I OVERVIEW

The Indian lending market has traditionally been dominated by banks (both government-owned and private). Since 2014 however, a growing recognition by the Reserve Bank of India (RBI)2 and banks of increasing non-performing assets (NPAs) and stressed assets3 has put tremendous pressure on the banking sector, resulting in a deceleration in growth of loans and advances (especially by public sector banks).4

The RBI is making strong efforts to require banks to recognise early stress triggers in loan accounts in order to ensure adequate provisioning and timely recovery. Several positive measures have been introduced in the recent past. These include RBI-led schemes for effecting strategic turnaround of companies (with greater creditor control over management), liberalisation of the regime governing sale of stressed assets including to asset reconstruction companies (ARCs), notification of the Insolvency and Bankruptcy Code, 2016 (the Insolvency Code) and the RBI being empowered to direct banks to initiate proceedings against defaulting borrowers under the Insolvency Code.5 The success of these measures, however, is yet to be fully ascertained.

Increasing stress in the banking sector has also led the RBI to discourage large borrowers from depending solely on the banking system for funding.6 Simultaneously with efforts to reduce credit concentration in the banking sector, the RBI and the government of India have attempted to open up new lending avenues for Indian corporates, especially in the beleaguered infrastructure sector. A recent example of such efforts includes an amendment to enable foreign portfolio investors (FPIs) to invest in unlisted debt securities in India. There has also been a dedicated effort by the RBI to develop guidelines on the sale of stressed assets by banks to put in place a resilient framework for the sale of non-performing assets by banks to institutions that may be better able to recover those assets, such as securitisation vehicles or non-banking financial companies (NBFCs). As an outcome of these efforts, NBFCs and new lending entities (such as FPIs and alternative investment funds (AIFs)) have significantly increased their share in the market in recent times.

Structured lending has also taken off in a big way, with Indian corporates looking for new (and cheaper) sources of funding. Recent liberalisation in the foreign exchange regulations allow Indian corporates to attract more offshore investment, including through the introduction of ‘masala bonds'(i.e., rupee denominated bonds issued offshore by Indian corporates). Given the volatility of the Indian rupee in recent times, these bonds have become popular, as they eliminate the currency risks associated with offshore borrowing.

Increasing instances of fire sales of stressed assets has seen a focus on acquisition finance. Many conglomerates are trying to reduce their debt levels by divesting and monetising cash flow from performing assets (with the Lanco group and Jaypee group being high-profile examples).

Indian creditors do not usually adopt Loan Market Association (LMA) or Asia Pacific Loan Market Association (APLMA) standard documentation, and each creditor may use its own format of loan documents.7 Indian loan documentation is typically covenant-heavy on the borrower (especially in a special purpose vehicle or project financing).

II LEGAL AND REGULATORY DEVELOPMENTS

The increasing stress in the Indian banking sector has resulted in several reforms and regulatory measures in the past few months, aimed at requiring lenders to resolve and restructure bad loans to reduce the gross NPA ration. India has also seen several broad-based changes, such as constitution of the National Company Law Tribunal for companies, introduction of the new Insolvency Code and measures to regulate and bring transparency in setting interest rates by banks. This section contains a high-level summary of the main recent and regulatory developments.

i Regulation of lenders

Different types of creditors in India are subject to differing levels of government oversight and scrutiny. Banks in India are heavily regulated, with RBI guidelines governing interest rates, extent of exposure to corporate groups, information sharing and reporting requirements and other prudential aspects. Indian regulations permit NBFCs to engage in lending business if they register with the RBI, although NBFCs are subject to lesser scrutiny. In recent years, however, the RBI has introduced several measures aimed at reducing regulatory arbitrage between banks and NBFCs.8 The past few years have also seen the introduction, by the RBI and the Securities and Exchange Board of India, of lightly regulated lending vehicles such as AIFs and FPIs in order to widen the Indian investment market.

ii Restructuring schemes

In order to combat the growing NPA problem, the RBI introduced out-of-court schemes allowing banks to restructure their stressed assets, giving banks greater management and control over borrowers in the restructuring process. The strategic debt restructuring scheme (SDR)9 allows banks to convert all or part of their loans into a majority equity stake in the borrower, take control of the borrower and sell the shares to a buyer to recover their loans. While this scheme has been invoked in 21 cases, only in two cases have the banks found buyers for the stressed borrowers at suitable valuations. The Scheme for Sustainable Structuring of Stressed Assets (S4A)10 that allows banks to convert part of their debt into equity, while retaining a sustainable amount of debt to be repaid has been successfully implemented only in a couple of cases. Creditors routinely require borrowers to acknowledge their right to convert debt to equity under these schemes in the loan documentation.

