As an anticipated measure for the banking and financial sector, the Reserve Bank of India (RBI) has, towards the close of past week, issued the comprehensive framework for the sale or transfer of loan assets. Taking immediate effect from the date of its issuance, the framework titled ‘Master Directions - Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021’ issued vide circular DOR.STR.REC.52/21.04.048/2021-22 dated September 24, 2021 (the ‘Master Directions’) is being seen as a pivotal move by the Regulator towards introducing an efficient secondary market for loans and ensuring proper credit-risk pricing, besides improving transparency in the identification of embryonic stress in the banking system as well as resolution of stressed loan exposures.
The Master Directions owes its genesis to the ‘Draft Framework for Sale of Loan Exposures’ which was released by RBI in course of the first COVID-19 induced lockdown in the Country. The draft had taken into consideration the recommendations of the ‘Task Force on Development of Secondary Market for Corporate Loans’ constituted by RBI under the chairmanship of Mr. T.N. Manoharan in May, 2019 and comments from the stakeholders were invited. One of the key components of the Task Force’s recommendation was to separate the regulatory guidelines for direct assignment transactions from the securitization guidelines and treat it as a sale of loan exposure. The RBI had, accordingly, reviewed the recommendations and thought it prudent to comprehensively revisit the guidelines for sale of loan exposures, both standard as well as stressed, which were earlier spread across various circulars. The erstwhile guidelines or circulars on sale of loan exposures were particular to the asset classification of the loan exposure being transferred and / or the nature of the entity to which such loan exposure is transferred as well as the mode of transfer of the loan exposures. The need for a review also stemmed from the necessity to dovetail the guidelines on sale of loan exposures with the Insolvency and Bankruptcy Code, 2016 (‘IBC’) and the Prudential Framework for Resolution of Stressed Assets dated June 7, 2019 (“Prudential Framework”), which has witnessed substantial traction and developments towards building a robust resolution paradigm in India in the recent past.
The consolidation by RBI of a self-contained, comprehensive, and independent set of regulatory guidelines on transfer/sale of loan exposures is being seen as a laudable step in the direction of putting together a ‘robust secondary market in loans which can be an important mechanism for management of credit exposures by lending institutions and also create additional avenues for raising liquidity’. This write-up attempts to briefly summarize some key components of the Master Directions.
The Master Directions whilst superseding a host of existing circulars/directions (or a portion thereof) in relation of transfer of loan exposures (Chapter VI), has put forth a unified and singular framework for the sale of loan exposures by banks and other financial institutions. The exhaustive breadth of the framework is quite evident from the Chapters under the Master Directions which not only provide for ‘General Conditions applicable to all Loan transfers’ (Chapter II), but also cater specifically to transfer of loan exposures of standard assets (Chapter III) as well as stressed loan exposures (Chapter IV), including their respective and intrinsic modalities. The framework concludes with the imperative of ‘Disclosures and Reporting’ (Chapter V) and stipulates the mechanism for the stakeholders in that regard.
On expected lines, nearly all constituents of the Financial sector regulated by RBI are mandated to ensure compliance to the Master Directions, both as a transferor as well as transferee of the loan exposures – Scheduled Commercial Banks, all NBFCs (including HFCs), Regional Rural Banks, Co-operative Banks, All India Financial Institutions and Small Finance Banks. In addition, the Master Directions also permits asset reconstruction companies (ARCs) and companies (save a financial service provider) to be ‘transferees’ of the loan exposures only if the same is pursuant to the resolution plan under the Prudential Framework and if they are permitted to take on loan exposures in terms of a statutory provision or under the regulations issued by a financial sector regulator.
It would be pertinent to take note that though all lenders permitted to acquire loans are required to ensure compliance to the extant Master Directions; yet, the acquisition of loans pursuant to securitization are required to be independently dealt under the provisions of RBI’s ‘Master Directions – RBI (Securitization of Standard Assets) Directions, 2021’ dated September 24, 2021 (the ‘Securitization Guidelines’). The coverage of the Master Directions includes transfer of loan exposures through novation, assignment, or risk participation. In cases of loan transfers other than loan participation, legal ownership of the loan shall be mandatorily transferred to the Transferee to the extent of economic interest transferred under the loan exposures.
