Draft Credit Derivatives directions: Will they start a market stuck for 8 years?

Vinod Kothari (vinod@vinodkothari.com) and Abhirup Ghosh (abhirup@vinodkothari.com)

Credit derivatives, an instrument that emerged around 1993–94 and then took the market by storm with volumes nearly doubling every half year, to fall off the cliff  during the Global Financial Crisis (GFC), have been a widely used instrument for pricing of credit risk of entities, instruments, and countries. Having earned ignoble epithet as “weapons of mass destruction” from Warren Buffet, they were perceived by many to be such. However, the notional outstanding volume of CDS contracts reached a volume of upwards of USD 9 trillion in June, 2020, the latest data currently available from BIS website.

In India, CDS has been talked about almost every committee or policy recommendation that went into promoting bond markets, and yet, CDSs have been a non-starter ever since the CDS guidelines were first issued in 2013. A credit derivative allows a synthetic trade in a credit asset, and is not merely a hedging device. One of the primary limitations with the 2013 guidelines was that the RBI had taken a very conservative stand and would permit CDS trades only for hedging purposes. The 2021 draft Directions seek to open the market up, on the realisation that much of the activity in the CDS market is not a hedge against what is on the balance sheet, but a synthetic trade on the movement in credit spreads, with no underlying position on the reference bonds or loans.

What is a CDS?

Credit derivatives are derivative contracts that seek to transfer defined credit risks in a credit product or bunch of credit products to the counterparty in the derivative contract. The counterparty to the derivative contract could either be a market participant, or could be the capital market through the process of securitization. The credit product might either be exposure inherent in a credit asset such as a loan, or might be generic credit risk such as bankruptcy risk of an entity. As the risks, and rewards commensurate with the risks, are transferred to the counterparty, the counterparty assumes the position of a virtual or synthetic holder of the credit asset.

The counterparty to a credit derivative product that acquires exposure (called the Protection Seller), from the one who passes on such exposure (called the Protection Buyer), is actually going long on the generalised credit risk of the reference entity, that is, the entity whose debt is being synthetically traded between the Protection Seller and Protection Buyer. The compensation (CDS premium) which the Protection Buyer pays and the Protection Seller receives, is based on the underlying probability of default, occurring during the tenure of the contract, and the expected compensation (settlement amount) that the Protection Seller may be called to pay if the underlying default (credit event) occurs. Thus, this derivative product allows the protection buyer to receive . Thus, the credit derivative trade allows the parties to express on view on (a) whether a credit event is likely to occur with reference to the reference entity during the tenure; and if yes, (b) what will be the depth of the insolvency, on which the compensation amount will depend. As a result, the contract allows people to trade in the credit risk of the entity, without having to trade in a credit asset such as a loan or a bond.

Credit default swaps (CDSs) are the major credit derivative product, which itself falls within the bunch of over-the-counter (OTC) derivatives, the others being interest rate derivatives, exchange rate derivatives, equity derivatives, commodity derivatives, etc.  There are, of course, other credit derivative products such as indices trades, basket trades, etc.

Structure of a plain vanilla CDS contract has been illustrated in the following figure:

Fame and shame

Credit derivatives’ claim to fame before the GFC, and shame thereafter, was not merely CDS trading. It was, in fact, synthetic CDOs and their more exotic variations. A synthetic CDO will bunch together several CDS contracts, create layers, and then trade those layers, mostly leaving the manager of the CDO with a fee income and an equity profit. While it could take years to ramp up a book of actual bonds or loans, a synthetic CDS book could be ramped in a matter of hours. In the benign market conditions before the GFC, there were not too many defaults, and therefore, synthetic CDOs and structured finance CDOs would be happily created and sold to investors, with happiness all over. However, since every synthetic CDO would, by definition, be a highly leveraged structure (the lowest tranche bearing the risk of the entire edifice), and multiple sequential layers of such leverage were built by structured finance CDOs, the entire edifice came crumbling during the GFC, as modeling assumptions based on good times of the past were no more true.

RBI hesitatingly allows CDS

The RBI developed cold feet looking at the mess in the global CDS market, and rightly so, and therefore, the RBI has never been bullish on unbridled CDS activity. Hence, the 2013 Guidelines were very guarded and limited permission – only for hedging purposes. Hedging was not something that the Indian bond market needed, as India mostly had highly rated bonds, and the bondholder earning fine spreads will not pay out of these spreads to shell out the risk of a highly rated, mostly held-to-maturity bond investment. Hence, the CDS market never took off.

Nearly every committee that talked about bond markets in India talked about the need to promote CDS. In August 2019[1], the FM announced several reforms that could boost economic growth. One of the proposals was that the MOF, in consultation with the RBI and SEBI will work on the regime for CDS so that it can play an important role in deepening the bond markets in India.

Latest move of the RBI

The Reserve Bank of India (“RBI”) in the Statement of Developmental and Regulatory Policies dated 4th December, 2020[2], expressed its desire to revise the regulatory framework for Credit Default Swaps as a measure to deepen the corporate bonds market, especially the ones issued by the lower rated issuers.

Subsequently, on 16th February, 2021[3], the RBI issued draft Reserve Bank of India (Credit Derivatives) Directions, 2021 (“Draft Directions” or “Proposed Directions”) to replace the Guidelines on Credit Default Swaps (CDS) for Corporate Bonds which was last revised on 7th January, 2013[4] (“2013 Guidelines”).

This write-up attempts to provide a detailed commentary on the Draft Directions, with references to the 2013 Guidelines as and where required, however, before that let us take a note of the key highlights of the proposed revised directions.

Highlights of the Draft Directions

  1. Participants in a CDS transaction:

The major participants in the proposed transactions:

    1. Market-makers: they are financial institutions
    2. Non-retail users: they can be protection buyers as well as protection sellers, and purpose of their engagement could be for hedging their risk or otherwise. An exhaustive list of the institutions has been laid down who can be classified as non-retail users
    3. Retail users: they can be protection buyers as well as protection sellers, however, the purpose of their engaged should be for hedging their risk only. A user who fails to qualify as non-retail user, by default becomes a retail user. Additionally, the Proposed Directions also allow non-retail users to reclassify themselves as retails users.

Persons resident in India are allowed to participate freely, however, persons resident outside India are allowed to participate as per the directions issued by the RBI, which are yet to be issued.

2. Only single-name CDS contracts are permitted:

The Proposed Directions allow single-name CDS contracts only, that is, the CDS contracts should have only one reference entity. Therefore, other forms of the CDS contracts like bucket or portfolio CDS contracts are not allowed.

3. Presence of a reference obligation:

Credit derivatives could either have a reference entity or a reference obligation. The Proposed Directions however envisages the presence of a reference obligation in a CDS contract. This is coming out clearly from the definition of the CDS states that the contract should provide that the protection seller should commit to compensate the other protection buyer for the loss in the value of an underlying debt instrument resulting from a credit event with respect to a reference entity, for a premium.

4. Eligible reference obligations:

The reference obligations include money market instruments like CPs, CDs, and NCDs with maturity upto 1-year, rated rupee denominated (listed and unlisted) corporate bonds, and unrated corporate bonds issued by infrastructure companies. In this regard, it is pertinent to note that the

5. Structured finance transactions:

Neither can credit derivatives be embedded in structured finance transactions like, synthetic securitisations, nor can structured finance instruments like, ABS, MBS, credit enhanced bonds, convertible bonds etc., be reference obligations for CDS contracts.

Commentary on some of the Key Provisions of the Draft Directions

Applicability

The Proposed Directions will apply on all forms of the credit derivatives transactions irrespective of whether they are undertaken in the OTC markets and or on recognised stock exchanges in India.

Definitions

5. Cash settlement:

Relevant extracts:

(i) Cash settlement of CDS means a settlement process in which the protection seller pays to the protection buyer, an amount equivalent to the loss in value of the reference obligation.

Our comments:

The Proposed Directions allow cash settlement of the CDS, where the protection seller pays only the actual loss in the reference obligation to the protection buyer. There are usually two ways of computing the settlement amount in case of cash settlement – first, based on the actual value of the loss arising from the reference obligation, and second, based on a fixed default rate which is agreed between the parties to the contract at its very inception.

To understand the second situation, let us take an example of a contract where the protection seller agrees to compensate the losses of the protection buyer arising from a reference obligation. Say, the seller agrees to compensate the buyer assuming a 10% default in the buyer’s exposure in a debt instrument on happening of a credit event. In this case, if the credit event happens, the seller will compensate the buyer assuming a 10% default rate, irrespective of the whether losses are more or less than 10%.

However, in the first case, settlement amount would work out based on the assessment of actual losses arising due to happening of the credit event.

Apparently, the definition of cash settlement seems to include only the first case, as it refers to an amount equivalent to the loss in value of the reference obligation.

6. Credit default swaps

Relevant extracts:

(iii) Credit Default Swap (CDS) means a credit derivative contract in which one counterparty (protection seller) commits to compensate the other counterparty (protection buyer) for the loss in the value of an underlying debt instrument resulting from a credit event with respect to a reference entity and in return, the protection buyer makes periodic payments (premium) to the protection seller until the maturity of the contract or the credit event, whichever is earlier.

Our comments:

CDS contracts can be drawn with reference to a particular entity or to a particular obligation of an entity. In the former case, the reference is on all the obligations of the reference entity, whereas in the latter case, the reference is on a particular debt obligation of the reference entity – which could be a loan or a bond.

However, the definition of CDS in the Proposed Directions states the contract should be structured in a manner where the protection seller commits to compensate the protection buyer for the loss in the value of an underlying debt instrument. Therefore, the exposure has to be taken on a particular debt obligation, and it cannot be generally on the reference entity.

 7. Credit event:

Relevant extracts:

(iv) Credit event means a pre-defined event related to a negative change/ deterioration in the credit worthiness of the reference entity underlying a credit derivative contract, which triggers a settlement under the contract.

Our comments:

In the simplest form of a credit derivative contract, credit event is a contingent event on happening of which the protection buyer could incur a credit loss, and for which it seeks protection from the protection seller. The definition used in the Proposed Directions is a very generalised one. As per ISDA, the three most credit events include –

  1. Filing for bankruptcy of the issuer of the debt instrument;
  2. Default in payment by the issuer;
  3. Restructuring of the terms of the debt instrument with an objective to extend a credit relief to the issuer, who is otherwise under a financial distress.

8.Deliverable obligation

Relevant extracts:

(v) Deliverable obligation means a debt instrument issued by the reference entity that the protection buyer can deliver to the protection seller in a physically settled CDS contract, in case of occurrence of a credit event. The deliverable obligation may or may not be the same as the reference obligation.

Our comments:

Refer discussion on physical settlement below.

In case of physical settlements, the question arises, what is the asset that protection buyers may deliver? As discussed under physical settlement, protection buyers may exactly hold the reference asset. A default on this asset would also imply a default on other parallel obligations of the obligor: therefore, market practices allow parallel assets to be delivered to protection sellers. Essentially, a protection buyer may select out of a range of obligations of the reference entity, and logically, will select the one that is the cheapest to deliver. To ensure that the asset delivered is not completely junk, certain filters are covered in the documents, and the deliverable asset must conform to those filters. In particular, these limitations are quite relevant when the reference entity has not really defaulted on its obligations, but only undergone a restructuring credit event.

