SECURITISTAION MARKET IN INDIA: NEED FOR NEW GUIDELINES FOR THE DEVELOPMENT OF THE MARKET

Abhishek gupta* & Anand Kumar**

INTRODUCTION

Securitisation is a process through which illiquid assets are transferred into a more liquid form of assets and distributed to a broad range of investors through capital markets. The lending institutions assets are removed from its balance sheet and are instead funded by investors through a negotiable financial instrument. The security is backed by the expected cash flows from the assets. The Securitisation market in India got its presence in the year 1990 but after 1999 it got developed. Today, this market needs some alternation in certain laws which became outdated with the passage of time thereby hindering the further development of securitisation market in India. Thus, there is need of amendment in the existing laws of the land such as Income Tax Act, Stamp Act, Transfer of Property Act, Indian Registration Act, to get function the securitisation market smoothly. In addition, bringing of new guidelines in this realm would provide additional advantage to securitisation market in India, which is indeed required. In the current market scenario a number of new issues infected the market for asset securitisation. The outcome is that the securitisation sphere has still not realised its full potential and there is need for new guidelines for the development of securitisation market of India.
I. UNDERSTANDING THE CONCEPT OF SECURITIZATION

Securitisation is the process of pooling and repackaging of homogenous illiquid financial assets into marketable securities that can be sold to investors.1Through it illiquid assets are converted into tradeable security with a secondary market.2 It is measure of replenishing the funds by recourse to the secondary market.3 Thus the securitization is not just a funding device or an
1

*Student 5th Year, B.A.LLB (Hons.), Hidayatullah National Law University, Raipur. The author can be reached at abhishekhnlu@gmail.com. **Student 5th Year, B.A. LLB (Hons.), Dr. Ram Manohar Lohia National Law University, Lucknow. See, only new guidelines can help Securitisation Market Grow, available at <http://economictimes.indiatimes.com/markets/analysis/Only-new-guidelines-can-help-securitisation-marketgrow/articleshow/2575436.cms, last accessed on 8th August, 2010. 2 See, ML Tannan, Tannans Banking Law and Practice in India, 22ndedition (Lexis Nexis Butterworths Wadhwa, Nagpur 2008) p. 2127. 3 See, Mardia Chemicals Ltd vs. Union of India (2004) 4 SCC 311.

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alternative to secured funding; it is a newfound way of lending a tradable character to business relationships, not limited to financial relationships.4
II. PARTIES INVOLVED IN THE PROCESS

There are primarily three parties to a securitization deal, namely5 a. Originator: It is the entity on whose books the assets to be securitized exist. It sells the assets on its books and receives the funds generated from such sale. In a true sale, the Originator transfers both the legal and the beneficial interest in the assets to the SPV.6 b. Special Purpose Vehicle (SPV): The issuer also known as the SPV is the entity that would typically buy the assets (to be securitized) from the Originator. It plays a very crucial role in as much as it holds the assets in its books and makes the upfront payment for them to the Originator and thereby removes the assets from the balance sheet of the Originator.7 c. Investors: The investors may be in the form of individuals or institutional investors like FIs, mutual funds, provident funds, pension funds, insurance companies, etc. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern.8
III. PROCESS OF SECURITIZATION

Fundamentally, there are four steps in a securitization process:9 a. Special Purpose Vehicle (SPV) is created to hold title to assets underlying securities; b. The transferor company is called the "originator" because it usually originates the assets sells the assets (existing or future) to the SPV; c. The SPV, with the help of an investment banker, issues securities which are distributed to investors; and d. The SPV pays the originator for the assets with the proceeds from the sale of securities. A securitization transaction generally involves some or all of the following parties:
4

See, Vinod Kothari, Securitisation Asset Reconstruction and Enforcement of Security Interests, 2nd Edition, (Wadhwa & Company, Nagpur), 2007, p. 5. 5 See, Rajkumar S Adukia, Securitization an Overview, available at <http://www.icai.org/resource_file/10465feb05978-985.pdf,> last accessed on March 17, 2010. 6 See, Justice B. P. Banerjee, Guide to Securitisation Reconstruction of Financial Assets & Enforcement of Security Interests, Act, 2002(Law & Practice), First edition, (Wadhwa Nagpur), p. 416. 7 See, ibid. 8 See, Ibid. 9 See, Ibid at p. 411.

