RBI has released a Draft Disclosure framework on Climate-related Financial Risks, 2024 (“Disclosure Framework”) on 28th February, 2024 proposing to make disclosure of climate-related financial risks mandatory for RBI-regulated entities. The proposed disclosures are based on the four thematic areas or pillars – (i) Governance, (ii) Strategy, (iii) Risk Management and (iv) Metrics and Targets – as recommended by the Task Force on Climate-related Financial Disclosures (“TCFD Recommendations”).
https://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.png00Payal Agarwalhttps://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.pngPayal Agarwal2024-02-29 19:06:232024-02-29 19:06:23Disclosure of climate related financial risks for financial sector entities
This quote by Beethoven remains relevant today, not only within the music industry but also in the realm of finance. In the continually evolving landscape of finance, innovative strategies emerge to monetize various assets. One such groundbreaking concept gaining traction in recent years is music royalty securitization. This financial mechanism offers investors a unique opportunity to access the lucrative world of music royalties while providing artists and rights holders with upfront capital.
The roots of this innovative financing technique can be traced back to the 1990s when musician David Bowie made history by becoming the first artist to securitize his future earnings through what became known as ‘Bowie Bonds’. This move not only garnered attention but also paved the way for other artists to follow suit. Bowie Bonds marked a significant shift in how music royalties are bought, sold, and traded.
As per the S&P Global Ratings[1], the issuance of securities backed by music royalties totaled nearly $3 billion over the two-year span 2021-22. The graph below shows a recent surge in issuance of securities backed by music royalties.
Data showing the growth of Music Royalty Securitization
This article discusses music royalty securitization, its mechanics, benefits, challenges along with implications for the music industry.
Understanding Music Royalties:
Before exploring music royalty securitization, it’s essential to understand the concept of music royalties. In the music industry, artists and rights holders earn royalties whenever their music is played, streamed, downloaded, or licensed for use. These royalties are generated through various channels, including digital platforms, radio, TV broadcasts, live performances, and synchronization licenses for commercials, movies, and TV shows. However, it’s important to note that artists only earn royalties when their music is utilized, whether through sales, streaming, broadcasting, or live performances.
As a result, the cash flows from these royalties being uncertain are received over time and continue to be received for an extended period. Consequently, artists experience a delay in receiving substantial amounts from these royalties, sometimes waiting for several years before seeing significant income.
The Birth of Music Royalty Securitization:
Securitization involves pooling and repackaging financial assets into securities, which are then sold to investors. The idea is to transform illiquid assets, such as mortgage loans or in our case, music royalties, into tradable securities. Music royalty securitization follows a similar principle, where the future income generated from music royalties is bundled together and sold to investors in the form of bonds or other financial instruments.
Future Flows Securitization:
Music royalty securitization is a constituent of future flows securitization and therefore before discussing the constituent, it is important to discuss the broader concept of future flows securitization.
Future flows securitization involves the securitization of future cash flows derived from specific revenue-generating assets or income streams. These assets can encompass a wide range of future revenue sources, including export receivables, toll revenues, franchise fees, and other contractual payments, even future sales. By bundling these future cash flows into tradable securities, issuers can raise capital upfront, effectively monetizing their future income. Future flows securitization differs from the traditional asset backed securitization by their very nature as while the latter relates to assets that exist, the former relates to assets that are expected to exist. There is a source, a business or infrastructure which already exists and which will have to be worked upon to generate the income. Thus, in future flows securitization the income has not been originated at the time of securitization. The same can be summed up as: In future flow securitization, the asset being transferred by the originator is not an existing claim against existing obligors, but a future claim against future obligors.
Mechanics of Music Royalty Securitization:
Music royalty securitization involves packaging the future income streams generated by music royalties into tradable financial instruments. The process begins with the identification of income-generating assets, which are then bundled into a special purpose vehicle (SPV). The SPV issues securities backed by these assets, which are sold to investors. The revenue generated from the underlying music royalties serves as collateral for the securities, providing investors with a stream of income over a specified period.
The process of music royalty securitization typically involves several key steps:
Asset Identification: Rights holders, such as artists, record labels, or music publishers, identify their future royalty streams eligible for securitization.
Valuation: A valuation is conducted to estimate the present value of the anticipated royalty income streams. Factors such as historical performance, market trends, and artist popularity are taken into account.
