Written by: Thumsi Sreedhar Venkata Spoorthi, B.A.LL.B ( 5th Year ), Damodaram Sanjivayya National Law University
In India, Asset Reconstruction Companies (ARCs) have recently sought permission from the Reserve Bank of India (RBI) to raise equity capital from the market. This move is designed to boost their liquidity and net worth, especially as they face stiff competition from the government-backed National Asset Reconstruction Co (NARCL) and navigate current regulatory challenges.
ARCs play a vital role in the financial system by purchasing Non-Performing Assets (NPAs) or bad loans from banks and financial institutions, helping these institutions clean up their balance sheets. However, the ARC industry requires significant capital, and existing investors often lack the resources needed for expansion. Granting ARCs access to capital markets would provide the necessary liquidity and bring increased public scrutiny and transparency.
The RBI has set a net worth target of Rs.300 crore[1] for ARCs which has to be achieved by March, 2026, but only a third of the 27 Asset Reconstruction Companies have reached this milestone so far. By raising equity capital, ARCs can step up acquisitions and improve their net worth, aligning with RBI norms.
This move is expected to bring several benefits, including increased resources for ARCs, improved transparency, and higher disclosures. It will also help ARCs compete more effectively with NARCL and other market players.
FUNCTIONING OF ARC:
Asset Restructuring companies are designed to help the banks in cleaning up their NPAs (Non-performing assets). The process begins with banks identifying NPAs, which are loans where borrowers have defaulted on payments. Banks then sell these NPAs to ARCs, usually through a competitive bidding process or direct sale. Before making the purchase, ARCs conduct thorough due diligence[2] to assess the value and recovery potential of the assets. Once this assessment is complete, ARCs acquire the NPAs, often at a price lower than the outstanding loan amount.
As part of the payment, ARCs may issue Security Receipts (SRs) to the selling banks. These SRs represent a share in the future recoveries from the acquired assets. The next step involves the reconstruction and resolution of the NPAs. ARCs employ various strategies, such as renegotiating loan terms, selling collateral, or pursuing legal actions, to recover the maximum value from the assets.
Throughout the recovery process, ARCs continuously monitor and follow up on the progress. Once the recovery is made, ARCs distribute the recovered funds to SR investors, including the selling banks, based on their share in the SRs. Throughout this process, ARCs maintain transparency and comply with regulatory compliances set by the (RBI), regularly reporting their activities and recovery progress.
By acquiring and resolving NPAs, ARCs helps the banks to focus on their core activities, contributing to the stability and efficiency of the financial system. Access to capital markets can further enhance ARCs liquidity, transparency, and competitive edge, benefiting the overall financial landscape in India.
ADVANTAGES:
Allowing Asset Reconstruction Companies (ARCs) to enter the capital markets in India has several advantages, particularly when considering the legal framework. By raising equity capital from the market, ARCs can access more funds to acquire ‘Non-Performing Assets (NPAs)’, which helps banks clean up their balance sheets. The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002[3], empowers ARCs to take possession of secured assets and sell them, enhancing their ability to manage and recover NPAs effectively.
Entering the capital markets enhances the net worth of ARCs, strengthening their financial position and enabling them to take on larger and more complex asset reconstruction projects. The Reserve Bank of India (RBI) mandates a minimum net worth requirement for ARCs i.e. Rs.300 crore, aiming to ensure their financial stability. Greater public scrutiny and regulatory oversight from being listed on stock exchanges, as required by the Securities and Exchange Board of India (SEBI), improves transparency and accountability in their operations.
With access to more funds, ARCs can better compete with government-backed entities like the National Asset Reconstruction Company (NARCL). The Insolvency and Bankruptcy Code (IBC), 2016, provides a legal framework for the resolution of stressed assets, and ARCs with stronger financial positions can leverage this framework more effectively. Allowing ARCs to raise equity capital from the public increases public participation in the financial sector, diversifying the investor base and providing more stable funding sources.
