Strengthening India’s Corporate Bond Market: A Look at NITI Aayog’s Recommendations

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Simrat Singh | finserv@vinodkothari.com

India’s aspiration to become a US $30 Trillion economy by 2047 rests on its ability to mobilise long-term, stable and affordable capital. Debt capital can be an attractive source for this. While banks have historically been the backbone of credit intermediation in India, a bank-dominated financial system may be inadequate to meet the financing needs of a developing country like India which includes long-gestation exposures to infrastructure, climate transition, manufacturing and other emerging sectors. Recognising this constraint, NITI Aayog’s report on Deepening the Corporate Bond Market in India (‘Report’) lays out reforms to develop corporate bonds as another major tool for mobilising long-term low-cost capital. 

In this note we highlight some of the reforms being advocated in the Report.

Key Thrust Areas of Reforms:

Regulatory Efficiency 

A central theme of the Report is the need to reduce regulatory friction arising from fragmented and overlapping oversight by SEBI, RBI and the MCA for corporate bonds. Inconsistent treatment of similar bonds, procedural complexity, overlapping disclosures and different approval timelines are identified as major constraints, particularly for public issuances and lower-rated issuers. A specific concern highlighted is issuer-based regulation: bonds issued by banks and NBFCs are regulated by the RBI, while similar bonds issued by non-financial corporates fall under SEBI and MCA oversight. This results in different disclosure standards and compliance processes for similar bonds

To combat this, first, the Report calls for stronger inter-regulatory coordination and recommends measures such as mutual recognition of disclosures, a joint regulatory help desk/single point of contact as well as joint circulars detailing the jurisdictions of each regulator – essentially a centralised coordination mechanism involving SEBI, RBI, MCA and the Ministry of Finance.

Second, the Report emphasises the need to rationalise disclosure norms for public bond issuances, which are significantly more onerous than those applicable to private placements. This asymmetry has led to an overwhelming reliance on private placements, which account for nearly 98% of corporate bond issuances in India (p. 25). Drawing on global practices, the Report recommends a differentiated disclosure regime for well-compliant issuers (p. 66). Specific reforms include extending the validity of offer documents from one year to two or three years, removing ISIN-wise issuance constraints, simplifying PAS-2 and Information Memorandum filings through digital automation on the MCA portal, and introducing a “Well-Known Seasoned Issuer” framework to enable fast-track access to public bond markets for reputed issuers.

Third, the Report stresses the need for regulatory clarity for hybrid instruments, including covered bonds1, securitised debt and infrastructure-linked securities. Many instruments used globally to fund long-term assets do not fit neatly within India’s regulator-specific silos. Jurisdictional ambiguity (which regulator oversees which instrument?) and the absence of standardised regulatory treatment have impeded market development. The Report recommends clearly defined frameworks to facilitate market clarity. In this context, it also highlights tax distortions; for instance, SDIs2 currently attract significantly higher TDS than corporate bonds. The Report states that SDIs are taxed at a higher rate than corporate bonds which prevents securitisation of bonds. However, effective 1.04.2025, SDI TDS rates are aligned with bond rate; both at 10% (See section 194LBC of Tax Act).

Market Infrastructure and Liquidity

Bonds are heterogeneous instruments, varying by type of issuer, tenor, covenants and structure. Unlike equities, electronic order matching alone cannot ensure immediacy of execution or continuous liquidity in the secondary market, particularly in lower-rated or infrequently traded bonds. Despite progress through electronic platforms such as RFQ for secondary trading and EBP for primary issuance, trading volumes remain shallow and concentrated in highly rated bonds.

The Report recommends expanding electronic trading, enhancing post-trade reporting (to improve price discovery) and increasing the proportion of trades settled on a Delivery-versus-Payment (DVP) basis3. Absence of a robust market-making ecosystem is seen as a major constraint on secondary-market liquidity (pp. 22, 36, 106). Limited risk appetite and balance-sheet constraints deter intermediaries from providing continuous two-way quotes, especially in lower-rated and longer-tenor bonds.

To address this, the Report recommends enabling market-making through regulatory incentives and improved access to repo markets. In particular, the creation of a standing repo facility by RBI for high rated corporate bonds would allow market makers4 to monetise inventories efficiently and support continuous liquidity provision. While corporate bonds are included in the RBI’s list of repo-eligible instruments, their treatment differs materially from Government securities (G-Secs). Repos in G-Secs are exempt from CRR and SLR computation which means Banks can access funds through G-Sec repos without providing SLR and CRR on those funds. In contrast, cash raised through repos backed by corporate bonds is treated as a liability for CRR and SLR purposes, hence banks have to provide CRR and SLR on the resulting liquidity. Also, unlike G-Secs, which are centrally cleared and settled through CCIL, corporate bond repos lack a single, standardised clearing and settlement mechanism; they are cleared through F-TRAC and stock exchanges. The result is that the volume of corporate bond repo is negligible (exact data on corporate bond repo could not be sourced).

The Report also flags structural weaknesses in the credit rating ecosystem, including rating inflation, conflicts of interest under the issuer-pays model, and excessive regulatory reliance on ratings (p. 71). Strengthening governance standards is the key recommendation for credit ratings. To improve credit rating access for smaller issuers, the Report suggests exploring alternative credit assessment models, including technology-driven frameworks using GST-returns and other turnover based data and digital transaction histories.

Further, the Report recommends strengthening the existing framework requiring large corporates to raise a portion of incremental borrowings through debt securities (LCB Framework)5. Proposed enhancements include increasing the minimum market borrowing requirement and progressively extending the framework to smaller corporates with lower thresholds.

Drawing on the IMF’s FSAP 2025, the Report also recommends allowing high-quality corporate bonds to be used as collateral in RBI’s repo operations. International experience from the ECB, Bank of Japan, and Reserve Bank of Australia suggests that such measures can enhance secondary-market liquidity and broaden the investor base, subject to appropriate safeguards.

Equally important is the creation of a government-backed, centralised corporate bond data repository. Fragmented data across regulators and exchanges currently hampers price discovery and covenant monitoring. A unified, real-time repository is recommended to improve transparency for issuers, investors, and regulators.

Innovation in Instruments and Market design

The Report makes it clear that regulatory reforms alone are insufficient; product and market innovation are essential to expand depth and distribute risk. India’s bond market remains narrow not only due to investor risk aversion but also due to the limited availability of instruments aligned with diverse risk–return preferences and long-gestation financing needs. Green bonds, sustainability-linked bonds6, and transition bonds are identified as important instruments for financing climate action and infrastructure. However, the absence of a standardised green taxonomy and concerns around greenwashing have constrained growth. The Report, therefore, recommends establishing clear definitions, disclosure standards and verification frameworks to ensure credibility and scale ESG-oriented bond markets.

