Extract taken from 'The Lending and Secured Finance Review' – edition 5

Credit support and subordination

i SecurityTypes of security interests

Creditors can choose from a variety of security options to safeguard their exposure to borrowers and minimise risks associated with lending in India. Typically, high-value transactions involve the creation of multilayered security packages. Though creditors may have preference for the type of security that is to be created, industry and company-specific diligence plays a key role in charting out the strategy for assets to be secured as well as the type of security interest to be created, to ensure the highest degree of protection.

Mortgages

A mortgage is a transfer of interest in immovable property to secure an existing or future debt or the performance of an engagement that may give rise to a pecuniary liability. Although there are different types of mortgages that may be created in India (such as usufructuary mortgage, mortgage by conditional sale), in secured lending transactions involving immovable property as security, typically a mortgage in the English form or by deposit of title deeds is created. Many traditional lending institutions in India still require a borrower to mortgage some immovable property for any lending, since this is seen to provide a greater assurance than security over movable or financial assets. Working capital is typically secured by receivables and the stock-in-trade of the borrower.

A mortgage in the English form is the preferred form of security, since it involves a complete transfer of property to the creditor subject to the right of redemption of the mortgagee. It is typically associated with ease of enforcement, since a creditor has private remedies available (such as appointment of a receiver for the property) under law and does not have to rely on a court process for protection or enforcement of security. There is ambiguity regarding whether these remedies are available to foreign creditors, however. Legal structuring of a mortgage in the English form allows borrowers to charge or assign movables, contracts and other assets along with the immovable property, affording the benefit of private remedies and ease of mortgage enforcement to all such assets. A mortgage in the English form can, thus, effectively secure all assets of the borrower.

A mortgage by deposit of title deeds requires the deposit of title deeds of the property with the creditor with an intention to create security over the property (usually demonstrated by a declaration issued by the borrower at the time of deposit of the title deeds). The mortgage can be created only over immovable property and, therefore, does not afford the convenience of stapled security, unlike a mortgage in the English form.

Pledges and liens

A pledge is a special form of 'bailment' under law and, therefore, requires actual or constructive delivery of possession of the assets being pledged. Since transfer of possession restricts the ability of the borrower to use the secured assets, a pledge is usually created over shares and financial assets, which are not required for day-to-day operations. The pledge is created by handover of the share or security certificates to the creditor, or if the securities are in electronic form, by the marking of a pledge over the securities in the records of the depository, which 'locks' the securities and does not permit any transaction without the consent of the creditor. Pledges are usually accompanied by a power of attorney in favour of the creditor (or the trustee) for exercise of rights in respect of the securities on the occurrence of a default.

Pledges are taken as security in all kinds of financing, including project financing and mezzanine or structured financing, since they allow borrowers to leverage financial securities held by them and provide ease of enforcement. Upon a default by the pledgor, a sale of the pledged assets can be effected without court intervention, and the proceeds can be used by the pledgee to discharge the pledgor or borrower of its obligations.

Indian law also recognises retention of title clauses and provides for security in the form of a lien to unpaid sellers.

Charges and hypothecations

Although movable assets are frequently 'stapled' with immovable property in an English mortgage (see the 'Mortgages' section), where immovable property is not available or is being secured by a mortgage by deposit of title deeds, creditors require the borrower to charge its movable assets (physical, financial and non-physical assets) under a hypothecation document. Though a stand-alone mortgage over movable properties has also been recognised, this is not the usual route adopted by creditors in India. A hypothecation is recognised in Indian law as a charge on existing or future movable property without delivery of possession. It is a contractual creation of a special property in assets, entitling the creditor to take possession of those assets in a default and sell them for realisation of outstanding debt. Both fixed and floating charges are recognised in India.

Substitution rights

In most public–private partnership projects (e.g., roads and airports), the government continues to own the project asset, with a concession being granted to the borrower to develop and operate the asset. Similarly, several assets such as telecom assets, spectrum and mining rights are owned by the government and licensed to private parties. These assets cannot be charged directly to creditors. Therefore, government authorities enter into tripartite arrangements with creditors, under which they allow the creditors a right to substitute the borrower with an eligible third party (subject to certain conditions). However, the sanctity of these arrangements is unclear.

