The banking sector is facing the brunt of Non-Performing Assets (NPAs or Bad Loans) and the situation has worsened to an extent that the total stressed assets portfolio of the commercial banks has reached an alarming level of approximately 11% of the total advances, as on 31st March, 2016. Tackling the NPAs and recovery therefrom has been the key agenda of the Regulator (Reserve Bank of India) and the Legislature alike. The RBI, in its effort to address the menace of growing NPAs of the bank, has promulgated several schemes and mechanisms. Accordingly, various guidelines/circulars were issued to enable the banks to re-structure their dues, enable the borrower entity to cruise through the troubled times and sustain itself or carry out a change of management in the event of the default being attributed to the deeds/misdeeds of the present management. The legislature has also enacted several legislations which contain numerous provisions to ensure a speedy recovery of the public money locked in NPAs and also to empower the lenders to enforce their security interest in the underlying assets without the intervention of the court or carry out a change in management with an intent to speedily recover their dues from the defaulting borrowers. The relevant portions of SARFAESI that encompass the provisions regarding change of management aspect are Section 9 (applicable to Asset Reconstruction Companies for effecting change of management for better reconstruction of financial assets), Section 13(4)(b) (which provides for secured creditors including banks, financial institutions and ARCs, to implement change of management aimed at recovery of debt) and also under Section15 (which provides for manner to affect any such change of management u/s 9 or 13).

The Regulators Initiatives
The regulator has issued numerous guidelines for ensuring a uniform recognition. Various norms, guidelines and circulars have been introduced to cope with the evolving issues and expedite recovery solutions. Some of the popular guidelines, norms and circulars are as follows:
•    Income Recognition and Asset Classification Guidelines (IRAC Norms)
•    Corporate Debt Restructuring
•    Flexi Restructuring Scheme for core sector industries & infrastructure sector (commonly known as the 5:25 scheme)
•    Long Term Infrastructure Bonds
•    Corrective Action Plan and Joint Lenders Forum Guidelines
•    Provisions with respect to Wilful and Non Co-operative borrowers
•    Strategic Debt Restructuring Scheme (SDR)
•    Change of Management of defaulting entities outside SDR
•    Scheme for Sustainable Structuring of Stressed Advances (S4A Scheme), etc.
Despite the proactive measures being promulgated by the regulator to check the menace of swelling NPAs, the results are not meeting the expectations.
Change of Management (within & outside SDR)
Amongst the various initiatives taken by the Regulator, those pertaining to Change of Management guidelines (within & outside SDR) has emerged as the most effective medium for recovery from the defaulters. These initiatives have been issued by RBI from time to time, with the underlying objective that `equity stake holders should bear the first loss than the debt holders’. The guidelines empower the lender(s) to effect a change in the management of the borrower companies, when the operational/managerial inefficiencies are observed to be one of the reasons behind the continuation or aggravation of the stress being felt at the borrower company.

In order to effect a change of management in the defaulting borrower entities within the framework of SDR and outside of the SDR, the lenders may, in terms of the already existing restructuring agreement (within SDR) or already existing loan agreement (outside SDR) collectively trigger a Change of Management upon the occurrence of a default, through conversion of loans into shares (within SDR), pledge invocation and/or through issuance of fresh equity shares (outside SDR) in a manner that, subject to the provisions of Banking Regulation Act 1949, the lenders collectively acquire at least 51% stake in the borrowing company with an intent to off load the same (at least 26%) in favour of a `new promoter’ within the stipulated time frame of 18 months to avail the benefits of asset classification. Further, upon change of guard in the company’s management, the lenders may consider refinancing/restructuring of the debt of the borrowing company. Such acquisition of stake by the lenders in the borrower company to effect change of management (specifically within the SDR and not outside the SDR framework) is exempt from the applicability of SEBI guidelines regarding issue price of shares and substantial acquisition of shares.

The SDR gives an incentive to the lenders to maintain a `status quo’ regarding asset classification for a period of 18 months from the date of invocation of SDR by the Joint Lender’s Forum (JLF). It also gives relief from making further provisions for the stated period of 18 months. Upon divestment of the shares in favour of the new promoter, the lenders may also consider re-financing the existing debt without treating this as restructuring, subject to banks making provision for any diminution in fair value of the existing debt on account of the refinance. SDR addresses both the issues of safeguarding value of assets of viable entities by ensuring continuity of operations, albeit under a new management. At the same time it also addresses the lenders’ concern with respect to the NPA status of an account as any change of management by the lenders (within and outside the SDR) will not be considered as restructuring.

