sarfaesi act

Overview of Banking and Insurance Laws 687

The Securitisation and Reconstruction ofFinancial Assets and Enforcement of Security

Interest Act (SARFAESI Act), 2002The SARFAESI Act was enacted on 21st June 2002 keeping in mind the following issuesfaced by the Banking and Financial Sectors.

• The recovery problem faced by banks due to ever-growing non-performing assets(NPA)

• The inadequate legal framework for enabling banks in recovering bad loans whichare otherwise based on valuable collateral. The failure of the Debt Recovery Tribunal(DRT) to speed up the recovery process was also a reason for enacting theSARFAESI Act.

The SARFAESI Act aims to achieve these twin objectives besides providing for a broadlegal framework for asset securitisation and asset reconstruction.

Scheme of the ActThe Securitisation Act contains 41 sections in 6 Chapters and a Schedule. Chapter 1 contains2 sections dealing with the applicability of the Securitisation Act and definitions of variousterms. Chapter 2 contains 10 sections providing for regulation of securitisation andreconstruction of financial assets of banks and financial institutions, setting up of securitisationand reconstruction companies and matters related thereto. Chapter 3 contains 9 sectionsproviding for the enforcement of security interest and allied and incidental matters. Chapter4 contains 7 sections providing for the establishment of a Central Registry, registration ofsecuritisation, reconstruction and security interest transactions and matters related thereto.Chapter 5 contains 4 sections providing for offences, penalties and punishments. Chapter 6contains 10 sections providing for routine legal issues.

Salient features.

The salient features of the Securitisation Act are as under:

• Incorporation of Special Purpose Vehicles viz. Securitisation Company andReconstruction company.

• Securitisation of Financial Assets.• Funding of securitisation.• Asset Reconstruction.• Enforcing security interest i.e. taking over the assets given as security for the loan.• Establishment of Central Registry for regulating and registering securitisation

688 Corporate Laws and Secretarial Practice

transactions.• Offences & Penalties.• Boiler - plate provisions.• Dilution of provisions of SICA.• Exempted transactions

Incorporation & Registration of Special Purpose Companies

The Securitisation Act proposes to securitise and reconstruct the financial assets throughtwo special purpose vehicles viz. 'Securitisation Company ('SCO')' and 'ReconstructionCompany (RCO)'. SCO and RCO ought to be a company incorporated under the CompaniesAct,1956 having securitisation and asset reconstruction respectively as main object.

The Securitisation Act requires compulsory registration of SCO and RCO under theSecuritisation Act before commencing its business. Further a minimum financial stabilityrequirement is also provided by requiring SCO and RCO to possess owned fund of Rs.2crore or up to 15% of the total financial assets acquired or to be acquired. The RBI has thepower to specify the rate of owned fund from time to time. Different rates can be prescribedfor different classes of SCO and RCO. Existing SCO and RCO are also required to getregistered under the Securitisation Act. The application for registration will have to be madeto RBI.

The SCO or RCO which has obtained the registration certificate under the SecuritisationAct shall be a Public Financial Institution within the meaning of Section 4A of the CompaniesAct, 1956.

Besides it's core business of securitisation and asset reconstruction a SCO/RCO may performthe following functions:

• Acting as recovery agent on behalf of any bank or financial institution.• Acting as manager1 to manage the secured assets the possession of which has been

taken over by the secured creditor.• Acting as receiver if appointed by any Court or Debt Recovery Tribunal.

A SCOO or RCOO, which is carrying on any other business other than that of securitisationor asset reconstruction before commencement of the Securitisation Act, has to discontinuesuch other business within one year from the commencement of the Securitisation Act.

Securitisation of financial Assets

Under the Securitisation Act only banks and financial institutions can securitise their financialassets pertaining to NPAs with a securitisation company. Securitisation means, according tothe Securitisation Act, acquisition of financial assets by any securitisation company or


reconstruction company from any financial institution or banks. The necessary funds forsuch acquisition may be raised from 'qualified institutional buyers ('QIB')'2, by issuing securityreceipts3 representing undivided interest in such financial assets or other wise.

Financial assets are as under:

• A claim to any debt or receivables or part thereof, whether secured or unsecured.• Any debt or receivables secured by, mortgage of, or charge on, immovable property.• A mortgage, charge, hypothecation or pledge of movable property.• Any right or interest in the security whether full or part underlying such debt or

receivables.• Any beneficial interest in property, whether movable or immovable, or in such debts,

receivables, whether such interest is existing, future, accruing, conditional orcontingent.

• Any financial assistance.

The word "future" used in the above definition would indicate that debts which exist todayand repayable in future can also be securitized.

The much-needed legal framework for the securitisation of financial assets has been madeby the enactment of the Securitisation Act. Securitisation of financial assets is a financial toolfor the lenders to securitise their future cash flows from the secured assets and thus torelease their funds blocked in them. In the hands of the SCO and RCO the secured assetsbecome "merchandise", realisation of which gives them their return. This aspect brings in themuch-needed expertise in adept handling in realisation of the secured assets. The legalimpediments of normal civil law procedure to foreclose the mortgaged assets have thus beeneffectively removed by empowering the enforcement of the secured assets.

