Moratorium on asset classification of past due accounts
– Anita Baid, finserv@vinodkothari.com
(Updated as on 24.04.2020)
Background
Due to sudden out-break and spread of COVID-19 across the globe, economic condition of the financial service sector has been adversely affected. In this regard RBI has issued several guidelines and advisories and brought into place regulatory polices to give benefit to the borrowers to ease the financial crisis. The Reserve Bank of India in its Statement of Development and Regulatory Policies dated March 27, 2020[1] has permitted banks and non-banking financial institutions to provide a moratorium to borrowers for a period of 3 months. Thereafter, the RBI came up with a notification titled COVID 19 Regulatory Package[2] providing a brief guideline about the relaxation. This was followed by the FAQs on RBI’s scheme for a 3-month moratorium on loan repayment[3] issued by the Ministry of Finance.
However, there are still certain issues that are not clear and due to the ambiguity around such issues, banks and NBFCs have been making their own interpretation[4]. One such major issue was with respect to the grant of moratorium to loan accounts having over dues as on March 1, 2020.
Regulatory Package by RBI
Before examining the issue let us understand that the underlying objective of the RBI’s guidelines was to inter-alia ease the financial stress caused by COVID-19 disruptions by relaxing repayment pressures and improving access to working capital. The COVID -19 Regulatory Package provides for rescheduling of the payments in respect of term loans and working capital facilities.
Several contentions have been raised stating that the moratorium is not applicable to the borrowers who are already in default as on March 1, 2020. The argument to support this contention is that the language of the Regulatory Package clearly states that the three month moratorium is applicable only to those instalments which fall due between March 1, 2020 and May 31, 2020. Accordingly, only those borrowers would be covered whose loan account is outstanding as on March 1, 2020 and were properly servicing their account till that date and were not in default.
This was further supported by a clarification issued by letter dated March 31, 2020 by the Chief General Manager-in-charge, Department of Regulation of the RBI to the Chairman, Indian Banks Association, wherein it stated that if a borrower has been in default even before March 1, 2020, such default cannot be said to be as a result of economic fall due pandemic and benefit of moratorium can be extended to such borrower in respect of payment falling due during the period March 1, 2020 to May 31, 2020. However, payments overdue on or before February 29, 2020 will attract the current Income Recognition and Asset Classification Guidelines (IRAC Guidelines)[5].
Such an approach will cause all past due accounts to become NPAs during the disruption period, and therefore, the regulatory recognition of the disruption period as not a case of contractual failure but a case of systemic failure, gets defeated. The relaxation or grant of moratorium presumes that during the period of March 1, 2020 to May 31, 2020, the borrower has not paid due to a systemic disruption. If the logic of disruption applies to the current dues during the moratorium period, the same logic cannot be inapplicable for the past dues.
For example, a borrower had payments due on February 29, 2020 which was 30 DPD. In case he cleared all his dues, say on 31st March, his account, which was, say, 60 DPD on 29th March, would have been a regular standard account. But the borrower was precluded from paying anything during the disruption period. Thus, the opportunity of clearing any past due payment is not available to the borrower during the period of disruption. What is a “default” on 1st March, 2020 continues to be a default, but the ageing of the default cannot increase during the disrupted period. The disruption is not a credit event, perhaps, it is an externality, and admittedly a force majeure. Therefore, the disruption causes a standstill on the obligations of the borrower.
The period of disruption is a period during which the clock of the payments in the system stops. If the ageing of past receivables changes, then the disruption will cause all regular accounts to become irregular. In such a case even a 10 DPD on February 29, 2020 will become an NPA around May 19, 2020. Such an approach will cause all past due accounts to become NPAs during the disruption period, and therefore, the regulatory recognition of the disruption period as not a case of contractual failure but a case of systemic failure, gets defeated.
Delhi High Court Ruling
The recent judgement of the Hon’ble Delhi High Court in the case of Anant Raj Limited Vs. Yes Bank Limited dated April 6, 2020[6] has given a different perspective to the entire situation.
The matter of dispute was the asset classification of the petitioner. The petitioner’s instalment that was due on 01.01.2020 was not paid within 30 days, due to which the account was classified as SMA-1 and thereafter since it was not paid within 60 days, the account was classified as SMA-2. Further, it was contended that since the instalment was not paid till 31.03.2020, the account of the petitioner was liable to be classified as NPA.
The court considered the fact that in view of the pandemic COVID-19, RBI has issued several guidelines and advisories and brought into place regulatory polices to give benefit to the borrowers to ease the financial crisis. The intention of the RBI is to maintain status quo as on March 1, 2020 with regard to all the instalments payment which had to be made post March 1, 2020 till May 31, 2020. Further, the relevant provision of the Regulatory Package with respect to classification of accounts also indicates that the intention of RBI is to maintain status quo with regard to the classification of accounts of the borrowers as they existed as on 01.03.2020. The relevant extract of the judgement is as follows:
- The restriction on change in classification as mentioned in the Regulatory Package shows that RBI has stipulated that the account which has been classified as SMA-2 cannot further be classified as a non-performing asset in case the instalment is not paid during the moratorium period i.e. between 01.03.2020 and 31.05.2020 and status quo qua the classification as SMA-2 shall have to be maintained.
This implies that for a period of three months there will be a moratorium from payment of the instalment. However, interest shall continue to accrue on the outstanding payment even during the moratorium period. Further, in case the borrower fails to pay the said instalment after the expiry of moratorium, the asset classification would change as per the IRAC Guidelines.
Bombay High Court Ruling
The Bombay HC has also taken a similar view on the issue of asset classification during moratorium. In the case of ICICI Bank against two real estate companies, namely Transcon Skycity Pvt. Ltd. and Transcon Iconica Pvt. Ltd.[7], the HC has directed ICICI Bank to exclude the period of moratorium amid coronavirus lockdown while computing 90 days for declaration of non-performing assets.
As per the facts of the case, the petitioner companies had availed finance facilities from ICICI Bank, which were to be repaid in instalments, but they failed in repaying two instalments. As per RBI norms, for classification of accounts as NPA, the 90-days period would end during the current lockdown period. The plea of the petitioners was to restrain ICICI Bank from taking any coercive actions against them and sought the court’s declaration that they were entitled to benefits under the RBI’s relief packages permitting lending institutions to allow a three month moratorium on all loan repayments.