The full enabling guidelines issued by RBI still met with some challenges. The red flags in the scheme are as below:

1.    The shareholders’ resolution (Section 62(3) of Companies Act, 2013) or for issuance (under Section 62(1)(c) of Companies Act, 2013) is required to issue shares to lenders towards the debt equity swap initiated under SDR. In case of un-willing/non cooperative borrowers, the special resolution becomes a challenge and the lenders face a bottleneck to proceed further. In many of the cases, despite the invocation of SDR, the share allotment to lenders has not fructified in the absence of the special resolution by the shareholders.

2.    Banks have to scout for a professional management to be able to manage the affairs of such a company and in the Indian context, where most of the business houses are `family driven’ there would be substantial key information which would only be with the erstwhile promoters. The extent to which they are willing/unwilling to share the same with the changed management, is a matter of grave concern. There is primarily no mechanism which is presently exercised to ensure successful continuation of business without active participation by the existing management.

3.    Funding the working capital requirements and the interest cost during the 18 months window shall be thrust upon the lenders, without even knowing the ultimate fate of the account which would go on to further the overall debt burden on the lenders. This will increase the flow of good money towards bad money thereby squeezing the overall credit availability in the system.

4.    In the event of failure of the scheme the account will again slip into NPA and adequate provisioning will have to be made as per the extant IRAC norms as if the said ‘stand-still’ clause for asset classification was never in force. The unrecovered interest funded by the bank during the 18 months’ window will have to be reversed in entirety, which would cast a huge pressure on the Banks’ Balance sheets.

5.    One of the critical problems of the Scheme is that the minimum conversion price is that of the face value. If market value is less, then loss needs to be booked by banks. Though initially, guidelines exempted acquisition of shares in this exercise from market-to-market norms, the circular released later allowed such provisioning during the period of 4 quarters.

6.    The `New promoter’ is not exempt from complying with the SEBI norms of minimum public shareholding. As per the SDR rules, upon finding a new promoter, lenders must exit the account as soon as possible. In such a case, the new buyer will take a 51 per cent stake and, in line with the Securities and Exchange Board of India rules, make an open offer for a further 25 per cent stake. If the open offer is fully subscribed, the buyer will own 76 per cent. SEBI rules mandate that any holding above 75 per cent must trigger a delisting. This issue needs to be addressed by SEBI and necessary exemptions from open offer for the new promoter should be put in place.

7.    The guidelines specifically require exiting clause in the Restructuring/Loan Agreement, in the absence of which, fresh loan agreements need to be executed
8.    RBI has, in its circular, clearly mentioned that Banks should be mindful of not resorting to violation of Sec. 19(2) of the Banking Regulation Act, 1949. Although till date, none of the cases have faced any legal challenges because of this issue, however, it may arise in due course of time.

The success of the SDR mechanism is clouded with uncertainty as during the last 15 months, especially when SDR guidelines was introduced, the lenders have initiated Change of Management in only 22 accounts approximately. However, any successful change of hands by way of offloading shares held by the lenders in favour of a `new promoter’ is still unheard and it has failed to prove a revolutionary measure to address the NPA problem. Rather the same has been effectively used by the lenders to `window dress the Bank’s Balance Sheet’ by successfully deferring the NPA recognition under the garb of SDR invocation.
An unsuccessful SDR would culminate into a situation where banks will be left holding 51% of shares belonging to unlisted companies in exchange of loans which are not repaid, thereby, catalyzing the already beleaguered position of the lenders.
The Legislative Initiatives

During the initial years of regulated economy, when the problems were limited and the objective was to prevent industrial undertakings from falling sick and consequently hampering the production of materials necessary for the economic development of the country of the Industries, the necessary provisions were casted in the IDRA [Chapter III AC of the [I (D & R) A]] which empowered the Central Government to decide to either sell the undertaking as a running concern or to prepare scheme for reconstruction of the company.
The legislature promulgated the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) followed by the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDB Act) and thereafter, the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act).

While the SICA offered protection to the industrial companies from institution or continuation of any legal proceedings or action, the SARFAESI empowered the lenders to enforce their security interest without any court intervention. Apart from the recovery through enforcement of security interest, the law also encapsulates the provisions regarding the mode of change/takeover of management while enabling recovery of bad loans.

Section 18 under SICA provided enabling provisions for effecting change of management, if required, for revival/rehabilitation of sick industrial company. Section 9 of SARFAESI empowers an Asset Reconstruction Company to inter-alia take over the management of business of the borrower company and Section 13(4)(b) of SARFAESI provides for takeover of management of the business of defaulting borrowers for the purposes of recovery of secured debt.

