Coronavirus: When Courts Rewrite Contracts And Regulatory NormsBloombergQuintOpinion
Last week, we critiqued an interim order of the Bombay High Court restraining IDBI Trusteeship from selling the shares of Future Retail Ltd. The shares were pledged by the promoters of the Future Group as security for the bonds issued by one of the Future Group companies. The main ground for such restraint was that the price of the shares of Future Retail Ltd. had collapsed by more than 60% since the onset of the nationwide lockdown.
Since then, the Bombay High Court has passed another order restraining one more creditor, namely ICICI Home Finance, from invoking the pledge of collateral and selling the shares of MEP Infrastructure Developers, in respect of defaults committed by MEP prior to the lockdown. In two other cases, the Bombay and Delhi High Courts have passed orders restraining ICICI Bank and Yes Bank respectively from classifying a couple of real estate companies’ accounts that defaulted prior to the lockdown, as non-performing assets. These orders are deeply problematic, perhaps more so than the order passed in the Future Retail case.
Unlike the Future Retail case, in all these cases the borrowers had committed a default in January 2020, perhaps earlier than the first Covid-19 positive case was detected in India. In the MEP Infrastructure case before the Bombay High Court, the court even recognised the lender’s right to invoke the pledge and sell the underlying shares as collateral. However, having done so, the judge drew up a revised schedule for the repayment of the defaulted amount, and held that the lender could invoke the pledge only if the borrower defaulted on the revised schedule so drawn up by the court. Finally, in these three cases, the courts restrained the lenders from classifying the borrowers’ accounts as non-performing assets in their books.
The cumulative effect of these orders is that the court has taken upon itself the role of re-writing the credit contract and the role of the banking regulator in setting prudential norms for the RBI regulated lenders.
The courts’ intervention in these cases is disturbing for several reasons.
Collateral Enforceability Now Uncertain
If a sharp fall in the share price is to be a basis to restrain a lender from invoking her pledge, outstanding collateral worth a significant sum in the Indian credit market would likely be written off by the lenders. Equity shares of listed companies are an especially attractive collateral in India because they can be easily liquidated in the stock market, and their price is easily discover-able. Moreover, pledging ownership interest in a company puts additional pressure on the promoters to be disciplined about repaying their debt obligations.
For these reasons, promoter pledges have emerged as a very important source of raising debt capital in India especially where the borrower does not have adequate fixed assets on its balance sheet, as shown below.
As on March 31, 2020, promoter shares worth Rs 1.34 lakh crore were reported as pledged on the BSE.
NSE data shows that the promoters of about 25 percent of the companies listed on the exchange have pledged their shares. A little over 5 percent of the promoters of such companies have pledged their entire shareholding and more than a quarter of them have pledged more than 75 percent of the shares held by them.
Equally, loan against collateral is an important mechanism to provide credit to low rated companies that would otherwise struggle to obtain credit on the strength of their business and balance sheet. A very large proportion of the loan portfolios of NBFCs comprises loan against property given to small and medium enterprises who do not get any credit from the banking system. As the banking system turned conservative due to rise of NPAs from 2014 onwards, such credit from NBFCs was a lifeline for MSMEs.
Repeated court intervention in the invocation of collateral increases the uncertainty on the enforceability of such collateral. This increases the cost of credit secured by such collateral disproportionately for firms that otherwise also find it difficult to access credit from a generally risk-averse banking system.
Such uncertainty would eliminate a vital source of credit for a large section of SMEs who would be completely starved of credit, which would have broader economic consequences.
The crux of the argument against the sale of equity shares as collateral is this: the price of the underlying shares might be disproportionately affected due to the exogeneous shock of the pandemic and may not reflect the true fundamentals of the borrower. Implicit in this argument is a distinction between equity shares and other assets often used as collateral, such as gold and real estate.
This is a tenuous proposition for two reasons.
First, the price of all asset-classes might well be disproportionately affected by the pandemic. If the ‘going’ price were to determine the enforceability of the pledge, no pledge or security interest in India can be enforced until the price ‘normalizes’. Equity shares often bear the brunt of such a perception as their pricing is more transparent than that of other asset classes such as real estate. Indeed, in such times, listed shares may well be the only sale-able collateral.
Second, if the fundamentals of the borrower or that of the company whose shares are pledged are strong, there would be no incentive for the lender to sell the pledged shares as she would indeed obtain a better price when the market ‘normalises’. As we argued in our previous article last week, the lender and borrowers are repeat players in the market and the conduct of each affects its prospects for a future transaction.
A Dangerous Precedent
Finally, the most damaging part of these orders is the direction of the court to not classify the borrower’s account as a non-performing asset. A direction to mis-classify a defaulted loan as a ‘performing asset’ ignores the very purpose of prudential standards applied by financial sector regulators. Too often, credit transactions are viewed simpliciter as a transaction between a creditor and a borrower. The truth is that the creditor itself is a borrower of the funds which it in turn lends out to businesses.
The purpose of a prudential regulatory framework is to mandate financial firms (banks, insurance companies, etc.) to recognise defaults on time, and compel such firms to set aside capital to absorb the loss that may arise from such defaults. The end-goal is to protect the creditors’ creditors. In the case of banks, for instance, the requirement to recognise a default in a timely manner and set aside capital to cover for such default, protects the depositors.
A court’s orders directing lenders to not classify a borrower’s account as a non-performing asset, therefore, ends up unwittingly enriching equity shareholders of banks and NBFCs, and jeopardises the depositors of the lenders.
While the RBI has, in its capacity as the banking regulator, done this for repayment on term loans falling due between March 1 and May 31, 2020, the court has effectively extended this concession for defaults committed by the debtor firms in the cases before them to defaults committed even before March 1, 2020. By doing so, the court has intervened with the regulatory mandate of the banking regulator without giving it an opportunity to present its case. It has unwittingly left the debtors in the cases before itself better off than other debtors in the system whose accounts may have been classified as NPAs due to defaults committed before March 2020.
At a time when loan defaults to financial firms are most likely and the need of the hour is to ensure that financial firms honour their promises to households and that there is transparency of the health of financial firms, the orders of the Bombay and Delhi High Courts in these cases set a dangerous precedent. Once such an instruction is issued by courts, it incentivises financial firms and promoters to litigate and seek the ‘protection’ of the courts to get loans rescheduled and not classified as NPAs. This cannot be a good thing.
Bhargavi Zaveri is a senior researcher at the Finance Research Group. Harsh Vardhan is Executive-in-Residence at the Center for Financial Studies of the SP Jain Institute of Management Research.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.