Special Situation Funds 
In the financial year 2018, the gross NPAs (non-performing assets) of public sector banks in India was significantly high at 8% of the net advances by public sector banks (equivalent to 14.6% of the gross advances), which is rivalled only by a similar rate at 8.2% of the net advances in 1998 . This was following yearly upswings, from 5.7% of the net advances in 2016 to 6.9% of the net advances in 2017 . As per data maintained by the Reserve Bank of India, the total value of NPAs in the banking sector as of early 2020 was INR 8.34 lakh crores (approx. USD 105 bn), with public sector banks contributing the major chunk of this value with INR 6.16 lakh crores (approx. USD 78 bn) in NPA.
Several measures have been attempted by Indian regulators, including the Reserve Bank of India/ RBI (Indian central bank), the Securities and Exchange Board of India/ SEBI (Indian securities market regulator), as well as the Indian parliament. In this article, we provide an overview of a special regime recently introduced by the Securities and Exchange Board of India, for foreign investment in special situations assets, identify its significant advantages and also summarize some areas requiring further consideration and clarity.
With a view to overhaul the extant regime for resolution of stressed assets outside of the framework for insolvency resolution, the Reserve Bank of India introduced the Prudential Framework for Resolution of Stressed Assets on June 7, 2019 (fondly referred to as the “June 7 Framework”). The June 7 Framework laid down a systemic and detailed regime for, inter-alia, early identification and reporting of stress, formulation of a resolution plan (for resolution of stressed assets), implementation of the resolution plan, applicable prudential norms (for Indian banks, financial institutions etc), and ancillary matters.
Unfortunately, the June 7 Framework was primarily addressed to Indian banks and specific financial institutions. Utility of the June 7 Framework for foreign investors has been limited. This has been part of a larger issue of limited routes available for entry of foreign capital for acquisition and restructuring of special situations assets in India since India is a foreign exchange controlled economy. Hitherto, in order to invest in non-performing loans, foreign investors have been required to use one of the following four routes – (i) foreign portfolio investor (FPI) route; (ii) alternate investment fund (AIF) route; (iii) external commercial borrowings (ECB) route; and (iv) asset reconstruction company (ARC) route. Each of these routes has different limitations. For instance – FPIs and AIFs (till now) were not permitted under their respective governing regulations to invest directly in loans; instead FPIs and AIFs can only directly invest in debt in the form of securities (such as bonds and debentures), which form a very small percentage of the overall secondary debt market in India. On the other hand, investments under the ECB route have strict all-in-cost limitations, posing as a significant commercial barrier for distressed debt investors.
This predicament is widely known and recognized; in a report by the Reserve Bank of India in 2019 the RBI noted that additional avenues of foreign investment need to be evaluated . It is in this background that the regime for investment via special situation funds recently introduced by SEBI has been well received.
The RBI issued the Reserve Bank of India (Transfer of Loan Exposures) Master Directions, 2021 (“Loan Trading MDs”) on September 24, 2021 (‘RBI Master Directions’), which inter-alia, deal with transfer of loan exposures between lending institutions and permitted transferees (being the specific entities permitted under the RBI Master Directions). But notably, the RBI Master Directions provided for a potentially wider class of transferees in case of transfer of ‘stressed loans’, i.e., for transfer to such entity which is permitted by its financial sector regulator, other than Reserve Bank of India (‘RBI’), to purchase the stressed loans. Such entities were permitted to acquire loans: (1) in terms of a resolution plan under June 7 Framework; and (2) which resolution plan resulted in exit of all specified Indian lenders (i.e., banks, non-banking financial companies, other financial institutions, etc.).
SEBI, being a financial sector regulator, had in its Board meeting on December 28, 2021, proposed to introduce a new sub-category of category I alternative investment funds (‘Category I AIFs’) known as ‘Special Situations Fund’ (‘SSF’) which would be permitted to invest in stressed loans. Subsequently, on January 24, 2022, SEBI notified amendments (‘Amendment Regulations’) to the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’) to formally introduce a new chapter on SSFs under the AIF Regulations. On January 27, 2022, SEBI also issued a Circular setting out further guidelines on SSFs (‘SSF Circular’).
What is a ‘special situation fund’?
The Amendment Regulations and the SSF Circular set out that SSFs are Category I AIFs which: (1) can only invest in ‘special situation assets’ in accordance with its investment objectives; and (2) additionally can act as a resolution applicant under the Insolvency and Bankruptcy Code, 2016 (‘IBC’) by complying with the eligibility requirements thereunder.
What are ‘special situation assets’ and permitted investments by SSFs?
In turn, ‘Special situation assets’ are defined under the Amendment Regulations to include:
- Stressed loans:
- available for acquisition in terms of Clause 58 of the RBI Master Directions (or in terms of any other policy of RBI or Government of India issued in this regard from time to time); and
- acquired as part of a resolution plan approved under IBC.
In our view, based on Paragraph 58 of the RBI Master Directions, SSFs can step in (arguably jointly with other buyers) for comprehensive resolution of all INR loans of a stressed borrower held by Indian banks / financial institutions. The guidelines do not, at this stage, contemplate or permit acquisition of individual loans only (for debt aggregation or otherwise) without ensuring the exit of all specified lenders.
Another point to note is that the market view is that for SSFs to acquire stressed loans under the aforesaid RBI Master Directions, it would need to be recognised by RBI as a permitted transferee under the RBI Master Directions (which recognition is awaited).
More clarity is also awaited on the ability of an SSF to acquire stressed loans as part of a resolution plan approved under the IBC, however, SSFs intending to act as resolution applicants under the IBC shall ensure compliance with the eligibility requirement provided thereunder.
- Security receipts issued by an asset reconstruction company registered with RBI.
