rbi guidelines on direct assignment

RBI'S Framework For Transfer Of Loan Assets

Contributor.

As an anticipated measure for the banking and financial sector, the Reserve Bank of India (RBI) has, towards the close of past week, issued the comprehensive framework for the sale or transfer of loan assets. Taking immediate effect from the date of its issuance, the framework titled ' Master Directions - Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021 ' issued vide circular DOR.STR.REC.52/21.04.048/2021-22 dated September 24, 2021 (the ' Master Directions ') is being seen as a pivotal move by the Regulator towards introducing an efficient secondary market for loans and ensuring proper credit-risk pricing, besides improving transparency in the identification of embryonic stress in the banking system as well as resolution of stressed loan exposures.

The Master Directions owes its genesis to the ' Draft Framework for Sale of Loan Exposures ' which was released by RBI in course of the first COVID-19 induced lockdown in the Country. The draft had taken into consideration the recommendations of the ' Task Force on Development of Secondary Market for Corporate Loans ' constituted by RBI under the chairmanship of Mr. T.N. Manoharan in May, 2019 and comments from the stakeholders were invited. One of the key components of the Task Force's recommendation was to separate the regulatory guidelines for direct assignment transactions from the securitisation guidelines and treat it as a sale of loan exposure. The RBI had, accordingly, reviewed the recommendations and thought it prudent to comprehensively revisit the guidelines for sale of loan exposures, both standard as well as stressed, which were earlier spread across various circulars. The erstwhile guidelines or circulars on sale of loan exposures were particular to the asset classification of the loan exposure being transferred and / or the nature of the entity to which such loan exposure is transferred as well as the mode of transfer of the loan exposures. The need for a review also stemmed from the necessity to dovetail the guidelines on sale of loan exposures with the Insolvency and Bankruptcy Code, 2016 (' IBC ') and the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019 (" Prudential Framework "), which has witnessed substantial traction and developments towards building a robust resolution paradigm in India in the recent past.

The consolidation by RBI of a self-contained, comprehensive, and independent set of regulatory guidelines on transfer/sale of loan exposures is being seen as a laudable step in the direction of putting together a ' robust secondary market in loans which can be an important mechanism for management of credit exposures by lending institutions and also create additional avenues for raising liquidity '. This write-up attempts to briefly summarize some key components of the Master Directions.

The Master Directions whilst superseding a host of existing circulars/directions (or a portion thereof) in relation of transfer of loan exposures (Chapter VI), has put forth a unified and singular framework for the sale of loan exposures by banks and other financial institutions. The exhaustive breadth of the framework is quite evident from the Chapters under the Master Directions which not only provide for ' General Conditions applicable to all Loan transfers ' (Chapter II), but also cater specifically to transfer of loan exposures of standard assets (Chapter III) as well as stressed loan exposures (Chapter IV), including their respective and intrinsic modalities. The framework concludes with the imperative of ' Disclosures and Reporting ' (Chapter V) and stipulates the mechanism for the stakeholders in that regard.

Applicability

On expected lines, nearly all constituents of the Financial sector regulated by RBI are mandated to ensure compliance to the Master Directions, both as a transferor as well as transferee of the loan exposures – Scheduled Commercial Banks, all NBFCs (including HFCs), Regional Rural Banks, Co-operative Banks, All India Financial Institutions and Small Finance Banks. In addition, the Master Directions also permits asset reconstruction companies (ARCs) 1 and companies 2 (save a financial service provider 3 ) to be 'transferees' of the loan exposures only if the same is pursuant to the resolution plan under the Prudential Framework and if they are permitted to take on loan exposures in terms of a statutory provision or under the regulations issued by a financial sector regulator.

It would be pertinent to take note that though all lenders permitted to acquire loans are required to ensure compliance to the extant Master Directions; yet, the acquisition of loans pursuant to securitisation are required to be independently dealt under the provisions of RBI's ' Master Directions – RBI (Securitisation of Standard Assets) Directions, 2021 ' dated September 24, 2021 (the 'Securitisation Guidelines'). The coverage of the Master Directions includes transfer of loan exposures through novation, assignment, or risk participation. In cases of loan transfers other than loan participation, legal ownership of the loan shall be mandatorily transferred to the Transferee to the extent of economic interest transferred under the loan exposures.

For the Transferees which are financial sector entities (not falling under clause 3 of the Master Directions) and the ARCs, the prudential norms (asset classification, provisioning norms etc) of their respective sectoral regulators (SEBI, IRDA, PFRDA etc) shall be applicable post-acquisition of loan exposure under the Master Directions.

Basic Ingredients

Before venturing into the other nuances, it is an imperative that one accounts for the understanding of some key 'constructs' which cut across the Master Directions:

• Transfer : Quite apparently, the expression denotes the process of transfer of the economic interest in a loan exposure by the transferor and acquisition of the same by the transferee. The subject matter of transfer being the ' economic interest ' of the transferor in the loan exposure, it is important that the risks and rewards associated with loans are clearly demarcated and separated in favour of the transferee; especially when some portion of the economic interest in the loan exposure is retained by the transferor.

It is significant to take note that the transfer of the said economic interest can be with or without the transfer of underlying contract. Essentially, even loan participation transaction have also been recognised under the Master Directions (for transfer of standard loans) wherein the transferor transfers all or part of its economic interest in a loan exposure to transferee without the actual transfer of the loan contract, and the transferee(s) fund the transferor to the extent of the economic interest transferred which may be equal to the principal, interest, fees and other payments, if any, under the transfer agreement.

• Transferor : Often referred as 'assignor' (in assignment transactions) or 'grantor' (for risk participation), transferor under the Master Directions would include Clause 3 entities which transfer their economic interest in the loan exposures.
• Transferees : These refer to entities in whose favour the economic interest in the loans are transferred and would include Clause 3 entities as well as the ARCs/companies to the extent permitted under the Master Directions. It is clarified that the transferee should neither be a person disqualified under the IBC 4 nor, in cases of loan exposures where frauds have been identified, belong to an existing promoter group 5 of the borrower or its subsidiary / associate / related party 6 (domestic as well as overseas).
• Minimum Holding Period (MHP) : As the expression suggests, the MHP refers to a threshold period for which the transferor should hold the loan exposures, along with its risks and rewards, before the economic interest in respect thereto is transferred. The intent of having a MHP is to ensure that the loan has been seasoned in the books of the originator (or the transferor) for a certain specified time period. The MHP for loans with tenor upto 2 years and more than 2 years, as per the Master Directions, have been capped at 3 months and 6 months, respectively.

