EMPEA Legal & Regulatory Bulletin | FALL 2017 9

Introduction As India’s economy has grown, so has its stressed assets. Stressed assets, which comprise non-performing assets (NPAs), restructured loans, and written-off assets, account for about 16.6% of total loans, which is the highest level out of all major economies. This problem is acute in assets related to industries such as infrastructure, steel, iron, and cement. With the Indian government and the Reserve Bank of India (RBI) mandating Indian banks to clean their balance sheets and making efforts in bringing regulatory reforms in participation in the debt market and improving security enforcement process, foreign investors have patently made a bee-line to participate in the Indian distressed market through the use of investment vehicles. Today, there are 3 potential investment vehicles in India that foreign investors could choose from: (a) Alternative Investment Funds (AIFs), (b) Asset Reconstruction Companies (ARCs), and (c) Non-Banking Finance Companies (NBFCs). The decision on which vehicle to choose largely depends on 2 parameters: (a) the kind of instruments that foreign investors want exposure to, and (b) the level of control that foreign investors wish to exercise in identifying assets and their ultimate resolution.

AIF as a Debt Investment Vehicle and Key Considerations for Foreign Investor ParticipationAIFs: In 2012, the Indian securities regulator, the Securities and Exchange Board of India (SEBI), enacted regulations governing AIFs. AIFs are pooling vehicles (such as trusts, limited liability partnerships, companies and other body corporates) that can pool

Foreign Investment in Distressed Debt in India: What’s the Best Vehicle?By Ganesh Rao, Partner and Pallabi Ghosal, Senior Associate, with assistance provided by Nayan Banerjee, Associate, AZB & Partners

monies from both Indian resident and offshore investors for deployment in Indian and, to a limited extent, in foreign companies. Depending on the investment objective and strategy of the AIF, AIFs are categorized as Category I (venture capital, infrastructure, social venture, small and medium enterprise, and angel funds), Category III (primarily listed, hedge funds, complex structured products) and Category II (miscellaneous including debt and real estate funds) AIFs. A Category II AIF, being a debt fund, can invest primarily in debt securities (both listed and un-listed), most common being non-convertible debentures (NCDs). It cannot however provide loans. SEBI has adopted a light-touch approach in regulating AIFs and gives flexibility to AIF managers to operate AIFs. Pursuant to liberalization, foreign investors can now invest in AIFs without seeking any Indian governmental approvals. Typical models used by foreign investors today are as follows: (a) as passive investors, foreign investors’ capital is managed (along with other investors in the AIF pool) by a local partner who sources deals and decides which deals to invest in and divest from; (b) foreign investors work with a local partner to identify deals and the decision to invest or not is made by the foreign investor (the typical ‘separately managed account’ model); or (c) foreign investors enter into joint venture arrangements with the local partner/manager and jointly decide whether or not to make an investment and divestment.

Pros: If structured appropriately, using AIFs as a debt investment vehicle has a number of benefits, including: (a) under Indian income tax laws, Category II AIFs (including debt funds) have a ‘pass-through’ status i.e. the rate of tax payable by a foreign investor

is the same as what the foreign investor would have had to pay if the investment was made directly in the portfolio entity; (b) Category II AIFs are categorized as ‘Qualified Institutional Buyers’ (QIBs) and hence may be able to invest in security receipts (SRs) issued by ARCs (refer to section on ‘ARCs’); and (c) foreign investors can invest through the Category II AIF in listed and unlisted debt instruments which otherwise would require foreign investors to obtain a foreign portfolio investor (FPI) license and/or comply with RBI’s guidelines on external commercial borrowings, which could be onerous.

Cons: The key downsides to using a Category II AIF are as follows: (a) undertaking of leverage at the AIF level is restricted to only for meeting temporary funding requirements; (b) a Category II AIF is closed ended and has a limited life; and (c) a Category II AIF itself may have no special enforcement rights (refer to section on: “The Role of Insolvency and Bankruptcy Code, 2016 (IBC)”). Given the lack of enforcement rights, typically foreign investors use a combination of AIFs and ARCs and/or NBFCs.