9. Physical settlement

Relevant extracts:

(xv) Physical settlement of CDS means a settlement process in which the protection buyer transfers any of the eligible deliverable obligations to the protection seller against the receipt of notional/face value of the deliverable obligation.

Our comments:

We discussed earlier that one of the ways of settling a CDS contract is the cash settlement. The other way of settling a CDS contract is the physical settlement. In case of physical settlement, protection buyers physically deliver; that is, transfer an asset of the reference entity and get paid the par value of the delivered asset, limited, of course, to the notional value of the transaction. The concept of deliverable obligation in a credit derivative is critical, as the derivative is not necessarily connected with a particular loan or bond. Being a transaction linked with generic default risk, protection buyers may deliver any of the defaulted obligations of the reference entity.

In case of physical settlement, there is a transfer of the deliverable reference obligation to protection sellers upon events of default, and thereafter, the recovery of the defaulted asset is done by protection sellers, with the hope that they might be able to cover some of their losses if the recovered amount exceeds the market value as might have been estimated in the case of a cash settlement. This expectation is quite logical since the quotes in case of cash settlement are made by potential buyers of defaulted assets, who also hope to make a profit in buying the defaulted asset. Physical settlement is more common where the counterparty is a bank or financial intermediary who can hold and take the defaulted asset through the bankruptcy process, or resolve the defaulted asset.

10. Reference entity:

Relevant extracts:

(xvi) Reference entity means a legal entity, against whose credit risk, a credit derivative contract is entered into.

Our comments:

As may be noted later on in the writeup, reference entity in the context of the Proposed Directions refers to a legal entity resident in India.

11. Reference obligation

Relevant extracts:

(xvii) Reference obligation means a debt instrument issued by the reference entity and specified in a CDS contract for the purpose of valuation of the contract and for determining the cash settlement value or the deliverable obligation in case of occurrence of a credit event.

Our comments:

Reference obligation is the underlying debt instrument, based on which the contract is drawn. In practice, this obligation could be loan, or a bond of the obligor. However, the Proposed Directions refer to certain money market instruments and corporate bonds. Discussed later.

12. Single-name CDS

Relevant extracts:

(xix) Single-name CDS means a CDS contract in which the underlying is a single reference entity.

Our comments:

Usually, CDS could be created with reference to either a single obligation, or obligations from a single reference entity, or a portfolio of obligations arising from different reference entities. The Proposed Directions completely rules out portfolio derivatives, and allows CDS contracts with reference to a single entity only.

Eligible participants

Relevant extracts:

  1. Eligible participants

The following persons shall be eligible to participate in credit derivatives market:

(i) A person resident in India;

(ii) A non-resident, to the extent specified in these Directions.

Our comments:

Any person resident in India is eligible to participate in the credit derivatives market. Even retail investors have been allowed to be a part of this, however, restrictions have been imposed on specific classes of users concerning the purpose of their participation.

Non-resident users, like FPIs, have also been allowed to participate on a restricted basis, however, specifics of their limitations will come by way of specific directions which will be issued by the RBI in due course.

Permitted products

  1. Permitted products in OTC market

(i) Market-makers and users may undertake transactions in single-name CDS contracts.

(ii) Market-makers and users shall not deal in any structured financial product with a credit derivative as one of the components or as an underlying.

As already discussed earlier, only single-name CDS contracts are allowed, bucket or portfolio CDS contracts are not permitted. One of the reasons for this could be that RBI might like to test the market before allowing the users to write contracts on exposures on multiple obligors.

Clause (ii) prohibits the use of credit derivatives in the structure finance products. Synthetic securitisation is one of the products that use embeds a credit default swap in the securitisation transaction. Presently, the Securitisation Guidelines[5] has put a bar on synthetic securitisation, in fact, the draft Guidelines on Securitisation, issued by the RBI in 2019[6], also retained the bar on synthetic securitisation.

Vinod Kothari, in his article Securitisation – Should  India be moving to the next stage of development?[7], stated:

It is notable that a synthetic securitisation uses CDS to shift a tranched risk of a pool of assets into the capital markets by embedding the same into securities, without giving any funding to the originator. Synthetic structures are intended mainly at capital relief, both economic capital as well as regulatory capital.

Synthetic securitisation may come in handy for Indian banks to gain capital relief. Synthetic securitisation structures are seen by many to have made a comeback after the GFC. In fact, the European Banking Authority has launched a consultation process for laying down a STS framework for synthetic securitisations as well[8]. A Discussion Paper of EBA says: “The 2008 financial crisis marked a crash of the securitisation market, after which, also due to stigma attached to the synthetic segment, the securitisation market has gradually emerged in particular in the traditional (and retained) form. With respect to synthetic securitisation following a few years of subdued issuance, the synthetic market has been recovering in the recent years, with both the number and volume of transactions steadily increasing. Based on the data collection conducted by IACPM, altogether 244 balance sheet synthetic securitisations have been issued since 2008 up until end 2018. In 2018, 49 transactions have been initiated with a total volume of 105 billion EUR.”[9]

In the USA as well, credit risk transfer structure has been used by Freddie Mac and Fannie Mae vide instruments labelled as Structured Agency Credit Risk (STACR) and Connecticut Avenue Securities™ (CAS) bonds. Reportedly, the total volume of risk transferred using these instruments, for traditional single family dwelling units, has crossed USD 2.77 trillion by end of 2018[10].

There may be merit in introducing balance sheet synthetic securitisations by banks and NBFCs. To begin with, high quality portfolios of home loans, consumer loans or other diversified retail pools may be the reference pools for these transactions. Gradually, as the market matures, further asset classes such as corporate loans may be tried.

Synthetic securitisations were frowned upon by financial regulators across the globe after the GFC, however, as may have been noticed in the extracts quoted above, several developed jurisdictions now allow synthetic securitisation, with the required level of precautions added to the regulatory framework dealing with it.

Reference entities and obligations for CDS

Relevant extracts:

  1. Reference Entities and Obligations for CDS

(i) The reference entity in a CDS contract shall be a resident legal entity who is eligible to issue any of the debt instruments mentioned under paragraph 5(ii).

(ii) The following debt instruments shall be eligible to be a reference / deliverable obligation in a CDS contract:

  1. Commercial Papers, Certificates of Deposit and Non-Convertible Debentures of original maturity upto one year;
  2. Rated INR corporate bonds (listed and unlisted); and
  3. Unrated INR bonds issued by the Special Purpose Vehicles set up by infrastructure companies.

(iii) The reference/deliverable obligations shall be in dematerialised form only.

(iv) Asset-backed securities/mortgage-backed securities and structured obligations such as credit enhanced/guaranteed bonds, convertible bonds, bonds with call/put options etc. shall not be permitted as reference and deliverable obligations.

Our comments:

As per Clause 5(i), only resident legal entities can be reference entities for the purpose of CDS contracts, however, the Proposed Directions are silent on the meaning of the term resident legal entity. One could argue that entities which are registered in India should be treated as resident legal entities, however, a clarification in this regard shall remove the ambiguities.

Clause (ii) allows the use of the following instruments as a reference obligations:

  1. Money market instruments like CPs, CDs and short-term NCDs
  2. Rated Rupee-denominated corporate bonds, both listed and unlisted
  3. Unrated rupee-denominated corporated bonds issued by infrastructure companies.

The 2013 Guidelines also provided for similar set of instruments. However, it is pertinent to note that the Proposed Directions provide for an express bar on usage of the following structured products as reference obligations:

  1. Asset backed securities
  2. Mortgage backed securities
  3. Credit enhanced or guranateed bonds
  4. Convertible bonds
  5. Bonds with embedded call/ put options

Loans continue to be ineligible for use as reference obligation.

Market makers and users

Relevant extracts:

6.1 Market-makers

(i) The following entities shall be eligible to act as market-makers in credit derivatives:

  1. Scheduled Commercial Banks (SCBs), except Small Finance Banks, Payment Banks, Local Area Banks and Regional Rural Banks;
  2. Non-Bank Financial Companies (NBFCs), including Housing Finance Companies (HFCs), with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet and subject to specific approval of the Department of Regulation (DoR), Reserve Bank.
  3. Standalone Primary Dealers (SPDs) with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet and subject to specific approval of the Department of Regulation (DoR), Reserve Bank.
  4. Exim Bank, National Bank of Agriculture and Rural Development (NABARD), National Housing Bank (NHB) and Small Industries Development Bank of India (SIDBI).

(ii) In case the net owned funds of an NBFC, an HFC or an SPD as per the latest audited balance sheet fall below the aforesaid threshold subsequent to the receipt of approval for acting as a market-maker, it shall cease to act as a market-maker. The NBFC, HFC or SPD shall continue to meet all its obligations under existing contracts till the maturity of such contracts.

(iii) Market-makers shall be allowed to buy protection without having the underlying debt instrument.

(iv) At least one of the parties to a CDS transaction shall be a market-maker or a central counter party authorised by the Reserve Bank as an approved counterparty for CDS transactions.

Our comments:

When compared to the 2013 Guidelines, the only addition to list of entities that are eligible to act as market makers is housing finance companies. The net-worth requirements for NBFCs and SPDs remain the same as that under 2013 Guidelines. However, here it is pertinent to note that while the banks are not required to obtain any specific approval from the RBI, NBFCs and SPDs will have to obtain specific approval from the Department of Regulation. The RBI may reconsider this position and remove the requirement of obtaining special approval for the NBFCs and SPDs and put them in a level playing field with the banks.

Relevant extracts:

6.2 User Classification Framework

(i) For the purpose of offering credit derivative contracts to a user, market-maker shall classify the user either as a retail user or as a non-retail user.

(ii) The following users shall be eligible to be classified as non-retail users:

  1. Insurance Companies regulated by Insurance Regulatory and Development Authority of India (IRDAI);
  2. Pension Funds regulated by Pension Fund Regulatory and Development Authority (PFRDA);
  3. Mutual Funds regulated by Securities and Exchange Board of India (SEBI);
  4. Alternate Investment Funds regulated by Securities and Exchange Board of India (SEBI);
  5. SPDs with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet;
  6. NBFCs, including HFCs, with a minimum net owned funds of ₹500 crore as per the latest audited balance sheet;
  7. Resident companies with a minimum net worth of ₹500 crore as per the latest audited balance sheet; and
  8. Foreign Portfolio Investors (FPIs) registered with SEBI.

(iii) Any user who is not eligible to be classified as a non-retail user shall be classified as a retail user.

(iv) Any user who is otherwise eligible to be classified as a non-retail user shall have the option to get classified as a retail user.

(v) Retail users shall be allowed to undertake transactions in permitted credit derivatives for hedging their underlying credit risk.

(vi) Non-retail users shall be allowed to undertake transactions in credit derivatives for both hedging and other purposes.

Our comments:

As brought out earlier under the highlights section, there can be two types of users – non retail and retail users. Financial institutions, resident corporates with networth of Rs. 500 crores or above, and FPIs can become non-retail users. The non-retail users can participate in these contracts either for hedging their credit risk or any other purposes.

