SEBI’s stringent norms for secured debentures

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Will it lead to a paradigm shift to unsecured debentures?

Shaifali Sharma | Vinod Kothari and Company

corplaw@vinodkothari.com

Introduction

The debt market in India has seen significant growth over the years. Amongst the various debt instruments, debentures are one of the most widely used instruments for raising funds. In India, the regulatory framework for debt instruments is governed by multiple regulators through multiple regulations. As far as secured debentures are concerned, more stringent provisions have been prescribed by the respective regulators to protect the interest of investors. In theory, it seems that hard earned money invested by the investors in secured debentures are safe and secured against the assets of the company. However, some major defaults witnessed by debt market in the recent years depict a different reality.

Absence of identified security, delay in payment due to debenture holders and other increased events of defaults witnessed in recent years, has encouraged SEBI to revise the regulatory framework in relation to secured debentures and Debenture Trustees and thereby SEBI vide its circular[1] dated November 03, 2020 (‘November 03 Circular’), has issued norms with respect to the security creation and due diligence of asset cover in furtherance to the recent amendment made in ILDS Regulations[2] and DT Regulations[3] w.e.f. October 8, 2020. Subsequently, on November 13, 2020, SEBI issued circular on Monitoring and Disclosures by Debenture Trustee[4], effective from quarter ended on December 31, 2020 for listed debt securities dealing with various issues namely monitoring of ‘security created’ / ‘assets on which charge is created’, action to be taken in case of breach of covenants or terms of issue, disclosure on website by Debenture Trustee and reporting of regulatory compliance.

The revised framework may pose challenges for corporates to raise fund through secured debentures and may leave them relying on unsecured debentures. In this article we shall discuss and analyse the impact and consequences of these stricter norms on companies and the way forward.

Current Scenario of Corporate Bond Market in India

The RBI Bulletin January, 2019[5] provides that the “total resource mobilisation by Indian corporates through public/private/rights issues is dominated by debt while equity accounts for close to 38%”.

In India, the corporate bond market is dominated by private placements, a graphical trend comparing corporate debt issuance under two routes i.e. public issue and private placement has been given below (‘table 1’). As per the latest data available with SEBI, the total amount raised through corporate bonds by way of private placement has increased from 4,58,073 crores to 6,74,702 crores in the last 5 years.

Table on amount raised through public and private placement issuances of Corporate Bonds in Indian Debt Market (Listed Securities)

Financial Year No. of Public Issues Total amount raised through Public Issue (in crores) No. of Private Placement (in crores) Total amount raised through Private Placement (in crores)
2015-16 20 33811.92 2975 458073.48
2016-17 16 29547.15 3377 640715.51
2017-18 7 4953.05 2706 599147.08
2018-19 25 36679.36 2358 610317.61
2019-20 34 14984.02 1787 674702.88
2020-21 (till Oct) 5 881.82 1157 442526

 

Source: Compiled from data available at SEBI’s website[6]

Table 1: Corporate Debt Issuance under Private Placement and Public Issue

As regards the concentration of secured borrowing in comparison to the unsecured borrowing in private placement market, the RBI Bulletin January 2019 further provides that ‘secured lending accounted for close to half of the total amount raised even in the private placement market of corporate debt’. The same may be understood from a graphical presentation below:

Source: RBI Bulletin January 2019

This includes secured and unsecured borrowing raised in the private placement market of corporate debt

As also noted by SEBI in its consolidation paper[7] dated February 25, 2020, in last 5 Financial Years the bond issuances were largely secured (approximately 76%).

Therefore, the above figures indicate that the volume of corporate bonds, particularly in private placement market, is higher in secured borrowings.

Regulatory Framework for issuing Secured Debentures

SEBI’s stringent norms for issuance of secured debentures

A company may issue secured debentures after complying with the extensive provisions as prescribed under the Companies Act, 2013 and SEBI Regulations. Further SEBI, in view of the increased events of defaults, challenges in relation to creation of charge, enforcement of security, Inter-Creditor Agreement process and other related issues, has reviewed the regulatory framework for Corporate Bond and Debenture Trustee and revisited the manner of issue of secured debentures by introducing amendments in DT Regulations[8], ILDS Regulations[9] and Listing Regulations[10] w.e.f October 08, 2020.

In furtherance to the above amendments made in ILDS Regulations and DT Regulations, SEBI vide November 03 Circular issued norms applicable to secured debentures intended to be issued and listed on or after January 01, 2021.

While the amended provisions aim to secure the interest of debenture holders, the same has raised compliance burden on issuer of secured debentures and thereby corporates may be inclined towards unsecured borrowing facilities due to following reasons:

  1. Creation of Recovery Expense Fund (REF)

Issuers shall create a Recovery Expense Fund (‘REF’) towards the recovery of proceeding expenses in case of default. The manner of creation, operation and utilization of Fund is prescribed by SEBI vide circular[11] dated October 22, 2020. It requires the Issuer to deposit 0.1% of the issue subject to a maximum of 25 lakhs per issuer. This means that all issuers with an issue size above of 250 crores will be required to deposit 25 lakhs to the REF irrespective of the amount.

All the applications for listing of debt securities made on or after January 01, 2021 shall comply with the condition of creation of REF and the existing issuers whose debt securities are already listed on Stock Exchange(s) shall be given additional time period of 90 days to comply with creation of REF.

This fund is in addition to the requirement of creation of Debenture Redemption Reserve and Debenture Redemption Fund and therefore would entails additional compliance cost to the issuer.

  1. Due diligence by Debenture Trustee for creation of security

The Debenture Trustee is required to assess that the assets for creation of security are adequate for the proposed issue of debt securities. However, there is no clarity on who is to bear the cost of due diligence. In case the same is to be borne by the issuer, the issue expense will unnecessarily increase.

In case of creation of further charge on assets, the Debenture Trustee shall intimate the existing charge holders via email about the proposal to create further charge on assets by issuer seeking their comments/ objections, if any, to be communicated to the Debenture Trustee within next 5 working days.

In cases where issuers have common Debenture Trustee for all issuances and the charge is created in favour of Debenture Trustee, the requirement seems impracticable.

  1. Creation of security and strict time frame of listing debentures through private placement

The November 03 Circular mandates creation of charge and execution of Debenture Trust Deed with the Debenture Trustee before making the application for listing of debentures.

SEBI vide its circular[12] dated October 5, 2020, effective for issuance made on or after December 1, 2020, requires the listing of private placement to be completed within 4 trading days from the closure of the issue. Where the issuer fails to do so, he will not be able to utilize issue proceeds of its subsequent two privately placed issuance until final listing approval is received from stock exchanges and will also be liable to penalty as may be prescribed.

In such scenario, it would be arduous for issuers and Debenture Trustee to comply with the procedural requirements in such stringent timelines.

  1. Entering into Inter-Creditor Agreement (ICA)

An ICA is an agreement between all lenders of a borrower through which lenders collectively initiate the process of implementing a Resolution Plan as per RBI guidelines in case of default. These provisions are applicable to Scheduled Commercial Banks, All India Term Financial Institutions like NABARD, SIDBI etc., small finance banks and NBFC-D. Trustees may join the ICA subject to the approval of debenture holders and conditions prescribed. Debenture Trustee may subject to the approval of debenture holders enter into ICA as per the RBI framework.

  • While the ICA is entered with the approval of debenture holders, however, the debenture holders may not be familiar of the concept of ICA and consequences, positive / negative, of joining ICA resulting into uninformed decision.
  • RBI guidelines on ICA applies to institutional entities and it does not provide any rights for debenture holders.
  • While the Debenture Trustee is free to exit the ICA, it will be challenging to exit ICA and enforce security in case of pari-passu charge.

In addition to the reasons stated above, other stringent compliances as introduced by the SEBI may impose burden and encourage corporates to give a second thought on shifting to unsecured debentures.

Should issuers move towards unsecured debt raising?

While the amendments focus on secured debentures, yet one of the major points in the SEBI Consultation Paper was creation of an ‘identified charge’ on assets. The proposal was in the light of the fact that in case of issuers like NBFCs, the debentures are secured by way of floating charge on receivables. Now, as is known, floating charges are enterprise-wide charges hovering on general assets of the company, unlike fixed charges. Floating charges are subservient to fixed charges. Further, the extant provisions of the Insolvency and Bankruptcy Code are not clear on the treatment of floating charges vis-à-vis unsecured debt. Hence, the prevalence of floating charges on receivables is not of much relevance in the case of issuers like NBFCs. Therefore, ‘secured’ debentures, might actually be an illusion and may have no concrete effect. Hence, with more stringent conditions coming in, it might actually be a motivation to the issuers to move to unsecured debentures.

