DHFL bankruptcy raises questions over securitisation

The resolution of Dewan Housing Finance Company (DHFL) has raised questions over securitisation deals in bankrupt non-banking finance companies.

What happens in case of receivables or loans securitised that were subject to a charge ( fixed or floating)? How can the investor/lender (who has purchased the loans via securitisation agreements) claim to have predominant rights over the receivables despite the pre-existing charge? Further, can the investor initiate recovery efforts against defaulting loans, in case the original lender (DHFL) is under insolvency proceedings?

According to information last available on loans sold by DHFL (last August), over ₹30,000 crore of retail loans had been sold through the direct assignment route – transfer of assets through an assignment deed. The RBI superseded the DHFL board and appointed an administrator and a three-member committee in November 2019. The resolution process was initiated on December 3, 2019.

Moratorium

With DHFL being referred to the IBC, there wereworries over whether the moratorium applicable under Section 14 of the Code would apply to securitised assets as well.

The MCA sought to iron out such ambiguities through two notifications.

One, it notified rules for Insolvency and Liquidation Proceedings of Financial Service Providers in November last year, where, according to Rule 10, moratorium under the IBC will not apply to ‘third-party assets or properties in custody or possession of the financial service provider, including funds, securities, and other assets required to be held in trust for the benefit of third parties.

Further, the MCA issued another notification on January 30 that clarified that ‘where a financial service provider is contractually obliged, as on the insolvency commencement date, to act as a servicing or collection agent on behalf of third parties in respect of a transaction such as securitisation or lending arrangement, the administrator should ensure that the receivables, in respect of such transactions collected are deposited and maintained in a separate account, and are not merged with the funds or other assets of such financial service provider’.

These two notifications, in effect, implied that loans bought by lenders from DHFL before the commencement of the insolvency do not fall under the moratorium under Section 14 of the IBC. Hence, collections made on such loans will continue to be done by DHFL as a servicer, and paid to the lenders who bought the loans through securitisation.

But there are other concerns that need to be put to rest.

Floating charge conundrum

According to additional information put out in DHFL’s March quarter results, the listed NCDs of the company are secured by way of pari passu charge on the company’s current and future loan assets (including monies receivable thereunder). Such a charge is called a floating charge, distinct from a fixed charge which fastens to specific assets only.

Hence, even outside of insolvency this raises the question on whether a ‘no-objection’ is required from the bondholders (chargeholders) or their trustee every time loans are sold under securitisation.

“In a securitisation transaction, the necessary due diligence should be done by the purchaser of loans. If there is a floating charge which covers the receivables in the securitisation transaction, then a no-objection must be taken from the existing creditors or bondholders. But how far this is done in the normal course of securitisation transactions is unclear. If DHFL is taken as a case in point, it would appear that such procedures are not generally followed in securitisation transactions,” says KS Ravichandran, Managing Partner, KSR & Co Company Secretaries LLP.

In case of DHFL, secured bondholders could argue that they have the first right on the current and future cash flows of the loans. Securitisation that evidently gives a superior right to the investor (who has purchased the loans), according to the MCA notification, could be contested on the ground that such sale or assignment of loans has not been given a ‘no-objection’ from them.

But this could threaten the very structure of securitisation transactions.

“A floating charge retains the full freedom, in ordinary course of business, in both disposal as well as encumbrance over the charged asset. The charged asset is generic and not specific. The more critical thing here is that the floating chargeholder will commonly put financial covenants, including a minimum asset cover maintenance. If the cover (say, 125 per cent of the outstanding debt) exists, there is no need to seek any NOC of the chargeholder,” says Vinod Kothari, a financial/ securitisation consultant and insolvency professional.

In the case of DHFL, these issues become pronounced in view of auditors in the past raising red flags and the ongoing investigations. According to detailed disclosures by DHFL, certain deficiencies in documentation of project/ mortgage loans (and whether certain loans were properly secured) that were flagged by the earlier auditors are under probe. DHFL has already marked down its wholesale loan book substantially in the March quarter, owing to change in basis of valuation by discounting the cash flow assessed by the external registered valuer against the contractual cash flow used by the erstwhile management. Wholesale loan portfolio aggregating ₹49,585 crore has been fair valued, resulting in fair value loss of ₹18,853 crore.

Also, another amount of ₹3,018 crore, which was disbursed in the past, could not be mapped to any security. Such observations only suggest that full-scale revaluation of assetscould reveal chinks in the past securitisation transactions by way of inadequate asset cover or improper sale of loans (same loans being sold over and over again).

Further, aspects arising from transactions such as preferential or undervalued transactions that are likely to be challenged under IBC also need to be looked into.

The pandemic crisis has put another spoke in the wheel of securitisation transactions, with the likely sharp rise in defaults. According to the March quarter results, DHFL has given moratorium on its loans to its borrowers – 35 per cent of account holders by number.

In case of securitisation transactions, normally the responsibility of the collection of loans still lies with the originator of the loans– DHFL. What happens if the DHFL borrower defaults?

“When a borrower signs a contract with any lender, he gives the right to the lender to assign his loans to any other person during the course of the loan. The actual collection of the debt and any other recovery action may or may not stay with the original lender. If the original lender continues to be the servicer, the original lender has to proceed against the underlying assets and initiate recovery efforts,” says Vinod Kothari.

DHFL currently under insolvency complicates the recovery process.

“In the case of DHFL, the administrator can take possession of the assets and proceed to recover the dues as clarified in the January MCA notification. Else, the administrator can authorise the new lender (who purchased the loans) to initiate recovery process,” says Ravichandran.