“Asset” to “Security” via Securitization – a legal insight
Introduction
Terms like structured finance and securitization have been the buzz words in the financial world for long. They are considered to be one of the foremost means of capital creation, and are an important tool of risk management as they allow elimination of substantial risk associated with bad or non-performing assets and allows diversification of asset portfolio. Hence, banks, financial institutions and several other entities are better able to manage their risk exposures by passing them on to investors or third parties.
The present bulletin attempts to briefly discuss the concept of securitization and elaborate upon the legal provisions governing securitization in India.
1.0 Securitization –
Concept and mechanismSecuritization involves conversion of assets or future cash flows into marketable securities. The conversion of existing assets into marketable securities is referred to as asset- backed securitization whereas conversion of future cash flows into marketable securities is known as future-flow securitization. An asset is converted into a capital market security to raise money from the capital markets. The following diagrammatic representation best describes a securitization process:
Thus, the steps involved in a securitization process (the basic process and form of securitization) are:
- SPV is created to hold title to assets underlying securities;
- The originator or holder of assets transfers the assets to the SPV;
- The SPV raises funds, with the help of an arranger/investment banker, by issuing securities which are placed with investors;
- The SPV pays the originator for the assets with the proceeds from the sale of securities.
The securities issued to the investors can either be Pass through Certificate (PTC) or Pay through certificates. In a PTC, the investors have a direct claim on the receivables transferred to the SPV while in the latter the SPV re-configures the cash flows by re- investing so as to pay the investors on fixed dates. SPV can be a partnership firm, a trust or a company. Common assets for securitization include credit cards, mortgages, auto and consumer loans, student loans, corporate debt, export receivables and offshore remittances. The credit quality of instruments is assessed by rating agencies who assign a credit rating to the instruments. The following section lists out some of the laws which assume significance in a securitization transaction
2.0 Legal provisions
2.1 Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests Act, 2002 (SARFAESI)
In India, SARFAESI was introduced in 2002. It has been recognized as facilitating asset recovery and reconstruction. SARFAESI deals with three aspects:
- Providing a legal framework for securitization of assets.
- Enforcement of security interest by secured creditor (banks/financial institutions).
- Transfer of non-performing assets to asset reconstruction companies, which then dispose off those assets and realize proceeds.
It has made provisions: (a) for registration and regulation of securitization companies or reconstruction companies by India’s federal bank, the Reserve Bank of India (“RBI”); (b) to facilitate securitization of financial assets of banks; (iii) to empower securitization companies and asset reconstruction companies to raise funds by issuing security receipts to qualified institutional buyers; (iv) for empowering banks and financial institutions to take possession of securities given for financial assistance and sell or lease them to take over management in the event of default.
In India, securitizations adopt a trust structure i.e. the assets are transferred by way of sale to a trustee, who holds it in trust for the investors. In this situation, a trust is not a legal entity in law but it is entitled to hold property that is distinct from the property of the trustee. Therefore, the trust performs the role of the SPV. Though SARFAESI is a securitization-linked law, in commercial practice, unfortunately, it is quite inadequate. Some of the shortcomings are – A security receipt (as defined in sub-clause 2 (zg) of SARFAESI) gives its holder a right of title in the financial asset involved in securitization. This definition holds good for structures where PTCs are issued. However, it is not legally adequate in case of ‘Pay through Securities’. Secondly, the legislation does not contain effective foreclosure laws. If an SPV wants to foreclose an asset owing to a default by a party, it has to resort to
the traditional means of litigation, which is time consuming and expensive. The legislation also fails to define a “true sale”, thereby, leaving it to the interpretation of the parties.
2.2 Stamp duty and registration law
Stamp duty is attracted on account of transfer of receivables (which constitute actionable claims) through a written instrument. The written instrument is considered a “conveyance”1 in law, which is an instrument liable to stamp duty. Several states in India do not draw a distinction between conveyances of real estate and conveyance of receivables and, thus, levy the same rate of stamp duty on both types of conveyances. The rates vary from state to state. However, some states have introduced concessional rates of stamp duty on actionable claims amounting to 0.1% or more on the value of the transferred receivables.