Fund raising via unsecured debentures and applicability of Deposit Rules

Given the stringent regulatory framework for issuance and listing of secured debentures as discussed above, corporates may start looking for other sources of raising funds, including unsecured debt issuances. In case of issue of unsecured debentures, one has to see the applicability of the Companies (Acceptance of Deposits) Rules, 2014 (‘Deposits Rules’) or Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016[13] (‘NBFC Deposit Directions’), in case of NBFCs, in this regard.

Applicability of Deposit Rules / NBFC Deposit Directions for issuance of unsecured debentures

Applicability Whether deposits?
Secured debentures Unsecured debentures

 
For Companies

 

(on which Deposits Rules apply)

 Secured debentures shall not be considered as deposits

Explanation:

Definition of ‘deposit’ under Rule 2 (1)(c)(ix) of the Companies (Acceptance of Deposits) Rules, 2014 excludes debentures which are secured by first charge or a charge ranking pari passu with the first charge on any assets referred to in Schedule III of the Companies Act, 2013 excluding intangible assets of the company or bonds or debentures compulsorily convertible into shares of the company within ten years.

Further, if such bonds or debentures are secured by the charge of any assets referred to in Schedule III of the Act, excluding intangible assets, the amount of such bonds or debentures cannot exceed the market value of such assets as assessed by a registered valuer.

 Unsecured debentures shall be considered as deposits, unless listed on any recognized Stock Exchange.

Explanation:

Amount raised by issue of unsecured non-convertible debentures listed on a recognised stock exchange as per applicable regulations made by SEBI shall not be considered as deposits since exempted under Rule 2(1)(c)(ixa) of the Companies (Acceptance of Deposits) Rules, 2014.
For NBFCs

 

(on which NBFC Deposits Directions apply)

 Secured debentures shall not be considered as public deposits

Explanation:

As per the definition of ‘public deposit’ under para 3(xiii)(f)  of the Master Direction – Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 2016, any amount raised by the issue of bonds or debentures secured by the mortgage of any immovable property of the company; or by any other asset or which would be compulsorily convertible into equity in the company provided that in the case of such bonds or debentures secured by the mortgage of any immovable property or secured by other assets, the amount of such bonds or debentures shall not exceed the market value of such immovable property/other assets;

 Unsecured debentures shall be considered as public deposits, except in case of issuance of non-convertible debentures with a maturity more than one year and having the minimum subscription per investor at Rs.1 crore and above

Explanation:

As per para 3(xiii)(fa) of said Master Directions, any amount raised by issuance of non-convertible debentures with a maturity more than one year and having the minimum subscription per investor at Rs.1 crore and above, provided that such debentures have been issued in accordance with the guidelines issued by the Bank as in force from time to time in respect of such non-convertible debentures shall not be treated as public deposits.

Thus, the debentures will either have to be secured, or will have to be listed in order to avail exemption from the Deposit Rules/ NBFC Deposit Directions.

Compliance Corner: How different is unsecured from secured debentures?

A brief comparison of the requirements of issuance of secured and unsecured debentures is summarized below:

Sr. No. Basis of Comparison Section/ Rule Secured Debentures Unsecured Debentures
1. Creation of security Section 71(3) of the Companies Act, 2013 read with Rule 18 of Companies (Share Capital and Debentures) Rules, 2014 (‘Debenture Rules, 2014’) Secured by the creation of a charge on the properties or assets of the company or its subsidiaries or its holding company or its associates companies, having a value which is sufficient for the due repayment of the amount of debentures and interest thereon.

 

Charge or mortgage shall be created in favour of the debenture trustee on:

  • any specific movable property of the company or its holding company or subsidiaries or associate companies or otherwise;
  • or any specific immovable property wherever situate, or any interest therein;
  • in case of a NBFCs, the charge or mortgage may be created on any movable property
 No security created.
2. Registration of charge Section 77 of the Companies Act, 2013 Issuer shall register the charge within 30 days of its creation/ modification or such additional period as may be prescribed. Not Applicable
3. Redemption Period Rule 18(1)(a) of Debentures Rules, 2014 To be redeem within 10 years from the date of issue

Companies engaged in setting up infrastructure projects, infrastructure finance companies, infrastructure debt fund NBFCs and companies permitted by the CG, RBI or any other statutory authority may issue for a period exceeding 10 years but not exceeding 30 years.

 No redemption time frame prescribed for unsecured debentures.
4. Voting Rights Section 71(2) the Companies Act, 2013 Does not carry voting rights Does not carry voting rights
5. Creation of Debenture Redemption Reserve (DRR) Section 71(4) read with Rule 18(7) of Debentures Rules, 2014 DRR/DRF requirement does not depend whether debentures are secured or unsecured, rather it depends on the type of company and the mode of issue i.e. public issue or private placement. Subject to same provisions

 
6. Appointment of Debenture Trustee Section 71(5) read with Rule 18(1)(c), (2) of Debenture Rules, 2014 Required in case the offer or invitation is made to the public or if the total number of members exceeds 500 for the subscription of debentures [Section 71(5)].

ILDS requires appointment of DT in case of every listed debentures.

 Subject to same provisions
7. Duties of Debenture Trustee Section 71(6) read with Rule 18(3) & (4) of the Debenture Rules, 2014, SEBI (ILDS) Regulations, 2008 and SEBI (DT) Regulations, 1993 In accordance with provisions of Section 71(6) read with Rule 18(3) & (4) of the Debenture Rules, 2014

Other obligations as prescribed under SEBI (ILDS) Regulations, 2008 and SEBI (DT) Regulations, 1993

 Subject to same provisions
8. Failure to redeem or pay interest on debentures Section 71(10), 164(2) of the Companies Act, 2013
  • In case of failure by the company to redeem the debentures on the date of their maturity or pay interest on the debentures when it is due, an application may be made by any or all of the debenture-holders, or debenture trustee to the Tribunal. The Tribunal can direct the company to redeem the debentures forthwith on payment of principal and interest due thereon.
  • If a company fails to pay interest on debentures, or redeem the same, and the failure continues for one year or more, all the directors of such delinquent company become disqualified.
 Subject to same provisions
9. Listing of Debentures SEBI (ILDS) Regulations, 2008, SEBI (LODR) Regulations, 2015 Issuer to comply with the provisions of SEBI (ILDS) Regulations, 2008. Post listing, the issuer, in addition to SEBI (ILDS) Regulations, 2008, shall also comply with provisions of SEBI (LODR) Regulations, 2015 and SEBI (Prohibition of Insider Trading) Regulations, 2015. Subject to same provisions

Neither the Companies Act, 2013 nor the Debenture Rules, 2014 elaborate the manner of issue of unsecured debentures. However, the provisions for issue of unsecured debentures are almost the same as that for secured debentures except certain conditions such as redemption period, requirement of creation of charge on the assets of the issuer and filing charge with the Registrar of Companies.

Investors perspective may also prove the same stand –the unsecured debentures don’t carry securities against any assets of the company unlike in case of secured debenture, however the debenture-holder(s) or the Debenture Trustee may approach the Tribunal which may then direct the company to honour its debt obligations.

Concluding Remarks

From the issuer’s perspective, the debentures have to be secured so as to escape from the Deposit Rules. This is one of the main reasons why companies issue secured debentures.  While the issuer may be able to avoid the rigorous compliances of Deposits Rules, issuing secured debentures have apparently become very stringent.

From investor’s viewpoint, it may seem that the investment in secured debentures is safe as company has created charge on its assets sufficient to discharge the principle and interest amount. Yet some major defaults in past have made the investors more hesitant to invest in the secured debentures.

While at this stage it was important for SEBI to make the norms more stringent to safeguard the interest of the debenture holders, however, it will be challenging for the issuers to comply with such norms, failing which they may be inclined towards issuance of unsecured debt issuances.

Although unsecured debentures do not provide any security against investment, issuer may still rewards investors with higher yields which is a pay-off for increased risk taken by the investor.

Given the new compliance burden and their stringencies for issuance and listing of secured debentures, it will be interesting to see how the ratio of secured and unsecured borrowings changes in the coming years. For the sake of it, the upcoming trends, preferences and acceptability of stringencies by the corporates will be very vital for observation.