For the Transferees which are financial sector entities (not falling under clause 3 of the Master Directions) and the ARCs, the prudential norms (asset classification, provisioning norms etc.) of their respective sectoral regulators (SEBI, IRDA, PFRDA etc.) shall be applicable post-acquisition of loan exposure under the Master Directions.
Before venturing into the other nuances, it is an imperative that one accounts for the understanding of some key ‘constructs’ which cut across the Master Directions:
* Transfer: Quite apparently, the expression denotes the process of transfer of the economic interest in a loan exposure by the transferor and acquisition of the same by the transferee. The subject matter of transfer being the ‘economic interest’ of the transferor in the loan exposure, it is important that the risks and rewards associated with loans are clearly demarcated and separated in favour of the transferee; especially when some portion of the economic interest in the loan exposure is retained by the transferor.
It is significant to take note that the transfer of the said economic interest can be with or without the transfer of underlying contract. Essentially, even loan participation transaction have also been recognized under the Master Directions (for transfer of standard loans) wherein the transferor transfers all or part of its economic interest in a loan exposure to transferee without the actual transfer of the loan contract, and the transferee(s) fund the transferor to the extent of the economic interest transferred which may be equal to the principal, interest, fees and other payments, if any, under the transfer agreement.
* Transferor: Often referred as ‘assignor’ (in assignment transactions) or ‘grantor’ (for risk participation), transferor under the Master Directions would include Clause 3 entities which transfer their economic interest in the loan exposures.
* Transferees: These refer to entities in whose favour the economic interest in the loans are transferred and would include Clause 3 entities as well as the ARCs/companies to the extent permitted under the Master Directions. It is clarified that the transferee should neither be a person disqualified under the IBC nor, in cases of loan exposures where frauds have been identified, belong to an existing promoter group of the borrower or its subsidiary / associate / related party etc. (domestic as well as overseas).
v Minimum Holding Period (MHP): As the expression suggests, the MHP refers to a threshold period for which the transferor should hold the loan exposures, along with its risks and rewards, before the economic interest in respect thereto is transferred. The intent of having a MHP is to ensure that the loan has been seasoned in the books of the originator (or the transferor) for a certain specified time period. The MHP for loans with tenor up-to 2 years and more than 2 years, as per the Master Directions, have been capped at 3 months and 6 months, respectively.
The holding period for the Transferor, in case of secured exposures, is to be computed from the date of registration of the underlying security interests; unless, of course, the loan is unsecured in which case the MHP runs from the date of first repayment under such unsecured exposure. However, in case of project loans, the foregoing months of MHP is required to be calculated from the date of commencement of commercial operations of the project being financed. Besides, the loans acquired by the Transferor itself are required to have a MHP of at-least 6 months from the date of acquisition of the loan on the books of the Transferor, irrespective of the tenor of the loan exposures.
It would be of significance to note that the MHP criteria prescribed under the Master Directions do not apply for loans transferred by an arranging bank under a syndication arrangement.
* Permitted Transferees: These include (i) Scheduled Commercial Banks, (ii) NBFCs (including HFCs), (iii) All India Financial Institutions and (iv) Small Finance Banks. The significance of carving out the foregoing financial sector entities from Clause 3 of the Master Directions lies in the fact that the transferor is permitted to transfer its loans (which are not in default) to permitted transferees only through novation, assignment, or loan participation. For the stressed exposures, the transfer is mandated only to such permitted transferees and ARCs and singularly through assignment or novation of such loan exposures.
