Overview of the SARFAESI Act – Background | Provisions | Features

The SARFAESI Act 'Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act', was enacted in 2002. This legislation allows banks and other financial institutions to auction residential or commercial properties to recover loans. The act enables the lenders to enforce security interests without the need for court intervention, which speeds up the recovery process.
Under SARFAESI, secured creditors (banks or financial institutions) have the authority to take possession of the secured assets (such as property) when borrowers fail to repay their loans. They can then manage, lease, appoint managers to manage, or even sell these assets directly. The objective of the act is to ensure asset quality in the banking system, reduce non-performing assets (NPAs), and streamline the process of debt recovery in India.

Table of Contents

1. Background
2. Salient features of SARFAESI Act
3. Some problems in SARFAESI Act

Check out Taxmann's SARFAESI & Debts Recovery Law Manual, which is a comprehensive, organised, and up-to-date resource on SARFAESI and Debts Recovery Laws. It provides detailed topic-wise commentary and includes all relevant statutory laws (Acts, Rules, Circulars, and Notifications).

1. Background

One of the major problems being faced by banks and financial institutions in India is that of bad debts, termed in glorified phrase as ‘Non-Performing Assets’ (NPA) in official terminology.

There are many reasons for the sorry state of affairs, major among them are

• Political interference
• Poor law enforcement
• Archaic laws and procedures and
• Corruption at various levels.

Non-Performing Assets (NPAs) of Banks and FI are increasing at alarming levels. Some NPAs are because of business failures due to conditions/situations beyond control of management. In such cases, entrepreneurs cannot be blamed much for defaults. However, some NPAs are because of unscrupulous managements, who misuse the funds or divert the funds elsewhere.

Thus the SARFAESI Act may be helpful in recovering NPAs in some cases, though not all.

The present psychology of many borrowers is that the money borrowed is not to be returned and they can fight legal battles endlessly without impunity. Sarfaesi Act failed to change this psychology. However, it seems Insolvency Code has made some change in psychology. If this psychology changes, the major purpose of Act will be served.

Added to this is the tendency developed in last 50 years of misappropriation of funds borrowed from banks and financial institutions and use the funds for personal benefit.

This has become a fashion now.

Added to this is loan waivers granted by Governments from time to time, due to which person repaying loans in time seems to be a fool.

Government is aware of the problem. RBI is becoming stricter and is tightening the norms in respect of Non-Performing Assets.

SICA was enacted in 1986 to ‘solve’ the problem of sick companies. SICA not only failed to solve the problem of sick companies, but in fact, helped in aggravating the problem of NPAs, as companies found ‘safe heaven’ and ‘unlimited protection’ in section 22 of the SICA. Now, the law has been repealed and has been replaced by Insolvency Code, 2016, which is much more effective than SICA.

Recovery of Debts Due to Banks and Financial Institutions Act, 1993’ (Now Recovery of Debts and Bankruptcy Act, 1993) was passed to expedite the recovery. After some false starts, the Act has stabilised. Results achieved by the formation of Debts Recovery Tribunals (DRT) and Appellate Tribunals formed under the RDB Act can at the most be said as ‘moderately encouraging’.

The ‘Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002’ (SARFAESI Act) made effective on 21-6-2002 was one more step (in fact three steps) in the direction of improving the health of banks and financial institutions by reducing NPAs.

Insolvency Code, 2016 is one more step in that direction.

1.1 Historical background of the present SARFAESI Act

Bank/FI almost always grant loans/credit facilities on basis of security. The security may be in form of mortgage, hypothecation, pledge etc. In addition, personal guarantees of directors/partners/ group companies are obtained. Thus, on paper, the lending by Bank/FI appears to be very secured. However, when the time comes, it is found that the security for advance/loan is only on paper and is of no use in recovering the bad debts.

Under provisions of section 69 of Transfer of Property Act, mortgagee can take possession of mortgaged property and sale the same without intervention of Court only in case of English mortgage, if the mortgagee makes default in making payment of mortgage money. In addition, mortgagee can take possession of mortgaged property where there is specific provision in mortgage deed and the mortgaged property is situated in towns of Kolkata, Chennai or Mumbai. In other cases, possession of property can be taken only with intervention of Court.