Common methods of taking security

The most common types of security interests associated with certain types of assets are:

  1. real estate: by way of a mortgage over immovable property, which may also encompass all other assets of the borrower under a stapled security structure;
  2. tangible movable property: by way of a mortgage (if stapled with land) or a hypothecation;
  3. financial securities: usually by way of a pledge, delivering possession to the creditors; and
  4. contractual rights, receivables, intellectual property, etc.: by way of a mortgage (if stapled with land) or a hypothecation. Additional perfection rights may be required depending on the nature of the asset (e.g., creation of charge over aircraft is required to be endorsed on the certificate of registration with the Directorate General of Civil Aviation). With respect to intellectual property, creation of any security interest is required to be notified to the relevant registration authorities.

Foreign creditors also require a no-objection certificate from the relevant authorised dealer prior to the creation of security over any Indian assets in their favour.

Common methods of enforcement

Enforcement of a security interest may be done either privately or through court intervention. A typical private enforcement process would take about two to four years, whereas a court process may extend to about 10 to 12 years. A mortgagee has the right to file a suit for foreclosure or sale on default in repayment; however, these rights have not been extended to foreign creditors under the Indian transfer of property regime. Thus, although foreclosure is not an option for mortgages in the English form or foreign creditors, creditors holding a mortgage in the English form are permitted to effect a private sale of the property or appoint a private receiver without approaching a court. The enforcement of a charge over movable assets requires the intervention of courts unless the terms of the underlying contract expressly provide for it. For a pledge, a creditor may simply sell the pledged assets in accordance with the terms of the underlying contract and after giving reasonable notice to the pledgor. Creditors have a duty to maximise recovery from secured assets.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002 (the SARFAESI Act) provides creditors private remedies to enforce any security interest (except a pledge on movable assets or a lien). Where a substantial part of the business is held as collateral by the creditors (such as in a project financing), they are also permitted to take over the management of the borrower. In the case of consortium lending, approval of 60 per cent of the creditors in value is required for the exercise of powers under the SARFAESI Act, and the approval is binding on all creditors (including dissenting creditors). Remedies under the SARFAESI Act are also available to the listed bond market in India and to notified non-banking financial companies.

Debt recovery tribunals (DRTs) were established in India under the Recovery of Debts Due to Banks and Financial Institutions Act 1993. Creditors (including secured creditors who have not received full repayment from enforcement of security) may apply to the DRTs for recovery of debt. Recovery officers of the DRT are empowered to, inter alia, attach property of the borrower (even property that is not offered as collateral) and require third-party debtors of the borrower to repay debt amounts to the officer. The efficacy of approaching the DRTs to seek recovery of debt is severely hampered by an immense backlog of cases. It is estimated that there are over 100,000 cases pending before the various DRTs.

Under extant foreign exchange regulations, foreign creditors require authorised dealer approval for enforcement of security and repatriation of proceeds. Further, enforcement would also need to comply with generally applicable foreign exchange restrictions, including that the sale of immovable property can only be to a resident and any invocation of pledge is to be in accordance with the foreign investment policies.

Formalities and registrationBoard approval

Any creation of security over a company's assets needs the approval of the board of directors of the company by way of a physical meeting. Creation of security over assets exceeding specified valuation thresholds or of third-party security for a loan to a group company also requires approval of three-quarters of the shareholders of a company. In the case of third-party security, additionally, the loan for which security is provided is required to be used for the principal business activities of the borrower.

Registration

All charges (including mortgages, pledges and liens) created over the property and assets of a company are to be registered with the Registrar of Companies within 300 days of the date of creation of the charge for the security interest to be enforceable as regards the company's creditors and its liquidator, for a fee ranging between US$3 and US$9.

Mortgages over immovable property (other than by way of deposit of title deeds) are also required to be registered with the sub-registrar of assurances in whose jurisdiction the property is situated. The registration fee varies across various states and may either be a capped amount (US$461 in Maharashtra) or ad valorem in respect of the amount secured. Mortgages by deposit of title deeds are required to be noted in the land registry in certain states.

Creditors are required to file details of mortgages created in their favour with the Central Registry of Securitisation Asset Reconstruction and Security Interest of India (CERSAI) under the SARFAESI Act. Additionally, specific assets may also require additional registration (i.e., the assignment or transmission of rights in relation to patents is required to be filed in the register of patents).