The Report proposes institutionalising a dedicated class of Corporate Bond Dealers (CBDs), modelled on the U.S. primary dealer system. Eligible banks, NBFCs and other financial institutions would be required to provide continuous two-way quotes, supported by incentives such as capital relief on bond inventories and access to RBI refinance and repo facilities. Enhanced market surveillance, real-time trade reporting, price dissemination and inventory disclosures are also recommended.

Investor and Issuer Participation

Broadening the investor base is identified as another critical reform pillar. Long-term institutional investors such as insurance companies, pension funds and provident funds are natural holders of long-duration bonds, yet regulatory investment norms constrain exposure only to higher-rated securities. The Report recommends a calibrated relaxation of these norms.

For retail investors, the Report proposes lowering minimum investment thresholds (from existing ₹ 10,000), increasing retail quotas in public bond issuances, particularly for tax-free and ESG-linked bonds7, and simplifying TDS provisions to address tax inefficiencies in secondary market trades. OBPPs have been acknowledged to contribute to secondary market liquidity, however, the volumes are low. Further, there is no mention of concerns w.r.t downselling through OBPPs which was recently highlighted by SEBI8

On the issuer side, India’s corporate bond market remains heavily concentrated among AAA and AA-rated entities. To address this imbalance, the Report advocates scaling up credit enhancement mechanisms such as PCEs and support from development finance institutions. It also highlights the need to promote longer-tenor issuances, especially for infrastructure and climate-linked projects, where asset lives significantly exceed typical corporate bond maturities. In this context, it is noteworthy that NITI Aayog has cited our resource, “Partial Credit Enhancement: A Catalyst for Boosting Infrastructure Bond Issuances?”, in the Report while discussing the role of partial credit enhancement mechanisms in deepening the corporate bond market (pp. 75 and 99). Further, regulatory subsidies for first-time or low-volume issuers and pooled issuance platforms to facilitate market access for smaller issuers is also recommended (pp. 65, 75).

The Report recognizes that CDS are underdeveloped. Currently, CDS can be purchased only by investors who already own the underlying bond, which prevents trading in the CDS market. Further, only single-name CDS are permitted, which means a separate CDS contract is required for each issuer, unlike global markets such as the U.S., where index CDS allows one CDS to cover a basket of bonds. Lastly, there is a limit on FPI investors providing CDS which is 5% of the outstanding corporate bond market. These restrictions have resulted in limited CDS protection. The Report also recommends bigger NBFCs to act as CDS market makers

Conclusion

NITI Aayog’s recommendations envisage a corporate bond market that evolves from a supplementary funding channel into a core pillar of India’s financial system. If implemented in a coordinated manner, these reforms could expand the market to ₹100–120 trillion by 2030, improve financial stability, and channel long-term capital into productive investment. The real challenge, however, lies in execution, particularly in achieving sustained regulatory coordination and market-making capacity. Addressing these constraints will be critical if corporate bonds are to play a meaningful role in financing India’s long-term growth and infrastructure ambitions under the vision of Viksit Bharat by 2047.

See our other resources on bonds

  1. Bond Credit Enhancement Framework: Competitive, rational, reasonable
  2. Demystifying Structured Debt Securities: Beyond Plain Vanilla Bonds
  3. Bond market needs a friend, not parent
  4. SEBI Securitisation Regulations: Track Record, Risk retention and Investment size among several new requirements
  5. Mandatory listing for further bond issues
  6. NHB’s PCE Scheme for HFCs
  7. Corporate Bonds and Debentures
  1. Covered bonds are secured debt instruments backed by a segregated pool of high-quality assets, offering investors dual recourse to both the issuer and the underlying assets. May refer to our resource on covered bonds. ↩︎
  2. May refer to our book Listing Regulations on Securitised Debt Instruments and Security Receipts ↩︎
  3. DVP is a settlement mechanism in which the transfer of securities and funds occurs simultaneously, eliminating counterparty and settlement risk
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  4.  May refer to our resource ‘Bond issuers set to become Market Maker to enhance liquidity’ ↩︎
  5. May refer to our resource ‘Mandatory bond issuance by Large Corporates: FAQs on revised framework’ ↩︎
  6. May refer to our resources ‘Sustainability or ESG Bonds’ and ‘From Rooftops to Ratings: India’s Green Securitisation Debut’ ↩︎
  7. May refer to our resource ESG Debt Securities: Framework for Issuance and Listing in India ↩︎
  8. May refer to our resource “Downstreamed through intermediaries: Deemed public issue concerns for privately placed debt” ↩︎

Round-Tripping Reined: RBI Rolls Out Relaxed Rules for Investments in AIFs

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-Sikha Bansal, Senior Associate & Harshita Malik, Executive | finserv@vinodkothari.com

Background

The RBI’s regulatory approach to investments by Regulated Entities (REs) in Alternate Investment Funds (AIFs) has undergone a remarkable transformation over the past two years. Initially, the RBI responded to the risks of “evergreening”, where banks and NBFCs could mask bad loans by routing fresh funds to existing debtor companies via AIF structures, by issuing stringent circulars in December 20231 and March 20242 (collectively known as ‘Previous Circulars’). The December 2023 circular imposed a blanket ban on RE investments in AIFs that had downstream exposures to debtor companies, while the March 2024 clarification excluded pure equity investments (not hybrid ones) from this restriction. This stance aimed to strengthen asset quality but quickly highlighted significant operational and market challenges for institutional investors and the AIF ecosystem. Many leading banks took significant provisioning losses, as the Circulars required lenders to dispose off the AIF investments; clearly, there was no such secondary market. 

In response to the feedback from the financial sector, as well as evolving oversight by other regulators like SEBI, the RBI undertook a comprehensive review of its framework and issued Draft Directions- Investment by Regulated Entities in Alternate Investment Funds (‘Draft Directions’) on May 19, 20253. The Draft Directions have now been finalised as Reserve Bank of India (Investment in AIF) Directions, 2025 (‘Final Directions’) on 29th May, 2025. The Final Directions shift away from outright prohibitions and instead introduce a carefully balanced regime of prudential limits, targeted provisioning requirements, and enhanced governance standards. 