3. Securities of investee companies:
- whose stressed loans are available for acquisition in terms of Clause 58 of the RBI Master Directions (read with the June 7 Framework), or as part of a resolution plan approved under the IBC or in terms of any other policy of the RBI or Government of India issued in this regard from time to time.
- against whose borrowings, security receipts have been issued by an asset reconstruction company registered with the RBI.
- whose borrowings are subject to corporate insolvency resolution process under Chapter II of IBC; and
- who have disclosed all the defaults relating to the payment of interest/ repayment of principal amount on loans from banks/ financial institutions/ systemically important non-deposit taking non-banking financial companies/ deposit taking non-banking financial companies and /or listed or unlisted debt securities in terms of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 and such payment default is continuing for a period of at least 90 calendar days after the occurrence of such
Provided that in case of sub-clauses (c) and (d) above, the credit rating of the financial instruments or credit instruments or borrowings of the company has been downgraded to ‘D’ or equivalent.
In other words, presently SSF also cannot invest in securities of companies which have not defaulted or are in default for less than 90 days and have a credit rating better than D (or equivalent of D).
Further, given the pre-condition that the securities of the investee company should have a credit rating, it will be difficult for SSFs to invest in unlisted debt securities because, firstly, unlisted debt securities typically do not have a credit rating to begin with and secondly, there can be challenges from the investee company in the process to obtain credit rating later. However unlisted debt securities may be acquired under the ARC or FPI route while keeping in mind certain considerations.
- Any other asset as may be specified by SEBI from time to time.
What are the other requirements specified for setting up SSFs?
The SSFs have to also meet the following requirements:
- The applicable minimum corpus requirement for SSFs is INR 1,000,000,000 (approx. US$ 14 million).
- The minimum capital commitment requirement for investors proposing to invest in SSFs is INR 100,000,000 (approx. US$ 1.4 million). The minimum capital requirement for an accredited investor to invest in SSF is INR 50,000,000 (approx. US$ 0.7 million). Further, in case of investors who are employees or directors of the SSF, or employees or directors of the manager of the SSF, the minimum value of investment is INR 2,500,000 (approx. US$ 33,395).
- The minimum diversification limit generally applicable to Category I AIFs of investing a maximum of 25% of its investable funds in an investee company, is not applicable to SSFs.
SSFs are also not permitted to invest in companies incorporate outside India or entities associated with that particular SSFs (for example – (i) their associates; (ii) the units of any other AIFs other than the units of an SSFs; and (iii) units of SSFs managed or sponsored by its manager, sponsor or associates of its manager or sponsor).
The only other category of AIF which an SSF can accept investment from is another SSF. Further, an SSF can only invest in special situation assets with a minimum lock-in period of 6 months being applicable.
SSF must comply with the same initial and continuous due diligence requirements for its investors, as those mandated by RBI for investors in asset reconstruction companies.
How do SSFs measure against other AIFs?
SSFs have certain advantages over category II alternative investment funds (‘Category II AIFs’). Category II AIFs are not permitted to acquire ‘loans’ (but instead can only hold securities), and further Category II AIFs have an investment limit (consequently reducing its investible funds). The advantage which Category II AIFs have is that they are permitted to invest in all securities irrespective of credit rating or duration of default (so long as majority of its investment is in unlisted securities), whereas an SSF is restricted to investing in special situation assets as elaborated above.
Comparison with ARCs
We mentioned above that another popular entry route for foreign investment is via ARCs. A key advantage available in the case of SSFs is direct participation in and oversight over the resolution of the stressed asset (a role typically undertaken by the ARC trustee company). Moreover, SSFs are expressly envisaged to act as resolution applicants (bidders) in resolution processes under the Indian insolvency regime, whereas the ability of ARCs to bid in for stressed companies in IBC processes has been challenged and is currently under judicial consideration. Additionally, in the case of an SSF, there are no restrictions on converting debt into equity (which is a strictly regulated for ARCs and not available for some ARCs in the market), allowing the SSF to take complete control of the company translating into efficient restructuring.
As a downside, SSFs do not themselves, have powers of asset reconstruction and special benefits under securities laws (amongst other laws) which are available to ARCs. In particular, SSFs would not have powers of outside court enforcement (which is considered as a key advantage otherwise available only to Indian banks, non-banking financial entities and ARCs).
The Amendment Regulations is a progressive step by SEBI and will help in attracting investments in special situation assets.
However, recognition by RBI for SSFs as permitted transferees under RBI Master Directions is still awaited by the market.
Clarity is also awaited on SSFs being permitted to acquire loans as part of a resolution plan approved under IBC.
SSFs are envisaged to step in for comprehensive resolution (singly or arguably, jointly with other buyers) of all INR loans of a stressed borrower held by Indian banks / financial institutions (and does not currently contemplate or permit acquisition of individual loans). The deletion of the diversification limits will encourage setting up of multiple alternative investment funds for investment in stressed assets without having to ensure that a suite of deals is available for such SSFs to invest in.
 By Nilang Desai, Suharsh Sinha, Saloni Thakkar and Shambhavi Shivdikar
https://dbie.rbi.org.in/BOE/OpenDocument/1807141045/OpenDocument/opendoc/openDocument.faces?logonSuccessful=true&shareId=2 and https://www.rbi.org.in/scripts/PublicationsView.aspx?id=19791
 ‘Movement of Non-Performing Assets (NPAs) of Scheduled Commercial Banks as on March 31, 2021, available at https://dbie.rbi.org.in/DBIE/dbie.rbi?site=publications#!4
 We may consider the observations of the RBI Task Force under ‘Market Participants’ in the Report of the Task Force on the Development of Secondary Market for Corporate Loans at https://www.rbi.org.in/Scripts/PublicationReportDetails.aspx?UrlPage=&ID=940#CHD3