The finer nuances of the Master Directions would certainly surface once the provisions have been widely given effect to by the stakeholders; however, as it stands, the framework undoubtedly promises to streamline the procedures and requirements for the stakeholders considering transfer of their loan exposures – standard as well as stressed. Some fundamental provisions of the Master Directions have been summarized as below:
* Overarching Transfer conditions: Quite categorically, the Master Directions stresses on the necessity of delineation of Transferor’s ‘risks and rewards’ associated with the loan exposures to the extent of the transfer. In fact, it is stated that not only should the transferee have the unrestrained and unconditional entitlement to transfer or dispose of the loans to the extent of economic interest acquired by it, but also in the event of any economic interest in the loan exposure is retained by the transferor, the loan transfer agreement should demarcate the distribution of the principal and interest income from the transferred loan between the transferor and the transferee. The Master Directions also caution against any modification of terms of the underlying financing agreement and require that any change, in course of such transfer, should withstand the test of not being categorized as ‘Restructuring’ under the Prudential Framework. It would be significant to take note that the transfer of loan exposures under the Master Directions not only should be without recourse to the Transferor, but also the transferor or transferee should not be constrained to obtain consent from the transferee/ transferor, as the case may be, in the event of resolution or recovery in respect of the beneficial economic interest retained by or transferred to the respective entity. In addition to the foregoing, the Master Directions also prescribe for the enumerated conditions applicable to all transfers of loan exposures:
(i) The Transferor shall have no obligation to re-acquire or fund the re-payment of the loans or any part of it or substitute loans held by the Transferee or provide additional loans at any time;
(ii) If the security interest is held by the Transferor in trust with the Transferee as the beneficiaries, the Transferee shall ensure that a mutually agreed and binding mechanism for timely invocation of such security interest is put in place;
(iii) Any rescheduling, restructuring or re-negotiation of the terms of the underlying agreement attempted by Permitted Transferee, after the transfer of assets to the transferee, shall be as per the Prudential Framework;
(iv) The Clause 3 entities, regardless of whether they are transferors or otherwise, should not offer credit enhancements or liquidity facilities in any form in the case of loan transfers.
In case the transfer of loan exposures which are not compliant with the requirements mentioned in the Master Directions, the onus is on the Transferee to maintain capital charge equal to the actual exposure acquired and the Transferor is required to treat the transferred loan in its entirety, as if it was not transferred at all in the first place, and the consideration received by it shall be recognized as an advance.
* Board-approved Policy: The Transferors are mandated to put in place a comprehensive Board-approved policy for transfer and acquisition of loan exposures under the Master Directions. These guidelines must, inter alia, lay down the minimum quantitative and qualitative standards relating to due diligence, valuation, requisite IT systems for capture, storage and management of data, risk management, periodic Board level oversight, etc. Further, the policy must also ensure the independence of functioning and reporting responsibilities of the units and personnel involved in the transfer/acquisition of loans from that of personnel involved in originating the loans.
* Transfer of Standard Assets: The transfer of loan exposures classified as ‘standard’ can be undertaken through the mechanisms of assignment or novation or a loan participation. The transfer of such loan exposures should be only on a cash basis to be received at the time of transfer of loans; besides, the requirement of the transfer consideration being arrived at in a transparent manner on an arm's length basis. The Master Directions require the Transferees to monitor, on an ongoing basis and in a timely manner, the performance information on the loans acquired, including through conducting periodic stress tests and sensitivity analyses, and take appropriate action required, if any. Further, the Transferor’s retention of economic interest, if any, in the loans transferred should be supported by legally valid documentation supported by a legal opinion.
The requirements of Chapter III of the Master Directions are, however, not applicable to certain identified loan transfers, as below:
(i) transfer of loan accounts of borrowers by a lender to other lenders, at the request/instance of borrower;
(ii) inter-bank participations as per the RBI’s circulars;
(iii) sale of entire portfolio of loans consequent upon a decision to exit the line of business completely;
(iv)sale of stressed loans; and
(v)any other arrangement/transactions, specifically exempted by the RBI.