Comparing Roles of ARCS and NBFCS: How Foreign Investors can ParticipateARCs: ARC is a registration that RBI gives to a company under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘SARFAESI Act’). ARCs can act as managers to securitization trusts that acquire distressed debt. The securitization trusts then issue security receipts (SRs) in relation to the underlying debt portfolio that the trust has acquired,which in turn may be subscribed to by QIBs.

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For the ARC to have skin in the game, they are required to subscribe (and hold until redemption) at least 15% of the SRs in each scheme. An ARC can acquire distressed debt portfolio in 2 ways: (a) by bidding in a public auction process; and (b) through bilateral arrangements between the holder of the debt and the purchaser. ARCs can acquire debt that meets a certain regulated grade of distress as prescribed by the RBI. Under the guidelines issued by the RBI, a bank offering stressed assets for sale shall offer the first right of refusal to ARCs which have already acquired the highest and at the same time a significant share (~25-30%) of the asset, for acquiring the asset by matching the highest bid. For undertaking such asset reconstruction, ARCs may charge management fees which are subject to limitations prescribed by the RBI.

Pursuant to liberalization, persons resident outside India can invest in the capital of ARCs up to 100% without seeking any approvals. However, the total shareholding of an individual FPI in an ARC should be below 10%, but if compliant with this requirement, an FPI can invest up to 100% of each tranche in SRs issued by ARCs. Despite liberalization, foreign investors still prefer partnering with local partners for participating in the debt portfolios of ARCs given that the local partners are better equipped to deal with regulatory and other demands on the ARC business.

NBFCs: An NBFC is a financial services company that is licensed by the RBI to operate in the Indian market. An NBFC is subject to the RBI mandated 50:50 test i.e. the company’s financial assets should be: (a) more than 50% of total assets (netted off by intangible assets); and (b) income from financial assets should be more than 50% of the gross income. NBFCs are broadly classified as deposit-taking or non-deposit taking and systemically or non-systemically important and depending on the classification, are required to maintain capital adequacy ratios prescribed by the RBI. Historically, NBFCs have been widely used as debt investment vehicles

A comparison table between ARCs and NBFCs is as follows:

CRITERIA ARCS NBFC (NON DEPOSIT TAKING)

Ease of structuring

Permitted to set up securitization trusts and issue SRs where the underlying asset is the financial asset and therefore, structuring returns to investors based on return on the underlying debt is relatively easy.

Not permitted to issue SRs, and therefore, alternative complex structures will need to be adopted in order to link the investor returns to the underlying debt.

Accounting Given that the ARC acquires the financial asset on the books of the trust, it does not have to make provisioning requirements on its own books for NPAs.

Given that the NBFC will be acquiring the financial assets in its own books, it will need to comply with provisioning requirements for NPAs.

Investment / loans

• Cannot give loans except to its own portfolio companies per regulations.

• Restricted options for investment by ARCs (e.g. government securities etc.).

Can invest in/give loan to companies which are not NPAs but distressed. This can help in turnaround of distressed companies.

RBI approval for change of management

Yes, for substantial changes of management (appointment of a director, managing director or CEO).

Yes for the following: (a) takeover or change of control (regardless of whether or not it results in a change of management); (b) the transfer of 26% of shares in the NBFC; or (c) a change of 30% of the board (excluding independent directors).

Stamp duty on acquisition of distressed debt portfolio

No (there is an exception under SARFAESI).

Yes.

Ability to borrow under the ECB guidelines

No, ARCs are not permitted to borrow under India’s ECB guidelines.

Yes, NBFCs are permitted to borrow under the ECB guidelines.

Tax implication Securitization trusts receive a complete tax pass through. The income is taxed in the hands of its investors. This would also apply to trusts set up by reconstruction companies or securitization companies for the purposes of the SARFAESI Act.

