April 30, 2011 04:14 PM
- Vinod Kothari The SARFARESI Act does not fulfill the purpose of registration of security interests. For, the Central Registry does not guarantee reliability. Therefore, the law as it stands is a futile and very costly exercise
After nine years in hibernation, the provisions of the SARFAESI Act pertaining to the Central Registry have been brought to life. The Central Registry was constituted by a notification on 31 March 2011. And in a separate notification on the same date, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (Central Registry) Rules, 2011 (Central Registry Rules) were also notified.
The SARFAESI Act has been criticised as shabbily drafted and thoughtlessly promulgated and was collecting dust for over nine years. It is also called the Securitisation Act, but it doesn’t deal with securitisation transactions at all. It has of course made a difference in the manner in which non-performing assets (NPAs) are handled in the country, but it has resulted in an inconsistency with the laws that deal with insolvency and revival of sick companies. The benign concept of reconstruction of NPAs, for which models exist in several other countries, has been used in India to create a model to buy NPAs. Overall, the SARFAESI Act is a unique Indian model; it was designed in line with Article 9 of the UCC of the United States, but has strayed completely.
One of the key principles of Article 9 of the UCC was registration of security interests, and providing priority to security interests based on the date of registration. According to common law principles underlying the Companies Act, a security interest (aka charge) is effective from the date of its creation, unless it is an unregistered charge. However, in the US system, it is not the date of creation, but the date of filing of the charge that determines priority.
It is for this reason that the concept of registration of security interests was enshrined in the SARFAESI Act. However, while the Act did provide for mandatory registration, it nowhere mentioned that priority of security interests will be based on the date of registration. On the contrary, section 20(4) of the Act states that the provisions of the Act shall NOT affect the priority or validity of charges registered/required to be registered either under the Companies Act or under the Registration Act, or other similar laws pertaining to registration of security interests. That is to say that even if the security interest is not registered as required by Central Registry Rules, the only implication will be the penal consequences of the law, and there will be no impact on the validity or priority of the security interest. There is, however, a provision for payment of a penalty of Rs5,000 per day of the default(1) .
The Rules have currently been implemented only in case of equitable mortgages. It is difficult to understand as to why equitable mortgages had to be distinguished. An RBI Press Release of 21 April (2) says that this has been done to prevent frauds. In fact, the chances of frauds are minimal in case of equitable mortgages, as the title deeds are physically with the lender. If the title deeds are indeed fabricated, then the Central Registry does not help at all, because registration of such mortgage does not validate what is actually invalid.
Unimaginable magnitude of the rules
The ambit of coverage of the Rules is vast, as described in Section 23 of the SARFAESI Act. In fact, neither the draftsmen nor the banks/financial institutions supposed to abide by the provisions of Section 23 may have imagined what the implications of are. But before we get into the implications, here are some important points to note.
> In the Companies Act, the obligation is on the borrower to register a charge; under Section 23 of the SARFAESI Act, the obligation is on the secured creditor, that is, the bank.
> Under the Companies Act, the obligation is only for registration of security interests created by a company. Under the SARFAESI Act, all security interests, no matter by whom created (except, of course, for the exceptions given in Section 31, but that will take out only where the loan amount is Rs1 lakh or less) can be registered.
Now, with this, the magnitude of the burden being thrown on the banks may be imagined, once the provisions of Section 23 are fully enforced. On any given trading day, one would imagine an average bank in the country would get some thousand security interests, in respect of corporate loans, car loans, home loans, property loans, trade loans, or any loan for that matter, irrespective of whom it is given to, as long as the loan amount exceeds Rs 1 lakh.
On any given business day, lots of these security interests may be modified, either because of extension of the limit or modification of the terms, etc. Hundreds may get satisfied. All of these need to be registered by the bank with the Central Registry. Failure to do so will attract a fine of upto Rs5,000 every day, obviously for every offence to so register. Of course, the validity of the charge is not affected, but would banks either be able to handle the magnitude, or will they be in a position to pay the penal charges. Note that Section 23 leaves no option with the bank–all creation of security interests, modifications and satisfactions are registrable mandatorily.