It was contented by the petitioners that if the moratorium period is not excluded from the NPA declaration period, the moratorium itself would be meaningless in situations such as those of petitioners. The HC also drew reference to the Delhi HC ruling discussed above, which concluded that the purpose of the moratorium and the entire rationale would be nullified if moratorium isn’t extended for accounts outstanding as on March 1, 2020.
The HC held that the moratorium period of March 1 till May 31, 2020 during which there is a lockdown will stand excluded from the NPA declaration computation until the lockdown is lifted. It further clarified that the relief is co-terminus with the lockdown period and not the declared end of the moratorium. The exclusion from the 90-day NPA-declaration timer and countdown can only therefore operate during the lockdown period and will end upon the complete lifting of the lockdown.
However, the concluding remarks of the order makes this a case specific decision. The HC cautioned that this order will not serve as a precedent for any other case in regard to any other borrower who is in default or any other bank and that each of these cases will have to be assessed on their own merits.
Another Ruling by Delhi HC
The Delhi HC has again addressed the issue of applicability of the moratorium period in the classification of an asset as an NPA. In the case of Shakuntala Educational & Welfare Society v Punjab & Sind Bank[8] the petitioner was a charitable society engaged in the business of technical and higher education which had sought the benefit of the moratorium period for loans that were due on December 31, 2019, and were payable until March 31, 2020.
The petitioner has been diligently making repayments in accordance with the restructured plan of it remaining two terms loan but before the instalments payable in March, 2020, could be paid, the pandemic COVID had set in and consequently the RBI permitted grant of three month moratorium, vide its circular dated March 27, 2020, in respect of all term loans as outstanding on March 1, 2020. The petitioner was liable to make payment of quarterly instalments, and the default qua instalments in respect whereof the respondent is proposing to declare the petitioner’s accounts as NPA had fallen due on 31.12.2019. However, the petitioner expressed its inability to pay as several of its schools run in Uttar Pradesh (UP) were affected by the state government directive by which they could not insist on students making fee payments.
The HC considered the fact that the petitioner still had time to make the payment of the due instalments till March 31, 2020, before which date on account of the lockdown and directive issued by the State Government, it has been prevented from demanding the due fees from the students of its various institutes.
The HC concurred with the view taken in the ruling discussed above that the regulatory package intended to maintain status quo as on 1 March as far as classification of accounts is concerned. Accordingly, an interim relief was granted to petitioner by restraining the respondent bank from declaring the loans as an NPA until the next hearing. The Court, further, agreed to the proposal of the petitioner and added a caveat in this order stating that in case the directive of the UP government prohibiting fee collection is lifted before the next hearing, the petitioner would be liable to pay the pending dues within one week of such lifting.
Though the HC made reference and agreed to the view taken in the earlier ruling of Anant Raj Limited Vs. Yes Bank regarding maintaining status quo due to the moratorium period, however, the judgement was linked to a specific impact of the lockdown that is, the state government directive. In effect, it has delinked the asset degradation from both the lockdown and the moratorium period.
Conclusion
The first judgement of Delhi HC is in favor of extending the moratorium period to loans outstanding before March 1, 2020 by stating maintenance of status quo and justifying the same by a contextual reading of the RBI’s Regulatory Package, however, the orders in the other two cases are fact specific, one of which even reiterates that it cannot be treated as a precedent.
Deterioration to NPA status has manifold consequences, including provisioning requirement that have an impact of the P&L accounts. For NBFCs, their drawing power from banks comes down as NBFCs are not allowed to borrow against past due receivables. This will exacerbate the liquidity issue with NBFCs. Further, under the ECL provisions under IndAS 109, the continuation of default will cause the bucket of the receivables to move from Bucket 1 to Bucket 2, thereby requiring computation of lifetime expected losses. This may mean a huge impact on long-term receivables, as those in case of housing or project loans.
Post the HC judgement, two things have been clarified:
- An account already classified as NPA as on 29th Feb remains an NPA.
- An account that is not an NPA on 29th Feb and is just classified as SMA then the ageing of the receivable shall not change during the moratorium and any further asset degradation shall not happen.
Accordingly, the possible scenarios can be summarized as follows:
| Existing Asset Classification | Whether moratorium can be granted? | Whether asset classification shall remain stand still? |
| Standard Asset | Yes | Yes |
| SMA-1 | Yes | Yes |
| SMA-2 | Yes | Yes |
| NPA | No | No |
As per the practice adopted by banks and NBFCs, including HFCs, it seems that most of them have extended the moratorium on all standard loans, irrespective of whether they were overdue as on 1st March, 2020. Further, post the HC ruling, the asset classification of account which has been classified as SMA cannot further be classified as a non-performing asset in case the instalment is not paid during the moratorium period and status quo qua the classification as SMA shall have to be maintained. However, there is a possibility that the ruling may be challenged in a higher court, and the outcome of that ruling could be completely different. Therefore, until this ruling is challenged further or any clarification contrary to this issued by the RBI or any other authority, financial institutions may consider this ruling to frame their policy for account classification.
This article is further being updated in accordance with the RBI Governor’s address on April 17, 2020[9] and a subsequent notification[10] on the issue that has clarified the position once and for all. The RBI circular states that in respect of all accounts classified as standard as on February 29, 2020, even if overdue, the moratorium period, wherever granted, shall be excluded by the lender from the number of days past-due for the purpose of asset classification under the IRAC norms. Effectively the circular stalls the dip in the asset classification by 3 months. Further, the asset classification relaxation is provided only if the account was to move from standard to sub-standard category during the moratorium period from March 1, 2020 to May 31, 2020. However, if the account was within the NPA category already, the benefit of the relaxation will not be available.
[1] https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=49582
[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0
[3] https://pib.gov.in/PressReleseDetail.aspx?PRID=1609820
[4] Our detailed FAQs on the subject can be viewed at http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/
[5] In terms of the IRAC Guidelines, if an instalment is overdue by a period of 30 days, the borrower’s account is classified as Special Mention Account 1 (SMA-1) and if the instalment is overdue by 60 days, the account is classified as Special Mention Account 2 (SMA-2) and if the instalment is overdue by a period of 90 days, the account is classified as Non-performing Asset (NPA).