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(i) The initial owner of the asset (the originator or sponsor) who has a loan agreement with the borrowers (obligors); (ii) The issuer of debt instruments who also is the SPV. The structure keeps the SPV away from bankruptcy of the originator, technically called bankruptcy remote; (iii) The investment bankers who assist in structuring the transaction and who underwrite or place the securities for a fee; (iv)The rating agencies that assess credit quality of certain types of instruments and assign a credit rating; (v) The credit enhancer, possibly a bank, surety company, or insurer, who provides credit support through a letter of credit, guarantee, or other assurance; (vi)The servicer, usually the originator, who collects payments due on the underlying assets and, after retaining a servicing fee, pays them over to the security holders; (vii) The trustee, who deals with issuer, credit enhancer and servicer on behalf of the security holders; 10 (viii) The legal counsel, who participates in the structuring of the transaction; and (ix) The swap counterparty that provides interest rate / currency swap, if needed. Rating Agency

Borrowers

Lender (Originator/Servicer)

Consideration SPV Issuer

Assigns Loans

Trustee

ABS

10

See, Report of the In-House Working Group on Asset Securitisation, available at <http://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/10788.pdf > last accessed on 17 March 2010.

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Investors

IV.

SECURITISATION MARKET IN INDIA

The development in the Indian securitisation market has been largely come by retail assets and residential mortgages of banks and FIs. This market has been in existence since the early 1990s, though has matured significantly only post-2000 with an established narrow band of investor community and regular issuers.11 According to Industry estimates, the structured issuance volumes have developed considerably in the last few years; yet still small compared to international volumes.
A. MARKET PARTICIPANTS

In India, issuers have usually been private sector banks, foreign banks and non-banking financial companies (NBFCs) with their original assets being mostly retail and corporate loans. The chief stimulus for Indian banks includes: i. Liquidity: Securitisation is an easy route than raising deposits that are subject to reserve requirements ii. Regulatory issues: Constrains arising out of Provisions, priority sector norms, etc Capital Relief: Major investors are mainly mutual funds (money market/liquid schemes), closeended debt schemes and banks. Long term investors like insurance companies and provident funds are presently dull because of regulatory limitations. Foreign institutional investors (FIIs) are also missing due to regulatory ambiguity. As per guidelines, mutual funds should declare their NAVs on a daily basis due to which they wish the structure/asset classes that have low pre-payment rates. The scarcity of domestic non-traditional hedge fund style investors to participate in equity and mezzanine tranches has led to originators holding them.12
11 12

See, supra note no. 5. See, Securitisation in Inida, available at < http://www.dnb.co.in/Arcil2008/Securitisation%20in%20India.asp> last accessed on 28th Feb. 2011.

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B. MARKET ACTIVITY

Till June 2007, the book value of total amount of assets acquired by SCs/RCs registered with the Reserve Bank stood at Rs 285,436 million. The security receipts subscribed to by banks amounted to Rs 68,942 million. The security receipts redeemed amounted to Rs 6,596 million.13
C. REGULATORY FRAMEWORK

Currently, there is no comprehensive regulatory framework for securitisation, understanbly so, since it is of recent origin even in developed countries. SPV can be formed as a company under the Companies Act, 1956 or as a Trust under the Indian Trusts Act, 1882. Hence, SPV formed as a company will have to be registered as an NBFC under the RBI Act and is subject to RBIs regulatory framework. Secondly, such an NBFC will also come under the regulations of Companies Act. Thirdly, SPV formed as a Trust will come under the purview of the Indian Trusts Act. Fourthly, to the extent banks and financial institutions are involved in securitisation, they will continue to fall under RBI regulations. Fifthly, the Securities/Pass Through Certificates issued by SPV fall under the definition of securities under Securities Contracts Regulation Act, 1956.14 There is thus a need to clarify and formalize a regulatory framework for securitisation. Therefore, only the financial sector has a patent framework for participating in securitisation. With the enactment of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI Act 2002) enabled securitisation of the non-performing assets of Banks that could sell off their NPAs to asset reconstruction companies registered with RBI. It provided the framework to the constitution of asset reconstruction companies (ARCs) specialising in securitising bothered assets purchased from banks. The issuance of security receipts has since grown significantly.