iii Insolvency Code

The Insolvency Code (which became effective recently) provides a comprehensive framework dealing with the insolvency resolution process of corporate entities, and is a complete overhaul of the earlier insolvency regime. Creditors are now given a greater role in arriving at a resolution for the borrower. The provisions of the Insolvency Code which allow operational (trade) creditors to file proceedings against borrowers for smaller defaults has caused many creditors to strengthen cross-default clauses in loan documents, while also imposing stricter covenants on borrowers with respect to trade creditors.

vi Constitution of the National Company Law Tribunal

The National Company Law Tribunal (NCLT) and the National Company Law Appellate Tribunal (NCLAT) were constituted in June 2016. These are meant to serve as a single window for all company law disputes, including insolvency proceedings, assuming powers previously exercised by High Courts, the Company Law Board and the Board of Industrial and Financial Reconstruction.

v Basel III

Basel III implementation has commenced in a staged manner in India, with full implementation expected by 31 March 2019. While it is generally expected that implementation of Basel III may increase lending rates, unlike LMA and APLMA jurisdictions, domestic creditors have not introduced a concept of ‘increased costs' for Basel III implementation in loan documentation. Foreign creditors in India however adopt the LMA standard of reserving a right to claim increased costs from the borrower, subject usually to negotiated caps.

vi Sanctions and Anti-Corruption Laws

Sanctions and anti-corruption laws were previously broadly subsumed by Indian creditors within the representations and covenants on compliance with all applicable laws. In recent times, based on recommendations of the Financial Action Task Force and the Basel Committee, the RBI has issued various guidelines on compliance by banks with these standards11 in respect of monitoring accounts and reporting of suspicious activity.

Banks are also now subject to enhanced ‘know your customer' (KYC) requirements, which are tailored to meet these guidelines. Most domestic banks require borrowers and security providers to complete a comprehensive KYC as a condition precedent to disbursement. International banks as well as domestic banks with a presence in the United States and the European Union may additionally require borrowers to comply with requirements of the Office of Foreign Assets Control regime or the relevant EU regime. Typically, creditors do not look to extend compliance requirements beyond these regimes (except in transaction-specific cases).

vii MCLR

While RBI guidelines permit banks and NBFCs to determine interest rates linked to market determined external benchmarks (such as the London Interbank Offered Rate), most domestic lenders adopt the ‘marginal cost of funds based lending rate' (MCLR). In April 2016, the RBI replaced the existing interest rate system with the MCLR. Under the MCLR, the lending rate is also pegged against change in rates and costs of borrowing by banks, including the repo rate. The MCLR adopts a tenor-based benchmark, and the final lending rate offered to individual borrowers includes the ‘spread' over and above the MCLR.

III TAX CONSIDERATIONS

i Indian withholding tax

An Indian borrower is required to withhold tax payable by a non-resident creditor on interest. Interest payable on a foreign currency denominated loan is subject to a withholding tax of 20 per cent (plus applicable surcharge and cess12), while interest on a rupee-denominated loan is subject to withholding tax of 40 per cent (plus applicable surcharge and cess). A lower withholding tax rate of 5 per cent (plus applicable surcharge and cess) may be available where an Indian company avails itself of a long term foreign currency loan, or issues long term foreign currency or rupee denominated bonds, subject to fulfilment of certain prescribed conditions linked to the Indian exchange control regulations.13 Interest on loans to Indian borrowers outside India for their offshore businesses are not subject to withholding in India, while loans taken out in India are subject to withholding taxes.

Indian tax laws also offer lower withholding tax rates to certain foreign investors who qualify as FPIs. Generally, FPIs suffer a withholding tax of 20 per cent (plus applicable surcharge and cess) in case of interest from any securities. However, a lower withholding tax rate of 5 per cent (plus applicable surcharge and cess) applies in case of payment of interest on rupee-denominated bonds of an Indian company.14

Non-resident creditors and FPIs may also be eligible to avail themselves of beneficial tax rates available under India's vast array of double tax avoidance agreements (DTAAs). Certain DTAAs exempt interest income from tax, should the interest be paid to certain specified creditors (such as government, specified governmental agencies, financial institutions and statutory or local authorities etc.). The rate of withholding tax on interest varies from 7.5 per cent to 40 per cent as per the DTAAs executed by India.

The introduction of the Goods and Services Tax in India may impact the cost of lending, since increased service tax will be leviable on banking services.

ii Documentary and transfer taxes

Documentary (or stamp) taxes are payable on every document signed in India or signed outside India but brought into India (including in some states, in electronic form). Therefore, if creditors anticipate a document being brought into India (for instance, to enforce), stamp duty is usually paid at the time of signing. Rates of stamp duty on most documents are determined by the respective state governments for where the document is to be executed or for the location of the immoveable property concerned. While some states (such as Delhi, Gujarat, Telangana and Andhra Pradesh) have lower stamp duty rates (with loan agreements subject to rates between US$3 and US$10), states such as Maharashtra impose a significantly higher stamp duty, at 0.2 per cent of the amount being lent. The rate of stamp duty payable on various types of security interests also varies significantly (from US$0.15 in Andhra Pradesh to US$15,500 in Karnataka) and is a consideration for creditors while choosing their security package. Following a 2015 judgment of the Supreme Court of India,15 although collateral is created in favour of a single agent or trustee in consortium lending, security documents are required to be stamped as though executed separately in favour of each creditor.

