The Central Government in consultation with the Reserve Bank of India on 30 January 2020 issued notification1 ("FSP Third Party Assets Notification") on dealing with third party assets in the custody or possession of financial service providers2 ("FSPs"), which undergoing insolvency proceedings under the Insolvency and Bankruptcy Code, 2016 ("Code"). This article summarizes the impact of the FSP Third Party Assets Notification on securitisation or direct assignment transactions where an assignor acts as servicer or collection agent for assigned receivables ("Assigned Assets").
Applicability of Code to FSPs
The Code provides a framework for insolvency of the corporate persons. However, initially FSPs were not covered by the Code. Throughout 2019 where there has been a liquidity crunch and solvency issues for many non-banking finance companies and other financial service entities, the Central Government notified the FSP Rules which broadly makes the Code for insolvency resolution and liquidation to FSPs as notified by the Central Government. On 18 November 2019, the Ministry of Corporate Affairs notified non-banking finance companies (and housing finance companies) with assets of Rs.500 crore or more, (based on their last audited balance sheet), as FSPs ("Finance Company") to whom the Code applies. Under the FSP Rules, the National Company Law Tribunal appoints an individual proposed by the appropriate regulator as the administrator3 who exercises powers and functions of an insolvency professional, interim resolution professional, resolution professional or liquidator for the purpose of a Finance Company insolvency ("Administrator").
Securitisation transactions in India
The Guidelines on Securitisation of Standard Assets dated 1 February 2006 ("Securitisation Guidelines") provides when an assignor transfers all risks and rewards and rights and obligations pertaining to assets to the assignee and is not liable to the assignee in any way with regard to the assets other than liability permitted under the Securitsation Guidelines, a sale of such assets constitutes a true sale. Any servicing of the assets by an assignor as collateral agent or servicer does not detract from the true sale nature. Pursuant to provisions of the Securitisation Guidelines, if the true sale under the Securitisation Guidelines is met, such assigned assets are beyond the reach of creditors of the assignor in the event of the assignor insolvency.
Why the need for FSP Third Party Assets Rules
In order to protect the rights of third parties with respect to their assets in possession or custody of the company at the time of such company's insolvency, the Code generically provides that the assets held on trust or in accordance with the contractual arrangements between the parties ("Third Party Assets") shall not be considered as assets of a company during the insolvency resolution process or in liquidation. This provides a framework for the purposes of the Code, but from a practical perspective, this has led to a lack of clarity as to how proceeds received in respect of Assigned Assets are to operationally deal with during insolvency. Practically, there are more challenges since during insolvency resolution process, the bank accounts of a company undergoing insolvency is managed by a resolution professional and consequently, an assignee will have to seek permission from such resolution professional or in few cases, the committee of creditors of such company for transfer of proceeds in respect of the Assigned Assets- which further complicates the operation of proceeds.
This recently came to the forefront in proceedings in the month of November, 2019 in respect of Dewan Housing Finance Corporation Limited ("DHFL") before the Bombay High Court.
The Finance Companies are the majority of the originators in the securitisation market in India. In order to protect the rights of the third parties in respect of Third Party Assets in the insolvency proceeding of the Finance Companies, Rule 10 of the FSP Rules clarified that the provisions pertaining to interim moratorium under the FSP Rules and moratorium under Code are not applicable to the Third Party Assets. However, there was no definitive wording under Rule 10 of the FSP Rules with respect to how the rights of the third parties will be protected once the control of the Third Party Assets has been obtained by the Administrator. Consequently, in order to bring more clarity on the said matter and to secure the rights of third party purchasers, the Central Government notified the FSP Third Party Assets Notification to provide much needed guidance with respect to the status, procedure and operational requirements in respect of the Assigned Assets in insolvency proceedings initiated against the Finance Companies. The FSP Third Party Assets Notification are clear and proactive step to mitigating any risk to the Assigned Assets during insolvency of the Finance Companies.
What do the FSP Third Party Assets Notification Require
The FSP Third Party Assets Notification read with Rule 10 of FSP Rules require that:
- the Finance Company only acts in the capacity of a servicer or collection agent for such Assigned Assets;
- no interim moratorium under the FSP Rules and no moratorium under the Code applies to Third Party Assets;
- permits the Administrator to take control or possession of such Third Party Assets for the benefit of a third party;
- the Administrator prepares a statement of such transactions and respective agency contract;
- the Administrator continues to discharge the obligations of the FSP as servicer or collection agent with respect to the Assigned Assets;
- the Administrator ensures that all receivables collected with respect to the Assigned Assets are deposited and maintained in a separate account and not merged with other funds or assets of the FSP ("Separate Account");and
- the Administrator oversees the operation of the Separate Account and transfers receivables deposited in the Separate Account in accordance with the terms and conditions of the servicing contract entered into by the FSP and the third party purchaser.
The FSP Third Party Assets Notification represent a crucial step towards the protection of the rights of the third parties with respect to the Assigned Assets in the insolvency of Finance Companies in India. It clearly establishes the bankruptcy remoteness that was otherwise unclear in any statutory legislations and provides a clear framework for Administrators in dealing with the Assigned Assets. It puts beyond doubt that validly assigned receivables by Finance Companies acting in the capacity of servicer or collection agent are beyond the reach of the creditors in the insolvency proceedings of Finance Company. In securitisation transactions where originators acting in the capacity of the servicer do not necessarily establish and operate separate bank accounts for each transaction, there will be significant commingling risk in respect of cashflows of the Assigned Assets with other cash flows of the originators. This risk is now mitigated in respect of receipt of monies during the insolvency period. However, the FSP Third Party Assets Notification do not provide for any clear guidance on what an Administrator is to do for Assigned Assets where the funds have been received prior to insolvency and not as yet paid over to the purchasers of the Assigned Assets. Depending on the payment cycle, this could pose a risk for a period of a few weeks to few months. Another aspect that will need consideration in due course is that if the insolvency company goes into liquidation, it will be ultimately wound up and so there will need to be a third party entity who takes over the servicing of the Third Party Assets until all amounts in respect thereof are received or written off. Internationally it is very common (and indeed a rating requirement) for securitisation to have a back-up servicer for transactions. The back-up servicing is structured so that a third party can immediately take over servicing the Assigned Assets at any point. The Indian securitization market has never had this - largely due to a lack of third parties to provide these services and also additional transaction costs that originators would not pay for as well as lack of rating or investor requirement to have this. We see this changing as Finance Companies head towards liquidation and require third party servicing and we have also seen this happen more recently following the DHFL insolvency. As there are no rules or regulations from Central Government or the Insolvency and Bankruptcy Board of India on servicing once a liquidation order has been passed, this will be up to parties (including Administrator) to contractually agree. Overall we believe this is a helpful development for the securitisation market in India.
1 Notification has been issued by the Ministry of Corporate Affairs under Rule 10 of the Financial Service Provider and Application to Adjudicating Authority) Rules, 2019 ("FSP Rules").
2 Under Section 3(17) of the Code, financial service provider means a person engaged in the business of providing financial services in terms of authorization issued or registration granted by a financial sector regulator.
3 Rule 5(a) (iii) provides that on admission of the application of initiation of corporate insolvency resolution process against the FSP, the adjudicating authority shall appoint the individual proposed by the appropriate regulator.
Originally published on 26 February 2020
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