Some basic dope on Asset Reconstruction Companies

Recently, I had decided to write, along with MSG on securitization and asset reconstruction for the DMH research paper. But due to time constraints we had to shelve it. Nonetheless, I was intrigued with the concept of asset reconstruction (AR). I would like to share some basic information regarding the same.

Broadly, there are two kinds of loans-good loans and bad loans. Good loans are those that can be recovered by the bank and bad loans are bad debts or non performing loans (NPL). Let me explain it with the help of an example. If a bank has 10 billion worth of assets, of which 8 billion constitutes good assets and the rest 2 billion of it are non-performing assets (NPAs). Now there are several reasons why the bank would want to get rid of its NPAs. The first reason is that NPAs are essentially loss assets, ie. they pose a very high risk in terms of recovery. Secondly, bank’s NPAs cause problems in its valuation- the balance sheets of the bank do not sufficiently disclose this distinction in its assets. Though the total value of its assets amounts to 10 billion, only 8 billion of it is actually in circulation. Thirdly and most importantly, the 2 billion worth capital of the bank gets locked up and cannot be utilized. Thus, till the bank realises the amount from the debtor by way of litigation, there is excessive opportunity loss and this lock up acts as an impediment to the free cash flow. All of this put together causes fiscal instability in the market.

This issue of bad loans or inefficient NPAs resulted in the birth of asset reconstruction companies (ARCs). The bank basically sells its NPAs to an ARC at a lesser price. These ARCs inturn use their skill and expertise to sell these NPAs, thereby recovering not only the capital invested, but also making profits over it. Relating this to the above example, the bank would sell its 2 billion worth of NPA to an ARC for say 0.75 billion. The ARC would sell this NPA for 1 billion, thereby recovering the 0.75 billion and mking a profit of 0.25 billion over it. The reason why the bank would sell its ARCs at a lower price is-

1. By selling the bad loans to the ARC, the bank’s balance sheets will no longer have any NPAs, there will only be good performing loans;

2. NPAs would now have some value, as against their zero value while they are locked up.

There are three approaches that an ARC could take in order to sell the NPAs-

1. Rapid disposal approach: In this approach the ARC immediately finds a bidder and sells the assets. This approach is used by the U.S.A and China

2. Warehousing approach: In this approach the ARC holds on to the NPAs (hoarding), till the price of the security increases and then sell it.

3. Combination of the above two: In this approach the ARC sells certain assets immediately, while few are held on for some time.

There are two types of ARC on the basis of ownership. Countries like the USA, Malaysia, Thailand have a centralised ARC- ie. there exists only one ARC in the country which deals with asset reconstruction and which is usually set up by the government, banks and financial institutions of the country, together.

Whereas, countries like India, China and Korea have private companies as ARCs. There are currently 13 ARCs which are registered in India under the SARFAESI Act. The disadvantage of having multiple ARCs as against a single ARC is that there is excessive competition between these companies to procure the bad loan for reconstruction. As a result of which these companies are ready to pay a higher amount than the actual valuation of the NPA. For instance, in the above case, if there are many ARCs who want to reconstruct the bad debt, though their valuation indicates the value to be paid for the 2 billion worth NPA should be 0.75 billion, they would be ready to pay a higher price say 0.80 billion for the same NPA.

This is essentially how an ARC works. There are several other interesting issues which I would like to discuss. I will delve into them in my next post. Till then, if there are any comments or corrections or additions, please do feel free to contribute :)

Deal update: The Patni Acquisition

The Deal

• Founder Narendra Patni along with his two brothers, Ashok and Gajendra Patni, hold 46 per cent stake in the company, Patni Computers. Private equity player General Atlantic has 17 per cent shareholding in the company via the American Depository Receipts (ADRs).
• US-based iGate has acquired nearly 63 per cent stake in country's sixth largest IT firm Patni Computer Systems for $1. 22 billion.
• iGate will buy 45.6 per cent of the shares of the three founders of Patni -- Narendra Patni, Gajendra Patni and Ashok Patni-- along with the 17.4 per cent stake of private equity firm General Atlantic.
• The transaction, valued at approximately $1.22 billion, includes the mandatory 20 per cent open offer to be made to the public shareholders of Patni.
• The deal is expected to be completed in the first half of 2011, after acquiring all the regulatory approvals.
• Shares of Patni Computer closed at Rs 463.85, up 0.82 per cent on the Bombay Stock Exchange and Rs 464.10 up 0.80% on the NSE.
• iGate will pay about $921 million for buying the 63 per cent share at Rs 503.50 a piece.
• iGate will issue equity to Apax Partners for $270-480 million, depending on the response to the open offer.
• The US-based company will also raise debt of about $700 million from Jefferies & Company and RBC Capital Markets to fund the acquisition.
• iGate had previously made attempts to acquire the fraud-hit Satyam Computer Services (two years ago).

There are certain taxation related issues which might cause hurdles in the deal. Particularly, tax issues relating to a non-compete fee to be paid to the firm’s promoters and levy of capital gains tax might delay the successful completion of the deal.

