In an auction process, the Banks/FIs put up stressed assets for auction after applying a haircut but with a reserve price through an invitation to the ARCs. But, prospective buyers need not be restricted to ARCs. Banks may also offer the assets to other banks/NBFCs/FIs, etc. who have the necessary capital and expertise in resolving stressed assets. Participation of more buyers will result in better price discovery.

The invitations for bids is publicly solicited which enables the participation of as many prospective buyers as possible.

Based on the ‘Preliminary Information’ and the corresponding ‘Reserve Prices ‘provided by the Banks/FIs, ARCs carry out due diligence on the short-listed accounts at the data rooms of banks/FIs. Generally, the terms of offer provide for payment of Management Fees to the acquirer ARC ranging between 1.5% to 2% per annum calculated on the Net Asset Value of the Security Receipts(SRs) or the outstanding acquisition cost, whichever is less. Banks/FIs, with a view to encourage quick recovery, also provide for payment of an incentive to the ARCs, ranging between 3 to 5% of the amounts recovered within 3 or 4 years.

The interested ARCs then place their bids account wise or for a pool of assets as per the terms of offer, subject to the cash component of the bid amount being not less than 15% or as stipulated by the seller Bank/FI.

The bank then, if required negotiates with the highest bidder and confirms the sale. The ARC forms a separate trust(SPV)and upon execution of an ‘Assignment Deed’ the Banks/QIBs and the ARC transfer their share of ‘Acquisition Cost’(Investment) to the trust account, which in turn is paid to the selling Bank/FI towards sale consideration. The trust then issues ‘Security Receipts’ to the investors corresponding to the investments made in the acquisition.

ARCs acquire these assets by paying in cash (minimum 15%) or by issuing security receipts or ‘hope notes’ whose redemption is contingent on the recoveries made. Since security receipts (SRs) are backed by impaired assets, without predicable cash flows, they have the characteristics of both debt and equity.

ARC functions more or less like a mutual fund. It transfers the acquired assets to one or more trusts at the price at which the financial assets were acquired from the originator.

Then, the trusts issue security receipts to QIB. The trusteeship of such trusts shall vest with the ARC. ARC will get only management fee from the trusts.

Post-acquisition of the debt, ARC will independently asses the borrower and explore various options available for maximising recovery within the stipulated 5-year period (which may be further extended to 8 years in deserving cases).

An ARC considers a number of different routes to maximise realisation from the assets, including liquidation/settlement/restructuring or rehabilitation and turnaround to ensure payment from the improved operating cash flows of the company. Proceeds, if any, are distributed according to the shareholding of the SRs. As an intermediary recovering dues on behalf of SR holders, ARC charge a management fee. The distribution of recovery proceeds follows a waterfall structure, with legal and resolution expenses incurred if any are appropriated first, the Management Fee and incentive if any payable to the ARC are appropriated next and the residual balance amount is used to redeem SRs proportionately. In case of excess recovery, beyond the principal acquisition cost, ARC gets paid 20% share of the upside.

Banks’ motivation for selling loans to ARCs: Under RBI’s guidelines, banks are required to make 100 percent provision within four years for NPAs consisting of secured loans. Till February 2014, banks were required to debit the loss from the sale of NPAs from their profit and loss account for that accounting year. To incentivise sale of NPAs, the RBI relaxed this norm after February 26, 2014, and up to March 31, 2016.

Under the new guidelines, banks can spread the loss on account of sale to ARCs over two years. The logic is that over longer time horizons bank balance sheets would recover. In any case, if banks hold on to stressed assets this will get reflected in their numbers on headline gross non-performing loans.

SRs are classified as investments and their Net Asset Value (NAV) is based on assessments of a credit rating agency “if the sale to SC/ RC is at a price below the net book value (NBV) (book value less provisions held), the shortfall should be debited to the profit and loss account”. ARCs are required to get their SRs rated by SEBI-registered rating agencies at regular intervals and inform the banks/financial institutions so that they can adjust the valuation of their investments.