RBI’s Revised Corporate Governance Norms For ARCs
Asset reconstruction companies (“ARCs”) play a critical role in handling stressed assets and in helping reduce non-performing assets (“NPAs”) in the banking system that can otherwise slow down credit growth in our economy, and pose substantial dangers to the health and stability of India’s financial system. In the 19 years since the enactment of India’s comprehensive legislation on securitisation and asset reconstruction – the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest, Act 2002, the number of ARCs has substantially increased. As of 31 July 2022, 29 ARCs were registered with the Reserve Bank of India (“RBI”) spread across Mumbai, New Delhi, Hyderabad, Bangalore, Chennai and Ahmedabad. Even with the number of ARCs now active, the assets under management of the top five ARCs as on 31 March 2021 constituted 70 per cent of the total assets under management of all of the ARCs when considering book value acquired, showing concentration amongst the larger ARCs.
The RBI noted in its Statement on Developmental and Regulatory Policies issued on 7 April 2021 that the regulatory guidelines for ARCs had become outdated since they were issued in 2003, in addition to the fact that India now had far more ARCs and that such ARCs had also increased in size over the past two decades. In particular, the RBI appeared concerned that ARCs had not been able to fully realise their potential for resolving stressed assets. Accordingly, the RBI constituted a committee chaired by Mr Sudarshan Sen to review the functioning of ARCs and suggest changes to how they were regulated (“Sen Committee”).
The Sen Committee identified a few interesting data points that brought to the forefront the need for relooking at the regulatory environment for ARCs. The ARCs were a major avenue for banks to recover NPAs from the inception of ARCs in 2003 until FY19, after which banks began to recover more NPAs pursuant to resolutions under the Insolvency and Bankruptcy Code, 2016 in FY20. The reasons for this appeared to be the time-bound recovery provided for under the IBC, and the relatively below par performance of ARCs in resolution of such stressed assets. The Sen Committee noted that the overall recovery of ARCs for the first nine financial years of operation (FY04 to FY13) was 68.6 per cent when measured by redemption of security receipts issued by ARCs as a percentage of total security receipts issued by them, but dropped significantly to 14.29 per cent when considered on the basis of book value of the assets acquired.
Accordingly, the RBI notified new guidelines on 11 October 2022 to update the existing regulatory framework on the functioning and operation of asset reconstructions companies (“New Guidelines”). The New Guidelines have introduced changes that can broadly be classified as (a) corporate governance improvements, and (b) operational, investment and fund requirement changes. The former category of changes include requirements concerning board composition, new mandated board committees, changes to tenures of senior management and introduction of age limits as well as fit and proper criteria, an impetus to succession planning, progressive increases in net owned fund requirements, relative liberalisation on deployment of surplus funds towards short-term instruments, modifications to mandatory ARC investments in security receipts and change in sponsor triggering prior RBI approval.
While all of these changes are significant, perhaps the most interesting set of changes are the RBI’s increased focus on corporate governance of ARCs. Chief amongst this bucket of changes is the focus on the role of independent directors on the board of ARCs. In this respect, an ARC’s board must be chaired by an independent director and the quorum for any board meeting will be 33 per cent of the total board size or at least three directors present, of which half should be independent directors. This has enhanced focus on the role of independent directors as non-affiliated overseers that can impartially guide key management decisions of ARCs. Also, by requiring at least half the quorum threshold for director attendance at board meetings being independent directors, the RBI has introduced a mechanism whereby independent directors are able to attend and participate productively at ARC board meetings.
The second important corporate governance change is the stipulation for two additional mandated board committees – (a) the audit committee, and (b) the nomination and remuneration committee. In terms of composition, the focus remains on the former consisting of only non-executive directors and the chair being an independent director who is not already the chairperson of the board. The audit committee is required to periodically assess the effectiveness of internal control systems, including the procedures governing asset acquisition and asset reconstruction, in addition to accounting of management fee, incentives and expenses of the ARC. The nomination and remuneration committee has been mandated to ensure the fit and proper status of existing directors and sponsors of the ARC. The New Guidelines increase the onus on the ARC’s board overall by mandating that the board of directors conduct an annual review of the performance of their MD/ CEO and any whole-time directors. Accordingly, ARCs will need to constitute these board committee and ensure they undertake the prescribed roles at regular meetings.
The third key change is how the New Guidelines look at the tenures of an ARC’s managing director or CEO, such officer’s age and the need to focus on searching for their replacement soon. Managing Directors or CEOs can have up to three five-year terms, after which such senior officers should undergo a three-year ‘cooling-off period’. In addition, the RBI has now capped the age of a CEO and all whole-time directors of ARCs at 70 years, but left it to the ARC’s discretion to provide an even lower retirement age. These measures should ensure that an ARC is not helmed by the same MD/CEO for more than 15 years at a stretch, and new blood is introduced in this position at such time. The cooling-off period is interesting as the RBI has stipulated that such officer should not be associated with any other ARC, whether directly or indirectly and in any capacity during such period. Given the special knowledge and experience required for MDs/ CEOs of ARCs, it will be worthwhile to see how this impacts the pool of senior talent available to helm ARCs, and whether this will lead to either (a) internally promoted ARC managers reaching the top role, or (b) banking and financial sector veterans being brought in to replace term-limited CEOs of some of the older ARCs. Given the prohibition on engagement with ARCs during the cooling-off period seems to be a blanket restriction, the ban on indirect engagements and potential consultant / advisor roles with ARCs may lead to ARCs having to put in place more collective decision-making processes and ensure institutional memory for key executive decisions in relation to stressed asset resolution by such ARCs. The focus of the New Guidelines on requiring ARCs to adopt succession planning measures will also lead to more institutional thinking on nurturing management talent and the second-rung of leadership at ARCs to take over.
Finally, the RBI has mandated that the CEO and directors of the ARC submit an annual declaration (and an initial binding covenant when first appointed) where they confirm compliance with prescribed fit and proper criteria. The annual fit and proper declaration includes disclosure of relationships of such director or CEO, a list of their professional achievements, details of any proceedings or disciplinary action (whether pending or resulting in conviction), including criminal prosecution, recognition as a wilful defaulter, the existence of certain disqualifications and violations of certain laws or having received adverse notices from a regulator. This is not a new approach in the realm of financial sector regulations in India, and continues to work on the principle of self-declaration, compliance and imposition of penalties upon the occurrence of contraventions.
While the RBI noted in its Financial Stability Report in June 2022 that gross NPA ratios of scheduled commercial banks are likely to reduce from 5.9 per cent in March 2022 to 5.3 per cent in March 2023, the significance of asset reconstruction companies continuing to play a major role in reduction of stressed assets in the banking system cannot be understated. Accordingly, the corporate governance changes introduced by the New Guidelines are well-intentioned and should lead to better accountability, increased efficiency and improved operational performance by ARCs. We will need to wait and see the theoretical focus of the New Guidelines.
Shuva Mandal is the Chairman and the Managing Partner of Fox Mandal & Associates LLP. Revered as an A-List Lawyer by the Indian Business Law Journal, he specialises in corporate, mergers & acquisitions, and private client advisory, in addition to providing general guidance in all the practice areas of the firm.
Rohan Singh is a Partner in the corporate practice of Fox Mandal & Associates LLP and has significant experience in a wide range of corporate transactions, including mergers and acquisitions, private equity, venture capital, joint ventures, and corporate restructuring. He has advised leading domestic and foreign corporations, private equity and venture capital funds in complex transactions in multiple industry sectors.
