Vision for Special Situation Funds: Decoding the SEBI Consultation Paper

[By Nikita Singh & Aishana]

The authors are students of Gujarat National Law University.

 

Introduction

In the dynamic landscape of India’s financial sector, the persistent challenge of stressed loans has prompted regulatory interventions and innovative strategies to revitalize the economy and banking system. The exploration from Asset Reconstruction Companies (ARCs) to the emergence of Special Situation Funds (SSFs) as a specialized avenue for addressing the complexities of stressed assets meticulously designed to inject capital and release funds entangled in stressed loans within Banks and NBFCs. The blog navigates through the unique role of SSFs in the resolution and recovery of stressed loans and sheds light on the recent proposed amendments by the RBI in the consultation paper released by the Securities and Exchange Board of India (SEBI) and their potential impact on SSFs, investors, and the broader financial ecosystem. Unveiling the challenges and implications, this exploration aims to provide a comprehensive understanding of the regulatory framework surrounding SSFs and their pivotal role in fostering financial stability and efficient resolution mechanisms.

Stressed Loan Conundrum: Evolution from ARCs to Special Situation Funds

India grapples with a prolonged issue of stressed loans, significantly impacting the banking system and the economy. The Reserve Bank of India (RBI) reports a surge in the gross Non-Performing Assets (NPAs) ratio of Scheduled Commercial Banks (SCBs) from 3.8% in March 2015 to 11.5% in March 2018.[1] The stressed loan ratio, encompassing NPAs and restructured loans, reached 12.6% as of June 2021, with the total stressed loans in SCBs exceeding Rs 93,240 crore by September 2020. In response to this challenge, Asset Reconstruction Companies (ARCs) were established, supported by frameworks like the one in 2014 for revitalizing distressed assets, the 2015 Strategic Debt Restructuring Scheme, the 2016 Scheme for Sustainable Structuring of Stressed Assets,[2] and the 2018 Revised Framework for Resolution of Stressed Assets. ARCs, mandated by the RBI and governed by the SARFAESI Act, 2002, aimed to acquire stressed assets from financial institutions for resolution and recovery. However, hindered by capital constraints, funding issues, market illiquidity, valuation gaps, and legal and operational challenges, ARCs encountered limitations in effectively addressing the complexities of stressed loans.

Special Situation Funds: A Specialized Approach to Stressed Asset Resilience

Special Situation Funds (SSFs), a sub-category of Category I Alternative Investment Funds (AIFs) regulated by the Securities and Exchange Board of India (SEBI), exclusively focus on stressed assets. These assets include securities from investee companies whose stressed loans are acquired either through the RBI Master Directions on Transfer of Loan Exposures or an approved resolution plan under the Insolvency and Bankruptcy Code, 2016 (IBC). Unlike Asset Reconstruction Companies (ARCs), which acquire stressed assets from banks, SSFs invest in the securities of these companies. Classified under Category I AIFs, which target socially or economically desirable sectors, SSFs offer flexibility in their investment approach,[3] allowing them to engage in equity and equity-linked instruments of investee companies, as well as Security Receipts (SRs) issued by ARCs[4]. This flexibility, along with the ability to act as resolution applicants under the IBC, positions SSFs to bring in capital, expertise, and diverse strategies, facilitating improved price discovery, valuation, and reducing the burden on lenders. This distinctive role enables SSFs to complement and supplement the efforts of ARCs and other resolution applicants in addressing the challenges associated with stressed assets.[5]

SEBI-RBI Synergy: The Framework for Special Situation Funds

Special Situation Funds (SSFs), a distinctive category of Alternative Investment Funds (AIFs), operate in the domain of securities for companies undergoing financial distress or insolvency resolution. Regulated by both the Securities and Exchange Board of India (SEBI) and the Reserve Bank of India (RBI), SSFs must comply with stringent regulations outlined by these authorities. Classified as a sub-category under Category I AIFs by SEBI, SSFs adhere to guidelines specified in the SEBI (Alternative Investment Funds) Regulations, 2012, and the SEBI circular dated 27 January 2022, governing eligibility, investment, transfer, monitoring, and supervision norms. Simultaneously, the RBI, through its Master Directions on Transfer of Loan Exposures and Prudential Framework for Resolution of Stressed Assets, delineates criteria, valuation, disclosure, and prudential norms for loan transfers from financial institutions to SSFs. However, a critical condition for SSFs to acquire stressed loans under RBI Master Directions is their inclusion in the Annex, a list of entities permitted by lenders for transferring stressed loan exposures. Despite the condition outlined in SEBI’s circular dated 27 January 2022, yet to be acknowledged by the RBI, the SEBI Consultation Paper highlights multiple suggestions for changes in the regulatory framework for SSFs, emphasizing eligibility criteria, valuation methodology, disclosure requirements, and prudential norms.