[English Mortgage is where mortgagor binds himself to repay the mortgaged money on a certain date, and transfers the mortgaged property absolutely to the mortgagee, but subject to a proviso that he will re-transfer the property to the mortgagor upon payment of the mortgage money as agreed. – section 58(e) of Transfer of Property Act].

Thus, under these laws, Banks/ Financial Institutions were required to enforce their security through Court. This is a very slow and time consuming process and by the time the Bank/FI is able to get possession of asset (if at all), the asset either does not exist or has become valueless.

Besides, there was no specific provision in the law in respect of hypothecation, though hypothecation is one of the major security interest taken by Bank/FI.

There was no specific provision in law for securitization of assets and asset reconstruction.

The SARFAESI Act is based on Narsimham Committee I & II and Andhyarujina Committee reports for enacting new law for regulation of securitisation and asset reconstruction and enforcement of security interest.

1.2 Constitutional Validity of SARFAESI Act

Constitutional validity of the Act has been upheld in Mardia Chemicals v. UOI  2004 AIR SCW 2541 = 136 Taxman 360 = 51 SCL 513 = AIR 2004 SC 2371 = (2004) 4 SCC 311 = 120 Comp Cas 373 (SC 3 member bench). In this case, it was held that even rights of private parties under contract can be altered with retrospective effect in public interest. Provision under Securitisation Act empowering Banks and Financial Institutions to take possession of charged assets without intervention of Court was held valid, even in respect of loan agreements entered into prior to the passing of Securitisation Act.

Constitutional validity of sections 13, 17, 18 and 19 was upheld in M R Utensils v. UOI (2002) 40 SCL 360 (Guj HC DB).

Constitutional validity of section 13 has been upheld in Garlon Polyfab v. State Bank of India (2003) 133 Taxman 493 = 48 SCL 617 (All HC DB), holding that on receipt of notice under section 13(2) of SARFAESI Act, borrower can give any explanation which must be considered by the secured creditor before taking action under section 13(4).

In Apex Electricals v. ICICI Bank Ltd. (2003) 46 SCL 592 (Guj HC), validity of Act was upheld. Provision extending Act to Cooperative Banks was also upheld. However, it was held that Bank should follow principles of natural justice and allow borrower to submit their replies after receipt of notice by them. Bank should consider the replies before taking action of possession of assets.

Court cannot compel rehabilitation – Court under its writ jurisdiction cannot compel Financial Institution to revive and rehabilitate sick industry by providing financial assistance. – IFCI v. Sri Krishna Oil Complex Ltd. (2002) 39 SCL 673 (AP HC DB).

1.3 SARFAESI Act applies to Jammu and Kashmir

SARFAESI Act is referable to Entry 45 in List I of Schedule VII of Constitution of India (Banking). It is not referable to ‘transfer of property’. Hence, SARFAESI Act is applicable to J&K – State Bank of India v. Santosh Gupta (2017) 2 SCC 538 = (2017) 140 SCL 216 = 76 taxmann.com 234 (SC) [In this case, it was held that SARFAESI Act is applicable to J&K. It was held that Section 140 of J&K Transfer of Property Act has to give way to SARFAESI Act and not the other way round].

In Bhupinder Singh Sodhi  v. UOI  (2016) 133 SCL 101 = 62 taxmann.com 95 (J&K HC DB), it was held that SARFAESI Act affects law and rights of State subjects as regards transfer of immovable properties to non-State subjects. Hence, SARFAESI Act cannot be enforced in State of J&K. Now this judgment is not valid.

Only exception is that appeal against action of secured creditor is required to be filed before Court of District Judge in case of J&K [section 17A of SARFAESI Act]

2. Salient features of SARFAESI Act

The long title of the Act, as amended in 2016 (w.e.f. 1-9-2016) reads as follows –

• Regulate Securitisation and Reconstruction of Financial Assets
• Enforcement of Security Interest
• Provide for Central Database of security interest created on property rights

These three provisions are independent of each other in many aspects.

The broad structure of SARFAESI Act is as follows –

The Act is really ‘three in one’ Act.  The Act makes provisions for following –

• Enforcement of security interest (which is most important part of the  Act)
• Securitisation
• Asset reconstruction

Salient features of these provisions (which are independent of each other in many aspects) are summarized below.