[6] W.P.(C) URGENT 5/2020
[7] WRIT PETITION LD-VC NO. 28 OF 2020 and WRIT PETITION LD-VC NO. 30 OF 2020
[8] W.P.(C)2959/2020
[9] https://rbidocs.rbi.org.in/rdocs/Content/PDFs/GOVERNORSTATEMENTF22E618703AE48A4B2F6EC4A8003F88D.PDF
[10] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11872&Mode=0
Timelines for holding board meetings amid the pandemic COVID 19
Nitu Poddar and Ambika Mehrotra
As one maybe aware that during this period of disruptions caused by COVID 19, several relaxations have ben provided by the Ministry of Corporate Affairs (MCA) vide its Notifications dated 19th March, 2020[1] and March 24, 2020[2] and the Securities and Exchange Board of India (SEBI) vide its Circular dated March 19, 2020[3]. Further the Institute of Company Secretaries of India has also issued its Guidance dated April 4, 2020[4] on the applicability of Secretarial Standards on board and general meetings.
A snapshot of the relaxations granted by the above authorities wrt board meetings are:-
| S. No | MCA for Companies Act, 2013 | SEBI for LODR |
| 1. | Time gap for conducting board meetings relaxed to 180 days from present 120 days – for the first two quarters of FY 2020-2021
i.e BM from 24th March 2020 till 30th September 2020 can be conducted with a larger gap of 180 days
|
Time gap for conducting board and audit committee meeting has been relaxed without any upper limit – for meetings held / proposed to be held between December 1, 2019 and June 30, 2020.
However, it is to be ensured that there are 4 meeting of board and audit committee held during the FY.
|
| 2. | Board meetings can be held through video conferencing or other audio visual means for all matters including the otherwise restricted matters mentioned in Rule 4 of the MBP Rules.
|
The time limit for submitting the annual financial results with the stock exchange has also been extended to June 30 from May 15 (for unaudited results) and May 30 (for audited results) |
| 3. | For the FY 2019-20, a ID meeting per se as per Schedule VI has been relaxed. If the IDs so deem necessary, the views may be shared through telephone / email or any other mode of communication
|
On close perusal of the relaxations granted by MCA and SEBI, it is understood that the relaxations are different for a listed and an unlisted company and the quarter for which the meeting pertains to. The major points to be kept in mind with respect to board meetings are:
- There has to be minimum 4 meetings in the FY;
- The maximum gap between two board meeting cannot be more than 180 days (stricter of the provisions to be applicable – MCA allows maximum time gap of 180 days and SEBI does not prescribes any maximum time gap.
Mostly, listed companies might have had their last board meeting held in the month of Feb, 2020. In that case, the next meeting can be held within 180 days but before 30th June, 2020 since that is the last date of filing financial results for Q4 of FY 2019-20 for both equity and debt[5] listed companies.
It is to be noted that the debt listed companies are required to make half-yearly intimation of financial result u/r 52 of LODR. However, where a debt-listed company is a subsidiary / joint venture or associate of an equity listed company, it needs to prepare and gets its results approved quarterly for the purpose of consolidation.
For unlisted company, the maximum time gap of 180 days is extended till all board meeting to be held before September 30, 2020.
- The relaxation is only with respect to the approval of financial results of Q4 of FY 19-20 which is till June 30, 2020. There is no relaxation w.r.t the approval of financial results for Q1 of FY 20-21. Accordingly, the same will have to be held within 45 days of the end of the quarter; i.e by 14th August, 2020.
In view of the same, we have put together the timelines wrt listed and unlisted companies in the table below:-
| BMs to be held/held during the quarter | MCA Relaxation | SEBI Relaxation | Equity Listed | Debt Listed | Unlisted |
| FY 2019-20 – Q4
|
Maximum time gap between two meetings can be 180 days | Results of Q4 to be approved latest by June 30, 2020
|
BM to be held within June 30, 2020 | BM to be held within June 30, 2020 | Maximum time gap between two meetings can be 180 days |
| FY 2020-21 – Q1
|
Maximum time gap between two meetings can be 180 days | No relaxation currently for approving results of Q1
|
BM to be held within August 14, 2020 | If the financial results are consolidated with an equity listed company – BM to be held within August 14, 2020
If the financial results are not consolidated with an equity listed company – will have to ensure that the gap between two board meeting is not more than 180 days |
|
| FY 2020-21 – Q2
|
Maximum time gap between two meetings can be 180 days | No relaxation currently for approving results of Q2
|
BM to be held within November 14, 2020 |
[1] http://www.mca.gov.in/Ministry/pdf/Rules_19032020.pdf
[2] http://www.mca.gov.in/Ministry/pdf/Circular_25032020.pdf
[3] https://www.sebi.gov.in/legal/circulars/mar-2020/relaxation-from-compliance-with-certain-provisions-of-the-sebi-listing-obligations-and-disclosure-requirements-regulations-2015-due-to-the-covid-19-virus-pandemic_46360.html
[4] https://www.icsi.edu/media/webmodules/Guidance_on_applicability_of_Secretarial_Standards.pdf
[5] https://www.sebi.gov.in/legal/circulars/mar-2020/relaxation-from-compliance-with-certain-provisions-of-the-sebi-listing-obligations-and-disclosure-requirements-regulations-2015-and-certain-sebi-circulars-due-to-the-covid-19-virus-pandemic-cont-_46395.html
FAQs on LLP Settlement Scheme, 2020
Updated as on 29th September, 2020
FAQs on Companies Fresh Start Scheme, 2020
A quick analysis of the Scheme is available at- https://youtu.be/lXUb4l8srM8
Global Securitisation – Are we heading into a coronavirus credit crisis?
Timothy Lopes, Executive, Vinod Kothari Consultants
The global financial credit crisis of 2007-08 was a result of severe financial distress arising out of high level of sub-prime mortgage lending. Top Credit Rating Agencies (CRA) downgraded majority securitization transactions, slashing ‘AAA’ ratings to ‘Junk’.
