Securitisation in India started taking shape in an unregulated environment (with the first securitisation transaction having been concluded in the early 1990s) and until 2006 there were no specific regulations governing securitisation transactions (in relation to performing assets) in India. The Reserve Bank of India (RBI) formulated guidelines in 2006 (which were modified in 2012) for governing securitisation of standard assets (Securitisation Guidelines). Standard assets (or performing assets) under Indian law, would generally be assets where amounts due have not been outstanding for more than 90 days.
At the time when the Securitisation Guidelines were issued, housing finance companies were regulated by the National Housing Bank (NHB) and NHB did not issue any separate regulations for governing securitisation transactions originated by housing finance companies. However, housing finance companies were in any event complying with the RBI Guidelines as the acquirers were mostly banks or other non-banking financial companies. Recently, the RBI has been vested with powers to regulate housing finance companies also. Accordingly, it is expected that the RBI Guidelines will also be extended to housing finance companies.
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 largely dealt with resolving, restructuring and securitisation of non-performing assets (NPAs) and accordingly references to securitisation in this chapter concern only to securitisation of standard (or performing) assets.
Securitisation transactions in India were largely dominated by single-loan securitisations until about 2008. In such transactions, a financial institution lends money to a large corporate entity and thereafter immediately securitises the cash flows, with the interval between the loan origination and the securitisation being greatly reduced to one or two days. Following the global economic crisis and an unfavourable interpretation of tax laws applicable to securitisation trusts, securitisation transactions came to a halt in 2008. Securitisation transactions made a comeback in the Indian market in 2013 after the RBI revised the Securitisation Guidelines and the relevant tax laws were modified to introduce specific provisions affirming the pass-through status of a securitisation trust.
In the past six years, there have been various mortgage-backed securitisations (MBS) and asset-backed securitisations. The key asset pools securitised have been housing loans, property backed loans, vehicle loans, equipment loans and consumer durable loans.
The investors in securitisations transactions are mostly banks and non-banking financial companies. The investment by banks in these transactions are also driven by the priority sector lending targets stipulated by the RBI for banks. However, in the past two to three years, the market has also seen new entrants like mutual funds and insurance companies participating as investors.
The key features in a typical securitisation transaction in India are as follows:
- The acquiring entity (a special purpose vehicle, or SPV) is set up in the form of a private trust. While the option to incorporate as a company exists, the taxation principles applicable to a company make it unattractive as a vehicle for securitisation transactions.
- The SPV issues pass-through certificates (PTCs) to the investors, for raising the funds required to acquire the assets.
- The sale is structured on a 'par' basis, with the originator entitled to residual cash flows.
- The originator makes available credit enhancement and also undertakes the servicing obligations.
- Credit enhancement is typically structured as a cash collateral placed in a fixed deposit with a bank. There are instances where the credit enhancement also comprises over-collateralisation or a second-loss piece in the form of a bank guarantee.
- The assets securitised have to be held on the books of the originator for a minimum period, prior to securitisation.
- The originator is also required to retain a minimum exposure to the securitisation transaction (from 5 per cent to 10 per cent), which is typically met by the credit enhancement made available by the originator.
There has been some activity in the market in relation to securitisation transactions that are not regulated by the RBI (i.e., where the originator is not a financial institution), but this has not grown beyond a few stray transactions. In future, however, with direct bank credit in India being tightened, we expect to see more transactions of this nature. In these transactions the requirements for minimum holding period and minimum retention requirements would not be applicable.
The past 12 months have been an interesting period for the securitisation market in India, as direct funding from banks to non-banking financial companies came to a standstill. The lack of direct funding left the non-banking financial institutions with the sole option of securitisation of loans to meet liquidity requirements. Accordingly, the past 12 months have seen the highest levels of activity in the Indian securitisation market.
According to the Report of the Committee on the Development of Housing Finance Securitisation Market published on the RBI website in September 2019, the total volume of securitisation increased from 235.45 billion rupees in the financial year 2005–2006 to 2.66 trillion rupees in the financial year 2018–2019, an elevenfold growth in 13 years. Note that the Indian market also considers direct assignment transactions between financial entities to be part of the 'securitisation market' and accordingly these figures may also include direct assignment transactions.
