Global Securitisation – Are we heading into a coronavirus credit crisis?

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Timothy Lopes, Executive, Vinod Kothari Consultants

finserv@vinodkothari.com

The global financial credit crisis of 2007-08 was a result of severe financial distress arising out of high level of sub-prime mortgage lending. Top Credit Rating Agencies (CRA) downgraded majority securitization transactions, slashing ‘AAA’ ratings to ‘Junk’.

Sub-prime borrowers could not repay, lenders were weary of lending further, investors investments in Mortgage Backed Securities (MBS) were stagnant and not reaping any return.

All these factors led to one of the worst financial crisis that affected global economies and not just the US alone. Recovering from such a crisis takes ample amount of time and efforts in the form of policy measures and financial stimulus / bail out packages of the government.

The rapid spread and depth of Coronavirus (COVID-19) outbreak has had severe impact across the globe in a matter of months. Stock markets are witnessing a global sell off. Countries have imposed complete lockdowns countrywide in order to mitigate the impact of this pandemic. Securitisation volumes are likely to witness a drop in light of the pandemic.

Daily, the situation only seems to be getting worse due to the unprecedented outbreak of COVID-19 and its rapid spread. There is absolutely no doubt that the impact on the financial sector and on economies worldwide is / will be a negative one.

As stated by the RBI Governor, in his nationwide address on 27th March, 2020 –

“The outlook is now heavily contingent upon the intensity, spread and duration of the pandemic. There is a rising probability that large parts of the global economy will slip into recession”

The question here is, “Are we headed for another global financial crisis?” We try to analyse this question in this write up, in light of the present scenario.

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Consensual restructuring of debt obligations, due to COVID disruption, not to be taken as default, clarifies SEBI

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Vinod Kothari

finserv@vinodkothari.com

The global economy, as also that of India, is passing through a systemic disruption due to the COVID crisis. The Reserve Bank of India in its Seventh Bi-monthly Monetary Policy Statement 2019-20 dated March 27, 2020[1] has permitted banks and non-banking financial institutions to provide a moratorium to borrowers for a period of 3 months.

As a result, cashflows of banks and financial institutions from underlying loans will be disrupted, at least for the period of the moratorium. It is a different thing that the disruption may actually prolong, but 3 months as of now is what is explicitly regarded by the RBI has COVID-driven.

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Deferral of applicability of amendments in the Indian Stamp Act, 1899

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Vinod Kothari & Company

corplaw@vinodkothari.com

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COVID- 19 AND THE SHUT DOWN: THE IMPACT OF FORCE MAJEURE

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-Richa Saraf (richa@vinodkothari.com)

 

COVID- 19 has been declared as a pandemic by the World Heath Organisation[1], and the Ministry of Health and Family Welfare has issued an advisory on social distancing[2], w.r.t. mass gathering and has put travel restrictions to prevent spreading of COVID-19. On 19th February, 2020, vide an office memorandum O.M. No. 18/4/2020-PPD[3], the Government of India has clarified that the disruption of the supply chains due to spread of coronavirus in China or any other country should be considered as a case of natural calamity and “force majeure clause” may be invoked, wherever considered appropriate, following the due procedure.

In view of the current situation where COVID- 19 has a global impact, and is resulting in a continuous sharp decline in the market, it is important to understand the relevance of force majeure clauses, and the effect thereof.

Meaning Of Force Majeure:

The term has its origin from French, meaning “greater force”. Collins Dictionary[4] defines “force majeure” as “irresistible force or compulsion such as will excuse a party from performing his or her part of a contract”

The term has been defined in Cambridge Dictionary[5] as follows:

“an unexpected event such as a war, crime, or an earthquake which prevents someone from doing something that is written in a legal agreement”.

In Merriam Webster Dictionary[6], the term has been defined as “superior or irresistible force” and “an event or effect that cannot be reasonably anticipated or controlled”.

In light of COVID- 19, a pertinent question that may arise here is whether COVID- 19 shut down will be regarded as a force majeure event for all the agreements, providing a leeway to the parties claiming impossibility of performance? Further, whether such non-compliance of the terms of the agreement will neither be regarded as a “default committed by any party” nor a “breach of contract”?  The general principle is that an event will be regarded as a force majeure event on fulfilment of the following conditions:

  • An unexpected intervening event occurred: The event should be one which is beyond the control of either of the parties to the agreement, similar to an Act of God;
  • The parties to the agreement assumed such an event would not occur: A party’s non-performance will not be excused where the event preventing performance was expected or was a foreseeable risk at the time of the execution of the agreement; and
  • The unexpected event made contractual performance impossible or impracticable: For instance, can the issuer of debentures say that there is no default if the issuer is unable to redeem the debentures? Whether an event has made contractual performance impossible or impracticable has to be determined on a case-to-case basis. It is to be analysed whether the problem is so severe so as to deeply affect the party, and thereby creating an impossibility of performance. This has to be, however, relative to the counterparty so as to create an impossibility of performance.
  • The parties have taken all such measures to perform the obligations under the agreement or atleast to mitigate the damage: It is required that a party seeking to invoke force majeure clause should follow the requirements set forth the agreement, i.e. to provide notice to the other party as soon as it became aware of the force majeure event, and should concretely demonstrate how the said situation has directly impacted the performance of obligations under the agreement.

