Debunking Special Situation Funds: Is India Ready for the Vultures?

[Aditya Shekhar and Abhishek Choudhary are Vth year B.A., LL.B. (Business Law Hons.) students at National Law University, Jodhpur]

The need for inclusion of special situation fund [“SSF”] in the Indian financial market was felt due to India’s bad debt problem. It is evident from the recent trend and eagerness of financial institutions to sell off their non-performing assets [“NPA”], which consequently leaves the financial sector with financial entities struggling with stressed assets. Such a practice harms the credit supply and economic growth, as higher debt eventually locks up more capital in the banking system. Introduction of SSFs corrects one major fallacy of the alternative investment funds [“AIF”] regulations framework. AIFs had a limited role in the distressed debt market. Prior to the inclusion of SSFs as Category I AIF, the secondary market for corporate loans provided by banks and NBFCs was not open to AIFs. In effect, now SSFs can participate in the secondary market. However, this participation is only limited for loans extended to companies that have defaulted their debt obligations and not to companies that have a tendency to default. Moreover, in the Indian insolvency regime, inclusion of SSFs cures the problem of round-tipping, wherein, the defaulting promoter had a chance to regain the management of the company by entering into the company as an AIF resolution applicant. This will not be possible through SSFs. Therefore, inclusion of SSFs is a step in the right direction, however, it’s potential must be unlocked sooner rather than later.

Inclusion of Special Situation Funds and What does it Entail?

Securities and Exchange Board of India [“SEBI”] in its board meeting dated 28 December 2021, through a press release, had approved an amendment to the SEBI (Alternative Investment Funds) Regulations, 2012 [“AIF Regulations”]. The amendment introduced SSF as a sub-category under Category I AIF. According to the press release, these SSFs are allowed to invest only in ‘stressed assets’.

The salient features of the same had been notified via the SEBI Circular dated 27 January 2022. The circular outlines these features in two contexts. First, it states that each scheme of SSF shall have a corpus of at least one hundred crore rupees, and an SSF, if it intends to act as a resolution applicant, shall comply with the eligibility requirements as specified under the Insolvency and Bankruptcy Code, 2016 [“IBC Code”]. Secondly, an SSF may acquire stressed loan in terms of clause 58 of the Master Direction – Reserve Bank of India (Transfer of Loan Exposures) Directions, 2021[“RBI Master Direction”].

This is a very crucial reform in the Indian financial market as it will help in protecting the interest of investors and develop the regulatory framework of the securities market. The AIF Regulations post amendment has introduced chapter III-B to govern SSF.  SSF is defined under regulation 19I(3), as a ‘Category I AIF that invests in special situation assets in accordance with its investment objectives and may act as a resolution applicant under the IBC Code.’[i] Meanwhile, regulation 19I(2) defines ‘special situation asset’ as; (i) stressed loan as per clause 58[ii] of the RBI Master Direction,[iii] (ii) security receipts issued by asset reconstruction company [“ARC”],[iv] (iii) securities of investee companies whose borrowings are subject to corporate insolvency resolution process [“CIRP”] under chapter II of the IBC Code.[v]

Investment in Distressed Debt Market: Learning from the US Framework

The concept of investing in SSFs, although novel in the Indian context, is well-recognized, in the USA and globally, as special situation investing. Such an investing is contingent upon a specific event such as merger, demerger, distress etc. Distress debt investing is one such special situation investing and is popularly known as ‘vulture’ investing. Interestingly, the name ‘vulture’ is a metaphor denoting the ‘vulture fund’ investors as vultures, a species of the bird family, which prey on the remains of a defenseless victim to extract as much as possible. In similar vein, vulture funds are nothing but a sub-set of hedge funds, which exclusively invest in distressed debts and securities, buy them at an extremely discounted price in the secondary market, and use various methods to gain an amount more than the purchase price.