Selling the future flows: The future flows from royalties are then sold off to the Special Purpose Vehicle (SPV) to make them bankruptcy remote. The sale entitles the trust to all the revenues that are generated by the assets throughout the term of the transaction, thus protecting against credit risk and sovereign risk as discussed later in this article.
Structuring the Securities: These future cash flows are then structured into securities. This may involve creating different tranches with varying levels of risk and return.
Issuance: The securities are then issued and sold to investors through public offerings or private placements. The proceeds from the sale provide upfront capital to the rights holders.
Revenue Collection and Distribution: The entity responsible for managing the securitized royalties collects the revenue from various sources which is then distributed to the investors according to the terms of the securities.
Importance of Over-collateralization:
Over-collateralization is an important element in music royalty securitization. In music royalty securitization and in all future flows transactions in general, the extent of over-collateralization as compared to asset backed transactions is much higher. The same is to protect the investors against performance risk, that is the risk of not generating sufficient royalty incomes. Over-collateralization becomes even more important since subordination structures generally do not work for future flow securitizations. This is because the rating here will generally be capped at the entity rating of the originator.
Why go for securitization ?
Now the question may arise as to why an artist or a right holder of a royalty has to go for securitization of his music royalties in order to secure funding. Why cant he simply opt for a traditional source of funding ? The answer to this question is two folds:
Firstly, the originator in the present case generally has no collateral to leverage and hardly there will be a lender willing to advance a loan based on assets that are yet to exist.
Secondly even if they are able to obtain funding it will be at a very high cost due to high risk the lender perceives with the lending.
Music royalty securitization, could be his chance to borrow at a lower cost. The cost of borrowing is related to the risks associated with the transaction, that is, the risk the lender takes on the borrower. Now, this risk includes performance risk, that is the risk that the work of the originator does not generate enough cash flows. While this risk holds good in case of securitization as well, it however takes away two major risks – credit risk and sovereign risk.
Credit risk, as divested from the performance risk would basically mean that the originator has sufficient cash flows but does not pay it to the lender. This risk can be removed in case of a securitization by giving the SPV a legal right over the cash flow.
Sovereign risk on the other hand emanates only in case of cross-border lending. This risk arises when an external lender gives a loan to a borrower whose sovereign later on in the event of an exchange crises either imposes a moratorium on payments to external lenders or may redirect foreign exchange earnings. This problem is again solved by giving the SPV a legal right over the cash flows from the royalties arising in countries other than the originator’s, therefore trapping cash flow before it comes under the control of the sovereign.
The lack of these two types of risks might reduce the cost of borrowing for the originator; thus making music royalty securitization a lucrative option.
Accounting Treatment:
As discussed, there is no existing asset in a music royalty transaction. In terms Ind AS 39, an entity may derecognize an asset only when either the contractual rights to the cash flows from the financial asset have expired or if it transfers the financial asset. However, here asset means an existing asset and a future right to receive does not qualify as an asset in terms of the definition under Ind AS 32.
Accordingly, the funding obtained through the securitization of music royalties should be shown as a liability in books as the same cannot qualify as an off-balance sheet funding.
Regulatory Framework in India:
It is crucial to discuss the applicable regulatory framework on securitization currently prevalent in India and whether music royalty securitization would fall under any of these:
Master Direction – Reserve Bank of India (Securitization of Standard Assets) Directions, 2021(‘SSA Master Directions)
SEBI (Issue and Listing of Securitised Debt Instruments and Security Receipts) Regulations, 2008 (SDI Framework)
Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002
While the SSA Master Directions primarily pertain to financial sector entities, and will not directly apply to this domain; however, there exists a possibility that the securitization of music royalties could fall under the purview of SEBI’s SDI Framework.
Music royalty securitization offers a range of benefits for both investors and rights holders:
Diversification: Investors gain exposure to a diversified portfolio of music royalties, potentially reducing risk compared to investing in individual songs or artists.
Steady Income Stream: Music royalties often provide a stable and predictable income stream, making them attractive to income-oriented investors, such as pension funds and insurance companies.
Liquidity: By securitizing music royalties, rights holders can access immediate capital without having to wait for future royalty payments, providing liquidity for new projects or business expansion.
Risk Mitigation: Securitization allows rights holders to transfer the risk of fluctuating royalty income to investors, providing a hedge against market uncertainties and industry disruptions.