Loan trading transactions attract stamp duty. While novation of commitment may attract a nominal stamp duty (since stamp duty is already paid on the loan agreement), stamp duty on an agreement for assignment of a loan and receivables (being treated as a conveyance of moveables) attracts stamp duty ranging from 3 per cent to 14 per cent of the loan amount being assigned. In order to give a boost to the securitisation market in the country, however, the legislature has recently exempted securitisation transactions involving the transfer of rights or interest of banks or financial institutions in financial assets from stamp duty incidence.

Typically, the adequacy of stamp duty on instruments is tested when: (1) they are sought to be registered or otherwise presented to a public authority who has the authority to impound such documents under the stamp laws; or (2) they are sought to be enforced or relied on as evidence (in court proceedings or private dispute resolution proceedings such as arbitration).

While the obligation to pay stamp duty is usually borne by the borrower under loan documentation, in the State of Maharashtra, creditors are liable to pay a penalty equal to the stamp duty on any instrument creating rights in their favour that is inadequately stamped. Documentation is typically structured in a manner that minimises stamp duty incidence (such as by executing in states that have a lower stamp duty rate and agreeing to jurisdiction clauses of such state).

FATCA and CRS

From 2015, the Foreign Account Tax Compliance Act (FATCA) and Common Reporting Standard (CRS) have become applicable in India, under the inter-governmental agreements executed by the Indian government. These arrangements have been implemented in India by requiring financial institutions to share relevant data with the Central Board of Direct Taxes, which will then transmit this information to the relevant offshore authorities. The RBI has also modified its KYC and reporting guidelines applicable to lending institutions to incorporate the FATCA and CRS requirements. Creditors typically address FATCA compliance by requiring the borrower and other creditors to confirm their FATCA status, and each party bears its own FATCA deductions, with no gross up (similar to the LMA arrangements on FATCA).

IV CREDIT SUPPORT AND SUBORDINATION

i Security
Types of security interest

Creditors can choose from a variety of security options to safeguard their exposure to borrowers and minimise risks associated with lending in India. Typically, high-value transactions involve the creation of multilayered security packages. While creditors may have preference for the type of security that is to be created, industry, and company-specific diligence plays a key role in charting out strategy for assets to be secured as well as the type of security interest to be created, in order to ensure the highest degree of protection.

Mortgages

A mortgage is a transfer of interest in immoveable property to secure an existing or future debt or the performance of an engagement which may give rise to a pecuniary liability. While there are different types of mortgages that may be created in India (such as usufructuary mortgage, mortgage by conditional sale), in secured lending transactions involving immoveable property as security, typically a mortgage in the English form or by deposit of title deeds is created. Many traditional lending institutions in India still require a borrower to mortgage some immoveable property for any lending, since this is seen to provide a greater assurance than security over moveable or financial assets. Working capital is typically secured by receivables and the stock-in-trade of the borrower.

A mortgage in English form is the preferred form of security, since it involves a complete transfer of property to the creditor subject to the right of redemption of the mortgagee. It is typically associated with ease of enforcement, since a creditor has private remedies available (such as appointment of a receiver for the property) under law and does not have to rely on a court process for protection or enforcement of security. There is ambiguity regarding whether such remedies are available to foreign creditors, however. Legal structuring of a mortgage in English form allows borrowers to charge or assign moveables, contracts and other assets along with the immoveable property, affording the benefit of private remedies and ease of mortgage enforcement to all such assets. A mortgage in English form can, thus, effectively secure all assets of the borrower.

A mortgage by deposit of title deeds requires the deposit of title deeds of the property with the creditor with an intention to create security over such property (usually demonstrated by a declaration issued by the borrower at the time of deposit of the title deeds). Such mortgage can be created only over immoveable property and, therefore, does not afford the convenience of stapled security unlike a mortgage in English form.

Pledge and lien

A pledge is a special form of ‘bailment' under law and, therefore, requires actual or constructive delivery of possession of the assets being pledged. Since transfer of possession restricts the ability of the borrower to use the secured assets, a pledge is usually created over shares and financial assets, which are not required for day-to-day operations. Such a pledge is created by handover of the share or security certificates to the creditor, or if the securities are in electronic form, by the marking of a pledge over the securities in the records of the depository,16 which ‘locks' the securities and does not permit any transaction without the consent of the creditor. Pledges are usually accompanied by a power of attorney in favour of the creditor (or the trustee) for exercise of rights in respect of the securities on the occurrence of a default.