In the American context, the distressed debt market grew exponentially post enactment of Bankruptcy Reforms Act, 1978. Introduction of chapter 11, and a rapid development of the high-yield bond market led to the dynamic growth. The Bankruptcy Reform Act of 1978, was a product of the 1970 Commission on the Bankruptcy Laws created by the Congress. It essentially revised the administrative, procedural, and legal aspects of corporate and personal bankruptcy in the USA.[vi] Post the reorganization enabled by chapter 11 of the Act, it was also observed that “vulture investors” who gained control of the target firm, improved their restructuring operations [vii] It can be safely argued that such results in the American financial market were possible because of Chapter 11 of the 1978 Act, which allowed the corporate debtor protection under the Bankruptcy Reforms Act, even without examining debtor’s insolvency.[viii] This gave the companies a scope to sell off the bonds at an early stage of financial stress, by voluntarily filing for bankruptcy pre-default. This gave vulture investors a space to thrive, and consequently marked a boom in the American distressed debt market.

SSFs in the Indian context must be given unrestricted access in the secondary market. They should be given an opportunity to trade loans, investment grade or non-investment grade, in the secondary market. The current framework restricts SSFs participation only to a post-default stage. As seen in the American context, participation of vulture investors, in a pre-default stage was a significant tool which propelled the American distressed debt market in the right direction. Further, it must also be noted that distressed debt opportunities are counter-cyclical. In other words, these opportunities increase when the economy slows. The pandemic coupled with other economic factors have provided a space for the Indian distressed debt market to thrive better. However, this can happen only if SSFs are allowed an unrestricted access in the secondary market.

SSFs and the Indian Insolvency Regime: A Step in the Right Direction

As stated earlier, according to regulation 19I(3), of the AIF Regulation, an SSF can act as a resolution applicant, if it satisfies the eligibility requirements under section 29A of the IBC Code. Section 29A, has been the most debated provision of the IBC Code.

Prior to section 29A of the IBC Code, the defaulting promoters, directors, or connected persons were not explicitly barred from participating in the bidding process of a corporate debtor subjected to CIRP. This gave the original promoters, directors, and people who were responsible for the default of the company, scope to regain the control of the company. Therefore, section 29A was introduced which explicitly barred defaulting promoters, related party, and connected persons.[ix] However, the catch arises in the cases of AIFs, as AIFs are classified as ‘financial entity’. According to the Insolvency Committee Report of March 2018, a need was felt to encourage the market of NPAs. Since business undertaken by asset reconstruction companies, scheduled banks and AIFs, are likely to be related to companies that are classified as NPA. Hence, to avoid their disqualification as resolution applicants, these financial entities were exempted from the eligibility criteria.[x] This also gave the defaulting promoter a chance to regain the reigns of the corporate debtor by re-entering disguised as an AIF resolution applicant.

However, this is not the case with SSFs. According to regulation 19M, SSFs shall invest only in special situation assets and may act as a resolution applicant. They are not allowed to invest in its associates. This eradicates the possibility of a defaulting promoter, director, or connected party, to re-enter through the AIF route.

Conclusion

Introduction of SSFs has been crucial on two fronts. First, it will hopefully usher a new era in the Indian distressed debt market; and secondly, it has brought a new player in the Indian insolvency regime. Expanding the reach of SSFs in the secondary markets in a pre-default stage would definitely help the growth of ‘vulture funds’ and the Indian distressed debt market. Now what we essentially need to wait for is, to look at how the insolvency regime and SEBI will, if it ever will, work in tandem to allow SSFs grow root in the secondary market.

– Aditya Shekhar & Abhishek Choudhary

 

[i] Reg 19I(3), SEBI (AIF) Regulations, 2012.

[iii] Reg 19I(2)(a), SEBI (AIF) Regulations, 2012.

[iv] Reg 19I(2)(b), SEBI (AIF) Regulations, 2012.

[v] Reg 19I(2)(c)(3), SEBI (AIF) Regulations, 2012.

[vi] Edward I. Altman, Edith Hotchkiss, ‘Corporate Financial Distress and Bankruptcy’, 87, (3rd ed. John Wiley & Sons, Inc., 2006).

[vii] Edward I. Altman, The Role of Distressed Debt Markets, Hedge Funds, and Recent Trends in Bankruptcy on the Outcomes of Chapter 11 Reorganizations, 22 AM. BANKR. Inst. L. REV. 75 (2014).

[viii]Edward I. Altman, Edith Hotchkiss, ‘Corporate Financial Distress and Bankruptcy’, 28, (3rd ed. John Wiley & Sons, Inc., 2006).

[ix] Section 29A(c), IBC, 2016.

[x]Insolvency Committee Report, March 2018, ¶14.4.

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