Particular challenges

Some of the specific challenges faced by creditors in the creation and enforcement of security are as follows:

  1. requirement of government consent for creation and enforcement of security. Consent of local authorities may be required in some states for mortgaging land, particularly if the creditor is not a recognised or notified creditor. Certain assets (such as production-sharing contracts or mining leases) require government approval for creation and enforcement of any security, and enforcement is also possible against a limited number of entities. Similarly, forest land cannot be mortgaged, as it belongs to the government and approval is required even for the removal of immovable plant and machinery located on it (which may itself be charged to the creditor). Securing government approvals may require approval of the relevant authority, and any transfer on enforcement may only be in favour of a similarly qualified entity;
  2. transaction costs remain high because of stamp and registration duties;
  3. private enforcement is limited to only certain types of creditors, and enforcement proceedings through the court process are highly protracted, resulting in a diminution in the value of the assets over time; and
  4. under Indian transfer of property laws, there may be dual ownership over fixed assets and the land on which such assets are located. This creates complications for the purposes of enforcement of security by creditors.
ii Guarantees and other forms of credit support

Corporate guarantees are usually sought by creditors from the parent or from associated companies of the borrower entity. Although guarantees are executed as deeds (and, therefore, do not require consideration to pass to the guarantor), most creditors require the guarantor to demonstrate consideration in the form of a corporate benefit accruing to it.

Given India's traditionally promoter-driven corporate market, creditors have historically required individual promoters to provide personal guarantees for corporate loans. Creditors also require promoters to provide personal guarantees as a condition of restructuring loans, on the principle that shareholders should bear the first loss. In view of the burgeoning NPA problem (see Section I), the RBI in 2014 allowed banks to classify guarantors who refuse to honour guarantees as 'wilful defaulters', restricting access to capital and debt markets. With the increasing focus on guarantors by both banks and regulators, many corporate groups resist guarantees by individual promoters. Creditors as beneficiaries of guarantees are also able to take the guarantor (following invocation) to a corporate insolvency resolution proceeding under the Insolvency Code.

Group company guarantees require a host of corporate compliance criteria to be met, including approval of the shareholders of the guarantor and a condition that the loan should be used by the borrower company for its principal business activities only.

iii Priorities and subordination

Secured creditors continue to have better protection and preferential access to borrower assets than unsecured creditors. Certain encumbrances created under law also have priority over secured creditor rights (such as banker's lien and an unpaid vendor's lien). Since these rely on a preferential status because of possession, priority rules gain significance in the context of non-possessory securities (such as charges and mortgage).

In the absence of contractual provisions to the contrary, the following rules of priority are applicable under Indian law:

  1. between two registered charges, the charge registered prior in time will have priority;
  2. an equitable mortgage takes effect against any mortgage deed subsequently executed and registered in relation to the same property;
  3. a mortgage of movables with possession has priority over a prior mortgage without possession;
  4. a mortgagee of movable property without possession that comes to court first will have priority over subsequent such mortgagees that approach the court;
  5. a fixed charge has priority over a floating charge;
  6. between two floating charges, the one created earlier in time will have priority; and
  7. the registration and fulfilment of perfection requirements of a charge give it priority over a non-registered and non-perfected charge, notwithstanding when the charge was created.

Contractual priorities in security are usually set out in an intercreditor or subordination agreement between the creditors. Intercreditor arrangements are fairly standard and are afforded sanctity by courts as well as participating lending institutions. It remains to be tested whether turnover subordination provisions will be binding on a liquidator appointed under the Insolvency Code or the Companies Act 2013.

Typical LMA and APLMA provisions requiring majority creditor consent for enforcement or other action against a borrower or obligor are viewed as unenforceable under Indian law, since the Indian Contract Act 1872 holds contracts restraining legal proceedings to be void. Therefore, enforcement priority in India is maintained by imposing wait periods (up to a year) on subordinated creditors for enforcement.

An intercreditor arrangement may become problematic where different types of creditors are party to it, since all creditors do not have equal access to special enforcement mechanisms. For instance, remedies under the SARFAESI Act are not available to foreign creditors who are not registered in India and to certain NBFCs. The imposition of wait periods for access to remedies under the SARFAESI Act also entitles some creditors to invoke remedies under the SARFAESI Act before others. Though an intercreditor arrangement may address these issues by requiring creditors who have the benefit of these regimes to share recoveries with other creditors, this results in an unsatisfactory situation where the notified creditors can not then recover their dues as they have (notionally) already received full payment from the borrower.