India: Strategic Debt Restructuring Scheme

The Reserve Bank of India (RBI) on 8 June 2015 announced Strategic Debt Restructuring (SDR) Scheme which allows banks and Term-lending and Refinancing Institutions to convert their loans into equity stake. SDR will provide banks with enhanced capabilities to initiate change of ownership in cases of restructuring of accounts where borrower companies are not able to come out of stress due to operational/ managerial inefficiencies despite substantial sacrifices made by the lending banks. RBI announced the scheme against the backdrop of huge surge in bad loans or Non Performing Assets (NPAs) in the banking system. As per ICRA estimate, the Gross NPAs may rise to 5.9 percent of total advances during 2015-16 against 4.4 percent during 2014-15.

The scheme is in furtherance to the framework for revitalizing distressed assets in the economy that was notified in February, 2014 which states that the general principle of restructuring should be that the shareholders bear the first loss rather than the debt holders.

JOINT LENDERS FORUM AND CORRECTIVE ACTION PLAN

At the time of initial restructuring, the Joint Lenders' Forum (JLF) must incorporate, in the terms and conditions attached to the restructured loan/s agreed with the borrower, an option to convert the entire loan (including unpaid interest), or part thereof, into shares in the company in the event the borrower is not able to achieve the viability milestones and/or adhere to 'critical conditions' as stipulated in the restructuring package. This should be supported by necessary approvals/authorisations (including special resolution by the shareholders) from the borrower company, as required under extant laws/regulations, to enable the lenders to exercise the option effectively. Restructuring of loans without the required approvals/authorisations for SDR is not permitted. On default on the part of borrower, the JLF must immediately review the account and examine its viability under the SDR scheme. The decision on invoking the SDR should be taken by the JLF as early as possible but within 30 days from the above review of the account. Such decision should be well documented and approved by the majority of the JLF members (minimum of 75% of creditors by value and 60% of creditors by number);

CHANGE IN OWNERSHIP

In order to achieve the change in ownership, the lenders under the JLF should collectively become the majority shareholder by conversion of their dues from the borrower into equity. However, the conversion by JLF lenders of their outstanding debt (principal as well as unpaid interest) into equity instruments shall be subject to the member banks' respective total holdings in shares of the company conforming to the statutory limit in terms of Section 19(2) of Banking Regulation Act, 19491. Post the conversion, all lenders under the JLF must collectively hold 51% or more of the equity shares issued by the company. The share price for such conversion of debt into equity will be determined as per a formula prescribed by the RBI. The formula for conversion of debt into equity will be different from existing norms laid down by the Securities & Exchange Board of India (SEBI) for banks. The conversion price of the equity is the fair value which shall be:

  • The lower of:
    • If there's a market value (listed companies), then at the 10 day average price in the market.
    • Book value after ignoring any revaluation reserves.
  • The price can't be lower than the face value of the share.

The above Fair Value will be decided at a 'reference date' which is the date of JLF's decision to undertake SDR.

DISINVESTMENT

According to the notification, JLF and lenders should divest their holdings in the equity of the company as soon as possible. The new management should not have any links to the old promoters. The New promoter should not be a person/entity/subsidiary/ associate, etc (domestic as well as overseas), from the existing promoter/promoter group. Banks should clearly establish that the acquirer does not belong to the existing promoter group. The new promoter has to acquire the entire 51%. In case where the acquirer is a non resident and the sectoral cap is less than 51%, the new promoter should own at least 26% of the paid-up equity capital or up to the applicable foreign investment limit whichever is higher, provided banks are satisfied with this equity stake the new non resident promoter controls the management of the Company.. On divestment of banks' holding in favour of a new promoter, the asset classification of the account may be upgraded to 'standard' At the time of divestment of their holdings to a 'new promoter', banks may refinance an existing debt of the company considering the changed risk profile of the company without treating the exercise as 'restructuring' subject to banks making provision for any diminution in fair value of the existing debt on account of the refinance.

The acquisition of shares under the notification is exempted from regulatory ceilings/restrictions on Capital Market Exposures, investment in Para-Banking activities and intra group exposure. However, the banks are required to disclose in their Notes to Accounts in Annual Financial Statements. Equity Shares of entities acquired by the banks under SDR are assigned a 150% risk weight for 18 months from the 'reference date' indicated in paragraph 4(ii). After 18 months from the 'reference date', these shares will be assigned risk weight as per the extant capital adequacy regulations. Further, it is important to note that the equity shares acquired and held by banks under the scheme are exempt from the requirement of a periodic mark to market (stipulated vide Prudential Norms for Classification, Valuation and Operation of Investment Portfolio by Banks) for the 18 month period. Similarly, conversion of debt into equity in an enterprise by a bank may result in the bank holding more than 20% of voting power, which otherwise result in an investor-associate relationship under applicable accounting standards. However under the present notification where the lender acquires more than 20% of voting power in the borrower entity in satisfaction of its advance under the SDR, and the rights exercised by the lenders are more protective in nature and not participative, such investment is not treated as investment in associate.

CONCLUSION

The new rules are a welcome step as it made the circular dated Feb 26, 2014 issued by RBI "Framework for Revitalizing Distressed Assets in the Economy" more near to the reality, wherein it was mentioned that the "general principle of restructuring should be that the shareholder bear the first loss rather than the debt holders" as the present scheme (SDR will ensure that the promoters are more involved in turning around a company and will help the banks reduce bad loans. It may help banks lessen their load of high provisioning as once banks manage to sell their stake fully in the defaulting company, the money set aside by the lenders to cover bad loans can be written back. Like any other innovation, the implementation of the scheme is a challenge due to the legal and procedural complications. Firstly, Lenders may choose to use their powers of conversion subject to the approval of 75% of lenders in value and 60% in number. This appears to be a difficult threshold to meet in a distressed debt situation with multiple lenders. Secondly, the scheme requires the banks to sell the equity as soon as possible while putting a bar on the promoter group(i.e. should not be a person/entity/subsidiary/associate etcdomestic as well as overseas) to purchase such stake from Banks. Banks will find it very difficult to find buyers for companies incurring perpetual losses. It will be useful in cases of willful defaulters and inefficient management, where change in management can overturn the fortunes of company securing the interest of lenders and other stakeholders. In other cases, where the default in payment is owing to reasons independent of the management of the company, the scheme would be ineffective as even after takeover, the company may continue to flounder and finding new promoters for the company would be a distant dream.

Footnote

1 No banking company shall hold shares in any company, whether as pledgee, mortgagee or absolute owner, of an amount exceeding thirty per cent. of the paid-up share capital of that company or thirty per cent. of its own paid-up share capital and reserves, whichever is less: Provided that any banking company which is on the date of the commencement of this Act holding any shares in contravention of the provisions of this sub-section shall not be liable to any penalty therefore if it reports the matter without delay to the Reserve Bank and if it brings its holding of shares into conformity with the said provisions within such period, not exceeding two years, as the Reserve Bank may think fit to allow.

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