Other reading materials on the similar topic:

  1. ‘This New Year brings more complexity to bond issuance as SEBI makes it cumbersome’ can be viewed here
  2. ‘SEBI responds to payment defaults by empowering Debenture Trustees’ can be read here
  3. Our other articles on various topics can be read at: http://vinodkothari.com/

Email id for further queries: corplaw@vinodkothari.com

Our website: www.vinodkothari.com

Our Youtube Channel: https://www.youtube.com/channel/UCgzB-ZviIMcuA_1uv6jATbg

Our presentation on structures of debt securities can be viewed here – https://vinodkothari.com/2021/09/structuring-of-debt-instruments/

[1] https://www.sebi.gov.in/legal/circulars/nov-2020/creation-of-security-in-issuance-of-listed-debt-securities-and-due-diligence-by-debenture-trustee-s-_48074.html

[2] SEBI (Issue and Listing of Debt Securities) Regulations, 2008

[3] SEBI (Debenture Trustees) Regulations, 1993

[4] https://www.sebi.gov.in/legal/circulars/nov-2020/monitoring-and-disclosures-by-debenture-trustee-s-_48159.html

[5] https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/2ICBMIMM141CFFF458BB4B3A9F4C006F4AE4897F.PDF

[6] https://www.sebi.gov.in/statistics/corporate-bonds/privateplacementdata.html

[7] https://www.sebi.gov.in/reports-and-statistics/reports/feb-2020/consultation-paper-on-review-of-the-regulatory-framework-for-corporate-bonds-and-debenture-trustees_46079.html

[8] http://egazette.nic.in/WriteReadData/2020/222323.pdf

[9] http://egazette.nic.in/WriteReadData/2020/222324.pdf

[10] SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015

[11] https://www.sebi.gov.in/legal/circulars/oct-2020/contribution-by-issuers-of-listed-or-proposed-to-be-listed-debt-securities-towards-creation-of-recovery-expense-fund-_47939.html

[12] https://www.sebi.gov.in/legal/circulars/oct-2020/standardization-of-timeline-for-listing-of-securities-issued-on-a-private-placement-basis_47790.html

[13] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=10563&Mode=0#C2

Market Linked Debentures – Adding Flavour to Plain Vanilla Bonds

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Sale of Legal Entity as an Asset: A step towards value maximization

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–Megha Mittal 

(resolution@vinodkothari.com)

Maximization of value of assets of the corporate debtor is one of the primary objectives of the Insolvency and Bankruptcy Code, 2016 (“Code”/ “IBC”); and it is towards this objective that the Code requires a mandatory corporate insolvency resolution process to ensue prior to liquidation. The rationale behind such specified order is that under corporate insolvency resolution process, the corporate debtor is taken over as a going concern, which as per settled economic argument attracts a much better value via-a-vis disposal of assets. It is in view of such rationale that the liquidation laws also provide sufficient flexibility to keep the corporate debtor a going-concern even after commencement of liquidation[1].

Having said so, while the Liquidation Regulations allow sale of the corporate debtor as a going-concern, one cannot overlook the fact that the likelihood of the going-concern sale is already rusted by the time the corporate debtor reaches the liquidation stage.

 It is a common economic understanding that sum of parts is better than sum of the parts; and it is by virtue of such principle that going-concern values are generally in excess of value of individual assets. The various assets, stitched together as one, constitute a much greater value than the same assets in isolation.

In this backdrop, what may be considered as a rather unexplored territory is the prospect of sale of the legal entity only, sans the other assets that the corporate debtor may have. In this note, we analyse and put forth a case for saleability of legal entity itself, without other conventional assets, under the Code.

Read more →

Corporate Restructuring- Corporate Law, Accounting and Tax Perspective

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–Resolution Division 

(resolution@vinodkothari.com)

Restructuring is the process of redesigning one or more aspects of a company, and is considered as a key driver of corporate existence. Depending upon the ultimate objective, a company may choose to restructure by several modes, viz. mergers, de-mergers, buy-backs and/ or other forms of internal reorganisation, or a combination of two or more such methods.

However, while drafting a restructuring plan, it is important to take into consideration several aspects viz. requirements under the Companies Act, SEBI Regulations, Competition Act, Stamp duty implications, Accounting methods (AS/ Ind-AS), and last but not the least, taxation provisions.

In this presentation, we bring to you a compilation of the various modes of restructuring and the applicable corporate law provisions, accounting standards and taxation provisions.

http://vinodkothari.com/wp-content/uploads/2020/11/Corprorate-Restructuring-Corporate-Law-Accounting-Taxation-Perspective.pdf

New Model of Co-Lending in financial sector

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Scope expanded, risk participation contractual, borders with direct assignment drawn 

-Team Financial Services (finserv@vinodkothari.com)

[This version dated 20th March, 2021]

Co-lending is coming together of entities in the financial sector – mostly, something that happens between banks and NBFCs, or larger banks and smaller banks. Financial interfaces between different financial entities may take the form of securitisation, direct assignment, co-lending, banking correspondents, loan referencing, etc.

While direct assignment and securitisation have been around for quite some time, co-lending was permitted by the RBI under its existing guidelines on ‘Co-origination of loans between banks and NBFC-SIs for granting loan to the priority sector’[1]. As per the Statement on Developmental and Regulatory Policies issued by the RBI dated October 9, 2020, it was decided to expand the scope of co-lending, currently permitted only for NBFC-SIs, to all NBFCs. Accordingly, the RBI came, vide notification on co-lending by banks and NBFCs (Co-Lending Model/CLM)[2] dated November 5, 2020, with a new regulatory framework for co-lending, of course, in case of priority sector loans. The CLM supersedes the existing guidelines on co-origination.

There is no clarity, still, on whether the non-priority sector loans (PSL  or Non-PSL) will also be covered by this regulatory discipline, or any discipline for that matter. In this write-up, we explore the key features of the co-lending regime, and also get into tricky questions such as applicability to non-PSL loans, the borderlines of distinction between direct assignments and co-lending, the sharing of risks and rewards, etc.

Applicability

The erstwhile Regulations for priority sector lending covered co-lending transactions of Banks and Systemically Important NBFCs. However, under the Co-Lending Model.The CLM covers all NBFCs (including HFCs) in its purview.

There is a whole breed of new-age fintech companies using innovative algo-based originations, and aggressively using the internet for originations, and these companies pass a substantial part of their lending to either larger NBFCs or to banks. Thus, the expanded ambit of the Co-Lending Model will increase the penetration and result into wider outreach, meet the objective of financial inclusion, and potentially, reduce the cost for the ultimate beneficiary of the loans. Smaller NBFCs have their own operational efficiencies and distribution capabilities; hence, this is a welcome move.

Further, the RBI has excluded foreign Banks, including wholly owned subsidiaries of foreign banks, having less than 20 branches, from the applicability of the CLM. Also, Small Finance Banks, Regional Rural Banks, Urban Cooperative Banks and Local Area Banks have been excluded from the applicability of CLM.

An interesting question that comes up here is whether such exclusion should be construed as a restriction on such entities from entering into co-lending transactions, or a relaxation from the applicability of the Co-Lending Model? It may be noted that the CLM a precondition for PSL treatment of the loans. This is clear from the title ‘Co-Lending by Banks and NBFCs to Priority Sector’. The intent is not to put a bar on existence of co-lending arrangements outside the CLM. That is to say, if the loan, originated by the principal co-lender, is a priority sector loan, then the participating co-lender will also be able to treat the participant’s share of the loan as a PSL, subject to adherence to the conditions specified in CLM. The implication of this is that where the loan does not meet the conditions of CLM, then the participating bank will not be able to accord a PSL status, even though the loan in question is a PSL loan.

With that rationale, in our view, there is no absolute prohibition in the excluded banking entities from being a co-lender. However, if the major motivation of the co-lending mechanism under the CLM is the PSL tag, that tag will not be available to the excluded banks, and hence, the very inspiration for falling under the arrangement may go away. This is also clear from the PSL Master Directions[3] which recognises co-origination of loans by SCBs and NBFCs for lending to the priority sector and specifically excludes RRBs, UCBs, SFBs and LABs.

Applicability date and the fate of existing transactions

In the absence of any specified timelines, the CLM supersedes the existing co-lending guidelines with immediate effect. However, it specifies that outstanding loans in terms of the erstwhile guidelines would continue to be classified under priority sector till their repayment or maturity, whichever is earlier.

This would mean grandfathering of existing loans, and not existing lending arrangements. That is to say, if there are existing co-lending arrangements, but the loan in question has not yet originated, even existing co-lending arrangements will have to abide with the Co-Lending Model. Needless to say, any new co-lending arrangements will nevertheless have to abide by the Co-Lending Model.