To understand this further, let us discuss the precedents laid down in several cases.

Principles in Other Jurisdictions:

Prior to the decision in Taylor vs. Caldwell, (1861-73) All ER Rep 24, the law in England was extremely rigid. A contract had to be performed after its execution, notwithstanding the fact that owing to an unforeseen event, the contract becomes impossible of performance, which was not at the fault of either of the parties to the contract. This rigidity of the common law was loosened somewhat by the decision in Taylor (supra), wherein it was held that if some unforeseen event occurs during the performance of a contract which makes it impossible of performance, in the sense that the fundamental basis of the contract goes, it need not be further performed, as insisting upon such performance would be unjust.

In Gulf Oil Corp. v. FERC 706 F.2d 444 (1983)[7], the U.S. Court of Appeals for the Third Circuit considered litigation stemming from the failure of the oil company to deliver contracted daily quantities of natural gas. The court held that Gulf- as the non- performing party- needed to demonstrate not only that the force majeure event was unforeseeable but also that the availability and delivery of the gas were affected by the occurrence of a force majeure event.

Illustrations: When Is An Event Not Considered As Force Majeure?

Inability to sell at a profit is not the contemplation of the law of a force majeure event excusing performance and a party is not entitled to declare a force majeure because the costs of contract compliance are higher than it would have liked or anticipated. In this regard, the following cases are relevant:

  • In the case of Dorn v. Stanhope Steel, Inc., 534 A.2d 798, 586 (Pa. Super. Ct. 1987)[8], it was observed as follows:

“Performance may be impracticable because extreme and unreasonable difficulty, expense, injury, or loss to one of the parties will be involved. A severe shortage of raw materials or of supplies due to war, embargo, local crop failure, unforeseen shutdown of major sources of supply, or the like, which either causes a marked increase in cost or prevents performance altogether may bring the case within the rule stated in this Section. Performance may also be impracticable because it will involve a risk of injury to person or to property, of one of the parties or of others, that is disproportionate to the ends to be attained by performance. However, “impracticability” means more than “impracticality.” A mere change in the degree of difficulty or expense due to such causes as increased wages, prices of raw materials, or costs of construction, unless well beyond the normal range, does not amount to impracticability since it is this sort of risk that a fixed-price contract is intended to cover.”

  • In Aquila, Inc. v. C.W. Mining 545 F.3d 1258 (2008)[9], Justice Neil Gorsuch authored an opinion for the U.S. Court of Appeals for the 10th Circuit, which excused a coal mining company’s deficient performance under a coal supply contract with a public utility only to the extent that partial force majeure, namely labor dispute, caused deficiency.
  • In  OWBR LLC v. Clear Channel Communications, Inc., 266 F. Supp. 2d 1214[10], it was observed- “To excuse a party’s performance under a force majeure clause ad infinitum when an act of terrorism affects the American populace would render contracts meaningless in the present age, where terrorism could conceivably threaten our nation for the foreseeable future”.
  • In Transatlantic Financing Corp. v. U.S. 363 F.2d 312[11], the D.C. Circuit Court of Appeals affirmed a finding that there was no commercial impracticability where one party sought to recover damages because its wheat shipment was forced to be re-routed due to the closing of the Suez Canal. The Court of Appeals held that because the contract was not rendered legally impossible and it could be presumed that the shipping party accepted “some degree of abnormal risk,” there was no basis for relief.

Some Landmark Rulings in India:

Deliberating on what is to be considered as a force majeure, in the seminal decision of Satyabrata Ghose v. Mugneeram Bangur & Co., 1954 SCR 310[12], the Hon’ble Apex Court had adverted to Section 56 of the Indian Contract Act. The Supreme Court held that the word “impossible” has not been used in the Section in the sense of physical or literal impossibility. To determine whether a force majeure event has occurred, it is not necessary that the performance of an act should literally become impossible, a mere impracticality of performance, from the point of view of the parties, and considering the object of the agreement, will also be covered. Where an untoward event or unanticipated change of circumstance upsets the very foundation upon which the parties entered their agreement, the same may be considered as “impossibility” to do as agreed.