* Minimum Risk Retention: The Master Directions are explicit in their requirement of the requisite due diligence in respect of the loans exposures and mention that the said exercise cannot be outsourced or delegated by the Transferee. In order to ensure a systemic departure from the conventional practice of placing solitary reliance on the due diligence of the originator (or the Transferor), the Master Directions mandate the Transferee to undertake the due diligence of the loan exposures through its own staff, at the level of each loan, and as per the same policies as would have been done had the Transferee been the originator of the loan. In case the due diligence of entire portfolio is undertaken by the Transferee, the requirement of a minimum retention requirement (MRR) of the Transferor can be dispensed with.
However, in case of loans proposed to be acquired as a portfolio, if a transferee is unable to perform due diligence at the individual loan level for the entire portfolio, the Transferor shall retain at least 10% of economic interest in the transferred loans as MRR. In such a case as well, the Transferee is required to undertake due diligence at the individual loan level for not less than one-third (1/3rd) of the portfolio by value and number of loans in the portfolio. As per the Master Directions, in case of multiple Transferees, the MRR would still be on the entire amount of transferred loan, even if any one of the transferee is unable to perform the due diligence at an individual level.
* Transfer of Stressed Assets: Chapter IV of the Master Directions deals specifically with the transfer of stressed loan exposures to ARCs and other Permitted Transferees. It is specifically stated that the mechanism for transfer of such stressed accounts can be consummated only through assignment or novation. Besides the requirement of a Board-approved policy for transfer as well as acquisition of stressed loan exposures and the parameters thereof, the Master Directions mandate such transfers to ARCs and other Permitted Transferees only. Importantly, the Transferor is necessarily required to undertake an auction through a ‘Swiss Challenge method’ both in cases where (i) the aggregate loan exposure to be transferred is Rs. 100 crore or more after bilateral negotiations; and even under (ii) a transfer pursuant to the Resolution Plan approved in terms of the Prudential Framework (irrespective of the monetary threshold).
The transfer of such stressed loan exposures, as per the Master Directions, should be bereft of any operational, legal or any other type of risks relating to the transferred loans including additional funding or commitments to the borrower / transferee. In fact, it is specifically required for the transferor to ensure that no transfer of a stressed loan is made at a contingent price whereby in the event of shortfall in the realization of the agreed price, the Transferor would have to bear a part of the shortfall.
In addition, the Transferor is required transfer the stressed loans to transferee(s) other than ARCs only on cash basis and the entire transfer consideration should be received not later than at the time of transfer of loans. The stressed exposure can be taken out of the books of the Transferor only on receipt of the entire transfer consideration.
Quite significantly, the Master Directions prescribed that if the Transferee of such stressed loan exposure (except ARCs) have no existing exposure to the borrower whose stressed loan account is acquired, the acquired stressed loan shall be classified as “Standard” by the transferee. However, in case the Transferee has an existing exposure to such borrower, the asset classification of the acquired exposure shall be the same as the existing asset classification of the borrower with the Transferee, irrespective of whether such acquisition is pursuant to the transferee being a successful resolution applicant under the IBC.
Further, the Master Directions require the Transferee to hold the acquired stressed loans in their books for a period of at least 6 months before transferring to other lenders; however, such holding period is not applicable in case the transfer of stressed loan exposure is to an ARC or is pursuant to a resolution plan approved in terms of the Prudential Framework.
As regards the mandate of undertaking the ‘Swiss Challenge method’ is concerned, the Master Directions require the lenders put in place a Board-approved policy which should, interalia, specify the minimum mark-up over the base-bid required for the challenger bid to be considered by the lender(s), which in any case, shall not be less than 5% and shall not be more than 15%. However, for transfer of stressed exposure under the Prudential Framework, the minimum mark-up over the base-bid required for the challenger bid is to be decided with the approval of signatories to the ICA representing 75% by value of total outstanding credit facilities and 60% of signatories by number.