On the other hand, anyone who is not eligible to become a non-retail user, by default becomes a retail user. Additionally, non-retail users have been given an option to reclassify themselves as retail issuers should they want. Retail users are allowed to undertake these transactions only for the hedging their credit risk.

The provisions under the Proposed Directions differ significantly from that under the 2013 Guidelines which allowed only financial institutions and FIIs to participate as users. Further, neither did the Guidelines differentiate between retail and non-retail users, nor did it allow the use of CDS for other than hedging purposes.

The classification between retail and non retail users is welcome move where they have not put any restriction on the more serious non-retail users, who can use these even for speculative purposes, apart from hedging. This could increase the liquidity of the instruments, therefore, deepening the market.

Operations and standardisations

Relevant extracts:

7.1 Buying, Unwinding and Settlement

(i) Market-makers and users shall not enter into CDS transactions if the counterparty is a related party or where the reference entity is a related party to either of the contracting parties.

(ii) Market-makers and users shall not buy/sell protection on reference entities if there are regulatory restrictions on assuming similar exposures in the cash market or in violation of any other regulatory restriction, as may be applicable.

(iii) Market-makers shall ensure that all CDS transactions by retail users are undertaken for the purpose of hedging i.e. the retail users buying protection:

  1. shall have exposure to any of the debt instruments mentioned under paragraph 5(ii) and issued by the reference entity;
  2. shall not buy CDS for amounts higher than the face value of the underlying debt instrument held by them; and
  3. shall not buy CDS with tenor later than the maturity of the underlying debt instrument held by them or the standard CDS maturity date immediately after the maturity of the underlying debt instrument.

To ensure this, market-makers may call for any relevant information/documents from the retail user, who, in turn, shall be obliged to provide such information.

(iv) Retail users shall exit their CDS position within one month from the date they cease to have underlying exposure.

(v) Market participants can exit their CDS contract by unwinding the contract with the original counterparty or assigning the contract to any other eligible market participant.

(vi) Market participants shall settle CDS contracts bilaterally or through any clearing arrangement approved by the Reserve Bank.

(vii) CDS contracts shall be denominated and settled in Indian Rupees.

(viii) CDS contracts can be cash settled or physically settled. However, CDS contracts involving retail users shall be mandatorily physically settled.

(ix) The reference price for cash settlement shall be determined in accordance with the procedure determined by the Credit Derivatives Determinations Committee or auction conducted by the Credit Derivatives Determinations Committee, as specified under paragraph 8 of these Directions.

Our comments:

The Proposed Directions imposes restrictions on the users to enter into contracts involving their related parties.

Further, as noted earlier, contracts entered into by the retail users must be for the purpose of the hedging credit risks only, in addition to it there are some other restrictions with respect to the tenor and amount of the protection. However, the onus to ensure that these conditions are met with have been imposed on the market makers. This leads to an additional compliance on the part of the market makers.

In terms of settlement, the Proposed Directions allow both cash and physical settlement, however, for retail users only physical settlement is allowed.

Further, the Proposed Directions also provide for the manner of exiting a CDS contract. In practice, there are three ways of settling a credit derivative contract – first, by settlement in cash or physically, second, by entering into a matching contract with a third party, therefore knocking off the contract in the hands of the protection buyer, and third, by assigning the contract to third parties. The Proposed Directions allow all of these.

Relevant extracts:

7.2 Standardisation

(i) Fixed Income Money Market and Derivatives Association of India (FIMMDA), in consultation with market participants and based on international best practices, shall devise standard master agreement/s for the Indian CDS market which shall, inter-alia, include credit event definitions and settlement procedures.

(ii) FIMMDA shall, at the minimum, publish the following trading conventions for CDS contracts:

  1. Standard maturity and premium payment dates;
  2. Standard premiums;
  3. Upfront fee calculation methodology;
  4. Accrual payment for full first premium;
  5. Quoting conventions; and
  6. Lookback period for credit events.

Our comments:

FIMMDA has been authorised to standardise the documents, and conventions for CDS contracts. World-over standard CDS products are prevalent with standard maturity dates, coupon payments, rates. Standardisation of key terms of a credit derivative contract transform the product from bespoke bilateral transactions to standard marketable products.

Some of the prevalent conventions used internationally are the Standard North Amercian Corporate Convention (SNAC) or the Standard European Corporate (SEC) Convention. The aim of both these conventions is to standardize the trading mechanics of credit default swaps (the SNAC for North American corporate names and the SEC for European corporate names) and facilitate trading through a central clearing counterparty, as well as to reduce uncertainty associated with credit events. This is because in order to make trades completely fungible (i.e., so they have the quality of being capable of exchange or interchange), all trading conventions have to be fully standardized.

Both the conventions have the following trading mechanics:

  1. They have a fixed coupon and an upfront fee.
  2. The first coupon of a CDS accumulates from the date of the last coupon, regardless of the trade date.
  3. The quoted spread for a given maturity is assumed to be a flat spread, rather than representing a point in the term structure.

References from the aforesaid conventions could be drawn while standardisation of the CDS conventions for the Indian market.

Prudential norms, accounting and capital requirements

Relevant extracts:

  1. Prudential norms, accounting and capital requirements

Market participants shall follow the applicable prudential norms and capital adequacy requirements for credit derivatives issued by their respective regulators. Credit derivative transactions shall be accounted for as per the applicable accounting standards prescribed by The Institute of Chartered Accountants of India (ICAI) or other standard setting organisations or as specified by the respective regulators of participants.

Our comments:

The market participants shall have to follow prudential norms and capital adequacy requirements for credit derivatives issued by the sectoral regulators. For NBFCs, for credit protection purchased, for corporate bonds held in current category – capital charge has to be maintained on 20% of the exposure, whereas for corporate bonds held in permanent category, and where there is no mismatch between the hedged bond and the CDS, full capital protection is allowed. The exposure shall stand replaced by exposure on the protection seller, and attract risk weights at 100%.

Similar provisions apply for banks, however, for bonds held in the permanent category, where there is no mismatch between the hedged bonds and CDS, the capital charge on the corporate bonds is nil, whereas, the capital charge on the exposure on protection sellers is maintained at 20% risk weight.

In terms of accounting, for NBFCs and HFCs, Ind AS 109 will have to be followed. Banks however will have to rely on ICAI’s Guidance Notes, if any, to do the accounting.

Our other resources on the topic:

  1. Our dedicated page on Credit Derivatives: http://vinodkothari.com/cdhome/
  2. Our articles on Credit Derivatives: http://vinodkothari.com/creart/
  3. Our book, Credit Derivatives & Structured Credit Trading, by Vinod Kothari – http://vinodkothari.com/crebook/

[1] https://static.pib.gov.in/WriteReadData/userfiles/ASss%2023%20August.pdf

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=50748

[3] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51138

[4] https://www.rbi.org.in/scripts/NotificationUser.aspx?Id=7793&Mode=0

[5] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/C170RG21082012.pdf

[6]https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/STANDARDASSETS1600647F054448CB8CCEC47F8888FC78.PDF

[7] http://vinodkothari.com/2020/01/securitisation-india-and-global/

[8] https://eba.europa.eu/eba-consults-on-its-proposals-to-create-a-sts-framework-for-synthetic-securitisation

[9] https://eba.europa.eu/file/113260/download?token=RpXCSVe2,

[10] Based on https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/CRT-Progress-Report-4Q18.pdf

Investment window for FPIs widened

Permitting FPIs to invest in defaulted debt securities

 

-Aanchal Kaur Nagpal (aanchal@vinodkothari.com)

 

While the Indian equity market has consistently shown a rigorous growth, the bond market in India has mostly been relatively lagging behind. The size and performance of the Indian bond market has been quite inappreciable as compared to the developed economies in the world. The COVID-19 pandemic further caused a turmoil in the market. Among the investor class, Foreign Portfolio Investors (FPI) are a major participant in the debt market contributing to approximately 10% of the total debt investment.

Source: CRISIL Yearbook on Indian Debt Market, 2018

Further, as depicted below, the investments by FPIs in debt market has not been a consistent or a straight line and has seen more downward trend than upward.

Source: NSDL

As on February 5, 2021, foreign investment in corporate bonds has only reached 25% of the total available limit[1]. Further, the proportion of FPI investment as a part of the total foreign investment in India, is constrained by various investment limits and regulatory requirements.

FPIs are allowed to invest in eligible government securities and eligible corporate bonds. In case of corporate bonds, the following restrictions are imposed –

  • Restriction on short term investment in corporate bonds

FPIs are not permitted to make short term investments of more than 20% of their total investment in corporate bonds. The above cap was increased from 20% to 30% of the total investment of the FPI providing more flexibility to FPIs in making investment decisions.

  • Issue limit

Investment by any FPI, including related FPIs, cannot exceed 50% of any issue of a corporate bond. In case an FPI, including related FPIs breaches the same and invests in more than 50% of any single issue, it cannot make further investments in that issue until the condition is met.

  • Minimum residual maturity

FPIs can only invest in corporate bonds with a minimum residual maturity of 1 years, subject to the condition that short-term investments limit in corporate bonds.

Exempted Securities –

However, there are certain securities that are exempt from the above restrictions –

  • Debt instruments issued by ARCs; and
  • Debt instruments issued by an entity under the CIRP as per the resolution plan approved by the NCLT under the Insolvency and Bankruptcy Code, 2016.

The aforesaid exemption was introduced with the intent to further widen the scope of investment by FPIs. It not only allowed FPIs to make short term investments in the above debt instruments without any limit but also bring in more options for FPIs to invest without having to consider the single/group investor-wise limits

FPIs are allowed to invest in security receipts issued by ARCs to address the NPA issue of financial institutions. Further, debt instruments issued by a corporate debtor under CIRP have also been made eligible for FPI investment. This was done with the intent to revive corporate debtors under a resolution plan. Thus, RBI has allowed FPIs to invest in such securities that are in dire need of investment, while granting various exemptions to make them more attractive.

Power of RBI to permit debt instruments or securities for FPI investment

As per SEBI (Foreign Portfolio Investors) Regulations, 2019, amongst other eligible debt instruments, FPIs are allowed to invest in any debt securities or other instruments as permitted by RBI [Regulation 20(1) (g)].

Thus, RBI has the power to prescribe eligible debt securities for FPI investment.

Foreign Portfolio Investors (FPIs) Investment in Defaulted Bonds

As discussed, investment by FPIs in debt instruments issued by ARCs or an entity under the CIRP, are exempted from the short-term limit and minimum residual maturity requirement. In order to further promote investment by FPIs in corporate bonds, RBI, in its Statement on Developmental and Regulatory Policies dated 5th February, 2021[2], has proposed to extend similar exemptions to defaulted corporate bonds. Accordingly, FPI investment in defaulted corporate bonds are proposed to be exempted from the short-term limit and the minimum residual maturity requirement. For this purpose, detailed guidelines will be issued separately by RBI.

Defaulted debt securities refer to ‘non-payment of interest or principal amount in full on the pre-agreed date and shall be recognized at the first instance of delay in servicing of any interest or principal on such debt.

At present, FPIs are permitted to invest in defaulted debt securities only against repayment of amortising bonds. Now, RBI is intending to permit FPIs to invest in defaulted corporate bonds as fresh issues as well and in all other cases as well.