Securitisation of financial assets may take some time to fructify as it requires sound accountingprinciples also for which standards to be prescribed. In other words there should be accountingframework, as well, besides legal framework.

Acquisition of Rights and interests in financial assets.

This is the main part of securitisation. Section 5 provides for the acquisition of rights orinterests in financial assets of any bank or financial institution by SCO / RCO, notwithstandingany thing contrary contained in any agreement or any other law for the time being in force,in either of the following manner:

• Issuing a debenture or bond or any other security in the nature of debenture, asconsideration agreed upon by a SCO /RCO and bank/financial institution, incorporatingtherein the terms and conditions of issue.


• Entering into an agreement with bank/financial institution for the transfer of suchfinancial assets on such terms and conditions as may be agreed upon.

Upon acquiring the financial assets from the bank/financial institution, the SCO/RCO stepsinto the shoes of the lender qua the borrower. The Securitisation Act has provided for allnecessary rights and powers for SCO/RCO to realize the financial assets from the borrower.

Funding of Securitisation.The SCO/RCO may raise the necessary funds, for the acquisition of financial assets, fromthe QIB by issuing a security receipt. Security receipt is exempted from compulsory registrationunder the Registration Act. Security receipts issued by any SCO or RCO shall be "securities"within the meaning of Section 2(h)(ic) of the Securities Contracts (Regulation) Act, 1956.

A Scheme of acquisition has to be formulated for every acquisition detailing therein thedescription of financial assets under acquisition, the quantum of investment, rate of returnassured etc. Further separate and distinct accounts have to be maintained in respect of eachscheme of acquisition. Realizations made from the financial assets have to be held andapplied towards the redemption of investments and payment of assured returns.

In the event of non-realization of financial assets, the QIB holding not less than 75% of thetotal value of the security receipts issued, are entitled to call a meeting of all QIB and passresolution and every such resolution is binding on the SCO/RCO.

Assets ReconstructionA SCO or RCO may, according to the guidelines prescribed by RBI, carry out assetreconstruction in any one of the following manners:

• Taking over the management of the business of the borrower.• Changing the management of the business of the borrower.• Selling or leasing of a part or whole of the business of the borrower.• Rescheduling of the payment schedule of the debt.• Enforcing the security interest.• Entering into settlement with the borrower for the payment of debt.

However, the above measures are subject to the provisions contained in any other law forthe time being in force.

Enforcing Security Interest

The second objective of the Securitisation Act is to provide for the enforcement of securityinterest i.e. taking possession of the assets given as security for the loan. Section 13 of theSecuritisation Act contains elaborate provisions for a lender (referred to as 'secured creditor')to take possession of the security given by the borrower. The sum and substance of theprovisions are as under:


• The Lender has to send a notice of demand, giving details of the amount payable and thesecured assets5 intended to be enforced in the event of non payment, to the defaultingborrower to discharge his liabilities.

• No borrower, after the receipt of the demand notice, shall transfer the secured assets inwhatsoever manner without prior written consent from the lender.

• The Borrower has to discharge the liabilities within 60 days from the date of receipt ofnotice of demand.

• In the event of non payment of demand by the borrower, the lender may take any one ormore of the following measures:

o Taking possession and / or management of the secured assets of the borrower witha right to transfer the same by way of lease, assignment or sale for realising thesecured asset.

o Appointing any person as manager to manage the secured assets the possession ofwhich has been taken over.

o Asking any person, who has acquired any of the secured assets from the borrowerand owes money to the borrower, to pay so much of the money which is sufficient topay the secured debt.

• Any transfer of secured assets made by the lender shall be deemed to be made by theowner of such secured asset.

• If the borrower pays all the dues together with all costs, charges and expenses incurredby the lender before the date fixed for the sale of the secured assets, the lender shall nottransfer or sell the secured assets.

• When the are more than one lender or joint financing, the approval of lender(s) representingnot less than 75% of the amount due is required to take any steps to enforce the securityinterest and such approval is binding on all the lenders.

• In the case of a corporate borrower under liquidation the sale proceeds from the securedassets shall be distributed as per Section 529A of the companies Act, 1956.

• In the event of lender opts to realise his security instead of relinquishing his security andproving his debt, may retain the sale proceeds of his secured assets after depositing theworkmen's dues with the Liquidator.

• If the sale proceeds of the secured assets are not fully satisfying the debt due, the lendermay file a claim before the DRT or before a competent court for the recovery of theshortfall.

• The lender also has an option to proceed against any of the guarantors or sell the pledgedassets without taking any measures against the borrower.


• The lender can take the assistance of the Chief Metropoliton Magistrate or DistrictMagistrate, as the case may be, in taking possession of the secured assets from theborrower.