Pledges are taken as security in all kinds of financing, including project financing and mezzanine or structured financing, since they allow borrowers to leverage financial securities held by them and provide ease of enforcement. Upon a default by the pledgor, a sale of the pledged assets can be effected without court intervention, and the proceeds can be used by the pledgee to discharge the pledgor or borrower of its obligations.

Indian law also recognises retention of title clauses and provides for security in the form of a lien to unpaid sellers.

Charge and Hypothecation

While moveable assets are frequently ‘stapled' with immoveable property in an English mortgage (see section on Mortgages, supra), where immoveable property is not available or is being secured by a mortgage by deposit of title deeds, creditors require the borrower to charge its moveable assets (physical assets, financial assets and non-physical assets) under a hypothecation document. While a standalone mortgage over moveable properties has also been recognised, this is not the usual route adopted by creditors in India. A hypothecation is recognised in Indian law as a charge on existing or future moveable property without delivery of possession. It is a contractual creation of a special property in assets, entitling the creditor to take possession of those assets in a default and sell them for realisation of outstanding debt. Both fixed and floating charges are recognised in India.

Substitution Rights

In most public-private partnership projects (e.g., roads and airports), the government continues to own the project asset, with a concession being granted to the borrower to develop and operate the asset. Similarly, several assets such as telecom, spectrum, mining rights etc. are owned by the government and licensed to private parties. These assets cannot be charged directly to creditors. Therefore, government authorities enter into tripartite arrangements with creditors, under which they allow the creditors a right to substitute the borrower with an eligible third party (subject to certain conditions). However, the sanctity of such arrangements is not clear.

Common methods of taking security

The most common types of security interests associated with certain types of assets are:

  • a real estate: by way of a mortgage over immoveable property, which may also encompass all other assets of the borrower under a stapled security structure;
  • b tangible moveable property: by way of a mortgage (if stapled with land) or a hypothecation;
  • c financial securities: usually by way of a pledge, delivering possession to the creditors; and
  • d contractual rights, receivables, intellectual property, etc., by way of a mortgage (if stapled with land) or a hypothecation. Additional perfection rights may be required depending on the nature of the asset (e.g., creation of charge over aircraft is required to be endorsed on the certificate of registration with the Directorate-General of Civil Aviation). With respect to intellectual property, creation of any security interest is required to be notified to the relevant registration authorities.

Foreign creditors also require a no-objection certificate from the relevant authorised dealer (AD)17 prior to creation of security over any Indian assets in their favour.

Common methods of enforcement

Enforcement of a security interest may be done either privately or through court intervention. A typical private enforcement process would take about two to four years, whereas a court process may extend to about 10 to 12 years.

A mortgagee has the right to file a suit for foreclosure or sale on default in repayment; however, such rights have not been extended to foreign creditors under the Indian transfer of property regime. Thus, while foreclosure is not an option for mortgages in English form or foreign creditors, creditors holding a mortgage in English form are permitted to effect a private sale of the property or appoint a private receiver without approaching a court. The enforcement of a charge over moveable assets requires the intervention of courts unless the terms of the underlying contract expressly provides for it. For a pledge, a creditor may simply sell the pledged assets in accordance with the terms of the underlying contract and after giving reasonable notice to the pledgor. Creditors have a duty to maximise recovery from secured assets.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI Act) provides creditors private remedies to enforce any security interest (except a pledge on moveable assets or a lien). Where a substantial part of the business is held as collateral by the creditors (such as in a project financing), they are also permitted to take over the management of the borrower. In cases of consortium lending, approval of 60 per cent of the creditors in value is required for exercise of powers under the SARFAESI Act, and such approval is binding on all creditors (including dissenting creditors). By way of recent amendments, the remedies under the SARFAESI Act have also been extended to the listed bond market in India.

Debt recovery tribunals (DRTs) have been established in India under the Recovery of Debts and Bankruptcy Insolvency Resolution and Bankruptcy of Individuals and Partnership Firms Act, 1993. Creditors (including secured creditors who have not received full repayment from enforcement of security) may apply to the DRTs for recovery of debt. Recovery officers of the DRT are empowered to, inter alia, attach property of the borrower (even such property which is not offered as collateral) and require third-party debtors of the borrower to repay debt amounts to the officer. The efficacy of approaching the DRTs to seek recovery of debt is severely hampered by an immense backlog of cases. It is estimated that there are over 70,000 cases pending before the various DRTs.18 It has also been a common grievance that the officers appointed to such tribunals are highly inexperienced and lack the requisite training to adjudicate on debt-related issues.

Under extant foreign exchange regulations, foreign creditors require AD approval for enforcement of security and repatriation of proceeds. Further, enforcement would also need to comply with generally applicable foreign exchange restrictions, including that the sale of immoveable property can only be to a resident and any invocation of pledge is to be in accordance with the foreign investment policies.