The regulators have recently been making attempts to increase the securitisation deal flow. In this regard, two initiatives are worth mentioning: (1) with a view to improving the MBS market, the RBI constituted the Committee on the Development of Housing Finance Securitisation Market, which then submitted its report to the RBI (the report quoted above) and the RBI is now waiting for comments from the public before taking steps to implement the recommendations; and (2) the government introduced a partial credit guarantee scheme under which government-owned banks have been encouraged to acquire high-rated assets by providing a partial guarantee for losses of up to 10 per cent of the pool assigned.
The Securitisation Guidelines prescribe a minimum retention requirement of 5 per cent to 10 per cent of the assets being securitised, and also that the assets be held on the books of the originator for a minimum period (normally from six to 12 months) prior to securitisation. There are no minimum retention requirements or minimum holding period requirements in relation to transactions that fall outside the Securitisation Guidelines.
The choice is left to the seller to fulfil the risk retention requirements either through investment in the securities issued by the SPV or through the provision of credit enhancement. Normally, this is met through the provision of first-loss credit enhancement and, if that is not sufficient, by subscribing to senior tranches of the securities issued by the SPV. The minimum retention requirement has to be met by the originator only and cannot be met by any other company forming part of the same group of companies, even though for the purposes of the Securitisation Guidelines the term 'originator' would include group companies.
Recently, to improve the liquidity situation for non-banking financing companies, the RBI has relaxed the minimum holding period for longer-tenure loans, subject to the minimum retention being increased to 20 per cent for securitisations of such loans.
i Prohibited securitisations
The Securitisation Guidelines stipulate certain assets that cannot be securitised, including assets purchased, securitisation exposures, revolving credit facilities and loans with bullet payment. While prohibiting securitisation of revolving credit facilities may make sense, the other prohibitions do create problems in relation to liquidity management for originators who hold assets of this nature and could, in turn, limit the appetite of investors in this market. For example, an entity purchasing assets from another entity pursuant to a business transfer has to keep in mind that, under the Securitisation Guidelines, the purchaser will not be able to securitise the loan assets acquired. While market participants have been working on structures around this, many representations have been made to the regulators to reconsider these restrictions.
The taxation issues surrounding securitisation transactions have been clarified in the relevant tax laws in so far as regulated securitisations are concerned (i.e., securitisation transactions governed by RBI regulations or regulations of the Securities and Exchange Board of India (SEBI), the capital markets regulator). However, even for unregulated securitisations, the tax laws that govern taxation of private trusts, the most commonly used securitisation vehicle in India, provide pass-through tax treatment to such vehicles, so long as the trust is not seen to be doing business.
Tax can be imposed on securitisation transactions in relation to the following elements:
- tax on income received by the SPV from the underlying loan assets;
- tax on fees payable by the SPV to any service provider, including collection and servicing agents, escrow banks or credit enhancement providers;
- tax on distribution of income by the SPV to the investors; and
- tax on the transfer of assets from the originator to the SPV.
Under current regulations, it is clear that there will be no Indian tax applicable on income received by the SPV from the underlying loan assets. In relation to fees payable by SPVs to service providers, goods and services tax would apply; however, these taxes can be passed on to the service providers and factored in to the fee payable to them.
In relation to distribution of income by the SPV to investors, the SPV is required to deduct tax at source, which means that although payment of tax is made by the SPV, the benefit of the payment is provided to the investors. Therefore, as long as the investor is an Indian tax resident, this deduction will not impact the commercial considerations of the transaction; however, for offshore tax residents this will impact commercial considerations.
In relation to tax on the transfer of assets from the originator to the SPV, although there is no impact under the laws specifically governing direct or indirect taxation, laws governing payment of stamp duty and registration fees have to be considered. Stamp duty would be applicable on all legal instruments executed in connection with a securitisation transaction. Stamp duty in India varies according to the state in which the document is being executed.
