Margin Calls In Times Of Covid-19BloombergQuintOpinion
The Bombay High Court recently passed an order injuncting IDBI Trusteeship Services Ltd. from selling the shares of Future Retail Ltd., which were pledged as a security for the debentures issued by another Future group promoter company. The reason underlying this relief is a sharp decline of over 60 percent in the value of the equity stock of Future Retail since the beginning of March, due to the spread of Covid-19 in India and the subsequent nationwide 21-day shutdown. The order will, by itself and for its precedent and persuasive value, have far-reaching implications for all financial market transactions which are secured by securities or margins.
As with all decisions in any commercial matter, the order has two facets – legal and economic. The order is an ad-interim order, that is, it is valid only until the next hearing of the case. For ad-interim relief, the court need not satisfy itself of the real merits of the dispute. It may restrict its enquiry to limited grounds, namely, whether the applicant for ad-interim relief (in this case, the Future group), would suffer from irreparable damage if the relief were not granted. The court seems to have applied this principle to grant the ad-interim injunction. However, the order of the court has far-reaching implications for the financial market, not the least because in a judiciary which is slow, ad-interim and interim relief is often effectively the only relief available for an indefinite period of time. For example, in this very case, unless the order is appealed against, the relief operates until May, by which time the bondholders would arguably by irreparably damaged by the injunction.
Pledged Shares Problem
Raising capital by pledging shares as a security is a very common practice followed by Indian promoters. The lenders are typically non-banking finance companies and mutual funds, as banks have regulatory restrictions on the amount of lending they can do against the security of shares.
Liquid shares, as security for loan, are attractive to lenders for two reasons. First, the value of exchange traded securities (and hence the cover it provides for the loan) is transparent and is easily ascertainable on a real time basis. Secondly, they are liquid and can be sold whenever needed.
The terms of such loan contracts generally empower the lender to liquidate these securities or ask the debtor to replenish the security (margin calls), as the value of the collateral declines. In fact, it is the fiduciary responsibility of the debenture trustee to ensure adequate collateral cover for the loan amount, and to protect the security on behalf of the bond holders.
Indeed, the liquid collateral becomes even more crucial in circumstances where there is a sharp, unprecedented decline in the stock market. Impediments to the lender’s or the trustee’s ability to sell the pledged shares as security will likely affect the price of these bonds if they are traded on the exchange. Also, a deterioration in the value of the collateral implies a possible haircut at the time of redemption especially if the redemption dates are in the next twelve months. The effect of this on retail investors should not be undermined as debt schemes of mutual funds might have invested in these bonds and a restriction on the sale of collateral will likely erode the NAV of such funds.
It might be argued that no contract could have possibly envisaged the pandemic and the attendant depreciation in the value of the collateral and this is akin to a force majeure event. It may be equally argued that there is a case for a moratorium on bond repayments and the liquidation of collateral, just akin to the RBI moratorium on the payment of interest and installments on term loans to households and firms. These are appealing arguments. However, there are two reasons why they might not hold true.
First, the RBI moratorium seeks to allow the debtor to tide over temporary cash-flow issues, and not solvency issues. Lenders are hardly incentivised to trigger acceleration and/or liquidate collateral where the debtor is undergoing temporary cash-flow issues. The lenders and borrowers are repeat players in this market, and the conduct of each impacts the future potential of the other as a suitor for the next transaction.
Second, these arguments get diluted and the same liberal approach is not likely to be taken if one assumes that the collateral is not promoter’s securities, but some other rather impersonal collateral, such as gold or government securities.
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Wider Impact Of Court Decision
More importantly, the questions raised by the Bombay High Court order are not limited to cases in which the lender invokes a pledge of securities due to the overall decline in their market value. The nationwide lockdown and the current circumstances raise similar questions on all transactions where securities are offered as collateral for credit or the performance of other obligations (such as settlement with clearing corporations).
In the context of such transactions, we might be faced with the following kinds of situations - most likely, a combination of them – over the next few months:
1. Requests for suspension of debts that fall due, in their regular course, over the next few months.
2. A default or a decline in the value of the collateral that accelerate the due date for repayment of the debt or trigger other covenants.
3. Deferment of ‘pay-ins’ obligation for settlement of trades conducted on exchanges.
4. A decline in the value of the collateral that might trigger margin calls.
Situations of the kind referred to in 1. and 2. are largely covered by the Reserve Bank of India moratorium on the payments of installments and interest on term loans due until May end.
However, owing to the precedential and persuasive value of the order, there is a real possibility that the principle underlying the order might be extended to situations of the kind referred to in items 3 and 4, namely, transactions backed by underlying margins. This is dangerous.
For instance, take the example of the impact of the precipitous decline in the equity market on margins deposited by clearing members with clearing corporations. Clearing members of securities market exchanges are required to maintain a margin with clearing corporations for all trades done on the exchange. The clearing corporation acts as a central counterparty for all trades executed on an exchange, that is, it stands as a guarantor for every order that is executed on the exchange. It is able to perform this critical function due to the margins deposited by the clearing members with it.
The margin (or a part of it) is maintained in the form of liquid securities such as stocks, bonds, or even units of mutual funds. The value of the margin is marked-to-market, that is re-assessed for its market value, on a real-time basis. The clearing member is called to replenish the margin if the value of the margin is less than the value of the outstanding settlement obligations of the clearing member.
An extension of the principle applied by the Bombay High Court in the Future Group case to margining systems, could endanger the stability of settlement corporations and their ability to settle trades executed on the exchange. This, in turn, can impact the financial stability of the clearing corporation.
As the real effect of the nationwide lockdown on economic distress is realised over the next few months, courts and policymakers are likely to face pressure to intervene in these situations, and the temptation to do so might also run high. The thumb rule should be to respect the sanctity of contracts, especially where the purpose of the underlying security and margins is to provide security in such admittedly extreme situations.
While a specific case may persuade them to grant some immediate relief, the second-order effects of such relief are too grave to ignore.
Harsh Vardhan is Executive-in-Residence at the Center for Financial Studies of the SP Jain Institute of Management Research. Bhargavi Zaveri is a senior researcher at the Finance Research Group.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.