Executive Summary & Our Take-Away
In what appears to be a setback to the mechanism for the sale of assets without the intervention of courts by asset reconstruction companies, banks and financial institutions, the Bombay High Court (Court), by its order dated 23 March 2016 (in the matter of Blue Coast Hotels Limited v IFCI Limited and Ors) (the Order), reversed the sale, by public auction, of the Park Hyatt (Goa) Hotel (Hotel) by IFCI Limited (IFCI) to ITC Limited (ITC). The sale had been undertaken pursuant to the exercise of rights by IFCI as a secured creditor under the provisions of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI), on account of a loan default by Blue Coast Hotels Limited (BCHL).
On the face of it, the Order portends bad news for lenders and distressed debt investors in India. While for the time being lenders need to grapple with the consequences of this Order (and examine it's implications on any proposed / pending enforcement actions), we are of the view that BCHL's lenders may be able to mount a successful legal challenge against several aspects of this Order. As such, it may not, eventually, withstand the scrutiny of the appellate court and thereby, not hinder the settled enforcement process available to lenders under SARFAESI.
BCHL availed loans of INR 1.5 billion from IFCI, secured by a mortgage on the Hotel property, along with hotel movables, and subsequently, failed to repay the outstanding dues. Accordingly, IFCI exercised its rights as a secured creditor by invoking the SARFAESI to recover its debts. On BCHL being unable to pay its debts, IFCI issued an auction notice for the Hotel, and sold it to ITC, the sole bidder.
IFCI's enforcement of the mortgage was challenged by BCHL on the ground that the sale was not in compliance with SARFAESI provisions, including that:
- the mortgaged property included agricultural land, against which no enforcement action is possible;
- the debtors representations against the enforcement notice was not considered by the creditor;
- physical possession of the property was not obtained by the creditor prior to the auction sale; and
- the manner of the auction sale suggested "collusion" between IFCI and ITC, as a result of which the sale failed to fetch "fair value".
Key Conclusions of the Bombay High Court
The Court annulled the sale / enforcement of security and ordered that the Hotel be returned to BCHL, on inter alia the following grounds:
- No enforcement against agricultural land: Even though security interest can be created on agricultural land, no proceedings or measures may be initiated under SARFAESI to enforce security interest over any property classified (or part of it) as agricultural land.
- Land classification dependent on Government records, and not actual usage: While SARFAESI does not define agricultural or non-agricultural land, land classification in government records would be the guiding factor (and not the manner of usage of the land in question). The fact that the relevant land was being used for non-agricultural purposes would not allow a creditor to invoke SARFAESI for enforcement of its security interest.
- Sale notice does not absolve the auction purchaser: The Court brushed aside ITC's contention that the SARFAESI sale notice issued in its favour absolved ITC (as purchaser) from any claims arising from the litigation between the borrower and the lender. A third party purchaser who is completely aware of pending litigation relating to, and existing encumbrances on, the secured property cannot argue the position of being a bona fide purchaser. A purchaser is expected to conduct necessary due diligence and cannot be permitted to show ignorance and claim equity after taking a calculated risk.
- Facts suggest "collusion": The Court was of the view that "collusion" between ITC and IFCI could not be ruled out: as there was only one participant in the auction i.e. ITC, the bid price of ITC was only INR 1000 higher than the reserve price set for the property (INR 5.15 billion), and ITC agreed to acquire the Hotel despite being aware that IFCI was, at the relevant time, not in physical possession of the Hotel – each of which factors prevented the property from realizing its fair market value in the auction.
- Debtor representations cannot be ignored: If the borrower makes any representations or objections against a SARFAESI notice, it is mandatory for the creditor to decide on such representation or objection and communicate its decision, with reasons, to the borrower within 15 days of receipt of such representation.
- No sale without taking physical possession: SARFAESI encapsulates the concepts of 'symbolic possession' and 'physical possession'. Symbolic possession is recognised to protect the interests of the creditor in the secured asset, once the borrower has failed to make the payment as demanded, and also to serve as a notice to the public at large that the relevant property amounts to secured assets of the creditor. This also implies that the borrower still retains the physical possession of the property and can continue to make efforts to procure repayment of the loans.
- No sale without taking physical possession (contd.): An auction process cannot be initiated by the creditor while having only symbolic possession of the secured assets. The Order has interpreted the mandatory provisions of SARFAESI to mean that, unless the secured creditor first obtains physical possession before initiating the auction process, the full and real market value of the assets may not be realised as purchasers may be hesitant to participate in the auction, solely on the basis of the creditor's symbolic possession. The purposive interpretation of SARFAESI requires the interests of the borrower to be safeguarded and thus, secure the maximum price of the mortgaged property by following due process. To give effect to such intent, the mortgaged property should be transferred to the third party purchaser only after acquiring physical possession and clear title.