The holding period for the Transferor, in case of secured exposures, is to be computed from the date of registration of the underlying security interests; unless, of course, the loan is unsecured in which case the MHP runs from the date of first repayment under such unsecured exposure. However, in case of project loans, the foregoing months of MHP is required to be calculated from the date of commencement of commercial operations of the project being financed. Besides, the loans acquired by the Transferor itself are required to have a MHP of atleast 6 months from the date of acquisition of the loan on the books of the Transferor, irrespective of the tenor of the loan exposures.

It would be of significance to note that the MHP criteria prescribed under the Master Directions do not apply for loans transferred by an arranging bank under a syndication arrangement.

• Permitted Transferees : These include (i) Scheduled Commercial Banks, (ii) NBFCs (including HFCs), (iii) All India Financial Institutions and (iv) Small Finance Banks. The significance of carving out the foregoing financial sector entities from Clause 3 of the Master Directions lies in the fact that the transferor is permitted to transfer its loans (which are not in default) to permitted transferees only through novation, assignment, or loan participation. For the stressed exposures, the transfer is mandated only to such permitted transferees and ARCs and singularly through assignment or novation of such loan exposures.

Underlying Elements

The finer nuances of the Master Directions would certainly surface once the provisions have been widely given effect to by the stakeholders; however, as it stands, the framework undoubtedly promises to streamline the procedures and requirements for the stakeholders considering transfer of their loan exposures – standard as well as stressed. Some fundamental provisions of the Master Directions have been summarized as below:

• Overarching Transfer conditions : Quite categorically, the Master Directions stresses on the necessity of delineation of Transferor's 'risks and rewards' associated with the loan exposures to the extent of the transfer. In fact, it is stated that not only should the transferee have the unrestrained and unconditional entitlement to transfer or dispose of the loans to the extent of economic interest acquired by it, but also in the event of any economic interest in the loan exposure is retained by the transferor, the loan transfer agreement should demarcate the distribution of the principal and interest income from the transferred loan between the transferor and the transferee. The Master Directions also caution against any modification of terms of the underlying financing agreement and require that any change, in course of such transfer, should withstand the test of not being categorised as 'Restructuring' under the Prudential Framework. It would be significant to take note that the transfer of loan exposures under the Master Directions not only should be without recourse to the Transferor, but also the transferor or transferee should not be constrained to obtain consent from the transferee/ transferor, as the case may be, in the event of resolution or recovery in respect of the beneficial economic interest retained by or transferred to the respective entity. In addition to the foregoing, the Master Directions also prescribe for the enumerated conditions applicable to all transfers of loan exposures:
• The Transferor shall have no obligation to re-acquire or fund the re-payment of the loans or any part of it or substitute loans held by the Transferee or provide additional loans at any time;
• If the security interest is held by the Transferor in trust with the Transferee as the beneficiaries, the Transferee shall ensure that a mutually agreed and binding mechanism for timely invocation of such security interest is put in place;
• Any rescheduling, restructuring or re-negotiation of the terms of the underlying agreement attempted by Permitted Transferee, after the transfer of assets to the transferee, shall be as per the Prudential Framework;
• The Clause 3 entities, regardless of whether they are transferors or otherwise, should not offer credit enhancements or liquidity facilities in any form in the case of loan transfers.

In case the transfer of loan exposures which are not compliant with the requirements mentioned in the Master Directions, the onus is on the Transferee to maintain capital charge equal to the actual exposure acquired and the Transferor is required to treat the transferred loan in its entirety, as if it was not transferred at all in the first place, and the consideration received by it shall be recognised as an advance.

• Board-approved Policy : The Transferors are mandated to put in place a comprehensive Board-approved policy for transfer and acquisition of loan exposures under the Master Directions. These guidelines must, inter alia , lay down the minimum quantitative and qualitative standards relating to due diligence, valuation, requisite IT systems for capture, storage and management of data, risk management, periodic Board level oversight, etc. Further, the policy must also ensure the independence of functioning and reporting responsibilities of the units and personnel involved in the transfer/acquisition of loans from that of personnel involved in originating the loans.
• Transfer of Standard Assets : The transfer of loan exposures classified as 'standard' can be undertaken through the mechanisms of assignment or novation or a loan participation. The transfer of such loan exposures should be only on a cash basis to be received at the time of transfer of loans; besides, the requirement of the transfer consideration being arrived at in a transparent manner on an arm's length basis. The Master Directions require the Transferees to monitor, on an ongoing basis and in a timely manner, the performance information on the loans acquired, including through conducting periodic stress tests and sensitivity analyses, and take appropriate action required, if any. Further, the Transferor's retention of economic interest, if any, in the loans transferred should be supported by legally valid documentation supported by a legal opinion.

The requirements of Chapter III of the Master Directions are, however, not applicable to certain identified loan transfers, as below:

• transfer of loan accounts of borrowers by a lender to other lenders, at the request/instance of borrower;
• inter-bank participations as per the RBI's circulars;
• sale of entire portfolio of loans consequent upon a decision to exit the line of business completely;
• sale of stressed loans; and
• any other arrangement/transactions, specifically exempted by the RBI.
• Minimum Risk Retention : The Master Directions are explicit in their requirement of the requisite due diligence in respect of the loans exposures and mention that the said exercise cannot be outsourced or delegated by the Transferee. In order to ensure a systemic departure from the conventional practice of placing solitary reliance on the due diligence of the originator (or the Transferor), the Master Directions mandate the Transferee to undertake the due diligence of the loan exposures through its own staff, at the level of each loan, and as per the same policies as would have been done had the Transferee been the originator of the loan. In case the due diligence of entire portfolio is undertaken by the Transferee, the requirement of a minimum retention requirement (MRR) of the Transferor can be dispensed with.