Formalities and registration

Board approval

Any creation of security over a company's assets needs the approval of the Board of directors of the company, by way of a physical meeting. Creation of security over assets exceeding specified valuation thresholds also requires approval of three-quarters of the shareholders of a company. In case of third party security, additional corporate compliances are required, including demonstrating that such collateral is being provided in the ordinary course of business, or that the party for whose benefit it is being provided is not a related party (such as, for instance, that there are no common directors).

Stamping

See Section III, supra.

Registration

All charges (including mortgages, pledges, lien, etc.) created over the property and assets of a company are to be registered with the Registrar of Companies within 300 days of the date of creation of the charge for the security interest to be enforceable vis-à-vis the company's creditors and its liquidator, for a fee ranging between US$3 and US$9.

Mortgages over immoveable property (other than by way of deposit of title deeds) are also required to be registered with the sub-registrar of assurances in whose jurisdiction the property is situated. The registration fee varies across various states and may either be a capped amount (US$461 in Maharashtra) or ad valorem in respect of the amount secured. Mortgages by deposit of title deeds are required to be noted in the land registry in certain states.

Creditors are required to file details of mortgages created in their favour with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI) under the SARFAESI Act. Additionally, specific assets may also require additional registration (for instance, the assignment or transmission of rights in relation to patents is required to be filed in the register of patents). By way of a recent amendment to the SARFAESI Act, it was proposed that the Central Government integrate all registration systems for recording security interests over all types of assets (which are currently regulated under diverse legislations such as the Companies Act, 2013, the Merchant Shipping Act, 1958 and the Patents Act, 1970) with the CERSAI. This integration process has not yet been made effective.

Particular challenges

Some of the specific challenges faced by creditors in the creation and enforcement of security in India are as follows:

  • a requirement of government consent for creation and enforcement of security. Consent of local authorities may be required in some states for mortgaging land, particularly if the creditor is not a recognised/notified creditor. Certain assets (such as production-sharing contracts or mining leases) require government approval for creation and enforcement of any security, and enforcement is also possible against a limited number of entities. Similarly, forest land cannot be mortgaged, as it belongs to the government and approval is required even for the removal of immoveable plant and machinery located on it (which may itself be charged to the creditor). Securing government approvals may require approval of the relevant authority, and any transfer on enforcement may only be in favour of a similarly qualified entity;
  • b transaction costs remain high on account of stamp and registration duties;
  • c private enforcement is limited to only certain types of creditors, and enforcement proceedings through the court process are highly protracted, resulting in a diminution in the value of the assets over time; and
  • d under Indian transfer of property laws, there may be dual ownership over fixed assets and the land on which such assets are located. This creates complications for the purposes of enforcement of security by creditors.
ii Guarantees and other forms of credit support

Corporate guarantees are usually sought by creditors from the parent or from associated companies of the borrower entity. Although guarantees are executed as deeds (and, therefore, do not require consideration to pass to the guarantor), most creditors require the guarantor to demonstrate consideration in the form of a corporate benefit accruing to it.

Given India's traditionally promoter-driven corporate market, many creditors require individual promoters to provide personal guarantees for corporate loans. Creditors also require promoters to provide personal guarantees as a condition of restructuring loans (including under the RBI's SDR guidelines), on the principle that shareholders should bear the first loss. In view of the burgeoning NPA problem (see Section I, supra), the RBI in 2014 allowed banks to classify guarantors who refuse to honour guarantees as ‘wilful defaulters', restricting access to capital and debt markets. With the increasing focus on guarantors by both banks and regulators, many corporate groups resist guarantees by individual promoters.

Group company guarantees require a host of corporate compliances to be met, including that the guarantor and the borrower should not have common directors and approval of the shareholders of the guarantor.

iii Priorities and subordination

As is the norm globally and with the changing landscape of insolvency laws in India, secured creditors continue to have better protection and preferential access to borrower assets than unsecured creditors.19 Certain encumbrances created under law also have priority over secured creditor rights (such as banker's lien and an unpaid vendor's lien). Since these rely on a preferential status by virtue of possession, priority rules gain significance in the context of non-possessory securities (such as charges and mortgage).

In the absence of contractual provisions to the contrary, the following rules of priority are applicable under Indian law:

  • a between two registered charges, the charge registered prior in time will have priority;
  • b an equitable mortgage takes effect against any mortgage deed subsequently executed and registered in relation to the same property;
  • c a mortgage of moveables with possession has priority over a prior mortgage without possession;
  • d a mortgagee of moveable property without possession that comes to court first, will have priority over subsequent such mortgagees that approach the court;
  • e a fixed charge has priority over a floating charge;
  • f between two floating charges, the one created earlier in time will have priority; and
  • g the registration and fulfilment of perfection requirements of a charge give it priority over a non-registered and non-perfected charge, notwithstanding when the charge was created.

