LEGAL ASPECTS OF NON-PERFORMING

ASSETS
G J BULSARA*
KNOWHOW FOR MANUFACTURE AND TECHNIQUES TO ELIMINATE NON-PERFORMING
ASSETS BY PROCESS OF SECURITISATION
Securitisation
The concept of securitisation has been adopted more recently from the American
financial system and has been described as processing of acquiring financial asset
and packaging the same for investments by several investors. The term
‘securitisation’ has not been defined as such, but has been used in certain rules,
regulations and notifications. In the recently enacted the Securitisation and
Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (for
short “the Securitisation Act”) the term securitisation has been defined as
“acquisition of financial assets by any securitisation company or reconstruction
company from any originator, whether by raising of funds by such securitisation
company or reconstruction company from qualified institutional buyers by issue of
security receipts representing undivided interests in such financial assets or
otherwise”.
The Securitisation Act, 2002
The Securitisation Act has been enacted mainly for tackling the growing menace
non-performing assets by securitisation of assets by sale to ARC, which is to issue of
security receipts to the investor and for enforcement of security interest by banks
and financial institutions. Initially, many were delighted to find that the securitisation
process as a class has come to stay in the Indian legal system, and the problem of
the non-performing assets of banks and financial institution would stand resolved
since the banks and financial institutions would be able to enforce its security interest
without intervention of the courts. The quantum of non performing assets has been
growing by leaps and bounds and has been playing havoc on the Indian financial
system since as at the end of the year 2001 the total amount of outstanding NPAs
stood at Rs.83,500/- crores. After enactment of the Securitisation Act, 2002 the wilful
defaulters cannot now hide behind long-winded judicial process but at the same time
the bank also cannot recover dues arising out of underwriting commitments
obligations and equity finance by way of share subscriptions, so also the shares
acquired by exercise of option for conversion of loan into equity. The Securitisation
Act, 2002 does not also ensure or guarantee full recovery of the entire outstanding
over dues fully. In the result the financial health of the banks will not improve
because, in absence of adequate assets not more than 20 percent of NPAs would be
recovered by resorting to the provisions of the Securitisation Act, 2002. The IT
Tribunal ruling in case of Vishvapriya Financial Service and Securities Ltd would jolt
development of asset securitisation in autofinance and housing finance sector. The
company was utilising funds obtained from the investors for deployment in fixed
income security and had guaranteed fixed rate of return. The contention of the
company that it was only agent for the investors and has evolved only a pay-through
structure was not accepted by the tribunal, which held that the company was liable
for the withholding taxes on the payments made to the investors.
Growth of Banking Practice in India
In the long run from the concept of ancient money lenders, India march forward to
the realm of banking, which has since branched out in the concept of the
development banking, the narrow banking and the universal banking. So also from
simple current and savings bank accounts, the bank finance has extended to
structured finance, trade finance and export finance and finance for

* ACS, LL.M., CAIIB.

infrastructure, and the last few years saw emergence of fee based services in form of
merchant bankers, financial advisers and managers to the public issue and private
placement of shares debentures and bonds, syndication of loan facilities, external
borrowings, forex services, treasury management and more recently investment and
portfolio management, e-broking and derivatives, futures and options trading
facilities plus back office services and services in takeover, mergers, acquisitions and
amalgamations, mostly through the bank subsidiaries or associates arms.
Reasons for Growth of NPAs
The development and proliferation in the activities of the bank has led to ever-
increasing non-performing assets that has mounted to an enormous amount during
the last decade or so. The quantum of NPAs has been calculated and put at different
figures mainly due to absence of proper statistics and the method on the basis
adopted for calculating the percentage of NPAs in relation to either the total assets of
the bank or the amount of loan portfolio or on the basis of the number of the
accounts or the size of the outstanding advances. But till recently little attention was
paid to the real reasons as to why and how non performing assets have appeared in
the books of the banks and also the books of many of the financial institutions. For a
large number of years, the banks have been taking credit in its books, on basis of
accrued interest income, even for the amount of periodic interest that was not
actually paid by the borrower. This was done by raising debit in suspense account
and crediting amount equal to the periodic interest in the loan account of the
borrower. After objections from the auditors and income tax authority the banks
changed strategy and started giving additional loans to the defaulting borrowers for
the purpose of making payments to the bank for adjustment of the overdues, in
many cases the due dates of payments were postponed and even the entire duration
of the loan was extended further again and again. As if to add fire to the fuel,
ambitious programme for branch development and extension of banking services led
to new recruitments, transfers, relocation and unhealthy competition amongst offices of the
same bank, but at the same time adequate facilities available for training of the staff were not
expanded. In the anxiety to achieve business targets the rules and procedures for prudent banking
were conveniently forgotten. Even the higher management setup conveniently relaxed the rules for
proper appraisal of the loan proposals, the provisions of standard bank sanction letter, errors in
execution of the loan agreements, deeds of hypothecation and mortgages were more often
overlooked for compliance in the hurry for disbursement and achievement of targets for purposes of
building up record of achievements and reporting.