13

See, Securitisation in India, available at<http://www.dnb.co.in/Arcil2008/Securitisation%20in%20India.asp>, last accessed on 6th August, 2010.
14

See, Supra note no.6 at p. 414.

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In February 2006, the RBI issued guidelines for securitisation of standard assets by Banks, FIs and NBFCs. It provided the regulatory framework for various decisive aspects of securitisation and are anticipated taking enhance the establishment of a vigorous structured credit market.15

D. MODE OF SECURITISATION

Securitisation in India mainly gets a trust structure with the underlying assets being transferred through sale to a trustee company. The SPV, made as a Trustee Company, issues securities that are either Pass through Certificates or Pay through Certificates (PTC). The trustee is the legal owner of the underlying assets in both the cases. The investors holding PTC are allowed to a beneficial interest in the underlying assets taken by the trustee. Investors having PTC are entitled to a beneficial interest only in the cash flows obtained from the underlying securities to the level of the obligation agreed with the holders of primary and secondary tranches of PTC.16
E. IMPEDIMENTS TO SECURITISATION MARKET IN INDIA

It is obvious that one of the major uncertain blocks in the development of securitised paper is the ignorance of the investors and nervousness in dealing with a fairly new instrument. As with other innovation, it is only a problem of transformation, but other more stable hurdles needs action to get the concept of securitisation acceptable in the market. Below are the problems in the road of development of securitisation. i. Segmented Debt Market: Low trading volumes in the debt market bang the door close on exit options for the investor and get inhibited the development of debt products. The pricing of the securitised paper is thwarted by the scarcity of a proper rupee yield curve without an active and deep secondary market, more advanced versions that adapt cash flows investor preferences will never see the existence. The government is to be responsible for artificially segmented the capital market by imposing the limitations on investment. For instance, insurance companies are forced to channel the bulk of their funds to government and government approved securities,

15

See, Guidelines on Securitisation of Standard Assets, available at http://rbi.org.in/scripts/NotificationUser.aspx? Id=2723&Mode=0, last accessed on 1st August, 2010. 16 See, Supra note 13.

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while pension and provident funds are debarred from investing their vast corpus in corporate papers. ii. Legal issues: The concept of securitisation and the issue of securitised paper have been got down by procedural squabbling and hurdles, thanks to the number of laws distressing it such as Transfer of Property Act, 1882, Stamp Act, Indian Contract Act, 1872, Income Tax Act, 1961 and Indian Registration Act, 1908.17All these laws certain provisions need amendments to remove the hurdle faced by securitsation market in India. iii. Taxation issues:18 Tax issues related to securitisation rotate around three main issues. They are tax occurrence in the hands of originator, the tax levy on the SPV and the tax occurrence in the hands of investor. The tax incidence may also differ from situation to situation as the taxation laws are obscure in India and significant haziness environs the tax treatment of the securitisation process on the following counts: It is not manifest whether originator as primary recipient of payment of interest and Whether SPV is a taxable entity (if it is a trust, then there is no tax liability). Whether investors can be treated as association of persons. Whether SPVs, PTCs shall be applicable to tax deducted at source (TDS) rule. Whether the borrowers of housing loans would continue to get tax concessions after

principal is subject to taxation of interest income.

securitsation. Presently for interest tax concession is available under the head of Income from House Property and for principal amount of repayment benefit is available under section 88. Similarly, ambiguities prevail under section 60, 160 and 164(1a).

iv. Accounting Issues:19 Another impediment in the growth of securitisation is accounting treatment of the securitisation transactions in the books of various parties-originator, SPV and investor. The realm of anxiety is to decide the conditions under which an asset sold by a financial institution for securitsation purposes could be considered off balance sheet and thus exempt form capital adequacy obligation of the central bank. Whether an asset sale is off
17 18

See, Supra note no. 6 at 413. See, P.K. Malik, Securitisation of Financial Assets, Status, Problems and Prospects, (Regal Publications, New Delhi), 2008, p. 16. 19 See, ibid at p. 17.