Additionally, the Master Directions provide for sharing of surplus between the ARC and the Transferor, in case of specific stressed loans; though, the clarity in respect of such specific stressed loans is not mentioned. The repurchase of stressed loan exposures is also stipulated from the ARCs in cases where the resolution plan has been successfully implemented
* Accounting: In the event the transfer of loan exposures results in loss or profit, which is realized, the same should be accounted for and, accordingly, reflected in the P&L account of the Transferor for the accounting period during which the Transfer is consummated. However, the unrealized profits (if any) arising out of such Transfers, shall be deducted from the Common Equity Tier 1 (CET 1) capital or net owned funds of the Transferor for meeting regulatory capital adequacy requirements till the maturity of such transferred exposures. The Master Directions prescribe maintenance of borrower-specific accounts both by the Transferor as well as the Transferee of the retained and transferred loan exposures, respectively. It has been further clarified that the extant requirements of RBI for ‘income recognition, asset classification, and provisioning’ shall, accordingly, be ensured by the transferor and the transferee with respect to their respective shares of holding in the underlying loan exposures.
Though it would be quite nascent to present an analysis of the Master Directions even before it has been actually implemented, yet there are indeed some crucial aspects which underline the significance of the Master Directions issued by RBI which can be summarized as follows:
*Identification and Resolution of Stressed Exposures: Though quite a premature assessment, yet it is felt that the framework under Master Directions could facilitate the development of a robust distressed asset ecosystem and speed-up the resolution of various stressed exposures, which could be driven by the ensuing characteristics of the Master Directions:
(i) Early Identification and Resolution of Stressed Exposures: The framework has expanded the definition of stressed exposures (‘stressed loans’) to include both non-performing assets (NPAs) and special mention accounts (SMAs). Also, the deregulation of the price discovery process will enable faster and more efficient pricing of exposures – especially when coupled with a wider range of eligible investors.
(ii) Enhanced Viability of Stressed Asset Takeover Structures: More importantly, the Master Directions allow investors in stressed assets to classify the exposure as standard, although subject to any other exposure to the same entity on the investor’s books not being sub-standard on the date of the acquisition of the asset. This could significantly lower capital charge and provisioning requirements for the acquirer/investor of the stressed assets. Given that most stressed assets are restructured as well – often including a complete management overhaul, the rationalization of the capital charge and provisions could make such assets more attractive to prospective acquirers.
*Impetus to Long-Term Funding structures: The Indian credit markets have for long been bereft of avenues for mobilizing capital through long-term debt instruments. As a result, liability structures for corporate borrowers in sectors such as power generation and roads front load cash outflows during the project life. This, at least in part, reflects the non-availability of long-dated liabilities for the financial sector. Therefore, an ecosystem which allows lenders to off-load long-dated exposures after a certain time period with reasonable foresightedness could enable borrowers to raise long-term debt instruments from the financial system in a cost-efficient manner.
*Independent Credit Evaluations Could Prove Critical: The Master Directions mentions that transferees may have the loan pools rated before acquisition so as to have a third-party view of their credit quality in addition to their own due diligence; though, the latter is a mandatory requirement and cannot substitute for the due diligence that the transferee(s) are required to perform. Also, in case of transfer of stressed assets, it becomes critical to ensure that the valuation of the exposure and associated risk capital allocation are based on an assessment of the asset to meet its contractual debt obligations. Even restructured accounts have subsequently come under stress in some cases due to fundamental weaknesses in the business profile, heightened management risk/weak governance structures and unsustainable debt levels even after restructuring. Though not prescribed as a mandatory requirement under the Master Directions, yet a third-party evaluation by a credit rating agency could provide an added layer of assessment and valuations for such exposures along with subsequent capital charge and provisioning norms could be linked to the outcome of such evaluation.
Aditya Bhardwaj, Associate Partner, Link Legal.
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Disclaimer: The contents of this article are for general information and discussion only and is not intended for any solicitation of work. This article should not be relied upon as a legal advice or opinion.