[Sikha Bansal is a Partner at Vinod Kothari & Company and can be reached at [email protected]]
A well-developed corporate bond market not only provides cost-effective funds to the issuer, but it also enables lenders such as banks and other financial institutions to streamline their asset-liability mismatches. As such, there have been considerable efforts to facilitate the development of the corporate bond market in India. While the market has been growing steadily, its size nevertheless remains small as compared to other emerging markets in Asia.
An important element in facilitating a smooth functioning of the bond market is to ensure that there is sufficient clarity on the options, remedies, and rights that debentureholders possess in a given scenario. One such aspect has been dealt with by the Supreme Court (‘SC’) recently in Securities and Exchange Board of India v. Rajkumar Nagpal (30 August 2022). The SC was dealing with the interplay between the RBI’s ‘Prudential Framework for Resolution of Stressed Assets’ issued in June, 2019 (‘RBI Resolution Framework’) and SEBI’s Circular on ‘Standardisation of procedure to be followed by Debenture Trustees in case of ‘Default’ by Issuers of listed debt securities’ (‘SEBI Circular’) and the consequent impact of the same on the rights of the debentureholders.
To provide a brief background, the RBI Resolution Framework facilitates an out-of-court resolution framework where the lenders (regulated by RBI) may enter into an intercreditor agreement (‘ICA’) and approve a resolution plan with a requisite majority. On the other hand, SEBI Circular provides for participation of debentureholders in the ICA. In the instant case, the debenture trust deeds were signed prior to SEBI Circular; however, voting on the resolution plan took place after the SEBI Circular was brought into force. The resolution plan, inter alia, provided for certain payments to debentureholders in full and final settlement of their claims; however, no consent of debentureholders was taken in terms of SEBI Circular. The same was challenged by the debentureholders and SEBI on grounds that SEBI Circular is retroactive and, as such, voting should have occurred in terms of SEBI Circular. They also asserted that debentureholders have only two options to restructure the debt – one under section 230 of the Companies Act and, second, in terms of the SEBI Circular. There is no third option available.
The SC held that SEBI Circular has retroactive application, and that contractual compromises cannot bind debentureholders. As we see below, the SC ruling is crucial in that it clears the air around the force which the SEBI Circular carries and protects dissenting investors from non-statutory compromises. However, most importantly, this SC ruling can be seen as highlighting the problems and gaps that may arise because of segregated rule-making where two regulators were bound by their respective regulatory ambit, thereby leading to a less than comprehensive resolution framework.
This post does not delve into the facts of the particular case (which, inter alia, necessitated the SC to invoke Article 142 of the Constitution). Instead, it deliberates on the key takeaways from the SC ruling.
Key Takeaways from the SC Ruling
Joining the ICA: an additionality not a mandate
As was abundantly clear from the language of SEBI Circular, the route prescribed therein should not be seen as a mandate on the debentureholders to join the ICA. Nor it is the only route to entering into a compromise with the issuer entity.
RBI’s Resolution Framework would stand on the same footing as a compromise under section 230 of the Companies Act, with certain distinctions. Of course, RBI’s Framework involves only the lenders covered by the such framework, who can collectively decide to enter into an ICA. Such an ICA binds only such lenders who participated in the same.
The SEBI Circular goes a step ahead to provide an option to debentureholders to be a part of the ICA, by way of collective decision; such a collective decision has to be arrived at by following the modalities as prescribed in the said Circular. If debentureholders do not wish to be a part of the ICA, they may consciously decide to do so, as the SEBI Circular requires positive consent by requisite majority to enter into an ICA. If such a majority consent is not obtained, the trustee cannot sign the ICA. Therefore, the SEBI Circular will apply only if the debentureholders wish to become a part of the ICA.
