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Monday, September 13, 2021

Management takeover under SARFAESI Act - A zombie law

by Pratik Datta.

Introduction

Ever since Caballero et al (2008) coined the phrase, ‘zombie firms’ have attracted much attention in both academic and policy circles. Macey (2021) recently extended the concept to a wholly new genre of zombies - ‘zombie laws’. Freedom from the clutches of zombie laws is a policy priority for India. The Prime Minister himself highlighted the challenge in his recent Independence Day speech. This piece will use the phrase ‘zombie laws’ broadly to refer to provisions of statutes, regulations, and judicial precedents that continue to apply after their underlying economic and legal bases dissipate. Although there are many obvious examples of zombie laws strewn across the Indian legal landscape, this post will illustrate the problem using a slightly more nuanced example. It will explain why section 13(4)(b) of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘SARFAESI Act’) has become a zombie law since the enactment of the Insolvency and Bankruptcy Code in 2016. To appreciate the original rationale behind this provision, it would be useful to set out the broader legislative backdrop.

Background

Section 69 of the Transfer of Property Act, 1882 allows only some mortgagees the right to sell the mortgaged property (security) without court intervention. This right is not available where the mortgagor is of native origin or where the mortgaged property is situated outside presidency towns or any notified area. This legislative design at the time was meant to ensure that the law does not inadvertently empower unscrupulous moneylenders (as mortgagees) against vulnerable native mortgagors in mofussil towns and villages across India. In contrast, European mortgagors in presidency towns were presumed capable enough to take care of their own interests.

Post-independence, this limited right to sell mortgaged property without court intervention proved unsatisfactory for a state-led financial system. Instead of reforming the general law, the Transfer of Property Act, special statutes were enacted to vest the power of sale without court intervention in certain financial institutions like Land Development Banks and State Finance Corporations (‘SFCs’). For example, section 29 of the State Finance Corporations Act, 1951, empowered an SFC to take over the management, possession, or both, of the borrower industrial concern for recovery of its dues. If the borrower still didn’t pay up, the SFC could sell the unit to recover its dues.

In late 1990s, demands were made to extend similar powers to banks and financial institutions to tackle the fledgling non-performing assets problem. This demand resonated with the Andhyarujina Committee, which in March 2000 recommended a special law to empower banks and financial institutions to take possession of securities anywhere in India and sell them for recovery of loans without court intervention. The SARFAESI Act 2002 was the result of this policy thinking.

Section 13 of SARFAESI Act empowers a secured creditor (bank or financial institution) to enforce a security interest created in its favour without court intervention anywhere in India. On default by a borrower, the creditor may serve a notice in writing to the borrower to repay in full within 60 days of receiving such notice. If the borrower fails to comply, the creditor may take recourse to various measures under section 13(4). Clause (b) of section 13(4) initially empowered banks and financial institutions to take over management of the secured assets of the borrower including the right to transfer by way of lease, assignment or sale and realise the secured assets.

In 2004, section 13(4)(b) was amended to empower banks and financial institutions to take over not only the ‘management of the secured assets’, but the entire ‘management of the business’ of the borrower company without court intervention. This includes the right to transfer by way of sale for realising the secured assets. These powers were not originally envisaged by the Andhyarujina Committee.

A Zombie law

In 2000, the Andhyarujina Committee had envisaged the SARFAESI Act as an exception to the general foreclosure law contained in the Transfer of Property Act. Consequently, SARFAESI Act was designed as a special foreclosure law. Like any other foreclosure law, it dealt only with transfer of security (mortgaged property) and not transfer of corporate control of the borrower’s business from shareholders to creditors (or an administrator). The latter is the subject of corporate insolvency law.

When a corporate debtor faces financial distress, shareholders have a perverse incentive to engage in risky strategies. If the strategy pays off, shareholders benefit. If the strategy fails, the creditors bear the losses. To address this moral hazard inherent in the structure of a limited liability company, corporate insolvency law shifts the power to decide on the future of a financially distressed company from its shareholders to its creditors. The creditors could use insolvency law to either restructure their debt in the company or sale the business as a going concern to a third party. This enables the business to exit financial distress with minimal value destruction.

