Insolvency of Financial Service Providers and Third Party Rights Under Securitisation Contracts

[Richa Saraf is an Advocate]

The Insolvency and Bankruptcy Code, 2016 (“Code”) does not, in general, deal with insolvency of financial service providers (“FSPs”), as FSPs are seen to be systemic and complex structures engaging in unique transactions. However, the collapse of Dewan Housing Finance Corporation Limited (“DHFL”) led to the notification of the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019 (“Rules”) under section 227 of the Code. The Rules apply the Code to FSPs, with certain modifications. With respect to third party assets, the Rules stipulate that the moratorium provisions of the Code will not apply to such assets or properties as are in custody or possession of the FSP, including any funds, securities and other assets required to be held in trust for the benefit of third parties. The Rules further state that the administrator shall take control and custody of such third-party assets or receivables, but only for the limited purpose of dealing with them in the manner as may be notified by the Central Government.

Pending notification of clear rules with regard to third party assets with the FSPs, certain ambiguities arose that demanded judicial intervention (see below). However, now, the Central Government has, by way of a notification dated 30 January 2020 (“Notification”), notified the manner in which third party assets in custody or possession of FSPs (against whom insolvency proceedings have been initiated) are to be dealt with.

The DHFL Issue

On 30 September 2019, the Bombay High Court passed an ad-interim order on an application filed by deposit-holders and injuncted DHFL from making any payments or disbursements to any of its unsecured creditors and secured creditors, except in cases where payments are made on a pro-rata basis to all secured creditors, without the sanction of the Court. Aggrieved by the said order, various banks, including State Bank of India, Bank of Baroda, Union Bank of India, Indian Overseas Bank, Canara Bank, Bank of India, Standard Chartered Bank, filed intervening applications before the High Court, seeking modification of the above order to the extent that DHFL is allowed to make payment of amounts due to banks pursuant to securitization and assignment agreements.

Finally, through its order dated 13 November 2019, the Bombay High Court allowed DHFL to make payments to banks and non-banking finance companies (“NBFCs”) that have entered into securitisation arrangements with the stressed mortgage financier. Pursuant to a notification dated 18 November 2019, DHFL became the first FSP against whom insolvency proceedings were initiated on 2 December 2019.

In the absence of the Notification dated 30 January 2020, the following issues arose in the DHFL case. First, while DHFL continued to be the servicer of the pool underlying the securitisation transaction, DHFL considered that transferring of collections from securitised assets and liquidation of cash collateral by the trustee would be in violation of the order of the National Company Law Tribunal declaring moratorium and, therefore, refrained from depositing the collections from securitised assets into the respective collection and payout accounts. Second, the accessibility of cash collateral to trustee was, thus, restricted as DHFL informed the trustees that until the Central Government notification related to “dealing with third party assets” is issued, any transfer, appropriation, or enforcement of security or collateral will be in contravention of the Code.

The Notification

To secure the rights of banks under securitisation agreements for cases, and to put an end to the unwarranted circumstances in future as in case of DHFL, the Central Government issued the Notification, which casts the following obligations on the administrator of the FSP:

Dealing with third party receivables

Where a FSP is contractually obliged, as on the insolvency commencement date, to act as a servicing or collection agent on behalf of third parties, the administrator is required to prepare a statement of such transactions and respective agency contract. The administrator is required to continue to discharge the obligations of the FSP as a servicing or collection agent. The administrator is also required to ensure that the receivables collected in respect of securitisation transactions are deposited and maintained in a separate account and are not merged with the funds or other assets of FSP.

Dealing with third party assets

Where the FSP has, as on the insolvency commencement date, in its custody or possession assets owned by third parties, and is under an obligation to return or transfer such assets in accordance with the terms and conditions of the contract, the administrator is required to prepare a statement of such assets and the respective contracts. Further, the administrator is required to ensure that third party assets are maintained in a separate and distinct manner, capable of identifying them contract-wise, and are not merged with those of FSP. The administrator is also required to return or transfer such assets to the person entitled to receive it in accordance with the terms and conditions of the contract. However, when due to breach of the terms of the contract, the FSP becomes entitled to retain certain assets or dispose of the same, the administrator shall not be required to return such assets.

Practical Observations

Appointment of alternate servicer or collection agent

In securitisation transactions, while the originator of the loan (assignor) is appointed as the servicer or collection agent on behalf of the assignees, the assignees are provided with the sole and unquestionable right to replace the servicer with an alternate servicer, particularly in the case of event of default (insolvency is an event of default in all the cases). In our view, the obligation cast upon the administrator to continue acting as collection agent does not take away or restrict such right of the assignee in any manner. If the assignees do not avail the option of appointing an alternative servicer and are desirous of continuing with the services of the FSP, only in such cases shall the administrator act for the FSP. Also, immediately upon termination of the services of the servicer, the servicer is required to transfer to the alternate or successor servicer the custody of all loan agreements, underlying documents, electronic payment instruments, cheques including post-dated cheques, drafts, instruments (if any), demand promissory notes, correspondence, records, information and monies held by the servicer with respect to the assets

Operation of collection accounts

Generally, it is seen that the receivables are first collected and deposited by the servicer in a common account, and thereafter disbursed to the beneficiaries in accordance with the waterfall provided in the assignment agreement. The Notification provides that the administrator will be required to maintain separate collection accounts for each securitisation transaction. The requirement to maintain separate accounts means the administrator, on appointment, will be required to open separate bank accounts for collection of funds received from each assignment, which might result in administrative difficulties.

Commingling of pool of loans

The Notification provides that the administrator shall prepare a statement of assets and the respective “contracts”, and further stipulates that the administrator shall ensure that such assets are maintained in a separate and distinct manner, capable of identifying them “contract-wise”. In securitisation transactions, as a pool of loans are transferred to the assignee through an assignment agreement, the language of the Notification may give rise to a confusion as to whether the term “contract” is used for loan agreement or assignment agreement. In our view, the intent was to distinguish between each securitisation transaction and not individual loans.

Security interest enforced by the administrator on behalf of the assignee

While the Notification provides that the assets which continue to be in the custody or possession of the FSP as on the insolvency commencement date shall be dealt with in the manner provided in the contract, there may be certain assets which might subsequently come in possession of the FSP or the administrator, the Notification is not clear about the treatment of such assets. We believe that the assets which subsequently come in possession or control of the FSP will also be dealt with in the same manner, i.e., in accordance with the terms and conditions of the respective assignment agreements. 

Concluding Remarks

While there seems to be some relief to the financial sector, since the Notification delinks the insolvency of one FSP from affecting the other financial entities, there still exists ambiguity so far, as the scope of the term “third party” is concerned. Also, there is a need to clarify the manner in which third party assets is to be treated in resolution plans or in case of liquidation.

Richa Saraf

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