However, in case of loans proposed to be acquired as a portfolio, if a transferee is unable to perform due diligence at the individual loan level for the entire portfolio, the Transferor shall retain at least 10% of economic interest in the transferred loans as MRR. In such a case as well, the Transferee is required to undertake due diligence at the individual loan level for not less than one-third (1/3 rd ) of the portfolio by value and number of loans in the portfolio. As per the Master Directions, in case of multiple Transferees, the MRR would still be on the entire amount of transferred loan, even if any one of the transferee is unable to perform the due diligence at an individual level.

• Transfer of Stressed Assets : Chapter IV of the Master Directions deals specifically with the transfer of stressed loan exposures to ARCs and other Permitted Transferees. It is specifically stated that the mechanism for transfer of such stressed accounts can be consummated only through assignment or novation. Besides the requirement of a Board-approved policy for transfer as well as acquisition of stressed loan exposures and the parameters thereof, the Master Directions mandate such transfers to ARCs and other Permitted Transferees only. Importantly, the Transferor is necessarily required to undertake an auction through a ' Swiss Challenge method ' both in cases where (i) the aggregate loan exposure to be transferred is Rs. 100 crore or more after bilateral negotiations; and even under (ii) a transfer pursuant to the Resolution Plan approved in terms of the Prudential Framework (irrespective of the monetary threshold).

The transfer of such stressed loan exposures, as per the Master Directions, should be bereft of any operational, legal or any other type of risks relating to the transferred loans including additional funding or commitments to the borrower / transferee. In fact, it is specifically required for the transferor to ensure that no transfer of a stressed loan is made at a contingent price whereby in the event of shortfall in the realization of the agreed price, the Transferor would have to bear a part of the shortfall.

In addition, the Transferor is required transfer the stressed loans to transferee(s) other than ARCs only on cash basis and the entire transfer consideration should be received not later than at the time of transfer of loans. The stressed exposure can be taken out of the books of the Transferor only on receipt of the entire transfer consideration.

Quite significantly, the Master Directions prescribed that if the Transferee of such stressed loan exposure (except ARCs) have no existing exposure to the borrower whose stressed loan account is acquired, the acquired stressed loan shall be classified as "Standard" by the transferee. However, in case the Transferee has an existing exposure to such borrower, the asset classification of the acquired exposure shall be the same as the existing asset classification of the borrower with the Transferee, irrespective of whether such acquisition is pursuant to the transferee being a successful resolution applicant under the IBC.

Further, the Master Directions require the Transferee to hold the acquired stressed loans in their books for a period of at least 6 months before transferring to other lenders; however, such holding period is not applicable in case the transfer of stressed loan exposure is to an ARC or is pursuant to a resolution plan approved in terms of the Prudential Framework.

As regards the mandate of undertaking the 'Swiss Challenge method' is concerned, the Master Directions require the lenders put in place a Board-approved policy which should, interalia , specify the minimum mark-up over the base-bid required for the challenger bid to be considered by the lender(s), which in any case, shall not be less than 5% and shall not be more than 15%. However, for transfer of stressed exposure under the Prudential Framework, the minimum mark-up over the base-bid required for the challenger bid is to be decided with the approval of signatories to the ICA representing 75% by value of total outstanding credit facilities and 60% of signatories by number.

Additionally, the Master Directions provide for sharing of surplus between the ARC and the Transferor, in case of specific stressed loans; though, the clarity in respect of such specific stressed loans is not mentioned. The repurchase of stressed loan exposures is also stipulated from the ARCs in cases where the resolution plan has been successfully implemented

• Accounting : In the event the transfer of loan exposures results in loss or profit, which is realised, the same should be accounted for and, accordingly, reflected in the P&L account of the Transferor for the accounting period during which the Transfer is consummated. However, the unrealised profits (if any) arising out of such Transfers, shall be deducted from the Common Equity Tier 1 (CET 1) capital or net owned funds of the Transferor for meeting regulatory capital adequacy requirements till the maturity of such transferred exposures. The Master Directions prescribe maintenance of borrower-specific accounts both by the Transferor as well as the Transferee of the retained and transferred loan exposures, respectively. It has been further clarified that the extant requirements of RBI for 'income recognition, asset classification, and provisioning' shall, accordingly, be ensured by the transferor and the transferee with respect to their respective shares of holding in the underlying loan exposures.

Though it would be quite nascent to present an analysis of the Master Directions even before it has been actually implemented, yet there are indeed some crucial aspects which underline the significance of the Master Directions issued by RBI which can be summarized as follows:

• Identification and Resolution of Stressed Exposures : Though quite a premature assessment, yet it is felt that the framework under Master Directions could facilitate the development of a robust distressed asset ecosystem and speed-up the resolution of various stressed exposures, which could be driven by the ensuing characteristics of the Master Directions:
• Early Identification and Resolution of Stressed Exposures : The framework has expanded the definition of stressed exposures ('stressed loans') to include both non-performing assets (NPAs) and special mention accounts (SMAs). Also, the deregulation of the price discovery process will enable faster and more efficient pricing of exposures – especially when coupled with a wider range of eligible investors.
• Enhanced Viability of Stressed Asset Takeover Structures :More importantly, the Master Directions allow investors in stressed assets to classify the exposure as standard, although subject to any other exposure to the same entity on the investor's books not being sub-standard on the date of the acquisition of the asset. This could significantly lower capital charge and provisioning requirements for the acquirer/investor of the stressed assets. Given that most stressed assets are restructured as well – often including a complete management overhaul, the rationalisation of the capital charge and provisions could make such assets more attractive to prospective acquirers.
• Impetus to Long-Term Funding structures : The Indian credit markets have for long been bereft of avenues for mobilising capital through long-term debt instruments. As a result, liability structures for corporate borrowers in sectors such as power generation and roads front load cash outflows during the project life. This, at least in part, reflects the non-availability of long-dated liabilities for the financial sector. Therefore, an ecosystem which allows lenders to off-load long-dated exposures after a certain time period with reasonable foresightedness could enable borrowers to raise long-term debt instruments from the financial system in a cost-efficient manner.
• Independent Credit Evaluations Could Prove Critical : The Master Directions mentions that transferees may have the loan pools rated before acquisition so as to have a third-party view of their credit quality in addition to their own due diligence; though, the latter is a mandatory requirement and cannot substitute for the due diligence that the transferee(s) are required to perform. Also, in case of transfer of stressed assets, it becomes critical to ensure that the valuation of the exposure and associated risk capital allocation are based on an assessment of the asset to meet its contractual debt obligations. Even restructured accounts have subsequently come under stress in some cases due to fundamental weaknesses in the business profile, heightened management risk/weak governance structures and unsustainable debt levels even after restructuring. Though not prescribed as a mandatory requirement under the Master Directions, yet a third-party evaluation by a credit rating agency could provide an added layer of assessment and valuations for such exposures along with subsequent capital charge and provisioning norms could be linked to the outcome of such evaluation.

