Subordinated debentures – A Capital Supporting Instrument

following guest post is contributed by Vinita
of Vinod Kothari & Co. The author may be contacted at]
Non Banking Financial Companies (NBFCs) in India
are always seeking sources of raising funds. Capital is costly and therefore
NBFCs rely more on public funds. Public funds as defined under the Systemically Important Non-Banking Financial
(Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank)
Directions, 2015 (the “2015 Directions”) include funds raised directly or
indirectly through public deposits, commercial papers, debentures,
inter-corporate deposits and bank finance but excludes funds raised by issue of
instruments compulsorily convertible into equity shares within a period not
exceeding 5 years from the date of issue.
Debentures can be
classified into various types based on several parameters viz. transferability,
convertibility, tenure, public participation, security, seniority, coupon and
rate of return. On the basis of seniority, debentures can be classified as
Senior debt and Subordinated debt. Subordinated debt is even included for
meeting regulatory capital requirements.
This post discusses
the statutory provisions for subordinated debt, features, rights of
subordinated debt holders as reflected in the information memorandum of NBFCs/
Banks issuing and listing the same and international practice.
Statutory provisions for issuance of Subordinated
debt by NBFCs and Banks in India
Subordinated debentures, as evident from the expression,
are subordinated to other debt of the Company. Subordinated debt has been
defined under the 2015 Directors means