Challenges and Considerations:
While music royalty securitization presents compelling opportunities, it also poses certain challenges and considerations:
Market Volatility: The music industry is subject to shifts in consumer preferences, technological disruptions, and regulatory changes, which can impact the value of music royalties.
Due Diligence: Thorough due diligence is essential to assess the quality and value of music assets, including considerations such as copyright ownership, market demand, and revenue potential.
Potential Risks:
Market Risk: Changes in consumer behavior, technological advancements, or regulatory developments could impact the value of music royalties.
Legal Risk: Disputes over ownership rights, copyright infringement, or licensing agreements could lead to litigation and financial losses.
Concentration Risk: Investing in a single music catalog or genre exposes investors to concentration risk if the popularity of that catalog or genre declines.
Cash Flow Variability: While music royalties can provide steady income, fluctuations in streaming revenues or changes in licensing agreements may affect cash flow stability.
Reputation Risk: The success of music royalty securitization depends on the ongoing popularity and commercial success of the underlying music assets. Negative publicity, controversies, or declining relevance can adversely affect investor confidence and returns.
Implications for the Music Industry:
While music royalty securitization presents exciting opportunities, it also raises certain considerations for the music industry:
Artist Empowerment: Securitization can empower artists by providing them with alternative financing options and greater control over their financial destiny.
Industry Evolution: The emergence of music royalty securitization could reshape the traditional music business model, fostering innovation and collaboration between artists, labels, and investors.
Way Forward
Music royalty securitization offers a compelling investment opportunity for investors seeking exposure to the lucrative music industry. By securitizing future royalty streams, music rights owners can unlock liquidity while providing investors with access to a diversified portfolio of music assets.
As the music industry continues to evolve, music royalty securitization is likely to play an increasingly prominent role in the financial landscape, providing new avenues for capital deployment and revenue generation. It has the potential to transform the rhythm of creativity into the melody of investment opportunity.
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In a recent Supreme Court ruling in the matter of Association for Democratic Reforms & Anr. v/s Union of India, Electoral Bond Scheme (EBS/ Scheme) was declared as unconstitutional, including certain amendments to section 182 of the Companies Act, 2013 (“CA”), amended vide the Finance Act, 2017 as arbitrary and violative of the Constitution of India (COI).
Naturally, a question arises: What is wrong? Contributions to political parties? No. It is only the opacity of the recipient which has been hit. Hence, if companies have contributed, they couldn’t have kept a shroud of secrecy over the same.
Two, if companies had to disclose, and the amendments on 2017 are now junked, does it mean companies have to go back and disclose? It doesn’t seem so. In fact, the apex court itself has taken care of the actionables and put the burden of disclosure on the Election Commission of India (ECI).
Corporate houses, apparently, the largest contributors to electoral bonds, have expressed concerns on what will be the implications of the ruling on donor companies. Several questions arise – What has been declared unconstitutional and what is still valid? What would be the fate of the political donations already made? What actionables arise on a company having made donations to political parties through electoral bonds or otherwise? In this write-up, the author has attempted to analyze the same in light of the 232-pager ruling.
Section 182 of CA – Pre and Post Finance Act 2017
In order to understand what has been rendered unconstitutional and why, let us analyse the provisions of section 182 of CA as it stood prior to the amendment pursuant to Finance Act 2017 v/s how it stands today.
Particulars
Position prior to Finance Act, 2017
Position post Finance Act, 2017
Whether unconstitutional as per SC ruling?
Limits on political contribution – Proviso to Sec 182(1)
Aggregate value of contribution to political parties cannot exceed 7.5% of 3-years’ average net profits
No maximum limit on political contributions
Yes. The SC concluded removal of limits to be “manifest arbitrariness” for removing a classification without recognising the harms thereof.
Disclosure in financial statements – Section 182(3)
Contributor company to disclose names of each parties against the total amount contributed to such parties
Only total amount contributed to be disclosed, without disclosing names
Yes. The SC concluded this to be an “essential” information for effective exercise of voting, and hence, non-disclosure as an infringement to the right of information of voter under Article 19(1)(a) of COI
Mode of contribution – Section 182(3A)
New insertion pursuant to Finance Act
Political contributions to be made only through banking channels (account paying cheque/ bank draft/ ECS) and through instruments issued under a scheme for political contributions (electoral bonds)
No impact. However, the Electoral Bond Scheme has been declared to be unconstitutional.
