India is implementing regulatory changes to tackle the credit crunch. How will the moves help cash-strapped corporations restructure their debt portfolios and access new sources of funding? Karan Singh and Ameya Khandge report
India escaped the worst of the Asian financial crisis in 1997. It was insulated from the fallout by its limited foreign currency exposure. The reverberations of the current financial crisis have hit the country much harder.
In 2007, India saw robust foreign capital inflows, both in foreign direct investment (FDI) and foreign currency borrowings. These inflows raised liquidity levels and caused the rupee to appreciate. The Reserve Bank of India (RBI) responded with measures to cool the economy and fight inflation, including a range of restrictions on the use of participatory notes. Measures were also taken to tighten inward investment through foreign currency borrowings: Ceilings on interest were introduced, rupee capital expenditure was removed from the automatic route for foreign investment and a US$20 million ceiling on such expenditure use was imposed. The use of proceeds for the development of integrated townships was also withdrawn around this time.
Normally, such measures would have had only a short-term impact, but the global financial meltdown changed that. One of the immediate consequences was a significant outflow of foreign investment from the Indian stock market.
By the middle of 2008 the government was reversing exchange control measures in a bid to boost FDI and tackle the liquidity crunch. Controls on external commercial borrowings (ECBs), for instance, were progressively lifted, as were regulations concerning security creation. Restrictions on the use of funds for rupee expenditure were relaxed and all-in-cost ceilings were substantially widened. More recently, the RBI went even further, relaxing borrowing norms and, for the first time, removing all-in-cost ceilings altogether under the approval route with the policy on this account subject to review in June 2009. Another temporary measure, permitted under the approval route and subject to review in June 2009, is the re-introduction of integrated township development as a permissible end use. In addition, non-banking financial companies (NBFCs) that are exclusively involved in financing the infrastructure sector are now permitted to tap ECBs from regional financial institutions and government-owned development financial institutions for on-lending to borrowers.
Restructuring foreign debt
The financial crisis has had a severe impact on companies seeking to raise foreign currency loans offshore. Indian companies had relatively easy access to cheap funds abroad before the curbs on ECBs were introduced in 2007. With the onset of the global financial crisis, foreign lenders became anxious about lending to companies in emerging markets. Indian companies suddenly faced a shortage of foreign currency liquidity and increasing costs on their offshore loans as well as on the refinancing of maturing debt.
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Increases in the underlying cost of funds have led some lenders in Asia to invoke market disruption clauses in their loan agreements. Where the cost of funds of a certain percentage of lenders in a syndicate (usually 30% in a typical market disruption clause) exceeds the quoted Libor rate, a market disruption clause can be triggered, enabling lenders to increase the interest rates charged to borrowers.
Faced with rising costs in this situation, borrowers have few options. Questioning the “reasonableness” of a lender, while a theoretical option, is in practice difficult. It is unclear whether any court would be willing to query a lender’s choice of funding. The clause may also create problems for lenders, who may be required to disclose the cost of their funds. In the current market, many lenders may be uncomfortable with this level of transparency. As a result, borrowers and syndicate lenders have sometimes agreed on blended rates for a number of deals.
Renegotiating interest rates with respect to foreign currency obligations poses an additional challenge for Indian companies, which must also conform to exchange control regulations. For example, any premature repayment of an ECB is subject to minimum average maturity restrictions prescribed in the ECB guidelines. Similarly, the all-in-cost ceilings specified in the ECB guidelines restrict the ability of borrowers to restructure the financial terms. Thus, any such refinancing must be at a lower all-in-cost rate than the refinanced facility. In a credit environment where the cost of financing is likely to be substantially higher than it was at the time the facility was first committed, these limitations severely curtail the success of such restructurings.
For Indian issuers of foreign currency convertible bonds (FCCBs), the situation was grim until recent regulatory intervention. With significant erosion in market capitalization since early 2008, the conversion price of many bonds now well exceeds the trading values.
Most FCCB issuers were faced with the option of diluted equity or imminent redemption. Recognizing the significant discounts at which FCCBs were trading in overseas markets, the RBI recently permitted companies to buy back the bonds using internally accrued rupee resources as well as dollar resources, in the latter case using accrued as well as leveraged funds. Authorized dealer banks have been granted powers to approve FCCB buyback proposals using foreign currency resources, while the use of rupee proceeds for such redemptions requires RBI approval. These measures have been well received, with numerous large-cap issuers announcing buybacks.
Borrowers may also be faced with a situation where lenders seek to withdraw obligations that were agreed under better market conditions. The market “material adverse change” (MAC) clause is a feature of most commitment letters which allows lenders to withdraw from their funding obligations if there is a MAC in the markets before the facility documentation has been signed. Whether or not a material adverse change has occurred is determined subjectively, but lenders do not have the unfettered discretion to call a MAC in order to escape their obligations. A combination of reputational concerns and a lack of judicial precedent have generally deterred lenders from invoking this clause.
The silver lining for Indian companies is the substantial relaxation of ECB norms as discussed earlier with regard to fresh foreign currency loans.
Stimulating domestic liquidity
If foreign currency funding is now available, it is only to blue-chip companies at a large premium. The pressure on foreign currency funding has therefore resulted in an increased demand for rupee liquidity. Fortunately, Indian banks have not been too seriously affected by the financial crisis and the RBI has undertaken a series of measures to ease the liquidity situation for domestic banks. These include a reduction of the cash reserve ratio; a reduction of the statutory liquidity ratio; a special repo window under the liquidity adjustment facility for banks for on-lending to NBFCs, housing finance companies and mutual funds; and a special refinance facility that banks can access without any collateral. The repo rate (the effective rate at which banks borrow from the central bank) has been slashed several times and, since 5 January 2008, has stood at just 5.5%. The resources available for deployment by the Small Industries Development Bank of India and the National Housing Bank have also been enhanced to assist small and medium-sized enterprises.