As we note below, one of the very important features of the Co-Lending Model is that risk-sharing and loan-sharing do not have to follow the same proportion. Additionally, it is possible for the participating bank to have an explicit recourse against the originating co-lender. This feature was not available under the earlier framework. This alone may be a sufficient motivation for existing CLMs to be revised or redrawn.

Co-lending, Outsourcing and Direct Assignment – new borderlines of distinction

For the purpose of entering into co-lending transactions, banks and NBFCs will have to enter into a ‘Master Agreement’. Such agreement may require the bank either to mandatorily take the loans originated by the NBFC on its books or retain discretion as to taking the loans on its books.

Where the participating bank has a discretion as to taking its share of the loans originated by the originating partner, the transaction partakes the character of a direct assignment. Para 1(c) of the CLM says that ”…if the bank can exercise its discretion regarding taking into its books the loans originated by NBFC as per the Agreement, the arrangement will be akin to a direct assignment transaction. Accordingly, the taking over bank shall ensure compliance with all the requirements in terms of Guidelines on Transactions Involving Transfer of Assets through Direct Assignment of Cash Flows and the Underlying Securities….with the exception of Minimum Holding Period (MHP) which shall not be applicable in such transactions undertaken in terms of this CLM.

That would mean, a precondition for the arrangement being treated as a CLM is that the participating bank takes the loans originated by the originating partner without discretion exercisable on a cherry-picking basis.

Does this mean that irrespective of whether the loan originated by the originating partner fits into the credit screen of the bank or not, the bank will still have to take it, lying low? certainly, this is not the intent of the CLM This is what comes form clause 1(a)- ‘…..the partner bank and NBFC shall have to put in place suitable mechanisms for ex-ante due diligence by the bank as the credit sanction process cannot be outsourced under the extant guidelines.’

Thus, even in case the bank gives a prior, irrevocable commitment to take its share of exposure, the same shall be subject to an ex-ante due diligence by the bank. Ex-ante obviously implies a prior  As per the outsourcing guidelines for banks[4], the credit sanction process cannot be outsourced. Accordingly, it must be ensured that the credit sanction process has not been outsourced completely and the bank retains the right to carry out the due diligence as per its internal policy. Notwithstanding the bank’s due diligence exercise, the co-lending NBFC shall also simultaneously carry out its own credit sanction process.

The conclusion one gets from the above is as follows:

  • The essence of co-lending arrangement is that the participating bank relies upon the lead role played by the originating bank. The originating bank is the one playing the fronting role, with customer interface. The credit screens, of course, are pre-agreed and it will naturally be incumbent upon the originating bank to abide by those. Hence, on a case by case basis or so-called “cherry picking” basis, the participating bank is not selecting or dis-selecting loans. If that is what is being done, the transaction amounts to a DA.
  • Subject to the above, the participating bank is expected to have its credit appraisal process still on. Where it finds deviations from the same, the participating bank may still decline to take its share.

It is important to note that if DA comes into play, the requirements such as MHP, MRR, true sale conditions will also have to be complied with. However, co-lending transactions do not have any MHP requirements, unlike in case of either DA or securitiastion. Of course co-lending transactions do have a risk retention stipulation, as the CLM require a 20% minimum share with the originating NBFC. Hence, the intent of the RBI is that co lending mechanism must not turn out to be a regulatory arbitrage to carry out what is virtually a DA, through the CLM.

(Almost) A new model of direct assignments: assignments without holding period

Para 1 c. of the Annex seems to be leading to a completely new model of direct assignments – direct assignments without a holding period, or so-called on-tap direct assignments. Reading para 1 c. suggests that while co-lending takes the form of a loan sharing at the very inception, the reference in para 1 c. is to loans which have already  been originated by the NBFC, and the participating bank now cherry-picks some or more of those loans. The cherry-picking is evident in “if the bank can exercise its discretion regarding taking into its books the loans originated by NBFC”. However, unlike any other direct assignment, this assignment happens on what may be called a back-to-back arrangement, that is, without allowing for lapse of time to see the loan in hindsight.

In essence, there emerge 3 possibilities:

  • A non-discretionary loan sharing, which is the usual co-lending model, where the originating co-lender has a minimum 20% share.
  • A discretionary, on-tap assignment, where the originating assignor needs to have a minimum 20% share
  • A proper direct assignment, with minimum holding period, where the assignor needs to have a minimum 10% share.

The on-tap assignment referred to above seems to be subject to all the norms applicable to a direct assignment, other than the minimum holding period.

Interest Rates

The erstwhile guidelines require that the interest rate charged on the loans originated under the co-lending guidelines would be calculated as per Blended Interest Rate Calculations, that is to say the rate shall be calculated by assigning weights in proportion to risk exposure undertaken by each party, to the benchmark interest rate of the respective lender.

The current guidelines require that the interest rate shall be an all inclusive rate that is mutually agreed by the parties. However it shall be ensured that the interest rate charged is not excessive as the same would breach the provisions of fair practice code, which is to be compulsorily complied.

This change would provide flexibility to the lenders and also ensure that the cost incurred in tracing and disbursals to remote sectors as well as enhanced risk exposure is appropriately compensated.

Determining the roles

Under the erstwhile provisions, it was mandatory that the share of the co-lending NBFC shall be at least 20%. The same has been retained in the CLM as well, requiring NBFCs to retain a minimum of 20% share of the individual loans on their books.

Under the CLM, the co-lending NBFC shall be the single point of interface for the customers. Further, the grievance redressal function would also have to be carried out by the NBFC.

Operational Aspects

Escrow Account

For the purpose of disbursals, collections etc. an escrow account should be opened. The co-lending banks and NBFCs shall maintain each individual borrower’s account for their respective exposures. It is only for the purpose of avoiding commingling of funds, that an escrow mechanism is required to be placed. The bank and NBFC shall, while entering into the Master Agreement, lay down the rights and duties relating to the escrow account, manner of appropriation etc.

Creation of Security

The manner of creation of charge on the security provided for the loan shall be decided in the Master Agreement itself.

Accounting

Each of the lenders shall record their respective exposures in their books. The asset classification and provisioning shall also be done for the respective part of the exposure. For this purpose, the monitoring of the accounts may either be done by both the co-lenders or may be outsourced to any one of them, as agreed in the Master Agreement. Usually, the function of monitoring remains with the NBFC (since, it has done the origination and deals with the customer.)

Non-PSL loans: whether the framework would apply in pari materia?

The guidelines on CLM have been issued for co-lending of loans that qualify for the purpose of priority sector lending. This does not bar lenders from entering into co-lending transactions outside the purview of these guidelines. The only difference it would make is such loans would not be eligible to be classified as loans to the priority sector (which is the primary motive for banks to enter into co-lending transactions).

This seems to form a view that the guidelines would not at all be applicable in case of non-priority sector loans. However, for a transaction to be a co-lending transaction, there has to be adequate risk sharing between the co-lenders. Hence, the guidelines on CLM shall be applicable in pari-materia.

[1] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11376&Mode=0

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11991&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11959&Mode=0

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=3148&Mode=0

 

Other related write-ups:

Co-lending arrangement between Banks and NBFCs for PSL

 

Summary of the cartload of amendments introduced towards DTs and corporate bonds

/0 Comments/in /by

SEBI implements measures proposed in the Consultation Paper on Corporate Bonds and Debenture Trustees

-Aanchal Kaur Nagpal, Executive & Burhanuddin Dohadwala, Manager

corplaw@vinodkothari.com

Introduction:

Owing to a wide array of defaults by various companies owning debt obligations SEBI, in order to secure the interest of the debenture holders, introduced various measures, particularly in respect of Debenture Trustees (‘DTs’), as they are the ultimate saviors of the debenture holders.

An effective mechanism in place for DTs would ultimately lead to better protection of the interests of the debenture holders increasing investor confidence.

SEBI had issued a consultation paper dated February 25, 2020 (‘Consultation Paper’)[1] to seek comments/ views on the measures that were expected to strengthen the regulatory framework for corporate bonds, secure the interest of the debenture holders, enhance the role of the DTs and empower them to effectively discharge their responsibilities towards the debenture holders of listed debt issues/ proposed to be listed debt issues.

The increased events of default by a few financial institutions and the lapses/ complications on the part of DTs in the expeditious enforcement of the security brought to the fore, the need for a review of the present regulatory framework for DT.

