As part of its ongoing putsch against stress in the banking system, the Reserve Bank of India (RBI) issued guidelines on sale of stressed assets by banks on 1 September. The guidelines continue the RBI's various efforts since 2014 to put in place a regulatory framework to identify and tackle stress in the banking system before loans are classified as non-performing assets (NPAs), and clean up banks' balance sheets. The guidelines are detailed and cover a vast swathe including when stressed assets should be sold, valuation, investment in security receipts by selling banks, and mode of sale (including a right of first refusal to be offered by the selling bank).

The guidelines require banks to have a board approved policy on the sale of stressed assets to securitization companies (SCs) and reconstruction companies (RCs). The policy should cover the nature of financial assets to be sold, procedure for sale, valuation methodology (with the intent that the realizable value of the asset is reasonably estimated), and decision making in respect of such sale. The guidelines emphasize early identification of stressed assets for sale so as to achieve a better price for the selling bank, and require the head office of the selling bank to be involved in this process.

At least once a year, banks must identify and list assets for sale to SCs and RCs. To enable better price discovery, the guidelines also allow banks to offer such assets for sale to other banks and non-banking financial companies. To press banks to operationalize this mechanism, the guidelines require banks' boards to consider for sale all assets classified as "doubtful" in their books and exceeding a particular threshold.

The sale must be conducted publicly, preferably through an e-action platform. The selling bank is also required to provide potential buyers adequate time for due diligence, with a minimum of two weeks.

In addition to the above, the guidelines mandate the use of the "Swiss challenge method" for sale of assets, which means: (a) a prospective buyer can offer a bid to a bank for a particular stressed asset, (b) if the bid exceeds the threshold prescribed in the banks' policy, then the bank must call for counter-bids on comparable terms.

Further, with a view to enabling improved debt aggregation, the selling bank must offer an SC or RC that has a significant share in the loan account a "right of first refusal" by allowing it to match the highest bid. In this method, the order of preference to sell the asset is as follows: (i) the SC or RC exercising its right of first refusal, (ii) the original bidder, and (iii) the highest bidder in the counter-bidding process.

To ensure transparency, banks' policies on sale of stressed assets must be clear on the valuation of stressed assets, including on the discount rate to be adopted, and on when an internal valuation will suffice and when an external valuation is required. However, where the selling bank's exposure exceeds `500 million (US$7.5 million), two external valuation reports would be required.

Further, presumably with a view to remove any hint of "conflict of interest" or "collusion", the selling bank must conduct the valuation at its own cost. The guidelines also preclude banks from repurchasing assets that they have sold to SCs and RCs. Any purchase of assets from an SC or RC by a bank can only be done where a restructuring plan has been implemented by the SC or RC, the asset has been classified as "standard", and such purchase complies with the RBI's guidelines.

In order to create a vibrant market for stressed assets and to ensure that a sale of stressed assets results in a "true sale" for the selling bank, the guidelines also prescribe restrictions on banks investing in security receipts issued against the assets sold by the bank. From 1 April 2017, where investment by a bank in a tranche of security receipts exceeds 50%, the bank would be required to provision for the investment as if the assets in question had remained on the books of the bank. From 1 April 2018, this provisioning requirement would be reduced to 10%.

The guidelines are unusually detailed and represent a shift from the gradual move towards principal-based rather than prescriptive rule making. This may reflect the RBI's frustration with banks' inactivity in this market, and the current stop-start-languish state of the stressed assets market. The emphasis on early identification is welcome as this will ensure that, at the time of sale, the value of the asset is not significantly impaired and there is scope of restructuring or revival by a financial sector entity that has the required expertise.

This article was first published in the November 2016 issue of the India Business Law Journal.

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