Debentureholders’ rights in Intercreditor agreements
Supreme Court lays principles in case of debenture defaults
– Sikha Bansal, Partner, Vinod Kothari & Company | corplaw@vinodkothari.com
A well-developed corporate bond market not only provides cost-effective funds to the issuer, but also enables lenders like banks and other financial institutions to streamline their asset-liability mismatches. As such, there have been a lot of efforts to facilitate the development of the corporate bond market in India. While the market is growing steadily, the size of the market remains small as compared to other emerging markets in Asia[1]. Therefore, India may still have a long way to go.
An important element in ensuring smooth functioning of the bond market is to ensure that there is sufficient clarity on the options, remedies, and rights which the debentureholders have or may have in a given scenario. One such aspect has been dealt with by the Supreme Court (SC) in the recent ruling Securities and Exchange Board of India v. Rajkumar Nagpal and Others[2] (‘SC ruling’). The SC was dealing with the interplay between the RBI’s ‘Prudential Framework for Resolution of Stressed Assets’ issued in June, 2019 (‘RBI Resolution Framework’) and SEBI’s Circular on ‘Standardisation of procedure to be followed by Debenture Trustees in case of ‘Default’ by Issuers of listed debt securities’ (‘SEBI Circular’) and consequent impact of the same on the rights of the debentureholders.
As we see below, the SC ruling is crucial – that it clears the air around the force which SEBI Circular carries and protects dissenting investors from non-statutory compromises. However, most importantly, this SC ruling can be seen as highlighting the problems and gaps which may arise because of segregated rule-making where two regulators were bound by their respective regulatory ambit, thereby leading to a not-so-comprehensive resolution framework.
The author, in this article, has not gone into the facts of the particular case (which, inter alia, necessitated the SC to invoke Article 142 of the Constitution). Instead, the author has deliberated on the key takeaways from the SC ruling.
Key takeaways from the SC ruling
Joining the ICA: an additionality not a mandate
As was abundantly clear from the language of SEBI Circular, the route prescribed therein should not be seen as a mandate upon the debentureholders to join the ICA. Neither, it is the only route to entering into a compromise with the issuer entity.
RBI’s Resolution Framework would stand on the same footing as a compromise under section 230 of the Companies Act, with certain distinctions. Of course, RBI’s Framework involves only the lenders covered by the such Framework, who can collectively decide to enter into an intercreditor arrangement (‘ICA’). Such ICA binds only such lenders who participated in the same.
SEBI Circular goes a step ahead to provide an option to debentureholders to be a part of ICA, by way of collective decision, and such collective decision has to be arrived at by following the modalities as prescribed in the said Circular. If debentureholders do not wish to be a part of ICA, they may consciously decide, as SEBI Circular requires positive consent by requisite majority to enter into an ICA. If such majority consent is not received, the trustee cannot sign ICA. Therefore, SEBI Circular will apply only if the debentureholders want to become part of the ICA.
Notably, and quite intuitively, debentureholders may find it feasible to be a part of ICA only other options before them seem to be less attractive – for instance, where the security interest is shared, enforcement of security interest would be a difficult remedy. Hence, it may make sheer sense for the debentureholders to enter into an ICA unless the security backing them is exclusive. If the security is shared with other lenders, there will be no point in debentureholders standing apart.
Hence, the decision has to be taken by the debentureholders whether or not they want to be a part of ICA. Modality of how such a decision should be taken, comes from the SEBI Circular.
Dissenting investors can be bound by statute only; contracts cannot bind dissenters
The SC discussed broadly three possible routes for the investors of arriving at a decision –
- section 230 of the Companies Act dealing with compromise and arrangements basis requisite extraordinary majority and sanction of the NCLT,
- SEBI Circular, which as the SC ruling holds, has a force of law (see below),
- Section 62 of the Contract Act, wherein parties to a contract may agree to substitute, rescind or alter the original contract, and then such original contract need not be performed.
While in the first two options above, the collective decision of the majority would bind the dissenting debentureholders by way of statutory force; the third option is completely contractual. Intending debentureholders can voluntarily enter into a contract in terms of section 62 of the Contract Act, however such provision would only bind the consenting party/ies.
Hence, the SC ruling makes it clear that contractual compromises, which do not fall either under section 230 of the Companies Act or under the SEBI Circular, cannot bind dissenting debentureholders.
SEBI Circular to take precedence over contractual arrangements
SEBI Circular has been held to have retroactive application – as in, while default may have occurred prior to the issuance of Circular, however the Circular provides for the manner of resolution of debt. Therefore, even if there are conflicting provisions in the trust deed, the same would be overridden by SEBI Circular. That is, a contractually vested right may be taken away by the operation of a statutory instrument (see, para 85 of SC ruling).
ISIN-level voting
SEBI Circular requires ISIN-level voting (para 3 and 6.6). In the instant case, concerns were raised that such ISIN-level voting would enable a single ISIN number to defeat the resolution plan. SC left it on SEBI to address any such concerns raised by stakeholders basis the objectives of orderly functioning of the securities market.
However, the author notes that such ISIN-level voting and any act in pursuance thereof may be rendered infructuous where multiple ISINs share the same security. In case of a common/shared security interest, any decision has to be backed by the collective sense of the creditors having such security interest (irrespective whether they fall under different ISINs). In such cases, the principle of ‘cramming down’ applies where majority decision binds the minority. This flows from the common principles of joint-financing, also embodied in section 13(9) of the Securitisation Asset Reconstruction and Enforcement of Security Interests Act, 2002.
The SC ruling, although acknowledges that SEBI has mandated ISIN-level voting; however, does not give conclusivity to the debate on the same. The regulators may have to arrive at a valid and feasible solution for the same.
Closing thoughts
While the SC ruling has clarified various aspects concerning debentureholders and their rights under the SEBI Circular; however, there are certain areas which might need further clarity – for instance, feasibility of ISIN-level voting in case of shared security interests.
However, in any case, two things are inescapable, and would highlight why this SC ruling will be quite significant in time to come.
First, going forward, we need to realise that formal insolvency and debt resolution mechanisms such as IBC are to be used as the very last option. These are extremely time taking and may lead to value erosion. Therefore, as far as possible, lenders/creditors should try to resolve outside of the formal resolution process of IBC. In light of this, lenders may, in times to come, find it much advantageous to use the RBI’s Resolution Framework.
Second, debentures will continue to remain important. More importantly because larger borrowers are required to move at least a part of their borrowings to bonds[3].
In light of the above, the need for an ICA for holistic resolution of a debt is extremely important. The regulators may need to jointly lay down a comprehensive framework allowing all kinds of financial creditors (banks/financial institutions/debentureholders) to enter into an ‘out-of-court’ compromise with the same statutory rigour. For this, the regulators might need to proceed with a consultative as well as accommodative approach.
Hence, there is an increasing need that the two regulators do more meaningful handshaking to come and settle the gaps.
[1] See; Corporate Bond Markets in India – Challenges and prospects
(Keynote address delivered by Shri T. Rabi Sankar, Deputy Governor, Reserve Bank of India – August 24, 2022 – at the Bombay Chamber of Commerce & Industry, Mumbai).
[2] Civil Appeal No. 5247 of 2022
[3] Under Large Corporate Borrower framework. See Chapter XII of the Operational Circular issued by SEBI.
More information on Law & Practice Relating to Corporate Bonds & Debentures can be read in our book on the same.
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