With the given challenges/hurdles observed in:

  • Charge creation;
  • Enforcement of security of the secured debentures;
  • Delay in enforcing the security in the event of default;
  • Inter Creditor Agreement (‘ICA’);
  • Creation of floating charges and
  • Other related issues in the recent cases of default,

SEBI intended to review the regulatory framework for DTs and put in place various provisions that would further secure the interests of the debenture holders of listed debt issues, enable the DTs to perform their duties in the interest of the investors more effectively and promptly in case of default.

Implementation of the proposed changes in the Consultation Paper:

SEBI implemented the amendments/changes as discussed in the consultation paper by way of the following:

  1. SEBI (Debenture Trustees) (Amendment) Regulations, 2020[2] dated 8th October, 2020 (‘DT Amendment Regulations’);
  2. SEBI (Issue and Listing of Debt Securities) (Amendment) Regulations, 2020[3] dated 8th October, 2020 (‘ILDS Amendment Regulations’);
  3. SEBI (LODR) (Third Amendment) Regulations, 2020[4] dated 8th October, 2020 (‘LODR Regulations’);
  4. Standardisation of procedure to be followed by Debenture Trustee(s) in case of ‘Default’ by Issuers of listed debt securities dated 13th October, 2020[5]; (‘SOP for DTs’)
  5. Contribution by Issuers of listed or proposed to be listed debt securities towards creation of Recovery Expense Fund dated 22nd October, 2020[6] , effective from January 01, 2021; (‘Circular on recovery fund’)
  6. Creation of Security in issuance of listed debt securities and ‘due diligence’ by debenture trustee; (Dated November 03, 2020[7]), effective for new issues proposed to be listed on or after January 01, 2021, (‘Circular on creation of security’).

Thus, all the above provisions are to be read together with the Consultation Paper.  We have tried to provide a holistic view of the proposals in the Consultation Paper as well the implementation of the same through the table below:

Sr. No. Point of consideration Recommendation by the Consultation Paper Implementation Status Our remarks/comments
Creation of Identified Charge
1) NBFCs create a floating charge on their entire receivables for all its lenders on a pari passu basis. Lack of identification of the charged assets leads to difficulty in enforcement of security. Also, possibility that the good assets are enforced by banks while debenture holders are left with sub-par assets. Creation of charge on identified assets viz. Identified receivables, investments, cash to be created by NBFCs instead of a floating charge on entire books. Debentures to be treated as secured only on creation of identified charge. Implemented.

1) Circular on creation of security

– Documents/Consent   required   at   the   time   of entering   into DTA;

– Due diligence by DT for creation of security;

– Disclosures  in  the offer document or private placement memorandum/ IM and filing of OD or PPM/IM by the Issuer;

-Creation and registration of charge of security by Issuer prior to listing.

 Due diligence:

–   No clarity as to who will bear DD expenses, in case issuer, then increased cost

–   Exemption to be provided for issuers having common DT for several issuances as DTs cannot obtain their own comments or objections as required under Para 6.1 (b) (ii) of the Circular.

–   Since issue opens and closes on the same day in case of private placement, issuers to start with the stated process much before opening of the offer.

Creation of charge-

Registration of charge within 30 days of creation, failure to be considered as breach of covenants/terms of issue. [unlike time limit of 120 days provided under Companies Act, 2013]

 To read our detailed analysis on the Circular, kindly refer to our article – ‘This New Year brings more complexity to bond issuance as SEBI makes it cumbersome’[1]
Due diligence of identified assets and Asset cover certificate
2a) ·       Pursuant to regulation 15(1)(t) of the DT Regulations, asset cover certificates are submitted to the DT on a quarterly basis by the independent auditor and on a yearly basis by a statutory auditor.

·       These aid in monitoring the adequacy of assets charged against the debt issued.

·       Format of these certificates varies for every DT and mostly indicate only a statement confirming that 100% asset cover us maintained rather than a detailed list of assets.

 ·    Asset cover certificates by the statutory auditor to be submitted on a half yearly basis.

·    Asset cover certificate to be made more granular to enhance monitoring of quality of assets by including the entire list of identified assets as security.

·    If quality of any asset deteriorates/ asset if pre-paid, then issuer to replace such assets and maintain asset cover as per DTD.

·    Certificate to also certify compliance with all covenants in the IM/ DTD.

 Implemented

1)   DT Amendment Regulations

As per amended Rule 15(1)(t) of DT Regulations, in case of listed debt securities secured by book debts/ receivables, the DT is required to obtain a certificate from the statutory auditor, giving the value of receivables/ book debts including compliance with covenants of the IM/ offer document in the manner as specified by the Board.

2)   DT Amendment Regulations

Listed entities are required to forward a half-yearly certificate regarding maintenance of 100% asset cover in respect of listed NCDs.

Not applicable to:

–        Bonds secured by a Government guarantee.

 ·    While it is imperative for DTs to follow a pro-active approach in monitoring of the asset cover, if the requirement to specify the entire list of identified assets (as required under the Consultation Paper) would have been implemented, the same would have made the certificate too bulky considering the amount of identified assets in the list.

·    Thus, SEBI has specified that the value of the assets would be mentioned.

 

·    Further, issuers may develop a shared database of receivables for the DT to monitor variations in the assets on a  real time basis which could also be subject to detailed/sample checking by the statutory auditor.
2b) Quality to be maintained as per following parameters:

·    Establishing a delinquency rate (‘DR’) benchmark (to be used as a factor for monitoring asset quality) by the DT at the time of signing of DTD.

·  If DR breaches threshold, issuer to replace such assets with standard assets.

·  Covenant for maintaining of quality of assets, conditions for replacing delinquent assets to be included in IM and DTD for transparency.

 Yet to be implemented. Guidance for determination of DR benchmark should be prescribed.
Calling of Event of Default (EoD)
3) ·  Determination of EoD is inconsistent among DTs.

·  Some call DTs at DTD level and some at ISIN level.

·  The above is owing to varied practices for issuing debentures- multiple ISINs are issued under one umbrella IM/DTD or single ISIN is split across multiple tranches with different IMs.

 ·  Event of default (‘EoD’) to include breach of any covenant mentioned in IM/ DTD.

·  EoD to be called at ISIN level. This is because if a single investor is invested in a debenture under an ISIN, he has full right to enforce security under that ISIN.

 Implemented by

1)    DT Amendment Regulations

Amended regulation 15(2)(b), event to include breach of covenants of offer document/IM and DTD.

2)    SOP for DTs

EoD shall be reckoned at ISIN level as all terms and conditions are same throughout a single ISIN. (para A.3)

 –
Inter-Creditor Agreement (ICA)
4a) Since, security interest of debenture holders is pari passu to other lenders, DTs are approached by banks to join the Inter-Creditor Agreement (‘ICA’) for resolution plan of a borrower. However, a DT would face multiple challenges in respect of interests of the debenture holders while joining an ICA. (same has been discussed below) DTs to join ICA subject to the approval of the debenture holders.

Also, the same is subject to various conditions along with an opportunity to the DTs to exit the ICA at various stages and in various circumstances as if it never signed the same. In such cases, the resolution plan would not be binding on the DTs. (same has been discussed below)

 Implemented

1)      DT Regulations

As per the inserted regulation 15(7), the DT may enter into ICAs on behalf of the debenture holders subject to the approval of the debenture holders and conditions as specified by SEBI.

Inclusion of manner of voting/conditions of joining ICAs in schedule I.

2)      SOP for DTs

All the conditions as stipulated in the Consultation Paper have been adopted in the SOP. (para C.7).

 Discussed below
4b) A debenture holder representative committee consisting of debenture holders having majority investment may be formed after default by the issuer in order to fast track the ICA process. 1)      SOP for DTs

DTs may form a representative committee of the investors to participate in the

ICA or to enforce the security or as may be decided in the meeting.

 Clarity should be given by SEBI as to composition of the committee-whether the same will consist of debenture holders having majority across series/ISIN or series-wise/ISIN-wise should be laid in the regulations.
Voting mechanism
5a) Procedural delay viz. a long notice period of 21 days to receive consent for future course of action, would further delay enforcement of security by the DT, especially in case of joining an ICA where the review period under RBI norms is 1 month for signing the ICA. ·  Notice period for receiving consent of debenture holders to be reduced to 15 days from 21 days.

·  Negative consent for enforcement of security and positive consent for joining ICA to be taken simultaneously in the same letter.

·  Proof of dispatch and delivery to be maintained by the DT.

 1)      ILDS Amendment Regulations

The amended regulation 18(2) specifies 15 days’ notice period.

2)      SOP for DTs

Process for seeking consent will be as follows:

– DTs to send 3 days’ notice to the debenture holders from the EoD.

– Positive and negative consent to be taken together as specified in the Consultation Paper

– Consent to be given 15 days.