An assignment transaction under stamp laws applicable in India would be considered a conveyance transaction and stamp duty would have to be paid accordingly. Stamp duty applicable on a conveyance transaction could vary from 3 per cent to 11 per cent of the debt being assigned depending on the state in which the transaction is being executed. Given the significant costs associated with a conveyance transaction, certain states in India, such as Maharashtra, Delhi, Rajasthan, Punjab, West Bengal and Gujarat, have reduced the stamp duty applicable for securitisation transactions. Given that only certain states have offer this benefit of a reduction in stamp duty, most securitisation transactions in India are concluded in these states.
Further, given that mortgage debt is treated at par with immovable property (i.e., land) for the purposes of transfer laws, in any MBS transaction, registration of the deed of assignment transferring the mortgage debt also has to be considered. Here again different states have different applicable rates and parties choose the state according to the fees payable. In fact, in certain transactions, to avoid this fee impact, parties also devise structures wherein the underlying security interest is not transferred and therefore there is no registration requirement.
iii Authorisations and licences
Under Indian laws, any entity that has financial assets that constitute more than 50 per cent of its total assets and financial income that constitutes more than 50 per cent of its total income is required to be registered with the RBI as a non-banking financial company. Therefore, most lenders in the Indian market are registered as non-banking financial companies.
The trustee of the SPV would normally be an entity that is registered with SEBI as a 'debenture trustee'.
The rating agencies that rate the PTCs would have to be registered with SEBI.
Domestic investors in the PTCs would not require any specific registration for investing in the PTCs; however, the test for determining status as a non-banking financial company should be borne in mind. The only route available to foreign investors looking to invest in PTCs is for the investor to be registered as a foreign portfolio investor (FPI) with SEBI and to invest in the PTCs under the relevant foreign exchange laws stipulated in the Foreign Exchange Management Act 1992 and in accordance with the rules and regulations issued under that Act.
There are no specific licences required for acting as a servicing agent for the SPV. However, given the number of people employed and the offices used for performing services for the servicing agent, general licences and registrations related to employment and business would have to be considered.
III SECURITY AND GUARANTEES
In relation to loan assets that are commonly securitised in India, the key security interests created would be as follows: mortgage, hypothecation, pledge, institutional guarantee and personal guarantee.
Generally, a mortgage is created over immovable property and a hypothecation is created where movable property is involved. Institutional guarantees could be made available by entities set up specifically for this purpose, such as the National Housing Bank or mortgage guarantee companies. Personal guarantees are obtained either from family members of the borrower (in the case of individual borrowers) or from directors or promoters of the borrower (in the case of incorporated borrowers).
The collateral over which mortgages are created includes land (both residential and commercial), buildings and houses. The mortgages themselves can be of different kinds, with the most common forms being an equitable mortgage (where the mortgage is created simply by depositing title deeds of the property with the lender and no documents are executed for creation of the mortgage), an English mortgage (where the mortgage is created by way of a written instrument that is duly registered with the relevant authorities and whereby all rights, title and interest in the mortgaged property are conveyed to the lender, subject to the right of the owner to obtain a reconveyance) and a simple mortgage (where the mortgage is created by way of a written instrument that is duly registered with the relevant authorities). The formalities required for creation and the manner of enforcement will vary according to the form of mortgage adopted.
The collateral over which hypothecation is created includes vehicles (two-wheelers, three-wheelers, four-wheelers and trucks used for both personal and commercial purposes), equipment (construction, medical, etc.) and receivables (whether from financing or trading activities). A hypothecation is usually created via a written instrument. Further, in relation to hypothecation created over vehicles, the registration certificate of that vehicle will also note the name of the financier.
A pledge is generally created over movable properties by handing over possession of the relevant property to the lender. This form of security creation is mostly followed when creating security over shares or gold. Although there are no documents specifically required for creation of this security interest, an agreement between the parties would normally record the terms of the pledge.
In relation to the creation of a security to the extent that the owner of the collateral is a company, the company would be required to make the appropriate filings with the registrar of companies to record the creation of the security interest. Apart from this and the registration requirements with respect to mortgages noted above, there are no generally applicable legal formalities required of the borrower (or the security provider) with respect to the creation of a security. The lenders, if governed by the Securitisation Act, are expected to register security interests created in their favour with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India.
There is currently no standard form of documentation followed in India for security creation, even though attempts are being made to streamline documentation.