Consequences for donor companies
The SC ruling does not declare “political donations” per se as unconstitutional or invalid, what is rendered violative of constitutional rights is the Electoral Bond Scheme and the amendments to section 182 of CA vide Finance Act, 2017 permitting unlimited and anonymous contributions to political parties.
The legal implications of declaring a statute unconstitutional has been discussed in various rulings in the past, such as, reBehram Khurshid Pesikaka v. State of Bombay, and others. These say the consequences are dealt with by the court only. In the present matter of Electoral Bond Scheme, the SC has directed SBI and the Election Commission of India to disclose the details of contributions received through electoral bonds, and refund the non-encashed amounts to the donor.
In essence it does not seem apt that any burden will be cast upon companies for going by a law which was valid till it was scrapped. Hence, no adverse implications should follow for the donor companies. However, for the sake of its corporate duty, a company which has contributed in the past may now do a disclosure in the forthcoming annual report. Thus, The omission of disclosure of particulars of political donations made along with names of the parties, between FY 2017-18 to FY 2022-23, may be made good by companies in the financial statement for the FY 2023-24 giving details of contribution made along with names of the political parties for each of the previous financial years, along with the current FY 23-24.
Principle of “manifest arbitrariness”
Having reference to various rulings and judicial precedents, the SC has summarized that the doctrine of “manifest arbitrariness” can be imposed to strike down a provision. Such a proposition can be applied where:
the legislature fails to make a classification by recognizing the degrees of harm, and
the purpose is not in consonance with constitutional values.
In the context of permitting unlimited contribution to political parties, on the grounds of removing classification between donations by “individuals” v/s “companies”, or between “loss making companies” and “profit making companies”, the degree of potential harm has been ignored. Section 182 was enacted to curb corruption in electoral financing, however, the amendment allowed companies, incorporated for a specific purpose as per their MoA, to contribute unlimited amounts to political parties without any accountability and scrutiny. This may also facilitate incorporation of “shell companies” solely for the purpose of making such political contributions and permit undue influence of companies in the electoral process, thus violating the principle of free and fair elections and political equality.
The hon’ble SC has ruled the deletion of maximum limit as “violative” of COI and “manifestly arbitrary” for not recognising the degrees of harm in removing the classification between –
Political donations by “companies” and “individuals” where the ability to influence electoral process is much higher with the former, since “Contributions made by individuals have a degree of support or affiliation to a political association. However, contributions made by companies are purely business transactions, made with the intent of securing benefits in return.”
“Profit-making” and “loss-making companies” for the purposes of political contributions, since “it is more plausible that loss-making companies will contribute to political parties with a quid pro quo and not for the purpose of income tax benefits.”
The present SC ruling quashes the anonymous political donations and the amendments in CA permitting unlimited corporate donations to political parties. Political donations are not unconstitutional, however a company, making such donations, shall ensure the same does not result into emptying the resources of the company while also ensuring transparency in disclosure of such political donations in its financial statements for the right of information of the concerned shareholders as well as larger stakeholder and voter base.
Streamlining internal compliance monitoring function
The recent RBI directive on streamlining the internal compliance monitoring function by leveraging technology has raised concerns regarding actionable on the part of regulated entities covered thereunder. The notification on Streamlining of Internal Compliance monitoring function – leveraging use of technology dated January 31, 2024 is based on RBI’s review of of the prevailing system in place for internal monitoring of compliance with regulatory instructions and the extent of usage of technological solutions to support this function.
This workshop precedes the 12th edition of the Securitisation Summit, an annual coming together of stakeholders in structured finance industry in India to be held on 15th May, 2024. The details of this event can be viewed here.
https://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.png00Vinod Kothari Consultantshttps://vinodkothari.com/wp-content/uploads/2023/06/vinod-kothari-logo.pngVinod Kothari Consultants2024-02-16 13:11:222024-02-20 10:55:50Full Day Workshop on Securitisation,Transfer of Loans and Co-lending
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A crisp, clear and key information about loan terms. KFS typically includes details such as the all-in-cost of the loan, interest rates, fees, repayment terms, and any associated risks.
Because KFS is standardised, it enables borrowers to make comparison with terms offered by other lenders.
Plus, it is at-a-glance view, enabling the borrower to avoid the legalese.
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