– Meeting to be convened of all holders within 30 days from EoD.(shall not be applicable in case of public issue)

– Necessary action to be taken by DT based on consent received.

– Consent of majority of investors shall mean ‘75% of investors by value of outstanding debt and 60% of investors by number at ISIN level’.

 Since the implications of entering/exiting ICA or going for enforcement actions might be huge; as such, an ordinary resolution might not suffice and a stricture approval should be specified.

Keeping that mind, SEBI has adopted an even stricture approach from a special resolution, by specifying dual condition in value and number.

SEBI has adopted the requisite consent for debenture holders from RBI norms on ICA.
5b) Contact details received from RTAs are not updated leading to difficulty in communication with the debenture holders.

Email-ids also not available as providing the same is not mandatory for debenture holders leading to hindrance in conducting e-voting.

 Email-ids to be provided mandatorily for debenture holders in case of private placement. Yet to be implemented. —
Creation of a recovery fund
6) In case of a default, DTs are required to fulfill their obligations to act in the interest of the debenture holders as well as enforcement of security even if they are able to recover their fees from the issuer.

The expenses towards the above the same are currently borne by the debenture holders in most cases.

Due to lags in receiving the money on time, there is a delay in the enforcement of the security.

 ·  A recovery fund to be created towards at the time of issue of debentures that will be used by DTs for recovery

·  Proceeding expenses.

 

·  Value of fund= 0.01% of issue subject to maximum of 25 lakhs per issuer.

 

·  The same will not be applicable on ‘AAA rated’ bonds. However, in case of downgrading of rating, issuer will be obligated to create such fund.

·  Amount to be returned to the issuer at the time of maturity in case of no default.

 Implemented

1)      ILDS Amendment Regulation

The inserted regulation 26(7) of ILDS Regulations specifies that a recovery expense fund will be created in the manner specified by SEBI and also inform the DT about the same.

Amendment in schedule I to insert details of creation of recovery expense fund and the details and purpose thereof.

2)      DT Amendment Regulations

Duties of DTs to include ensuring the implementation of the conditions relating recovery expense fund under regulation 15(1)(h).

3)      Circular on Recovery fund

Details relating to creation, operation, maintenance and refund of the recovery fund has been specified.

 The statutory auditor should certify, besides the asset cover, that the recovery fund is being adequately maintained, and well demarcated from other general funds of the company.

 

 
Disclosures on the website by DTs
7) While the DT Regulations mandate various duties on DTs, investors are generally not aware of the monitoring by the DTs as well as the compliance status of issuers regarding covenants of the IM. DTs to be mandatorily required to provide minimum disclosures on their website viz. Quarterly compliance report, defaults by the issuer, compliance status of asset cover, maintenance of various funds by the issuer, status of proceedings of cases under default etc.

This would enhance transparency and hold the DTs responsible.

 Yet to be implemented The intention behind such disclosures is to promote transparency in the performance of DTs. Keeping the same in mind, SEBI should instruct issuers to provide the link of such website in the IM as well as annual report of the issuer, in addition to the disclosure of details of the DT  [as required under regulation 53(e) of LODR regulations] for the information of the investors.
Disclosures regarding Performance of DTs
8) There exists no performance indicators to enable investors to ascertain the performance of a DT. Disclosure to be made by DTs w.r.t. the following parameters to reflect their performance:

– timeliness of action taken

Monitoring of covenants

Effectiveness in enforcing securities or taking remedial actions in case of default, etc.

 Yet to be implemented ·       DTs should also report at prescribed intervals that they have monitored the asset cover in the prescribed duration, and have obtained auditor’s certificate, and in their independent assessment, there is no deterioration in the asset cover, both in terms of value and quality. In case, they have observed any deterioration, the same should be disclosed, and reported along with steps taken to rectify the same.
Public Disclosure of all covenants by the issuer in IM
9) ·       There are instances where issuers enter into separate agreements with debenture holders containing additional/ specific covenants that do not form part of the principal IM.

·       These agreements, known as ‘side letters’ contain an accelerated payment clause” which states that if the borrower violates the terms of the covenants, including default or

·       downgrade of debt, such lender is entitled to

·       demand immediate repayment.

·       Such clauses hamper the interests of the issuer as well as other lenders.

 ·     All covenants including the ‘accelerated payment clause’

·     Shall be incorporated in the IM.

·     Issuer to inform DT of such covenants for monitoring the same.

·     Also, para 3.11 states that the IM should disclose that it has no side letter with any debenture holder except as disclosed in the

·     IM and on the stock exchange website where the debt is listed.

 Implemented by the ILDS Amendment Regulations amended schedule I of the ILDS Regulations to include details of all covenants of the issue (including side letters, accelerated payment clause, etc. Instead of allowing side letter to be a part of the IM, the concept of side letter should be discouraged totally. All covenants should be there in the IM only.

The issuer should also be made to undertake in the IM that it has not signed any side letter and that all covenants as included in the IM are the only covenants agreed to by the issuer.
Standardization of Debenture Trust Deed (DTD)
10) A DTD consists of standard covenants as specified under DT Regulations and as per form SH-12 under Companies Act, 2013 as well as customized clauses specific to an issuer.

DTDs are lengthy and thus should be standardized to make them comprehensible and easy to read and understand.

 DTD to be bifurcated into two parts:

– Part A: generic and standard clauses common to all DTs.

– Part B: specific and customized clauses relevant to the particular issue for which the DTD is executed.

(same as per offer document of mutual funds)

 Implemented

1)      ILDS Amendment Regulations

Regulation 15(2) has been amended to provide that the trust deed shall consist of 2 parts:

a) Part A containing statutory/standard information pertaining

to the debt issue

b) Part B containing details specific to the particular debt issue

2)      DT Amendment Regulations

Regulation 14 amended to include that trust deed shall consist of 2 parts:

(same as ILDS Amendment Regulations)

 SEBI should provide clarity as to what clauses would fall under part B.
Enhanced Disclosures
11) Details about the terms of the debentures, duties of DTs and redressal mechanisms in case of default, are not known to the investors.

The investors thus are not fully aware of the risks undertaken while investing.

 

 In order to enhance transparency, the issuer is required to provide additional disclosures in the IM such as:

– A risk factor to state that while the debenture is secured against a charge to the tune of 100% of the principal and interest amount in favour of DT, the possibility of recovery of 100% of the amount will depend on the market scenario at the time of enforcement of security.

– That the issuer has no side letter

– Pari passu charge of the investors, etc.

 Partly Implemented

1) ILDS Amendment Regulations

Schedule I of the ILDS Regulations has been amended to include a note as to the risk factor.

 SEBI to also make necessary amendments in order enable inclusion of other disclosures as well.
Framework and Standard Operating Procedure(SOP) for imposing fines
12) There have been a lot of instances of non-co-operation of the issuers as well as violations of the LODR Regulations by the issuer. Actions and adjudication proceedings initiated in this regard by the DT, usually take up a lot of time and the, non-compliance may continue during such proceedings as well. An SOP to be prepared that would list out penalties for specific violations by the issuer.

This would enable better compliance and co-operation on the part of the issuer.

 Yet to be implemented –

Points for consideration:

There are certain issues in the Consultation Paper that if not thought through would pose various complications in their implementation.

1) Creation of charge on identified assets

The Consultation Paper aims to discourage floating charge on the entire balance sheet and requires that debentures are to be secured by way of a charge on identified assets which would include identified receivables, investment and cash. Further, the debentures would be considered secured only if the charge is created on identified assets of the NBFC.

The rationale for the above is that, unlike other Companies where there are fixed charges created, NBFCs usually create a floating charge in favour of lenders. The problem arises when all such lenders are secured by way of pari passu charge on the entire receivables of the NBFC. The same leads to lack of identified/ specific security interest for each lender leading to difficulty in the enforcement of the same. Further, there is a change that the higher quality assets are handed over to banks and other major lenders, leaving only the sub-par assets in favour of the debenture holders.

Our comments:

Receivables are floating assets and are dynamic in nature. The intention of SEBI is to mandate NBFCs to create a pool of assets as identified asset towards secured debentures. Thus, creating a demarcated pool of receivables as security interest in debentures would not be possible as the pool would still keep fluctuating due to various transactions such as repayment, prepayments and default.

Thus, even if there is an identified pool created, the same would still be a floating charge due to various fluctuations.

In our view, the approach adopted by the Consultation Paper is akin to covered bonds where there is a pool of assets (identified assets) monitored by a pool monitor (DT). Hence it is suggested that SEBI gives recognition to covered bonds.