Proposed Amendments: Enhancing AIF Regulations for Special Situation Assets and Oversight

SEBI’s Consultation Paper, released on 28 November 2023, outlines crucial amendments to the regulatory framework for Special Situation Funds (SSFs).[6] The proposed amendments encompass key areas, starting with the definition and scope of Special Situation Asset (SSA), including it within the permissible investment scope for SSFs with specified conditions. Notably, the eligibility criteria for SSFs and their investors are under scrutiny, with proposals allowing SSFs with prior investments in stressed companies’ securities to acquire stressed loans, provided it aligns with regulatory guidelines. It emphasizes adherence to Section 29A of the IBC to ascertain investor eligibility, advising SSFs to refrain from investing in or acquiring SSA if any investors are disqualified under Section 29A of the IBC. Further, the proposed amendments explicitly bar SSFs from investing in their related parties, as per the Companies Act, 2013, defining related parties for SSFs as entities sharing common investors, directors, key managerial personnel, or sponsors with the SSF or its manager.

Moreover, the minimum holding period for SSFs to retain SSA is set at one year, contingent upon the resolution of the stressed company. Moreover, SSFs can only transfer or sell SSA to entities enlisted in the Annex of the RBI Master Directions, subject to lender and resolution professional approval. To enhance transparency and oversight, the paper mandates SSFs to submit pertinent information to a designated trade reporting platform, including details on units issued, investors, unit holdings, resolution strategies, recoveries, and any other information specified by SEBI. The proposal also introduces a dedicated supervisory framework for SSFs acquiring stressed loans under Clause 58 of the RBI Master Directions, empowering SEBI to inspect or audit SSFs’ books of accounts, records, and documents, taking necessary actions in case of violations or non-compliance. The paper concludes by inviting public comments and suggestions on the proposed amendments until 28 December 2023.

The Empowering Impact of the Proposed Amendment on Special Situation Funds

The proposed amendment significantly empowers SSFs, allowing active participation in the secondary market for stressed loans, thereby enhancing liquidity and facilitating improved price discovery for lenders. This expansion capitalizes on SSFs’ expertise in stressed companies, fostering the development and execution of effective resolution plans. The overall impact of this amendment is positive, benefitting stressed companies, lenders, and SSFs, ultimately contributing to enhanced financial stability. Crucially, the amendment acts as a safeguard, preserving the integrity and credibility of SSFs and the IBC resolution process. It prevents SSFs from acting as proxies for ineligible entities and ensures investor compliance with Section 29A of the IBC before acquiring special situation assets,[7] thereby elevating transparency and accountability. The amendment also maintains the independence and objectivity of SSFs by prohibiting investments in related entities, mitigating biases and potential conflicts of interest. Furthermore, strict adherence to regulatory guidelines for the transfer or sale of stressed loans is mandated, reinforcing transparency and accountability in the secondary market. Lastly, the amendment strengthens supervision and oversight by SEBI and RBI, emphasizing timely and accurate reporting to regulators and trade reporting platforms. This enhances monitoring, analysis, and coordination between SEBI and RBI, contributing to the overall quality and efficiency of SSFs and the resolution of stressed assets. Compliance with prescribed best practices and guidelines ensures the sustained performance and collective benefit of SSFs, investors, lenders, stressed companies, and the broader financial system.

