Debt restructuring to raise promoter ‘skin in the game’

Over the past couple of years, debt transactions have been centred on providing relief to highly leveraged Indian companies, and India has seen a series of regulations aimed at mitigating the financial stress and strengthening the enforcement regime for recovery of overdue debts.

In February 2014, the Reserve Bank of India (RBI) issued a circular titled “Framework for Revitalising Distressed Assets in the Economy – Guidelines on Joint Lenders’ Forum (JLF) and Corrective Action Plan (CAP)”, which envisaged the procedure to be followed by all lenders to deal with certain “special mention accounts”.

On 8 June 2015, the RBI issued a circular titled “Strategic Debt Restructuring Scheme” (SDR circular) by which lenders, through the JLF, will have a right to gain management control over borrowers. The intent is to ensure that promoters have more “skin in the game”.

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Strategic debt restructuring

The SDR circular stipulates that at the time of initial restructuring, the JLF may finalize critical conditions and/or viability milestones, which, if not fulfilled by the borrower, will trigger SDR.

SDR will enable the lenders to convert the whole or part of the outstanding loan and interest into equity. Upon such conversion, lenders are required to jointly become majority shareholders of the borrower in a manner that they collectively hold 51% or more of the equity shares of the borrower. This effectively means that a security trustee or an agent would hold the shares on behalf of all the lenders. The SDR circular also requires conformity with section 19(2) of the Banking Regulation Act, 1949, which would mean that no bank can hold more than 30% in the borrower.

Lenders can also resort to SDR for accounts restructured prior to the date of the SDR circular if the agreement entered into between the lender and the borrower has the requisite clauses for enabling SDR. As regards prospective restructuring agreements, they should include the necessary covenants to enable effective invocation of SDR.

Timeline and procedure

The decision to invoke SDR must be taken within 30 days from review of the account by the JLF, after triggering of the relevant condition. Within 90 days from the date of the decision (reference date), the conversion package should be approved by the JLF. The conversion of the debt into equity must be completed within 90 days of the approval of the conversion package.

The SDR circular stipulates that the invocation of SDR will not trigger restructuring for the purposes of asset classification and provisioning norms. Upon conversion of the loan to equity, the asset classification of the account on the reference date would continue for 18 months from that date.

The conversion of the debt to equity is to be in accordance with the pricing formula specified in the SDR circular. Requisite exemptions have been provided under the Securities and Exchange Board of India’s Issue of Capital and Disclosure Requirements Regulations and Takeover Regulations for such conversions of loan to equity. Such a conversion would also not be considered as an investment in an associate under the accounting standards.

As the intent of the SDR circular is to provide lenders with interim management control so as to sway the borrower in the correct direction, the JLF lenders are required to divest their shareholding in the borrower to a “new promoter” who is not part of the existing promoter group of the borrower. Once the lenders have divested their holdings, the asset classification of the account may be upgraded to “standard” and the loan may be refinanced.

Where there are restrictions on foreign investment, the new non-resident promoter should hold at least 26% of the paid-up equity capital or the applicable foreign investment limit, whichever is higher.

Conclusion

The SDR circular provides a statutory “blessing” to a right that was contractually available to a lot of lenders after an event of default under the loan documents. Lenders seldom exercised such a right and no detailed procedure was provided.

The SDR circular, if properly implemented, will be a cause of concern for borrowers. Several issues arise from the facilitation provided under the SDR circular – the tax implications on conversion and divestment have to be considered, the existing liabilities of the borrower have to be dealt with by the interim management, whether the promoters are relieved from the personal obligations under the loan arrangements needs to be ascertained, etc. Moreover, it is unclear whether lenders will have the wherewithal and willingness to run the management of their borrowers, albeit for an interim period, especially where there may be no possibility for an upside and all that the lenders would receive is the repayment of their dues.

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Babu Sivaprakasam is a partner, Deep Roy is an associate partner and Megha Agarwal is an associate at Economic Laws Practice. This article is intended for informational purposes and does not constitute a legal opinion or advice.