Comparison at a Glance

A compressed comparison between Previous Circulars and Final Directions is as follows –

ParticularsPrevious CircularsFinal DirectionsIntent/Implication
Blanket BanBlanket ban on RE investments in AIFs lending to debtor companies (except equity)No outright ban; investments allowed with limits, provisioning, and other prudential controlsMove from a complete prohibition to a limit-based regime. Max. Exposures as defined (see below) taken as prudential limits
Definition of debtor companyOnly equity shares excluded for the purpose of reckoning “investment” exposure of RE in the debtor companyEquity shares, CCPSs, CCDs (collectively, equity instruments) excluded Therefore, if RE has made investments in convertible equity, it will be considered as an investment exposure in the counterparty – thereby, the directions become inapplicable in all such cases.
Individual Investment Limit in any AIF schemeNot applicable (ban in place)Max 10% of AIF corpus by a single RE, subject to a max. of 5% in case of an AIF, which has downstream investments in a debtor company of RE.Controls individual exposure risk. Lower threshold in cases where AIF has downstream investments.
Collective Investment Limit by all REs in any AIF schemeNot applicableMax 20%4 of AIF corpus across all REsWould require monitoring at the scheme level itself.
Downstream investments by AIF in the nature of equity or convertible equityEquity shares were excluded, but hybrid instruments were not. All equity instruments Exclusions from downstream investments widened to include convertible equity as well. Therefore, if the scheme has invested in any equity instruments of the debtor company, the Circular does not hit the RE.
Provisioning100% provisioning to the extent of investment by the RE in the AIF scheme which is further invested by the AIF in the debtor company, and not on the entire investment of the RE in the AIF scheme or 30-day liquidation, if breachIf >5% in AIF with exposure to debtor, 100% provision on look-through exposure, capped at RE’s direct exposure5 (see illustrations below)No impact vis-a-vis Previous Circulars. 
For provisioning requirements, see illustrations later. 
Subordinated Units/CapitalEqual Tier I/II deduction for subordinated units with a priority distribution modelEntire investment deducted proportionately from Tier 1 and Tier 2 capital proportionatelyAdjustments from Tier I and II, now to be done proportionately, instead of equally. 
Investment PolicyNot emphasizedMandatory board-approved6 investment policy for AIF investmentsOne of the actionables on the part of REs – their investment policies should now have suitable provisions around investments in AIFs keeping in view provisions of these Directions
ExemptionsNo specific exemption. However, Investments by REs in AIFs through intermediaries such as fund of funds or mutual funds were excluded from the scope of circulars. Prior RBI-approved investments exempt; Government notified AIFs may be exempt
Provides operational flexibility and recognizes pre-approved or strategic investments.No specific mention of investments through MFs/FoFs – however, given the nature of these funds, we are of the view that such exclusion would continue.
Transition/Legacy TreatmentNot applicableLegacy investments may choose to follow old or new rulesSee discussion later.

Key Takeaways: 

Detailed analysis on certain aspects of the Final Directions is as follows:

Prudential Limits 

Under the Previous Circulars, any downstream exposure by an AIF to a regulated entity’s debtor company, regardless of size, triggered a blanket prohibition on RE investments. The Final Directions replace this blanket ban with prudential limits:

  • 10% Individual Limit: No single RE can invest more than 10% of any AIF scheme’s corpus.
  • 20% Collective Limit: All REs combined cannot exceed 20% of any AIF scheme’s corpus; and
  • 5% Specific Limit: Special provisioning requirements apply when an RE’s investment exceeds 5% of an AIF’s corpus, which has made downstream investments in a debtor company.

Therefore, if an AIF has existing investments in a debtor company (which has loan/investment exposures from an RE), the RE cannot invest more than 5% in the scheme. But what happens in a scenario where RE already has a 10% exposure in an AIF and the AIF does a downstream investment (in forms other than equity instruments) in a debtor company? Practically speaking, AIF cannot ask every time it invests in a company whether a particular RE has exposure to that company or not. In such a case, as a consequence of such downstream investment, RE may either have to liquidate its investments, or make provisioning in accordance with the Final Directions. Hence, in practice, given the complexities involved, it appears that REs will have to conservatively keep AIF stakes at or below 5% to avoid the consequences as above. 

Now, consider a scenario – where the investee AIF invests in a company (which is not a debtor company of RE), which in turn, invests in the debtor company. Will the restrictions still apply? In our view, it is a well-established principle that substance prevails over form. If a clear nexus could be established between two transactions – first being investment by AIF in the intermediate company, and second being routing of funds from intermediate company to debtor company, it would clearly tantamount to circumventing the provisions. Hence, the provisioning norms would still kick-in. 

Provisioning Requirements

Coming to the provisioning part, the Final Directions require REs to make 100 per cent provision to the extent of its proportionate investment in the debtor company through the AIF Scheme, subject to a maximum of its direct loan and/ or investment exposure to the debtor company, if the REs exposure to an AIF exceeds 5% and that AIF has exposure to its debtor company. The requirement is quite obvious – RE cannot be required to create provisioning in its books more than the exposure on the debtor company as it stands in the RE’s books. 

The provisioning requirements can be understood with the help of the following illustrations:

ScenarioIllustrationExtent of provisioning required
Existing investment of RE in AIF Scheme (direct loan and/or investment exposure exists as on date or in the past 12 months)For example, an RE has a loan exposure of 10 cr on a debtor company and the RE makes an investment of 60 cr in an AIF (which has a corpus of 800 cr), the RE’s share in the corpus of the AIF turns out to be 7.5%. The AIF further invested 200 cr in the debtor company of the RE. The proportionate share of the RE in the investment of AIF in the debtor company comes out to be 15 cr (7.5% of 200 cr). However, the RE’s loan exposure is 10 crores only. Therefore, provisioning is required to the extent of Rs. 10 crores.
Existing investment of RE in AIF Scheme (direct loan and/or investment exposure does not exist as on date or in the past 12 months)Facts being same as above, in such a scenario, the provisioning requirement shall be minimum of the following two:-15 cr(full provisioning of the proportionate exposure); or-0 (full provisioning subject to the REs direct loan exposure in the debtor company)Therefore, if direct exposure=0, then the minimum=0 and hence no requirement to create provision.

Some possible measures which REs can adopt to ensure compliance are as follows: 

  1. Maintain an up-to-date, board-approved AIF investment policy aligned with both RBI and SEBI rules;
  2. Implement robust internal systems for real-time tracking of all AIF investments and debtor exposures (including the 12-month history);
  3. Require regular, detailed portfolio disclosures from AIF managers;
  4. appropriate monitoring and automated alerts for nearing the 5%/10%/20% thresholds; and
  5. Establish suitable escalation procedures for potential breaches or ambiguities.

Further, it shall be noted that the intent is NOT to bar REs from ever investing more than 5% in AIFs. The cap is soft, provisioning is only required if there is a debtor company overlap. But the practical effect is, unless AIFs develop robust real-time reporting/disclosure and REs set up systems to track (and predict) debtor overlap, 5% becomes a limit for specifically the large-scale REs for practical purposes. 

Investment Policy

The Final Directions call for framing and implementing an investment policy (amending if already exists) which shall have suitable provisions governing its investments in an AIF Scheme, compliant with extant law and regulations. Para 5 of the Final Directions does not mandate board approval of that policy, however, Para 29 of the RBI’s Master Directions on Scale Based Regulations stipulates that any investment policy must be formally approved by the Board. In light of this broader governance requirement, it is our view that an RE’s AIF investment policy should similarly receive Board approval. Below is a tentative list of key elements to be included in the investment policy:

  • Limits: 10% individual, 20% collective, with 5% threshold alerts;
  • Provision for real-time 12-month debtor-exposure monitoring and pre-investment checks;
  • Clear provisioning methodology: 100% look-through at >5%, capped by direct exposure; proportional Tier-1/Tier-2 deduction for subordinated units; and
  • Approval procedures for making/continuing with AIF investments; decision-making process
  • Applicability of the provisions of these Directions on investments made pursuant to commitments existing on or before the effective date of these Directions.