Existing provision on FPI investment in corporate bonds under default –

Investments by FPIs in corporate bonds under default [Para 15 of Operating Guidelines for FPIs[3]]

  1. FPIs are permitted to acquire NCDs/bonds, which are under default, either fully or partly, in the repayment of principal on maturity or principal instalment in the case of an amortising bond.
  2. FPIs will be guided by RBI’s definition of an amortising bond in this regard.
  • The revised maturity period for such NCDs/bonds restructured based on negotiations with the issuing Indian company, should be as per the norms prescribed by RBI from time to time, for FPI investments in Corporate Debt.
  1. The FPIs shall disclose to the Debenture Trustees, the terms of their offer to the existing debenture holders/beneficial owners of such NCDs/bonds under default, from whom they propose to acquire.
  2. All investments by FPIs in such bonds shall be reckoned against the prevalent corporate debt limit. All other terms and conditions pertaining to FPI investments in corporate debt securities shall continue to apply.

SEBI also issued an operational framework[4] for transactions in defaulted debt securities post redemption date along with obligations of Issuers, Debenture Trustees, Depositories and Stock Exchanges while permitting such transaction

However, the motive for FPIs for investing in such defaulted corporate bonds is still to be understood. Since defaulted debt securities refer to securities even with one-time defaults, corporate bonds with favourable future prospects or where the security against such bonds is sufficient and promising, may attract FPI investments. RBI’s intent behind this move is to deepen the financial market, bring better liquidity in defaulted debt securities and also provide an additional investment opportunity to FPIs. The detailed guidelines are awaited to be issued by RBI.

 

[1] Source: NSDL- https://www.fpi.nsdl.co.in/web/Reports/ReportDetail.aspx?RepID=1

[2] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=51078

[3]https://www.sebi.gov.in/sebi_data/commondocs/nov-2019/Operational%20Guidelines%20for%20FPIs,%20DDPs%20and%20EFIs%20revised_p.pdf

[4]https://www.sebi.gov.in/legal/circulars/jun-2020/operational-framework-for-transactions-in-defaulted-debt-securities-post-maturity-date-redemption-date-under-provisions-of-sebi-issue-and-listing-of-debt-securities-regulations-2008_46912.html

Our articles on related topics-

Law relating to collective investment schemes on shared ownership of real assets

-Vinod Kothari (finserv@vinodkothari.com)

The law relating to collective investment schemes has always been, and perhaps will remain, enigmatic, because these provisions were designed to ensure that enthusiastic operators do not source investors’ money with tall promises of profits or returns, and start running what is loosely referred to as Ponzi schemes of various shades. De facto collective investment schemes or schemes for raising money from investors may be run in elusive forms as well – as multi-level marketing schemes, schemes for shared ownership of property or resources, or in form of cancellable contracts for purchase of goods or services on a future date.

While regulations will always need to chase clever financial fraudsters, who are always a day ahead of the regulator, this article is focused on schemes of shared ownership of properties. Shared economy is the cult of the day; from houses to cars to other indivisible resources, the internet economy is making it possible for users to focus on experience and use rather than ownership and pride of possession. Our colleagues have written on the schemes for shared property ownership[1]. Our colleagues have also written about the law of collective investment schemes in relation to real estate financing[2]. Also, this author, along with a colleague, has written how the confusion among regulators continues to put investors in such schemes to prejudice and allows operators to make a fast buck[3].

This article focuses on the shared property devices and the sweep of the law relating to collective investment schemes in relation thereto.

Basis of the law relating to collective investment schemes

The legislative basis for collective investment scheme regulations is sec. 11AA (2) of the SEBI Act. The said section provides:

Any scheme or arrangement made or offered by any company under which,

  • the contributions, or payments made by the investors, by whatever name called, are pooled and utilized solely for the purposes of the scheme or arrangement;
  • the contributions or payments are made to such scheme or arrangement by the investors with a view to receive profits, income, produce or property, whether movable or immovable from such scheme or arrangement;
  • the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors;
  • the investors do not have day to day control over the management and operation of the scheme or arrangement.

The major features of a CIS may be visible from the definition. These are:

  1. A schematic for the operator to collect investors’ money: There must be a scheme or an arrangement. A scheme implies a well-structured arrangement whereby money is collected under the scheme. Usually, every such scheme provides for the entry as well as exit, and the scheme typically offers some rate of return or profit. Whether the profit is guaranteed or not, does not matter, at least looking at the definition. Since there is a scheme, there must be some operator of the scheme, and there must be some persons who put in their money into the scheme. These are called “investors”.
  2. Pooling of contributions: The next important part of a CIS is the pooling of contributions. Pooling implies the contributions losing their individuality and becoming part of a single fungible hotchpot. If each investor’s money, and the investments therefrom, are identifiable and severable, there is no pooling. The whole stance of CIS is collective investment. If the investment is severable, then the scheme is no more a collective scheme.
  3. Intent of receiving profits, produce, income or property: The intent of the investors contributing money is to receive results of the collective investment. The results may be in form of profits, produce, income or property. The usual feature of CIS is the operator tempting investors with guaranteed rate of return; however, that is not an essential feature of CISs.
  4. Separation of management and investment: The management of the money is in the hands of a person, say, investment manager. If the investors manage their own investments, there is no question of a CIS. Typically, investor is someone who becomes a passive investor and does not have first level control (see next bullet). It does not matter whether the so-called manager is an investor himself, or may be the operator of the scheme as well. However, the essential feature is there being multiple “investors”, and one or some “manager”.
  5. Investors not having regular control over the investments: As discussed above, the hiving off of the ownership and management of funds is the very genesis of the regulatory concern in a CIS, and therefore, that is a key feature.

The definition may be compared with section 235 of the UK Financial Services and Markets Act, which provides as follows:

  • In this Part “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
  • The arrangements must be such that the persons who are to participate (“participants”) do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions.
  • The arrangements must also have either or both of the following characteristics—
  • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
  • the property is managed as a whole by or on behalf of the operator of the scheme.
    • If arrangements provide for such pooling as is mentioned in subsection (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single collective investment scheme unless the participants are entitled to exchange rights in one part for rights in another.

It is conspicuous that all the features of the definition in the Indian law are present in the UK law as well.

Hong Kong Securities and Futures Ordinance [Schedule 1] defines a collective investment scheme as follows:

collective investment scheme means—

  • arrangements in respect of any property—
  • under which the participating persons do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management;
  • under which—
  • the property is managed as a whole by or on behalf of the person operating the arrangements;
  • the contributions of the participating persons and the profits or income from which payments are made to them are pooled; or
  • the property is managed as a whole by or on behalf of the person operating the arrangements, and the contributions of the participating persons and the profits or income from which payments are made to them are pooled; and
  • the purpose or effect, or pretended purpose or effect, of which is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive—
  • profits, income or other returns represented to arise or to be likely to arise from the acquisition, holding, management or disposal of the property or any part of the property, or sums represented to be paid or to be likely to be paid out of any such profits, income or other returns; or
  • a payment or other returns arising from the acquisition, holding or disposal of, the exercise of any right in, the redemption of, or the expiry of, any right, interest, title or benefit in the property or any part of the property; or
  • arrangements which are arrangements, or are of a class or description of arrangements, prescribed by notice under section 393 of this Ordinance as being regarded as collective investment schemes in accordance with the terms of the notice.

One may notice that this definition as well has substantially the same features as the definition in the UK law.

Judicial analysis of the definition

Part (iii) of the definition in Indian law refers to management of the contribution, property or investment on behalf of the investors, and part (iv) lays down that the investors do not have day to day control over the operation or management. The same features, in UK law, are stated in sec. 235 (2) and (3), emphasizing on the management of the contributions as a whole, on behalf of the investors, and investors not doing individual management of their own money or property. The question has been discussed in multiple UK rulings. In Financial Conduct Authority vs Capital Alternatives and others,  [2015] EWCA Civ 284, [2015] 2 BCLC 502[4], UK Court of Appeal, on the issue whether any extent of individual management by investors will take the scheme of the definition of CIS, held as follows:  “The phrase “the property is managed as a whole” uses words of ordinary language. I do not regard it as appropriate to attach to the words some form of exclusionary test based on whether the elements of individual management were “substantial” – an adjective of some elasticity. The critical question is whether a characteristic feature of the arrangements under the scheme is that the property to which those arrangements relate is managed as a whole. Whether that condition is satisfied requires an overall assessment and evaluation of the relevant facts. For that purpose it is necessary to identify (i) what is “the property”, and (ii) what is the management thereof which is directed towards achieving the contemplated income or profit. It is not necessary that there should be no individual management activity – only that the nature of the scheme is that, in essence, the property is managed as a whole, to which question the amount of individual management of the property will plainly be relevant”.

UK Supreme Court considered a common collective land-related venture, viz., land bank structure, in Asset Land Investment Plc vs Financial Conduct Authority, [2016] UKSC 17[5]. Once again, on the issue of whether the property is collective managed, or managed by respective investors, the following paras from UK Financial Conduct Authority were cited with approval:

The purpose of the ‘day-to-day control’ test is to try to draw an important distinction about the nature of the investment that each investor is making. If the substance is that each investor is investing in a property whose management will be under his control, the arrangements should not be regarded as a collective investment scheme. On the other hand, if the substance is that each investor is getting rights under a scheme that provides for someone else to manage the property, the arrangements would be regarded as a collective investment scheme.

Day-to-day control is not defined and so must be given its ordinary meaning. In our view, this means you have the power, from day-to-day, to decide how the property is managed. You can delegate actual management so long as you still have day-to-day control over it.[6]

The distancing of control over a real asset, even though owned by the investor, may put him in the position of a financial investor. This is a classic test used by US courts, in a test called Howey Test, coming from a 1946 ruling in SEC vs. Howey[7]. If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.

The financial world and the real world

As is apparent, the definition in sec. 235 of the UK legislation has inspired the draft of the Indian law. It is intriguing to seek as to how the collective ownership or management of real properties has come within the sweep of the law. Evidently, CIS regulation is a part of regulation of financial services, whereas collective ownership or management of real assets is a part of the real world. There are myriad situations in real life where collective business pursuits,  or collective ownership or management of properties is done. A condominium is one of the commonest examples of shared residential space and services. People join together to own land, or build houses. In the good old traditional world, one would have expected people to come together based on some sort of “relationship” – families, friends, communities, joint venturers, or so on. In the interweb world, these relationships may be between people who are invisibly connected by technology. So the issue, why would a collective ownership or management of real assets be regarded as a financial instrument, to attract what is admittedly a  piece of financial law.

The origins of this lie in a 1984 Report[8] and a 1985 White Paper[9], by Prof LCB Gower, which eventually led to the enactment of the 1986 UK Financial Markets law. Gower has discussed the background as to why contracts for real assets may, in certain circumstances, be regarded as financial contracts. According to Gower, all forms of investment should be regulated “other than those in physical objects over which the investor will have exclusive control. That is to say, if there was investment in physical objects over which the investor had no exclusive control, it would be in the nature of an investment, and hence, ought to be regulated. However, the basis of regulating investment in real assets is the resemblance the same has with a financial instrument, as noted by UK Supreme Court in the Asset Land ruling: “..the draftsman resolved to deal with the regulation of collective investment schemes comprising physical assets as part of the broader system of statutory regulation governing unit trusts and open-ended investment companies, which they largely resembled.”