1. Registered with the Reserve Bank of India under Section 3 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002

2. Sub-section (20) of Section 2 of the Companies Act, 2013

3. Sub-section (17) of Section 3 of the Insolvency and Bankruptcy Code, 2016

4. Section 29A of the Insolvency and Bankruptcy Code, 2016

5. As defined under SEBI (ICDR) Regulations, 2018

6. As defined under the Insolvency and Bankruptcy Code, 2016

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Finance and Banking

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India Corporate Law

Rbi’s move to revamp loan transfers in india.

On June 08, 2020, the Reserve Bank of India ( RBI ) released two draft frameworks — one for securitisation of standard assets ( Draft Securitisation Framework ) and the other on sale of loan exposures ( Draft Sale Framework ). In our previous article (available here ), we had dealt with key revisions introduced by the RBI under the Draft Securitisation Framework. This article contains a brief summary of the Draft Sale Framework.

The Draft Sale Framework is addressed to the same constituents as the Draft Securitisation Framework and is expected to operate as an umbrella framework, which will govern all loan transfers (standard and stressed assets).

The Draft Sale Framework is broadly divided into three parts viz., (i) general conditions applicable to all loan transfers; (ii) provisions dealing with sale and purchase of standard assets; and (iii) provisions dealing with sale and transfer of stressed assets (including purchase by ARCs).

The core principles of transfer appear like the previous guidelines on direct assignment. However, the scope of transfer has now been expanded to include various kinds of economic transfers of loan assets, including participation arrangements and transactions in which the loan exposure remains on the books of the transferor even after the said transactions.

Three types of transfers that have been recognised under the Draft Sale Framework viz., (i) assignment; (ii) novation; and (iii) loan participation (which includes both risk participation and funded participation). Whilst loans can be transferred via any of the aforesaid transfer methods, (a) revolver loans and loans with bullet payments of principal and interest can only be transferred through novation and loan participation; and (b) stressed assets can only be transferred through assignment and novation. Transfer by way of novation is exempt from the applicability of the guidelines, except for a diktat that approval of all parties, including the borrower, is required for novation.

RBI has indicated that all these transfers are required to result in immediate legal separation of the transferor from the assets, which are transferred and put beyond the reach of the transferor as well as the creditors of the transferor. RBI has also suggested that these should be bankruptcy remote and a legal opinion should be obtained in this regard.

In line with the position in the 2012 guidelines, transferors are not permitted to offer any credit enhancement or liquidity facility for loan transfers. Diligence requirements continue to be strict and the purchasing lender is required to apply the same standard of care while assessing the asset, as if it were originating the asset directly and cannot outsource its due diligence.

The RBI has also permitted transfer of a single loan asset or part of a single asset to a financial entity through novation or loan participation. Only financial entities carrying on business in India will be eligible to participate. Loans acquired from other entities can also be assigned.

Participation Agreements

The Draft Sale Framework also seeks to permit and regulate participation arrangements. Participation arrangements though popular in certain other jurisdictions were not common here, except inter alia , in accordance with the guidelines issued by the RBI on December 31, 1998. The1998 guidelines permitted two types of participations, inter-bank participations with risk sharing and inter-bank participations without risk sharing. While the assignment agreements that were entered into earlier were akin to participation agreements in spirit, the permissibility of participation is an interesting development and a regulatory headway made in the growth of the loan market. The Draft Sale Framework seeks to allow both risk participation and funded participation in loans. Participation agreements in respect of stressed assets has not been specifically permitted.

The Draft Sale Framework specifically recognizes transfer of external commercial borrowings by ‘eligible lenders’ (as defined under the Master Direction on External Commercial Borrowings, Trade Credits and Structured Obligations), subject to any loss or hair cut being to the account of the transferor.

It is expected that the RBI will provide further clarity on whether all lenders (i.e. overseas branches, onshore branches, etc.) can purchase such assets and whether the exposure must continue to remain in foreign currency, both for standard and stressed assets

The RBI has not stipulated the requirement for a transferor to maintain minimum risk retention for loan transfers. This will enable the transferee to deal with the loan independently. However, transferors will have to comply with the ‘minimum holding period’ requirement.

Transfer of loan accounts at the instance of the borrower, inter-bank participations, trading in bonds, sale of entire portfolio of assets consequent upon a decision to exit the line of business completely, sale of stressed assets and consortium and syndication arrangements continue to remain exempt from the applicability of Chapter III of the Draft Sale Framework (which only applies to transfer of standard assets).

Stressed Assets

Stressed assets have been defined as: ‘ assets that are classified as NPA or as special mention accounts, and generally includes accounts, which are in default, as well as where lenders have given concessions for economic or legal reasons relating to the borrower’s financial difficulty ’.

Currently, the Master Circular on Prudential Norms on Income Recognition, Asset Classification and Provisioning (pertaining to advances), 2015, detail the criteria for standard assets, special mention accounts and non-performing assets. The classification has also been replicated in the Reserve Bank of India (Prudential Framework for Resolution of Stressed Assets) Directions 2019 ( Prudential Stressed Asset Directions ).

The Draft Sale Framework does not replace or limit the application of existing RBI directions (especially the Prudential Stressed Asset Directions). Any regulated entity (that is permitted to take on loan exposures by its statutory or regulatory framework), can purchase stressed assets directly.

Promoters and Similar Persons Not Eligible to Buy Stressed Assets

The transferor is required to ensure that the transferee is not disqualified in terms of Section 29A of the Insolvency and Bankruptcy Code, 2016, and is not otherwise a promoter, associate, subsidiary or related person of the underlying obligor. Therefore, if there is an existing option to put loans on a promoter / similar entity, then the same may not be possible if the loan is a stressed asset.

In case of standard assets, the Draft Sale Framework has stipulated a table for MHP based on tenure of the loan. However, stressed assets are required to be held in the books of the lender for a period of 12 months.