Subsequently, in Naihati Jute Mills Ltd. v. Hyaliram Jagannath, 1968 (1) SCR 821[13], the Supreme Court also referred to the English law on frustration, and concluded that a contract is not frustrated merely because the circumstances in which it was made are altered. In general, the courts have no power to absolve a party from the performance of its part of the contract merely because its performance has become onerous on account of an unforeseen turn of events. Further, in Energy Watchdog v. CERC (2017) 14 SCC 80[14], it was observed as follows:

“37. It has also been held that applying the doctrine of frustration must always be within narrow limits. In an instructive English judgment namely, Tsakiroglou & Co. Ltd. v. Noblee Thorl GmbH, 1961 (2) All ER 179, despite the closure of the Suez canal, and despite the fact that the customary route for shipping the goods was only through the Suez canal, it was held that the contract of sale of groundnuts in that case was not frustrated, even though it would have to be performed by an alternative mode of performance which was much more expensive, namely, that the ship would now have to go around the Cape of Good Hope, which is three times the distance from Hamburg to Port Sudan. The freight for such journey was also double. Despite this, the House of Lords held that even though the contract had become more onerous to perform, it was not fundamentally altered. Where performance is otherwise possible, it is clear that a mere rise in freight price would not allow one of the parties to say that the contract was discharged by impossibility of performance.

38. This view of the law has been echoed in ‘Chitty on Contracts’, 31st edition. In paragraph 14-151 a rise in cost or expense has been stated not to frustrate a contract. Similarly, in ‘Treitel on Frustration and Force Majeure’, 3rd edition, the learned author has opined, at paragraph 12-034, that the cases provide many illustrations of the principle that a force majeure clause will not normally be construed to apply where the contract provides for an alternative mode of performance. It is clear that a more onerous method of performance by itself would not amount to a frustrating event. The same learned author also states that a mere rise in price rendering the contract more expensive to perform does not constitute frustration. (See paragraph 15-158)”

General Force Majeure Clauses in Agreements and the Impact Thereof:

While some of the agreements do have a force majeure clause, one question that may arise is whether the excuse of force majeure event be taken only if there is a specific clause in the agreement or event otherwise? Typically, in all the agreements, whether the promisor is under the obligation to promptly inform the promisee in case of occurrence of any event or incidence, any force majeure event or act of God such as earthquake, flood, tempest or typhoon, etc or other similar happenings, of which the promisor become aware, which is reasonably expected to adversely affect the promisor, or its ability to perform obligations under the agreement.

The terms of the agreement and the intent has to be understood to determine the effect of force majeure clause.  In Phillips P.R. Core, Inc. v. Tradax Petroleum Ltd., 782 F.2d 314, 319 (2d Cir. 1985)[15], it was observed that the basic purpose of force majeure clauses is in general to relieve a party from its contractual duties when its performance has been prevented by a force beyond its control or when the purpose of the contract has been frustrated.

The next question that may arise is whether every force majeure leads to frustration of the contract? For instance, if the agreement was hiring of a car on 24th March, the occurrence of COVID- 19 may just have the impact of altering the timing of performance. In some other cases, the event may only affect one part of the transaction. Therefore, the impact of the force majeure event cannot be generalised and shall vary depending on the nature of transaction.

Usually, occurrence of a force majeure event provides the promisee with a right to terminate the agreement, and take all necessary actions as it may deem fit. For instance, in case of lease, if the lessor considers that there is a risk to the equipment, the lessor may seek for repossession of the leased equipment.

Further, in case the force majeure event frustrates the very intent of the agreement, then the parties are under no obligation to perform the agreement. For instance, if the agreement (or performance thereof) itself becomes unlawful due to any government notification or change in law, which arises after execution of the agreement, then such agreements do not have to be performed at all. In such cases, if the agreement contains a force majeure or similar clause, Section 32 of the Indian Contract Act will be applicable. The said section stipulates that contingent contracts to do or not to do anything if an uncertain future event happens, cannot be enforced by law unless and until that event has happened; If the event becomes impossible, such contracts become void. Even if the agreement does not contain a specific provision to this effect then in such a case doctrine of frustration under Section 56 of the Indian Contract Act shall apply. The section provides that a contract to do an act which, after the contract is made, becomes impossible, or, by reason of some event which the promisor could not prevent, unlawful, becomes void when the act becomes impossible or unlawful.

Impact of COVID- 19 on Loan Transactions:

The Reserve Bank of India has, vide notification No. BP.BC.47/21.04.048/2019-20 dated 27th March, 2020[16], has announced that in respect of all term loans (including agricultural term loans, retail and crop loans), all commercial banks (including regional rural banks, small finance banks and local area banks), co-operative banks, all-India Financial Institutions, and NBFCs (including housing finance companies) are permitted to grant a moratorium of three months on payment of all instalments falling due between 1st March, 2020 and 31st May, 2020. Further, in respect of working capital facilities sanctioned in the form of cash credit/overdraft, the lending institutions have been permitted to defer the recovery of interest applied in respect of all such facilities during the period from 1st March, 2020 upto 31st May, 2020.

