Indian rupee banknotes and coins of various denominations sit in a bowl at a chili vendor’s stall in Mumbai, India. (Photographer: Dhiraj Singh/Bloomberg)

Attention Shareholders Of Insolvent Companies - Here’s What Your Paper’s Worth

Shares of Electrosteel Steels Ltd. hit the lower circuit in trade on Wednesday, dropping 5 percent after news that existing shareholders will be reduced to less than 10 percent of the company post the insolvency process.

This should have come as no surprise for a company burdened by over Rs 13,000 crore in debt and just Rs 145 crore in earnings before interest, depreciation, taxation and ammortisation for the financial year ended March 31, 2017.

And yet for many minority shareholders, the new insolvency process unfolding in India, serves as a lesson in corporate finance.

Equity shareholders are at the bottom of the pile and they take all the risk, said leading corporate lawyer Cyril Shroff.

When a company is insolvent and unable to pay its debt, by definition, it ranks at the bottom and is technically worth zero.
Cyril Shroff, Managing Partner, Cyril Amarchand Mangaldas

To put it simply, equity has the last claim over any assets of a company, after dues to the government, financial institutions, other creditors and bondholders are paid off. The Insolvency and Bankruptcy Code, 2016 puts financial institutions and workers’ dues at the top of the list, before statutory dues, but equity shareholders stay at the bottom.

The only thing is that sometimes there may be value at the bottom of the pile too, and that’s the hope that some shareholders have, countered Abizer Diwanji, partner and national leader of financial services at consultancy EY. Diwanji was commenting on why some investors were still betting on shares of companies undergoing insolvency proceedings.

Shareholders believe that if the debt is rescheduled or reduced then the equity value will go up. But people normally will write down equity and then reduce debt.
Abizer Diwanji, Partner and National Leader - Financial Services, EY

Legally too, the IBC circumscribes rights of equity holders. So corporate actions, such as capital reduction, that ordinarily need shareholder approval, no longer do if the resolution plan proposing them is approved by the National Company Law Tribunal. That means, shareholders don’t get to vote on any resolution plan. Even takeover code regulations have been relaxed for insolvent companies. Acquirers are not required to do a mandatory tender offer.

There needs to be a framework to deal with a variety of scenarios which could develop in a resolution plan, said Shroff. For instance, whether there should be an exit option for shareholders? What about the applicability of delisting and minimum public shareholding norms?

The Securities and Exchange Board of India has raised these issues in a recent discussion paper but in the absence of any framework yet, shareholders may be confused about where they stand in an insolvency process and what they should do with their shares. That SEBI has not announced any trading restrictions on shares of companies in insolvency proceedings may have added to the confusion and volatility.

So what should shareholders do when confronted with a part or complete dilution of their shareholding?

Scenario 1 - Existing Equity Wiped Out

Diwanji: First of all, under the Companies Act, you will come and say I can write the stock down and hence you will write the stock down. So, you can do that completely or you can say I will infuse more money and dilute the existing company. So, you write the stock down, you go by the Companies Act and pass a resolution saying I want to write down the stock down to zero, input fresh capital and run the business. In which case, there is no delisting norm today, so that is an issue. You may have to either apply to SEBI for a delisting and hope that SEBI will grant you that approval. Or the second issue is that you cannot dilute a full 100 percent. You can only dilute up to to 75 percent leaving behind the 25 percent public shareholding. So, everybody including the erstwhile promoter, effectively becomes public.

Shroff: There is a regulatory gap in terms of lack of a delisting framework in the scenario where equity has been written down completely. So, the regulator will have to fix this gap quickly. My understanding is that this is being worked on.

Doshi: Currently, if there is no relaxation of the delisting guidelines and let’s say a resolution plan gets approved tomorrow that looks at this scenario, does a shareholder stand to gain from the delisting point of view because then there is the reverse book building process that comes in?

Shroff: It will be a special process and the answer will be found in the resolution plan itself because at this point of time until there is a separate framework, it is the comprehensiveness of the resolution plan which will be sanctioned by the NCLT that will have to deal with it. So, both options are possible where there could be a resolution plan-based delisting type process, where there is an offer which is given to the shareholders to exit at whatever value if any. Or alternatively they just merge into the acquirer and get securities at some value, however small that is which gives them a substituted security. It is hard to generalise on this. But at this point unless there is a separate framework for this, the solution will be crafted in the resolution plan.