Non-compete fee issue

• There is no non-compete fee agreed to in this deal. Non-compete fee is paid to the selling promoters, so that they do not re-enter the business and pose competition to the acquired company.
• The Patni promoters, who hold about 45% in Patni Computer Systems, have refused to sign a non-compete agreement with the prospective buyers, which include a private equity consortium comprising Carlyle and Advent, and iGate Technologies, backed by Apax Partners.
• The promoters have declined to give assurances regarding future business dealings with clients of Patni, raising concern among the private equity partners about the poaching of clients.
• The pressing concern for the bidders is that the promoters should not use their extensive knowledge of the sector to compete with them in the same space almost immediately.
• The other promoters, private equity firm General Atlantic, Gajendra and Ashok Patni, the brothers of Narendra Patni, are not involved in the firm and therefore don’t need to give any personal assurances. The PE firms are also concerned that the promoters, especially Narendra Patni, are not giving any assurances about giving up their right to solicit customers of Patni after the sale. Such an assurance is crucial as the promoters can use their extensive contacts and relationships with clients to lure business away from the new buyers.

Capital Gains issue

·      Indian tax laws mandate the seller in a transaction to pay capital gains tax. However, parties to the transaction can mutually agree on who will pay the tax.

·      There is nothing in Indian tax laws that prohibit the structuring of a transaction in a way where the buyer will pay the tax.

·      While by default, the seller is liable to pay tax, there have also been much-publicised cases such as the tax dispute between the Indian tax authorities and British telecommunications giant Vodafone Plc where, despite being a buyer, Vodafone is now asked to pay Rs12,297 crore as tax involving a 2007 acquisition. Vodafone bought Hutchison Telecommunications International Ltd’s 66.98% stake in Indian telecom company Hutch Essar Ltd by paying $11.2 billion. Hutchison’s ownership of its Indian telecom subsidiary was through a Cayman Islands entity, which sold its stake to an overseas subsidiary of Vodafone. Hutch did not pay tax to the Indian authorities as the parties to the transaction were both overseas entities. The tax liability is under litigation in the Supreme Court.

Importance

The deal is one of the biggest acquisitions in the Indian software industry and is expected to be completed in the first half of 2011, after acquiring all the regulatory approvals.

With the merger of the two companies, a decision about the Patni brand name will also be taken soon and the Patni name might give way to the iGate Global brand.

Debit balance not an ‘International Transaction’: What was the Tribunal thinking?

The Mumbai Income Tax Appellate Tribunal in its recent ruling of Nimbus Communications Limited v. Assistant Commissioner of Income Tax[1], has held that a ‘debit balance’ would not constitute to be an ‘International Transaction’ per se under section 92B of the Income Tax Act, 1961 (“Act”), but is merely a result of such transaction. Essentially the case concerns whether the arm’s length price adjustment that was computed by the transfer pricing officer and the commissioner of income tax was justified. However, for the purpose of this discussion, I wouldn’t delve into that aspect but concentrate on whether the transaction in question qualified to be an ‘International Transaction’ under the Act. In order to ascertain that, it is essential to look at the definition of the same under the Act.

Section 92B defines an international transaction as

“…transaction between two or more associated enterprises, either or both of whom are non-residents, in the nature of

·         purchase, sale or lease of tangible or intangible property, or

·         provision of services, or

·         lending or borrowing money, or

·         any other transaction having a bearing on the profits, income, losses or assets of such enterprises”  

For a transaction to fall within the ambit of the section, it needs to be in the nature of one of the aforementioned transactions. The Tribunal in the present case without determining the nature of the transaction between the assessee and its associated enterprises has stated that an ‘overdue payment’ or ‘a continuing debit balance’ to the assessee from its associated enterprise will not satisfy any of the above heads. It has failed to look into the origin of such overdue payment. In my opinion the source of the debt is of utmost importance to decipher the true nature and substance of the commercial transaction between the related parties. The judgement does not discuss the commercial relation between the two related parties; hence we do not know if there had been a sale, lease, rendering of services or lending-borrowing.

However, interestingly, the Tribunal has examined the last limb of the definition: the residuary clause i.e., whether the debit balance would have a bearing on the profits, incomes, losses or assets of the assessee. Though the Tribunal, without giving any sufficient justification, has rejected the proposition that a debit balance could have any impact on profits, incomes, losses or assets of the assessee, I think there is much depth in this aspect than what was considered by the judges.

In plain accounting terms, a debit balance is an amount which is due to a company. If this amount is legally and validly due, it constitutes a ‘receivable’ vis-a vis that company and wouldn’t feature in its balance sheet until paid. An asset of an enterprise is defined as a resource controlled by the enterprise as a result of past events and from which future economic benefits are expected to flow to the enterprise. Thus, irrespective of the source transaction from which it accrues, such ‘receivable’ that is lawfully due would definitely have an impact or bearing on the assets of the company.  Therefore, the debit balance would definitely fall under the last sub clause of section 92B- as to having a bearing on the ….assets of the company and thus qualify as an international transaction.

In cases pertaining to transfer pricing and arm’s length adjustment, cases are distinguished on the basis of their factual matrix. Whether or not provisions pertaining to transfer pricing can be applied solely depends upon the fact whether the transaction in question falls with Section 92B. The Tribunal has not delved into the facts of the case and has not analyzed the nature of the transaction. In my opinion, the Tribunal’s ruling is patently erroneous and thus, it is dubious if the case can set a strong precedent for future transfer pricing cases involving overdue payments.

---

[1] ITA No.: 6597/Mum/09, Assessment year: 2004-05