The security created can be set aside if the owner of the collateral is subject to bankruptcy proceedings within the suspect period (i.e., the period leading up to the bankruptcy order) set out in the applicable law. The principles in Indian law regarding the suspect period as applicable to companies are explained below (see Section V) and these principles would apply even for the setting aside of the security interest created.
Credit enhancement for securitisations
The credit enhancement made available for securitisation transactions could include cash collateral placed in the form of fixed deposits, corporate guarantees provided by the originator or a group company, and bank guarantees provided by a third party over collateral made available by the originator.
There are questions as to whether credit enhancement made available by the originator, whether in the form of over-collateral or fixed deposits held in the name of the originator, would be bankruptcy remote in relation to the originator (see Section V).
While there are no fixed limits on the credit enhancement that can be made available, the Securitisation Guidelines do provide that where the exposure of the originator to the securitisation transaction exceeds 20 per cent (taking into account all exposure, including the credit enhancement made available) the originator will have to risk-weight the excess exposure at a much higher level.
The government has also recently introduced the partial credit guarantee scheme referred to in Section I.
IV PRIORITY OF PAYMENTS AND WATERFALLS
The typical waterfall mechanism in a securitisation transaction would be as follows:
- statutory dues;
- costs and expenses of the SPV, including fees payable to servicers of the SPV;
- payment of expected cash flows on PTCs;
- reinstatement of the credit enhancement made available (with the second loss being reinstated prior to the first loss); and
- residual cash to the originator.
The key issue to be borne in mind in this regard is ensuring that underlying cash flows are sufficient to meet the payments set out under the waterfall mechanism. While there are no statutory dues currently payable by an SPV set up in the form of a private trust, this could change. In relation to fees and expenses, the fees and expenses of the collection and servicing agent and credit enhancement providers would get covered. In this regard, it is typical for the agreements to provide that the servicer will only be entitled to a fee and all costs and expenses of the servicer will be borne by the servicer (if not recovered from the borrowers) to ensure that there are no claims on the SPV beyond the identified amounts.
Given that originators continue as the collection and servicing agent in most securitisation transactions, the commingling risk of the originator must also be considered. Typically, all cash flows arising from securitised assets are collected in the bank accounts of the originator and are transferred to the SPV only on a monthly basis with the time lag between collection by originator and deposit with SPV extended to 30 days in some cases. Therefore, it may be prudent to monitor the credit situation of the originator and also to have triggers in place in the documentation that would require the originator to transfer the cash flows more frequently if the identified triggers have occurred. These triggers could be linked to the rating of the originator.
In the event that all cash flows from a particular set of assets that have been securitised are being received by the originator in an identified account, investors may also consider entering into escrow arrangements with respect to that account to avoid commingling issues. Security can be taken over a bank account in India. The typical process for this is to mark a lien over the bank account and the monies credited to the account in the records of the bank. Additionally, in some cases a hypothecation is also created over the bank account and the monies credited to the account through a deed of hypothecation and this document is filed with the relevant registrar of companies.
Given that most securitisation transactions are carried out on a par basis there would be an excess spread in each such transaction on account of the difference between the underlying loan rates and the agreed rate on the PTCs. This spread is normally subordinated and will be paid to the originator on a monthly basis only if all payments due on the PTCs have been met and the credit enhancement has been reinstated. However, in certain transactions, this excess spread may also be trapped until the PTCs have been repaid in full.
V ISOLATION OF ASSETS AND BANKRUPTCY REMOTENESS
The Securitisation Guidelines codify the parameters for achieving a 'true sale' in connection with a securitisation transaction and this is the standard that would typically be used in determining whether the true sale criterion is met for any securitisation transaction, whether regulated or not.
The true sale parameters as set out under the Securitisation Guidelines require one to look into the economic characteristics of the transaction, as an asset can be derecognised from the accounts books of the seller only once the substantial risks and rewards associated with the asset have been transferred. In relation to whether substantial risks and rewards have been transferred, the Securitisation Guidelines does provide that the originator continuing to act as collection and servicing agent or providing credit enhancement would not vitiate the true-sale nature of the transaction.
