A Breath of Fresh Air for Stressed Debts? Demystifying SEBI’s Consultation Paper on SSFs

[Mahim Raval is a 3^rd year B.Sc., LL.B. (Hons.) student at Gujarat National Law University in Gandhinagar]

India’s financial landscape has been grappling with the persistent burden of stressed assets, hampering the flow of credit and impacting economic growth. While the Reserve Bank of India (“RBI”) has introduced multiple schemes to resolve the burgeoning non-performing assets of banks, the progress has been slow. To revitalize the stressed asset market, specialized investment vehicles called Special Situation Funds (“SSFs”) were established under the SEBI (Alternative Investment Funds) Regulations, 2012, offering a unique avenue for capital infusion into stressed assets. However, currently the RBI Transfer of Loan Exposures Directions, 2021 (“RBI Master Directions”) only allow certain entities to acquire stressed loans. SSFs are not on that list, thereby creating a regulatory loophole. In an effort to address this, the Securities and Exchange Board of India (SEBI) recently released a consultation paper proposing amendments to the regulatory framework governing SSFs. The goal is to facilitate SSFs’ acquisition of stressed loans under the RBI Master Directions.

The aim of this post is to explain the key proposals of the consultation paper, to analyse the implications and potential challenges that may arise in implementation and suggest recommendations for the same.

Key Proposals in the SEBI Consultation Paper

Changes to the Definition of Special Situation Assets

Under the current framework, SSFs can invest in two categories of stressed assets: “available for acquisition” loans adhering to RBI guidelines or those arising from insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 (“IBC”) or RBI resolutions. However, the recent consultation paper proposes a narrower definition, limiting investments to loans that are already “acquired”. This restriction could hinder SSFs’ flexibility, particularly during ongoing resolutions where early participation is key. To address this potential drawback, a broader framework is necessary, one that allows SSFs to acquire stressed loans both before and after a resolution plan is finalized. This approach would not only empower SSFs but also potentially accelerate resolutions and contribute to a more resilient financial sector. Therefore, the definition of “special situation assets” should encompass both “acquired” and “available for acquisition” stressed loans, ensuring SSFs can play a more active role in tackling these crucial financial challenges

Expanding SSF Investor Eligibility

The consultation paper proposes aligning the eligibility criteria for asset reconstruction companies (“ARCs”) and SSFs under section 29A Of The IBC. This would extend the existing requirements, which currently apply only to the SSF itself, to encompass its underlying investors. This additional layer of scrutiny stems from the broader investor base typically associated with alternative investment funds (“AIFs”) compared to ARCs or other regulated financial institutions authorized to acquire such stressed assets. Essentially, the consultation paper aims to ensure that not just the SSF, but also its investors, meet the necessary criteria for involvement in such transactions. However, expanding the eligibility requirement to investors could bring potential challenges, such as increased due diligence and documentation requirements for SSFs.

Definition of Related Party

Recognizing the limitations of the current associate company definition, the SEBI consultation paper proposes tightening regulations by prohibiting SSFs from investing in any “related parties” as defined under the Companies Act, 2013. This broader scope aims to address potential conflicts of interest and ensure ethical investment practices by capturing entities not categorized as associates under the existing framework. However, the ambiguity surrounding the applicability of this threshold to sponsors/investors, rather than just fund managers, could pose operational challenges and hinder flexibility for SSFs.

Enhanced Reporting Requirements

The consultation paper calls for SSFs to report details on all investments in stressed loans to an RBI-notified trade reporting platform. This includes information on units issued, changes in unit holdings, resolution strategies, and recoveries to promote transparency. While enhanced reporting could strengthen oversight, it also increases compliance costs and may deter some investors. Perhaps limiting reporting to systematically important SSFs or those above a minimum assets under management (“AUM”) threshold could balance these aims.

Minimum Holding Period

The consultation paper seeks to address concerns regarding the potential misuse of SSFs for “round tripping” of distressed loans. To this end, it proposes two key measures. First, it mandates a six-month minimum holding period for stressed loans acquired under specific RBI guidelines. Second, it suggests restricting subsequent transfers of these loans to a predefined pool of entities listed in the annex to the RBI Master Directions. This targeted approach aims to create a closed ecosystem for stressed assets, fostering responsible lending practices through a minimum 15% investment requirement for SSFs in issued security receipts, similar to the existing framework for ARCs. This regulatory alignment with ARCs could promote credit discipline and prevent the unrestricted circulation of distressed loans.

Potential Challenges & Recommendations

Regulatory Asymmetry Threatens ARC-SSF Collaboration in a Stressed Debt Market

The SEBI consultation paper’s proposal to introduce SSFs into the stressed debt market, long the domain of ARCs, presents an opportunity for both entities to collaborate and revitalize the sector. However, the success of this collaboration hinges upon addressing regulatory asymmetries between ARCs governed by RBI regulations on the one hand and AIFs that under SEBI’s purview on the other. These disparities create an uneven playing field, potentially hindering the effectiveness of ARCs. While SSFs are anticipated to inject fresh capital into the sector, ensuring a level playing field is paramount to avoid jeopardizing the sustainability of existing ARC models. To foster a synergistic environment where SSFs complement, rather than replace, ARCs in resolving stressed assets, SEBI must consider harmonizing the regulatory frameworks for both entities. This harmonization would ensure a level playing field and pave the way for a collaborative approach towards stressed asset resolution.

Compliance Costs Could Strangle SSF Growth

While transparency and accountability are crucial, the Consultation Paper’s proposed reporting requirements might be wielding a sledgehammer to crack a nut. A more balanced approach may consider:

• Risk-based reporting: Tailoring reporting requirements to the specific risk profile of each SSF could reduce the burden on smaller or lower-risk players.
• Phased implementation: Gradually rolling out the reporting requirements, allowing SSFs time to adjust and build necessary infrastructure, could ease the transition.
• Technology adoption: Embracing technology solutions for data collection, maintenance, and reporting could streamline the process and reduce costs for SSFs.

Broader “Connected Entity” Definition Restricts SSF Investment Scope

The consultation paper’s focus on preventing conflicts of interest through redefining “connected entity” is laudable. However, its broad categorization risks unintended consequences for SSFs’ investment capabilities. Imagine a large conglomerate with its subsidiaries facing financial distress. Under the proposed definition, SSFs might be barred from investing in any subsidiary due to intricate cross-ownership within the group. This scenario showcases the unintended consequences of the broad definition, potentially depriving the stressed company of much-needed turnaround capital and hindering the efficient resolution of bad loans, ultimately weakening the entire financial ecosystem. Perhaps a more nuanced approach, one that considers the nature and depth of relationships within corporate groups, could achieve the desired transparency while preserving SSFs’ crucial role in the stressed debt market.

Conclusion

The SEBI consultation paper paves the way for a brighter future for the distressed asset market. By aligning its regulations with the RBI and broadening the scope of SSF investments, it has the potential to unlock greater liquidity, attract foreign investors, and ultimately empower a larger pool of capital to tackle stressed assets. Regulatory disparities pose a significant hurdle, potentially creating an uneven playing field and hindering SSFs’ ability to contribute effectively. SEBI must prioritize harmonization of key frameworks, aligning minimum investments, capital adequacy, exit options, and reporting standards. Ultimately, these suggested measures could be a crucial catalyst for fostering a more robust and vibrant secondary debt market.

– Mahim Raval