Secondly, if the securitized instrument issued to the investors is in the nature of a bond or debenture, it is once again exposed to stamp duty. On the contrary, if the instrument is structured as a PTC, it does not attract stamp duty. Levy of stamp duty at two different stages on the same underlying receivables renders such deals economically unviable. Hence, it is important to have uniformity in stamp duty law so that there are no variations in rates prevailing amongst states, which causes financial burden on players/entities involved in the transaction.
Further, under section 8 of SARFAESI, security receipt issued by securitization company or asset reconstruction company which does not create, declare, assign, limit or extinguish any right, title or interest to or in immovable property except where it entitles the holder of security receipt to an undivided interest afforded by a registered instrument, is not required to be compulsorily registered. Also, any transfer of security receipt is optionally registrable. This section is an exception to the registration rules stipulated in section 17 (1) of the Registration Act, which lists the documents that are compulsorily registrable. Section 8 of SARFAESI is a non-obstante clause i.e. it overrides the Registration Act. Registered documents/instruments have a legal standing and are admissible as evidence in a court of law in the event of a dispute. On the contrary, non-registration renders the document redundant for all practical purposes.
2.3 RBI Guidelines
The RBI issued securitization guidelines in February 2006. These cover the regulatory framework for securitization of standard assets by banks, all-India term lending and refinancing institutions and Non Banking Financial Companies. The guidelines address several aspects. For example, they describe what constitutes a true sale, criteria to be met by SPV, other aspects like representation and warranties by originator and re-purchase of assets
from SPVs, policy on provision of credit enhancement/ liquidity/ and underwriting facilities, prudential norms for investment in securities issued by SPV, accounting treatment of the securitization transactions and disclosures. The present bulletin does not address the regulatory scope of each of these issues which, by themselves, are quite exhaustive.
The regulations are not free from shortcomings. For instance, structures wherein SPVs buy assets from many sellers and then issue securities are not covered in the guidelines. The guidelines in their current form are applicable to securities based on the asset portfolio of banks. They do not include a secured loan form of securitization in which assets are not transferred to the SPV but the SPV provides loan to the originator who, in turn, creates a security interest on the assets.
- Other laws
- In addition to the above, tax is another important consideration in a securitization transaction. Tax is leviable at various stages on the participating entities depending on the transaction. Based upon the securitization structure, the originator, SPV and the investors are all liable to pay tax at different rates, as applicable to them.
- The SEBI (Public Offer and Listing of Securitised Debt Instruments), Regulations 2008 provides for public issue and listing of instruments that are issued by a SPV that purchases securities through securitization. Until the word “security” was amended under section 2 (h) of the Securities Contracts (Regulation) Act, 1956, securitized instruments were prohibited from being listed on the stock exchange. In fact, the 2008 Regulations specify the details of the SPV, the manner in which it can acquire receivables as well as the form of instruments it can issue – overall, they have been drafted quite elaborately.
3.0 Summing up
Numerous securitization transactions are structured by diverse entities all over the world. India is not far behind. Securitization as a financial instrument has been prevalent in India since 1990s. It has been a tremendous boon for banks/financial institutions which are beleaguered by excess illiquid and non-performing assets. It has also significantly galvanized the financial market. However, laws governing such transactions, which were introduced later, although tried to regulate securitization but left much to be desired owing to ambiguity and shortcomings. Hopefully, the gaps will be plugged and the necessary steps will be taken soon to alleviate all concerns.
Authored by: Priyatha Rao
1 Under clause 2 (10) of the Indian Stamp Act, “conveyance” includes a conveyance on sale and every instrument by which property, whether moveable or immoveable, is transferred inter vivos and which is not otherwise specifically provided for by Schedule. The Schedule contains the list of all the instruments which are chargeable to stamp duty along with the corresponding rates. The list includes instruments like affidavit, lease, memorandum and articles of company, bill of exchange, bond, mortgage, conveyance, receipt, debenture, share, partnership deed, shares etc. Thus, if an instrument is not listed in the schedule, no stamp duty is payable.