The RBI has taken steps to encourage the flow of credit to cash-strapped sectors. These include extensions to the period of pre-shipment and post-shipment credit for exports; expansions to the refinance facility for exports; extensions to the contra-cyclical adjustment of provisioning norms for all types of standard assets (except in the case of direct advances to agriculture and small and medium enterprises, which continue to be 0.25%); and increases to the risk weights on the exposure of banks to certain sectors.
In addition, the government reaffirmed its commitment to the infrastructure sector when the RBI requested banks to undertake fresh financial viability studies of seven large-scale projects to assess their eligibility for restructuring. The total exposure of the banking sector to these projects is approximately US$3 billion. If the viability studies confirm the eligibility of a project for restructuring, banks will be permitted to continue classifying it as a standard asset, even if the project was non-performing at the time of restructuring. The only requirement is that the restructuring must be implemented within a period of six months. This was accompanied by a slew of other monetary and fiscal measures in the stimulus packages announced recently.
Protecting creditors
In India, the global financial crisis appears, until now, to have acutely affected only the financial sector. But if recently introduced measures prove inadequate to contain the damage, there is likely to be a spill-over into the rest of the economy. Some reports are predicting that corporate defaults in the US may treble in the next 12 months. If the liquidity crisis persists, and if it continues to be difficult to restructure debt, companies that need credit but are otherwise financially sound will be threatened. Such a situation would further increase the cost of lending and could result in an even greater scarcity of credit.
In light of the economic woes that now afflict almost every national economy, the ability of India’s restructuring and insolvency regime to positively influence the response of lenders faced with potential bad debts is likely to come under heavy scrutiny. The Corporate Debt Restructuring system (CDR), a voluntary and non-statutory debt restructuring mechanism used by banks and financial institutions, warrants special mention in this regard. Lenders (banks and financial institutions) wishing to join the CDR system must accede to a predetermined format of inter-creditor agreements (ICAs). Similarly, the debtor must execute a debtor-creditor agreement (DCA) agreeing to abide by the terms of the CDR system.
A bank or financial institution can elect to join the CDR system on a limited basis by signing an ICA that refers to a particular borrower only, or to a specific transaction. Foreign banks licensed to conduct business in India have not yet acceded to the standard ICAs, and do so only on a transaction-specific basis.
The restructuring process under the CDR involves the preparation of a rehabilitation plan by member lenders and the debtor. If approved by 75% of the CDR lenders, the plan becomes binding on all the other CDR lenders as well. Typically, CDR restructurings resemble the Chapter 11 process in the US, but without the involvement of the courts. They invariably involve write-offs of accrued and compound interest, a waiver of default interest and a one-time settlement of the outstanding principal at varying levels of loss. The process may also include the provision of additional finance to borrowers, the conversion of borrowers’ loans into equity shares, a moratorium or rescheduling of interest payments and a one-time settlement of certain loans and/or interest sacrifice. These restructuring mechanisms could provide effective solutions for lenders and borrowers alike.
The CDR restructuring mechanism is particularly significant given the complexity and piecemeal nature of India’s insolvency laws. The formal process of restructuring with liquidation (under the Companies Act) is protracted. Several pieces of central and state legislation address different aspects of company bankruptcy, while separate laws have been enacted to facilitate the rehabilitation of sick companies and the recovery of dues by secured creditors. Foreign lenders, however, do not share many of the benefits of this legislation.
The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI), for example, was enacted to expedite self-help enforcement of security for qualified creditors. Secured lenders other than SARFAESI lenders have to approach the courts for enforcement. Most international lenders do not qualify as “secured lenders” under the SARFEASI definition and are therefore unable to benefit from the fast track enforcement regimes. This dichotomy often results in elaborate negotiations on inter-creditor documentation where a borrower’s project is being financed through a combination of loans from SARFAESI lenders and international institutions.
SARFAESI lenders are also exempt from the usual immunity of company proceedings pending before the Board of Industrial and Financial Reconstruction.
Secured creditors eligible to approach a debt recovery tribunal under the Debt Recovery Act are permitted to continue their proceedings for the enforcement of security, with notice to the winding up court. Debt recovery tribunals are expected to expedite claims by banks and financial institutions against borrowers, and are empowered to proceed against all the assets of a borrower (rather than simply the assets secured to the enforcing creditor) for the recovery of decreed debts. Foreign creditors do not enjoy these benefits.
The Companies Bill, 2008 – a comprehensive new law that will govern India’s corporate sector – seeks to foster entrepreneurship, investment and growth. It proposes a revised framework for the regulation of insolvency, including the rehabilitation, winding-up and liquidation of companies, a move that is particularly welcome in the current environment. The bill is now pending before the Indian parliament. It is expected to be passed later this year.
Instilling confidence
As the global financial flux enters its second phase, the fallout is likely to extend beyond the financial sector and into the mainstream economy. As it does so, a growing number of corporations and NBFCs will inevitably find themselves in distressed situations. Distressed companies require injections of funds, but despite the thousands of billions of dollars pumped into the financial sector in rescue measures, banks have shown little willingness to resume lending. Their caution is founded, in part, on the difficulties they face in recovering bad debts.
Emerging markets like India therefore need to put sound insolvency regimes in place. The regimes must provide, among other things, greater parity between offshore and onshore lenders in security enforcement. Such moves will go a long way towards dispelling the fears of domestic and foreign lenders.
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Karan Singh is a partner and Ameya Khandge is a counsel at Trilegal in Mumbai. Trilegal is a full-service law firm that advises on corporate and commercial law in India and provides commercially oriented legal advice in relation to all sectors of the economy.