Notably, and quite intuitively, debentureholders may find it feasible to be a part of the ICA only if the other options before them seem to be less attractive; for instance, where the security interest is shared, enforcement of security interest would be a difficult remedy. Hence, it may make sheer sense for the debentureholders to enter into an ICA unless the security backing them is exclusive. If the security is shared with other lenders, there will be no point in debentureholders standing apart. Hence, the decision has to be taken by the debentureholders whether they want to be a part of ICA or not. The modality of how such a decision should be taken emanates from the SEBI Circular.
Dissenting investors can be bound only by statute; contracts cannot bind dissenters
The SC discussed broadly three possible routes for the investors in arriving at a decision:
- section 230 of the Companies Act dealing with compromise and arrangements based on requisite extraordinary majority and sanction of the National Company Law Tribunal (‘NCLT’);
- the SEBI Circular which, as the SC ruling holds, has the force of law (see below); and
- section 62 of the Contract Act, wherein parties to a contract may agree to substitute, rescind or alter the original contract, and then such original contract need not be performed.
While under the first two options above the collective decision of the majority would bind the dissenting debentureholders by way of statutory force, the third option is altogether contractual. Intending debentureholders can voluntarily enter into a contract in terms of section 62 of the Contract Act; however, such a provision would only bind the consenting parties. Hence, the SC ruling makes it clear that contractual compromises, which do not fall either under section 230 of the Companies Act or under the SEBI Circular, cannot bind dissenting debentureholders.
SEBI Circular to take precedence over contractual arrangements
The SEBI Circular has been held to have retroactive application; while default may have occurred prior to the issuance of Circular, the Circular provides for the manner of resolution of debt. Therefore, even if there are conflicting provisions in the trust deed, the same would be overridden by SEBI Circular. That is, a contractually vested right may be taken away by the operation of a statutory instrument (see, para 85 of SC ruling).
The SEBI Circular requires ISIN-level voting (paras 3 and 6.6). In the instant case, concerns were raised that such ISIN-level voting would enable a single ISIN number to defeat the resolution plan. The SC left it to SEBI to address any such concerns raised by stakeholders based on the objectives of orderly functioning of the securities market.
However, the author notes that such ISIN-level voting and any act in pursuance thereof may be rendered infructuous where multiple ISINs share the same security. In case of a common or shared security interest, any decision has to be backed by the collective sense of the creditors having such security interest (irrespective whether they fall under different ISINs). In such cases, the principle of ‘cramming down’ applies where majority decision binds the minority. This flows from the common principles of joint-financing, also embodied in section 13(9) of the Securitisation Asset Reconstruction and Enforcement of Security Interests Act, 2002.
Although the SC ruling acknowledges that SEBI has mandated ISIN-level voting, it however does not conclusively resolve the debate on the same. The regulators may have to arrive at a valid and feasible solution for the same.
While the SC ruling has clarified various aspects concerning debentureholders and their rights under the SEBI Circular, there are however certain areas that might need further clarity, for instance, the feasibility of ISIN-level voting in case of shared security interests.
However, in any case, two things are inescapable, and would highlight why this SC ruling will be quite significant. First, going forward, one needs to realise that formal insolvency and debt resolution mechanisms such as the Insolvency and Bankruptcy Code, 2016 (‘IBC’) are to be used as the very last option. These are extremely time consuming and may lead to value erosion. Therefore, as far as possible, lenders or creditors should seek to resolve the issues outside of the formal resolution process of IBC. In light of this, lenders may find it more advantageous to use the RBI’s Resolution Framework.
Second, debentures will continue to remain important, more importantly because larger borrowers are required to moveat least a part of their borrowings to bonds. In light of the above, the need for an ICA for a holistic resolution of a debt is extremely important. The regulators may need to jointly lay down a comprehensive framework allowing all types of financial creditors (banks, financial institutions, and debentureholders) to enter into an ‘out-of-court’ compromise with the same statutory rigour. For this, the regulators might need to proceed with a consultative as well as accommodative approach. Hence, there is an increasing need that the two market regulators work in harmony to iron out any creases.
– Sikha Bansal