Subordinated Units Treatment

Under the Final Directions, investments by REs in the subordinated units7 of any AIF scheme must now be fully deducted from their capital funds, proportionately from Tier I and Tier II as against equal deduction under the Previous Circulars. While the March 2024 Circular clarified that reference to investment in subordinated units of AIF Scheme includes all forms of subordinated exposures, including investment in the nature of sponsor units; the same has not been clarified under the Final Directions. However, the scope remains the same in our view.

What happens to positions that already exist when the Final Directions arrive?

As regards effective date, Final Directions shall come into effect from January 1, 2026 or any such earlier date as may be decided as per their internal policy by the REs. 

Although, under the Final Directions, the Previous Circulars are formally repealed, the Final Directions has prescribed the following transition mechanism:

Time of making Investments by RE in AIFPermissible treatment under Final Directions
New commitments (post-effective date)Must comply with the new directions; no grandfathering or mixed approaches allowed
Existing InvestmentsWhere past commitments fully honoured: Continue under old circulars
Partially drawn commitments: One-time choice between old and new regimes

Closing Remarks

The RBI’s evolution from blanket prohibitions to calibrated risk-based oversight in AIF investments represents a mature regulatory approach that balances systemic stability with market development, and provides for enhanced governance standards while maintaining robust safeguards against evergreening and regulatory arbitrage. 

Of course, there would be certain unavoidable side-effects, e.g. significant operational and compliance burdens on REs, requiring sophisticated real-time monitoring systems, comprehensive debtor exposure tracking, board-approved investment policies, and enhanced coordination with AIF managers. Hence, there can be some challenges to practical implementation.  Further, the success of this recalibrated regime will largely depend on the operational readiness of both REs and AIFs to develop transparent monitoring systems and proactive compliance frameworks. 

  1.  https://vinodkothari.com/2023/12/rbi-bars-lenders-investments-in-aifs-investing-in-their-borrowers/ 
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  2.  https://vinodkothari.com/2024/03/some-relief-in-rbi-stance-on-lenders-round-tripping-investments-in-aifs/ 
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  3.  https://vinodkothari.com/2025/05/capital-subject-to-caps-rbi-relaxes-norms-for-investment-by-res-in-aifs-subject-to-threshold-limits/ ↩︎
  4.  The limit was 15% in the Draft Directions, the Final Directions increased the limit by 5 percentage points.
    ↩︎
  5.  This cap at RE’s direct loan and/or investment exposure has been introduced in the Final Directions.
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  6.  Para 29 of the RBI’s Master Directions on Scale Based Regulations stipulates that any investment policy must be formally approved by the Board. 
    ↩︎
  7. SEBI, vide Master Circular for AIFs, had put restrictions on priority distribution model. Later, pursuant to Fifth Amendment to SEBI (AIF) Regulations, 2024, SEBI issued a Circular dated December 13, 2024 wherein certain exemptions were allowed and differential rights were allowed subject to certain conditions. See our article here. ↩︎

Has the cover fallen off Covered Bonds?

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– Anita Baid, anita@vinodkothari.com

Recent activity in the Covered Bonds space

  • The Covered Bond issuance have been surging in the Indian market since 2019
  • FY 2019 witnessed the first instance of covered bonds, which was backed by vehicle loan
  • Issuance of covered bonds witnessed a sharp growth in FY 2021, as the numbers increased to INR 22 Bn, as against INR 4 Bn in FY 2020[1]
  • However, certain media reports suggest that the recent RBI regulations on transfer of loan exposures have killed the market for Covered Bonds[2]

What are Covered Bonds?

Read more →

Use of dual recourse instruments for SME finance: The Making of European Secured Notes

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– Vinod Kothari and Abhirup Ghosh (finserv@vinodkothari.com)

The European financial regulators are working on a new funding instrument whereby banks and primary lenders can raise refinance against their portfolio of SME loans, by issuing a bond which is directly linked with such portfolios, called European Secured Notes (ESNs). ESNs are a dual recourse instrument, following the time-tested structure of covered bonds.

Covered bonds, developed more than 250 years ago in Europe, use dual recourse structure. The first recourse, against the issuer, is prone to the risk of bankruptcy of the issuer. In that situation, the investors have recourse against the assets of the issuer, and that recourse is made immune from other bankruptcy claims or priorities. This ring-fencing is granted either by explicit legislation, or by use of contract law flexibility. Covered bonds are currently used, to an overwhelming extent, for prime residential mortgage loans. Given their bankruptcy-protected asset backing, covered bonds allow the issuer to get a rating higher than the issuer’s own default rating. This phenomenon, called “notching up”, may cause the ratings on the bonds to go up over the rating of the issues by some 6 to 9 notches.

European regulators are trying to build on the methodology of covered bonds to see if a similar instrument can be used by banks to refinance their SME loan pools.

Development of European Secured Notes:

There have been past instances, sporadically, of dual recourse bonds, on lines similar to ESNs,. A notable instance was Commerzbank’s SME-backed structured covered bond programme established in 2013 but fully repaid in 2018[1]. Besides this, there were several issuances in France, though they are no longer used.

There has been a multi-issuer platform called French “Euro secured Note issuer” (ESNI), established in 2014 and supported by the Banque de France. Though the programme was open to all French and European Banks, only four French banks opted for this. There were around 20 issuances totalling to over Euro 10 Bn. Banque de France acted as the monitor for the asset quality of the SME loans. It used its internal rating model to examine the assets and score them. The scoring, in combination with haircuts on such assets established the minimum over-collateralisation level.

The Italian regulators also proposed to come up with an enabling regulatory framework to permit domestic issuers to issue Obbligazioni Bancarie Collateralizzate (OBC);  however, this seems to have been stranded into oblivion.

Similar efforts were made by the Spanish regulators when they amended the covered bonds framework in 2015.

The work done all this while might have been the inspiration for the European Commission when it proposed the use of ESN as a financial instrument backed by SME loans and infrastructure loans, to be used by banks, as a part of the Capital Markets Union proposals in 2017[2].

Subsequently, the Commission requested a report from the European Banking Authority to set out probable structures of ESNs, which was issued in July 2018[3].

It was originally meant to be kept on the backburner until 2024, however, with the COVID 19 pandemic, the European Parliament asked the European Commission to accelerate the introduction of ESNs to help financing the recovery from the pandemic.

In April 2021, the ESN Task Force, that is, ECBC along with EMF, issued the ESN Blueprint[4]. It appears that ESNs may be rolled out ahead of the original implementation schedule.

Structure of ESNs

Originally, at the time of conceptualisation, there were two structures which were contemplated:

  1. A structure that mirrors the structure of covered bonds,
  2. A structure that mirrors the structure of ABS

However, EBA suggested the first structure in its report.