- When may the Creditor
apply to the Magistrate to take Physical Possession:
If the creditor is unable to take physical possession on account of
resistance from the borrower, such a creditor may, under the
SARFAESI, apply to the Magistrate to assist in acquiring physical
possession of the secured property. The Magistrate, while acting on
such an application, has to be provided with an affidavit setting
forth the required information, and only after perusing and being
satisfied with the contents of the affidavit, the Magistrate may
pass suitable orders enabling the applicant / secured creditor to
take physical possession of the secured assets. It is imperative to
note that the Order specifies that compliance with the foregoing is
not merely procedural but mandatory in nature.
More importantly, where the debt of the creditor has been satisfied before it has been able to take over physical possession of the secured asset e.g. where the receipt of the sale consideration from the purchaser of the secured asset satisfies the debt, neither the creditor nor the purchaser will be able to attain physical possession of the property by resorting to the aforesaid assistance of the Magistrate. As such, in the facts of this case, IFCI was not in a position to take the assistance of the Magistrate in handing over physical possession to ITC.
- Debts Recovery Tribunal (DRT) will not enforce in absence of compliance with procedure: The scheme of SARFAESI is such that where mandatory provisions have not been complied with, the enforcement actions undertaken by the creditor are open to scrutiny. If such enforcement is found to be non-compliant, the DRT is empowered to not only set aside the actions of the secured creditor, but also restore possession of the secured assets to the borrower.
- Once invoked, SARFAESI is the sole remedy: Under the SARFAESI, there is no bar on financial institutions or banks to invoke other laws and related provisions for enforcement of security interest. However, once the SARFAESI has been invoked and the mandatory provisions of the SARFAESI have not been complied with, the creditor cannot seek protection under other laws, including but not limited to, the power of sale under the Transfer of Property Act, 1882 (as conferred pursuant to a mortgage in favour of the creditor).
Some key implications of the Order and its divergence from the SARFAESI framework
Strict interpretation of SARFAESI in a manner which puts several checks and balances on the enforcement process
The SARFAESI was essentially enacted to enable secured creditors to recover amounts due to them, by the enforcement of security without the intervention of courts. However, a strict interpretation of the enforcement provisions of the SARFAESI by the Court has skewed the enforcement process in a manner which was not originally contemplated. For instance:
- the SARFAESI does not mandate that a secured creditor can enforce against assets charged in its favour, only if such creditor has physical possession of the assets1; and
- the SARFAESI is also silent on the criteria for determination of agricultural land, and in light of this, the classification of land purely on the basis of government records ignoring the actual use of such land by the creditor may create challenges in enforcement of security, especially where only a part of the security comprises agricultural land.
Extinguishment of the debt (via receipt of sale proceeds) deprives a creditor of related enforcement rights?
Unlike as stated in the Order, a holistic reading of the SARFAESI clarifies that the receipt of sale consideration by the creditor on the sale of the assets from a third party purchaser does not strip such a creditor of its rights under the SARFAESI, as receipt of sale consideration and handing over of possession is part of the same transaction. This inter alia includes the creditor's right to seek the Magistrate's assistance in taking and transferring possession of immovable properties as part of the sale process to the third party purchaser.
A literal interpretation of this Order will strongly discourage prospective purchasers from participating in SARFAESI linked asset sale processes in which the creditor has not taken physical possession of the secured asset(s), and consequently, hamper the efficacy of any planned enforcement actions of a creditor.
Public auction v privately negotiated transactions?
Based on the aspersions cast on the sole bidder's conduct in the auction process, to avoid claims of collusion, potential purchasers of secured assets may, for the time being, be well advised to rely on the "private treaty" route provided under the SARFAESI for their acquisitions. At the very least, the terms of the negotiated purchase from lenders will thereafter not be open to claims of "bid-rigging" by the defaulting borrower.
The conditions laid down by the Court pose multiple difficulties in enforcement of security, and our analysis is that several of the Court's positions are not consistent with the purport of SARFAESI; and are therefore not likely to sustain a challenge from the lenders. Further, the appeal which now lies before the Supreme Court, will be determined in the backdrop of increasing bad debts in the economy and mounting public scrutiny on inaction against defaulting borrowers: all factors which, in our view, go against the operation of several aspects of this Order.
 For the purposes of enforcement and valuation, SARFAESI does not make a distinction between physical possession and symbolic possession, as has been drawn in this Order. In fact, it may be counter-productive for lenders to take physical possession of units if they do not have the capabilities to operate such units in the interim period, prior to the sale.
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