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Banking and financial institutions are the backbones of finance sector of an economy. The well being of such institutions is extremely important for the capital to flow into the economy as their two-way functionalities i.e. accepting deposits and lending. These are the channels for capital flow. However, clogging of these channels endanger the entities of deposits and lending. Bad loans or non-performing assets is one of such problems which can endanger the very survival of the banking and financial institutions.
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 ( the SARFAESI Act, 2002) allows banks and other financial institutions (FIs) to auction residential or commercial properties (except agricultural lands) to recover loans.
Debt or asset securitisation is one of the booming and skilful approach which the financial sector has been witnessing. In asset securitisation, a financial institution grants individual loans and receivables thereby creating securities against such loans, get such securities evaluated and further selling them to the investor market. Thus, asset securitisation is a process of stimulating assets into securities and securities into ongoing and continuous liquidity, thereby enhancing the turnover of business and profits, while providing for flexibility in yield, pricing, pattern, size, risks and marketability of instruments.
The SARFAESI Act, 2002, allows the financial institutions (including banks) to recover the debt or dues accrued upon default in the loan granted to borrowers by such FIs, through the auction of such properties (residential and commercial except agricultural land), when borrowers fail to repay their loans as agreed on the stipulated terms and conditions while granting the loan. It empowers the banks and financial institutions to reduce their non-performing assets (NPA) by adopting measures for recovery or reconstruction.
Under the Act, upon default in the loan, banks and other financial institutions can seize the securities (except agricultural land). SARFAESI is an effective tool specifically where the loans are secured, thus, enabling the banks and FIs to enforce the underlying security which may have been secured by way of hypothecation, pledge and mortgage. On the flip side, the act does not apply to unsecured loans. However, in case of the asset in question is unsecured, the bank or the FI would have to take other civil recourse by filing a civil case against the defaulter(s) before a competent court.
What is a Non-Preforming Asset (NPA)?
A Non-Performing Asset (NPA) is a loan or advance for which the principal or interest or both payments remained overdue generally for a period of 90 days or as the scheme may suggest.
Banks generally classify NPAs further into Substandard, Doubtful and Loss assets.
- Sub-standard assets: Assets which has remained NPA for a period less than or equal to 12 months.
- Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
- Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”
Besides, Section 2 (1) (o) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, defines Non-performing asset as:
” an asset or account of a borrower, which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset, in accordance with the directions or under guidelines relating to asset classifications issued by the Reserve Bank”
Evolution of SARFAESI Act, 2002
Earlier, under various Central and State guidelines loans were granted to companies, industries being small, medium and large scale, etc. by banking and financial institutions. Growth in the market of banking is always directly proportional to lending which means, although the lending business was exponentially increasing as the banking sector was stretching its geographical limits, facilitation of lending loans kept growing with the same pace, simultaneously. This led to a rise in bad loans resulting in financial losses to the FIs. Hence, the banking sector faced a surge in success and survival, leading to an aggressive rise in NPA levels. This further led to the stagnation of public money in the market.
To curb the ongoing phenomenon, the Government introduced The Sick Industrial Companies Act, 1985 (SICA) with a view and propaganda to resolve the diminishing state of affair that the FIs were facing. Contrarily, the act rather aggravated the sole issue of a rise in NPA levels than curbing it.
In 1991, the Government then felt an immediate need to meet the emerging crunch of NPA and formed the First Narsimham Committee. Accordingly, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 was enacted to enhance and ensure speedy debt recovery to the financial institutions. The act, however, did not prove to be of great advantage due to lengthy legal processes as well as insufficient infrastructure provided to the Debt Recovery Tribunals.
In 1998, the Second Narsimham Committee was formed which recommended the legal reforms to equalize the pace with the change in the commercial practices. It further, recommended to formulate statues wherein the financial institutions should have powers to sale the asset without judicial intervention and reconstruction of assets. Transfer of doubtful or stressed or bad loans to Asset Reconstruction Company (ARC) was also recommended by the committee.
Both Narsimham committees proved to be of importance in the formulation of guidelines and legal reform to the banking and financial institutions, however, the act still had loopholes which resulted in the formulation of Andhyarujina Committee in 1991. The report suggested reforms in the then prevailing laws. It also recommended vesting of power with the banks to take possession of the mortgaged properties and then selling of the same without any judicial intervention.
However, still, the problem of NPA kept growing and the Government felt the need for an act to come in force to curb the NPA levels prevailing in the country. This led to the enactment of The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (the SARFAESI Act, 2002) which came into force on 21st June 2002.
Section 31 of the SARFAESI Act, provides with the provisions of this Act not to apply in a certain cases. Section 31 (i) specifically talks about non-applicability of the act in case of any security interest created in agricultural land.
However, in the matter of Sarif Abibi Mohmed Ibrahim vs Commissioner Of Income-Tax; AIR 1993 SC 2585, the Supreme Court held that:
“Whether a land is an agricultural land or not is essentially a question of fact. Several tests have been evolved in the decisions of this Court and the High Courts, but all of them are more in the nature of guidelines. The question has to be answered in each case having regard to the facts and circumstances of that case. There may be factors both for and against a particular point of view. The Court has to answer the question on a consideration of all of them a process of evaluation. The inference has to be drawn on a cumulative consideration of all the relevant facts.”
“if said land has been converted into NA and is used for residential purposes provisions of SARFEASI act would be applicable”
The SARFAESI Act gives detailed provisions for the formation and activities of Asset Securitization Companies (SCs) and Reconstruction Companies (RCs). Scope of their activities, capital requirements, funding etc. are given by the Act. The Reserve Bank of India (RBI) is the regulator for these institutions.
The Act covers the interests of secured creditors as a legal mechanism. Several provisions of the Act give directives and powers to various institutions to manage the issue of bad loans. Following are the main objectives of the SARFAESI Act:
- To provide the legal framework for securitization activities
- To give the procedures for the transfer of NPAs to asset reconstruction companies for the reconstruction of the assets.
- To enforce the security interest without judicial intervention
- To give powers to financial institutions including banks to take over the immovable property which has been hypothecated to enforce the debt recovery.
Pre-Conditions for Enforcement by Creditors
The Act stipulates four conditions for enforcing the rights by a creditor.
- The debt should be secured;
- The debt should have been classified as an NPA by the banks or FI as the case may be;
- For Banks, the outstanding dues should be Rs. 1 lakh above and more than 20% of the principal loan amount and interest. However, for Non-Banking Finacial Institutions (NBFC’s), the loan amount should be Rs. 50 lakhs and above thereon;
- The security to be enforced should not be an agricultural land.