“an instrument,
which is fully paid up, is unsecured and is subordinated to the claims of other
creditors and is free from restrictive clauses and is not redeemable at the
instance of the holder or without the consent of the supervisory authority of
the non-banking financial company. The book value of such instrument shall be
subjected to discounting as provided hereunder:
Maturity of the instruments                                               Rate
of discount
(a) Upto one year
per cent
(b) More than one
year but upto two years                                        
80 per cent
(c) More than two
years but upto three years                                     60
per cent
(d) More than
three years but upto four years                                   
40 per cent
(e) More than
four years but upto five years                                      20
per cent
to the extent
such discounted value does not exceed fifty per cent of Tier I capital.”
Companies are not permitted to issue unsecured
debentures under provisions of Companies Act, 2013 except to exempted
categories under Companies (Acceptance of Deposits) Rules, 2014. NBFCs were,
however, permitted even under Non-Banking Financial (Non Deposit Accepting or
Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007 to issue
subordinated debt. Pursuant to issuance of
on Private Placement of non-convertible debentures (“NCDs”) (maturity more than
1 year) by NBFCs
by Reserve Bank of India (“RBI”) on 20 February
2015, NBFCs have been permitted to issue unsecured debentures subject to
minimum subscription of Rs. 1 crore per investor. Thus, in addition to
subordinated debt, NBFCs can raise funds by issue of unsecured NCDs subject to
compliance of the prescribed guidelines.
Indian banks, until September 2009 were
permitted to raise lower Tier II subordinated bonds without special features
such as Call and Step up options. On a review of international practices in
this regard, it was decided by RBI to permit banks to issue subordinated debt
as Tier II capital with call and step-up options subject to conditions
specified in the Notification
No. RBI/2009-10/147 DBOD.No.BP.BC. 38 /21.01.002/2009-10
dated September 7,
2009. The bonds should have a minimum maturity of 5 years. However if the bonds
are issued in the last quarter of the financial year, i.e. from 1st January to
31st March, they should have a minimum tenure of sixty-three months.
of subordinated debt
In the order of ranking of priority of claims,
in case of a company being wound up, the claim of subordinated debt is settled
before that of preference and equity shares. In case of NBFCs, subordinated
debt is included as Tier II capital along with preference shares, perpetual
debt instruments, hybrid debt instruments etc.
Subordinated debt provides a support to capital
and can be utilized by companies for paying senior debt. In case of default by issuer
company in paying coupons of subordinated debt, the debt holders can make the
bonds due and payable. Clauses pertaining to claiming of liquidated damages or
initiating action for attachment of assets or cashflows as available after
taking care of interest of senior lenders and creditors can also be included.
However, understanding the purpose of subordinated debt, providing right to sub
debt holders to proceed against the company by filing petition for liquidation
may not seem appropriate. We have perused the information memorandum filed by
NBFCs/ Banks with stock exchanges for details regarding rights of subordinated
debt holders, events of default and remedies in case of event of default and
generalized the observations as set out below.
of Default
on the part of a bank to forthwith satisfy all or any part of payments in
relation to the bonds when it becomes due (i.e. making payment of any
installment of interest or repayment of principal amount of the Bonds on the
respective due dates) (except in case of regulatory requirements prescribed
under Applicable RBI Regulations), shall constitute an Event of Default for the
purpose of the Issue.
(a) The
issuer does not pay, on the due date, any amount payable pursuant to any of the
Transaction Documents;
(b) If
the issuer voluntarily or compulsorily goes into liquidation or ever has a
receiver appointed in respect of its assets or refers itself to the Board for
Industrial and Financial Reconstruction or under any other law providing
protection as a relief undertaking;
(c) If
the issuer commences a voluntary proceeding under any applicable bankruptcy,
insolvency, winding up or other similar law now or hereafter in effect, or
admits inability to pay its respective debts as they fall due, or consents to
the entry of an order for relief in an involuntary proceeding under any such
law, or consents to the appointment of or the taking of possession by a
receiver, liquidator, assignee (or similar official) for any or a substantial
part of its respective property;
(d) If
a petition is filed for the winding up of the issuer and the same is admitted,
and such petition is not dismissed or stayed within a period of 30 (thirty)
days of such petition being admitted;
 (e) Breach of any representations and/or
warranties or covenants contained in this Deed or any other Transaction
Document, which is detrimental to the interest of the Debenture Holders in the
discretion of the Debenture Trustee (acting on the instructions of the Majority
Debenture Holders) or any such representations and/or warranties are found to
be untrue, misleading or incorrect, when made or deemed to be made;
(f) Any
material adverse event, as defined in the Transaction Documents.
As evident from above, any representation or
warranty, general covenants should be carefully worded to avoid any undue or
unreasonable trigger of any default clause. Representations and warranties
should not be such that unduly interferes with the management of the issuer
company – e.g. issuer company defaults on any agreement or in violation of its
articles of association. Such violation should not result in triggering
acceleration and repayment of the subordinated debt.
in case of event of default
The Bondholders shall have no rights to
accelerate the repayment of future scheduled payments (coupon or principal)
except in bankruptcy and liquidation. This is mandated in Para 1.7 of Annex 5 of
Circular – Basel III Capital Regulations
. Further, Annex 16 of the said
Master Circular contains criteria for loss absorption through conversion /
writeoff of all non-common equity regulatory capital instruments at the point
of non-viability.
The terms and conditions of all non-common
equity Tier 1 and Tier 2 capital instruments issued by banks in India must have
a provision that requires such instruments, at the option of RBI, to either be
written off or converted into common equity upon the occurrence of the trigger
event, called the ‘Point of Non-Viability (PONV) Trigger’ stipulated below: The
PONV Trigger event is the earlier of:
a. a
decision that a conversion or write-off, without which the firm would become
non-viable, is necessary, as determined RBI; and
b. the
decision to make a public sector injection of capital, or equivalent support,
without which the firm would have become non-viable, as determined by the
relevant authority. Such a decision would invariably imply that the write-off
or issuance of any new shares as a result of conversion or consequent upon the
trigger event must occur prior to any public sector injection of capital so
that the capital provided by the public sector is not diluted.
the occurrence of any of the Events of Default, the Trustees shall on
instructions from majority Debenture holder(s), declare the amounts outstanding
to be due and payable forthwith. Debenture holders will have the right to
accelerate the repayment/ redemption of debentures along with all outstanding
dues including interest and demand immediate repayment of the principal.
Further, the Debenture Trustee shall have other recourse as provided for in the
transaction documents.
Office of the Comptroller of the Currency, US
department of treasury issued guidelines
for subordinated debt
on April 3, 2015. The guidelines require banks to
comply with applicable OCC rules and federal and state securities law. In
Canada, Office of Superintendent’s (OSFI) guidelines pertaining to Subordinated
Debt are observed.
With respect to remedies in case of event of
default, as observed from one the disclosure
from CIMB Bank, in case of event of default being triggered, the
Trustee may institute such proceedings as it chooses to enforce the obligations
of the Issuer under the Trust Deed and/or institute proceedings for the winding
up of the Issuer, provided that the Trustee shall have no right to accelerate
payment of the indebtedness in the case of a default in the performance of any
covenant of the Issuer under the Trust Deed. However, in case of other
countries the remedies include making the note due and payable forthwith and
that too only in the event of a receivership, insolvency, liquidation or
similar proceeding of Bank.
Viable Contingent Capital ( NVCC)
These subordinated debt get converted
into common equity upon a trigger event.  The multiplier is used for determining the
number of shares to be issued. Royal Bank of Canada has already made
issuances of NVCC
. For OSFI, the federal financial institution regulator,
two circumstances can bring about a trigger event:
a) when
it announces that the financial institution “has ceased or is about to cease
being viable”, and that conversion of the conversion of the contingent
instrument “will restore or maintain viability,” and;
b) the
financial institution “has or will” accept a capital injection from the
government, “without which the firm would cease to be viable.”
Further, as per FIIG
research paper
, any new subordinated debt issuances in Australia made post
January, 2013 have clauses viz. Non-viability clause, contingent capital
conversion clause, step up clause and expectation to call.
Subordinated debt is surely a capital-supporting
instrument. NBFCs making issuances of the same should be careful in framing the
covenants and remedies in case of events of default and should take into
consideration best practice followed internationally.
According to RBI estimates, public and private
sector banks will together need additional capital of Rs 5 lakh crore to comply
with Basel III regulations. Of this, the equity
capital requirement
will be Rs 1.75 trillion and the non-equity portion will
be Rs 3.25 trillion. Banks will also gradually increase issuance of
subordinated debt.

Vinita Nair

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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