## Sunday, May 29, 2016

### Analysis of the recent proposed SARFAESI amendments : are these consistent with the Insolvency and Bankruptcy Code?

by Rajeswari Sengupta and Richa Roy.

The Insolvency and Bankruptcy Code (IBC, 2016) recently passed in both Houses of the Parliament is a significant step towards improving the bankruptcy resolution framework in India. Among other things, the IBC seeks to replace all existing laws related to bankruptcy resolution. This constitutes a significant departure from the present system that is characterised by multiple laws and forums as well as an inherent bias towards secured financial creditors. The existing laws such as SARFAESI, 2002 and the RDDBFI, 1993 (that set up the Debt Recovery Tribunals or DRTs) Acts are designed to exclusively benefit secured creditors such as banks and financial institutions while limited legal recourse is available to other unsecured creditors and operational creditors in the event of insolvency of the debtor firm. The IBC seeks to resolve this issue by according rights to all types of creditors, and not just secured financial creditors, to trigger insolvency proceedings against the debtor firm.

However the IBC by itself cannot achieve better bankruptcy resolution outcomes, and needs to also be supported with related laws and regulations. Earlier this month the Enforcement of Security Interest and Recovery of Debts Laws and Miscellaneous Provisions (Amendment) Bill, 2016 was tabled in the Parliament. This bill proposes amendments to the SARFAESI Act of 2002 and has been referred to the same Joint Parliamentary Committee that reviewed the IBC. The underlying objective is that along with IBC, an amended SARFAESI Act will help expedite the debt recovery process in India.

While there is an inherent tension between laws for security enforcement and those for insolvency or bankruptcy resolution, these two actions must work in harmony in order to be successful. Our analysis suggests that the proposed amendments to the SARFAESI Act need to be modified in order to be consistent with the IBC. In addition, there are certain provisions in the IBC itself relating to security enforcement that need to be sharpened to improve the efficacy of the IBC as well as individual security enforcement. The review by the same JPC that reviewed the IBC offers an opportunity to do this.

### 1   Interaction between security enforcement laws and insolvency laws

In the existing legal regime in India, there are multiple debt recovery and security enforcement laws (SARFAESI being an example) which create opportunity for individual recovery action, as opposed to an insolvency law that deals with collective action. The former is about enforcing a specific contract or foreclosing one or more specific security interest(s). Insolvency law on the other hand deals with collective assessment of viability of the debtor's business as a going concern. If the business is found to be viable, resolution involves restructuring of the firm and its business and/or its debts. If the business is found to be unviable, then the firm is liquidated and secured financial creditors are given the right to enforce their security if they so choose.

It is critical that during an insolvency resolution process, the rights of debt recovery and enforcement of security interest be suspended as that is the only way in which creditors can be made to adopt collective action. If the secured financial creditors are given the right to enforce while an insolvency resolution is in progress, it is highly likely that they will choose individual enforcement action which may undermine the overall resolution process, thereby hurting the interests of the other creditors.

This is what is happening currently in India as maybe evidenced by the fact that banks rely mostly on SARFAESI and DRTs rather than creditor arrangements. (While they do undertake some forms of non collective out-of-court mechanisms such as CDR and JLF, arguably this is to get provisioning benefits. Also these measures distort the incentives in the credit process and skew the same towards large debtors and creditors). This issue is even more important in India given that secured credit from banks and financial institutions continues to be the dominant source of debt financing for companies. For instance in 2012-13, out of all the sources of funds for non-financial firms in India, borrowing amounted to 21.57% out of which bank credit alone was 15.20%. Multiple actions by various classes of creditors also leads to confusion and forum shopping.

### 2  Amendments needed in SARFAESI Act for Indian bankruptcy reform

SARFAESI Act, 2002 provides a safety net to secured financial creditors (banks and financial institutions) by empowering them to enforce their security interests without the intervention of any court. On the other hand, under IBC, the rights and interests of all types of creditors have been taken into consideration including that of secured creditors. The natural question that arises now is how will these two parallel legal processes coexist. More specifically, how will the rights of secured creditors be governed in presence of both these laws and whether, going forward, there may be any ground for conflict in the interaction between these two laws.

While taking away the rights of secured creditors to enforce security as vested in them by SARFAESI may not thus be a viable option at present, without the IBC having proven its success, it is critical that the provisions of SARFAESI are dovetailed with IBC, such that the former Act does not undermine the effectiveness of the latter. The IBC as passed in the Parliament contains provisions that explicitly refer to the rights of secured creditors under SARFAESI. Section 14(1)(c) of the IBC provides that the moratorium would apply to : "any action to foreclose, recover or enforce any security interest created by the corporate debtor in respect of its property including any action under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002." Accordingly this moratorium applies to all acts by any kind of creditor under SARFAESI. Also, Schedule 7 of the IBC amends SARFAESI to subject all collective action under SARFAESI to the provisions of the IBC.

Given that these provisions are already incorporated in the IBC, now the SARFAESI Act also needs to be amended accordingly such that provisions of both these laws are in sync with each other and there is no confusion about applicability of the laws to the specific economic actors at specific stages of the insolvency resolution process.

### 3  Amendments to SARFAESI Act, 2002 as tabled in Parliament

The proposed changes in the amendment bill with regard to the SARFAESI Act significantly enhance the rights of the asset reconstruction companies (ARCs) in the acquisition of assets of the debtor, include the debenture trustee as a secured creditor, widen the scope of powers of the RBI in regulating ARCs and extend the scope of the Central Registry (CERSAI) created under the Act.

