Role of Asset Reconstruction Company in the Insolvency Process

Introduction

In the 1990s, India’s banking sector witnessed a notable rise in Non-Performing Assets (NPAs) due to factors like economic slowdown, liberalization, and new lending practices.To address the increasing NPAs, the Indian government, following the Narasimham Committee II’s recommendations, introduced the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (“SARFAESI”) Act, 2002. The said act facilitated the creation of Asset Reconstruction Companies (ARCs) in India. ARCs are specialized financial institutions set up to acquire and manage the non-performing assets of banks and financial institutions, and they were established in India in 2003 under the SARFAESI Act, 2002.

With the intention of better value realization and to improve the efficiency of ARCs, the Reserve Bank of India (RBI) in terms of the recommendation given by Sudarshan Sen committee, issued the regulatory framework titled “Review of Regulatory Framework for Asset Reconstruction Companies (ARCs)” RBI/2022-23-128 on October 11, 2022. Through the said framework, RBI allowed the ARCs to be resolution applicant entities under the Insolvency and Bankruptcy Code, 2016 (“IBC”). The said framework marked as the revolutionary step in terms of the asset valuation of the Corporate debtor as it focused on enabling the ARC to function in a “more transparent and efficient manner”.

While the primary focus of Asset Reconstruction Companies (ARCs) has traditionally been on recovering bad debts, industry experts now anticipate a more proactive role for them. As the sector grows, ARCs are expected to take on a crucial role in reviving struggling companies at an early stage, which could significantly benefit India’s economy. This shift towards timely intervention will require regulatory support. The present article discusses the interplay between the new RBI Guidelines of 2024 and the evolving role of ARCs

Significance of ARCs in the resolution process

As forecasted, ARCs played vital role in the resolution process than acting merely as the recovery agent. ARCs brought specialized expertise in asset management and recovery. Unlike traditional banks, ARCs employed professionals with experience in turnaround strategies, legal frameworks, and sector-specific knowledge. This expertise enabled them to devise innovative resolution strategies, negotiate with stakeholders, and maximize recovery values. The role of ARCs proved to be indispensable in ensuring that the distressed assets are efficiently managed and productive resources are optimally utilized, ultimately contributed to overall economic growth. Following are the key advantages of including the ARCs as resolution applicants under IBC:

1. ARCs possess in-depth expertise in managing and resolving distressed assets, thus making it the best source for assets realization.
2. Due to high number of NOF, ARCs have the ability to customize resolution plans specific to the needs of each case, enhancing the likelihood of achieving coherent and mutually beneficial outcomes.
3. The ARCs, being are large firms are well equipped with the management which covers every aspect of the resolution process, thus their involvement ensures higher degree of governance in the resolution process.

New role of ARCs

ARC have primarily played a reactive role, focusing on recovering assets from non-performing assets (NPAs). With nearly 30 licensed ARCs currently operating in the country, this sector has seen significant growth since the Reserve Bank of India first introduced this licensing category. Now with the change in sector, it is expected that the ARCs play more proactive role in early detection of the distressed assets. At present, IBC only applies when businesses are struggling severely. However, with the evolving role of ARCs, the expectation is that they will intervene much earlier to prevent companies from reaching this critical stage. Consequently, in general parlance, ARCs comes into play when the assets of the company are termed as NPAs. While the model was satisfactory when it was first proposed, today ARCs can offer much more than simply reviving bad loans. With the proper setup, ARCs can gain much more by early identification of the assets from turning bad and subsequent repair them for maximum value. To prevent Companies from slipping into the vicious cycle of bad debts and loans, ARCs can use indicators and flags data to show lack of innovation, customer satisfactions, continue demands, future sustainability of the products etc as the early warning signs. By analyzing these warning signs and coordinating effectively with the bank, ARCs can play a more proactive role within the IBC framework.

Regulatory Framework and Future Directions

As the way to protect the interest stakeholders of the insolvency proceedings and to further strengthen and streamline the role of ARCs, RBI later in 2024 issued the Mater Direction on Asset Reconstruction Companies, 2024 (“Directions 2024”) RBI/DOR/2024-25/116. It is pertinent to mention that while the previous the RBI framework focused on the internal governance of the ARCs, this time the directions were elaborative and covered several aspects of the ARCs workings.

Following are the Checks and Balances provision mentioned in the Directions, 2024 to prevent Collusion.