The key recommendations of the EBA on the structure are as follows:

  1. Dual recourse – The bond must grant the investor a claim on the covered bond issuer, and if it fails to pay, a priority claim on the cover pool limited to the fulfilment of the payment obligations. Further, if the cover pool turns to be insufficient to fulfil the payments, the investor shall have recourse back to the insolvency estate of the issuer, which shall rank pari passu with the claims of the unsecured creditors.
  2. Segregation of cover assets – The next important suggestion was with respect to the segregation of cover assets. The segregation of assets could be either be achieved through registration of the cover pool into a cover register or by transferring them to a special purpose vehicle (SPV). Note that registration of covered bonds is required by several European jurisdictions, as well as Canada.
  3. Bankruptcy-remoteness of the covered bond: The legal/ regulatory framework should facilitate the bankruptcy-remoteness by not requiring acceleration of payments in case of issuer default.
  4. Administration of the covered bond programme after the issuer’s insolvency or resolution: The legal/regulatory covered bond framework should provide that upon issuer’s default or resolution the covered bond programme is managed in an independent way and in the preferential interest of the covered bond investor.
  5. Composition of cover pool: The cover pool should comprise of non-defaulted SME loan and leasing exposures. Further, the pool should be dynamic. Given the high risk associated with SME loans, the EBA recommended incorporating strict eligibility criteria at both loan and pool levels in the form of:
    • selected SME exposures
    • sufficient granularity,
    • concentration limit,
    • quality standards.
  6. Coverage principles and legal/regulatory overcollateralization: The claims against the cover pool should not exceed the receivables arising out of the cover pool. Further, the EBA considered a minimum over-collateralisation must be prescribed for SME ESNs. In this regard, the EBA recommended a minimum over-collateralisation of 30%.

Use of capital market instruments for refinancing SME loans:

“SMEs are important actors in economic growth and transformation, creating positive value for the economy and contributing towards sustainable and balanced economic growth, employment and social stability”[5]. The use of capital market instruments for refinancing SME loans has been engaging the attention of policymakers and regulators alike. The extent of penetration of bank finance to SMEs is far from optimal, and additionally, there are gaping differences across geographies.

Direct access of SMEs to capital markets for debt funding is quite limited, since most of the SMEs do not have the size to be able to attract the attention of institutional investors in the capital market. An OECD-World Bank report notes that “individual SMEs issuances do not easily align with the risk appetite and prudential requirements of institutional investors.”[6] On the other hand, institutional investors may easily participate in bonds or similar instruments which refinance or repackage SME lenders’ loan portfolios. The aforesaid OECD-World Bank report envisages 4 types of capital market instruments for SME refinancing –corporate bonds issued by SME lenders, securitisation of SME loans, SME covered bonds, and SME loan & bond funds, as collective investment schemes.

Issuance of bonds by banks, for on-lending to SMEs or refinancing SME loan portfolios, is quite common in many countries. Such bonds are, however, linked with the performance and rating of the issuer bank.

As for securitisation of SME loans, the overall contribution of SME loans as an asset class in the global securitisation volumes will be in the region of 2%, which obviously dwarfs in comparison to popular asset classes such as residential mortgage loans. Post the GFC, several European jurisdictions have used securitisation of SME loans, but looking at the huge proportion of retained securitisations (see Graph below), it is quite evident that such activity was motivated by the objective of refinancing by ECB. This low volume is despite the fact that  asset backed securitisation is the most natural choice to fund SME loans through capital market, as they provide three benefits:

  1. Provide funding to the banks
  2. The assets move off the books of the originator, depending on the structure
  3. Can be tailor made to the specifications of the investor
  4. Regulatory capital relief

In the recent times, SME ABS issuances in Europe peaked in 2019, of which almost 97% were issued in retained format.

Source: Scope Ratings[7]

Outside of Europe, Korea and India have seen several securitisations of SME loan pools.

Relevance of dual recourse instrument for SME funding

Covered bonds are mostly supported by legislation to provide bankruptcy protection in European jurisdictions. In several other jurisdictions, the flexibility of the common law structure is utilised for providing bankruptcy protection. However, the essential premise in either case is the same –which is the ability of the cover pool to be a backstop for redemption of the bonds, in the event of failure of the issuer to pay them. Therefore, the pool of assets have to be liquid and robust to be able to pay off the bondholders.

There is substantial difference between mortgage pools backing up covered bonds, and SME loans. SME loans have lesser granularity, heterogeneity, and higher historical default rates. The servicing of SME loans from the viewpoint of ongoing collections is also not as easy as in case of mortgage loans. However, these will be ultimately be the factors that would have to be borne in mind by the rating agencies while sizing up the level of over-collateraliation and fixing the level of rating notch-ups for SME-loan-backed covered bonds. As a matter of principle, if there is a market for securitisation of SME loans as demonstrated by recent global transactions, a covered bond structure only tries to marry the benefits of securitisation and corporate bonds. Hence, introducing covered bonds backed by SME loans may be the right idea.

The robustness of covered bond with a history of over 250 years is explained, other than by the legislative protection, by the good quality of the cover pool. The transparency of loan-level performance data of SME loans is much lesser than mortgage loans. Even more importantly, the question is the ability and liquidity of the cover pool, given the insolvency of the issuer, to redeem the bonds. SME loans do not have as liquid secondary market, and the migration of servicing to an alternate servicer makes the liquidity of such loan pools even more difficult. The layering of a credit guarantee support by credit guarantee schemes, which exist practically in every jurisdiction in the world, could also be considered as a credit support.

Should there be a legislative bankruptcy protection, which removes these loan pools completely from the bankruptcy estate and makes the same available to covered bond investors only? This question becomes a complicated one, involving inter-creditor rights. Insolvency for other creditors becomes deeper if there are more bankruptcy-protected instruments.

The urgency for ESNs is also a part of the post-Covid worries of regulators all over the world, and clearly, SMEs are seen as a huge agent of post-Covid revival. However, the need for availability of more liquidity for SMEs has always been crucial. Therefore, the introduction of SME-loan-backed covered bonds may be an agenda items for countries outside of Europe too.