Sub-prime borrowers could not repay, lenders were weary of lending further, investors investments in Mortgage Backed Securities (MBS) were stagnant and not reaping any return.
All these factors led to one of the worst financial crisis that affected global economies and not just the US alone. Recovering from such a crisis takes ample amount of time and efforts in the form of policy measures and financial stimulus / bail out packages of the government.
The rapid spread and depth of Coronavirus (COVID-19) outbreak has had severe impact across the globe in a matter of months. Stock markets are witnessing a global sell off. Countries have imposed complete lockdowns countrywide in order to mitigate the impact of this pandemic. Securitisation volumes are likely to witness a drop in light of the pandemic.
Daily, the situation only seems to be getting worse due to the unprecedented outbreak of COVID-19 and its rapid spread. There is absolutely no doubt that the impact on the financial sector and on economies worldwide is / will be a negative one.
As stated by the RBI Governor, in his nationwide address on 27th March, 2020 –
“The outlook is now heavily contingent upon the intensity, spread and duration of the pandemic. There is a rising probability that large parts of the global economy will slip into recession”
The question here is, “Are we headed for another global financial crisis?” We try to analyse this question in this write up, in light of the present scenario.
Consensual restructuring of debt obligations, due to COVID disruption, not to be taken as default, clarifies SEBI
Vinod Kothari
The global economy, as also that of India, is passing through a systemic disruption due to the COVID crisis. The Reserve Bank of India in its Seventh Bi-monthly Monetary Policy Statement 2019-20 dated March 27, 2020[1] has permitted banks and non-banking financial institutions to provide a moratorium to borrowers for a period of 3 months.
As a result, cashflows of banks and financial institutions from underlying loans will be disrupted, at least for the period of the moratorium. It is a different thing that the disruption may actually prolong, but 3 months as of now is what is explicitly regarded by the RBI has COVID-driven.
COVID- 19 AND THE SHUT DOWN: THE IMPACT OF FORCE MAJEURE
-Richa Saraf (richa@vinodkothari.com)
COVID- 19 has been declared as a pandemic by the World Heath Organisation[1], and the Ministry of Health and Family Welfare has issued an advisory on social distancing[2], w.r.t. mass gathering and has put travel restrictions to prevent spreading of COVID-19. On 19th February, 2020, vide an office memorandum O.M. No. 18/4/2020-PPD[3], the Government of India has clarified that the disruption of the supply chains due to spread of coronavirus in China or any other country should be considered as a case of natural calamity and “force majeure clause” may be invoked, wherever considered appropriate, following the due procedure.
In view of the current situation where COVID- 19 has a global impact, and is resulting in a continuous sharp decline in the market, it is important to understand the relevance of force majeure clauses, and the effect thereof.
Meaning Of Force Majeure:
The term has its origin from French, meaning “greater force”. Collins Dictionary[4] defines “force majeure” as “irresistible force or compulsion such as will excuse a party from performing his or her part of a contract”
The term has been defined in Cambridge Dictionary[5] as follows:
“an unexpected event such as a war, crime, or an earthquake which prevents someone from doing something that is written in a legal agreement”.
In Merriam Webster Dictionary[6], the term has been defined as “superior or irresistible force” and “an event or effect that cannot be reasonably anticipated or controlled”.
In light of COVID- 19, a pertinent question that may arise here is whether COVID- 19 shut down will be regarded as a force majeure event for all the agreements, providing a leeway to the parties claiming impossibility of performance? Further, whether such non-compliance of the terms of the agreement will neither be regarded as a “default committed by any party” nor a “breach of contract”? The general principle is that an event will be regarded as a force majeure event on fulfilment of the following conditions:
- An unexpected intervening event occurred: The event should be one which is beyond the control of either of the parties to the agreement, similar to an Act of God;
- The parties to the agreement assumed such an event would not occur: A party’s non-performance will not be excused where the event preventing performance was expected or was a foreseeable risk at the time of the execution of the agreement; and
- The unexpected event made contractual performance impossible or impracticable: For instance, can the issuer of debentures say that there is no default if the issuer is unable to redeem the debentures? Whether an event has made contractual performance impossible or impracticable has to be determined on a case-to-case basis. It is to be analysed whether the problem is so severe so as to deeply affect the party, and thereby creating an impossibility of performance. This has to be, however, relative to the counterparty so as to create an impossibility of performance.
- The parties have taken all such measures to perform the obligations under the agreement or atleast to mitigate the damage: It is required that a party seeking to invoke force majeure clause should follow the requirements set forth the agreement, i.e. to provide notice to the other party as soon as it became aware of the force majeure event, and should concretely demonstrate how the said situation has directly impacted the performance of obligations under the agreement.
To understand this further, let us discuss the precedents laid down in several cases.
Principles in Other Jurisdictions:
Prior to the decision in Taylor vs. Caldwell, (1861-73) All ER Rep 24, the law in England was extremely rigid. A contract had to be performed after its execution, notwithstanding the fact that owing to an unforeseen event, the contract becomes impossible of performance, which was not at the fault of either of the parties to the contract. This rigidity of the common law was loosened somewhat by the decision in Taylor (supra), wherein it was held that if some unforeseen event occurs during the performance of a contract which makes it impossible of performance, in the sense that the fundamental basis of the contract goes, it need not be further performed, as insisting upon such performance would be unjust.
In Gulf Oil Corp. v. FERC 706 F.2d 444 (1983)[7], the U.S. Court of Appeals for the Third Circuit considered litigation stemming from the failure of the oil company to deliver contracted daily quantities of natural gas. The court held that Gulf- as the non- performing party- needed to demonstrate not only that the force majeure event was unforeseeable but also that the availability and delivery of the gas were affected by the occurrence of a force majeure event.
Illustrations: When Is An Event Not Considered As Force Majeure?