Detail discussion on the same has been done in our article “Moratorium on loans due to Covid-19 disruption”, which can be accessed from the link below:

http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

Further, our article “RBI granted moratorium on term loans: Impact on securitisation and direct assignment transactions” can be accessed from the following link:

http://vinodkothari.com/2020/03/rbi-moratorium-on-term-loans-impact-on-sec-and-da-transactions/

 

 

[1] https://www.who.int/emergencies/diseases/novel-coronavirus-2019/events-as-they-happen

[2] https://www.mohfw.gov.in/pdf/SocialDistancingAdvisorybyMOHFW.pdf

[3] https://doe.gov.in/sites/default/files/Force%20Majeure%20Clause%20-FMC.pdf

[4] https://www.collinsdictionary.com/dictionary/english/force-majeure

[5] https://dictionary.cambridge.org/dictionary/english/force-majeure

[6] https://www.merriam-webster.com/dictionary/force%20majeure

[7] https://casetext.com/case/gulf-oil-corp-v-ferc

[8] https://law.justia.com/cases/pennsylvania/supreme-court/1987/368-pa-super-557-0.html

[9] https://www.courtlistener.com/opinion/171400/aquila-inc-v-cw-mining/

[10] https://law.justia.com/cases/federal/district-courts/FSupp2/266/1214/2516547/

[11] https://www.casemine.com/judgement/us/59149a86add7b0493462618f

[12] https://indiankanoon.org/doc/1214064/

[13] https://indiankanoon.org/doc/1144263/

[14] https://indiankanoon.org/doc/29719380/

[15] https://law.justia.com/cases/federal/appellate-courts/F2/782/314/300040/

[16] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

 

Further content related to Covid-19: http://vinodkothari.com/covid-19-incorporated-responses/

Impact on Expected Credit Loss Model (ECL) amid COVID-19 disruptions

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-The test of a Financial Crisis-driven model in times of Global Crisis

By Rahul Maharshi, Financial Services Team , (rahul@vinodkothari.com, finserv@vinodkothari.com)

The disruption throughout the globe due to the COVID-19 disease has caused tremendous uncertainty and difficulty in the financial sector. The Expected Credit Loss (ECL) model was introduced as an aftermath of the 2008 global financial crisis, to curb the loopholes of the incurred loss model and to provide a forward looking approach in the accounting of loan loss provisioning by inclusion of various credit measures. The model which is built up with the focus on credit strength of a particular exposure, is likely to get tested is these testing times.

This write-up is an attempt to explore how the ECL model should be looked given the disruption caused by COVID 19.

The approach to ECL at time of COVID-19 disruption

The ECL model requires application of judgement and differs from entity to entity. Such application of judgement and approaches are considered based on the industrial practices as well as the business environment in which the entity operates. For example, a financial institution may not have an aggressive approach in determination of ECL for the portfolios serving to the affluent sections of the economy as compared to the low credit-score portfolios.

However, conventional assumptions taken in the ECL model may not hold well in the current environment the financial sector across the world is going through. The assumptions of significant increase in credit risk (SICR), at times when there is extension in the repayment structure may be a classical example of SICR which would result in stage-shifting of the credit exposure. But the same would not hold well, in times of such a disruption, where the financial sector regulator has proposed to extend a three month moratorium for repayment of term loans, considering the disruption to the economy.

We arrive at ECL estimates with the help of three primary data points [B5.5.49] –

  • Best available information about the past events;
  • Best available information about the current conditions; and
  • Forecast of economic conditions

In the current COVID-19 disruptions, the entities should actively consider the effects of the COVID-19 disruption as well as the measures taken by the government and regulators in the current situation as well as the prospective measures which would affect the forecast. Such measures should be considered as forward looking “macro-economic information” [B5.5.4] and accordingly be considered by the entities.

However, it is easier said than done, considering the rapid changes and updates in the current stressed environment. But if the ECL estimates are arrived at, after proper consideration of reasonable and supportable information, the same can provide better transparency to the financial statements and aid in providing assurance to the stakeholders.

Ind AS 109 is clear in the assessment of SICR, where the assessment has to be done on the changes in the risk of default occurring over the expected lifetime of a financial instrument. Such an assessment has to be done by the entity based on information that is available to it without undue cost or efforts. The grant of a payment holiday at times of the disruption would not be construed as a change in the risk of default occurring over the expected lifetime of a financial instrument.

Globally, various regulators, Central Bank of various countries have come up with publications and directives for assistance in such times of disruption. Some of the publications and initiatives have been discussed at length below:

Global response to the COVID-19 disruption for sound application of the ECL model

In light of the current COVID-19 disruption, the International Accounting Standards Board (IASB) published[1] a document intending to support the consistent application of the IFRS Standards which are applicable on approximately 120 countries. In its document the IASB has indicated that extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in all those instruments being considered to have suffered an SICR.  The assessment of SICR has to be based on information that is available to an entity without undue cost and effort.

The European Central Bank (ECB), the apex banking authority for the 19 European Union countries has also published[2] a document as a guidance for financial institutions in careful implementation of the ECL and avoidance of excessive pro-cyclical assumptions in ECL during the COVID-19 disruptions.