The wide sweep of the regulatory definition is obviously intended so as not to leave gaps open for hucksters to make the most. However, as the UK Supreme Court in Asset Land remarked: “The consequences of operating a collective investment scheme without authority are sufficiently grave to warrant a cautious approach to the construction of the extraordinarily vague concepts deployed in section 235.”

The intent of CIS regulation is to capture such real property ownership devices which are the functional equivalents of alternative investment funds or mutual funds. In essence, the scheme should be operating as a pooling of money, rather than pooling of physical assets. The following remarks in UK Asset Land ruling aptly capture the intent of CIS regulation: “The fundamental distinction which underlies the whole of section 235 is between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value; and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can be either pooled or managed in common, in return for a share of the profits generated by the collective fund.”

Conclusion

While the intent and purport of CIS regulation world over is quite clear, but the provisions  have been described as “extraordinarily vague”. In the shared economy, there are numerous examples of ownership of property being given up for the right of enjoyment. As long as the intent is to enjoy the usufructs of a real property, there is evidently a pooling of resources, but the pooling is not to generate financial returns, but real returns. If the intent is not to create a functional equivalent of an investment fund, normally lure of a financial rate of return, the transaction should not be construed as a collective investment scheme.

 

[1] Vishes Kothari: Property Share Business Models in India, http://vinodkothari.com/blog/property-share-business-models-in-india/

[2] Nidhi Jain, Collective Investment Schemes for Real Estate Investments in India, at http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/

[3] Vinod Kothari and Nidhi Jain article at: https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html

[4] http://www.bailii.org/ew/cases/EWCA/Civ/2015/284.html

[5] https://www.supremecourt.uk/cases/docs/uksc-2014-0150-judgment.pdf

[6] https://www.handbook.fca.org.uk/handbook/PERG/11/2.html

[7] 328 U.S. 293 (1946), at https://supreme.justia.com/cases/federal/us/328/293/

[8] Review of Investor Protection, Part I, Cmnd 9215 (1984)

[9] Financial Services in the United Kingdom: A New Framework for Investor Protection (Cmnd 9432) 1985

 

Our Other Related Articles

Property Share Business Models in India,< http://vinodkothari.com/blog/property-share-business-models-in-india/>

Collective Investments Schemes: How gullible investors continue to lose money < https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html>

Collective Investment Schemes for Real Estate Investments in India, < http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/>

 

Market-Linked Debentures – Real or Illusory?

Aanchal Kaur Nagpal and Shreya Masalia

Vinod Kothari and Company | corplaw@vinodkothari.com  

Introduction

Market linked debentures (MLDs) are a type of debt security that provides returns based on the performance of an underlying index/security. When the underlying security does well, the return on MLDs will be high and vice-versa. While the underlying security to which the MLDs are linked is at the discretion of the issuer, the same, however, needs to be related to the market, e.g. indices such as Nifty 50, SENSEX etc., or securities like equity, debt securities, government securities etc. For an in-depth understanding of the concept and the regulatory framework of MLDs, read our article here.

The previous article touched upon the concern of MLDs being used for the purpose of regulatory arbitrage, without being truly market-linked. The regulatory arbitrage may come in the form of additional ISINs, exemption from EBP mechanism, etc. The same has been discussed in detail in the previous article.

In this article, we shall examine various case studies (picked from various information memorandum available on the stock exchange and websites of companies) to prove the point.

The case studies are tabulated below:

S. No. Underlying The basis for coupon payoff Likely/unlikely conditions
1. NIFTY 50 If final fixing level > 25% of initial level, coupon – 8.1767% (XIRR 8.000%)

Suppose,
Initial level (NIFTY 50) index = 11400
25% of initial level (NIFTY 50) = 2850

So, if the final fixing level is above a value of 2850, then coupon pay off will be 8%.
If the final fixing level is below 2850, the coupon will be 0%.

Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that NIFTY 50 would fall below the level of 2850 is very low.

2. NIFTY 50 If Final >= Initial, Principal Amount * 20.50%
If Final < Initial, Principal Amount * 19.65%
Conclusion-
This is a likely condition. However, in all cases, the investor is going to receive coupon payoff, even if the underlying performs negatively, there is a payoff.The level of rise in Nifty is not related to the return that the investor will receive. i.e. if the initial level is 10,000 and nifty either rises to 20,000 or 10, 200, the return will be the same.

Difference between coupon payoffs in both the scenarios i.e. whether the underlying performs or not is less than 1%.

3. G-sec The initial fixing level is 105.94 (which is the price of G-sec on the initial fixing date)

Suppose,
If the final fixing level is >=79.455 – then the coupon will be 8%
If the final fixing level is <79.455 but >= 26.485 then the coupon will be 7.95%
If the final fixing level is <26.485 then the coupon will be 0%.

 

Conclusion –

The downside condition is highly unlikely to happen. The probability that the price of the G-sec on the final fixing date will fall below 26.485 from a level of 105.94 is very low. In fact, on the final fixing date, the price of the G-sec was 108.17 which is higher than the initial fixing level.

4. NIFTY 50 Initial level – an average of 6 observations
Final level – an average of 6 observations
Nifty performance- final level/initial level – 1
Fixed coupon- 26.70%
Participation rate (variable component)- 85%Coupon payoff –
If Final Level >= Initial Level, Principal + Max Fixed-Coupon, Participation rate * Nifty Performance)
Else, If Final Level < Initial Level; Principal + Fixed-Coupon.
Conclusion –

This is a likely condition. Here the coupon payoff is a combination of the fixed and variable part (Directly depending on the performance of nifty)
Even if the underlying performs negatively, the investor will still earn the fixed component along with the principal.

5. NIFTY 50 If Final Fixing Level <= 25% of Initial Fixing Level: 0.000%
If Final Fixing Level > 25% of Initial Fixing Level: 7.4273% p.a.
(XIRR 6.95% p.a.)Suppose,
Initial level (NIFTY 50) index = 9106.25
25% of initial level (NIFTY 50) = 2276.56

So, if the final fixing level is above a value of 2276.56, then coupon pay off will be 6.95%.
If the final fixing level is below 2276.56, the coupon will be 0%.

Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that NIFTY 50 would fall below the level of 2376.56 is very low.

6. G-sec If Final Fixing Level >=25% of the Initial Fixing level, then coupon+ principal
If Final Fixing Level < 25% of the Initial Fixing level, then only principal.
Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that G-sec would fall below 25% of the initial level is low.

7. 10-year G-sec Underlying performance- Final level/ Initial level * 100
Coupon payoff-
If UP >= 75% of initial level- 8.45%
If UP < 75% but >= 25% of initial level, then 8.40%
If UP < 25%, then 0.
Conclusion-
This condition is highly unlikely to happen. Looking at past trends, the probability that G-sec would fall below 25% of the initial level is low.
Also, the difference between the two coupon rates is 0.5%
8. NIFTY 50 Reference Index-Linked Return=
Debenture Face Value* Reference Index Return FactorFactor = Max [0%, 115%* {(Observation Value of the Reference Index / Start Reference Index Value) – 100%}]

115% is the participation rate

Observation Value of the Reference Index shall Mean Closing Value of CNX Nifty on the scheduled valuation date for redemption.

Conclusion
This condition is likely to happen- since the return is directly dependent on the performance of the index.Here, the value of Nifty for example is 5700, if nifty falls below 5700, there will be 0% pay off, if nifty rises above 5700, then the payoff would be 115% of the performance of NIFTY,

For example, if Nifty is 5700 and it rises to 6000- rise is 5%- coupon payoff shall be 115% of 5% = 6.05%.

9. G-sec If the performance of underlying final fixing date –

greater than 50% of digital level : Coupon= 8.6819 p.a.
less than or equal to 50% of digital level: Coupon = 0%

*Digital level: 100% of the Closing price of the reference security, of 7.17 G-Sec 2028 as on Initial Fixing Date.

Conclusion
The condition is unlikely to happen.
E.g. The Value of G-sec on the initial date is 97. 72- The chances that the same will fall below 48.86 is very low.
10. NIFTY 50 If Final Fixing Level <= 25% of Initial Fixing Level: 0.000%
If Final Fixing Level > 25% of Initial Fixing Level: 8.70% p.a. (XIRR 8.35% p.a.)Suppose,
Initial level (NIFTY 50) index = 9106.25
25% of initial level (NIFTY 50) = 2276.56

So, if the final fixing level is above a value of 2276.56, then coupon pay off will be 6.95%.
If the final fixing level is below 2276.56, the coupon will be 0%.

Conclusion –

This condition is highly unlikely to happen. Looking at past trends, the probability that Nifty 50 would fall below the level of 2376.56 is very low.

Further, put option is given- participation rate is lower i.e. 65%.

11. NIFTY 50 Coupon amount –

A) If Final > 140% of Initial, then coupon rate =Performance% of the initial principal amount
Or
B) If Final <= 140% of Initial, then coupon rate = 40% of the initial principal amount.

Conclusion –

This condition is highly unlikely to happen as the possibility of Nifty falling to 40% is rare.

12. NIFTY 50 Coupon = Max(Underlying Performance, Min(48.85%,Max(4.885*Underlying
Performance,0)))Underlying performance – (Final Fixing Level / Initial Fixing Level) – 1
Conclusion –

The condition is likely to happen.
Here, if the initial level is 11404.80 and Nifty is below 11404.80 (negative or 0% performance), then the coupon rate is 0%.
Here, if the Nifty rises above 11404.80 till 12431.23 (up to 9% rise), then the coupon rate shall be as per the formula.
If Nifty rises above 12545.28 till 16977.19 (above 9% up to 48.86% rise), then coupon shall be 48.86%)
If Nifty rises above 16993.15 (above 48.86% rise), then the coupon shall be equal to the underlying performance.

13. G-sec If Final Fixing Level <= 25% of Initial Fixing Level: 0.000%
If Final Fixing Level > 25% of Initial Fixing Level: 6.80% p.a.Suppose,
The initial level of g-sec is 100
25% of initial level (G Sec) = 25
So, if the final fixing level is above a value of 25 then the coupon payoff will be 6.80%.
If the final fixing level is below 25, the coupon will be 0%.
Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that g-sec will fall to 25% is very low.

14. Nifty 10 YR Benchmark G-Sec (Clean Price) index 100% of Principal Amount * (Coupon A + Coupon B) Where,

“Coupon A” shall mean:
A) If Final Level >= 30% of Initial Level (i.e. 0.30 * Initial Level),
Coupon shall mean Rebate i.e. 21%

Or

B) If Final Level < 30% of Initial Level (i.e. 0.30 * Initial Level),
Coupon shall be Nil

“Coupon B” shall mean:

(1 + Coupon A) * 10.50% * (Day-Count/365)

Suppose,
The initial level of g-sec is 925
30% of initial level (G Sec) = 277.5

So, if the final fixing level is above a value of 277.5 then coupon pay off will be 21%.
If the final fixing level is below 25, the coupon will be 0%.

Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that g-sec will fall to 30% is very low.

15. NIFTY 50 If Final Fixing Level >=25% of the Initial Fixing level = 36.405%
If Final Fixing Level < 25% of the Initial Fixing level = 0%Suppose,
Initial level 10710.45
final below 2677.61 only then will the coupon be 0%.
Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that Nifty 50 will fall to 25% is very low.

16. CNX Nifty Here, the entry NIFTY is calculated as average for 3 dates in 3 months.

For the final level- NIFTY on 11 observation dates is calculated.

Increases have been divided into levels – and for each level, there is a percentage for coupon rate.

The highest coupon rate out of all the 11 levels will be taken for the final coupon rate.

The minimum level is 115% of the entry Nifty.

Below that- no level and no coupon.

Conclusion –
The coupon is based on the performance of Nifty and hence is likely to happen.
17. 10 year Government security price (a) if IGB 5.79 05/11/30 Corp Price => 75% of *Digital Level the Coupon rate shall be at 11% p.a. (Maximum)

b) if IGB 5.79 05/11/30 Corp Price is less than 75% but equal to or greater than 25% of *Digital Level the Coupon rate shall be at 10.95% p.a. (Minimum)

(c) if IGB 5.79 05/11/30 Corp Price < 25% of *Digital Level then no Coupon shall be
payable.

*Digital Level – 100% of IGB 5.79 11/05/2020 Corp price at Initial Observation Date.

Conclusion –

As such it’s highly unlikely to receive no coupon at all as the probability of the g-sec falling to 75% is negligible looking at the past trends. Even the probability of the G-sec value falling between 25 – 75 % is unusual, but even if it does, the difference is the coupon rate is merely that of .05% which is negligible.

18. CNX Nifty If Final Fixing Level >=25% of the Initial Fixing level = 32.143%
If Final Fixing Level < 25% of the Initial Fixing level = 0%Suppose,
The initial level is 10252.10
If the final level falls below 2563.03 then the coupon rate will 0 and above that coupon rate will be 9.25%.
Conclusion –

The condition is highly unlikely. Looking at past trends, the probability that Nifty 50 will fall to 25% is very low.

Analysis of the MLD market in India

On an analysis of the cases given above, one can clearly observe that the conditions on which the performance of the underlying is based, are highly unrealistic. An instance where the value of Nifty or a G-sec would fall by 50-75% seems quite impossible where even ‘The Great Depression of 2008’ caused a fall of only 40% in stock indices. Hence in almost all conditions, the investor will always be receiving a coupon and thus the hedging shown is more of a hoax. The MLDs are, thus, not market-linked at all thereby defeating the purpose of introducing MLDs. On lifting the veil of the underlying condition used, it reveals that the MLDs are in fact equivalent to plain vanilla debentures.

Conclusion

The true intent and spirit of introducing the concept of MLDs can be seen missing from a lot of the issuances by the companies. Instead, MLDs, are being issued, rather in some of the most farcical avatars, to gain regulatory arbitrage otherwise not available to plain vanilla debentures. This is indicative of what the market perceives as a bottleneck or a disadvantage, and what the market desires.

This, in itself, may call for a relook at the extant regulatory framework. Relaxations or exemptions should be considered where laws are not meeting the requisite purpose or are harsher than required, except where such relaxations become unconscionable or go against the basic tenets of policy-making.

 

 

 

 

2020 – Year of changes for AIFs

Timothy Lopes – Senior Executive                                                                             CS Harshil Matalia – Assistant Manager

finserv@vinodkothari.com

The year 2020 – ‘Year of pandemic’, rather we can say the year of astonishing events for everyone over the globe. Without any doubt, this year has also been a roller coaster ride for Alternative Investment Funds (‘AIFs’) with several changes in the regulatory framework governing AIFs in India.

Recent Regulatory Changes for AIFs

In continuation to the stream of changes, Securities Exchange Board of India (‘SEBI’), in its board meeting dated September 29, 2020, has approved certain amendments to the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’). The said amendments have been notified by the SEBI vide notification dated October 19, 2020. The following article throws some light on SEBI (AIFs) Amendment Regulations, 2020 (‘Amendment Regulations’) and tries to analyse its impact on AIFs.

Clarification on Eligibility Criteria

Regulation 4 of AIF Regulations prescribes eligibility criteria for obtaining registration as AIF with SEBI. Prior to the amendment,  Regulation 4(g), provided as follows:

“4 (g) the key investment team of the Manager of Alternative Investment Fund has adequate experience, with at least one key personnel having not less than five years experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets and has relevant professional qualification;”

The amended provision to 4 (g) extends the meaning of relevant professional qualification, the effect of which seems to add more qualitative criteria to the management team of the AIF, to be evaluated  at the time of grant of certification. The newly amended section 4(g) of the AIF Regulations reads as follow:

“(g) The key investment team of the Manager of Alternative Investment Fund has –

  • adequate experience, with at least one key personnel having not less than five years of experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets; and
  • at least one key personnel with professional qualification in finance, accountancy, business management, commerce, economics, capital market or banking from a university or an institution recognized by the Central Government or any State Government or a foreign university, or a CFA charter from the CFA institute or any other qualification as may be specified by the Board:

Provided that the requirements of experience and professional qualification as specified in regulation 4(g)(i) and 4(g)(ii) may also be fulfilled by the same key personnel.”

It is apparent from the prima facie comparison of language that the key investment team of the Manager may have one key person with five years of experience (quantitative) as well as a personnel holding professional qualification (qualitative) from institutions recognised under the regulation. Further, clarity has been appended in form of proviso to the section that quantitative and qualitative requirements could be met by either one person, or it could be achieved collectively by more than one person in the fund.

With this elaboration, SEBI has harmonized the qualification requirements as that with the requirement specified for other intermediaries such as Investment Advisers, Research Analysts etc. in their respective regulations. Detailed prescription on degrees and qualifications for AIF registration by SEBI is a conferring move and is expected to aid as a clear pre-requisite on expectations of SEBI from prospective applications for registration of the fund.

Formation of Investment Committee

Regulation 20 of AIF Regulations specifies general obligations of AIFs. Erstwhile, the responsibility of making investment decisions was upon the manager of AIFs. It has been noticed by the SEBI from the disclosures made in draft Private Placement Memorandums (‘PPMs’) filed by AIFs for launch of new schemes, that generally Managers prefer to constitute an Investment Committee to be involved in the process of taking investment decisions for the AIF. However, there was no corresponding obligation in the AIF Regulations explicitly recognizing the ‘Investment Committee’ to take investment decisions for AIFs. Such Investment Committees may comprise of internal or external members such as employees/directors/partners of the Manager, nominees of the Sponsor, employees of Group Companies of the Sponsor/ Manager, domain experts, investors or their nominees etc.

These  amendments are based on the recommendations to SEBI to recognize the practice followed by AIFs to delegate decision making to the Investment Committee.[1] The rationale behind amendments to AIF Regulations is based on the following merits as proposed in the recommendations::

  1. Presence of investors or Sponsors or their nominees in an Investment Committee which may serve to improve the due diligence carried out by the Manager, as they are stakeholders in the AIF’s investments.
  2. Presence of functional resources from affiliate/group companies of the Manager (legal advisor, compliance advisor, financial advisor etc.) in the Investment Committee may be useful to ensure compliance with all applicable laws.
  3. Presence of domain experts in the committee may provide comfort to the investors regarding suitability of the investment decisions, as the investment team of the Manager may not have domain expertise in all industries/ sectors where the fund proposes to invest.

Thus, the insertion was made, giving the option to the Manager to constitute an investment committee subject to the following conditions laid down in the newly inserted sub-regulation, i.e. Regulation 20(6) of the AIF Regulations given below –

  1. The members of the Investment Committee shall be equally responsible as the Manager for investment decisions of the AIF.
  2. The Manager and members of the Investment Committee shall jointly and severally ensure that the investments of the AIF comply with the provisions of AIF Regulations, the terms of the placement memorandum, agreement made with the investor, any other fund documents and any other applicable law.
  3. External members whose names are not disclosed in the placement memorandum or agreement made with the investor or any other fund documents at the time of on-boarding investors shall be appointed to the Investment Committee only with the consent of at least seventy five percent of the investors by value of their investment in the Alternative Investment Fund or scheme.
  4. Any other conditions as specified by the SEBI from time to time.

The constitution of investment committee is a global standard practice followed by the Funds. However, funds structure in India might be altered with the new defining role of investment committee under the AIF Regulations. The investment committee generally comprises of nominees of large investors in the fund and at times other external independent professional bodies that act as a consenting body towards prospective deals of the fund. The amendment will alter the role of investors holding positions at investment committee as the new defining role might deter them from taking underlying obligations. From the funds perspective seeking external independent professionals might get costly as there is an obligation introduced by way of this amendment regulation. Further, it casts an onus on the investment committee to be involved in day to day functioning of the fund, which used to be otherwise (where members were usually involved in mere finalising the deals).  Lateral entry of the members to investment committee post placement of memorandum with the consent of investors is aimed at greater transparency in funds functioning.

Test for indirect foreign investment by an AIF

As per Clause 4 of Schedule VIII of FEMA (Non-Debt Instrument) Rules, 2019 (‘NDI Rules’) any investment made by an Investment Vehicle into an Indian entity shall be reckoned as indirect foreign investment for the investee Indian entity if the Sponsor or the Manager or the Investment Manager –

(i) is not owned and not controlled by resident Indian citizens or;

(ii) is owned or controlled by persons resident outside India.

Therefore, in order to determine whether the investment made by AIFs in Indian entity is indirect foreign investment, it is essential to identify the nature of the Manager/Sponsor/investment manager, whether he is owned or controlled by a resident Indian citizen or person resident outside India.

RBI in its reply to SEBI’s query on downstream investment had clarified that since investment decisions of an AIF are taken by its Manager or Sponsor, the downstream investment guidelines for AIFs were focused on ownership and control of Manager or Sponsor. Thus, if the Manager or Sponsor is owned or controlled by a non-resident Indian citizen or by person resident outside India then investment made by such AIF shall be considered as indirect foreign investment.

Whether an investment decision made by the Investment Committee of AIF consisting of external members who are not Indian resident citizens would amount to indirect foreign investment?

In light of the above provisions of the NDI Rules and with the introduction of the concept of an “Investment Committee”, SEBI has sought clarification from the Government and RBI vide its letter dated September 07, 2020[2].

Conclusion

With the enhancement in eligibility criteria, SEBI has ensured that the investment management team of the AIF would have relevant expertise and required skill sets.

Further, giving recognition to the concept of an investment committee will cast an obligation on investment committee fiduciary like obligations towards all the investors in the fund. . However, there exists certain ambiguity under the NDI Rules, for applications wherein external members of investment committee who are not ‘resident Indian citizens’,   which is currently on hold and pending receipt of clarification.