Asset Classification and Provisioning

A purchased stressed asset can be classified as a ‘standard asset’ by the purchasing entity, in cases where the purchasing entity has no existing exposure to the borrower. However, in case, the purchasing entity has an existing exposure to the borrower whose stressed loan account is acquired, the asset classification of the purchased exposure shall be the same as the existing asset classification of the borrower with the transferee.

Transfer of Stressed Assets to ARCs

The Draft Sale Framework also deals with sale of stressed assets to asset reconstruction companies ( ARC ).

While Section 7 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ( SARFAESI ) always provided that ARCs could issue debt instruments in lieu of the consideration payable for the acquisition of assets, RBI has now specifically provided for the same in the Draft Sale Framework. If such deals are done, it must clearly be established that the sale is effective. However, the Draft Sale Framework also provides that these instruments will have to be considered as debt on the books of the ARC, therefore implying that the ARC has an obligation to repay the debt and such oblgation cannot be linked to realization of the underlying asset. While this enabling provision is useful, ARCs are unlikely to opt for this route given that there is an obligation to repay the debt, the present structure of PTC may be the preferred option.

It is relevant to note that FPI entities continue to have the right to invest in security receipts and will also have the right to invest in the bonds issued by the ARC.

It is specifically clarified that transfer of stressed assets to non-ARCs can only be on a cash-consideration basis.

Swiss Challenge Method

In an attempt to de-regulate price discovery, the mandatory Swiss Challenge Method has been done away with. Lenders are now expected to put in place board approved policies on adoption of an auction-based method for price discovery.

Right of First Refusal

Under the current Guidelines on Sale of Stressed Assets by Banks, issued by the RBI on September 1, 2016, a bank selling a stressed asset is required to offer the right of first refusal to an ARC, which has already acquired the highest and significant share (~25-30%) in the asset. Such ARC is required to be provided the right to match the highest bid. In line with these guidelines, the Draft Sale Framework also provides the right of first refusal to ARCs, which hold a significant stake in the asset. Additionally, the Draft Sale Framework also provides that in the event such ARC does not want to purchase the asset or if no ARC holds a significant portion, then such right of refusal will have to be extended to a ‘financial institution’, if such institution holds a significant stake in the asset.

The Draft Sale Framework is a significant move by the RBI and is expected to streamline loan transfers in the country. This framework reinforces the RBI’s focus on addressing the health of banks and bad debt in the country, whilst remaining committed to a balanced approach on sale of assets. If passed in its current form, it will be a positive move by the regulator in developing a robust market for secondary transfers.

*Authors would like to thank Vidhi Sarin , Associate for her inputs.

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Firms open close, lawyers open close, in-house open close, knowledge centre open close, events open close, about us open close, new directives on securitisation of standard assets – revamping the securitisation landscape.

February 1, 2022 > India > Finance

Juris Corp | View firm profile

The Reserve Bank of India (“RBI”) on 24 th September 2021, issued the Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021 (“Master Directions”). These Master Directions repeal the existing RBI guidelines on securitisation of standard assets. The Master Directions apply to the following entities:

• all Scheduled Commercial Banks (including Small Finance Banks but excluding Regional Rural Banks);
• all all-India Term Financial Institutions (NABARD, NHB, EXIM Bank and SIDBI); and
• all Non-Banking Financial Companies (“NBFCs”) including Housing Finance Companies (“HFCs”).

The Master Directions have evolved from the ‘ Draft Framework for Securitisation of Standard Assets ’ which was released by the RBI on 8 th June 2020, wherein the aim was to align the regulatory framework surrounding the securitisation regime with Basel III requirements and deepen the secondary loan trading market. The Master Directions have also taken into account the recommendations of the Committee on Development of Housing Finance Securitisation Market in India (Chair: Dr. Harsh Vardhan) and the Task Force on the Development of Secondary Market for Corporate Loans (Chair: Shri T.N. Manoharan) ( “Task Force” ) which were set up by the RBI in May 2019. One of the key components of the Task Force’s recommendation was to separate the regulatory guidelines for direct assignment transactions from the securitisation guidelines and treat it as a sale of loan exposure. To that effect, the guidelines for direct assignment transactions, which formed part of the repealed securitisation guidelines, have been separated from the securitisation guidelines and subsumed under a separate set of guidelines on transfer of loan exposures including stressed loans or loan exposures classified as fraud.

This article aims to briefly summarise and highlight key components of the Master Directions and its subsequent implication on the banking and financial sector.

Basic Deviations:

• The Master Directions permit single asset securitisation which was prohibited under the erstwhile guidelines. It is interesting to note that securitisation of single assets was common prior to the 2012 Guidelines pursuant to which it was not allowed. However, exposures to other lending institutions can no longer be securitised.
• In a major deviation from the repealed guidelines, the Master Directions have now revised the minimum holding period ( “MHP” ) and minimum retention requirement ( “MRR” ) for the assets being securitised. While a 12-month MHP is no longer required for residential mortgage-backed securitisations and the MHP is no more linked to repayment frequency but to the tenor of the loan, the percentage of MRR to be maintained has not undergone any revision. However, an exception has been carved out for residential mortgage-backed securitisation wherein only a 5% MRR is required to be maintained irrespective of the original maturity.

In addition to the above, overcollateralization is no longer considered as a form of MRR.

Accordingly, MRR may be achieved by issuance of equity tranches or pari passu investment in senior tranches.

• The timelines for credit enhancement reset for residential mortgage-backed securities have also been reduced.
• The risk weights for high rated senior tranches have been reduced while the risk weights of junior tranches are higher.

New Inclusions:

• Investment threshold for securitisation notes will be at a minimum of INR 10 million. If the securitisation notes are offered to more than 50 persons, it will have to be listed as per the terms of the Securities and Exchange Board of India (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008 (as amended).
• Simple, transparent, and comparable securitisation (“STC”)

Under the Master Directions, two methods of securitisation have been introduced:

• STC securitisations; and
• non-STC securitisations.

STC compliance permits alternative capital treatment and the compliance itself is primarily linked to enhanced transparency requirements. STC transactions enable lower risk weights effectively leading to higher yields. Hence originators undertaking securitisation on an ongoing basis may consider securitisation that is STC compliant.

