Lessons for Recovery

Context: For extracting maximum value under Insolvency and Bankruptcy Code (IBC), Asset Reconstruction Companies (ARCs) must be allowed to turn around distressed businesses.

Overview of Asset Reconstruction Companies in India:

• First recommended by the Narasimhan Committee 1998: for purchasing Non-performing Assets (NPAs) from banks and financial institutions.
• Legal Framework: was created by the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, (SARFAESI) 2002 for establishing multiple private ARCs.

Challenges to the ARCs

• Low Recovery Rate:

• • • The RBI's Financial Stability Report (June 2019) indicates fairly low recovery for banks through the ARC model between 2004 and 2018. 
    • The maximum average recovery by ARCs as a percentage of total bank claims stood at 21.5% in 2010. Since then, it has steadily declined and reached 2.3% in 2018. 
    •  Such low recovery is likely the outcome of a resolution model heavily dependent on collateral disposal rather than genuine business turnarounds. 
• No incentives to turn around businesses: Absence of effective bankruptcy system in the past had required the ARCs to hand over the distressed business back to the original promoter once they had generated value to repay the debt.

• Limited role in insolvency resolution: An ARC can participate in resolutions under the Insolvency and Bankruptcy Code, 2016 (IBC) only if it partners with an equity investor, which is the resolution applicant. 

Way Forward: A Case for direct investment by ARCs in the equity of distressed companies:

• Better realization of the value of loans: when there are fewer bids in a bankruptcy auction, the value on loans is better realized if a bad bank (ARC) takes over the borrower and places the firm under new management.

• Stronger incentives: ARC as a private equity manager (shareholder) will have a stronger incentive than the creditors, ARC could hold more equity instead of debt in the resolved company.

• No limitations as against other domestic vehicles: None of the following limitation of investment vehicles applied to the ARCs -

• Alternative Investment Funds (AIF): While they can invest in debt as well as equity subject to certain limitations, they don't enjoy enforcement rights under the SARFAESI Act, 2002
• Non-Banking Finance Companies (NBFC): They enjoy the enforcement rights but are subject to provisioning norms for NPAs they purchase from banks.

Conclusion: If only ARCs are allowed to directly participate in IBC resolutions by infusing equity, they could emerge as the most efficient vehicle for turning around distressed Indian businesses.