[1] https://www.sebi.gov.in/sebi_data/meetingfiles/oct-2020/1602830063415_1.pdf

[2] https://www.sebi.gov.in/sebiweb/about/AboutAction.do?doBoardMeeting=yes

SEBI’s stringent norms for secured debentures

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

[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

This New Year brings more complexity to bond issuance as SEBI makes it cumbersome for DTs and Issuers

Due diligence, consents/NOC, Charge creation before listing coupled with mandatory listing deadline may be daunting compliance

FCS Vinita Nair | Senior Partner, Vinod Kothari & Company

When the going gets tough, the tough gets going; however, this may not hold good for issuers and debenture trustees (DT) in case of secured debentures intended to be issued and listed on or after January 1, 2021. SEBI, vide Circular dated November 3, 2020[1] (‘November 3 Circular’), has rolled out norms on several aspects of 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. Among other things, the November 3 Circular requires creation of security interest before listing, and if one combines it with the standardization of timeline for listing of securities issued on private placement basis (effective from December 1, 2020) which requires application for listing to be made within 4 trading days of closure of issue, issuers will be fighting for breath in making listing applications on allotment. Additionally, DTs have been loaded with the responsibility of giving two certifications giving their affirmation of due diligence, mainly dealing with security cover creation and maintenance. One forms part of the disclosure document, another is to be submitted along with the listing application.

The inspiration for the changes is not difficult to understand – some of the recent defaults with financial sector issuers saw violations of asset cover norms and potential overlaps in assets for multiple issuances. However, it will be curious to see whether the revised norms will be easy to comply, given the fact that most of the issuances in India are from the financial sector, and the assets in all such cases are a fluid pool of receivables.

The November Circular deals with following:

  1. Documents/ Consents required at the time of entering into DT agreement;
  2. Due diligence by DT for creation of security;
  3. Disclosures in the offer document (OD) or Private Placement Memorandum (PPM)/ Information Memorandum (IM) and filing of OD or PPM/ IM by the Issuer
  4. Creation and registration of charge in relation to security by Issuer.

Thereafter, on November 13, 2020 SEBI issued circular on Monitoring and Disclosures by DT[4] (November 12 Circular) that is effective from quarter ended on December 31, 2020 for listed debt securities. The November 12 Circular deals with following:

  1. Monitoring of ‘security created’ / ‘assets on which charge is created’;
  2. Action to be taken in case of breach of covenants or terms of issue;
  3. Disclosure on website by DT;
  4. Reporting of regulatory compliance

This article discusses the impact that the both the aforesaid circulars will have on issue of secured debentures. The November Circular is applicable in case of public issue as well as private placement of debt securities. Having said this, it is well known fact that the market in India is essentially a market for private placements, mostly bespoke, mostly secured on loans and receivables.

Information to be provided at the time of entering DT Agreement

DT Agreement is entered into by the issuer with the DT in accordance with Regulation 13 of DT Regulations before the opening of the subscription list for issue of debentures. The agreement mainly contains an undertaking in relation to compliance with applicable law for allotment till redemption of debentures and the time limit within which the security shall be created. However, the November 3 Circular mandates furnishing of following documents by the issuer at the time of entering into DT Agreement. Additionally, the terms and conditions with respect to exercising due diligence shall also be included in the debenture trustee agreement.

The detailed list to be furnished is given in Annexure 1. Basis the nature of security, the DT is required to submit details periodically to the stock exchange as per November 12 Circular. Certain critical issues are discussed hereunder.

  1. In case of security created on moveable/ immoveable property, the issuer is required to give copy of evidence of registration with Sub-registrar, Registrar of Companies, Central Registry of Securitization Asset Reconstruction and Security Interest (CERSAI) etc even prior to issuance of debentures. [Para 4.1 of November 3 Circular].
  2. Further, in case of encumbered assets, Consent/ No-objection certificate (NOC) from existing charge holders. [Para 4.3(b) of November 3 Circular]. In several cases, issuers have common DT for all issuances and the charge is created in favour of DT. There should be suitable carve out or exemption in those cases as the DT cannot be furnishing Consent/ NOC to itself.
  3. In case of negative lien created by issuer, Consent/NOC is required to be obtained from existing unsecured lenders [Para 4.3(c) of November 3 Circular]. By definition, if the creditor is unsecured, there is no question of the creditor having any right over any asset. Hence, the question of any consent of unsecured lenders does not arise. In case of negative lien, the issuer agrees to keep the agreed quantum of assets free from encumbrance, therefore, the requirement of seeking consent/NOC is not justified.
  4. In case of corporate guarantee, the guarantor is required to furnish audited financial statements (not older than 6 months from the date of debenture trustee agreement) giving details of all contingent liabilities [Para 4.3(c) of November 3 Circular]. The issuers intending to list debt securities are permitted to submit limited reviewed financial results and not necessarily audited financial statements. However, the guarantor is required to furnish latest audited financial statements.

Submission of periodic reports by DT to Stock Exchange (SE)

As per November 12 Circular, the DT is required to submit following to the SE for every issuer.

Periodicity Nature of submission Timeline Format Remarks
Quarterly
  • Asset Cover Certificate;
  • Statement of value of pledged securities;
  • Statement of value of Debt Service Reserve Account or any other form of security offered;
Within 60 days from end of each quarter Annexure A to November 12 Circular
  • Details of all outstanding issuance is to be furnished.
  • Asset cover details to be furnished ISIN wise for secured as well as unsecured debt securities.
  • Formula for computation of asset cover has been provided in Table I for secured debt and Table II for unsecured debt in November 12 Circular.
  • The DT will also confirm compliance on the covenants and terms of issue.
Half yearly Net worth certificate of guarantor (in case of personal guarantee) Within 60 days from end of each half year NA  
Annually
  • Financials/ value of guarantor prepared on basis of audited financial statement etc. of the guarantor (secured by way of corporate guarantee)
  • Valuation report and title search report for immoveable/ moveable assets, as applicable.
Within 75 days from end of each financial year. NA  

Enabling provision in DTD

As per November 12 Circular, the DT is required to incorporate the terms and conditions of periodical monitoring in the DTD pursuant to which the issuer will be liable to share information to enable DT to submit details to the stock exchange as provided in table above. For existing debt securities, issuers and DT shall enter into supplemental/amended debenture trust deed within 120 days from November 12 2020 incorporating the changes in the DTD.  In  case,  a  listed  entity  has  more  than  one  DT  for  its  listed  debt securities, then DTs may choose a common agency for preparation of asset cover certificate.

Due diligence by DT for creation of security

The due diligence may be carried out by the DTs by itself or through its advisers or experts. The DT, by itself or through its appointed agencies viz. chartered accountant firm, registered valuer, legal counsel etc., is required to prepare one or more reports viz. valuation report, ROC search report, title search report/ appraisal report, asset cover certificate, any other report/ certificate as applicable etc. The DT is also required to independently assess that the assets for creation of security are adequate for the proposed issue of debt securities. DTs are required to maintain records and documents pertaining to due diligence exercised for a minimum period of 5 years from redemption of the debt securities.

List of documents to be verified during due diligence and the format of due diligence certificate in given as Annexure 2. Certain issues in relation to the same is discussed hereunder:

  1. There is no clarity on who is to bear the cost of due diligence. If the same is to be borne by the issuer, the issue expense will increase. The issuer will be required to provide due diligence certificates obtained from DT, one at the time of filing the OD or PPM/IM and another at the time of filing the listing application.
  2. In case of creation of further charge on assets, the DT is required to intimate to 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 DT within next 5 working days. [Para 6.1 (b) (ii) of November 3 Circular]. Further, information about the consents is required to be furnished in the OD or PPM/IM.

In several cases, issuers have common DT for all issuances and the charge is created in favour of DT. There should be suitable carve out or exemption in those cases as the DT cannot be intimating and seeking its own comments/objections.

In case of private placement, where the issue opens, closes and debentures are allotted on same day, the process will have to be commenced much before opening of offer, given the requirement to wait for 5 working days.

Disclosure in OD or PPM/IM by issuer

The issuer is required to disclose following in the OD or PPM/IM:

  • “Debt securities shall be considered as secured only if the charged asset is registered with Sub-registrar and Registrar of Companies or CERSAI or Depository etc., as applicable, or is independently verifiable by the debenture trustee.”
  • Terms and conditions of DT agreement including fees charged by debenture trustees(s), details of security to be created and process of due diligence carried out by the debenture trustee;
  • Due diligence certificate (To be furnished at the time of filing OD or PPM/IM)

Creation of security

The November 3 Circular mandates creation of charge prior to listing. Due diligence certificate confirming execution of DTD and creation of charge is required to be furnished along with listing application.

The November 3 Circular, further mandates registration of charge within 30 days of creation. Failure to register the charge within 30 days of creation (as opposed to 120 days permitted under Act, 2013) will be considered as breach of covenants/terms of the issue by the Issuer.

What will be the consequence of breach of covenant? Whether it will deemed as an event of default requiring redemption? In our view, this may not be required. As per November 12 Circular, in case of breach of covenants or terms of the issue by listed entity, the DT shall  take  steps  as  outlined  in  para  6.1  and  6.3  of  SEBI  Circular SEBI/HO/MIRSD/CRADT/CIR/P/2020/203 dated October 13, 2020[5] (October Circular). Para 6.1 and 6.3 of the October Circular mandates DT to send notice to investors within 3 days of event of default and convene meeting of the investors within 30 days of the event of default. The DT shall thereafter take necessary action as decided in the meeting of holders of debt securities in this regard. One needs to ascertain if meeting of debenture holders is relevant for delay in creation of charge.

As evident from the format of certificate given at the time of listing, the DTD is required to be executed before listing (as opposed to 3 months from the date of closure of an issue or an offer under ILDS Regulations and CA, 2013)

Disclosure on website by DT

The consultation paper provided for certain mandatory disclosures to be made by DT on the website. The November 12 Circular provides list of disclosures to be made along with the format prescribed in Annexure B thereto.

Disclosure prescribed in Consultation Paper Disclosure required to be made as per November 12 Circular Periodicity and Timeline Information to be furnished as per the format prescribed
Quarterly Compliance Reports received from the issuers Monitoring of Asset cover certificate and  Quarterly  compliance  report  of the listed entity Quarterly basis. Within 60 days of end of each quarter.
  • Confirmation about receipt of periodical status/ performance report from listed entity to be provided;
  • Information about utilisation certificate, asset cover certificate and asset cover ratio maintained is required to be furnished.
Compliance status on the receipt of asset cover from the issuers, maintenance of various funds by the issuers Covered above    
Defaults by the company Status of information regarding any default  by  listed  entity  and  action taken by debenture trustee Annually. Within 75 days of end of financial year. Details of default, date of intimating and sending notice to debenture holders, results of voting, date of meeting, date of enforcement, date of other actions viz. joining ICA, appointment of nominee director etc to be furnished.
Status of the proceedings of the cases under default Covered above    
Compliance status of each covenant-issue wise on a half yearly basis Status  of  information  regarding breach  of  covenants/terms  of  the issue,  if  any  action  taken  by debenture trustee Half yearly basis. Within 60 days of end of each half year. Details of covenants/ terms of issue breached during HY, details of security to be enforced, date of actual breach, detecting the breach and date of intimation to debenture holders, SE, SEBI etc to be provided.
Revision in Credit ratings Continuous    basis within  T+1  day  from receipt of information Details of immediate previous credit rating and revised credit rating, along with hyperlink of the press release of the CRA to be furnished.
Status  of  payment  of  interest/ principal by the listed entity Continuous    basis within  T+1  day  from receipt of information Status of Payment (Default / Delayed / Non-Cooperation, No Information etc. to be furnished along with date of information given to SE and CRA by DT and other actions taken by DT.
Details of Debenture issues handled by debenture trustee and their status Half yearly basis. Within 60 days of end of each half year. Details of issues accepted during HY, issues fully redeemed during HY, issues outstanding during HY and cumulative issue handled during HY to be furnished.
Complaints  received  by  debenture trustee(s) including default cases Half yearly basis. Within 60 days of end of each half year. Details of complaints pending prior to, received during, resolved during and pending at the end of half year to be furnished.
  Status  regarding  maintenance  of accounts    maintained    under supervision of debenture trustee Annually. Within 75 days of end of financial year. Details of maintenance of DRR, DRF, recovery expense fund, Accounts/ funds in case of municipal debt securities to be provided.
  Monitoring of Utilization Certificate Annually. Within 75 days of end of financial year. Information about utilisation certificate furnished on quarterly basis while monitoring asset cover.