The annexure of the above letter provided guidance for the institutions to take into account when using forecasts to estimate the ECL:

  • The collective assessment of the significant increase in credit risk (SICR);

The ECB perceived deterioration to the GDP outlook could lead to manifold increase in probability of default (PD), in turn leading to transfer of the financial instrument from stage 1 to stage 2.  In times of economic disruptions, such as the COVID-19, even factors usually assessed individually become very sensitive to macroeconomic scenarios. For tackling such a situation, the ECB advised the institutions to :

  • Consider whether a top-down approach to stage transfer can be taken and in the context of that approach, recognise lifetime expected credit losses on a portion of the financial assets for which credit risk is deemed to have increased significantly without the need to identify which individual financial instruments have suffered a SICR.

 

As per para B5.5.6 of IFRS 9 (Ind AS 109) A top-down approach to ECL is such, where the identification of a particular sub-portfolio on the basis of shared risk characteristics that represent customers whose credit risk is expected to have increased significantly, is not possible. In such a case, an assessment can be made of a proportion of the overall portfolio that has SICR since initial recognition.

Example of Top-down approach will be as follows:

Where there is high chance of a risk of default occurring and thus an increase in credit risk, results from an expected increase in interest rates during the expected life of the portfolio held by a financial institution. In such a case, assessing an increase in interest rates of 200 basis points will cause a significant increase in credit risk on 20% of the variable interest-rate portfolio and accordingly, recognition of lifetime ECL on 20% of the variable rate mortgage portfolio, and a loss allowance at an amount equal to 12-month ECL for the remainder of the portfolio.

  • The use of long term macroeconomic forecasts ;and

The IFRS 9 provisions lead to the conclusion that where there is no reliable evidence for specific forecasts, long-term macroeconomic outlooks will provide the most relevant basis for estimation. The ECB provided guidance for financial institutions to:

  • use available historical information, but only as far as this information is representative for the long-term horizon and free of bias;
  • Where historical information depends on macroeconomic variables, consider information covering at least one or more full economic cycles or that is otherwise adjusted to avoid biases, e.g. a recency bias.

 

  • The use of macroeconomic forecast for specific years

To include forward-looking information in ECL models, it is quite a common practice among significant institutions to establish a baseline macroeconomic scenario. In doing so, ECB guided the financial institutions to consider the following:

  • Consider macroeconomic forecasts for specific years and long-term forecasts, as previously described;
  • Factor these two types of forecasts into the baseline scenario with weights based on their respective relevance;
  • Assign more weight to the specific-period macroeconomic forecast for the short-term outlook and systematically reduce that weight as the forecast loses relevance for time horizons in the more distant future;
  • Use the long-term forecast (e.g. the long-term GDP growth rate) whenever the specific forecast has lost relevance.

Institutions that use other scenarios in addition to the baseline scenario are expected to:

  • Estimate the probabilities of these scenarios and their deviation from the baseline according to the above principles;
  • Ensure that the probabilities assigned to scenarios and the deviations of such scenarios beyond the reliable forecasting horizon reflect experience collected over a sufficiently long-term horizon and not be based on specific year projections.

The Basel Committee on Banking Supervision (BCBS)[3] had set out additional measures to reduce the impact of COVID-19 on the global banking system. In its press release, the BCBS reiterated the importance of ECL frameworks, referring to both IFRS 9 and Current Expected Credit Loss Model (CECL) by the Financial Accounting Standards Board (FASB), urging banks to:

“Use the flexibility inherent in these frameworks to take account of the mitigating effect of the extraordinary support measures related to Covid-19.”

BCBS further stated that:

“Extraordinary support measures should be taken into account by banks when they calculate their ECLs.”

“Regarding the SICR assessment, relief measures to respond to the adverse economic impact of Covid-19 such as public guarantees or payment moratoriums, granted either by public authorities, or by banks on a voluntary basis, should not automatically result in exposures moving from a 12-month ECL to a lifetime ECL measurement.”

The approach towards the assessment has to be holistic, considering the effect on all the components considered in the computation of ECL.

The Institute of Chartered Accountants of India (ICAI), as a joint initiative of Accounting standards Board (ASB) and Auditing and Assurance Standards Board (AASB) has come out with a publication ICAI ACCOUNTING & AUDITING ADVISORY Impact of Coronavirus on Financial Reporting and the Auditors Consideration[4] which has provided guidance on various areas of financial reporting and Audit of financial statements, which require particular attention in respect of financial statements for the year 2019-20.

The guidance has provided the following points in relation to impairment losses as per Ind AS 109:

  • Measurement of ECL: the impact on business of borrowers or debtors to impact credit risk parameters in the following ways:
  • Increase in PD due to reduced business activity.
  • Adverse impact on value of collaterals and business cash flows in turn affecting the loss given default (LGD)
  • Full utilisation of undrawn limits and loan commitments in times of disruptions to impact exposure at default (EAD).
  • Entities to develop more than one scenarios considering the potential impact of COVID-19.
  • As a guidance from Appendix A of Ind AS 109: Borrower specific concession(s) given by lenders, on account of economic or contractual reasons relating to the borrower’s financial difficulty, which the lenders would not have otherwise considered. Such a condition to be considered as an evidence that a financial assets is credit-impaired.
  • Entities to consider impact of Prudential Regulatory actions to sustain the economy such as loan repayment holidays, reduction in interest rates etc.
  • Disclosures of the impact of COVID-19 on various credit related aspects such as methods, assumptions and information used in estimating ECL, policies and procedures for valuing collaterals etc.
  • Non-Banking Financial Companies (NBFCs) and Asset Reconstruction Companies (ARCs) should also carefully consider the recent guidance provided by Reserve Bank of India (RBI) on implementation of Ind AS[5]

The major component in ECL computation is the probability of default (PD). To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.