• The provision relating to credit monitoring and valuation has been revised under the Master Directions. Board approved policies for the valuation of securitisation notes need to be put in place. Lenders need to now put in place formal procedures to assess the risk profile of the underlying assets. They also need to monitor on an ongoing basis and in a timely manner, performance information on the exposures underlying their securitisation positions and take appropriate action, if any, required.
• Under the provisions of the Master Directions, holders of securitisation notes can now pledge or trade their holding without any restriction unless the restriction is imposed by a statutory or regulatory risk retention requirement.
• Further, assets purchased from other lenders can now also be securitised including securitisation of trade receivables is now specifically provided for. Assets purchased from other lenders can now be securitised. This inclusion can help in repackaging and risk diversification. In this regard it has also been clarified that the conditions of separation from the transferred asset applicable to the originator shall apply to such lender from whom the asset is purchased although only either of such lender or originator can have a representative on the board of the special purpose entity.
• The Master Directions envisage a new requirement that there should not be a gap of more than 30 days between transfer of the assets and the issuance of securitisation notes .
• The Master Directions have expressly provided for :
• mortgage-backed securitisation;
• replenishment structures; and
• securitisation of trade receivables.

It should be noted that while securitisation for the above structures were being undertaken in the past, an express provision has now been included.

In a nutshell:

Following in the footsteps of the global market, the securitisation market in India has steadily evolved over the years. The Master Directions is a step in this direction. While certain provisions thereunder remain ambiguous and curtail otherwise emerging structures, undoubtedly, the changes introduced will result in more transparent securitisation structures and give an impetus to the Indian financial sector. In this backdrop, we anticipate innovative structures, specifically in relation to mortgage-backed securitisation, replenishment structures, single asset securitisation to name a few.

All in all, the Master Directions are a nod from the regulator towards a more developed structured finance market, hopefully resulting in a steady increase of securitisation deals in the Indian market.

Ankit Sinha Partner, Juris Corp Email: [email protected]

Teza Jose Principal Associate, Juris Corp Email: [email protected]

Disha Saxena Associate, Juris Corp Email: [email protected]

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RBI increases responsibilities of loan transfer parties

T he Reserve Bank of India (RBI) issued the Transfer of Loan Exposures Directions, 2021 (directions) in September 2021, which prescribe a comprehensive and robust framework to facilitate the sale, transfer and acquisition of loan assets, both standard and stressed, in the secondary market by lenders. These directions are applicable to all forms of loan transfers, including novation, assignment and loan participation.

Based on the recommendation of the Task Force on the Development of Secondary Market for Corporate Loans, the Committee on Development of Housing Finance Securitisation Market in India and the public responses received, it was decided to separate the regulatory guidelines for direct assignment transactions from the securitisation guidelines, and to revisit the guidelines for the sale of both standard and stressed exposures, which currently are contained in a number of circulars.

The directions make existing guidelines consistent with the changed resolution paradigm in the form of the Insolvency and Bankruptcy Code, 2016 (IBC) and the Prudential Framework for Resolution of Stressed Assets issued by way of the circular of 7 June 2019 (prudential framework). The directions are specific to the asset classification of the loan exposure being transferred; the nature of the entity, and the mode of transfer.

Other important provisions of the directions include situations where, in loan participation transactions, the legal ownership remains entirely with the transferor even after the beneficial interest has been transferred to the transferee. In such cases, the roles and responsibilities of the transferor and transferee shall be clearly delineated contractually. Loan transfers should result in the transfer of economic interest with no change in the loan contract. If there are any modifications, such as take-out financing, they shall be evaluated against the definition of restructuring contained in the prudential framework.

A loan transfer should result in the immediate removal of the transferor from the risks and rewards associated with loans to the extent that the economic interest has been transferred. In the case of any retained economic interest, the loan transfer agreement should clearly specify the distribution of the principal and interest income. The transferee should have the unfettered right to transfer or otherwise dispose of the loans free of any restraining conditions, including any consent requirement when it comes to resolution or recovery, to the extent of the economic interest transferred to them.

Lenders, regardless of whether they are transferors or otherwise, should not offer credit enhancements or liquidity facilities in any form in the case of loan transfers. A transferor cannot re-acquire a loan exposure, either fully or partially, that has been transferred by the entity previously, except under the prudential framework or the IBC.

In domestic transactions, the transferee should ensure that the transferor has strictly adhered to the minimum holding period requirements (MHP), which are three months for loans up to two years, and six months for loans of longer periods. For project loans, the period is calculated from the date of commencement of commercial operations of the project being financed. MHP is not applicable to the transfer of syndicated loans.

A transferor may transfer a single loan or a portfolio of loans that are not in default to permitted transferees through assignment or novation, or a loan participation contract. The transfer shall be for cash, received no later than at the time of transfer, transparently on an arm’s length basis. Where transfers result in a change of lender of record under a loan agreement, the transferor and transferee should ensure that the existing loan agreement provides for consent by the borrower to such transactions.

The transfer of stressed loans must be through assignment or novation only, not through loan participation. Lenders shall transfer stressed loans, including by way of bilateral sales or e-auction platforms, only to permitted transferees and asset reconstruction companies. The transferor must not assume any operational, legal or any other type of risks relating to the transferred loans, including additional funding or commitments to the borrower or transferee that relate to the loan transferred.

Aditya Vikram Dua is an associate partner and Parvathi Menon is an associate at SNG & Partners .