[1] https://www.scoperatings.com/ScopeRatingsApi/api/downloadstudy?id=dfa74ad6-f1ca-4860-a916-bc0638846bb1

[2] https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52017DC0292

[3] https://www.eba.europa.eu/sites/default/documents/files/documents/10180/2087449/6fe04a31-ec0b-4ea1-9508-258ad2cf72d8/EBA%20Final%20report%20on%20ESNs.pdf

[4] https://hypo.org/app/uploads/sites/3/2017/05/ECBC-ESN-Blueprint-April-2021.pdf

[5] IOSCO Report, 2015, titled SME Financing Through Capital Markets, at https://www.iosco.org/library/pubdocs/pdf/IOSCOPD493.pdf

[6] https://www.oecd.org/g20/topics/development/WB-IMF-OECD-report-Capital-Markets-Instruments-for-Infrastructure-and-SME-Financing.pdf, page 46

[7] https://www.scoperatings.com/ScopeRatingsApi/api/downloadstudy?id=dfa74ad6-f1ca-4860-a916-bc0638846bb1

Our other resources on Covered Bonds:

https://vinodkothari.com/2021/07/covered-bonds-the-story-of-the-indianised-version-of-a-global-instrument/ 

https://vinodkothari.com/covered_bonds-2/ 

https://www.youtube.com/watch?v=XyoPcuzbys4

Covered Bonds in India: creating a desi version of a European dish

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Abhirup Ghosh | abhirup@vinodkothari.com

It is not uncommon to have Indianised version of global dishes when introduced in India, and we are very good in creating fusion food. We have a paneer pizza, and we have a Chinese bhel. As covered bonds, the European financial instrument with over 250 years of history were introduced in India, its look and taste may be quite different from how it is in European market, but that is how we introduce things in India.

It is also interesting to note that regulatory attempts to introduce covered bonds in India did not quite succeed – the National Housing Bank constituted Working Group on Securitisation and Covered Bonds in the Indian Housing Finance Sector, suggested some structures that could work in the Indian market[1]  and thereafter, the SEBI COBOSAC also had a separate agenda item on covered bonds. Several multilateral bodies have also put their reports on covered bonds[2].

However, the market did not wait for regulators’ intervention, and in the peak of the liquidity crisis of the NBFCs, covered bonds got uncovered – first slowly, and now, there seems to be a blizzard of covered bond issuances. Of course, there is no legislative bankruptcy remoteness for these covered bonds.

There are two types of covered bonds, first, the legislative covered bonds, and second, the contractual covered bonds. While the former enjoys a legislative support that makes the instrument bankruptcy remote, the latter achieves bankruptcy remoteness through contractual features.

To give a brief understanding of the instrument, a standard covered bond issuance would reflect the following:

  1. On balance sheet – In case of covered bonds, both the cover pool and the liability towards the investor remains on the balance sheet of the issuer. The investor has a recourse on the issuer. However, the cover pool remains ring fenced, and is protected even if the issuer faces bankruptcy.
  2. Dual recourse – The investor shall have two recourses – first, on the issuer, and second, on the cover pool.
  3. Dynamic or static pool – The cover pool may be dynamic or static, depending on the structure.
  4. Prepayment risk – Since, the primary exposure is on the issuer, any prepayment risk is absorbed by the issuer.
  5. Rating arbitrage – Covered bonds ratings are usually higher than the rating of the issuer. Internationally, covered bonds enjoy upto a maximum of 6-notch better rating than the rating of the issuer.

Therefore, covered bond is a half-way house, and lies mid-way between a secured corporate bond and the securitized paper. The table below gives comparison of the three instruments:

  Covered bonds Securitization Corporate Bonds
Purpose Essentially, to raise liquidity Liquidity, off balance sheet, risk management,

Monetization of excess profits, etc.

 To raise liquidity
Risk transfer The borrower continues to absorb default risk as well as prepayment risk of the pool The originator does not absorb default risk above the credit support agreed; prepayment risk is usually transferred entirely to investors. The borrower continues to absorb default risk as well as prepayment risk of the pool
Legal structure A direct and unconditional obligation of the issuer, backed by creation of security interest. Assets may or may not be parked with a distinct entity; bankruptcy remoteness is achieved either due to specific law or by common law principles True sale of assets to a distinct entity; bankruptcy remoteness is achieved by isolation of assets A direct and unconditional obligation of the issuer, backed by creation of security interest. No bankruptcy remoteness is achieved.
Type of pool of assets Mostly dynamic. Borrower is allowed to manage the pool as long as the required “covers” are ensured. From a common pool of cover assets, there may be multiple issuances. Mostly static. Except in case of master trusts, the investors make investment in an identifiable pool of assets. Generally, from a single pool of assets, there is only issuance. Dynamic.
Maturity matching From out of a dynamic pool, securities may be issued over a period of time Typically, securities are matched with the cashflows from the pool. When the static pool is paid off, the securities are redeemed. From out of a dynamic pool, securities may be issued over a period of time.
Payment of interest and principal to investors Interest and principal are paid from the general cashflows of the issuer Interest and principal are paid from the asset pool Interest and principal are paid from the general cashflows of the issuer.
Prepayment risk In view of the managed nature of the pool, prepayment of loans does not affect investors Prepayment of underlying loans is passed on to investors; hence investors take prepayment risk Prepayment risk of the pool does not affect the investors, as the same is absorbed by the issuer.
Nature of credit enhancement The cover, that is, excess of the cover assets over the outstanding funding. Different forms of credit enhancement are used, such as excess spread, subordination, over-collateralization, etc. No credit enhancement. Usually, the cover is 100% of the pool principal and interest payable.
Classes of securities Usually, a single class of bonds are issued Most transactions come up with different classes of securities, with different risk and returns Single class of bonds are issued.
Independence of the ratings from the rating of the issuer Theoretically, the securities are those of the issuer, but in view of bankruptcy-proofing and the value of “cover assets”, usually AAA ratings are given AAA ratings are given usually to senior-most classes, based on adequacy of credit enhancement from the lower classes. There is no question of independent rating.
Off balance sheet treatment Not off the balance sheet Usually off the balance sheet Not applicable.
Capital relief Under standardized approaches, will be treated as on-balance sheet retail portfolio, appropriately risk weighted. Calls for regulatory capital Calls for regulatory capital only upto the retained risks of the seller Not applicable

 

This article would briefly talk about the issuance of Covered bonds world-wide and in India, and what are the distinctive features of the issuances in India.

Global volume of Covered Bonds

Since most volumes for covered bonds came from Europe, there has been a decline due to supply side issues. This is evident from the latest data on Euro-Denominated Covered bonds Volume. The performance in FY 2020 and FY 2021 has been subdued mainly due to COVID-19. Though, the volumes suffered significantly in the Q3 and Q4 of FY 20, but returned to moderate levels by the beginning of FY 2021.

The figure below shows Euro-Denominated Covered bond Issuances until Q2 2021.

Source: Dealogic[3]

Countries like Denmark, Germany, Sweden continues to be dominant markets for covered bond issuances. The countries in the Asia-Pacific region like Japan, Singapore, and Australia continues to report moderate level of activities. In North America, Canada represents all the whole of the issuance, with no issuances in the USA.

The tables below would show the trend of issuances in different jurisdictions in 2019 (latest available data):

Source: ECBC Factbook 2020[4]

Covered Bonds in India

In India, the struggle to introduce covered bonds started way back in 2012, when the National Housing Bank formed a working group[5] to promote RMBS and covered bonds in the Indian housing finance market. Though the outcome of the working group resulted in some securitisation activity, however, nothing was seen on covered bonds.[6]

Some leading financial institutions attempted to issue covered bonds in the Indian market, but they failed. Lastly, FY 2019 witnessed the first instance of covered bonds, which was backed by vehicle loans.