The effect of a pandemic on the ECL parameters have been discussed at length below.

The effect on ECL parameters in times of disruptions

The parameters used in reaching to the ECL are:

  • Probability of default (PD)
  • Loss given default (LGD)
  • Exposure at default (EAD)
  • Discount factor (df)

Further the ECL formula can be defined as “ECL= PD*LGD*EAD*df”.

To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.

The LGD is the indicator of quantum of loss from a transaction, given that a default occurs.  The LGD takes into consideration the exposure at default and post default classifications, valuation of any collateral as well as allocation of the same. The resultant decline in the economic activities due to lockdowns can have severe effects on the value of collaterals as well as cash flows of the business.

EAD is basically the estimation of the extent to which the financial entity may be exposed to a counterparty in the event of a default and at time of the counterparty’s default. EAD also takes into consideration, the expected payments in future scenarios. In estimation of EAD, the strength of the financial entity, in terms of assets (i.e loan given) and liabilities (i.e. loan taken) are kept in tandem to for assessment of contractual cash flows. However, in such times of disruption, the trend may be for the borrowers to fully exhaust the credit drawing limits and loan commitments, creating stress on the exposures, more so in case of revolving lines of credit facilities.

The discounting of the above components have to be done using the original effective interest rate (EIR). The EIR is arrived at after considering the current interest rate for the facility and adjusting with it, any fee or income charged. In times of such global disruptions, there is always a likelihood that the prevailing market interest rates takes a hit. As already we have seen by the RBI purchasing Rs 10,000 crore in government bonds under the open market operations programme as a measure against the disruption, the same would result in change in the risk free rate as well.

Effect of the moratorium grant on loan repayments on ECL by the RBI[6]

To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI to mitigate the burden on debt-servicing caused due to the disruption. These measures include moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. The lending institutions have been permitted to allow a moratorium of three months on payment of all instalments falling due between March 1, 2020 and May 31, 2020. The below explanation specifies effect of the moratorium.

Effect on credit risk and stage shifting

Since the moratorium is to be considered as a repayment holiday where the borrower is granted an option to not pay during the moratorium period, the same cannot be considered as a factor in determining change in the credit risk complexion of the borrower. The provisions of para 5.5.12 of Ind AS 109 are self-explanatory on the point that if there has been a modification of the contractual terms of a loan, then, in order to see whether there has been a SICR, the entity shall compare the credit risk before the modification, and the credit risk after the modification. Sure enough, the restructuring under the disruption scenario is not indicative of any increase in the probability of default.

Accordingly, the same should ideally not be considered as a factor for considering SICR and in turn, should not result in shifting of the financial instruments from one stage to another.

Effect on rebuttable presumptions about credit deterioration

The moratorium granted by the RBI seeks to amend the payment schedule without resulting in a restructuring. There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. However, the rebuttal may be offered in case the payments are more than 30 days past due. The very meaning of “past due” is something which is not paid when due. The moratorium amends the payment schedule. What is not due cannot be past due.

Effect on Effective interest rate (EIR) for the loan and income during the moratorium

The whole idea of the modification is to compute the interest for the deferment of EMIs due to moratorium, and to compensate the lender fully for the same. The IRR for the loan after restructuring should, in principle, be the same as that before restructuring. Hence, there should be no impact on the EIR.

As the EIR remains constant, there will be recognition of income for the entire Holiday period. For example, for the month of March, 2020, interest will be accrued. The carrying value of the asset (POS) will stand increased to the extent of such interest recognised. In essence, the P/L will not be impacted

Also, there will not arise any modification gain or loss as per para 5.4.3 of Ind AS 109 since the EIR remains constant.

Requirement of Impairment-testing of financial asset

The revision in the payment schedule does not result in a modification of the financial asset, which could have resulted in an impairment testing of the financial asset. Since the contractual modification in case of the moratorium is not a result of a credit event, the question of any impairment for this reason does not arise.

Conclusion

The concept of ECL being a fallout of the Global Financial Crisis, it will be interesting to see how fairly the model lives up in providing transparency to the users of financial statements at this time of global disruption. It is worth mentioning that ECL, being a reserve built up in good times which could be used in bad ones, the current situation is difficult, creating high levels of uncertainty but certain measures may be adopted by entities in curbing the situation to some extent, such as:

  • Developing more than one scenarios for the potential impact of the COVID-19 disruptions treated as macro-economic information as per para B5.5.4 of Ind AS 109
  • Effect of measures taken by the government and the regulators in the true spirit with which the same is implemented.