Diwanji: You first write down the share capital to zero or whatever you want and then just go ahead and merge the companies. If you merge the companies then hopefully the acquirer company will have 25 percent of the public shares. You will get a pittance of the shares of the new company, may be half a share or something or nothing.

Scenario 2 - Existing Equity Diluted

Diwanji: At the end of the day, you can write down the shares to whatever. People will look for what was the enterprise value of the whole transaction, what kind of money have you put in, what kind of debt have you assumed vis-à-vis what you have acquired. Does it make sense as a transaction? If it makes sense as a transaction and as a result of that minority shareholders get nothing, it is quite acceptable.

Doshi: Give me an illustration.

Diwanji: Vedanta in the Electrosteel case is saying we will put Rs 1,800 crore odd of equity. For 90 percent stake, that values the company at Rs 2,000 crore. So, 10 percent of that is what the creditors and shareholders get - Rs 200 crore. The market capitalisation today is Rs 700 crore. Now, you have to prove the fallacy of the market cap. So, how do you prove the fallacy of market cap? That’s when you compare what Vedanta has put in as capital, what it has assumed as debt and what is the contingent liability in the business. If you look at the numbers they are comparable with bids for other steel companies. If that be the case, then Rs 200 crore is a justified number.

Scenario 3 - Existing Equity Preserved

Doshi: Using the Binani case, if there is residual value for the shares then you not technically a shareholder of an insolvent company?

Diwanji: You are a shareholder of a company which is an administration.

Doshi: So you are entitled to some value to your shares. How do you determine what that value should be?

Diwanji: That’s a market driven force. You decide then enterprise value and then take the total debt. The difference between the two should be equity value.

Doshi: How do public shareholders gauge whether they are holding shares of a company that deserves to be undergoing the insolvency process or has been dragged erroneously into the insolvency process? It may not be insolvent but has a liquidity issue and therefore the shares are worth something. How do you determine what that value is?

Shroff: This goes to the disclosure issue because the basic thesis of equity markets is about fair disclosure and symmetry of information. Even in some of the hypothetical situations where until the resolution plan is crystallised you have no idea whether your equity is worth zero or there is some equity value left. I think it takes us to the disclosure issue of what should be the extent of disclosure that should be made to the equity markets and at what point of time so that the market can judge for itself whether there is residual value left in then equity and then they can trade on that basis. It is a chicken and egg situation. The regulatory and policy establishments should put on their thinking hats and come up with a fair disclosure environment of perhaps while the insolvency process is going on, freeze trading so that there is no trading on incomplete information.

Doshi: Minority shareholders have to take a call on whether they should stay invested, whether they will be written down to zero, whether they will get written down to 10 percent of their pre-insolvency value or whether they in fact might be able to preserve their value. How are they supposed to make that call?

Diwanji: Let’s talk about the 12 big cases. It is apparent that all these have debt which will never be serviced and never be paid. There were not merely liquidity issues. Questions can be answered by the minority shareholders. Is this organization generating enough EBITDA and that information is always available quarter on quarter. Figure out what actual EBITDA generation will service the loans. If they are not being able to service consistently then you know that they are over trading. If you know that they are overtrading, then there is no equity value left. You are at benevolence of whoever is buying it to give you equity value. There is no science to it. My view is they should not be holding those shares and exiting because they know equity value is zero and whatever they are getting in the market they should take.

I am in favour of a ban for the reason that you give an exit opportunity to one shareholder at the cost of another shareholder, so somebody else will buy in the name of greed, hoping that the share price will go up. I don’t think you are benefitting the shareholder community at large by keeping the trading open.

Doshi: Generally speaking, what should minority shareholders do? Should they stay invested or get out?

Shroff: Wait and watch. Because this entire regulatory environment is changing and evolving. Whilst it is a new system designed primarily for debt, as far as the implication on equity is concerned it has not been thought through but is being thought through. If minority shareholders are looking for clear answers they will just have to wait and see. There may be some early cases meanwhile which will not have perfect resolution. But at least issues are emerging case by case basis, and they will get solved. It may not be a great answer but that is the real answer.

Diwanji: Rebuttable presumption - Sell.

These are edited excerpts from a discussion with Shroff and Diwanji. For the full discussion watch this video.

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