SNG & Partners One Bazaar Lane, Bengali Market New Delhi – 110001 India

www.sngpartners.in

Contact details Tel: +91 11 4358 2000 Email: [email protected]

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Securitisation Transactions in India – Legal Validity

Pratish Kumar (Partner, Juris Corp)

Ankit Sinha (Principal Associate)

Garima Parakh (Associate)

1)        Background

Securitisation was introduced in India as part of the wave of financial reforms in 1999 to expand the funding capacity of banks and non-banking financial companies ( “NBFCs” ). With a volume of INR 1.57 lakh crore in December 2019 [1] , securitisation is a popular resource-raising mechanism, especially amongst NBFCs and housing finance companies ( “HFCs” ). This is also common in banks for meeting the priority sector lending requirements. The steady upward trend in securitisation transactions, from INR 1.44 lakh crore in the nine months preceding the financial year 2019 to INR 1.57 lakh crore in the nine months preceding the financial year 2020, is also reflective of the severe liquidity crunch faced by NBFCs and HFCs in recent times. [2]  

Redistribution of risk can be achieved by way of sale of certain assets by banks or financial institutions, in any of the following manners – 

(a)      Direct assignment : In a direct assignment transaction, assets owned by the originator bank or financial institution ( “Originator” ) are sold directly to the buyer(s). The said assets are reflected in the books of account of the buyer(s). A key principle in direct assignment transactions is that of true sale, which is required to be adhered to for a valid assignment of the standard assets. A direct assignment transaction is the most preferred mode of down selling standard assets. [3]

(c)       Listed transactions : The Securities and Exchange Board of India( “SEBI” ) has notified the SEBI (Public Offer and Listing of Securitised Debt Instruments) Regulations, 2008 ( “SDI Regulations” ). These regulations, inter-alia specify disclosure requirements for public issuance and listing of securitised debt instruments ( “SDIs” ) (both publicly issued and privately placed) and obligations of the parties involved in the transaction. Under the SDI Regulations, a special-purpose distinct entity is a trust that acquires debt or receivables from funds mobilised by the entity, by issuing SDIs through one or more schemes. A certificate or instrument is issued to an Investor by the special purpose distinct entity, which possesses any debt or receivable, including mortgage debt assigned to such an entity by the Originator and the trustee. This certificate acknowledges the beneficial interest of the Investor in such debts or receivables.

Certain securitisation transactions which do not involve loan receivables (for example, lease receivables) are undertaken under the SDI Regulations. Securitisation of loan receivables may also be listed under the SDI Regulations. However, due to lack of an investor base, such transactions are not very common in India.

We have received many queries in relation to the legal validity of securitisation transactions. In specific, interested clients have raised questions as to whether Courts in India have upheld the validity of securitisation transactions (not Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 related provisions). While we have seen very few case laws on securitisation transactions in India, it is noteworthy to mention that all such judicial pronouncements indicate that the Courts in India have recognized and upheld the structure of securitisation transactions, their legality and feasibility.

The underlying basis of securitisation transactions is assignment of actionable claims. This forms part of laws relating to transfer of property. In this article, we are not dealing with case laws relating to ‘actionable claims’ and have restricted it to those relating to securitisation transactions.

2)        Case laws

Two landmark judgments, of the Hon’ble Supreme Court of India and Hon’ble High Court of Bombay recognise the role of Investors / buyers under securitisation and direct assignment transactions to be as creditors and further uphold the principles of true sale and bankruptcy remoteness.

(a)      ICICI Bank Limited v. Official Liquidator of APS Star [6]

The core question before the Hon’ble Supreme Court of India was whether assignment of debt is a permissible activity under the Banking Regulation Act, 1949 ( “BR Act” ). In this case, ICICI Bank Limited ( “Assignor” ) had, by way of deeds of assignment, assigned certain non-performing loans, including that availed by APS Star Industries Ltd. ( “Debtor” ), to Kotak Mahindra Bank ( “Assignee” ). Winding-up proceedings were initiated against the Debtor, and the Assignee sought to substitute the Assignor in the winding-up petitions. The Hon’ble Supreme Court of India relied upon certain provisions of the BR Act and the Reserve Bank of India’s ( “RBI” ) Guidelines on Purchase / Sale of Non Performing Financial Assets Scope dated 13 th July 2005, to hold that banking companies can venture into new areas of business apart from their principle business of lending and accepting deposits, as long as they do not attract prohibitions and restrictions such as those contained in Sections 8 and 9 of the BR Act. In arriving at this conclusion, the Hon’ble Supreme Court of India relied upon Section 6(1)(a) read together with Section 6(1)(n) of the BR Act which permits banks to, inter se , deal in non-performing assets ( “NPAs” ). The Hon’ble Supreme Court of India concluded that, dealing in NPAs is a bona fide banking business and that assignment of NPAs is a well-recognised tool used in the interest of banking policy to resolve the issue of NPAs.

(b)      Interim applications in the Dewan Housing Finance Corporation Limited (DHFL) cases

A series of applications were filed by the assignees of DHFL against an ad-interim order of the High Court of Bombay dated 10 th October 2019 ( “Order” ), which had restrained DHFL from making any payments to its creditors, unless made to all secured creditors on a pro-rata basis from its current and future receivables. The applications sought a modification to the Order to allow payments to be made to the plaintiffs under securitisation and assignment agreements entered into with DHFL. The Hon’ble High Court of Bombay while accepting the contentions put forth by the plaintiffs, modified the Order to allow payments to be made to banks under such agreements. In doing so, the Hon’ble High Court of Bombay recognised the aspect of bankruptcy remoteness of such securitisation and direct assignment transactions.

3)        Securitisation Transactions: Legal Framework

(a)      The guidelines pertaining to securitisation and direct assignment of standard assets were issued by the RBI on 1 st February 2006. These guidelines were subsequently revised by the RBI on receipt of comments from concerned stakeholders and issued on 7 th May 2012 (the “Guidelines” ). The Guidelines are organised in three Sections. Section A contains provisions relating to securitisation of assets. Section B contains stipulations regarding transfer of standard assets through direct assignment of cash flows. Section C enumerates the securitisation transactions which are currently not permissible in India.

(b)      Section A of the Guidelines deals with requirements to be met by the originating bank and the assets eligible for securitisation. The said Section of the Guidelines states that in a single securitisation transaction, the underlying assets should represent the debt obligations of a homogeneous pool of obligors. Section A of the Guidelines also specify the assets that cannot be transferred.

(c)       Section B of the Guidelines deals with the requirements to be met by the originating bank and the assets eligible to be transferred by way of direct assignment. The said Section of the Guidelines states that banks are permitted to transfer a single standard asset or a part of such asset or a portfolio of such assets to financial entities through an assignment deed. Section B of the Guidelines also specifies the assets which cannot be transferred. Specifically, assets purchased from other entities cannot be transferred by way of direct assignment.

(d)      The Guidelines also stipulate the minimum holding period and minimum retention requirement to be satisfied under Sections A and B, respectively and the true sale criteria which in effect requires immediate legal separation of the selling bank from the assets that are sold.