[1] https://cdn.ifrs.org/-/media/feature/supporting-implementation/ifrs-9/ifrs-9-ecl-and-coronavirus.pdf?la=en

[2]https://www.bankingsupervision.europa.eu/press/letterstobanks/shared/pdf/2020/ssm.2020_letter_IFRS_9_in_the_context_of_the_coronavirus_COVID-19_pandemic.en.pdf?b543f9408a8480e04748a3b0185d8cf3

[3] https:/www.bis.org/press/p200403.htm and  https://www.bis.org/bcbs/publ/d498.htm

[4] https://resource.cdn.icai.org/58829icai47941.pdf

[5] https://rbidocs.rbi.org.in/rdocs/Notification/PDFs/NOTI170F341D8DE49C04D4B8382D855A9858583.PDF

[6] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

Contribution to PM CARES Fund qualifies as CSR expenditure

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Vinod Kothari & Company

corplaw@vinodkothari.com

Actionables arising out of COVID 19- Regulatory Package brought in by RBI

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By Team Corporate Laws, (corplaw@vinodkothari.com)

To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI as a part of its Seventh Bi-monthly Policy. The RBI also issued a Press Release on 27th March, 2020 namely, Statement on Developmental and Regulatory Policies followed by a Notification on the same date titled COVID 19- Regulatory Package. These measures are intended to mitigate the burden on debt-servicing caused due to disruptions on account of COVID-19 pandemic such as providing moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. Considering the need of the hour, we have tried to jot down the immediate actionable arising out of the said Notification as below:

Sl. No Sequence of Events/ Actionables
1 Issue notice for calling Board Meeting at a shorter notice via VC mode or circulate the draft policy along with draft resolution for seeking approval through circular resolution.

 

Considering the urgency of the matter, VC may be the most viable option to get the necessary approval of the Board. Notice shall be accompanied with the draft agenda and draft of the policy to be adopted by the Board as per the Notification.

 

Where the company intends to pass resolution by circulation, the company may consider providing lesser time to the Board to revert with their vote on the resolution, instead of seven days from the date of circulation.
2. Conduct of Board Meeting through VC mode/ resolution by circulation to discuss the following

 

a.        to discuss the requirements of the RBI Press Release ‘Statement on Developmental and Regulatory Policies’ dated 27th March, 2020 and RBI Notification pertaining to COVID-19 – Regulatory Package. The significant points are:

i.            Moratorium of three months on payment of instalments in respect of all term loans outstanding as on March 1, 2020 and May 31, 2020;

ii.            Deferment of the recovery of interest applied in respect of all working capital facilities in the form of CC/ OD during the period from March 1, 2020 upto May 31, 2020;

iii.            recalculating  the  ‘drawing power’ in case of working capital facilities sanctioned in the form of CC/OD by reducing the margins and/or by reassessing the working capital cycle- in case applicable

 

b.       To adopt the draft of the Policy circulated to the Board Members. The Policy shall broadly include:

i.            Eligibility of the borrowers;

ii.            Restrictions/ conditions w.r.t rescheduling of payments of term loans and working capital facilities outstanding as on period from March 1, 2020 upto May 31, 2020;

iii.            Restrictions/ conditions w.r.t deferment of the recovery of interest applied in respect of all working capital facilities in the form of CC/OD during the period from March 1, 2020 upto May 31, 2020

iv.            Restrictions/ conditions w.r.t recalculating  the  ‘drawing power’ in case of working capital facilities sanctioned in the form of CC/OD; (in case applicable)

v.            Manner of such re-schedulement/ recalculation/ deferment;

vi.            Grounds for considering deemed acceptance by the eligible borrowers;

vii.            Process to be followed in case of customers do not opt for the re-schedulement/ recalculation;

viii.            Development of an MIS for exposure of INR 5 Cr. or more including the borrower-wise and credit-facility wise information regarding the nature and amount of relief granted;

ix.            Maintenance of records of customers opting/ not opting for the option;

x.            Process to be followed for implementation of the Policy.

 

c.        To authorize an officer to send necessary communication to eligible customer(s);

 

d.       To authorize an officer/ KMP to communicate the aforesaid developments at organizational level and give necessary instructions for the purpose of effective implementation thereof.
3 Prepare minutes of the meeting and circulate to all the Directors;

 
4. Display the Policy on the website of the Company;

 
5. Authorised person to give necessary intimation to the eligible borrowers by email or the tele callers will intimate. Alternatively, the moratorium may be extended to only those borrowers who expressly seek for the same from the lender. Further instructions must be given to the respective departments/ personnel within the organisation to ensure compliance with the policy;

 
6. Maintain record of the borrower communicating their acceptance of the option/ or expressly denying the option/ deemed acceptance in the manner as provided in the Policy;

 
7. Communicate the revised repayment terms and obtain confirmation from the borrower by way or email or telecommunication or such other feasible means. The communication will have to happen immediately, in order to take benefit of the moratorium.