• If any person, including the borrower, is aggrieved by any of the measures adopted bythe lender, he may prefer an appeal to the DRT within 45 days by depositing atleast 75%of the claim of the lender. The decision of the DRT is further appealable to an AppellateTribunal.

• The lender can initiate any proceedings to enforce the security interest unless his claimof the financial asset is made within the period prescribed under the Limitation Act,1963.

Enforcement of security interest has taken a flying start. It is pertinent to mention here thatICCI (having NPA of Rs.6918 Crore) and IDBI (having NPA of Rs.13297 Crore) hasalready taken measures under the Securitisation Act, against 20 corporate houses, to enforcetheir security interest6. Many banks and financial institutions may follow suit.

Establishment of a Central Registry

The functions relating to securitisation, asset reconstruction and creation of security interestis sought to be administered and regulated by a Central Registry. Branch offices of theCentral Registry may be established as and when the need is required. A Central Registrarshall head the Registry. The functions of the Central Registry are as under:

• Particulars relating to securitisation of assets, reconstruction of financial assets andcreation of security interest are entered in a record called Central Register.

• The records can be kept in electronic form also i.e. in floppies, diskettes etc.

• The particulars of every transaction of securitisation, asset reconstruction or creationof security interest shall be filed within 30 days of the transaction by SCO, RCO orthe lender as the case may be.

• Modifications made in the security interest registered with the Registry are to befiled within 30 days of such modification.

• Satisfaction of security interest is required to be filed with the Registry within 30days of satisfaction.

• Records maintained at the Central Registry are open to inspection for any person onpayment of the prescribed fee.

Offences & Penalties

Following are the offences prescribed under the Securitisation Act:• " Default in filing particulars of transactions relating to asset securitisation, asset


reconstruction and creation of security interest.• Default in filing particulars of modification.• Default in giving intimation of particulars satisfaction.• Non-compliance of RBI directives by SCO and RCO.• Contravention, including attempt to contravene and abetting in contravention, of any

of the provisions of the Securitisation Act or any rules made thereunder.

Following are the penalties prescribed in the Securitisation Act:

• For default in filing particulars of transactions mentioned above, every company andevery officer of the company or every lender or officer of the lender shall be punishedwith a fine which may extend to Rs.5000/- for every day during which the defaultcontinues.

• For non-compliance of RBI directives every company and every officer of thecompany shall be punished with a fine which may extend to Rs.5, 00,000/-; and forcontinuing offence an additional fine of Rs.10, 000/- for every day during which thedefault continues.

• For contravention of any provisions of the Securitisation Act, the punishment isimprisonment for a term which may extend to one year, or with a fine, or with both.

Only a Metropolitan Magistrate or Judicial magistrate of the First Class has powers to takecognizance and try an offence under the Securitisation Act.

Boiler-plate Provisions

• The following are the general provisions of the Securitisation Act:

• The matters, over which DRT or Appellate Tribunal has jurisdiction under thisSecuritisation Act, shall not be tried by any Civil Court.

• The provisions of the Securitisation Act shall override the provisions of other laws orany instruments.

• However the provisions of the Securitisation Act are in addition to and not in derogationof the following enactments:

o The Companies Act, 1956.

o The Securities Contracts (Regulation) Act, 1956.

o The Securities and Exchange Board of India Act, 1992.

o The Recovery of Debts due to Banks and Financial Institutions Act, 1993.

• The Central Government has powers to make rules for carrying out the provisions ofthe Securitisation Act.


• Since the Central Registry is not yet established, the provisions relating to the CentralRegistry shall be applicable after the setting up of the Central Registry.

Dilution of provisions of SICA.The protective umbrella of registering with BIFR under Sick Industrial Companies (SpecialProvisions) Act 1985('SICA'), which has hitherto encouraged industrial sickness, has beenremoved by inserting two provisos in Section 15 of the SICA.they are as under:

• After the commencement of the Securitisation Act, where any SCO or RCO hasacquired financial assets, no reference shall be made to BIFR.

• After the commencement of the Securitisation Act, any pending reference beforeBIFR shall come to an end where secured creditors, representing not less than 75%of the value of the amount outstanding, have taken any measures to recover theirsecured debts under the provisions of the Securitisation Act.

Exempted transactions

• The following transactions are exempted from the provisions of the SecuritisationAct:

• Lien on any goods, money or securities given under the Contract Act,1872.

• Pledge of movables under the Contract Act,1872.

• Creation of security on aircraft.

• Creation of security interest on vessel.

• Conditional sale, hire-purchase or lease in which no security interest is created.

• Rights of unpaid seller under the Sale of Goods Act,1930.

• Non attachable properties under the civil Procedure Code.

• Security interest on an amount less than or equal to Rs.1 lakh.

• Security interest created on agricultural land.

• Amount due is less than 20% of the principal sum and interest thereon.

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