(e)      For securitisation under the SDI Regulations, please refer to paragraph 1) (c) above.

(f)        As regards stamp duty laws, stamp duty is applicable on such transaction documents at the time of execution. Many States (for example, Maharashtra, Karnataka and the National Capital Territory of Delhi) have provided certain relaxations on payment of stamp duty re assignment of debt. The quantum of stamp duty may be ascertained once the place of execution is finalised.

(g)      As regards registration of the transaction documents, the law in certain States (for example, the National Capital Territory of Delhi) require the document relating to the assignment of loan receivables to be mandatorily registered.

[1]   ICRA, ‘ICRA: Securitisaton market on path to see all-time high issuance volume in FY2020 despite some headwinds’, press release dated 21 st January 2020.

[2]   ICRA, ‘ICRA: Securitisaton market on path to see all-time high issuance volume in FY2020 despite some headwinds’, press release dated 21 st January 2020.

[3]   Anand Shah et. al., ‘India: Securitisation 2020: Trends and Developments in India’, (Mondaq, 21 st  January 2020) <https://www.mondaq.com/india/securitization-structured-finance/885822/securitisation-2020-trends-and-developments-in-india>

[4]   RBI, ‘Report of the In-house Working Group on Asset Securitisation’, 29 th December 1999   <https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/10788.pdf>

[5] Anand Shah et. al., ‘India: Securitisation 2020: Trends and Developments in India’, (Mondaq, 21 st January 2020) <https://www.mondaq.com/india/securitization-structured-finance/885822/securitisation-2020-trends-and-developments-in-india>

[6]   Civil Appeal No.8393 of 2010.

• Submission Guidelines

Securitization and Direct Assignment Transactions in the Indian Economy

[ Vineet Ojha is Manager – IFRS & Valuation Services at Vinod Kothari Consultants Pvt Ltd]

The current financial year has witnessed a sharp surge and a life time high in the volume of securitization and direct assignment transactions in the Indian economy. Consequent to the funding problems that non-banking finance companies (NBFC) and housing finance companies (HFCs) have been facing over the last few months, direct assignments of retail portfolios have picked up considerable pace, with volumes touching an all-time high of Rs. 1.44 lakh crore during the nine-month period (April-December) of financial year 2019 (FY 19). Of this, around Rs. 73,000 crore was raised by NBFCs and HFCs through sell-down of their retail and small and medium enterprises (SME) loan portfolio to various investors (primarily banks). Investor appetite, particularly from public sector banks and private banks, is high at present, considering investors are not exposed to entity-level credit risk, and are seen taking exposure to the underlying pool of retail and SME borrowers. Yields have gone up significantly with the changing market dynamics. The momentum in the securitization market is likely to remain strong in the current fiscal as it is emerging as an important tool for retail-focused NBFCs for raising funds at reasonable costs while simultaneously providing a hedge against asset-liability mismatches. A visual trend of the market over the years can be seen below:

Source: India Securitization Market: Booklet by VKCPL

Why the sudden surge?

Looking at the figure above, we can see a sharp surge in the direct assignment volumes in FY19. A majority of the issuances comes from the third quarter with around Rs. 73,000 crores. Although the major driver is the Infrastructure Leasing and Financial Services Limited (IL&FS) imbroglio, it is not the only reason for this development.

IL&FS crisis

Following the IL&FS crisis, the Reserve Bank of India (RBI) has time and again prompted banks to assist NBFCs to recover from the cash crunch. However, wary of the credit quality of the NBFCs and HFCs, the banks have shown more interest in the underlying loan portfolios than on the originator itself. Through direct assignment and securitization, these institutions get upfront cash payments against selling their loan assets. This helps these institutions during the cash crunch. Funds raised by NBFCs and HFCs through this route helped the financiers meet sizeable repayment obligations of the sector in an otherwise difficult market.

RBI relaxes MHP norms for long tenure loans

Another reason that explains this sudden surge in the volume of direct assignment or securitization volumes is the relaxation of the minimum holding period (MHP) criteria for long-tenure loans by the RBI. This increased the quantum of assets eligible for securitization in the system. The motivation was the same is to encourage NBFCs and HFCs to securitize their assets to meet their liquidity requirements. More details about this can be found here.

Effects of Securitization

Primarily, priority sector lending (PSL) requirements were the primary drivers for securitization. The number of financial institutions participating in securitization were quite low. Now, for liquidity concerns, NBFCs and HFCs were forced to rely on securitization to meet their liquidity needs. This not only made them explore a new mode of funding, but also solved other problems like asset liability mismatches. In the nine months of FY19 and FY18, the share of non-PSL transactions has increased to 35 per cent compared to 24 per cent in FY17 and less than 20 per cent in the periods prior to that.

However, it is not a rosy picture all over. Due to the implementation of IFRS, upon de-recognition of a loan portfolio from the financial statements of the company, the seller shall have to recognize a gain on sale on the transaction. These gains disturb the stability of the profit trend in these financial institutions which would result in volatile earnings in their statements. The NBFCs have been trying to figure out solutions which would allow them to spread the gain on transfer over the life of the assets instead of booking it upfront.

The securitization market remained buoyant in the third quarter driven by the prevailing liquidity crisis following defaults by IL&FS and its subsidiaries. This surge is good for the Indian securitization market as India’s contribution to global securitization market, at about USD 12 billion, is barely recognized, for two reasons – firstly, India’s market has so far been largely irrelevant for the global investors, and secondly, bulk of the market has still been driven by PSL requirements. PSL-based securitizations obviously take place at rates which do not make independent economic sense. Now due to the surge in non-PSL based securitization, the rates at which the portfolios are sold are attractive to investors. This could attract global investors to the market.

Now that financial institutions have gained exposure to the securitization markets, they find that the transactions are attractive for sellers as well as investors. Our interaction with leading NBFCs reveals that there are immediate liquidity concerns. Banks are not willing to take on-balance sheet exposure on NBFCs; rather they are willing to take exposure on pools. Capital relief and portfolio liquidity are additional motivations for the originators (and other potential investors) to enter into securitization transactions.

– Vineet Ojha

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RBI's final guidelines on securitisation, direct assignment

Icra research has come out with its report on rbi final guidelines on securitisation and direct assignment transactions- significant decline in volumes expected..

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