 

 

 

Moratorium on loans due to Covid-19 disruption

 

press release [https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49582]

Notification [https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0]

 

 

Buy-back of shares during Covid-19 Pandemic

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By CS Vinita Nair, Senior Partner| Vinod Kothari & Company

corplaw@vinodkothari.com

Share Buy-Back During COVID-19 Pandemic:

 

Moratorium on loans due to Covid-19 disruption- Webinar & Presentation

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RBI granted moratorium on term loans: Impact on securitisation and direct assignment transactions

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Abhirup Ghosh

abhirup@vinodkothari.com

In response to the stress caused due to the pandemic COVID-19, the regulatory authorities around the world have been coming out relaxations and bailout packages. Reserve Bank of India, being the apex financial institution of the country, came out a flurry of measures as a part of its Seventh Bi-Monthly Policy[1][2], to tackle the crisis in hand.

One of the measure, which aims to pass on immediate relief to the borrowers, is extension of moratorium on term loans extended by banks and financial institutions.  We have in a separate write-up[3] discussed the impact of this measure, however, in this write-up we have tried to examine its impact on the securitisation and direct assignment transactions.

Securitisation and direct assignment transactions have been happening extensively since the liquidity crisis after the failure of ILFS and DHFL, as it allowed the investors to take exposure on the underlying assets, without having to take any direct exposure on the financial intermediaries (NBFCs and HFCs). However, this measure has opened up various ambiguities in the structured finance industry regarding the fate of the securitisation or direct assignment transactions in light of this measure.

Originators’ right to extend moratorium

The originators, will be expected to extend this moratorium to the borrowers, even for the cases which have been sold the under securitisation. The question is, do they have sufficient right to extend moratorium in the first place? The answer is no. The moment an originator sells off the assets, all its rights over the assets stands relinquished. However, after the sale, it assumes the role of a servicer. Legally, a servicer does not have any right to confer any relaxation of the terms to the borrowers or restructure the facility.

Therefore, if at all the originator/ servicer wishes to extend moratorium to the borrowers, it will have to first seek the consent of the investors or the trustees to the transaction, depending upon the terms of the assignment agreement.

On the other hand, in case of the direct assignment transactions, the originators retain only 10% of the cash flows. The question here is, will the originator, with 10% share, be able to grant moratorium? The answer again is no. With just 10% share in the cash flows, the originator cannot alone grant moratorium, approval of the assignee has to be obtained.

Investors’ rights

As discussed above, extension of moratorium in case of account sold under direct assignment or securitisation transactions, will be possible only with the consent of the investors. Once the approval is placed, what will happen to the transactions, as very clearly there will be a deferral of cash flows for a period of 3 months? Will this lead to a deterioration in the quality of the securitised paper, ultimately leading to a rating downgrade? Will this lead to the accounts being classified as NPAs in the books of the assignee, in case of direct assignment transactions?

Before discussing this question, it is important to understand that the intention behind this measure is to extend relief to the end borrowers from the financial stress due to this on-going pandemic. The relief is not being granted in light of any credit weakness in the accounts. In a securitisation or a direct assignment, the transaction mirrors the quality of the underlying pool. If the credit quality of the loans remain intact, then there is no question of the securitisation or the direct assignment transaction going bad. Similarly, we do not see any reason for rating downgrade as well.

The next question that arises here is: what about the loss of interest due to the deferment of cash flows? The RBI’s notification states that the financial institutions may provide a moratorium of 3 months, which basically means a payment holiday. This, however, does not mean that the interest accrual will also be suspended during this period. As per our understanding, despite the payment suspension, the lenders will still be accruing the interest on the loans during these 3 months – which will be either collected from the borrower towards the end of the transaction or by re-computing the EMIs. If the lenders adopt such practices, then it should also pass on the benefits to the investors, and the expected cash flows of the PTCs or under the direct assignment transactions should also be recomputed and rescheduled so as to compensate the investors for the losses due to deferment of cash flows.

Another question that arises is – can the investors or the trustee in a securitisation transaction, instead of agreeing to a rescheduling of cash flows, use the credit enhancement to recover the dues during this period? Here it is important to note that credit enhancements are utilised usually when there is a shortfall due to credit weakness of the underlying borrower(s). Using credit enhancements in this case, will reduce the extent of support, weaken the structure of the transaction and may lead to rating downgrade. Therefore, this is not advisable.

We were to imagine an extreme situation – can the investors force the originators to buy back the PTCs or the pool from the assignee, in case of a direct assignment transaction? In case of securitisation transactions, there are special guidelines for exercise of clean up calls on PTCs by the originators, therefore, such a situation will have to be examined in light of the applicable provisions of Securitisation Guidelines. For any other cases, including direct assignment transactions, such a situation could lead up to a larger question on whether the original transaction was itself a true sale or not, because, a buy-back of the pool, defies the basic principles of true sale. Hence, this is not advisable.

[1]https://rbidocs.rbi.org.in/rdocs/Content/PDFs/GOVERNORSTATEMENT5DDD70F6A35D4D70B49174897BE39D9F.PDF

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0

[3] http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/