Off Balance Sheet Transactions (OBS)
The Banks in India are long familiar with off balance sheet finance by way of
standby letters of credit, revolving letters of credit, repurchase agreements, backup
line of credit for issue of commercial paper, note issuance facility, interest rate
exchange and swap and hedging transactions. Some of these OBS transactions are
intended to avoid and circumvent regulatory taxes like payment of deposit insurance
premium, cash reserve requirements and capital adequacy norms, but the
securitisation and sale of loan portfolio and receivables as form of OBS transaction
tops the list, so much so that even the income tax, capital gains tax, sales tax, lease
tax and tax on transfer of right to use the property, as applicable are not paid since
the OBS transaction is seldom reflected in the balance sheet of the bank or the
borrower company concerned. Further, the OBS transactions eliminate funding risk
and even the credit risk. In India the banks and institutions and also the investors and
the borrowers were too happy to finance off balance sheet transactions. Even though
assets given on hire purchase basis do appear in the balance sheet of the company,
the future receivables in form of hire charges payable by the hirer are not shown in
the balance sheet of the originator. It is very happy situation for the originator to sell
the future receivables and raise finance and show surge in the case on the balance
sheet and raise the bottom line and also the top line. Further, for the financing bank,
it was much more advantageous as the amounts paid are shown as investments in
PTC and not as the loan transaction. This type of structures of giving finance by
investment in PTC and not as a loan, the financing bank has easy escape from CRR
and SLR requirements. As the future receivables are purchased at discounted value
and the banks could easily amount of liability under the Interest Tax Act, 1974 for the
period before the interest tax was withdrawn. The originator also benefited by
securitisation and sale of future receivables on which the originator need not now pay
hire purchase tax. The originator has added advantages because of sale of
receivables, an amount of cash is generated and shown in the balance sheet even
without the removal of any assets. In this way the originator could show better
results, improve balance sheet figures and raise further finance
O Lord forgive them, for they know not what they are doing
The term securitisation was not defined but was used in the year 1994 in the
Maharashtra Government Notification under the Bombay Stamp Act, 1958 dealing
with reduction of stamp duty in respect of “instruments of securitisation of loans or
of assignment of debt with underlying securities” chargeable under the Schedule I,
Article 25(a) of the Bombay Stamp Act, 1958. Subsequently, SEBI amended the SEBI
(Mutual Funds) Regulations, 1996 and the Seventh Schedule dealing with Restrictions
on Investments by mutual funds and allowed mutual funds to make investments
within the prescribed limits “in the mortgaged-backed securitised debt”. More
recently, even the recognized Stock Exchanges have started listing of the PTC (Pass
Through Certificates), without realizing that the PTC is not a “security” within the
meaning of the definition of the term “Security”, as given in Section 2(h) of the
Securities Contracts (Regulation) Act, 1956. Soon thereafter some of the banks and
even public financial institutions started business of securitisation of future
receivables. Credit Rating Agencies started assigning triple-A ratings to the PTCs on
basis of feedback and select information supplied at the instance of the hire-purchase
and lease finance companies. Certain State Governments followed the bandwagon
and notified reduction in stamp duty on securitisation transaction, even though the
expression securitisation was nowhere defined in the relevant Stamp Act provisions
as applicable in the State concerned or in the Indian Stamp Act, 1899.

Why banks could not prevent loan defaults

The banks are required to give loans under the priority sector lending and
complete requisite quota for each of the segments for the reporting year. In case of
agriculture lending the rural borrowers are often under impression that the
disbursement is by way of grant and there is no need for any repayment. Very often
the loan documents are not properly signed by the particular borrower. The amount
and the rates of interest are higher than what was conveyed to the borrower. Most of
the time the borrower has not benefitted and in absence of higher earnings, the
repayments of the bank loan cannot be made. Even in the urban sector and in towns
and cities situation is no better. At times accounts are opened without proper
identification and due introduction. This is mainly due to procedural lapse and
inadequate control mechanism and loosening of bank supervision. Every type of
fraud is committed often with connivance with the staff, perhaps due to absence of
proper reporting and due vigilance. The instruments are stolen in transit and
encashed fraudulently. The remittance of cash, money transfers and issue of demand
drafts often fall to fraudulent practices.