Inability to sell at a profit is not the contemplation of the law of a force majeure event excusing performance and a party is not entitled to declare a force majeure because the costs of contract compliance are higher than it would have liked or anticipated. In this regard, the following cases are relevant:
- In the case of Dorn v. Stanhope Steel, Inc., 534 A.2d 798, 586 (Pa. Super. Ct. 1987)[8], it was observed as follows:
“Performance may be impracticable because extreme and unreasonable difficulty, expense, injury, or loss to one of the parties will be involved. A severe shortage of raw materials or of supplies due to war, embargo, local crop failure, unforeseen shutdown of major sources of supply, or the like, which either causes a marked increase in cost or prevents performance altogether may bring the case within the rule stated in this Section. Performance may also be impracticable because it will involve a risk of injury to person or to property, of one of the parties or of others, that is disproportionate to the ends to be attained by performance. However, “impracticability” means more than “impracticality.” A mere change in the degree of difficulty or expense due to such causes as increased wages, prices of raw materials, or costs of construction, unless well beyond the normal range, does not amount to impracticability since it is this sort of risk that a fixed-price contract is intended to cover.”
- In Aquila, Inc. v. C.W. Mining 545 F.3d 1258 (2008)[9], Justice Neil Gorsuch authored an opinion for the U.S. Court of Appeals for the 10th Circuit, which excused a coal mining company’s deficient performance under a coal supply contract with a public utility only to the extent that partial force majeure, namely labor dispute, caused deficiency.
- In OWBR LLC v. Clear Channel Communications, Inc., 266 F. Supp. 2d 1214[10], it was observed- “To excuse a party’s performance under a force majeure clause ad infinitum when an act of terrorism affects the American populace would render contracts meaningless in the present age, where terrorism could conceivably threaten our nation for the foreseeable future”.
- In Transatlantic Financing Corp. v. U.S. 363 F.2d 312[11], the D.C. Circuit Court of Appeals affirmed a finding that there was no commercial impracticability where one party sought to recover damages because its wheat shipment was forced to be re-routed due to the closing of the Suez Canal. The Court of Appeals held that because the contract was not rendered legally impossible and it could be presumed that the shipping party accepted “some degree of abnormal risk,” there was no basis for relief.
Some Landmark Rulings in India:
Deliberating on what is to be considered as a force majeure, in the seminal decision of Satyabrata Ghose v. Mugneeram Bangur & Co., 1954 SCR 310[12], the Hon’ble Apex Court had adverted to Section 56 of the Indian Contract Act. The Supreme Court held that the word “impossible” has not been used in the Section in the sense of physical or literal impossibility. To determine whether a force majeure event has occurred, it is not necessary that the performance of an act should literally become impossible, a mere impracticality of performance, from the point of view of the parties, and considering the object of the agreement, will also be covered. Where an untoward event or unanticipated change of circumstance upsets the very foundation upon which the parties entered their agreement, the same may be considered as “impossibility” to do as agreed.
Subsequently, in Naihati Jute Mills Ltd. v. Hyaliram Jagannath, 1968 (1) SCR 821[13], the Supreme Court also referred to the English law on frustration, and concluded that a contract is not frustrated merely because the circumstances in which it was made are altered. In general, the courts have no power to absolve a party from the performance of its part of the contract merely because its performance has become onerous on account of an unforeseen turn of events. Further, in Energy Watchdog v. CERC (2017) 14 SCC 80[14], it was observed as follows:
“37. It has also been held that applying the doctrine of frustration must always be within narrow limits. In an instructive English judgment namely, Tsakiroglou & Co. Ltd. v. Noblee Thorl GmbH, 1961 (2) All ER 179, despite the closure of the Suez canal, and despite the fact that the customary route for shipping the goods was only through the Suez canal, it was held that the contract of sale of groundnuts in that case was not frustrated, even though it would have to be performed by an alternative mode of performance which was much more expensive, namely, that the ship would now have to go around the Cape of Good Hope, which is three times the distance from Hamburg to Port Sudan. The freight for such journey was also double. Despite this, the House of Lords held that even though the contract had become more onerous to perform, it was not fundamentally altered. Where performance is otherwise possible, it is clear that a mere rise in freight price would not allow one of the parties to say that the contract was discharged by impossibility of performance.
38. This view of the law has been echoed in ‘Chitty on Contracts’, 31st edition. In paragraph 14-151 a rise in cost or expense has been stated not to frustrate a contract. Similarly, in ‘Treitel on Frustration and Force Majeure’, 3rd edition, the learned author has opined, at paragraph 12-034, that the cases provide many illustrations of the principle that a force majeure clause will not normally be construed to apply where the contract provides for an alternative mode of performance. It is clear that a more onerous method of performance by itself would not amount to a frustrating event. The same learned author also states that a mere rise in price rendering the contract more expensive to perform does not constitute frustration. (See paragraph 15-158)”
General Force Majeure Clauses in Agreements and the Impact Thereof:
While some of the agreements do have a force majeure clause, one question that may arise is whether the excuse of force majeure event be taken only if there is a specific clause in the agreement or event otherwise? Typically, in all the agreements, whether the promisor is under the obligation to promptly inform the promisee in case of occurrence of any event or incidence, any force majeure event or act of God such as earthquake, flood, tempest or typhoon, etc or other similar happenings, of which the promisor become aware, which is reasonably expected to adversely affect the promisor, or its ability to perform obligations under the agreement.
The terms of the agreement and the intent has to be understood to determine the effect of force majeure clause. In Phillips P.R. Core, Inc. v. Tradax Petroleum Ltd., 782 F.2d 314, 319 (2d Cir. 1985)[15], it was observed that the basic purpose of force majeure clauses is in general to relieve a party from its contractual duties when its performance has been prevented by a force beyond its control or when the purpose of the contract has been frustrated.
The next question that may arise is whether every force majeure leads to frustration of the contract? For instance, if the agreement was hiring of a car on 24th March, the occurrence of COVID- 19 may just have the impact of altering the timing of performance. In some other cases, the event may only affect one part of the transaction. Therefore, the impact of the force majeure event cannot be generalised and shall vary depending on the nature of transaction.
Usually, occurrence of a force majeure event provides the promisee with a right to terminate the agreement, and take all necessary actions as it may deem fit. For instance, in case of lease, if the lessor considers that there is a risk to the equipment, the lessor may seek for repossession of the leased equipment.
