Asset Reconstruction Companies

The Indian banking system is reeling under a glut of Non Performing Assets (NPA’s). The unpaid debts of Indian corporations and households have risen to alarming levels.

High level bureaucratic meetings are being held to get rid of this menace. Nonperforming assets could appear on the balance sheet of banks.

This could cause a ripple effect as fears that one bank is unstable makes the entire banking industry unstable. Hence it is absolutely imperative that these bad debts be taken off the books immediately.

Asset reconstruction firms help banks to get these non performing assets off their books.

What do Asset Reconstruction Companies Do?

Asset reconstruction companies are in the business of buying bad loans from banks. For instance, if a bank lends money to a person or company, they expect to receive periodic payments of principal and interest.

However, when they do not receive those periodic payments for an extended period of time, (let’s say 90 days) these loans are classified as nonperforming assets. If these NPA’s are allowed to stay on the bank’s balance sheet, they erode investor confidence in the bank.

Hence, banks sell these bad loans to specialists called asset reconstruction companies. The business of these companies is to buy bad loans from banks at a steep discount.

These companies then take special measures to recover the money owed. If they are able to recover the money, they make a profit, if not they lose the money.

Regulation and Legality

For legal purposes, these entities are considered to be banking entities. Therefore the laws that apply to banking companies also apply to Asset Reconstruction Companies. Also, they are subject to the same regulation as banks are. Therefore they are also governed by the same regulators as banks are i.e. banking ombudsmen.

In the absence of proper law enforcement in India, there is a demand for separate legislation governing the functioning of ARC’s. This is because ARC’s are known to use strong arm tactics to recover debt from delinquent creditors.

How Reconstruction Companies Acquire Assets ?

Asset reconstruction companies acquire assets in a couple of ways. Each and every aspect of their operation including asset acquisition is closely monitored by the banking regulator.

• Raising Funds: ARC’s are allowed to raise funds from Qualified Institutional Buyers (QIB) in order to raise cash to make an upfront payment required to buy discounted debts.

  ARC’s could issue debt instruments or even sell equity to raise this cash. However, it is the responsibility of the ARC to ensure that retail investors are not investing their money in these instruments.

  ARC’s are high risk business and therefore only restricted to QIB’s that have the capacity to take such a loss.

• Partnership Model: Many times ARC’s do not directly buy debt from the banks. In such cases the debt remains on the banks books.

  However, the bank hires the ARC to perform debt recovery services. Revenues that are generated in this manner are split between the bank and the ARC according to a pre-determined percentage.

Complex Accounting Requirements

ARC’s have complex accounting requirements. This is because they buy debt from several parties. However, they are not allowed to pool in these debts together.

This means that they have to keep separate accounts for every lot of debt that they purchased. This is a regulatory requirement to protect the interests of investors who invest their money in ARC’s.

However, it also helps the ARC’s determine how much profit they made on which lot. This allows them to make better decisions while purchasing debt in the future.

Link between Securitization and Asset Reconstruction

In India, the process of taking debt off the balance sheets is called asset reconstruction. However, in other countries it is called securitization.

In essence, both these words mean the same thing. However, in India there are specialist companies that perform asset reconstruction. In developed countries like the United States, there are fewer restrictions on the sale of debt.

Hence debt can be sold to different types of corporate entities and even individuals.

Recourse in Case of Non Payment

Asset reconstruction companies have the same rights to recourse as banks do. This means that if the debt they are recovering is secured by an asset, they can take possession of the said asset after a reasonable period of time (usually 60 days).

On the other hand, if the debt is not secured, then the companies can file civil suits against the creditors to recover such debts.

Statute of Limitations

Asset reconstruction companies are also governed by an important statute in the contracts act. This is called the statute of limitations.

It governs which debts are collectible and which are not.

According to the statute of limitations, if a debt has not been paid off for three years then it is deemed uncollectible and the court will disqualify such a civil suit.

This has important implications for the Asset Reconstruction Company. It is because this puts an expiry date on the NPA’s that they buy.

If they are not collected during a three year period, these debts are simply worthless.

The closer the debts are to the three year mark, the deeper the discounts at which they are sold to the Asset Reconstruction Company.