Public Issue of Securitised Instruments — the new SEBI Regulations

(b) The Securitisation and Reconstruction of Financial Assets
and Enforcement of Security Interest Act, 2002 (often referred to as SARFESI Act
or, simply, the Securitisation Act) is known more for the powers that
particularly institutional lenders are given under this Act to recover their
dues. The other half of this Act is securitisation of assets.

(c) While I am sure that readers are familiar with this term,
a quick description of securitisation may be worthwhile. To take a typical
example, a lender may have debts of various kinds arising out of loans granted
by it. The debts may be payable over a long period of time.. For rotation of
these funds or for other reasons, the lender may want to assign these debts to a
buyer who then simply collects the debts. Such buyer, in turn, may be a person
with his own money or, more often, raises monies from investors who may be
interested in relatively safer returns. This process can be loosely
referred to as securitisation. Effectively, securities are issued to the
investors towards their interests in the debt so bought.

(d) The buyer may invest his own money or raise monies from
private investors. However, a bigger source of money may be the public for
various reasons. Firstly, the public may be interested in safe returns from
securities. The returns may be relatively higher than other instruments.
Properly securitised and issued in small amounts, such instruments may become
attractive to the public. However, issue to the public requires necessary legal
provisions of investor protection and it is at this stage SEBI steps in. SEBI
has to ensure that the process of issue to the public of such instruments is
transparent, with full and fair disclosures and after the issue, the interests
of the investors are safeguarded. Also, the monies received are managed by
registered intermediaries.

(e) Thus, SEBI has recently, on 26th May 2008, notified the
Securities and Exchange Board of India (Public Offer and Listing of Securitised
Debt Instruments) Regulations, 2008 (‘the Regulations’) which contain very
detailed provisions relating to issue and listing of such instruments. It is
worth reviewing these new though quite specialised Regulations.

(2) Scheme of the Regulations :

(a) The Regulations seek to make comprehensive provisions
relating to the formation, constitution and structuring, etc. of an entity
issuing securitised instruments, called ‘Special Purpose Distinct Entity’ (‘SPDI’)
in the Regulations. The Regulations provide for : How and in what form would
such a SPDI be formed and structured, what type of Securitised Debt Instruments
(‘SDI’) they can issue, what would be the disclosures, and how it would be
managed, etc.

(b) The structure of SPDI can be loosely compared with the
structure for mutual funds though SPDI seems to have lesser flexibility. SPDIs
and instruments issued by them are comparable with mutual funds in the sense
that the investments are made effectively on behalf of the unit holders and
managed by persons on behalf of such investors. The essential difference is that
these Regulations focus on a very specialised type of securitisation and hence
make very specific requirements for them.

(c) It would be also worth describing the process involved in
the securitisation of debt and thereafter making a public issue of SDI and
related matters. There would be a Sponsor who would establish an SPDI. The SPDI
has to be in the form of a Trust. There would be Trustees who would manage the
SPDI and carry out other related functions. There would be an Originator who
assigns certain debts to the SPDI. The SPDI would then issue the SDI to the
public under a Scheme and then list such SDI on the stock exchange. The SPDI
would then collect dues in respect of the debts so acquired and distribute such
monies, after deducting costs, to the investors. The investors, in turn, may
hold the SDI and enjoy the steady returns or they may at any time sell the SDI
on the stock exchange at which they are listed at the prevailing market price.
The Scheme would come to an end normally when all the debts are recovered and
the investors are fully paid off.

(d) With this very broad overview of the Regulations, let us
look at some interesting aspects of the Regulations.

(3) Trustees :

(a) The Trustees have perhaps the greatest of responsibility
under the Regulations. They have to take great care while acquiring the
specified debts and particularly ensure that these debts are recoverable,
enforceable and also assignable to SPDI. They have to make the requisite
disclosures in the offer document. They have to manage the debts and recover
them and distribute the proceeds to the investors. They have personal and direct
responsibility in case of contraventions. Having said that, though the
responsibilities cannot be understated, it also appears that each of these
obligations is not absolute, but the intention is more of preventing negligence
and fraud. If, for example, there are bad debts beyond the control and
reasonable foresight of the Trustees, they would not be held
responsible.

(b)    Interestingly, the Trustees need not necessarily be Trustees registered as such intermediaries with SEBI.However, they would require to be registered with SEBI under these Regulations if they are not so registered otherwise as Trustees. Certain other entities would also not require such registration under the Regulations. Thus, a person can get himself registered as a Trustee under these Regulations and qualify to manage the SPDI.The Trustee can also be a corporate entity.

