[Harsh Mittal and Sidhanth M K Majoo are 3rd year B.B.A. LL.B. (Hons.) students at National Law University, Odisha]
The Indian financial system has long been burdened by the prevalence of stressed assets, necessitating substantial capital infusions into banks, non-banking financial companies (“NBFCs”), and other financial institutions. These stressed assets have constrained the ability of financial institutions to provide credit facilities to sectors that could contribute to India’s overall economic development. Asset reconstruction companies (“ARCs”) were initially established to address this challenge. However, their effectiveness has been limited due to various factors. Recognizing these limitations, the Indian Government introduced Special Situation Funds (“SSFs”) in 2022 as a sub-category of Alternative Investment Funds (“AIFs”) to revitalize the stressed asset market.
Considering the Reserve Bank of India’s (“RBI”) primary role in regulating stressed debt transactions in India, the Securities and Exchange Board of India (“SEBI”) has proactively engaged with the RBI to establish a harmonized regulatory framework for SSFs. Pursuant to this collaborative effort, SEBI has issued a consultation paper on 28 November 2023 proposing several amendments to the existing regulations governing SSFs. In this post, the authors seek to examine SEBI’s proposed amendments to the regulatory framework governing SSFs, exploring their impact on the Indian financial landscape and the potential challenges they pose to the market.
The Birth of Special Situation Funds: A Response to ARC Inefficiency
Prior to the emergence of SSFs, the RBI limited stressed loan acquisition to “permitted transferees”, with ARCs playing a central role. They were instrumental in assisting banks and financial institutions by managing their stressed assets and reducing non-performing assets through either direct acquisition or the establishment of asset reconstruction trusts issuing security receipts (“SRs”). However, these SRs were restricted to qualified buyers as defined by the RBI. This regulatory framework served as the foundation for stressed loan resolution in India until the emergence of SSFs.Despite their pivotal role in managing bad loans and stressed assets in India, ARCs have faced significant hurdles that render them less effective in their intended functions.
The inefficacy of ARCs stems from various inherent challenges that hinder their effectiveness in resolving stressed assets. Firstly, ARCs have faced challenges in redeeming SRs. The RBI report revealed that merely two ARCs possess 62% of the total SRs issued. The recovery of SRs serves as a pivotal metric for assessing ARC efficacy. Secondly, limited funding flexibility further constrains ARCs, as they face hurdles in providing necessary liquidity due to adverse asset classifications and, to worsen this, the RBI placed a cap on restrictions in restructuring support finance at 25% only. Moreover, ARCs lack the ability to acquire equity in borrower companies, hampering their restructuring efforts, unlike SSFs which can invest in both debt and equity without constraints.
Considering the challenges the ARC sector was facing, the RBI constituted a committee to review the working of ARCs which found that their performance in revival of business was unsatisfactory. Further, the committee recommended that ARCs should be allowed to sponsor AIF, duly registered with SEBI, which will helping the ARCs in investing in stressed assets. SEBI also went a step further and enabled a regime for SSFs, which does not require an ARC to be the sponsor.
Special Situation Fund : A saviour for distressed assets market
SEBI expanded AIFs’ scope in 2022 through the Securities and Exchange Board of India (Alternative Investment Funds) (Amendment) Regulations, 2022, enabling them to attract capital from investors prepared to undertake high-risk endeavours. Initially restricted to debt securities, AIFs were barred from distressed loans. The new rules permit AIFs to pursue two key activities: investing in “special situation assets” and participating as a “resolution applicant” under the Insolvency and Bankruptcy Code, 2016 (“IBC”).
Special situation assets, as defined in the Amendment Regulations, encompass stressed loans, SRs issued by ARCs, securities of investee companies facing financial distress, and other assets specified by the Board. SEBI’s introduction of SSFs brings forth several relaxations to attract investors and facilitate fund managers. The key issues addressed by SSFs that were hindering the ARCs are mainly two-fold. First, SSFs are exempt from investment concentration limits, enabling them to allocate their entire portfolio towards a single special situation asset, whereas ARCs are subject to diversification constraints in restructuring finance. Secondly, SSFs have a broader investment scope, encompassing both debt and equity in distressed companies, while ARCs can only acquire stressed loans that have been in default for more than 60 days or are classified as non-performing assets. These restrictions are not applicable to SSFs.