In India, issuance of covered bonds witnessed a sharp growth in FY 2021, as the numbers increased to INR 22 Bn, as against INR 4 Bn in FY 2020. Even though the volume of issuances grew, the number of issuers failed to touch the two-digit mark. The issuances in FY 2021 came from 9 issuers, whereas, the issuances in FY 2020 were from only 2 issuers. Interestingly, all were non-banking financial companies, which is a stark contrast to the situation outside India.

The figure below shows the growth trajectory of covered bonds in India:

Source: ICRA, VKC Analysis

The growth in the FY 2021 was catapulted by the improved acceptance in Indian market in the second half of the year, given the uncertainty on the collections due to the pandemic, and the additional recourse on the issuer that the instrument offers, when compared to a traditional securitisation transaction.

Almost 75% of the issuances were done by issuers have ‘A’ rating, the following could be the reasons for such:

  1. Enhanced credit rating – In the scale of credit ratings, ‘A’ stands just above the investment grade rating of ‘BBB’. Therefore, it signifies adequate degree of safety. With an earmarked cover pool, with certain degree of credit enhancements and, covered bonds issued by these entities fetched a much better credit rating, going up to AA or even AAA.
  2. AUM – FY 2021 was a year of low level of originations due to the pandemic. As a result, most of the financial sector entities stayed away from sell downs, which is evident from the low of level of activity in the securitisation market, as they did not want their AUM to drop significantly. In covered bonds, the cover pool stays on the books, hence, allowing the issuer to maintain the AUM.
  3. Better coupon rate – Improved credit ratings mean better rates. It was noticed that the covered bonds were issued 50 bps – 125 bps cheaper than normal secured bonds.

The Indian covered bonds market is however, significantly different from other jurisdictions. Traditionally, covered bonds are meant to be long term papers, however, in India, these are short to medium term papers. Traditionally covered bonds are backed by residential mortgage loans, however, in India the receivables mostly non-mortgages, gold loans and vehicle loans being the most popular asset classes.

In terms of investors too, the Indian market has shown differences. Globally, long term investors like pension funds and insurance companies are the most popular investor classes, however, in India, so far only Family Wealth Offices and High Net-worth Individuals have invested in covered bonds so far.

Another distinct feature of the Indian market is that a significant share of issuances carry market linked features, that is, the coupon rate varies with the market conditions and the issuers’ ability to meet the security cover requirements.

But the most important to note here is that unlike any other jurisdiction, covered bonds don’t have a legislative support in India. In Europe, the hotspot for covered bonds, most of the countries have legislations declaring covered bonds as a bankruptcy-remote instruments. In India, however, the bankruptcy-remoteness is achieved through product engineering by doing a legal sale of the cover pool to a separate trust, yet retaining the economic control in the hands of the issuer until happening of some pre-decided trigger events, and not with the help of any legislative support. In some cases, the legal sale is done upfront too.

Considering the importance and market acceptability of the instrument, rating agencies in India have laid down detailed rating methodologies for covered bonds[7].

Conclusion

Covered Bonds issued in India will not match most of the features of a traditional covered bond issued in Europe, however, the fact that finally the investors community in India has started recognizing it as an investment opportunity is very encouraging.

The real economics of covered bonds will come to the fore only when the market grows with different classes of investors, like the mutual funds, pension funds, insurance companies etc. in the demand side, which seems a bit far-fetched for now.

 

 

[1] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[2] In 2014-15, the Asian Development Bank appointed Vinod Kothari Consultants to conduct a Study on Covered Bonds and Alternate Financing Instruments for the Indian Housing Finance Segment

[3] https://www.icmagroup.org/resources/market-data/Market-Data-Dealogic/#14

[4] https://hypo.org/app/uploads/sites/3/2020/10/ECBC-Fact-Book-2020.pdf

[5] A working group was constituted by the National Housing Bank to promote RMBS and Covered Bonds, the report of the working group can be viewed here: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

[6] Vinod Kothari Consultants has been a strong advocate for a legal recognition of Covered Bonds in India. They were involved in the initiatives taken by the NHB to recognize Covered Bonds as a bankruptcy remote instrument in India.

[7] The rating methodology adopted by ICRA Ratings can be viewed here: https://www.icra.in/Rating/ShowMethodologyReport/?id=709

The rating methodology adopted by CRISIL can be viewed here: https://www.crisil.com/mnt/winshare/Ratings/SectorMethodology/MethodologyDocs/criteria/crisils%20criteria%20for%20rating%20covered%20bonds.pdf

—

Our Video on Covered Bonds can be viewed here <https://www.youtube.com/watch?v=XyoPcuzbys4>

Some resources on Covered Bonds can be accessed here –

Introduction to Covered Bonds by Vinod Kothari: https://vinodkothari.com/2015/01/introduction-to-covered-bonds-by-vinod-kothari/

The Name is Bond. Covered Bond. By Vinod Kothari: http://www.vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

NHB’s Working Paper on Covered Bonds: https://www.nhb.org.in/Whats_new/NHB%20Covered%20Bond%20Report.pdf

 

Covered Bonds

Covered bonds and the COVID disruption

 

SEBI’s stringent norms for secured debentures

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Will it lead to a paradigm shift to unsecured debentures?

Shaifali Sharma | Vinod Kothari and Company

corplaw@vinodkothari.com

Introduction

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

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

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

Current Scenario of Corporate Bond Market in India

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

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

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

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

 

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

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

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

Source: RBI Bulletin January 2019

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

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

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

Regulatory Framework for issuing Secured Debentures

SEBI’s stringent norms for issuance of secured debentures

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

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

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

  1. Creation of Recovery Expense Fund (REF)

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

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

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

  1. Due diligence by Debenture Trustee for creation of security

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

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

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

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

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

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

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

  1. Entering into Inter-Creditor Agreement (ICA)

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

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

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

Should issuers move towards unsecured debt raising?

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

Fund raising via unsecured debentures and applicability of Deposit Rules

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

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

Applicability Whether deposits?
Secured debentures Unsecured debentures

 
For Companies

 

(on which Deposits Rules apply)

 Secured debentures shall not be considered as deposits

Explanation:

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

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

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

Explanation:

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

 

(on which NBFC Deposits Directions apply)

 Secured debentures shall not be considered as public deposits

Explanation:

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

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

Explanation:

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

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

Compliance Corner: How different is unsecured from secured debentures?