Further, in case the force majeure event frustrates the very intent of the agreement, then the parties are under no obligation to perform the agreement. For instance, if the agreement (or performance thereof) itself becomes unlawful due to any government notification or change in law, which arises after execution of the agreement, then such agreements do not have to be performed at all. In such cases, if the agreement contains a force majeure or similar clause, Section 32 of the Indian Contract Act will be applicable. The said section stipulates that contingent contracts to do or not to do anything if an uncertain future event happens, cannot be enforced by law unless and until that event has happened; If the event becomes impossible, such contracts become void. Even if the agreement does not contain a specific provision to this effect then in such a case doctrine of frustration under Section 56 of the Indian Contract Act shall apply. The section provides that a contract to do an act which, after the contract is made, becomes impossible, or, by reason of some event which the promisor could not prevent, unlawful, becomes void when the act becomes impossible or unlawful.
Impact of COVID- 19 on Loan Transactions:
The Reserve Bank of India has, vide notification No. BP.BC.47/21.04.048/2019-20 dated 27th March, 2020[16], has announced that in respect of all term loans (including agricultural term loans, retail and crop loans), all commercial banks (including regional rural banks, small finance banks and local area banks), co-operative banks, all-India Financial Institutions, and NBFCs (including housing finance companies) are permitted to grant a moratorium of three months on payment of all instalments falling due between 1st March, 2020 and 31st May, 2020. Further, in respect of working capital facilities sanctioned in the form of cash credit/overdraft, the lending institutions have been permitted to defer the recovery of interest applied in respect of all such facilities during the period from 1st March, 2020 upto 31st May, 2020.
Detail discussion on the same has been done in our article “Moratorium on loans due to Covid-19 disruption”, which can be accessed from the link below:
http://vinodkothari.com/2020/03/moratorium-on-loans-due-to-covid-19-disruption/
Further, our article “RBI granted moratorium on term loans: Impact on securitisation and direct assignment transactions” can be accessed from the following link:
http://vinodkothari.com/2020/03/rbi-moratorium-on-term-loans-impact-on-sec-and-da-transactions/
[1] https://www.who.int/emergencies/diseases/novel-coronavirus-2019/events-as-they-happen
[2] https://www.mohfw.gov.in/pdf/SocialDistancingAdvisorybyMOHFW.pdf
[3] https://doe.gov.in/sites/default/files/Force%20Majeure%20Clause%20-FMC.pdf
[4] https://www.collinsdictionary.com/dictionary/english/force-majeure
[5] https://dictionary.cambridge.org/dictionary/english/force-majeure
[6] https://www.merriam-webster.com/dictionary/force%20majeure
[7] https://casetext.com/case/gulf-oil-corp-v-ferc
[8] https://law.justia.com/cases/pennsylvania/supreme-court/1987/368-pa-super-557-0.html
[9] https://www.courtlistener.com/opinion/171400/aquila-inc-v-cw-mining/
[10] https://law.justia.com/cases/federal/district-courts/FSupp2/266/1214/2516547/
[11] https://www.casemine.com/judgement/us/59149a86add7b0493462618f
[12] https://indiankanoon.org/doc/1214064/
[13] https://indiankanoon.org/doc/1144263/
[14] https://indiankanoon.org/doc/29719380/
[15] https://law.justia.com/cases/federal/appellate-courts/F2/782/314/300040/
[16] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0
Further content related to Covid-19: http://vinodkothari.com/covid-19-incorporated-responses/
Impact on Expected Credit Loss Model (ECL) amid COVID-19 disruptions
-The test of a Financial Crisis-driven model in times of Global Crisis
By Rahul Maharshi, Financial Services Team , (rahul@vinodkothari.com, finserv@vinodkothari.com)
The disruption throughout the globe due to the COVID-19 disease has caused tremendous uncertainty and difficulty in the financial sector. The Expected Credit Loss (ECL) model was introduced as an aftermath of the 2008 global financial crisis, to curb the loopholes of the incurred loss model and to provide a forward looking approach in the accounting of loan loss provisioning by inclusion of various credit measures. The model which is built up with the focus on credit strength of a particular exposure, is likely to get tested is these testing times.
This write-up is an attempt to explore how the ECL model should be looked given the disruption caused by COVID 19.
The approach to ECL at time of COVID-19 disruption
The ECL model requires application of judgement and differs from entity to entity. Such application of judgement and approaches are considered based on the industrial practices as well as the business environment in which the entity operates. For example, a financial institution may not have an aggressive approach in determination of ECL for the portfolios serving to the affluent sections of the economy as compared to the low credit-score portfolios.
However, conventional assumptions taken in the ECL model may not hold well in the current environment the financial sector across the world is going through. The assumptions of significant increase in credit risk (SICR), at times when there is extension in the repayment structure may be a classical example of SICR which would result in stage-shifting of the credit exposure. But the same would not hold well, in times of such a disruption, where the financial sector regulator has proposed to extend a three month moratorium for repayment of term loans, considering the disruption to the economy.
We arrive at ECL estimates with the help of three primary data points [B5.5.49] –
- Best available information about the past events;
- Best available information about the current conditions; and
- Forecast of economic conditions
In the current COVID-19 disruptions, the entities should actively consider the effects of the COVID-19 disruption as well as the measures taken by the government and regulators in the current situation as well as the prospective measures which would affect the forecast. Such measures should be considered as forward looking “macro-economic information” [B5.5.4] and accordingly be considered by the entities.
However, it is easier said than done, considering the rapid changes and updates in the current stressed environment. But if the ECL estimates are arrived at, after proper consideration of reasonable and supportable information, the same can provide better transparency to the financial statements and aid in providing assurance to the stakeholders.
Ind AS 109 is clear in the assessment of SICR, where the assessment has to be done on the changes in the risk of default occurring over the expected lifetime of a financial instrument. Such an assessment has to be done by the entity based on information that is available to it without undue cost or efforts. The grant of a payment holiday at times of the disruption would not be construed as a change in the risk of default occurring over the expected lifetime of a financial instrument.