The Proposed Changes
The recent SEBI consultation paper proposes substantial amendments to the regulatory framework for SSFs to facilitate their acquisition of stressed loans pursuant to the RBI (Transfer of Loan Exposures) Directions, 2021 (“RBI Master Directions”). To address the limitations of the current definition of “special situation asset”, which assumes pre-approval visibility of stressed loans, the paper suggests replacing “available for acquisition” with “are acquired”, aligning the definition with the actual availability of stressed loans. This modification will not impede SSFs that have previously invested in stressed company securities from acquiring stressed loans.
The paper imposes restrictions on SSFs from acquiring special situation assets if any of their investors are disqualified under section 29a of IBC. This aligns SSFs’ due diligence with that of ARCs to prevent regulatory arbitrage. The proposal also broadens the scope of connected entities to curb fund round-tripping. Previously, SSFs were prohibited from investing in their associates, but this restriction has been extended to “related parties” as defined by the Companies Act, 2013.
To ensure transparency and effective monitoring, it has also been proposed that SSFs transfer or sell stressed loans exclusively to entities listed in the annexure of RBI Master Direction. SSFs holding stressed loans should be subject to a specialized supervisory framework. Additionally, SSFs are mandated to submit information regarding their stressed loan investments to an RBI-designated trade reporting platform. This information should encompass details of units issued, investor particulars, subsequent changes in unit holdings, implemented resolution strategies, and recoveries achieved.
Critical Analysis: The Right Way Forward?
The proposed reforms within the Indian financial system herald significant implications that, if effectively implemented, could unlock tied-up capital in stressed loans, potentially amplifying lending activities and catalysing economic growth across pivotal sectors. These changes advocate a structured investment framework and heightened regulatory oversight for SSFs, aligning due diligence requirements with investors in ARCs to prevent potential regulatory loopholes. However, it poses some challenges which needs to be addressed for its effective implementation.
Firstly, the proposed redefinition of connected entity to encompass the concept of related party could significantly restrict the investment scope of SSFs. This broader definition could effectively preclude SSFs from investing in a substantial portion of the stressed debt market, considering that many stressed companies are part of larger corporate groups with intricate ownership structures. This could impede the ability of SSFs to participate in the resolution of stressed assets and hinder their contribution to the overall well-being of the Indian financial system.
Secondly, the proposed reporting requirements for SSFs are likely to impose significant compliance costs on SSFs. These costs associated with data collection, maintenance, and reporting could strain the profitability of existing SSFs and deter potential entrants from joining the market. The increased complexity and financial burden could stifle the growth and participation of SSFs in the stressed debt market.
Lastly, the proposed introduction of SSFs into the stressed debt market, a domain traditionally dominated by RBI-regulated ARCs, is poised to intensify competition, potentially challenging the sustainability of ARCs’ business models. While the influx of distressed capital from SSFs is anticipated to revitalize the sector, concerns regarding regulatory asymmetry between ARCs and AIFs must be addressed to ensure a level playing field, as the purpose of introducing SSFs is to complement ARCs’ efforts in resolving stressed assets, not to replace them. The differential regulatory frameworks governing ARCs and AIFs create an uneven playing field, potentially disadvantaging ARCs. To foster a fair environment, SEBI should consider harmonizing the regulatory requirements for both entities, allowing them to operate on a level playing field.
Moreover, confining SSFs solely to post-default activities within the corporate debt secondary market could limit their capacity to effectively manage financial risks. Allowing them pre-default access to both investment and non-investment grade debt would yield substantial benefits. This shift would empower lenders and investors to offload stressed assets with minimized losses, equip SSFs with ample time for debt consolidation, and fortify market fluidity.
The changes in India’s financial framework for SSFs herald a transformative shift. These amendments, spearheaded by SEBI in consultation with the RBI, aim to unlock capital tied up in stressed loans, revitalizing crucial sectors like banks and NBFCs. The transition from ARCs to SSFs underscores the need for a more direct and agile approach in tackling distressed assets. SEBI’s consultation paper outlines nuanced amendments, seeking streamlined operations and robust oversight for SSFs. However, these changes pose potential challenges, including increased administrative burdens and limitations on investment scope.
– Harsh Mittal & Sidhanth M K Majoo