Challenges and Implications of the Proposed Amendment for SSFs and Investors

The proposed amendment introduces several challenges for Special Situation Funds (SSFs) and their investors. SSFs may face concentration risks by acquiring stressed loans from companies with existing equity or debt exposure, heightening vulnerability. Operational and legal challenges, including due diligence, valuation, documentation, and enforcement issues, pose obstacles to SSFs in acquiring and resolving stressed loans. Compliance with SEBI and RBI regulatory requirements may result in overlaps and inconsistencies, adding complexity. Investors may encounter increased risks and extended lock-in periods due to the inherent illiquidity of stressed assets.[8] SSFs’ structural intricacies and strategies may challenge investor monitoring and evaluation. The amendment imposes constraints and costs, necessitating extensive due diligence on investor eligibility under Section 29A of the IBC[9], potentially impacting confidentiality. Disclosure and reporting to regulators and resolution professionals may compromise confidentiality, and investors risk becoming ineligible during their investment, impacting returns and exit options. Stringent Section 29A requirements may limit investment opportunities and flexibility, leading to legal consequences for ineligible investors. The amendment may restrict investment scope, requiring due diligence on related parties and changes during the investment period, impacting confidentiality and competitiveness. Liquidity and flexibility for SSFs and investors may be compromised, influencing pricing and returns. Complying with regulatory requirements for stressed loan transfers could entail additional costs. Investors may face uncertainties in recovery and exit strategies, unable to sell or transfer assets as desired. The complex regulatory framework may impact investment decisions and expectations, imposing burdens, constraints, and costs on SSFs and investors, ranging from compliance challenges to market uncertainties.[10]

Conclusion

The proposed amendments discussed, facilitated by collaborative efforts between RBI and SEBI, underscore a concerted commitment to enhance transparency, efficiency, and oversight in the SSF domain. While the amendments empower SSFs to actively engage in the secondary market and contribute to liquidity and price discovery, they also bring forth challenges and implications for both SSFs and investors. Striking a delicate balance between empowerment and regulation, the amendments should have a nuanced approach to fostering financial stability and resilience. As India continues its pursuit of effective resolution mechanisms for stressed assets, the role of SSFs stands prominently, offering a specialized and adaptive avenue to navigate the complexities of stressed loans and bolster the overall health of the financial ecosystem.

[1]The Economics times https://economictimes.indiatimes.com/news/economy/indicators/banks-gross-npa-fell-to-a-10-year-low-of-3-9-in-march-rbi-in-financial-stability-report/articleshow/101337543.cms  (last visited December. 21, 2023).

[2] Reserve bank of India https://ibbi.gov.in/uploads/whatsnew/fba385910d34d21ebc14549ae5e4a41e.pdf, (last visited December 21, 2023).

[3] Harsh Mittal, Sidhhartha M K Majoo, Inside SEBI’s Consultation Paper: Reshaping SSFs in Indian Finance, Indiacorp ( Dec 21, 2023, 6:14 PM), https://indiacorplaw.in/2023/12/inside-sebis-consultation-paper-reshaping-ssfs-in-indian-finance.html?amp=1.

[4] Harsh Mittal, Sidhhartha M K Majoo, Inside SEBI’s Consultation Paper: Reshaping SSFs in Indian Finance, Indiacorp ( Dec 21, 2023, 6:14 PM), https://indiacorplaw.in/2023/12/inside-sebis-consultation-paper-reshaping-ssfs-in-indian-finance.html?amp=1.

[5] Divaspati Singh, Khusboo Agarwal,  Introduction of special situations fund- step towards De- stressing Stressed assets, Mondaq (Dec. 4, 2023, 9:29 PM), https://www.mondaq.com/india/securities/1156344/introduction-of-special-situations-fund–step-towards-de-stressing-stressed-assets.

[6] The Legal world, https://legal.economictimes.indiatimes.com/news/regulators/sebi-proposes-changes-in-regulatory-framework-for-special-situation-funds/105572837 ( last visited December 21, 2023)

[7] The Economics times, https://economictimes.indiatimes.com/markets/stocks/news/sebi-moves-to-prevent-misuse-of-ssfs/articleshow/105575762.cms ( last visited December 21, 2023).

[8] Mini Raman, Angelina Talukdar, Special situation funds: the concept and framework, Mondaq, (Dec. 4, 2023, 9:57 PM), https://www.mondaq.com/india/financial-services/1155832/sebi-details-regulatory-norms-for-special-situation-funds-ssf-for-investment-in-special-situation-assets.

[9] Taxguru , https://taxguru.in/sebi/sebis-consultation-paper-special-situation-funds-regulatory-changes.html, (last visited December 21, 2023).

[10] Mahendra Singh, Tanvi Goyal, SEBI details regulatory norms for special situation funds (SSF) for investment in special situation assests, Mondaq, (Dec. 4, 2023, 9:57 PM), https://www.mondaq.com/india/financial-services/1155832/sebi-details-regulatory-norms-for-special-situation-funds-ssf-for-investment-in-special-situation-assets.

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