(c)    The requirements of registration under these Regulations are elaborate and are similar to registration of other intermediaries.

(4)    Debts or receivables  that can be acquired:

(a)    These would be the core assets of the SPDI just as shares and other specified securities are the core assets of mutual funds. However, the definition of these debts that can be acquired by SPDI is quite narrow and would include items such as mortgage debt, financial assets as defined in the Securitisation Act, etc.

(5) SPDI:

(a)    This is the entity, a Trust, that would acquire debts and issue securities to investors. The SPDI has to be quite specialised – in fact, it practically cannot do any other activity except of securitisation. The reason is obvious. The objective is to acquire a chunk of debts and then issue instruments to investors representing an appropriate interest in these debts. The SPDI would then only manage and recover these debts. If it does any other activity, and if there is any loss, the investors would suffer since the loss would go to reduce the debts. However, certain passive investment of surplus monies is, for example, allowed.

(b)    There is an entity termed ‘Servicer’ who can do/be given the job of collecting the debts and distributing the proceeds to the investors. Strangely,it is not required that such ‘Servicer’ should be a registered intermediary. In my opinion a person who could be given the control of all the assets of the SPDI for collection and even the further distribution to the investors should be registered with SEBI for proper control.

(6)    Scheme:

(a)    As in the case of mutual funds, the SPDI can frame schemes pursuant to which it can issue SDI to the investors. Thus, there can be multiple schemes. This also means that recovery of one lot of debts and repayment in full to the investors would not mean the end of the SPDI itself.The SPDI can issue securities under another scheme. In fact, it can issue securities under multiple schemes. Again, quite obviously, each of the schemes would have to be kept segregated in all respects.

(b)    Each scheme would have its own disclosures ~ and features which would have to be complied with regard to that particular scheme.

(7) Accounts and Audit:

(a)    The SPDI would be a Trust and thus would not be subject to the normal requirements of accounts and audit as, for example, companies are subject to. Thus, the Regulations make specific though quite general and broad requirements relating to accounting and audit. The Regulations also require compliance of Guidance Notes issued by the Institute of Chartered Accountants of India.

(8) Dematerialisation:

(a)    The SDI issued should be capable of dematerialisation. However, at the option of the investor, securities in physical form can also be issued.

(9)    Credit rating:

(a)    Where the core assets are debts, credit rating is required as this helps in the assessment of the risk being assumed by the investor.

(b)    The SPDI would have to obtain at least two credit ratings. Interestingly, it will have to disclose all the credit ratings obtained by it and not just the ones it found acceptable. Thus, the SPDI can go shopping for credit ratings, but SPDI will have to disclose all the ratings received.

(c)    Having said that, no minimum credit rating has been prescribed for the issue of SDI as for example is the case in case of deposits issued by NBFCs. Apparently, the objective may be that it would be up to the investor to balance the credit rating received with the return expected and take his decision accordingly. Hence, in line with the logic of the above, no maximum rate of return is prescribed as so provided for NBFCs.

(d)    The credit rating would have to be reviewed periodically, but not later than a period of one year from the previous rating.

(10) Miscellaneous provisions:

(a)    There are elaborate provisions for inspection of the accounts, records, etc. In case violations are found, there are specific provisions in the Regulations themselves. Further the general provisions in the SEBI Act and the Securities Contracts (Regulation) Act to penalise the violations would also be applicable.

(b)    There are provisions relating to minimum sub-scription, underwriting, etc. which are conceptually similar to the public issue of securities.

(c)    The SDI would have to be listed and where they are not listed, the amounts raised would have to be refunded. However, it appears that no time limit is specifically provided for the time within which the SDI should be listed.

(11) Conclusion:

(a) One could argue that SEBI has been proactive in issuing regulations even when the instrument is not popular – for example – the regulations relating to buyback were issued in 1998and they were barely used for some years. Presently, the global economy is suffering from the sub-prime crisis and securitised assets are said to be the major culprit. Hence, perhaps investors may be frightened of such assets. Having said that, securitised instruments offer an otherwise well-developed alternative to investors for investments. I am sure that sooner or later these instruments will gain popularity in India.

(b) The Regulations also show a level of maturity in the sense that many of the problems faced by SEBIover the past few years have been addressed. Of course, this is perhaps another reason that the Regulations are unduly complex! The coming years will show the fate of the innovative and sophisticated instruments. In India it will be a learning experience for both the investors and their advisors and of course for the auditors.