[Rashmi Birmole is a III year B.A., LL.B. student at ILS Law College, Pune]
Infrastructure Leasing & Financial Services (“IL&FS”), a non-banking finance company (“NBFC”) belonging to a sub-category of systemically important non-deposit accepting core investment companies was, at the time, engaged in financing and developing infrastructure projects. In June 2018, the collapse of IL&FS emerged into what is now known as the “shadow banking” crisis. The infrastructure lending giant’s default on bank payments, term deposits and commercial paper redemption obligations triggered a series of consequential defaults by other financial institutions. Relying on an inherently flawed model of issuing short term bonds and debt instruments to fund long term projects, NBFCs were faced with the challenge of mobilising capital from underconfident investors and risk-averse banking institutions. Reliance Capital’s recent default on interest and principal obligations on bonds serves as a contemporary example of the cascading effect of the crisis. Since a substantial portion of the funds are raised by way of secured debentures or bonds, any delay in enforcing the security in the event of a default became a hurdle in securing the interest of debenture holders.
In light of the growing defaults on secured debentures by financial institutions, the Securities and Exchange Board of India (“SEBI”) on 25 February 2020 released a Consultation Paper on Review of the Regulatory Framework for Corporate Bonds and Debenture Trustees. The paper outlines a number of proposals seeking to strengthen the regulatory framework surrounding corporate bonds and debentures and invites comments from the public on the same. This post briefly outlines the challenges identified by the market regulator and analyses the proposals set out in the consultation paper.
Non-convertible debentures or bonds are debt instruments issued by a company in order to raise medium to long term finance, as a supplemental or additional source of funding. Debentures do not form a part of the share capital of the company and are repayable on maturity. Such debt instruments are most suited to companies and institutions with sufficient profit margins to service the debt and where there are adequate unencumbered assets that can be offered as a security. A security interest or a charge is created on the assets of the company to secure repayment in the case of a default or liquidation. To enforce the said interest, a trust deed is executed between the issuer company and a debenture trustee. The debenture trustee holds the secured property in the capacity of a trustee and acts as a liaison between the issuer company and the debenture holder.
Challenges in the Enforcement of Security Interest
The paper identified a number of existing challenges in the expeditious enforcement of security interest, including lapses and complications on part of the debenture trustees. The primary challenge concerns the nature of charge created on the assets of the issuer, specifically NBFCs, which operates as a major barrier in securing timely enforcement. Generally, NBFCs meet the financing requirements of long term housing projects which typically come with their own set of contingencies and risks. In such a scenario, a floating charge is created on the existing and future receivables of the company which are dynamic in nature. The charge, also known as a pari passu charge, is created on the entire balance sheet of the company entitling the lenders to a claim on the same assets proportionate to the amounts borrowed. The unspecific nature of such charge led to issues in ensuring maintenance of adequate security cover by the debenture Trustees.
The paper notes the operational difficulty in enforcing a charge of such nature in the absence of an identified security. The paper also notes the concerns of debenture holders’ in joining the Inter-Creditor Agreement (“ICA”) introduced by the Reserve Bank of India (“RBI”) as a part of the Prudential Framework for Resolution of Stressed Assets by its circular dated 7 June 2019. The need to review the present regulatory framework was felt in order to counter the challenges observed in charge creation, enforcement of security and the ICA process and to enable the debenture trustees to perform their duties with promptness in the event of default in the cases of listed debt.
The primary proposals contained in the consultation paper are explained below:
Creation of Identified Charge
The paper proposes the creation of a specified charge on identified assets of the issuer NBFC, instead of a floating pari passu charge on the entire balance sheet of the company as is the existing mandate. A debenture issued by an NBFC shall be treated secured only upon the creation of an identified charge. The proposal included a transition period of three to five years for companies to make this change. This requirement was proposed to address the uncertainty surrounding the underlying security and the floating charge created on it. This move was also directed at enabling debenture trustees to ensure the quality and adequacy of the asset cover.