Tough time ahead

As per SEBI Circular dated October 5, 2020[6] effective for issuance made on or after December 1, 2020, listing of private placement will be required to be done within 4 trading days from closure of issue, failing which, the issuer 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 penalty will be separately payable. Given the procedural compliances given in the November Circular, it will be challenging for the issuer as well as DT to achieve the timeline.

While, SEBI has rolled out stringent norms for issue and listing of secured debentures, one will have to see how equipped the DTs are to carry out the due diligence and ensure adherence by issuer to these stringent timelines, given the quantum of secured debt issuance done by various issuers. Additional compliances imposed on the DT in terms of November 12 Circular will further add actionables for the DT and also on the issuers as the said information will be required to be furnished by the issuer. Disclosures regarding performance of the DTs, as was proposed in the consultation paper, has not been enforced yet.

In view of increased complexity in issuance of secured debentures, Corporates may consider opting for unsecured debt issuances. Further, Issuers and DTs will have to pull up socks to comply with several actionables lined up this New Year.

 

Annexure 1

Sr. No. Nature of securities extended by Issuer Information/Documents required to be furnished to Debenture Trustee
1. Movable property and Immovable property
  • Details of assets including title deeds (original/ certified true copy by issuers/ certified true copy by existing charge holders, as available) or;
  • title reports issued by a legal counsel/ advocates;
  • copies of the relevant agreements/ Memorandum of Understanding;
  • copy of evidence of registration with Sub-registrar, Registrar of Companies, Central Registry of Securitization Asset Reconstruction and Security Interest (CERSAI) etc.
2. Unencumbered assets
  • An undertaking that the assets on which charge is proposed to be created are free from any encumbrances.

 

3. Encumbered assets Following consents along-with their validity as on date of their submission:

  • Details of existing charge over the assets along with details of charge holders, value/ amount, copy of evidence of registration with Sub-registrar, Registrar of Companies, CERSAI, Information Utility (IU) registered with Insolvency and Bankruptcy Board of India (IBBI) etc. as applicable;
  • Consent/ No-objection certificate (NOC) from existing charge holders for further creation of charge on the assets or relevant transaction documents wherein existing charge holders have given conditional consent/ permission to the Issuer to create further charge on the assets, along-with terms of such conditional consent/ permission, if any;
  • Consent/ NOC from existing unsecured lenders, in case, negative lien is created by Issuer in favour of unsecured lenders.
4. Personal guarantee or any other document/ letter with similar intent
  • Details of guarantor viz. relationship with the Issuer;
  • Net worth statement (not older than 6 months from the date of debenture trustee agreement) certified by a chartered accountant of the guarantor;
  • List of assets of the guarantor including undertakings/ consent/ NOC as mentioned in Sr. No. 2 and 3 above;
  • Conditions of invocation of guarantee including details of put options or any other terms and conditions which may impact the security created;
  • Executed copies of previously entered agreements for providing guarantee to any other person, if any.
5. Corporate guarantee or any other document/ letter with similar intent
  • Details of guarantor viz. holding/ subsidiary/ associate company etc.;
  • Audited financial statements (not older than 6 months from the date of debenture trustee agreement) of guarantor including details of all contingent liabilities;
  • List of assets of the guarantor along-with undertakings/ consent/ NOC as mentioned in Sr. No. 2 and 3 above;
  • Conditions of invocation of guarantee including details of put options or any other terms and conditions which may impact the security created;
  • Impact on the security in case of restructuring activity of the guarantor;
  • Undertaking by the guarantor that the guarantee shall be disclosed as “contingent liability” in the “notes to accounts” of financial statement of the guarantor;
  • Copy of Board resolution of the guarantor for the guarantee provided in respect of the debt securities of the Issuer;
  • Executed copies of previously entered agreements for providing guarantee to any other person, if any.
6. Securities such as equity shares etc.
  • Holding statement from the depository participant along-with an undertaking that these securities shall be pledged in favour of debenture trustee(s) in the depository system.
7. Any other form of security
  • Debt Service Reserve Account etc.

Table 1: Information/Documents required to be furnished to Debenture Trustee

Annexure 2

The due diligence w.r.t. creation of security shall inter-alia include the following:

Nature of Security and things required to be verified by DT Manner of verification
1.  Assets provided by the issuer for creation of security are:

a.  free from any encumbrances; or

b.  necessary permissions or consents has been obtained from existing charge holders

 

1.  Verify from Registrar of Companies, Sub-registrar, CERSAI, IU or other sources where charge is registered/disclosed as per terms.

2.  In case where existing charge holders have given a conditional consent/ permission to the issuer to create further charge on the asset, DT will be required to verify following:

a.  Verify whether such conditional consent/ permission given to issuer by existing charge holders is valid as per terms of transaction documents;

b.  Intimate to 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 DT within next 5 working days.

2.  Personal guarantee, corporate guarantee and any other guarantees/form of security. Verify from relevant filings made on websites of MCA, Stock Exchange(s), CIBIL, IU etc. and obtain appraisal report, necessary financial certificates viz. from the statutory auditor in case of corporate guarantee, certificate from Chartered Accountant in case of personal guarantee, as applicable, of the guarantor/ issuer.

Table 2: Due diligence by DT at the time of creation of security

 

Contents of due diligence certificate

To be furnished at the time of filing OD or PPM/IM To be furnished at the time of filing listing application
  • Adequate provision has been made to provide adequate security for the debt securities to be issued;
  • Issuer has obtained necessary permissions/consents for creation of security, further charge;
  • Issuer has made all relevant disclosures, including all covenants proposed to be included in OD or PPM/IM.
  • Issuer has given an undertaking that charge shall be created in favour of DT.
  • The issuer has created charge over its assets in favour of DTs;
  • The issuer has executed Debenture Trust Deed (DTD) and DT agreement;
  • The issuer has given undertaking for registration of charge within 30 days of creation.

Table 3: Contents of Due diligence certificate to be furnished by DT

 

[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://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/standardization-of-timeline-for-listing-of-securities-issued-on-a-private-placement-basis_47790.htm

 

Other reading materials on the similar topic:

  1. ‘SEBI responds to payment defaults by empowering Debenture Trustees’  can be read here
  2. 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

 

SEBI subtly mandates debt listed companies to prepare quarterly financial results

Stock exchange circular stipulates submission of financials not older than 6 months

Aanchal Kaur Nagpal | Senior Executive, Vinod Kothari & Company

 

NSE, vide clarification dated 14th July, 2020[1], has clarified that audited financials or unaudited financials with limited review, submitted by issuers for listing of their privately placed debentures, including for the stub period, shall not be older than 6 months from the date of the private placement disclosure document.

Schedule I to SEBI (ILDS) Regulations, 2008 mandates furnishing financial parameters upto latest half year in the offer document in addition to providing abridged version of audited consolidated (wherever available) and standalone financial information ( like profit & loss statement, balance sheet and cash flow statement) for at least last three years and auditor qualifications , if any and abridged version of latest audited / limited review half yearly consolidated (wherever available) and standalone financial information (like profit & loss statement, and balance sheet) and auditors qualifications, if any.

There was no express requirement that the half yearly financial results being submitted cannot be older than 6 months. In case of Commercial Paper (‘CPs), SEBI had expressly specified that the audited financial statements to be submitted by an issuer intending to list its CPs, shall not be older than 6 months from the date of the application of listing. [Para 5.2 of Annexure I of SEBI Circular on Framework for Listing CPs dated 22nd October, 2019[2]]

Carve out from the above requirement was provided, as amended vide SEBI Circular dated December 24, 2019[3], to listed issuers who were in compliance with SEBI (LODR) Regulations, 2015. Such listed entities could file unaudited financials with limited review for the stub period in the current financial year, subject to making necessary disclosures in this regard including risk factors.

Impact:

While a clarification in the above context was much needed, however the requirement for financials to be not older than 6 months would pose difficulties on debt-listed companies.

Debt listed entities are required to prepare financials (unaudited or audited) on a half yearly basis within 45 days (except in case of advance intimation) from the end of each half year [Regulation 52(1) of LODR Regulations] while equity listed entities are required to prepare the financials on a quarterly basis within 45 days from the end of each quarter and within 60 days from the financial end of the year for annual financials.

The aforementioned clarification will not impact the following companies:

  1. Equity-listed entities intending to list their privately placed debentures as they would be preparing quarterly financials;
  2. Debt-listed entities that are subsidiaries of equity-listed entities as they would be required to prepare quarterly financials for the purpose of consolidation with their holding equity-listed entity.

However, debt listed entities that are neither subsidiaries of equity listed entities nor having their specified securities listed, won’t be able to raise funds pursuant to issuance of NCDs if the financials are older than 6 months.

Debt-listed entities are required to prepare their financials within the following due dates:

Period of Financials Due Date Period during which financials would be more than 6 months old
Half year ended 31st March 15th May 1st April to 14th May
Half year ended 30th September 15th November 1st October to 14th November

For e.g. a debt listed entity won’t be able to list debt securities on Oct 1 based on financial results of March 31. Such companies will have to either prepare quarterly financials till June 30 or get the half yearly results for September 30 finalized on priority.

Clarity or Complication?

The said NSE clarification serves as a complication rather than a clarity. The said circular strains the ability to raise funds by debt-listed entities. NBFCs too would take a huge hit due to the said restriction on raising funds during periods where latest financials are not available. Where the world is already in a crisis due to the COVID-19 pandemic, liquidity of the debt market becomes all the more crucial.

On one hand, SEBI has mandated Large Corporates to raise minimum 25% of their incremental borrowings, by way of issuance of debt securities (as defined under SEBI ILDS Regulations), and on the other restriction by way of the said clarification has been imposed wherein the debt listed entities will have to prepare financials on a quarterly basis to be able to issue and list privately placed debt securities as and when there is requirement of funds.

[1] https://www.sebi.gov.in/legal/circulars/dec-2019/framework-for-listing-of-commercial-paper-amendments_45448.html

[2] https://www1.nseindia.com/content/debt/NSE_Circular_14072020_1.pdf

[3] https://www.sebi.gov.in/legal/circulars/oct-2019/framework-for-listing-of-commercial-paper_44715.html