2.1 Enforcement of Security Interest

The highlights are as follows :

• One very important aspect of the Act is that a secured creditor (Bank/FI) can enforce the security directly, without intervention of Court or Tribunal, after giving 60 days notice. [section 13(2) of SARFAESI Act].
• Borrower can make representation or take objection and secured creditor can consider and either accept or reject the same [section 13(3A) of SARFAESI Act]
• If borrower does not pay the principal and interest as specified in the notice within 60 days, the secured creditor can take possession of assets, take over management of assets, appoint any person to manage the assets etc. [section 13(4) of SARFAESI Act].
• This power can be exercised only if the asset is ‘Non-Performing Asset’ as per guidelines prescribed by RBI or other regulatory authority.
• The secured creditor can sell the assets. If dues are not fully recovered, he can file application with Debt Recovery Tribunal for balance amount. He can also proceed against guarantors or sale the pledged assets directly. [section 13(11) of SARFAESI Act].
• Instead of Bank/FI itself taking possession and selling the asset, the Bank/FI can hand over the asset to Asset Reconstruction Company. That Asset Reconstruction Company will then enter the shoes of Bank/FI and can act as if it is a ‘secured creditor’. However, handing over asset to Asset Reconstruction Company is at option of Bank/FI.
• Application can be filed by borrower with Debt Recovery Tribunal (DRT) along with prescribed fees, only after the asset or management is taken over and not at the stage of receiving notice from secured creditor. [section 17(1) of SARFAESI Act].
• Jurisdiction of Civil Court has been completely barred [section 34 of SARFAESI Act]. [Of course, writ petition can be filed with High Court at any time].
• Appeal from order of DRT lies with Debt Recovery Appellate Tribunal [DRAT]. [section 18(1) of SARFAESI Act].
• If borrower succeeds in appeal (at DRT or DRAT), he is entitled to get back possession of asset plus compensation and costs as may be fixed by DRT or Appellate Tribunal. [section 19 of SARFAESI Act]. Thus, he is entitled to only ‘compensation’ and not ‘damages’.

2.2 Securitisation

The highlights are as follows :

• In layman’s terms, ‘securitisation’ means sale and purchase of pooled (bundled) secured assets.
• Securitisation can be of good assets and even future assets. However, SARFAESI Act makes provisions only in respect of distressed assets i.e. stressed assets.
• The basic idea is to form an independent ‘Asset Reconstruction Company’ such company will have to be registered with RBI. [section 3(1) of SARFAESI Act]. Such company will be a Public Financial Institution.
• The ‘Asset Reconstruction Company’ can acquire any ‘financial asset’ (which is in nature of debt or receivable) from bank/FI. The ‘asset’ as such is not taken over.
• In factoring also, receivable is acquired. However, the difference is that in factoring, only existing receivables  (which are accrued but not due for payment) can be acquired, while in securitisation, even future receivables can be acquired.
• Purpose of securitisation is to avoid mismatch between assets and liabilities of banks/FI. The lending company really ‘sells’ its loans to the investors through SPV.
• The Asset Reconstruction Company (ARC) can acquire ‘financial asset’ from banks and financial institutions, for which payment is made by raising funds through issuing debentures, bonds or by entering into any arrangement with Bank/FI. [section 5(1) of SARFAESI Act].
• Once the Asset Reconstruction Company takes over ‘financial asset’, that ARC will be treated as lender and ‘secured creditor’ for all the purposes. [section 5(3) of SARFAESI Act].
• The Asset Reconstruction Company (ARC) will devise a separate scheme for each of the financial asset taken over. QB (Qualified Buyers) will invest in such ‘scheme’. The Asset Reconstruction Company will issue ‘security receipts’ to QB [section 7 of SARFAESI Act].
• The security receipt will represent undivided interest in such financial assets. [section 2(1)(zg) of SARFAESI Act].
• The Asset Reconstruction Company will realise the financial asset and redeem the investment and payment of returns to QB under each scheme. [section 7(2) of SARFAESI Act]
• Any dispute between Bank/FI, Asset Reconstruction Company and QB shall be compulsorily referred to conciliation or arbitration under Arbitration and Conciliation Act, 1996. [section 11 of SARFAESI Act]

