In the US, Uniform Commercial Code (UCC) was introduced to bring uniformity in the commercial laws and introduce new concepts for facilitating trade, commerce and creation of security interest on movable properties and enforcement of such security interests4 .
2.3 Some of the important features of the UCC for the purposes of this paper are5 :
it applies to the transaction and not the form creating a security interest, be it fixtures or personal property;
wide definitions are given to terms like ‘goods’, ‘intangibles’, ‘accounts’ and ‘security interest’;
Retention or reservation of title by a seller of goods is in effect treated as security interest;
Under UCC any stipulations in a contract or law requiring consent of the account debtor for assignment/ sale of any account or intangibles or promissory note is considered to be void without any waivers or exceptions;
General obligation of good faith has been imposed on performance and enforcement- honesty in fact and observance of reasonable commercial standards for fair dealing;
debtors rights in collateral may be transferred or assigned under UCC but every aspect of disposition of collateral must be commercially reasonable6 .
2.4 It becomes apparent from the above that the Act has borrowed some of the concepts from the UCC. In India, under the Act, the financial assets are freely assignable without any stipulations. Definition of security interest is also wide and general keeping in view the substance and not the form to a limited extend. Banks and financial institutions have been given powers of enforcement of security interest without courts intervention. Wide definition of property is intended to cover wide variety of property rights7 .
3. The Process involved in Securitisation Transactions
3.1 The process involved in securitization transaction includes several steps. The originator pools the similar set of assets that generate a predictable stream of payment and sells/ assigns them to special purpose vehicle (SPV)8. Any asset having a cash flow profile over a period of time can be securitized. Some of the assets which has the potential to be securitized are housing loans, car loans, term loans, export credits, and future receivables like credit card payments, ticket sales, album sales, car rentals, electricity and telephone bills receivables etc.9. These assets are known as ‘financial assets’10 .
3.2 Under section 5(1) of the Act only banks and financial institutions can securitize their financial assets, thereby restricting the originator of the securitization. The SPV converts the financial assets into securities for the purposes of selling them to the investors. SPV has the option to take the credit rating for the securities from the credit rating agency and investor receives the return on capital from the securities over the financial assets11 .
3.3 Broadly, securitization transaction can be divided into main players and the facilitators. The main players being the originator, obligor, SPV, and Investors (also known as QIBs - qualified institutional buyers). On the other hand, the facilitators of the securitization transaction can be considered as credit rating agency, insurance company or underwriters, trustees, and receiving & paying agent12 .
3.4 The very inception of the securitization transaction starts from the originator13. Originator is the one who owns the financial assets by making loans to the borrowers or obligors. In India, the originator can only be banks or financial institutions14. Hence, the scope and limits of the securitization transaction in India is not as broad as UK and US. The obligor15 or the borrower, can be any one person including legal person, who takes the loan from the originator, which are to be returned to the originator (receivables). The SPV16 can be institutionalised in the form of a trust or company with the main object to support the securitization transaction. Its main aim is to buys receivables from the originator and convert them into security receipts, which are sold to the investors. Section 2(v) and 2(za) of the Act describes the SPV as a company under the Companies Act, 1956. However, nothing under the Act stops the SPV from floating a trust17. Further, to have proper supervision over SPV-like companies, Section 3 of the Act prescribes ‘registration’, ‘net worth’ and corporate governance requirements, to keep a check on the transaction and the SPV. Investors under Section 7 the Act are restricted to only the QIBs, who can invest in the security receipts.
3.5 Facilitators play a very important role in enhancing the credit worthiness of the financial assets. Credit rating agency evaluates the securitized instruments and their credit worthiness. This helps the investors and other players to take prudent steps in investing their money. Insurance company and underwriters covers the risk, which might be faced by the investors in future due to any unforeseen losses. The Trustee owes a responsibility towards the beneficiary i.e., investors. Trustee acts on behalf of its beneficiaries i.e., the investors. This legal relationship gives the right to the trustee to have the priority interest in the financial asset for their beneficiaries. The Trustee can protect the investor’s interest by way of reviewing the assets, distributing cash flow to the investors and taking legal action to protect the investors interest. And, last but not the least is the role of the receiving and paying agent. This role is normally played by the originator himself. In this, the agent has to make sure periodic payments from the obligor and further payment transferred to the investors.18
3.6 The diagram showing a typical securitization transaction19 and the parties involved given at the end of this article.