The paper traced the delay in enforcement of security in cases of an event of default majorly to the non-specificity of the charge. The transition to a specified, fixed charge is likely to restrain companies from utilizing the identified assets in the usual course of business, as opposed to scenarios involving floating charges where utilization of assets was possible. A fixed charge will also act as a safeguard against securitizing the receivables over which a pari passu floating charge has been created in favour of the secured debenture holders, as was the case in Reliance Nippon Asset Management Ltd. vs. Dewan Housing Finance Corporate Ltd. (“DHFL”), where the latter entered into securitization agreements with banks, which caused significant delay in enforcement of security. The paper also proposes a more granular asset cover certificate to ensure adequate asset cover and quality of underlying assets. However, the paper fails to take into account the possibility of overstatement of loan receivables or the way ahead in the event of unanticipated default in the identified receivables with no standard assets to replace them with.
Joining the ICA
The Prudential Framework for Resolution of Stressed Assets released by the RBI introduced ICAs as bank-led processes for the time bound resolution of stressed assets. The framework is applicable to banks, financial institutions and NBFCs. The paper proposes the inclusion of debenture holders in the ICA subject to their approval. It further proposes an exit option to the debenture holders in the event the resolution plan violates any regulations and is not finalized within a period of 180 days, empowering them to exit with the same rights. The paper also proposes reduction in the time sought for seeking consent to 15 days and negative consent for the enforcement of security. The paper settles the regulatory uncertainty over the inclusion of debenture holders within the lender pool of the ICA, which was expressed when the debenture trustee approached the retail debenture holders of DHFL for their consent to join the ICA. It enables the lenders to be a part of the consensual restructuring process without having to resort to long, protracted proceedings at the Debt Recovery Tribunal. However, the resulting regulation may be benefitted by requiring the debenture trustees to offer complete and true details of any draft resolution plan, if sent to the debenture holders while obtaining their consent for an ICA, in order to ensure an informed decision from their end. The exit option independently entitles the holders to pursue other legal remedies if the finalization and implementation of the plan is delayed, without being subject to additional provisioning. Additionally, it offers protection against having to compulsorily accept liquidation value in case the lender dissents.
Creation of a Recovery Fund
The paper also proposes the creation of a recovery fund at the time of the issuance of debt that shall be used by the debenture trustee towards recovery proceedings expenses. The value of the fund shall be capped at 0.1% of the issue subject to a maximum limit of Rs. 25 lakhs per issuer. However, the above shall not be applicable to AAA rated bonds. The creation of such a recovery fund in the favour of the debenture holders and trustees was needed after NBFCs were exempted from the requirement of maintaining a Debenture Redemption Reserve, leaving the amount deposited in banks or invested in government securities as the only layer of protection. The fund shall also ensure timely enforcement proceedings by adequately funding the Debenture Trustees in advance.
The paper proposes a set of exhaustive disclosures to be made by the debenture trustees in order to ensure prompt discharge of duties. They are required to make disclosures on the issuer’s compliance reports, ensure adequate asset cover, and monitor defaults and status of proceedings of cases under defaults, among others. The paper also sets out a number of disclosures with respect to timeliness of action required to be taken, intimations of breach, raising of red flags, and effectiveness in enforcing security or taking any other remedial action. These serve as performance indicators meant to induce an element of transparency and accountability in the actions of the Debenture Trustees.
In the wake of the recent NBFC crisis and the current precarious economic situation, the consultation paper has been long overdue. The paper signifies one of the regulator’s many efforts to enhance the role of debenture trustees in the market ecosystem, while balancing the interests of the debenture holders. After the recent inclusion of financial service providers and NBFCs under the Insolvency and Bankruptcy Code 2016, the paper marks another step towards resolving the damage caused by the crisis, reviving investor confidence and strengthening the bond market in India.
– Rashmi Birmole