SPECIALIST OFFICER LAW STUDY MATERIAL ON SARFAESI ACT 2002

SARFAESI Act (The Securitization and Reconstruction of Financial Assets and Enforcement of Securities Act, 2002) was enacted to regulate securitization and reconstruction of financial assets and enforcement of security interest created in respect of Financial Assets to enable realization of such assets.

The SARFAESI Act provides for the manner for enforcement of security interests by a secured creditor without the intervention of a court or tribunal. If any borrower fails to discharge his liability in repayment of any secured debt within 60 days of notice from the date of notice by the secured creditor, the secured creditor is conferred with powers under the SARFAESI Act to

a) take possession of the secured assets of the borrower, including transfer by way of lease, assignment or sale, for realizing the secured assets

b) takeover of the management of the business of the borrower including the right to transfer by way of lease, assignment or sale for realizing the secured assets,

c) appoint any person to manage the secured assets possession of which is taken by the secured creditor, and

d) require any person, who has acquired any of the secured assets from the borrower and from whom money is due to the borrower, to pay the secured creditor so much of the money as if sufficient to pay the secured debt.

The Central Government has prescribed Security Interest (Enforcement) Rules, 2002 pursuant to the powers conferred on it under the SARFAESI Act. The foregoing enforcement measures must be exercised by a secured creditor in accordance with the Enforcement Rules and are further subject to guidelines issued by the RBI.

In exercise of powers conferred by SARFAESI Act, 2002, Reserve Bank of India has issued guidelines to registration, measures of asset reconstruction, prudential norms, acquisition of financial assets etc., namely 'The Securitisation Companies and Reconstruction Companies (Reserve Bank) Guidelines and Directions, 2003'. The Guidelines are available at the Downloads segment.  



Issues under the SARFAESI
Right of Title
A securitisation receipt (SR) gives its holder a right of title or interest in the financial assets included in securitisation. This definition holds good for securitisation structures where the securities issued are referred to as ‘Pass through Securities’. The same definition is not legally inadequate in case of ‘Pay through Securities’ with different tranches.
Thin Investor Base
The SARFAESI Act has been structured to enable security receipts (SR) to be issued and held by Qualified Institutional Buyers (QIBs). It does not include NBFC or other bodies unless specified by the Central Government as a financial institution (FI). For expanding the market for SR, there is a need for increasing the investor base. In order to deepen the market for SR there is a need to include more buyer categories.
Investor Appetite
Demand for securities is restricted to short tenor papers and highest ratings. Also, it has remained restricted to senior tranches carrying highest ratings, while the junior tranches are retained by the originators as unrated pieces. This can be attributed to the underdeveloped nature of the Indian market and poor awareness as regards the process of securitisation.
Risk Management in Securitisation
The various risks involved in securitisation are given below:
Credit Risk: The risk of non-payment of principal and/or interest to investors can be at two levels: SPV and the underlying assets. Since the SPV is normally structured to have no other activity apart from the asset pool sold by the originator, the credit risk principally lies with the underlying asset pool. A careful analysis of the underlying credit quality of the obligors and the correlation between the obligors needs to be carried out to ascertain the probability of default of the asset pool. A well diversified asset portfolio can significantly reduce the simultaneous occurrence of default.
Sovereign Risk: In case of cross-border securitisation transactions where the assets and investors belong to different countries, there is a risk to the investor in the form of non-payment or imposition of additional taxes on the income repatriation. This risk can be mitigated by having a foreign guarantor or by structuring the SPV in an offshore location or have an neutral country of jurisdiction
Collateral deterioration Risk: Sometimes the collateral against which credit is sanctioned to the obligor may undergo a severe deterioration. When this coincides with a default by the obligor then there is a severe risk of non-payment to the investors. A recent example of this is the sub-prime crisis in the US which is explained in detail in the following sections.
Legal Risk: Securitisation transactions hinge on a very important principle of “bankruptcy remoteness” of the SPV from the sponsor. Structuring the asset transfer and the legal structure of the SPV are key points that determine if the SPV can uphold its right over the underlying assets, if the obligor declare bankruptcy or undergoes liquidation.
Prepayment Risk: Payments made in excess of the scheduled principal payments are called prepayments. Prepayments occur due to a change in the macro-economic or competitive industry situation. For example in case of residential mortgages, when interest rates go down, individuals may prefer to refinance their fixed rate mortgage at lower interest rates. Competitors offering better terms could also be a reason for prepayment. In a declining interest rate regime prepayment poses an interest rate risk to the investors as they have to reinvest the proceedings at a lower interest rate. This problem is more severe in case of investors holding long term bonds. This can be mitigated by structuring the tranches such that prepayments are used to pay off the principal and interest of short-term bonds.
Servicer Performance Risk: The servicer performs important tasks of collecting principal and interest, keeping a tab on delinquency, maintains statistics of payment, disseminating the same to investors and other administrative tasks. The failure of the servicer in carrying out its function can seriously affect payments to the investors.
Swap Counterparty Risk: Some securitisation transactions are so structured wherein the floating rate payments of obligors are converted into fixed payments using swaps. Failure on the part of the swap counterparty can affect the stability of cash flows of the investors.
Financial Guarantor Risk: Sometime external credit protection in the form of insurance or guarantee is provided by an external agency. Guarantor failure can adversely impact the stability of cash flows to the investors.
 
 
Provisions of the SARFAESI Act
The Act has made provisions for registration and regulation of securitisation companies or reconstruction companies by the RBI, facilitate securitisation of financial assets of banks, empower SCs/ARCs to raise funds by issuing security receipts to qualified institutional buyers (QIBs), empowering banks and FIs to take possession of securities given for financial assistance and sell or lease the same to take over management in the event of default.
The Act provides three alternative methods for recovery of NPAs, namely:
  • Securitisation: It means issue of security by raising of receipts or funds by SCs/ARCs. A securitisation company or reconstruction company may raise funds from the QIBs by forming schemes for acquiring financial assets. The SC/ARC shall keep and maintain separate and distinct accounts in respect of each such scheme for every financial asset acquired, out of investments made by a QIB and ensure that realisations of such financial asset is held and applied towards redemption of investments and payment of returns assured on such investments under the relevant scheme.

  • Asset Reconstruction: The SCs/ARCs for the purpose of asset reconstruction should provide for any one or more of the following measures:
    • the proper management of the business of the borrower, by change in, or take over of, the management of the business of the borrower
    • the sale or lease of a part or whole of the business of the borrower
    • rescheduling of payment of debts payable by the borrower
    • enforcement of security interest in accordance with the provisions of this Act
    • settlement of dues payable by the borrower
    • taking possession of secured assets in accordance with the provisions of this Act.

  • Exemption from registration of security receipt: The Act also provides, notwithstanding anything contained in the Registration Act, 1908, for enforcement of security without Court intervention: (a) any security receipt issued by the SC or ARC, as the case may be, under section 7 of the Act, and not creating, declaring, assigning, limiting or extinguishing any right, title or interest to or in immovable property except in so far as it entitles the holder of the security receipt to an undivided interest afforded by a registered instrument; or (b) any transfer of security receipts, shall not require compulsory registration.
The Guidelines for SCs/ARCs registered with the RBI are:
  • act as an agent for any bank or FI for the purpose of recovering their dues from the borrower on payment of such fees or charges
  • act as a manager between the parties, without raising a financial liability for itself;
  • act as receiver if appointed by any court or tribunal.
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