Dividends declared by NBFCs will be exempt in the hands of its shareholders, but the NBFC would be required to pay dividend distribution tax. Similarly, consideration paid by NBFCs to its shareholders pursuant to a share buy back would be exempt in the hands of its shareholders, but taxable in the hands of the NBFC.

Listing No current framework for listing of SRs. However, in its latest budget, the Indian government has allowed listing of SRs, and SEBI is expected to form guidelines for listing of SRs during the current financial year.

NBFCs can be listed

EMPEA Legal & Regulatory Bulletin | FALL 2017 11

primary because NBFCs are able to undertake a broad range of financial activities. However, up till now, NBFCs were not used for asset reconstruction due to lack of availability of powers under the SARFAESI Act. Pursuant to a recent notification, 196 NBFCs (having an asset size of INR 500 crores and above) have been notified as “financial institutions” and may, subject to certain restrictions, exercise rights given to ARCs under the SARFAESI Act. While the recent notification will likely give NBFCs greater power to be involved in the stressed assets industry, NBFCs (unlike ARCs) will not be able to issue SRs, thus restricting their ability to raise funds for acquiring financial assets. Foreign investment in NBFCs has been liberalized, and the earlier stipulations on capitalization by foreign investors, the quantum of existing foreign investment in the NBFC and the activity carried out by the NBFC have been done away with. Under the foreign direct investment policy, foreign investment of up to 100% is now permitted in NBFCs. However, foreign investment in NBFCs remains subject to regulations issued by financial sector regulators such as the RBI, the SEBI, and the Insurance Regulatory and Development Authority.

The role of Insolvency and Bankruptcy Code, 2016 (IBC) The provisions relating to corporate insolvency under the IBC were notified in December 2016. The IBC enables financial creditors (including ARCs and NBFCs to whom a financial debt is owed), operational creditors, or the company itself to initiate an insolvency resolution process. An application is made to the National Company Law Tribunal (NCLT) on a payment default of at least INR 100,000. Once the NCLT admits the application and

commences the insolvency resolution process, financial creditors assume control of the company. Financial creditors have a 180 day moratorium (extendable by 90 days) to effect a restructuring of the company, failing which the company is mandatorily liquidated. Unlike under the SARFAESI Act which enables creditors to enforce individual rights, the IBC is a collective insolvency procedure. Accordingly, once a process is commenced under the IBC, SARFAESI rights cannot be exercised as a moratorium is imposed on ‘any action to foreclose, recover or enforce any security interest’. The question that then arises is whether the IBC weakens the role of ARCs and NBFCs. For ARCs and NBFCs to be effective, they will need to enforce their rights under SARFAESI well before an insolvency is triggered under the IBC. Given that in most cases the company in question is on the verge of insolvency, it may be challenging to start and complete the SARFAESI process before IBC comes into play. However, the IBC is a new law that will take time to evolve and during this phase, SARFAESI tools should continue to be useful.

ConclusionFor foreign investors looking to access the Indian debt market, all 3 vehicles, i.e. AIFs, ARCs and NBFCs have their respective benefits depending on the kind of strategy that the foreign

investor investing in India has in mind. From an enforcement standpoint, an ARC may be more advantageous than an NBFC but both vehicles are expensive to establish, is time consuming and heavily regulated by the RBI. Further, ARCs have not been entirely successful in undertaking asset reconstruction largely because the purchase of debt has been expensive and significant cooperation is required from the shareholders and management of the company for the ARC to successfully undertake the reconstruction. Foreign investors will need to carefully analyse the nature of participation it would want in the debt portfolio before making a choice as to whether it wants to use one or a combination of debt investment vehicles for achieving desired results. It will also be critical to keep an eye on the evolution of the IBC in India and how successfully it is able to enforce rights of creditors.

About the Authors

Ganesh Rao is Partner at AZB & Partners

Pallabi Ghosalis is Senior Associate at AZB & Partners

“ Foreign investors will need to carefully analyse the nature of participation it would want in the debt portfolio before making a choice as to whether it wants to use one or a combination of debt investment vehicles for achieving desired results.