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

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

 

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

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

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

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

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

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

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

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

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

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

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

Concluding Remarks

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

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

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

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

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

Other reading materials on the similar topic:

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

Email id for further queries: corplaw@vinodkothari.com

Our website: www.vinodkothari.com

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

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

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

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

[3] SEBI (Debenture Trustees) Regulations, 1993

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

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

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

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

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

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

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

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

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

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

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

/5 Comments/in , , , , /by

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: https://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

 

Covered bonds and the COVID disruption

/0 Comments/in , , , /by

-Vinod Kothari

finserv@vinodkothari.com

Last year, the European Covered Bonds Council celebrated 250th anniversary of covered bonds[1]. That year also marked a substantial increase in global volumes of covered bonds issuance, which had been flat for the past few years. However, no one, joining the 250 years’ celebration, would have the COVID disruption in mind

With a history of more than 250 years now, covered bonds would have withstood various calamities and disruptions, both economic and natural, over the years. Covered bonds have not seen defaults over all these years. Will they be able to sustain the COVID disruption as well, given the fact that the major countries where they have been used extensively, have all suffered COVID casualties or infections, in varying degrees? In addition to the challenging credit environment, covered bonds will also be put to another question – does this device of refinancing mortgages in Europe hold the answer to sustaining continuous funding of home loans, thereby mitigating the impact of the crisis?

While, over the years, the instrument has been talked about (and less practiced) in lots of jurisdictions over the world, EU countries are still the bastion for covered bonds. About 82% of the world’s Euro 2.50 trillion dollar outstanding covered bonds are issued by EU entities.

European banks’ dependence on covered bond funding

European banks have a substantial dependence on covered bonds. Germany, where covered bonds have widely been regarded as a “fixture of German banking”, account for nearly 32% of the total capital market funding. In some countries, albeit with smaller bank balance sheets, the number goes up to as high as 78 – 81% [See Graph].

Figure 1  source: https://www.spglobal.com/_media/documents/spglobalratings_spglobalratings-coveredbondsprimer_jun_20_2019.pdf

If covered bonds were to prove resilient to the crisis, the investors’ confidence in these bonds, which have so had several regulatory privileges such as lower risk weights, will stand justified. On the other hand, if the bonds were to prove as brittle as some of their issuing banks, the claim to 250 years of unblemished vintage will be put to question.

Robustness of covered bonds

Covered bonds have a dual recourse feature – the issuer, and the underlying pool, in that order. Covered bonds are generally issued by mortgage-lending banks in Europe. Therefore, a default of covered bonds may occur only the issuing banks face the risk of default. Even if that were to happen, the extent of over-collateralisation in the cover pool may be sufficient to hold the bondholders safe. The recourse that the bondholders have against the loan pool is further strengthened by inherent support in a mortgage loan in form of the LTV ratio.

After the Global Financial Crisis and the introduction of Basel III norms, the capital of EU banks has generally strengthened. Data published by European Central Bank shows that European banks have a common equity tier 1 [CET 1] ratio of about 14.78%, as against the regulatory minimum of 4.5%. Therefore, the issuer banks seem to be poised to withstand pressure on the performance.

Past instances of default

Robustness of covered bonds is not the only factor which has kept them standing over all these years – another very important factor is sovereign support. European sovereigns have been sensitive to the important of covered bonds as crucial to maintain the flow of funds to the housing sector, and hence, they have tried to save covered bonds from defaulting.

In the period 1997 to 2019, out of covered bonds, there have been 33 instances of default by covered bond issuers, in various other on-balance sheet liabilities. However, these issues did not default on their covered bonds[2].

There are several regulatory incentives for covered bonds. Central banks permit self-issued covered bonds to be used as collateral for repo facilities. ECB also permits covered bonds as a part of its purchase program. In addition, there are preferential risk weights for capital requirements.

Rating downgrades in covered bonds correlate with sovereign downgrades

Rating agency Moody’s reports [16th April, 2020 report][3] that the potential for rating downgrades for covered bonds was strongly correlated with the ratings of sovereigns. “for countries with Aaa country ceilings, the average 12-month downgrade rate between 1997 and 2019 was 6.5% for covered bonds and 15.5% for covered bond issuers. However, in countries with lower country

ceilings, representing lower sovereign credit quality, the average 12-month downgrade rate increased to 24% for covered bonds and 25% for covered bond issuers”.

Rating agency Fitch also had a similar observation – stating that the rating downgrades for covered bonds were mostly related to sovereign downgrades, as in case of Greece and Italy.

Risk of downgrades in covered bonds

Risk of downgrades in covered bonds arises mainly from 2 reasons: weakening health of issuer banks, and quality of the underlying mortgage pools. Mortgage pools face the risks of reducing property prices, strain on urban incomes and increase in unemployment levels, etc. Over-collateralisation levels remain a strength, but unlike in case of MBS, covered bonds lean primarily on the health of the issuer banks. As long as the bank in question has adequate capital, the chances that it will continue to perform on covered bonds remain strong.

At the loan level, LTV ratios are also sufficiently resilient. Moody’s report suggests that in several jurisdictions, the LTV ratios for European covered bonds are less than 60%.

Additionally, in several European jurisdictions, the regulatory requirement stipulate non-performing loans either to be replaced by performing loans, or not to be considered for the purpose of collateral pool.

Unused notches of rating upliftment

A covered bond rating may rise by several notches, because of a combination of factors, including issuer resolution framework, jurisdictional support, and collateral support[4]. Either because of the strength of the pool, or because of the legislation support, or because of both. However, in any case the issuer’s credit rating is already strong, say, AAA, the notching up that could potentially have come has not been used at all. This is what is referred to as “unused notches”.

In order to assess the ability of covered bonds to withstand the pressure on the issuer bank’s rating will be the extent of unused notches of rating upliftment. In a report dated 25th March, 2020[5], rating agency S&P gave data about unused notches of rating upliftment of covered bonds in several jurisdictions. These ranged between 1 to 6 in many countries, thus pointing to the ability of the covered bond issuances to withstand rating pressures.

Conclusion

We are at the cusp of the disruption in global economies caused by the COVID pandemic. Any assessment of the impact of the crisis on capital market instruments may verge on being speculative. However, current signals are that the 250 years of history of performance does not face the risk of a collapse.

Links to our other resources on covered bonds –

https://vinodkothari.com/wp-content/uploads/Introduction-to-Covered-Bonds-by-Vinod-Kothari.pdf

vinodkothari.com/wp-content/uploads/covered-bonds-article-by-vinod-kothari.pdf

Securitisation and covered bonds for housing finance

Conditional Pass-Through Covered Bonds: A New Innovation

Some notable structured covered bonds globally

Comparative table on key legislative features on covered bonds in different countries

MBS and covered bonds after the crisis for APUHF conference

[1] 29th August, 1769, Frederick the Great of Prussia signed an order permitting the issuance of a landowners’ cooperative.  It was in 1770 that the first German pfandbrief was issued. Going by this, the 250th anniversary should actually be this year.

[2] See Moody’s report here: https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1117861

[3] https://www.moodys.com/researchdocumentcontentpage.aspx?docid=PBS_1221857

[4] Rating agency Standard and Poor’s, for example, considers at least 2 notches for resolution framework, three notches for jurisdictional support, and four notches for collateral support.

[5] https://www.spglobal.com/ratings/en/research/articles/200325-global-covered-bonds-assessing-the-credit-effects-of-covid-19-11402802