According debenture trustees the same rights as other secured creditors (banks and financial institutions) is a useful step and is in line with the IBC's aim of creating a level playing field for all lenders. So also is significantly expanding the scope of the information available in the CERSAI. Similarly, permitting banks and financial institutions to transfer financial assets to ARCs prior to them being declared as non performing assets (90 days post a payment default) is also in line with the IBC's aim at early detection and resolution of distress. While these amendments are in line with the spirit of IBC, it is now necessary to further clarify how these additional changes will dovetail into IBC and this is what the JPC should consider in its review.

### 4  Corrections in the SARFAESI Amendment Bill and the IBC

First, the SARFAESI should include the manner in which each action thereunder can be taken in reference to resolution and liquidation under the IBC. For instance, it should be specified that any action under Section 13 of the amendment bill, by a bank or a financial institutions or under the new Section 9 by ARCs will be subject to the moratorium under Section 14 of the IBC. It could further be clarified that the transfer of a financial asset from a bank or financial institution to an ARC during the moratorium under IBC would be permitted. Indeed, under IBC one would expect several secondary transfers of debt to occur during the insolvency resolution process (IRP) for creditors to be able to influence voting in the creditors' committee.

Following the 180 day period of IRP in the IBC there are two possibilities: (a) a resolution plan; or (b) liquidation. The SARFAESI amendments need to clarify that any enforcement action following the moratorium should be compliant with the IBC resolution plan that has been voted on by majority of creditors. In liquidation under IBCa, all secured creditors have the right to stand outside the proceedings and enforce their security using SARFAESI or otherwise. The SARFAESI amendments could clarify this as well and also the manner in which this would occur for instance mandating the secured creditors to inform the liquidator and pay their portion of the liquidation costs.

Secondly an important feature of IBC is a mandatory moratorium during the IRP in order to stay all creditor action. The moratorium applies to the enforcement of security interests under the SARFAESI as well. However under the IBC as passed in the Parliament, the Central Government reserves the right to provide exemptions to specific transactions in consultation with a financial sector regulator. It is not clear why this exemption is needed and how wide its scope can be.

Does it mean this provision can be used to exempt secured creditors such as banks and financial institutions from enforcing their collateral during the moratorium? As a corollary, does this mean using this exemption, banks can invoke the SARFAESI Act to enforce their security even as an IRP is in progress triggered by another creditor? This could be dangerous and would defeat the purpose of the moratorium, not to mention strip the IBC of its very essence. The amendments to the SARFAESI Act do not provide any clarity on how such interactions between the two laws will be dealt with.

This power of the central government should either be removed or the precise basis on which this power will be exercised should be tightly set out in the amendment Act. Since debt recovery action and insolvency resolution can be at loggerheads with each other for reasons described above, amendment to SARFAESI can specifically provide that individual debt recovery action would not be exempted under this provision. The central government should potentially exercise this right of exemption only for attachment of assets by enforcement authorities in the respect of financial crimes. Alternatively IBC needs to be amended or specific rules need to be written now, clarifying the reach of this provision.

Third, under the IBC, all corporate insolvency resolution cases will be adjudicated upon by the NCLT whereas all individual insolvency resolution cases will be dealt with by the DRTs. Even after the amendments, all SARFAESI cases will continue to be referred to DRTs as is the practice now. DRTs are overburdened with cases and highly capacity constrained. The amendment bill itself mentions that approximately 70,000 cases are pending at DRTs for many years due to adjournments and prolonged hearings. Given this state of affairs, perhaps the corporate recovery cases under SARFAESI could be shifted to the newly constituted NCLT, in sync with the IBC. Given that NCLT itself will handle the IBC cases, existing winding up cases as well as adjudicate upon matters related to company law, perhaps only SARFAESI related appeals can be referred to the NCLT, to reduce the burden on DRTs. This presumes that NCLT will use new ideas in how to organise courts, without which it will rapidly collapse with a huge backlog of cases.

Fourth, in the IBC framework of `information utilities' (IU), there would be a private competitive industry of IUs. This is inconsistent with a single statutory CERSAI which is a monopoly.

In summary the following corrections maybe proposed to the SARFAESI amendments: (i) Remove all kinds of SARFAESI enforcements from the exemption provision of the moratorium under IBC that the central government can grant (ii) Provide greater clarity regarding interaction of the provisions of SARFAESI to IBC (iii) Refer SARFAESI related appeals to NCLT, (iv) Locate CERSAI in the IBC concept of information utilities.

A primary intent of the IBC is to have a unified, consolidated law that applies to all economic actors. Effective implementation of IBC is now of utmost importance in order to achieve the goal of a simpler and faster resolution mechanism that produces a higher recovery rate. Lack of sufficient clarity in the proposed amendments to the SARFAESI Act will create uncertainty about the rights of secured creditors and dilute the working of the IBC in practice. The existence of dual laws (IBC and SARFAESI) and forums (NCLT and DRTs) to deal with the debt recovery problems of secured creditors will result in more time being spent in resolving confusion and create opportunity for litigation, the very problem that the IBC is aimed at resolving. This uncertainty needs to be addressed by the JPC reviewing the amendments.

Richa Roy is a lawyer and public policy analyst at AZB Partners. Rajeswari Sengupta is an academic at IGIDR, Bombay. Both were part of the drafting team for the Insolvency and Bankruptcy Code. The authors thank Bhargavi Zaveri for useful discussions.

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