To achieve this outcome, corporate insolvency laws usually provide sophisticated rules to facilitate collective bargaining by the company’s creditors for debt restructuring, appoint an administrator (resolution professional) to monitor a sale, and market the business publicly to maximise the sale value. They also provide various safeguards to check against unfair wealth transfer away from vulnerable claimants of the corporate debtor such as dissenting financial creditors and operational creditors. These safeguards include several unique provisions dealing with preferential transactions, avoidance transactions, wrongful trading, cram down provisions etc. Implementing these safeguards require court supervision.

Foreclosure laws do not require such complicated rules and safeguards since they simply deal with transfer of security and not transfer of corporate control. As a result, court supervision is not as relevant in foreclosure laws. Since SARFAESI Act was initially designed as a special foreclosure law, neither did it provide for the usual safeguards necessary during transfer of corporate control nor did it mandate court supervision to protect vulnerable claimants during such transfers.

The 2004 amendment fundamentally altered this basic design of SARFAESI Act as a foreclosure law. The amended section 13(4)(b) empowered a secured creditor to take over control of the corporate debtor’s business and decide on its future through a sale, a function akin to that of a corporate insolvency law. Yet, unlike a corporate insolvency law, the amendment did not introduce any safeguard or court supervision during takeover of management and subsequent sale of the distressed business. Effectively, the 2004 amendment inserted selective features of corporate insolvency law within a foreclosure law. As a result of this legislative mashup, the amended SARFAESI Act vested disproportionate powers with secured creditors, without safeguarding the interests of other claimants of a corporate debtor. This is not expected of either a foreclosure law or a corporate insolvency law.

This hybrid section 13(4)(b) of SARFAESI Act could have been justified in 2004 as a mechanism to achieve going concern sale of distressed businesses in the absence of a modern corporate insolvency law in India. In 2016 however, India got a comprehensive corporate insolvency law - the Insolvency and Bankruptcy Code (‘IBC’). The IBC now provides a well-defined mechanism to take over management of a distressed corporate debtor to achieve a going concern sale.  On triggering the IBC, the promoter loses control of the corporate debtor. A resolution professional takes over the management, invites plans from potential investors, and places the eligible plans before a committee of financial creditors. This committee can approve a resolution plan by not less than 66% voting share. Such a resolution plan becomes binding only after it is approved by the court (adjudicating authority). Given such elaborate mechanism (with appropriate safeguards) to achieve going concern sales under the IBC, the underlying economic and legal bases for section 13(4)(b) of SARFAESI Act have dissipated. Yet, when SARFAESI Act was amended in 2016 to harmonise it with the IBC, section 13(4)(b) was not revisited. This provision lives on in the statute book only as a zombie law.

Continued existence of such a zombie law is not only unnecessary but it can also be harmful. For instance, the IBC provides stringent safeguards to prevent unfair wealth transfer from dissenting financial creditors and operational creditors. In contrast, section 13(4)(b) of the SARFAESI Act is designed to protect only the interests of secured creditors. It does not offer any credible safeguard for other claimants of a distressed corporate debtor. Therefore, continued use of this section of the SARFAESI Act to take over the management of a distressed corporate debtor without court intervention is detrimental to a wide range of corporate stakeholders.

This problem could be resolved simply by amending section 13(4)(b) to revert to its pre-2004 position. Banks and financial institutions should be able to use section 13(4)(b) only to take over the ‘management of the secured assets’ of the corporate debtor without court intervention and not the management of its entire business. The latter should be permissible only under the IBC. This legal architecture would restore the character of the SARFAESI Act as a special foreclosure law, as originally recommended by the Andhyarujina Committee.

Conclusion

Section 13(4)(b) of SARFAESI Act became a zombie law with the introduction of the IBC. Many such zombies remain scattered across the Indian legal landscape. The government had in 2014 taken a conscious initiative to repeal such laws. Such initiatives are mostly ad hoc. There is no institutional mechanism to tackle the menace. While highlighting this lacuna, former Finance Secretary Dr. Vijay Kelkar suggested that every new economic legislation should ideally have a sunset clause. Incorporating such clauses could nudge the development of requisite institutional capacity to periodically review parliamentary laws and check the rise of the zombies.


Pratik Datta is a Senior Research Fellow at Shardul Amarchand Mangaldas & Co. All views expressed are personal. The author thanks Rajeswari Sengupta, Ajay Shah and two anonymous referees for their useful suggestions.