Where the buck stops
All the ills for mounting figure of loan defaults and rising amount of NPAs are
invariably put at the door of the legal system and procedural delays, costs and
expenses involved and the lengthy procedures involved in litigation and execution of
decrees obtained from the court. Even provisions contained in law for corrective
action by way of review and appeal against judgments of the trial courts are branded
as causes for delay in recovery of loan from the defaulting borrower. But the same
persons when aggrieved by order for transfer or non-promotion himself approaches
the temple of justice for redress of his own grievance. The Securitisation Act, 2002
seeks to improve mechanism available to the secured lender for enforcement of the
security interest held by them, but fails to notice the difference between willful
defaulter and the borrower who is unable to make payments on the due dates due to
change in market conditions and regardless of the intention or the reasons leading to
such defaults like change in government policy, competition from new technology,
power shortages. No attempt is made for inducting fresh finance to tide over the
difficulty or for diversification, upgradation or rehabilitation of the defaulting unit.
Implementation issues relating to management and financing of the business of the
company are mostly ignored before taking drastic step for sale of the units by the
lenders.
The potential buyers would turn weary as no one wants to pay for the mortgaged
unit in forced sale anything more than its scrap value. Taking over of the defaulting
company, which has unpaid secured over dues will only go to deter the ARC as also
the potential buyers, who would make payments after borrowing from the banks and
financial institutions as the lenders.
The potential buyers has become weary and can therefore offer only the scrap
value, for purchase by the same management in the name of new promoters, with
moneys raised from the same lender bank, which initiated steps for enforcement of
security against the borrower concerned. Take over of the defaulting unit with large
amounts of overdues would only go to deter the ARC and potential purchaser. It seeks
to improve mechanism available to secured creditors for enforcement of the security
available to them.
Securitisation Versus Securitisation
The Securitisation Act has been enacted for dealing with and solving problem of
NPAs, but look at the manner in which perfectly healthy accounts with AAA ratings
are now being securitised for raising finance that is free from regulatory requirements
prescribed by the Reserve Bank or SEBI. Mostly the hire-purchase and loan
receivables generated by non-banking finance companies, hire purchase finance
companies, housing finance companies and even commercial bank loans receivables
are purchased in the guise of securitisation by an SPV established in the form of a
trust, set up by the non-banking finance company itself, and thereafter receivables
are sold to mutual funds as the Investors by issue of Pass Through Certificates (PTC).
By device of issuing PTC, the SPV merely undertakes to pass on the receivable to the
PTC holder, only after and on condition that the loan receivables are paid by the hirer
or the borrower concerned and received by the non-banking finance company as the
originator. There is no independent obligation or any assurance by the SPV or the
Trustees of the SPV to independently make any payments, unless the regular
payment is made on due dates by the hirer or the loan borrower to the originator.
There is absolutely no indemnity or any guarantee or even an assurance provided to
the holder of PTC regarding due and timely payment of the periodic payments falling
due to the PTC holder, as the investor. The PTCs are not negotiable instruments and
are not transferable by endorsement and delivery. There is no statutory register of
PTC holders and therefore there is no question of transfer of PTC by execution of duly
stamped and registered formal transfer deed, as in the case of shares and
debentures. These are also not approved securities for the purpose of investments
by a banking company, a financial institution or by public or charitable trust or by LIC,
GIC and its subsidiaries. Further, the amounts due and payable under the PTC cannot
be recovered even by the bank or financial institution as the holder thereof by
application made to the Debt Recovery Tribunal. The benefits available under Section
88 of the Income Tax Act for repayment of housing loans for construction or
acquisition of residential house would no longer be available after the housing loan
portfolio along with the security interest therein stands transferred and assigned by
way of securitisation by the housing finance company. While adopting securitisation
of mortgage debt as a new tool for financing the banks have failed to appreciate that
MBS is the same instrument as a secured non convertible debentures. There is no
legal basis for securitisation of the mortgage loans and the holder of the MBS will be
unable to enforce the mortgage or to sue for sale of hypothecated movable assets.
Unfair Advantages
The bandwagon of securitisation concept was readily adopted one after the other
by not number of non banking finance companies, housing finance companies and
some of the banks for their own advantages and benefits, especially because the
concerned regulatory authorities failed to comprehend the precise nature of
securitisation transaction in the context of the financial market in India. Unnecessary
and vague comparisons were made with securitisation transaction in America and
with the practices and procedures followed by Fannie Mae, Freddie Mae and Ginnie
Mae in America for financing of growth of housing finance in that country, without
look at the statutory provisions the federal structures and system of insurance for
housing loans prevailing in USA.