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balance sheet or not is also a significant issue in the preparation of financial accounting statements. v. Narrow Investor Base:20 There is no market without buyers. They may be domestic or foreign buyers, individual or institutional buyer, financial or non-financial buyer, regulated or non-regulated buyers and sovereign or non-sovereign buyers investors look for the following: Asset Performance: Lack of historical or meaningful performance data make it difficult Third party performance: it includes reliance on asset service, credit support providers, Currency disclosure and the availability of swap opportunities at reasonable cost. Secondary market liquidity. The status of pass through Certificates (PTCs) is not clear in India. Investment in securitised paper in case of India needs to be specifically permitted for The non-performing assets (NPAs) standards as applicable to securitised debts also need Adequate disclosure needed to give the investors.

to forecast the performance of the asset. etc.

financial institutions. to be clarified.

vi. Behavioral Factor:21 In many emerging markets, the choices for loans are compromised decisions rather than rational decisions. The loans given by the process are less homogeneous and are not of good quality. In addition, nature of participation certificates as different change to accept financial claim in case of securitisation of future flows as collateral because the institutional investor look ahead to security in the form of creation of charge over physical assets. vii. Poor Capital Markets:22 In many of the emerging markets the debt markets are at their infancy due the under development of the institutions. Moreover, securitised paper is not expressly included in the notification exempting stamp duty on transfer of debts instrument in the depository mode. The market needs the emergence of backup services to defend against any
20 21

See, ibid. See, ibid at p. 19 22 See, ibid at p. 20.

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negligence by the originator and the foreclosures standard need to be cut down to provide the speedy recovery. viii. Regulatory Environment:23 The regulations in a country for capital adequacy requirements are substantial for the originators to undertake securitisation. Clear guidelines for the treatment of true sale and off balance sheet items can give the road for developed securitsation market. Further many financial experts believed that by decreasing the pivotal role of financial institutions in financial intermediation, securitisation removes the effectiveness of monetary policies. In India following issues requires attention: The guidelines for investments by insurance companies need to be clarified for investing Investments by mutual funds, pension funds and provident funds in securitised papers

in securitised instrument. need to be permitted. ix. Quality of Assets:24 The originators should have a minimum feasible amount of quality assets to get the securitisation transaction attractive in regard to some minimum expenses to be incurred for fees for structural, rating agency, lawyers, auditors, road shows, etc. The success of securitisation depends upon the quality of the loan assets originated by the originator and the quality of the securitised instruments issued by the SPV. xi. Others:25 In addition to the above impediments in the process of securitisation, third party services are also not used in India. The originator generally acts as the servicer for the securitised pool of assets which shows he collects the installments of principal and interest payments on behalf of SPV from the borrowers and pay to SPV. It gives impression that dependence on the originator continues even after the sale of receivables. Another impediment is non-availability of data across economic cycle.
V. NEED FOR NEW GUIDELINES FOR THE DEVELOPMENT OF THE

MARKET
23 24

See, ibid at p. 20. See, ibid at p.21. 25 See, ibid at p. 22.