Amendment under IBC:

Currently, IBC does not make any express distinction on the basis of floating or fixed charge, and both such charges are treated as secured debentures in the waterfall under IBC. However, flaoting charges are subservient to fixed charges. Thus, an amendment would be required under IBC regarding the same.

The above recommendation is still required to be implemented

2) Joining the ICA by the DTs on behalf of the debenture holders

Firstly, the ICA applies to institutional investors alone. Hence debenture holders that would fall under the above category would only be allowed to be a part of such ICA.

Secondly, the rights of debenture holders also depend on the nature of the charge- when the same is exclusive or pari passu. It is only when the rights are par passu that the debenture holders will be required to be a part of the ICA.

The recommendations under the Consultation paper have been implemented by the SOP for DTs wholly.

The provisions relating to the same allow a way-out to the DTs in various circumstances and exit the ICA altogether, for instance, if the resolution plan is not in accordance with SEBI regulations, if terms of ICA are contravened by any party, if the resolution plan is not finalized within 180 days from the review period (with an extension upto 365 days). Under these circumstances, if the DT exits the CIA it will treated as if it never entered the ICA and the same will not be binding.

Now the above leads to various problems:

  • If the DT will be treated as exiting the ICA altogether, would that mean that DT could now take independent action? Since the language used is ‘ it will be treated as if the DT never entered the ICA’. [Lenders as party to the ICA, along with dissenting lenders, are prohibited from initiating any other legal action/ proceeding against the borrower, including proceedings under IBC]
  • If the DT initiates insolvency proceedings under IBC, how will the lenders be a part of the committee of creditors since they are barred from taking any other action?
  • How would the DT enforce security that is equally in favour of the other lenders as well?
  • In case of joint financing of a secured asset, consent of a minimum of 60% (in value) of creditors is required under SARFAESI to initiate enforcement action. Therefore, the debenture holders may not be having a practical solution by exiting the ICA.
  • Lastly, resolution of an entity is a collective process, and the process might require collective compromises as well. If creditors are provided exceptions, it is difficult to find success of either of the proceedings. Individual actions against the company can erode the asset base to the prejudice of the Company.

3) Certification of covenants under the asset cover certificate

As per regulation 56(1)(d) of the amended SEBI LODR Regulations,

The listed entity shall forward the following to the debenture trustee promptly

(d) a half-yearly certificate regarding maintenance of hundred percent asset cover or asset cover as per the terms of offer document/Information Memorandum and/or Debenture Trust Deed, including compliance with all the covenants, in respect of listed non-convertible debt securities, by the statutory auditor, along with the half-yearly financial results:

Thus the question arises as to what does ‘including compliance with all the covenants’ mean and what kind of covenants are required to be certified.

As per the rationale provided under the Consultation Paper and Discussion (Agenda) in the SEBI Board Meeting dated 29th September, 2020

  1. Consultation paper:

(i) Requirement for the asset cover certificate falls under the head ‘Due diligence and monitoring of asset cover by DT’ in the consultation paper;

(ii) As per para 3.2.2 of the consultation paper,

Point c- Issuer shall disclose the covenants of maintaining the quality of assets, conditions of replacing the bad/ delinquent assets in IM and DTD to create transparency and reduce the information gap regarding the covenants of the charge creation and the process thereafter.

Point d-The asset cover shall also certify the compliance with all the covenants mentioned in the IM or DTD, as applicable.

Thus, both the above points should be read in conjunction.

  1. SEBI Board Meeting dated 29th September, 2020

(i) Also reference should be made to paras 9.2.2, 9.2.3, 9.2.6, 9.2.7, 9.2.8 of the Agenda of the Board Meeting.

(ii) As per para 9.2.6, However, certain types of undertakings in support of creation of charge such as personal guarantee, negative lien are not registered with any independent agencies and hence there exists the issue of verification of such undertakings. Therefore, disclosures with respect of these undertaking need to be made in the offer document/ Information Memorandum.

Amended regulation 56(1)(d)- a half-yearly certificate regarding maintenance of hundred percent asset cover or as per the terms of offer document/ Information Memorandum including compliance with all the covenants, in respect of listed non-convertible debt securities, by the statutory auditor, along with the half-yearly financial results.

Our view:

Thus, on a holistic reading, it is observed that SEBI intends to monitor the quality of the charged asset. For the same, SEBI has instructed issuers to include undertakings i.e. covenants, in support of creation of charge such as personal guarantee, negative lien in the offer document/ IM/ DTD and compliance with such covenants needs to be ensured. Thus, ‘including compliance with all covenants’ under the amended regulation 56(1)(d) should be read in reference to maintenance of asset cover.

Therefore, statutory auditors will be required to only certify those covenants that revolve around the asset cover of debt securities.

Conclusion

SEBI has focused in strengthening the role of DT in case of default by issuers of listed debt securities. Thus, the measures as stated above are truly in the right direction and would help in easing the strained enforcement of rights of debenture holders. While most of the measures are a welcome moves, there are some moves that may be too ambitious and would definitely require thorough consideration.

Our write-up/video can be accessed below:

1. SEBI responds to payment defaults by empowering Debenture Trustees:

http://vinodkothari.com/2020/10/sebi-responds-to-payment-defaults-by-empowering-debenture-trustees/

2. This New Year brings more complexity to bond issuance as SEBI makes it cumbersome

http://vinodkothari.com/2020/11/sebis-new-year-gift-to-dts-and-issuers-makes-issue-of-secured-debentures-cumbersome/

3. Youtube Channel:

https://www.youtube.com/channel/UCgzB-ZviIMcuA_1uv6jATbg

4. Other write-ups:

http://vinodkothari.com/category/corporate-laws/

[1] http://vinodkothari.com/2020/11/sebis-new-year-gift-to-dts-and-issuers-makes-issue-of-secured-debentures-cumbersome/

[1] https://www.sebi.gov.in/reports-and-statistics/reports/feb-2020/consultation-paper-on-review-of-the-regulatory-framework-for-corporate-bonds-and-debenture-trustees_46079.html

[2] http://egazette.nic.in/WriteReadData/2020/222323.pdf

[3] http://egazette.nic.in/WriteReadData/2020/222324.pdf

[4] http://egazette.nic.in/WriteReadData/2020/222322.pdf

[5] https://www.sebi.gov.in/legal/circulars/oct-2020/standardisation-of-procedure-to-be-followed-by-debenture-trustee-s-in-case-of-default-by-issuers-of-listed-debt-securities_47855.html

[6] https://www.sebi.gov.in/legal/circulars/oct-2020/contribution-by-issuers-of-listed-or-proposed-to-be-listed-debt-securities-towards-creation-of-recovery-expense-fund-_47939.html

[7] https://www.sebi.gov.in/legal/circulars/nov-2020/creation-of-security-in-issuance-of-listed-debt-securities-and-due-diligence-by-debenture-trustee-s-_48074.html

FAQs on restructuring of securitised loans

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– Kanakprabha Jethani, Ass. Manager

(finserv@vinodkothari.com)

Background

The first half of this financial year came with lots of schemes to “apparently” support the financial sector during this time of crisis starting from moratoriums, restructuring, interest subvention and so much more. All these schemes were then adorned with an extension of their time limits, so much that at one point the borrower would altogether tend to forget he has an outstanding liability with some lender.

While the credit risk is an issue lenders cannot ignore, they also cannot ignore the fact that a huge chunk of their borrowers are not going to or will not be able to pay. Considering this, they are bound to allow moratoriums and offer restructuring benefits to them.

A lending transaction is between the lender and the borrower. Providing benefits such as moratorium, restructuring etc. is a matter of agreement between the two. However, in certain cases where there is an involvement of external parties, such as in the case of securitisation or direct assignment of a loan pool, practical dfficulties may arise.

The following FAQs intend to answer the basic questions regarding providing the restructuring benefit to borrowers of loans that have been securitised/assigned by the originator.

Stage1: While contemplating the decision to provide benefit of the schemes

1.     Can the originator provide such benefit?

The originator retains/invests in a very small portion of the portfolio. The rest of it is sold off to the assignee/SPV. The moment an originator sells off the assets, all its rights over the assets stand 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 the case of the direct assignment transactions, the originators retain only 10% of the cash flows. The question here is, will the originator, with a 10% share, be able to grant moratorium? The answer again is No. With just 10% share in the cash flows, the originator cannot suo-moto grant moratorium, hence, approval of the assignee has to be obtained.