Contractual priorities in security are usually set out in an intercreditor or subordination agreement between the creditors. Intercreditor arrangements include turnover provisions (requiring subordinated creditors to turn over any out-of-turn recoveries to senior creditors) and trust provisions (whereunder subordinated creditors agree that any out-of-turn recoveries will be held in trust for senior creditors). Intercreditor arrangements are fairly standard and are afforded sanctity by courts as well as participating lending institutions. It remains to be tested whether turnover subordination provisions will be binding on a liquidator appointed under the Insolvency Code or the Companies Act, 2013.

Typical LMA and APLMA provisions requiring majority creditor consent for enforcement or other action against a borrower or obligor are viewed as unenforceable under Indian law, since the Indian Contract Act, 1872 holds contracts restraining legal proceedings to be void. Therefore, enforcement priority in India is maintained by imposing wait periods (up to a year) on subordinated creditors for enforcement.

An intercreditor arrangement may become problematic when different types of creditors are party to it, since all creditors do not have equal access to special enforcement mechanisms. For instance, remedies under the SARFAESI Act are not available to foreign creditors who are not registered in India and to certain NBFCs. The imposition of wait periods for access to remedies under the SARFAESI Act also entitles some creditors to invoke remedies under the SARFAESI Act before others. While an intercreditor arrangement may address these issues by requiring creditors who have the benefit of these regimes to share recoveries with other creditors, this results in an unsatisfactory situation where the notified creditors can then not recover their dues as they have (notionally) already received full payment from the borrower.

Recent RBI guidelines mandate the formation of a ‘joint lender's forum' (JLF) comprising all creditors, when certain stress triggers are met.20 While such fora may include foreign creditors, it is not mandatory for creditors who are not subject to RBI regulation to be a part of a JLF. All members of such a joint forum are required to sign an intercreditor agreement to govern priority, voting and decision-making; however preexisting agreements between JLF members are usually honoured.

V LEGAL RESERVATIONS AND OPINIONS PRACTICE

i Limitations on the validity and enforceability of guarantees and security

Although India broadly adopts a pro-creditor approach in ensuring the least possible hindrance in the enforcement of security interests and guarantees, there are certain limitations to enforceability that find their origin in law and apply in a universal fashion. These include the necessity of demonstrating a corporate benefit, aspects pertaining to financial assistance and the existence of clawback risks in the context of insolvency. These issues have been elaborated upon in more detail below.

ii Corporate benefit

A corporate benefit is required to be demonstrated in different ways, depending on the type of transaction being entered into and the person or entity to whom loans are being advanced or on behalf of whom security interests are being created (e.g., in favour of lenders). There applies a blanket prohibition on loans being advanced or security being created by a company in favour of its own directors or persons in whom the directors are interested. The exceptions to this rule include the provision of loans or security as part of the service ordinarily extended by the company to its employees or pursuant to a scheme expressly approved by the members of the company.

Financial assistance

The Companies Act, 2013 restricts public companies from giving loans or guarantees, or providing security or any financial assistance in connection with the purchase or subscription of shares by any person (including any shares in its holding company).

Clawback risks

As the insolvency regime applicable to corporate entities is spread over the provisions of the Companies Act, 2013 and the Insolvency Code, there are several clawback risks that apply depending on the framework under which the relevant antecedent transaction is being scrutinised. These have been set out in the table below:

Antecedent transaction

Counterparty to the transaction

Effect

Look-back period

Consequence

Who may apply

Fraudulent preference under the Companies Act, 2013

Creditor, surety or guarantor

Puts person in better position in liquidation than would be if no preference given

Six months prior to making of winding up application

The NCLT may restore position to what it would have been if no preference given

Suo moto

Transfers not in good faith under the Companies Act, 2013

A purchaser or encumbrancer in good faith

A transfer of property or delivery of goods not being a transfer or delivery made in the ordinary course of business

One year before presentation of a petition for winding up by the NCLT

The NCLT would deem such transfer or delivery void against the company liquidator

Suo moto

Creation of a floating charge under the Companies Act, 2013

Any person

Creation of a floating charge on the undertaking or property of the company, unless it is proved that the company was solvent immediately after the creation of the floating charge

One year before presentation of a petition for winding up by the NCLT

The NCLT would deem such floating charge invalid except to the extent of any money paid in consideration for the charge together with interest on this amount

Disclaimer of onerous property under the Companies Act, 2013

Any person party to a land of any tenure, shares, non-saleable property or unprofitable contract

Onerous on the company

N/A

The NCLT may allow the official liquidator to disclaim such property

Official liquidator

Preferential transactions under the Insolvency Code

Creditor, surety or guarantor

Transfer of property or an interest thereof on account of an antecedent financial liability, operational debt or other liability owed by corporate debtor having an effect of putting person in a better position than under waterfall mechanism under Section 53

Related party: during period of two years preceding insolvency commencement date

Other than related party: during period of one year preceding insolvency commencement date

Avoidance of preferential transactions or any order made by the Tribunal under Section 44 of the Code

Liquidator or resolution professional

Undervalued transactions under the Insolvency Code

If the transaction was deliberately entered into by the company to keep assets beyond the reach of creditors or adversely affect a person's claims, such transaction can be treated as a transaction defrauding creditors.