Therefore, the test for determining a true sale under the Securitisation Guidelines would be to establish whether there are any obligations being undertaken by the originator apart from the servicing obligations and the credit enhancement. In this regard, even if representations are provided regarding the future performance of the securitised pool, these representations would be treated as retention of risk in the assets, through the implied indemnity for breach of representations.
In relation to the collection and servicing arrangement, it should be ensured that the originator, as agent of the SPV, is not undertaking any obligations as servicer that an independent third party would not take.
In relation to credit enhancement being made available by the originator, the Securitisation Guidelines stipulate that if the exposure of the originator to the SPV exceeds 20 per cent of the loans securitised, the excess exposure should be risk-weighted at a higher level. In this regard, therefore, if on account of credit enhancement being made available the exposure of the originator is going beyond the stipulated level, the parties should also analyse whether this would result in substantial risk being retained by the originator.
It must also be noted that the accounting standards in India have recently been changed and the revised accounting standards, which are in line with global standards, do not permit derecognition of assets sold in a securitisation transaction if the credit enhancement made available by the originator is higher than the inherent risk in the assets securitised. On account of the revised accounting standards, most originators are not able to achieve derecognition on balance sheet for assets securitised (as credit enhancements made available are typically in the 5 per cent to 10 per cent range, whereas inherent risk in these assets could range from 3 per cent to 4 per cent) even though they meet the true-sale requirements under the Securitisation Guidelines.
The new accounting standards do present a challenge when it comes to testing bankruptcy remoteness of securitised assets, as the general principle of bankruptcy applicable in India is that all assets shown on balance sheet will form part of the estate of the debtor under bankruptcy. However, under Indian insolvency laws, for assets held in trust, there is also a carve-out from the estate of the debtor under bankruptcy, and therefore in relation to the assets securitised, it could be argued that these should not be treated as assets of the originator, especially when the RBI true-sale standards have been met.
In this regard, it is also worth noting that the law regarding insolvency of banks, non-banking financial companies and housing finance companies is currently in flux, as the Insolvency and Bankruptcy Code 2016 (IBC), which is a stand-alone ordinance governing bankruptcy, excludes from its ambit 'financial service providers', and this term would generally include banks and non-banking financial companies. However, any law addressing financial service providers should in our view incorporate some of the basic principles of insolvency as set out under the IBC, including the fact that assets held in trust should not form part of the estate of the debtor under bankruptcy.
As stated in Section III, it is also important to note that any securitisation transaction may also be set aside pursuant to the provisions of law dealing with the suspect period, which is codified in Sections 328 and 329 of the Companies Act 2013 and Sections 43 and 45 of the IBC.
These provisions set out the following two principles. First, if the winding-up of the seller commences (or is deemed to have commenced), within one year of the transaction being entered into, then the assignment of the assets may be challenged on the grounds of 'fraudulent preference' or 'preferential transaction'. However, in the event of such a challenge, it may have to be first established that the assignment was made in favour of a creditor (or a surety or a guarantor in respect of any of the liabilities of the company being wound up), and not made in favour of a bona fide transferee or for valuable consideration. Second, if the winding-up of the seller commences (or is deemed to have commenced), within one year of the transaction being entered into, then the assignment of the assets may be challenged on the grounds that the assignment is void. However, in the event of such a challenge, it has to be first established that the transfer was not made either in the ordinary course of business of the seller, or in good faith and for valuable consideration.
Given the turmoil currently facing the financial sector, and regulators' focus on improving the securitisation market, we are expecting various relaxations of the Securitisation Guidelines, including relaxations of prohibited securitisations, minimum retention requirements and minimum holding period requirements.
Furthermore, pursuant to the recently submitted report on MBS transactions by the RBI-constituted Committee on the Development of Housing Finance Securitisation Market, we are expecting the regulators to initiate a consultative process to move towards uniformity of stamp duty and registration laws.
There has also been a clamour to rationalise the withholding tax applicable in relation to FPIs investing in PTCs with corporate bonds (for which withholding tax is currently set at 5 per cent). If this were to happen, investments in PTCs would also become an attractive avenue for foreign investors.
1 Nihas Basheer is a partner at Wadia Ghandy & Co.