SPV
On its part SPVs are mostly organized as a trust and as such indeed they escape
all the regulatory requirements as applicable to the companies the non-banking
finance companies, the mutual funds and cooperative banks or cooperative societies.
When the trust receives income on behalf of the beneficiary, the provisions of Section
161 of the Income Tax Act 1961 would be attracted, and as representative assesses
the Trustee would be liable to pay tax in like manner and to the same extent as the
beneficiary. The Income Tax Act imposes the liability to tax on the trustee as the
representative assesses on all income.

Banking Utopia
For the ages the banks have been living in its own utopia and taking for its
finance security by way of hypothecation and mortgage by way of deposit of title
deeds. The banks looked to savings in payment of stamp duties and registration
charges and avoid botheration of investigation of title, but the banks did not realise
that hypothecation can hardly be called a charge on the movable assets of the
borrower. The term hypothecation has not been defined either in the Indian Contract
Act, 1872 nor in the Transfer of Property Act, 1882. The hypothecation is often loosely
described as pledge without possession, and it creates only a floating charge on the
movables whose possession remains with the borrower, who can use the movables
for the purposes of his business. The courts do not recognise right of the bank either
to attach the stocks or sell them inspite of clauses in the hypothecation agreement
executed by the borrower. The Supreme Court in case of K.L. Johar has held that the
hypothecatee has no right to take over possession of the goods. The bank has to file
suit and obtain orders for sale of the goods by public auction for recovery of the
defaulted amount. The bank will have to bear the loss in case the goods had
deteriorated or lost or sold in the meanwhile by the borrower. Justice Ameer Ali had
pointed out that the use of the word hypothecation should be abandoned. It is
equivocal and therefore dangerous word. Mr. J.C. Shah, former Chief Justice of India
has opined that a creditor who has advanced monies on hypothecation of goods has
no property in goods hypothecated and that it would be misnomer to call him a
secured creditor. The now famous case of C.T. Sentianathan, after going deep through
the concept underlying hypothecation agreements, it was held that there is no
transfer of interest in the goods and the right of the hypothecatee is only to sue on
the debt and proceeds in execution of the hypothecated goods only, use the goods
are in possession and available with the borrower.
The correct position in the case of hire purchase and vehicle finance is even
worse. The vehicles are registered in the name of the customer, as owner of the
vehicle with the RTO under provisions of the Motor Vehicles Act, 1988 and the finance
company is never registered nor regarded as owner of the vehicle, but mere entry is
made to the effect that the vehicle is acquired under a hire-purchase arrangement.
The Supreme Court of India in the case of Sundaram Finance Ltd. v. the State of
Kerala, while dealing with payment of sales tax under the Travancore Cochin General
Sales Tax Act has decided that the clauses appearing in the hire-purchase agreement
for option to take possession of the vehicle by the financer is only license to seize to
facilitate recovery of loan advanced for purchase of the vehicle. The Hire-Purchase,
1972 was in terms of the Government Notification dated 31st May, 1973 to come into
force from 1st September, 1973, but the said notification was subsequently rescinded
by the Government Notification dated 30th August, 1973. Thereafter, the Hire-
Purchase (Amendment) Act was passed but the amendment has not been brought
into force, due to court decisions as to true nature of the hire-purchase and deferred
installment payments transactions. In addition after the Constitution 46th
Amendment Act, 1982 for amendment of Article 366, the hire purchase transactions
as such involve payment of sales tax under the relevant sales tax law as applicable in
the particular state concerned.In the state of Kerala in terms of the notification under
the revenue recovery Act, 1820 the nationalised banks are entitled to recover their
dues by simple requisition to the district collector as arrears of land revenue.
Adoption of Different Forms of Security Devices
There is no reason to believe that non-banking finance companies, banks and
financial institutions are helpless as against the borrower. As lenders they are all
equipped with a number of legal remedies and rights for speedy recovery of amounts
due from defaulting borrower. But the banks in general and of their own volition are
either ignorant or not willing to take benefit of provisions of the law or the relevant
legislation for various reasons including defect in the loan documentation signed by
the borrower. For example, the erstwhile IFCI Act, 1948 which established the very
first financial institution in India and the State Financial Corporations Act, 1951
contained special provisions for speedy recovery of due from the defaulting borrower.