Any person

A gift is made to a person; or

A transaction is entered into that involves transfer of one or more assets or consideration that is significantly less than the value of consideration provided by corporate debtor.

Related party: during period of two years preceding insolvency commencement date

Other than related party: during period of one year preceding insolvency commencement date

Declaration of transaction as void or reversal of effect of transaction (as provided under Section 48), release of security created or return of benefits

Liquidator, resolution professional, or creditor, member or partner of the corporate debtor

Extortionate credit transaction under the Insolvency Code

Any person other than financial service companies

Requires the company to pay exorbitant payments for credit provided or is unconscionable under laws of contracts

Two years from insolvency commencement date

Set aside the transaction, restore the position or modify the transaction

Liquidator or resolution professional

v Legal opinions practice

The issuance of legal opinions is standard practice for the purposes of Indian lending. Such opinions usually contain statements regarding the capacity of the counterparty to execute the necessary documentation and to enter into the transaction. For the purposes of secured lending, such opinions also explicitly comment on the validity of the security interest being created. It is the creditors' counsel who usually delivers such opinions. However, in some cases, opinions are sought from the borrower's counsel along with a supporting confirmation from the creditors' counsel.

vi Choice of Law

Decrees passed by courts of a ‘reciprocating territory' may be executed in India as Indian decrees, except in certain limited circumstances (for example, where the judgment has not been pronounced by a court of competent jurisdiction, where it has not been given on the merits of the case or where it appears on its face to be founded on an incorrect view of international law). The government notifies jurisdictions that qualify as ‘reciprocating territories' by way of notification in the Official Gazette. So far only 12 jurisdictions have been notified as reciprocating territories, and this list does not include several key jurisdictions, including the US. Judgments or decrees of courts in non-reciprocating territories can be enforced only by filing a lawsuit in an Indian Court for a judgment based on the foreign judgment.

It is also relevant to mention here that certain changes have recently been carried out to the framework governing domestic and international arbitration. By way of these amendments, the scope for challenging a foreign award on the basis of violation of public policy has been narrowed, and awards have been prohibited from being set aside merely on the ground of an erroneous application of the law or by way of re-appreciation of evidence.

VI LOAN TRADING

Loan trading is common in India, with most documentation structures providing for loan trading without borrower consent by way of novation (usually of undisbursed commitment) and assignment (of a disbursed facility). Large loans involve agent and security trustee structures, allowing new creditors the benefit of existing collateral without requiring action on the part of the borrower. In the event of trading of bilateral loans, however, a release and recreation of security with the cooperation of the borrower is inevitable, which has also its own stamp taxes and registration cost implications. See section III, supra for a more detailed analysis.

Sub-participation and risk participation without a change to the creditor on record have seen an increase in Indian markets in light of the NPA issue, the market having been estimated to have grown by over 45 per cent in the financial year 2015-2016 and being worth over US$4 billion.21 This has encouraged banks to trade stressed assets. Securitisation (i.e. assignment of loans and receivables to ARCs that issue security receipts to holders) is governed by the SARFAESI Act, which contemplates transfer of stressed assets to ARCs, which would then undertake recovery measures against the borrower. There has been a big push to promote such entities by the RBI and the Indian government in the recent past, including liberalising foreign investment in such companies. Foreign investment by eligible FPIs is also now permitted in securitised debt instruments issued by ARCs.

In September 2016, the RBI permitted banks to sell their stressed assets to other creditors, NBFCs and financial institutions. As per these guidelines, ‘scheduled commercial banks' are required to identify assets for sale on an annual basis and periodically review the classification of their financial assets. Banks are also required to invite public bids for the same, in order to attract more buyers and improve the price discovery mechanism. Banks have also now been permitted to buy back financial assets which have been successfully restructured by ARCs (other than those which were sold by the banks themselves).

VII OTHER ISSUES

There are certain other issues under the current regulatory framework that act as impediments to entities or persons looking to lend in India. Some of these issues are specific to foreign creditors, while others affect domestic and foreign creditors alike.

Some of the issues that impact creditors include the ‘lock-in' that applies to FPIs, which are permitted to invest in unlisted corporate debt securities only subject to a minimum residual maturity of three years and several end-use restrictions (the lock-in restrictions do not apply to investments in securitised debt instruments, however).