It is evident that the legislature has enabled takeover or change of management of the borrowers to enforce faster recovery of debt by the lenders. However, till date, there are rare instances of invocation of any such provisions by the creditors to takeover/change the management under the provisions of SARFAESI. Several reasons may be attributed to such reluctance of lenders resorting to such practices:

1.    In India, the businesses are driven by the personal goodwill attached to the promoters/owners of the entities. The business is rarely seen as being separate from its owners. Hence, any such change in management, by completely eluding the existing management, will eventually lead to death of business.
2.    Prolonged litigations have resulted in hindering smooth transition of new management.
3.    All the stakeholders viz. the promoters, lenders, trade creditors, and state departments, etc. should take a consolidated view to effect such change of management.
The intent of the legislature, while incorporating Section 9 was to enable Asset Reconstruction Companies (ARCs) to affect change of management for better reconstruction of acquired assets by the ARCs as reflected under the provisions of Section 9(a) of the SARFAESI Act. It empowers the ARCs to take over the management of the business of the borrower or change the management of the business of the borrower.

However, one supreme principle which has to be borne in mind by the lenders exercising any such action for takeover of management of business under this Section, is that, creation of security interest does not mean transfer of ownership rights to the lenders. Any property over which security interest is created, belongs to the borrower and the rights of secured creditors over such property are limited to the extent of recovery of outstanding loan. Therefore, once such recovery is made, the property or surplus sale proceeds must be refunded to the borrower, who created such security interest.

Amongst the several measures available to secured creditors to recover their dues from the defaulting borrowers as envisaged u/s 13(4), one is the change/takeover of management of business of the borrower [Section 13(4) (b)]. In addition to the takeover of the management of the borrower’s business, the secured creditor is also entitled to transfer by way of sale, lease or assignment of the borrower’s for the recovery of secured creditors’ dues.

The major difference that is evident from the legislation of the two sections viz. 9(a) and 13(4)(b) is, that the applicability of Section 9 is restricted only to ARCs whereas Section 13(4)(b) provides powers to all the secured creditors including ARCs. The difference is well understood by the intent of the law makers in promulgating the two sections i.e. Section 9, which is intended to better reconstruction of assets/ business of the borrower (including recovery) while section 13 (4)(b) is targeted at only recovery of secured creditor’s dues.

In addition, the provisos to section 13(4)(b) prescribe certain limitations under which the secured creditor can exercise such powers. First proviso provides that in the case of transfer by way of sale or lease or assignment of the business of the borrower, the secured creditor should exercise such right only where the substantial part of the business of the borrower is held as security for the debt. In other words, partial business of the borrower cannot be transferred by the secured creditor under the said powers. The second proviso restricts exercise of such power to the circumstance where the management of the business of the borrower is severable from the rest of the borrower’s business over which security interest has been created. For example, in case of a borrower with multiple activities, where the secured creditor has security interest over only one of the units and the management of the borrower’s business is capable of being severed from the rest of the business, the secured creditor shall take action only on such separate undertaking over which security interest has been created by the secured creditor.

Inferring from the above, on one hand, the legislature has provided absolute powers to the lenders for dealing with the secured assets in a way that suits the lenders; the insertion of such proviso provides very restricted options to secured creditors. Of course, such limitations are necessary to provide for principles of natural justice and at times, such restrictions on the powers are also important to avoid any future litigation.

Section 15(4) lays down that upon realization of the secured debt in full, the management of the borrower’s business shall be restored.

The amendment of 2016 states that in case of conversion of debt into equity shares of the borrower by the secured creditor(s) and thereby, acquiring controlling interest in the borrower company, the restoration of management of such borrower would not be necessary. This, to some extent, has done away with the above stated apprehension that the revival burden has been placed upon the secured creditor and may also draw interest of new promoter to manage the affairs of the Company without the fear or apprehension of restoring status quo position post recovery of the entire debt.

Any change of management under the above discussed SDR guidelines shall now be in line with the provisions of SARFAESI Act. Hence, litigations to some extent may be avoided.

Summing Up
The legislature always intended and has accordingly, equipped the secured creditor with enough powers to control the affairs of the borrower. The Regulator has endeavoured to strengthen secured creditors in affecting a Change of Management through conversion of debt into shares, issuance of additional shares and invocation of pledge of shares.

Although the provisions do exist but the effectiveness of the same is still unpredicatble. The lenders have resorted to SARFAESI only as a recovery mechanism rather than revival through a Change in Management. The ARCs have majorly resorted to restructuring and re-alignment of debt with the defaulting management only. Even the SDR provisions have been used by the lenders to their own advantage to keep the Banks’ Balance sheet healthy rather than the underlying objective of revival through a Change of Management to give a fillip to the sagging economy.
 
The need of the hour is a robust and well defined Bankruptcy Law to deal with the distressed situation at the nascent stage itself. The Insolvency and Bankruptcy Code 2016 has also been promulgated as an Act but the same is yet to be notified. Once it is notified, we can expect a firmer check on the growing problem of NBAs. A favourable economic climate will also contribute significantly in preventing problems emerging out of tackling bad loans.