2.     Is approval of investors required?

As discussed above, when an asset is securitised/assigned, the investor becomes the ultimate owner of the asset to the extent of his/her investment in the said asset. Hence, any change in the terms of the loan impacts the rights/liabilities of such investors. Hence, the investors, being the actual owners of the asset, must agree to offer the benefit of any restructuring, moratorium etc.

As for schemes which provide an additional/separate credit facility to the existing borrower such as ECLGS scheme[1], such facilities are treated as separate facilities and are not linked with the existing loans (the one which is securitised). Hence, in such cases, the approval of the investor or trustee shall not be required. However, it is recommended that a NOC is obtained from the investor or trustee to the effect that the originator is providing the additional funding based on the existing lending exposure on the borrower.

3.     How will the approval be obtained ?

The investors may decide on the manner of providing approval. The originator, in the capacity of the investor (to the extent of retention in the transaction), may propose and initiate the process and obtain approval of other investors.

4.     Is it mandatory for the investor to approve?

The investors, like in any other investment, has the right to consider their benefits and losses and accordingly decide on whether to approve. Further, investors may also give conditional approvals, say a change in payout structure, alteration of interest rate etc., considering the increased risk and the fact that investor is, for the time being, foregoing its returns.

5.     What happens if investors do not agree?

In case the investors do not agree, no benefit of restructuring/moratorium can be provided to the borrower. But, considering the liquidity crunch in the economy, it is very likely that the borrower will fail to pay the loan instalments, thereby resulting in reduced cashflows from the borrower. However, in case the investors did not agree to grant restructuring benefits and amend the payout structure, they will have to be paid. This would call for the credit support to be utilised. Over time, when credit enhancement is utilised, the rating of the PTCs may be downgraded.

6.     What happens if investors agree?

In case the investors agree for providing the benefit to the borrower, the same shall come be put into effect by a revision in payout structure for the investors. The payout structure will be revised as per the terms of restructuring or moratorium as the case may be.

7.     What happens with the remaining investors if the majority  agrees?

The assignment agreement usually provides the nature of approval required to amend the payment terms- either majority or else 100% of the investor, either in number or in value (usually 100%). Hence, in case the majority has agreed, the rest of the investors shall have to bear the outcome of moratorium/restructuring.

Implementation stage:

8.     What will be the immediate impact on investors agreeing to provide the benefit?

When the investors agree for providing any such benefits, they simultaneously agree for an added arrangement concerning the payout structure. Hence, the immediate impact shall be on the cashflows arising out of the underlying assets.

9.     What will be the impact on the agreed payout structure?

The payouts may be reduced or deferred or structured in any other way as per the restructuring terms.

10. Can the investors in a securitisation transaction agree for moratorium/restructuring but not for reschedulement or recomputation of payout structure?

In case the investors agree for moratorium/restructuring, such approval would inherently come with reschedulement or recomputation of the payout structure. This is because, if moratorium/restructuring benefit is provided, the cashflows on the underlying asset would be impacted. This, in turn, would affect the cashflows in the securitisation transaction. Hence, when agreeing to provide the benefit to the borrower, investors must bear in mind that there would be a simultaneous change in their payout structure as well.

11. Can the credit enhancements be used to make payments to the investors in case they have agreed to provide the benefit?

Credit enhancements are utilised usually when there is a shortfall due to credit weakness of the underlying borrower(s). In case the investor have agreed for the restructuring, consequently the payout structure must have also been revised and hence, avoiding any default leading to utilisation of the credit enhancement. Irrespective of granting the restructuring benefit,  if there is still default, though credit enhancements can be utilised, however, it will reduce the extent of support, weaken the structure of the transaction and may lead to rating downgrade.

12. What will be the impact on the rating of the transaction?

Usually, any delays in payout, defaults etc. lead to a downgrade in the rating of the transaction. However, here it is important to consider that in a securitisation or a direct assignment, the transaction mirrors the quality of the underlying pool. Now, in case of moratorium, there will be a standstill on asset classification and in case of restructuring, the asset classification will be upgraded to standard. Hence, there is no impact on the credit quality of the underlying asset.

If the credit quality of the loans remain intact, then there is no question of the securitisation or the direct assignment transaction going bad. Therefore, we do not see any reason for rating downgrade as well.

Further, the SEBI had on March 30, 2020, issued a circular[2] directing rating agencies to not consider delays/defaults caused due to COVID disruption, as a default event for the purpose of rating.

After implementation:

13. What will be the impact in the books of the investor?

In case of securitisation, the income will be booked by the investor as per the revised payout structure. In case of direct assignment, the assignee shall take the impact of restructuring in its books. Say, in case there is a reduction in interest rate, the asset must be booked at such revised interest rate in the books.

14. What will be the impact on asset classification and provisioning for such loans?

In case of moratorium, the asset classification will be on a standstill for the period for which moratorium is granted. After the moratorium period is over, the asset classification as per IRAC norms shall be applied. Further, as per the RBI guidelines for moratorium[3], additional provisions shall be required to be maintained.

In case of restructuring, the asset classification shall be on the revised loan, as per the IRAC norms.

15. Who will be required to maintain additional provisions?

Usually, investors maintain provisions corresponding to the PTCs held by them. The asset classficiation and provisioning is done on the basis of payout from such PTCs. Similarly, any additional provision that is required to be maintained, shall be maintained by the investor corresponding to the value of PTCs held.

Further, in the case of DA,both the assignee and assignor shall maintain the provisions, in their respective share of interest in the loan.

16. Suppose, after restructuring, the borrowers still fails to pay as per the restructured terms, what will be the impact on the rating?

In case the borrower fails to repay as per the restructured terms, it is a case of default beyond the moratorium/restructuring allowed by the RBI. This would result in a downgrade in the quality of the underlying asset. Hence, it is quite probable that the rating of the transaction may downgrade.

17. In case there is a rating downgrade, can the size of classes/tranches be changed?

The prime motivation for tranching a securitisation transaction is to obtain high rating for atleast a part of the transaction. Hence, the upper class, say class A, gets the maximum amount of credit support and is sized in a manner that it is able to get superior rating.

Now, when there is a threat of rating downgrade, the size of classes/tranches cannot be changed to maintain the rating. It is crucial to consider that the rating is allotted based on the structure of the transaction and not the other way round.

Hence, if at all, the originator intends to maintain the rating to the transaction, it may introduce further credit support to the transaction, but the size of classes should not be changed.

_____________________________________________________________________________________________________________________________________

[1] Refer our write-up on http://vinodkothari.com/2020/05/guaranteed-emergency-line-of-credit-understanding-and-faqs/

[2] https://www.sebi.gov.in/legal/circulars/mar-2020/-relaxation-from-compliance-with-certain-provisions-of-the-circulars-issued-under-sebi-credit-rating-agencies-regulations-1999-due-to-the-covid-19-pandemic-and-moratorium-permitted-by-rbi-_46449.html

[3] Refer: https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11872&Mode=0

Samagrata-October,2020

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Schemes of Arrangement under the Scanner

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Listed Companies made subject to stricter scrutiny and multilevel approvals

-Megha Mittal

(mittal@vinodkothari.com)

With the objective of empowering the stock exchanges and streamlining the processing of draft schemes filed with the stock exchanges, the Securities and Exchange Board of India has issues a Circular dated 3rd November, 2011[1] (“Amendment Circular”) thereby amending the Circular dated March 10, 2017[2] (“March, 2017 Circular”) which lays down the framework for Schemes of Arrangement by listed entities and relaxation under Rule 19(7) of the Securities Contracts (Regulation) Rules, 1957.

The Amendment Circular shall be effective for scheme submitted to the Stock Exchange after 17th November, 2020 and for those companies which are either listed, seeking to be listed or awaiting trading approval after 3rd November, 2020.

Schemes of Arrangement is unarguably a material event for the listed company, and as such, optimum transparency, disclosure by the company, coupled with stringent checks by the Committees, viz Audit Committee and Committee of Independent Directors, becomes a very crucial factor for decision making by the shareholders.

The Amendment Circular primarily aims at ensuring that the recognized stock exchanges refer draft  schemes  to  SEBI  only  upon  being fully convinced that the listed entity is in compliance with SEBI Act, Rules, Regulations and circulars issued thereunder. While the amendments introduced, bring to light the tenet of the regulatory bodies to ensure higher levels of transparency and disclosures with respect to the proposed schemes, there also seems to be an underlying tone of stress and responsibility that has been imposed on the Audit Committee and Independent Directors to assess the viability of the proposed Schemes.

In this article, the author has given a detailed comparison of the provisions, before and after the Amendment Circular, along with comments on the same.

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