Besides this, there also apply several restrictions on remittances outside India. Any remittance of proceeds from the enforcement of security by a secured creditor may also require RBI approval.

Another recent development that creditors may need to be mindful of, is the notification of the Real Estate (Regulation and Development) Act, 2016, which provides for greater regulation of borrowers in the real estate sector and provides for, inter alia, stringent timelines for the completion of projects and for restrictions on the usage of money received from buyers for purposes other than for the development of the project. The empowered authority under the Act is authorised to revoke the registration of promoters for contravention of provisions of the Act. Lenders to borrowers in the real estate sector may be required to enforce stricter compliance and escrow mechanisms.

VIII OUTLOOK AND CONCLUSIONS

The Indian lending market is currently in a state of transition, with creditors exploring new structures and avenues for lending on the one hand, and borrowers exploring new avenues for fund raising on the other.

We expect the market to take some time to settle following the recently introduced measures to tackle the NPA problem, with several banks still in the process of identifying and addressing bad loans. The growth of ARCs, the introduction of the Insolvency Code and the granting of greater powers to the RBI/Ministry of Finance, among other measures, are also likely to have a big impact on lending in India.

New institutions and sources of investments, such as masala bonds, high-yield bonds, mezzanine finance, etc., are also likely to affect traditional lending, with borrowers looking for cheaper funds from more lightly regulated institutions.

1 L Viswanathan is the chair of finance and projects and Dhananjay Kumar is a partner at Cyril Amarchand Mangaldas. The authors acknowledge the help received from Surya Sreenivasan and Gautam Sundaresh.

2 The RBI is the central bank constituted under the Reserve Bank of India Act, 1934, which is accorded the statutory mandate to govern the functioning of the banking sector in India.

3 The estimated number of stressed assets has doubled since 2013. https://rbi.org.in/Scripts/BS_SpeechesView.aspx?Id=1035 (last accessed on 6 June 2017). At the direction of the RBI, proceedings have been initiated against 12 of the largest corporate defaulters by banks, with directions to resolve NPAs being issued by the RBI in respect of other defaulters (a six-month time period has been provided for such resolution, after which the RBI may refer these cases to insolvency proceedings).

4 RBI, Report on Trend and Progress of Banking in India 2015-16.

5 As per the Financial Stability Report of June 2017 released by the RBI, the gross NPAs of scheduled commercial banks rose from 9.2 per cent in September 2016 to 9.6 per cent in March 2017, with an estimated increase to 10.2 per cent in March 2018.

6 ‘Guidelines on Enhancing Credit Supply for Large Borrowers through Market Mechanism' notified on 25 August 2016 and effective from 1 April 2017. The RBI has also implemented the Basel Committee for Banking Supervision Standards on ‘Supervisory framework for measuring and controlling large exposures' through its ‘Large Exposures Framework', notified on 1 December 2016 and effective from 1 April 2019.

7 The Indian Banks Association has notified some standard formats, the broad terms of which are adopted by lenders.

8 RBI, Report on Trend and Progress of Banking in India 2015-2016.

9 Introduced by the RBI in June 2015.

10 Introduced by the RBI in June 2016.

11 Consolidated in the RBI Master Direction - ‘Know Your Customer' Direction dated 25 February 2016.

12 Surcharge may be zero per cent, 2 per cent or 5 per cent depending on the income thresholds. Rate of cess will be 3 per cent.

13 This reduced rate of withholding tax is applicable until 30 June 2020.

14 Subject to fulfilment of certain conditions. Also, this reduced rate of withholding tax is applicable until 20 June 2020.

15 Chief Controlling Revenue Authority v. Coastal Gujarat Power Limited & Ors, Civil Appeal No. 6054 of 2015 (arising out of SLP (C) No. 32319 of 2013).

16 A depository is an entity registered with the Securities and Exchange Board of India to hold dematerialised securities in its system and maintain records for the beneficial owners of such securities.

17 AD banks are banks which are authorised by the RBI to deal in foreign exchange in India.

18 http://ibbi.gov.in/16_Joint_Committee_on_Insolvency_and_Bankruptcy_Code_2015_1.pdf (last accessed 1 June 2017).

19 Under the Insolvency Code, secured creditors have the option of enforcing their security interests without relinquishing the same to the liquidation estate. In such scenarios, the unpaid debt of secured creditors ranks at par with government dues and below unsecured financial creditors under the liquidation waterfall.

20 Currently required for categorisation of asset as ‘SMA-2' in the books of the creditor (i.e., where the principal or interest payment has been overdue between 61-90 days).

21 www.indiainfoline.com/article/print/news-top-story/indian-securitization-market-grew-by-45-in-fy16-outlook-positive-in-fy17-116052400757_1.html (last accessed on 1 June 2017).