4. The Indian Scenario
4.1 At this point it is relevant to note that ‘securitization’ has been used sparingly within the Indian financial sector. Some of the sectors where securitization transactions have been used popularly are discussed below.
4.2 Auto loans/ finance20 is a popular business in India. TELCO, Ashok Leyland Finance, Kotak Mahindra and Magma Leasing have been involved in the securitization transactions, with ICICI and Citibank, which were primarily bilateral buyouts. Credit Rating Agencies namely, CRISIL and ICRA provide credit ratings to the various financial assets in the market. Apart from the bilateral buyouts, ICICI in some of its transactions used the SPV structure and issued securities to the corporate investors and banks21 .
4.3 Infrastructure Finance: A famous structured finance transaction in India was by the India Infrastructure Developers Ltd. (IIDL). IIDL incorporated an SPV, through which they set up the building and operating a power plant for IPCL. IIDL raised finances on its future receivables from IPCL and L&T. This transaction was rated ‘AA’- (SO) by CRISIL22. Further, ICICI has been involved in various bilateral asset backed securitization deals, some of the note worthy securitization transactions by ICICI are where it securitized the receivables of Department of Telegraph from Sterlite Industries and Usha Beltron23 .
4.4 Housing Finance: Mortgage Based Securitization (MBS) in India has been used sparingly. In US, MBS constitutes 76 percent24 of the securitized debt market. National Housing Bank (NHB) along with HDFC and LIC Housing Finance issued India’s first MBS. The potential of MBS in India is very bright and big. NHB aims to develop the Secondary Mortgage Market (SMM) in India, which means MBS has the potential to overtake all other securitization transactions India. But the problem in the current legal framework sets back the whole process. There is still lack of mortgage foreclosure norms and the high incidence of stamp duty for assignment of mortgage necessary for securitization25 .
5. Critical Analysis of the Provisions of the Act
5.0 Having touched upon the present scenario of securitization transactions in India, it would be pertinent to analyse the import of the provisions of the Act, which facilitates securitization to a limited extent.
5.1.1 Section 2 (z) of the Act contemplates the acquisition of financial assets by securitization /reconstruction company from ‘any originator’. Under section 5 of the Act, financial assets are transferred, enables acquisition by a securitization/reconstruction company of ‘financial assets of any bank or financial institution’. The interesting point to note is that there is a further classification of ‘any originator’, which is mentioned in section 5 of the Act, which restricts originator to only Banks and FIs. Hence, by reading both the sections together it may be inferred that only Banks or FIs are allowed to do the securitization transactions.
5.2 Security Interest
5.2.1 The term “security interest" under the Act means right, title and interest of any kind whatsoever upon property, created in favour of any secured creditor and includes any mortgage, charge, hypothecation, assignment other than those specified in section 31.
5.2.2 The term security interest for the purposes of enforcement of security interest as per the Act is too wide and ambiguous for instance, if a creditor has only a negative lien (i.e. merely in the form of a covenant prohibiting the borrower from alienating or dealing with certain assets in a certain manner) over the assets of a borrower he can undertake enforcement action under the Act.
5.2.3 This would also create a practical problem as any and every interest, which could qualify, as “security interest" would also be required to be ‘registered’ under the Act.
5.3 Enforcement of Security Interest
5.3.1 Section 13 of the Act contemplates that pursuant to a notice period of 60 days by the secured creditor if the borrower is unable to discharge his liability in full, the secured creditor may take recourse to one or more mentioned in the section 13(4) to recover his secured debt26 .
5.3.2 It is felt that the Act has made a fair attempt at securing the creditors rights to recover the secured debt. The provision adequately provides the recourse for recovering the debts after giving sufficient notice of two months to the debtor to discharge his liabilities. However, it is felt that the Act could have alternatively provided for a flexible mechanism for working out a formulae to secure the debts on a mutually acceptable plan. In case of failure of the debtor to act upon the agreed upon formulae to discharge his liability within a stipulated time frame, the creditor could proceed to take action under the section 13(4).