Capital market participation introduces market discipline, encouraging better corporate governance practices and more prudent financial management, as required by SEBI’s listing regulations. Efficiently managing and resolving NPAs contributes to the overall health of the banking sector and the economy[4], with the RBI’s regulatory framework supporting ARCs in their recovery efforts. Access to capital markets encourages ARCs to innovate and adapt to changing market conditions, leading to the development of new strategies and approaches for asset reconstruction, supported by the SARFAESI Act and the IBC.
DISADVANTAGES:
Allowing Asset Reconstruction Companies (ARCs) to enter the capital markets in India could have some disadvantages. Firstly, regulatory challenges pose a significant issue. The Reserve Bank of India (RBI) has stringent rules and requirements for ARCs, such as maintaining a net worth of ₹300 crore. Many ARCs struggle to meet these requirements, which can limit their ability to raise funds effectively.
Additionally there is chance of transfer in market/credit risk from banks to the public sector[5], but allowing the private capital market would become an ideal solution for RBI in order to strengthen the ARC activities, as the government-backed entities like National Asset Reconstruction Company offers more attractive security receipts guaranteed by the government, making it challenging for private ARCs to compete effectively.
Another concern is the trust deficit between regulators and ARCs. The RBI has expressed worries about some transactions potentially helping defaulting promoters regain control of their assets, which is against the provisions of Section 29A[6] of the Insolvency and Bankruptcy Code (IBC). This scrutiny can lead to increased regulatory hurdles for ARCs.
The lack of a vibrant distressed debt market in India is also a concern. Selling NPAs can be difficult due to price mismatches between selling banks and buying ARCs. This mismatch makes it hard to reach a consensus on asset valuation, complicating the resolution process.
Operational inefficiencies and the need for professional expertise are significant challenges for ARCs[7]. Many ARCs lack the necessary skills and resources to manage turnaround stories effectively. Additionally, regulatory issues can prevent them from offering competitive compensation packages to attract top talent.
CONCLUSION:
The entry of ARCs into the capital markets can lead to market saturation and potential overvaluation of assets, causing instability in the market. The influx of funds might encourage ARCs to take on riskier assets, which could impact their financial health and lead to broader market implications.
[1]Aathira Varier, RBI’s compiled master direction on ARCs to be effective from April 24, BUSINESS STANDARD, (Apr. 24, 2024, 7:19 PM), https://www.business-standard.com/industry/news/rbi-s-compiled-master-direction-on-arcs-to-be-effective-from-april-24-124042400508_1.html
[2]Mayashree Acharya, Asset Reconstruction Companies (ARCs) – Business Model, CLEAR TAX, (Jun. 17, 2024), https://cleartax.in/s/asset-reconstruction-companies-arcs
[3] Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, No. 54, Acts of Parliament, 2002
[4]Mahesh Nayak, PE funding of asset reconstruction firms to transform bad loans market ,BUSINESS TODAY MAGAZINE,( Mar. 29, 2015), https://www.businesstoday.in/magazine/corporate/story/all-about-private-equity-funding-of-asset-construction-firms-142258-2015-03-25
[5]Jaimini Bhagwati, M. Shuheb Khan, Ramakrishna reddy Bogathi, Can Asset Reconstruction Companies (ARCs) be part solution to the Indian Debt Problem, INDIAN COUNCIL FOR RESEARCH ON INTERNATIONAL ECONOMIC RELATIONS, (Apr. 2017), https://icrier.org/pdf/Working_Paper_338.pdf.
[6]The Insolvency and Bankruptcy code, 2016, No. 31, Acts of Parliament, 2016 (India).
[7]Sucheta Dalal, Asset Reconstruction Companies: Controversies, Questions and a bleak future, MONEY LIFE, (Nov. 22, 2024), https://www.moneylife.in/article/asset-reconstruction-companies-controversies-questions-and-a-bleak-future/75663.html.
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