Why Are Asset Reconstruction Companies In Trouble?

Some Asset Reconstruction Companies (ARC) landed in trouble after being accused of colluding with defaulters and indulging in fraudulent and unfair trade practices.

The Income Tax department has raided four asset reconstruction companies after it allegedly found irregularities at these companies.

What Went Wrong?

Simplistically put, an ARC’s business model involves buying bad loans from the banks at a low value, turning around the asset, and recovering the loan amount.

In return, it receives management fees, expenses reimbursement, and other incentives. It must also invest in security receipts of the asset, in order to have some skin in the game.

As a result, banks would free up significant capital and recover a part of their money. However, some players appear to have misused to system to benefit the owners of the assets that defaulted in the first place.

According to the Income Tax department, these companies received funds from the promoters of the companies that defaulted, and the minimum pay-outs to banks was made using the money received from the money received from promoters.

Further, the assets had been acquired at low valuations from the banks, according to the Income Tax department. The remaining money was transferred to the promoters under various guises such as consultancy fees.

In addition, in several cases, the assets were sold off by the previous promoters at extremely low prices.

While so far, only four ARCs have been raided by the I-T department, the situation does raise questions about how ARCs and promoters have managed to game the system together.

One of the ARCs that was raided had records of over Rs 850 crore in cash transactions. Ultimately, as a result of such transactions, banks have recovered a lower sum than they would have earned, had ARCs been honest.

In addition, by showing high costs, low income, and other fraudulent accounting, ARCs have saved on taxes as well.

Slowing Down The Resolution Process

Recently, a case saw a tussle between the defaulter and an ARC where the ex-Chairman of a large public sector bank was arrested. However, the ARC alleged that the defaulters were only trying to drag the case in order to receive their assets back.

RBI’s Suggestions To Improve ARC Performance

The RBI had constituted a committee to look into the functioning of ARCs. The data showed that between financial year (FY) 2004 and 2013, banks could recover only 14.29 per cent of the money owed to them through ARCs.

Between FY14 and FY21, the recovery rate has fallen further to 10.4 per cent. In addition, the committee highlighted that approximately, 80 per cent of the resolutions are happening through methods that do not necessarily revive the business.

Hence, the assets might not really be “reconstructed” in the true sense.

The report also highlighted the fact that an increasing proportion of banks have opted to use the Insolvency and Bankruptcy Code to resolve debt recovery issues.

The report highlighted that IBC has a time bound resolution procedure while ARCs don’t. In addition, the ARCs do not have a great track record of recovering money or reviving assets as well. For FY20, the amount of non-performing assets being resolved under IBC was higher than the NPAs amounts being handled by ARCs.

The central bank proposed that sponsors should own 20 per cent of the ARC as opposed to the current 10 per cent. According to the central bank, hiking the sponsor ownership would instill more confidence among other investors.

Other measures suggested by the RBI involved selling off loans before they turned into NPAs in order to aid recovery. The sale would be made in the special mention account (SMA) stage. Further in several cases, a few lenders would not agree with selling the loan to a particular ARC.

Hence, the RBI has suggested that if 66 per cent of the lenders agree to the ARC offer, the same decision would be binding to the other lenders as well. As a result, debt resolution would be over faster rather than being drawn out due to disagreements between lenders themselves.

Further, the committee recommended that certain investors be allowed to trade in security receipts and that the security receipts be publicly listed.

However, the RBI’s recommendations do not touch upon the subject of such problematic relationships between owners of defaulting assets and the ARCs. Such corporate governance issues could create problems for India’s banking system as it attempts to salvage its NPAs.

It remains to be seen whether these turn out to be one-off cases or a prevalent trend in the industry.