2.3 Asset Reconstruction

The highlights are as follows :

• The provisions of ‘asset reconstruction’ combine the features of securitisation and enforcement of security interest. Like securitisation, in ‘Asset Reconstruction’ also, ‘financial asset’ (debt or receivable) is acquired from bank/FI, and not the asset as such. However, in asset reconstruction, the right or interest of any bank/FI is acquired for the purpose of realisation of such financial assistance. [section 2(1)(b) of SARFAESI Act].
• Thus, non-performing asset can alone be acquired for asset reconstruction.
• The work will be done by ‘Asset Reconstruction Company’. The Asset Reconstruction Company will have to be registered with RBI. [section 3(1) of SARFAESI Act].
• The Asset Reconstruction Company can acquire financial asset of bank/FI for purpose of realisation of the financial assistance.
• Idea is to hand over non-performing assets in the banking sector to asset reconstruction company, so that Bank/FI can concentrate on their core business of lending.
• The asset reconstruction company can acquire NPAs from banks and financial institutions, by issuing debentures, bonds or by entering into any arrangement with Bank/FI. [section 5(1)].
• Once the asset reconstruction company takes over assets, that company will be treated as lender and ‘secured creditor’ for all the purposes. [section 5(3) of SARFAESI Act].
• The asset reconstruction company will devise a separate scheme for each of the financial asset taken over. QB (Qualified Buyers) (earlier QIB) will invest in such ‘scheme’. The ‘Reconstruction Company’ will issue ‘security receipts’ to QB. The security receipt will represent undivided interest in such financial assets. [section 2(1)(zg) of SARFAESI Act].
• The asset reconstruction company will realise the financial assets and redeem the investment and payment of returns to QB under each scheme. [section 7(2) of SARFAESI Act]
• Any dispute between Bank/FI, Asset Reconstruction Company and QB shall be compulsorily referred to conciliation or arbitration under Arbitration and Conciliation Act, 1996. [section 11 of SARFAESI Act]

2.4 Registration of securitization, reconstruction and creation of security interest

The highlights of provisions are as follows –

• Central Registry will be set up for registration of securitization, reconstruction and creation of security interest [section 20 of SARFAESI Act]
• Central Registry will be integrated with other registrations of security interest on property [section 20A of SARFAESI Act]
• Register will be maintained for transactions relating to securitization, reconstruction and creation of security interest [section 22 of SARFAESI Act]
• There is also provision for registration of security interest by secured and unsecured creditors over any property of borrower [sections 26B to 26E of SARFAESI Act]

3. Some Problems in SARFAESI Act

It would be interesting to note that powers to directly take over possession/management of assets without intervention of Court were provided in State Financial Corporations Act, 1951 also. However, these provisions had neither helped in reducing industrial sickness nor in reducing bad debts.

Now, these powers in SARFAESI Act are irrelevant at least for companies, as Insolvency Code, 2016 provides much better provisions for this purpose.

SARFAESI Act is useful to take over possession of individual assets and sale them. Taking over management is extremely rare.

Some major problems in SARFAESI Act are discussed below:

Asset should be transferred free of liabilities  – One major problem is that as per section 13(6) of SARFAESI Act, if the assets taken over by secured creditor are transferred, all rights are vested in the transferee as if the transfer has been made by owner of such asset. Thus, the buyer cannot get a title better than what original owner had. In other words, the transferee gets the assets saddled with all liabilities.

The liabilities may be pertaining to

• Labour
• Past electricity dues (without which electricity supply may not be restored)
• Earlier taxation dues relating to excise, sales tax etc.

Strictly legally, the transferee is getting only assets of the Company and not the company as such. However, quite possibly, these liabilities will haunt him. If so, the price the secured creditor may get from the buyer will be much lower.

Clear legal provision that the transferee will get assets without past liabilities will ensure that the transferee can start using the asset acquired by him without any apprehensions about past liabilities.

This problem has been answered in Insolvency Code, but firstly, those provisions apply only to companies, and secondly, they can apply only when the company is undergoing Insolvency Resolution Process (CIRP or PPIRP).

Past liabilities of electricity bills – Past electricity bills are always a problem in taking over assets.