5.3.3 It would also be pertinent to mention that the Act requires that, in order to avoid security enforcement action27 by a secured creditor, the defaulting borrower should discharge his liability in full (i.e. pay not only the amount in respect of which the default has occurred but also the remaining amount of the loan, which may not be due and payable in terms of the contract between the borrower and the secured creditor). The provision, therefore is unreasonable to the extent that the purpose of creation of SPV is lost and there is no room for working out a formulae to secure the rights and obligations of the parties in the transaction. It is therefore proposed that the provision ought to be made subject to the ‘contract to the contrary’ between the parties.
5.3.4 Further, the provision allowing the secured creditor to takeover the management of the secured assets of the borrower also seems to be unreasonable. It is because, working out a mechanism to manage the whole unit is a cumbersome proposition. In this process, if it is not sold, all the costs are incurred by the secured creditor towards security and maintenance over the acquired asset(s) in question.
5.4 The term ‘Appeal’ is wrongly used in Section 17 of the Act
5.4.1 As per Section 17 of the Act any person (including borrower), aggrieved by any of the measures referred to in sub-section (4) of section 13 taken by the secured creditor or his authorised officer, may prefer an ‘appeal’ to the Debts Recovery Tribunal (‘DRT’) having jurisdiction in the matter within forty-five days from the date on which such measure had been taken28 .
5.4.2 As commonly understood an ‘appeal’ lies from the order of a judicial or quasi-judicial authority. Therefore, the use of the word ‘appeal’ is inappropriate for a complaint/ application against the wrongful measures adopted by a secured creditor with whom the borrower merely has a commercial arrangement29 .
5.5 No difference between Securitization company and Reconstruction company under the Act
5.5.1 The Act proposes to securitize and reconstruct the financial assets through two types of special purpose vehicles viz. 'Securitisation Company' and 'Reconstruction Company'. SCO and RCO ought to be a company incorporated under the Companies Act, 1956 having securitisation and asset reconstruction respectively as main object. It is observed that there seems no difference between the Securitization and Reconstruction company under the section 2 (v) and (za) of the Act. Neither is the securitization company restricted to the transaction of securitization nor is the reconstruction company restricted to the transaction asset reconstruction under the Securitization Act30 .
5.5.2 Securitization31 as commonly understood is a method of structured finance adopted by the companies / banks / financial institutions for the purposes of conversion of financial assets into marketable securities; raising cheaper funds; liquidity; access to new market; balance sheet management.
5.5.3 Asset reconstruction, on the other hand, normally relates to Non Performing Assets of Banks and Financial Institutions, which are transferred to specialized entities (i.e. reconstruction company) for the purposes of recovery of the NPA and better balance sheet management.
5.5.4 Therefore, the Act has tried to relate the transactions of securitization and asset reconstruction, which by its nature and purpose is different from one another.
5.6 Measures under Section 9(a) and (b) of the Securitization Act are too wide
5.6.1 The powers set forth under Section 9 of the Act in respect of asset reconstruction are in addition to the powers under Section 13 of the Act and therefore suffers from similar flaws as Section 13 of the Act.
5.6.2 Also, empowering the RBI to frame directions more particularly in respect of Section 9(a) and 9(b) could be prejudicial to the interests of the borrowers as the RBI may completely ignore the interest of the borrower. Thus, it is necessary to explicitly set out the guidelines to use the powers, which may be exercised in respect of asset reconstruction rather than allowing RBI to frame guidelines from time to time.
5.7 Legal framework in a broader context
5.7.1 There are various legal issues concerning Stamp Duty, Registration Act, Tax law, RBI Regulations, SEBI rules which are not addressed in the Act sufficiently32. The coordination between these laws is very important to encourage the securitization transactions in India. Hence, the regulatory framework must be framed to be a workable scheme of law. Apart from this domestic legal issue, it is important to have the law feasible and in coherence with the international standards, so that in future when the law on securitization widen its horizon, their will be no difficulty in its transition.
6.1 Legal framework for securitization is at a nascent stage in India as it is restricted to certain institutions namely, banks and financial institutions only. The Act is certainly a futuristic step and well-deserved appreciation must be given towards the step. It is hoped that in future more and more transactions may be included under the Act so that the market matures and reach to an advanced stage like UK or US, as this process will help in growth of the economy. As discussed in this essay, there are some provisions, which are loosely worded in the Act. It is the need of the time that the Act must be amended to cope up with the market demands and be prepared for the finer aspects of securitization.
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