Restructuring of debt securities not to be treated as default, clarifies SEBI

-Financial Services Division (finserv@vinodkothari.com)

Unprecedented crises call for unprecedented measures; the good thing is that all regulators are responding soon enough to the need for tweaking regulations, valuation rules, provisioning norms, accounting norms, and so on, to allow companies to adjust themselves to the new world that we are being ushered in.

SEBI has come up with a Circular no SEBI/HO/IMD/DF3/CIR/P/2020/70 dated 23rd April, 2020[1] (Circular), to the effect that mutual funds will not have to treat restructuring of a debt security as a case of “default”. With this, the funds have been able to avert having to make as much as 50% provision for what was deemed as a case of default.

It is notable that there have been court rulings whereby companies have evoked the “force majeure” clause to seek breather to repayment of debt securities[2].

Given the sensitiveness of the situation, this Circular has come as breather for a lot of financial sector entities, especially the ones actively engaged in securitisation, and ofcourse mutual funds. This write-up intends to first set a context to the Circular and then discuss the potential impact of the Circular.

Deemed Default in Case of Restructuring and Valuation Rules

A circular on valuation of money market and debt securities[3] issued by SEBI stated that “Any extension in the maturity of a money market or debt security shall result in the security being treated as “Default”, for the purpose of valuation”.

As per the valuation norm, mentioned above, mutual funds are required to take a haircut on the value of debt securities declared as default. In this regard, AMFI[4] has issued benchmarks for haircuts, based on which the valuation agencies are required to consider haircut as high as 50%, thereby reducing the value of the securities to half.

This circular turned out to be a major stumbling block for the mutual funds while extending the tenure of PTC transactions vis-à-vis the RBI’s moratorium on term loans in the wake of COVID 19 pandemic. The same has been discussed at length in the following section.

Restructuring of Pass Through Certificates

On March 27, 2020, the Reserve Bank of India (RBI) introduced COVID-19 Regulatory Package[5]  which provided for moratorium on payment of instalments for term loans falling due between 1st March, 2020 and 31st May, 2020[6]. The moratorium has to be extended to all the loans, irrespective of whether they have been sold off by the originators by way of securitisation or direct assignment.

The moratorium as per the RBI’s framework, forced the originators to alter the payout structures originally agreed with the investors under PTC/ DA transactions, so as to pass on effect of moratorium to the investors as well. However, the problem arose when the matter was placed before mutual funds. The mutual funds are major investors in PTCs, representing approximately 43% of securitisation issuances in India[7]. The mutual funds became wary of any extension or modification in the terms of the PTCs, due to apprehensions on valuation losses due to reasons discussed earlier in this write-up.

This created a deadlock between the originators and mutual funds (as investors). On one hand, there was a pressure on the originators to extend moratorium across all the borrowers, on the other hand, the mutual funds were apprehensive in accepting the revised terms due to a potential valuation loss.[8]

Considering the situation, the SEBI issued the Circular to address the issues with respect to valuation of debt securities.

Restructuring of Debentures

Restructuring by deferral of the maturity is something that may be done in case of debentures as well. Debentures may have been (a) private placed; or (b) publicly offered. The former is the more common route for mutual funds to invest.

Any change in the terms of issue amounts to modification of rights of debenture-holders. There is no provision under the Companies Act or SEBI regulations dealing with modification of rights of debenture-holders. Therefore, such modification can be done subject to and in accordance with the terms of issue.

Typically, in case of private placement, the consent of debenture-holders, either directly or through the debenture trustees, is required to be obtained. On the part of the Company, the power to modify the terms usually reside with the Board of Directors or are delegated by the Board to a Committee or a person or persons.

In case of publicly offered debentures, in addition to obtaining the above mentioned consent, compliance with provisions of SEBI LODR Regulations is also required to be ensured.

How can Debenture Issuers Make Use of the SEBI Circular?

  • The restructuring must be solely on account of the COVID crisis. It should be possible to demonstrate that the asset pool or ALM arrangement, but for the impact of the crisis, was adequate enough to take care of the scheduled maturity of the bond.
  • It should be possible to demonstrate that the underlying asset cover still remains healthy, and conditions such as asset cover etc. are benign complied with.
  • The necessary formalities of obtaining required consents must have been done.

If these conditions are fulfilled, a bond issuer may be able to get the consent of the investors without the investors having to provide deep haircuts on account of a deemed default.

Specific Provisions of the Circular

  • An extension of term of a security would not be considered as a default only when the valuation agency is of a view that such delay in payment or extension of maturity has  arisen  solely  due  to  COVID-19 pandemic  lockdown  and/or  in  light  of  the  moratorium  permitted  by  the RBI.
  • In case of difference in the valuation of securities provided by two valuation agencies, the conservative valuation i.e. the lower of the two values shall be accepted.
  • The relief from attraction of provision of default shall be limited to the period the moratorium is in operation.
  • AMCs shall continue to be responsible for true and fairness of valuation of securities.

Conclusion

Due to the obvious outcome of reduction in value of the assets, the mutual funds, as investors of debentures or PTCs, had been rejecting the proposals of issuers/originators/servicers as the case maybe with respect grant of moratorium to the borrowers. Mostly the Mutual Funds which are major investors in PTCs have been denying the grant of moratorium benefit to the borrowers owing to the reduction in value of AUM that would follow. With introduction of this Circular, the problem of taking deep haircuts on the value on account of deemed default stand resolved.

Mutual Funds are now expected to give a green signal on grant of moratorium by lenders. This would help to finally meet the objective of providing relief to the country at the time of the current crisis.

 

 

 

 

[1] https://www.sebi.gov.in/legal/circulars/apr-2020/review-of-provisions-of-the-circular-dated-september-24-2019-issued-under-sebi-mutual-funds-regulations-1996-due-to-the-covid-19-pandemic-and-moratorium-permitted-by-rbi_46549.html

[2] Our write-up dealing with Force Majeure clauses in agreements may be referred here: http://vinodkothari.com/2020/03/covid-19-and-the-shut-down-the-impact-of-force-majeure/

[3] https://www.sebi.gov.in/legal/circulars/sep-2019/valuation-of-money-market-and-debt-securities_44383.html

[4] https://docs.utimf.com/v1/AUTH_5b9dd00b-8132-4a21-a800-711111810cee/UTIContainer/Standard%20Hair%20Cut%20matrix__AMFI20190606-110846.pdf

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

[6] Our detailed FAQs relating to the moratorium may be viewed here: http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/

[7] http://vinodkothari.com/2020/01/shadow-banking-in-india/

[8] Issue discussed at length in a virtual conference organised by Indian Securitisation Foundation: Agenda and minutes may be referred on the following links:

http://vinodkothari.com/2020/04/virtual-conference-on-impact-of-rbis-moratorium-on-ptc-transactions/

http://vinodkothari.com/2020/04/minutes-of-the-isf-virtual-conference/

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