The erstwhile IRBI Act for establishment of the Industrial Reconstruction Bank of India
contained provisions for creation of charge by execution and filing mere declaration
into prescribed format. Such declaration is not required to be registered under
Section 17 of the Indian Registration Act, 1908. This declaration creates mortgage
interests on immovable property and is deemed to be treated as creation of simple
mortgage by the borrower and accordingly all rights and remedies available to a
simple mortgage were made available to IRBI. Some of the State Governments have
passed special legislation akin to law for revenue recovery for speedy recovery of its
dues by the banks as arrears of land revenue. The provisions of Section 69 of the
Transfer of Property Act, 1882 deals with powers and rights for recovery of its dues by
the mortgagee by private sale and without intervention of the courts. Further
Section 69A of the Transfer of Property Act provides for appointment of receivers and
management of the property of the borrower without intervention of the courts.
Nearly 100 year-old enactment the Code of Civil Procedure, 1908 in the Order 37 Rule
40 provides for summary procedure for recovery of dues by the bank.The shares,
debentures and government securities dematerialised format can now very easily be
pledged by filing necessary details in the Form No W. with the Depository Participant
concerned in accordance with the terms of the Depositories Act,1996.

In spite of the various statutory provisions mentioned above, it is wonder of all

wonderers as to how the banks have been able to build-up mountains of NPAs.
Further, very often the banks are not able to recover amounts due on a simple
demand promissory note or even from the Government under the Government
Guarantee. The blame is thereafter put at the door of defective legal system,
procedural delays and on the judiciary. At times the usual care is not taken just to
verify and ensure that the documents are duly signed by the authorised official of the
borrower and that proper stamp duty and registration charges have been paid as per
applicable law prevailing in the particular city or the State in which the documents
have been executed. No doubt that the attention was concentrated on avoidance of
stamp duty and escape from payment of Income Tax and Interest Tax as applicable.
Ignorance is not always bliss
The banks and financial institutions have been adopting practice of taking
memorandum of hypothecation of movable assets and creation of equitable
mortgage by deposit of title deeds on the immovable assets of the borrower , instead
of taking registered legal mortgage in English form over all the assets of the
borrower. The banks started taking equitable mortgage by deposit of title deeds and
hypothecation of movable assets merely in order to save on stamp duty and
botheration for registration of the mortgage deed with the concerned sub-registrar of
assurances under the provisions of Section 17 of the Indian Registration Act, 1908.
The banks did not take note of the fact that an equitable mortgage can be enforced
by filing a money suit in the court and that receiver of the assets of the borrower can
be pointed only with and under orders of the court of competent jurisdiction. In their
anxiety to save on stamp duty and registration charges the banks have in their own
wisdom conveniently overlooked provisions of Section 69 of the Transfer of Property
Act,1882 which gives them right of private sale without intervention of the court and
right for appointment of receiver of its choice. In short, registered legal mortgage in
English form gives to the banks right to appoint receiver of its own choice and sell the
mortgaged property at its own option without intervention of the courts.
The Deposit Insurance and Guarantee Corporation of India Ltd. guarantees the
repayment of the amounts of account holder upto the sum of rupees one lakh to the
bank depositors, but even after decades of its existence no insurance or guarantee is
made available to the banks against default by the borrower. Exporters are made
available different types of insurance cover and guarantee for recovery of the dues
on failure of the foreign buyers to make payment of the purchase price of the goods
exported by an exporter in India. The Export Credit and Guarantee Corporation of
India Ltd (ECGC) covers not only the finance risk, but also foreign currency
remittance risk and the political risk in the event of change in the policy and political
structure of the foreign country to which the goods have been exported.
The banks often take personal guarantee even in case of professionally managed
companies from the individual directors, but they are not able to recover anything
from the guarantors, as obligation under the personal guarantee is not secured by
mortgage of assets of the guarantor concerned in favour of the bank.
Finale
Each bank should evolve structured letter of sanction, a detailed loan agreement
and elaborate security documents including deed of pledge of securities,
undertakings, declarations and deeds of registered mortgage deed, deed of further
mortgage and additional charge, as also debenture trust deed, all duly supported by
drafts of relevant resolutions to be passed by the general body meeting and at the
meeting of the board of directors of the borrower company. These documents can be
evolved under ages of the Indian Banks Association or by bodies like the Institute of
Bankers in India.
A word for non-performing Banks
The banks concerned must, rather than relying on panel of lawyers at different
centers, have the post of chief legal adviser with the rank of an Executive Director, in
full charge and control of drafting, stamping, registration, execution of security
interest created by the borrower in favour of the lending bank.
Non Recourse Finance
It is high time that the banks must learn the need for non-recourse lending, where
repayments are based and made out of profits generated by the business activity
financed by the bank and not by enforcement of security and sale of assets leading
to the closure of the manufacturing capacity. The bank should necessarily modify its
approach and disburse finance on basis of projections and viability of the project and
the cash flow generated out of the business activity.