Globally, various regulators, Central Bank of various countries have come up with publications and directives for assistance in such times of disruption. Some of the publications and initiatives have been discussed at length below:
Global response to the COVID-19 disruption for sound application of the ECL model
In light of the current COVID-19 disruption, the International Accounting Standards Board (IASB) published[1] a document intending to support the consistent application of the IFRS Standards which are applicable on approximately 120 countries. In its document the IASB has indicated that extension of payment holidays to all borrowers in particular classes of financial instruments should not automatically result in all those instruments being considered to have suffered an SICR. The assessment of SICR has to be based on information that is available to an entity without undue cost and effort.
The European Central Bank (ECB), the apex banking authority for the 19 European Union countries has also published[2] a document as a guidance for financial institutions in careful implementation of the ECL and avoidance of excessive pro-cyclical assumptions in ECL during the COVID-19 disruptions.
The annexure of the above letter provided guidance for the institutions to take into account when using forecasts to estimate the ECL:
- The collective assessment of the significant increase in credit risk (SICR);
The ECB perceived deterioration to the GDP outlook could lead to manifold increase in probability of default (PD), in turn leading to transfer of the financial instrument from stage 1 to stage 2. In times of economic disruptions, such as the COVID-19, even factors usually assessed individually become very sensitive to macroeconomic scenarios. For tackling such a situation, the ECB advised the institutions to :
- Consider whether a top-down approach to stage transfer can be taken and in the context of that approach, recognise lifetime expected credit losses on a portion of the financial assets for which credit risk is deemed to have increased significantly without the need to identify which individual financial instruments have suffered a SICR.
As per para B5.5.6 of IFRS 9 (Ind AS 109) A top-down approach to ECL is such, where the identification of a particular sub-portfolio on the basis of shared risk characteristics that represent customers whose credit risk is expected to have increased significantly, is not possible. In such a case, an assessment can be made of a proportion of the overall portfolio that has SICR since initial recognition.
Example of Top-down approach will be as follows:
Where there is high chance of a risk of default occurring and thus an increase in credit risk, results from an expected increase in interest rates during the expected life of the portfolio held by a financial institution. In such a case, assessing an increase in interest rates of 200 basis points will cause a significant increase in credit risk on 20% of the variable interest-rate portfolio and accordingly, recognition of lifetime ECL on 20% of the variable rate mortgage portfolio, and a loss allowance at an amount equal to 12-month ECL for the remainder of the portfolio.
- The use of long term macroeconomic forecasts ;and
The IFRS 9 provisions lead to the conclusion that where there is no reliable evidence for specific forecasts, long-term macroeconomic outlooks will provide the most relevant basis for estimation. The ECB provided guidance for financial institutions to:
- use available historical information, but only as far as this information is representative for the long-term horizon and free of bias;
- Where historical information depends on macroeconomic variables, consider information covering at least one or more full economic cycles or that is otherwise adjusted to avoid biases, e.g. a recency bias.
- The use of macroeconomic forecast for specific years
To include forward-looking information in ECL models, it is quite a common practice among significant institutions to establish a baseline macroeconomic scenario. In doing so, ECB guided the financial institutions to consider the following:
- Consider macroeconomic forecasts for specific years and long-term forecasts, as previously described;
- Factor these two types of forecasts into the baseline scenario with weights based on their respective relevance;
- Assign more weight to the specific-period macroeconomic forecast for the short-term outlook and systematically reduce that weight as the forecast loses relevance for time horizons in the more distant future;
- Use the long-term forecast (e.g. the long-term GDP growth rate) whenever the specific forecast has lost relevance.
Institutions that use other scenarios in addition to the baseline scenario are expected to:
- Estimate the probabilities of these scenarios and their deviation from the baseline according to the above principles;
- Ensure that the probabilities assigned to scenarios and the deviations of such scenarios beyond the reliable forecasting horizon reflect experience collected over a sufficiently long-term horizon and not be based on specific year projections.
The Basel Committee on Banking Supervision (BCBS)[3] had set out additional measures to reduce the impact of COVID-19 on the global banking system. In its press release, the BCBS reiterated the importance of ECL frameworks, referring to both IFRS 9 and Current Expected Credit Loss Model (CECL) by the Financial Accounting Standards Board (FASB), urging banks to:
“Use the flexibility inherent in these frameworks to take account of the mitigating effect of the extraordinary support measures related to Covid-19.”
BCBS further stated that:
“Extraordinary support measures should be taken into account by banks when they calculate their ECLs.”
“Regarding the SICR assessment, relief measures to respond to the adverse economic impact of Covid-19 such as public guarantees or payment moratoriums, granted either by public authorities, or by banks on a voluntary basis, should not automatically result in exposures moving from a 12-month ECL to a lifetime ECL measurement.”
The approach towards the assessment has to be holistic, considering the effect on all the components considered in the computation of ECL.
The Institute of Chartered Accountants of India (ICAI), as a joint initiative of Accounting standards Board (ASB) and Auditing and Assurance Standards Board (AASB) has come out with a publication ICAI ACCOUNTING & AUDITING ADVISORY Impact of Coronavirus on Financial Reporting and the Auditors Consideration[4] which has provided guidance on various areas of financial reporting and Audit of financial statements, which require particular attention in respect of financial statements for the year 2019-20.
The guidance has provided the following points in relation to impairment losses as per Ind AS 109:
- Measurement of ECL: the impact on business of borrowers or debtors to impact credit risk parameters in the following ways:
- Increase in PD due to reduced business activity.
- Adverse impact on value of collaterals and business cash flows in turn affecting the loss given default (LGD)
- Full utilisation of undrawn limits and loan commitments in times of disruptions to impact exposure at default (EAD).
- Entities to develop more than one scenarios considering the potential impact of COVID-19.
- As a guidance from Appendix A of Ind AS 109: Borrower specific concession(s) given by lenders, on account of economic or contractual reasons relating to the borrower’s financial difficulty, which the lenders would not have otherwise considered. Such a condition to be considered as an evidence that a financial assets is credit-impaired.
- Entities to consider impact of Prudential Regulatory actions to sustain the economy such as loan repayment holidays, reduction in interest rates etc.
- Disclosures of the impact of COVID-19 on various credit related aspects such as methods, assumptions and information used in estimating ECL, policies and procedures for valuing collaterals etc.