Every transfer of a receivable, where there is a security interest, is also a case of modification of security interest. Hence, every transfer of receivable also becomes a registrable transaction.
Note that the registration of security interests under Section 23 would be in addition to registration under the Companies Act, Motor Vehicles Act, and so on. This would mean several registries of a single charge. For example, if there is a hypothecation of a motor vehicle by a company in favour of a bank, it requires registration under the Motor Vehicles Act, and under the Companies Act, and under the SARFAESI Act. The same is the case with land mortgages.
Registration of securitisation/asset reconstruction transactions
While every bank in the country would, therefore, face tremendous strain complying with the mandatory provisions of Section 23, asset reconstruction companies would be lost in the confusing words of the section.
The section says, every transaction of securitisation and asset reconstruction, and every satisfaction of such transaction, is registrable. First of all, as we have mentioned above, the real-life financial transactions of securitisation do not come within the ambit of this law because of the flawed definition of a “securitisation company”. The only securitisation companies in the country are the reconstruction companies. The transactions of securitisation of receivables, for example, a housing finance company or a microfinance company securitising a portfolio of receivables, do not come under this law as they are sales to either SPVs or to other financial entities.
However, let us understand the applicability of the Rules to an asset reconstruction company. Most of the transactions of sale of NPAs in India take place between banks and ARCs, with the latter acting as trustees of a trust. It may be contended that such a sale of NPAs is not a sale to the ARC, but a sale to the trust, and hence, the transaction is not covered by Section 23. However, as practically almost all transactions take place through the trust route, taking this interpretation would make Section 23 almost redundant for reconstruction transactions.
On the contrary, if Section 23 is taken as applicable, the biggest enigma would be, what exactly is the transaction of “asset reconstruction” that is required to be registered, the transfer of the NPA itself, or its refinancing by issuing security receipts? Going by the purpose of registration requirements, it should be the transfer of the NPA to a reconstruction company.
Section 23 has further strange words: satisfaction of an asset reconstruction. One understands satisfaction of a charge, but satisfaction of “asset reconstruction” is a term difficult to understand. Since the repayment of security receipts is contingent upon realisation of cash from the NPA, full redemption of the security receipts may either never happen, or may happen after a substantial number of years. Hence, if satisfaction of asset reconstruction is taken to mean the redemption of security receipts, the registration would be required at that uncertain future date.
Not that clarity is a great attribute of the rest of the SARFAESI Act, but the complete confusion underlying a mandatory administrative compliance section that Section 23 is, would make its implementation extremely difficult.
And what does the country gain by this?
Assuming that banks all over the country incur massive compliance costs and register all transactions in security interests, and all transfers of security interests, and all transfers to asset reconstruction companies, etc, what does the country gain out of this massive exercise? We mentioned earlier that registration of security interests is not unique to India. Several countries have adopted the US UCC model to require central filing of security interests. The perceived benefit of central registration is to enable searching of security interests, so that a lender, wanting to give a loan against an asset, may search whether a security interest already exists. If a security interest is not registered on an asset, a lender may presume the asset is free from security interests, because, as was mentioned earlier, the priority of security interests is based on the date of registry.
This benefit of searching, and drawing a presumption about the existence or otherwise of a security interest, does not apply to India. As we have said earlier, Indian law, exactly contrary to the very spirit of international laws, says that the non-filing of security interest will not affect priority. This would mean, a lender may have obtained security interest, and not filed it, and yet claim priority over a second lender who would have searched the Central Registry, not found the charge, and hence, went ahead and sanctioned a loan on the same asset. If the fact of non-registration does not affect the validity or priority of a security interest, then the very reliability of the searching process gets negated. And if the search of the Central Registry does not have an unquestionable reliability, one wonders why it exists at all? After all, the Central Registry is not a library of security interests, displaying its proud possessions!
The drafting of the Act has killed the very purpose of registration of security interests. As it stands, it would be a futile, and yet very costly, exercise.
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