SEBI Debenture Proposals: With Improved Protection Against NBFC Defaults, Comes Greater Complexity

The Securities and Exchange Board of India, in a Feb. 25 discussion paper, suggested that the practice of non-bank lenders issuing debentures with a floating charge be replaced with a more tangible, identifiable fixed charge. It also suggested improved disclosures and a bigger role for debenture trustees.

The discussion paper followed recent bond defaults by non-bank lenders like Dewan Housing Finance Corporation Ltd., which led to disputes regarding the rights of lenders, debt investors, and debenture trustees.

From Floating To Fixed Charge

SEBI has proposed that bonds and debentures issued by NBFCs be mapped to identified receivables, investment and cash.

At present, investors in NBFC bonds and debentures aren’t tied to receivables from any identified pool of assets. In contrast, manufacturing companies create a fixed and identifiable charge on land or plant and machinery.

SEBI proposed to change this.

“A debenture issued by an NBFC shall be treated as secured only on the creation of identified charge,” SEBI said. “A transition period of 3-5 years shall be provided to shift from floating pari passu charge to identified charge.”

If SEBI finalises this mechanism, NBFCs will need to create and maintain separate escrow accounts for each bond issue to ensure that the money flows from a specific underlying pool of loans directly to the bondholders. But there could be a delay in doing this, said Abizer Diwanji, partner and head of financial services at EY India.

“One will have to assign a specific pool to debenture holders with a registered charge, which would come with a lag,” he said. “Hence, debenture holders would initially be unsecured with a charge created over a deployment period or out of an unsecured lending pool.”

A second challenge will emerge in asset-liability management.

Under the proposed practice of fixed charges, if a Rs 100-crore bond is issued for three years, the issuer would need to ensure that it has an equivalent amount of loans of the same tenure on its books. If the loans are of shorter maturities, say 12 to 18 months, the issuer will need to churn the portfolio and lend again to maintain the security cover with similar asset quality, an executive with a credit rating agency said on the condition of anonymity.

Vibhor Mittal, chief product officer at Vivriti Capital, said that medium- and large-sized NBFCs, with retail and wholesale loan portfolios, could find it challenging to raise funds if this proposal is implemented. “Investors may insist on the NBFCs charging only retail loans, due to the perceived risks in the wholesale portfolio,” he said. “This could influence the pricing on bonds by these entities.”

According to Leena Chacko, partner at Cyril Amarchand Mangaldas, the regulatory framework would need to provide measures for ring-fencing the identified receivables of an NBFC and provide a safeguard to prevent co-mingling of the identified receivables of the NBFC charged as security.

“Since the operational aspects for these bond issuances are going to become complex and cumbersome, the compliance costs for issuers will rise,” she said. “Not only is it a challenge in terms of creating a fixed charge on retail loans, but bond/debenture issuances could become expensive for NBFCs.”

Joining Inter-Creditor Agreements

The discussion paper also suggests that debenture trustees be allowed to sign inter-creditor agreements, subject to approval of debenture holders and provided the resolution plan is in accordance with existing SEBI regulations. Trustees can exit the ICA and the plan would not be binding on them, if the resolution plan is not finalised within 180 days, the market regulator said.

SEBI has also laid out a voting mechanism whereby trustees need to seek the consent of bondholders when it comes to enforcing a security and joining the ICA. It has proposed to reduce the time period allowed to seek the consent of bondholders to 15 days from 21 days at present.

The fact that the market regulator has enabled debenture trustees to sign the ICAs is a positive step, as in the past it had pulled up investors that had entered into standstill arrangements, said Chako. “The revised consent requirements seek to eliminate procedural problems faced by debenture trustees in obtaining consent of the debenture holders in order to enforce the security.”

Improving Transparency

Apart from proposing a move to a fixed-charge methodology and allowing debenture trustees to join ICAs, the market regulator has also proposed several new measures to improve transparency.

SEBI has suggested that covenants between issuers, trustees and specific investors and creditors be disclosed to all other investors in that issue. These disclosures would be made on stock exchanges—if a security is listed—or in the investment memorandum.

One commonly used covenant by investors and issuers is the accelerated payment clause, which allows the lender to demand immediate repayment in case of a default. “This accelerated repayment exercised by one lender may have a bearing on other lenders and may have a cascading effect on the liquidity and operations of the borrower, leading to insolvency,” SEBI said.

Some of the other measures intended to improve transparency include:

• Issuers should list the identified assets/receivables, investment or cash in a detailed asset cover certificate, on a half-yearly basis versus the current practice of annual disclosures.
• Debenture trustees should fix a delinquency rate benchmark at the time of signing of ‘debenture trust deed’ to monitor the asset quality.
• Debenture trustees should provide minimum disclosures and enhanced disclosures on their websites. The ‘debenture trust deed’ should be standardised.
• ‘Event of Default’ should be declared at the ISIN or International Securities Identification Numbers level.
• Standard operating procedure should be put in place for penalties that will be levied against bond/debenture issuers for specific violations.

“SEBI is pushing debenture trustees to play a more active role in collecting the right information and in enforcing the securities, in case of defaults or loss to the final investor,” said Ajay Shaw, partner at DSK Legal. “This is because ultimately they have a fiduciary responsibility when it comes to bondholders.”