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Presently, there are several issues which plague the market for asset securitisation. The end result is that the securitisation sphere has still not realised its full potential and there is urgent need to address the issues facing the Indian Securitisation Market in order to develop the market.26 The issues written underneath are in the perspective of securitisation transactions of standard assets which are not governed by the SARFESI. It governs the instruments known as security receipts that can only be issued by asset reconstruction companies in respect of distressed assets. a. True sale: To facilitate the transferred assets to be removed from the balance sheet of the originator in a securitisation structure, the segregation of assets or true sale from the originator to SPV is a necessary requirement.27 b. Stamp Duty: One of the major hurdles facing the development of the securitisation market is the stamp duty structure as in many states still have a high stamp duty. In India, stamp duty is payable on any instrument which seeks to transfer rights or receivables.28 c. Registration Act, 1908: Under this transfer requires compulsory registration. This also imposes additional costs to the transaction. d. Transfer of Property Act: According to some legal views, has held that assignment of a debt should be in whole and not a part assignment. Further, both the Transfer of Property Act and the Sale of Goods Act hold that only a property currently in existence is capable of being transferred. The laws impede development of securitisation in future receivables as transfer of future property does not fall under the definition of debt.

e. Income-Tax Laws: Some provisions of the Income Tax Act, 1961 are reported to have an impact on securitisation such as Section 60 of the Act, contemplates transfer of income without transfer of assets which are the source of the income. In such a case, the income so transferred is chargeable to income tax as the income of the transferor and is included in his total income. Similarly, there are other sections in the Act which inhibit the progress of securitisation.29
26 27

See; supra note 6 at p. 413.

See, Supra note no.1.

28

See, Securitisation in India-Opportunities & Obstacles, a discussion paper, available at <http://www.vinodkothari.com/india_article_iimc.pdf,> last accessed on 2nd August, 2010, 29 See, Supra note no.17 at p. 18.

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d. Accounting: ICAIs new guidance note on accounting for securitisation provides for de-

recognition as well as computation of gain on sale in certain conditions, such as the originator should surrender control of the asset and SPV should acquire control of the asset.30 Further, de-recognition of assets would not be allowed where the originators creditors have a charge on the transferred assets, SPV does not have a legal right to deal in the assets transferred and where the originator has a call option and an obligation to purchase at a later date, the asset so transferred. Further, for originators, the revised RBI guidelines31, would act as a deterrent from a commercial perspective, given that the revenues from the true sale cannot be booked in the year of sale but would need to be amortised. e. Foreclosure Laws: Lack of effective foreclosure laws also prohibits the growth of securitisation in India. The existing foreclosure laws are not lender friendly and increase the risks of MBS by making it difficult to transfer property in cases of default.32 g. The SARFAESI Act, 2002: A security receipt (SR) gives its holder a right of title or interest in the financial assets included in securitisation. This definition holds good for securitisation structures where the securities issued are referred to as pass through certificates. Also, the SARFAESI Act has been structured such that SRs can be issued and held only to Qualified Institutional Buyers (QIBs).33 Lastly, there is a view that a SPV structured as a company under the Companies Act may come under the definition of non-banking financial companies and hence is subject to prudential norms.

CONCLUSION

30

See, ibid, at p. 19. For Originator: states that any profit derived from securitising a pool of assets would need to be amortised over the life of the instruments issued to the investors and can no longer be booked upfront by the originator.
31
32 33

See, Supra note no. 11 at p.8. See, ibid.

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Securitisation is beneficial for the lenders of money and in India; it has provided security and relief to the Banks and Financial Institutions in the case of non-payment of money borrowed. The Banks and Financial Institutions, these days very easily lends money and feel safe about it. In India, the concept of Securitisation got statutory recognition with the enactment of SARFESI in the year, 2002. In India the Securitisation market has not developed efficiently and it needs certain guidelines and regulations for the development of the market. Currently, the securitisation market is facing various problems such as true sale, stamp duty, Income Tax laws, Accounting, Foreclosure Laws and certain deficiency in SARFESI.

The factors creating hindrance in the proper functioning and development of the securitisation market are transaction of true sale is not determined, variance in stamp duty in each and every state, in income tax laws there is no provision dealing with the aspects of securitisation, current accounting practice is complicated, there is no effective foreclosure laws, and certain deficiencies in SARFESI prohibits the development of securitisation market.

There is need of new guidelines and regulations to determine true sale, for the imposition of uniform stamp duty in all states on all instruments of transfer or sale, only SPV should not be taxed because of representative capacity of all-end investors. In SARFESI, investor base should be expanded by including, NBFCs, non-NBFCs, private equity funds, etc.

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