1. Regulatory Oversight and Registration Requirements

• •  Stringent Registration Norms: The RBI requires ARCs to obtain a certificate of registration before commencing operations. This involves a thorough vetting process, including an assessment of the promoters’ background, the company’s financial strength, and its proposed business plan.
  • Continuous Monitoring: ARCs are subject to continuous monitoring and periodic inspections by the RBI to ensure compliance with regulatory norms and to detect any signs of malpractices, including collusion.

2. Governance and Management Controls

• • Fit and Proper Criteria: The RBI mandates that the directors and key management personnel of ARCs must meet the ‘fit and proper’ criteria, which includes assessments of their integrity, experience, competence, and financial soundness.
  • Independent Directors: ARCs are required to have a certain number of independent directors on their boards to ensure impartiality and to provide an external perspective on the company’s operations and decision-making processes.

3. Valuation and Acquisition Practices

• • Fair Valuation of Assets: The RBI has set guidelines for the fair valuation of NPAs to ensure that ARCs do not overpay or underpay for these assets, which could be a sign of collusion. As per the Directions, the valuation process should be uniform and is done in a scientific and objective manner.
  • Independent Valuation: The Directions provides provision for engaging independent valuers to assess the value of NPAs before acquisition. This prevents any manipulation of asset prices that could facilitate collusion.

4. Conflict of Interest Policies

• • Code of Conduct: ARCs must adhere to a strict code of conduct that prohibits any activities that could lead to conflicts of interest, including collusion with corporate debtors.
  • Whistleblower Mechanism: A robust whistleblower mechanism should be in place to allow employees and stakeholders to report any suspicious activities or potential collusion without fear of retaliation.

5. Regulatory Penalties and Sanctions

• • Penalties for Non-compliance: The RBI has the authority to impose penalties on ARCs for non-compliance with regulatory norms, including instances of collusion with corporate debtors.
  • Revocation of Registration: In severe cases of malpractice, including proven collusion, the RBI can revoke the registration of an ARC, effectively ceasing its operations.

6. Disclosure Requirements and Transparency

Transparency in operations is critical for ARCs to maintain trust with stakeholders and regulators. Key disclosure requirements include:

• • Annual Reports: ARCs must publish detailed annual reports that include financial statements, details of asset acquisitions, recoveries, and resolution strategies.
  • Periodic Filings: Regular filings with the RBI, including quarterly and half-yearly reports on operational metrics and financial performance

 Conclusion

The inclusion of ARCs as part of the resolution process has undoubtedly contributed to quicker and more effective company resolutions. By acting as resolution applicants, ARCs bring their specialized expertise in asset management, which helps in maximizing the recovery of distressed assets and improving governance during the resolution process. This shift from a reactive to a more proactive role is expected to significantly enhance the overall effectiveness of the insolvency framework in India.

As ARCs begin to intervene earlier, their ability to identify potential distress signs before assets turn non-performing can help prevent companies from entering the vicious cycle of bad debts and insolvency proceedings. This proactive approach can not only improve asset recovery but also reduce the economic burden of distressed businesses on the broader economy.

However, the success of this initiative will largely depend on the pecific policies and operational frameworks that each ARC establishes, particularly with regard to sectoral exposure limits and their ability to manage early-stage distressed assets. The regulatory changes outlined in the RBI’s Directions 2024 are a crucial factor in determining how effectively ARCs can perform their new role. These guidelines, which include stringent registration norms, transparency in operations, and conflict-of-interest policies, will ensure that ARCs operate in a sound and ethical manner, safeguarding the interests of all stakeholders involved in the resolution process.

Looking forward, it is essential for ARCs to effectively implement these regulatory directions, focusing not only on financial outcomes but also on ensuring fair, transparent, and efficient resolution procedures. If these guidelines are adhered to, ARCs can play a transformative role in India’s insolvency landscape, promoting faster economic recovery and enabling a healthier business environment for the future.

References

• The Securitisation and Reconstruction of Financial Assets And Enforcement Of Security Interest Act, 2002
• Insolvency and Bankruptcy Code, 2016
• RBI/2022-23/128 DoR.SIG.FIN.REC.75/26.03.001/2022-23.
• RBI/DOR/2024-25/116 DoR.FIN.REC.16/26.03.001/2024-25.
• Yash Gupta, Asset Reconstruction Company- A way ahead as a Resolution Applicant under IBC, IBC Laws.
• Report of the Committee to Review the Working of Asset Reconstruction Companies.
• Abhizer Diwanji and Srinath Sridharan, Asset reconstruction companies should change their orientation.