- Non-Banking Financial Companies (NBFCs) and Asset Reconstruction Companies (ARCs) should also carefully consider the recent guidance provided by Reserve Bank of India (RBI) on implementation of Ind AS[5]
The major component in ECL computation is the probability of default (PD). To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.
The effect of a pandemic on the ECL parameters have been discussed at length below.
The effect on ECL parameters in times of disruptions
The parameters used in reaching to the ECL are:
- Probability of default (PD)
- Loss given default (LGD)
- Exposure at default (EAD)
- Discount factor (df)
Further the ECL formula can be defined as “ECL= PD*LGD*EAD*df”.
To arrive at the PD, we use historical PD by assessing the entities internal credit rating data as well as forward looking-macroeconomic factors in determining PD term structures. While assessing the forward looking PD, entities will have to consider the disruption in the business of the borrowers. Such disruption would have resulted in reduced economic activity, which in turn would have significantly increased the likelihood of default.
The LGD is the indicator of quantum of loss from a transaction, given that a default occurs. The LGD takes into consideration the exposure at default and post default classifications, valuation of any collateral as well as allocation of the same. The resultant decline in the economic activities due to lockdowns can have severe effects on the value of collaterals as well as cash flows of the business.
EAD is basically the estimation of the extent to which the financial entity may be exposed to a counterparty in the event of a default and at time of the counterparty’s default. EAD also takes into consideration, the expected payments in future scenarios. In estimation of EAD, the strength of the financial entity, in terms of assets (i.e loan given) and liabilities (i.e. loan taken) are kept in tandem to for assessment of contractual cash flows. However, in such times of disruption, the trend may be for the borrowers to fully exhaust the credit drawing limits and loan commitments, creating stress on the exposures, more so in case of revolving lines of credit facilities.
The discounting of the above components have to be done using the original effective interest rate (EIR). The EIR is arrived at after considering the current interest rate for the facility and adjusting with it, any fee or income charged. In times of such global disruptions, there is always a likelihood that the prevailing market interest rates takes a hit. As already we have seen by the RBI purchasing Rs 10,000 crore in government bonds under the open market operations programme as a measure against the disruption, the same would result in change in the risk free rate as well.
Effect of the moratorium grant on loan repayments on ECL by the RBI[6]
To address the stress in the financial sector caused by COVID-19, several measures have been taken by the RBI to mitigate the burden on debt-servicing caused due to the disruption. These measures include moratorium on term loans, deferring interest payments on working capital and easing of working capital financing. The lending institutions have been permitted to allow a moratorium of three months on payment of all instalments falling due between March 1, 2020 and May 31, 2020. The below explanation specifies effect of the moratorium.
Effect on credit risk and stage shifting
Since the moratorium is to be considered as a repayment holiday where the borrower is granted an option to not pay during the moratorium period, the same cannot be considered as a factor in determining change in the credit risk complexion of the borrower. The provisions of para 5.5.12 of Ind AS 109 are self-explanatory on the point that if there has been a modification of the contractual terms of a loan, then, in order to see whether there has been a SICR, the entity shall compare the credit risk before the modification, and the credit risk after the modification. Sure enough, the restructuring under the disruption scenario is not indicative of any increase in the probability of default.
Accordingly, the same should ideally not be considered as a factor for considering SICR and in turn, should not result in shifting of the financial instruments from one stage to another.
Effect on rebuttable presumptions about credit deterioration
The moratorium granted by the RBI seeks to amend the payment schedule without resulting in a restructuring. There is a rebuttable presumption that the credit risk on a financial asset has increased significantly since initial recognition when contractual payments are more than 30 days past due. However, the rebuttal may be offered in case the payments are more than 30 days past due. The very meaning of “past due” is something which is not paid when due. The moratorium amends the payment schedule. What is not due cannot be past due.
Effect on Effective interest rate (EIR) for the loan and income during the moratorium
The whole idea of the modification is to compute the interest for the deferment of EMIs due to moratorium, and to compensate the lender fully for the same. The IRR for the loan after restructuring should, in principle, be the same as that before restructuring. Hence, there should be no impact on the EIR.
As the EIR remains constant, there will be recognition of income for the entire Holiday period. For example, for the month of March, 2020, interest will be accrued. The carrying value of the asset (POS) will stand increased to the extent of such interest recognised. In essence, the P/L will not be impacted
Also, there will not arise any modification gain or loss as per para 5.4.3 of Ind AS 109 since the EIR remains constant.
Requirement of Impairment-testing of financial asset
The revision in the payment schedule does not result in a modification of the financial asset, which could have resulted in an impairment testing of the financial asset. Since the contractual modification in case of the moratorium is not a result of a credit event, the question of any impairment for this reason does not arise.
Conclusion
The concept of ECL being a fallout of the Global Financial Crisis, it will be interesting to see how fairly the model lives up in providing transparency to the users of financial statements at this time of global disruption. It is worth mentioning that ECL, being a reserve built up in good times which could be used in bad ones, the current situation is difficult, creating high levels of uncertainty but certain measures may be adopted by entities in curbing the situation to some extent, such as:
- Developing more than one scenarios for the potential impact of the COVID-19 disruptions treated as macro-economic information as per para B5.5.4 of Ind AS 109
- Effect of measures taken by the government and the regulators in the true spirit with which the same is implemented.
[1] https://cdn.ifrs.org/-/media/feature/supporting-implementation/ifrs-9/ifrs-9-ecl-and-coronavirus.pdf?la=en
[2]https://www.bankingsupervision.europa.eu/press/letterstobanks/shared/pdf/2020/ssm.2020_letter_IFRS_9_in_the_context_of_the_coronavirus_COVID-19_pandemic.en.pdf?b543f9408a8480e04748a3b0185d8cf3
[3] https:/www.bis.org/press/p200403.htm and https://www.bis.org/bcbs/publ/d498.htm
[4] https://resource.cdn.icai.org/58829icai47941.pdf
[5] https://rbidocs.rbi.org.in/rdocs/Notification/PDFs/NOTI170F341D8DE49C04D4B8382D855A9858583.PDF
[6] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11835&Mode=0
