SEBI Proposes Enhanced Protection For Debenture Holders

Based on the negative experience of debenture holders of Dewan Housing Finance Corporation Ltd., the market regulator has proposed the creation of an identified charge, or underlying security, for bonds and debentures issued by non-banking finance companies, among other changes.

In a discussion paper, Securities and Exchange Board of India has noted the difficulty in enforcing security of underlying bonds/debentures issued by NBFCs in the event of a default.

Secured debentures issued by manufacturing companies carry a fixed charge on tangible assets such as plant and machinery. But in the case of secured bonds issued by NBFCs, the charge is floating—created on loan receivables, which are dynamic and intangible in nature and often include the entire balance sheet of the company.

In the event of a default, debenture trustees, that safeguard the interests of debenture holders, enforce the security. This is easier to do for manufacturing companies but has proven to be complicated in the recent past for NBFCs due to the lack of an identified security, the SEBI paper said. For instance, in the DHFL debt default matter, debenture holders have been entangled in a dispute with banks who had bought loan pools from the NBFC via securitisation transactions (allegedly in exchange for unpaid loans). Both sides laid claim to the same set of receivables.

The market regulator has pointed out that

• while NBFCs are required to maintain a prescribed asset cover for the tenure of the debentures, the underlying assets are indiscernible to the debenture trustee as all it receives from the NBFC is a certificate from an independent chartered accountant mentioning the value of entire assets and asset cover.
• this opacity makes it difficult for the debenture trustee to monitor the quality of the underlying assets.
• in case of a default it is possible that, due to this opacity, the good assets (i.e. higher quality loan receivables) maybe enforced as security by banks, leaving debenture holders with sub-par assets or inadequate cover.

Hence, SEBI has proposed that a floating charge be replaced with an identified charge that may include identified receivables, investment and cash.

The identified assets/receivables, investment or cash should be listed in a detailed asset cover certificate, to be submitted on a half-yearly basis versus the current annual basis, SEBI has proposed.

In case of deterioration in quality of the underlying asset, the issuer should compensate for by adding to the asset pool and maintaining adequate cover.

To monitor the quality of the underlying asset, the debenture trustee will fix a delinquency rate benchmark. If the delinquency rate at the issuer breaches this pre-set threshold then it will have to shore up the asset securities with other standard assets.

Joining The ICA

In the matter of DHFL, before it came under special insolvency proceedings, there was also confusion over whether debenture holders could join the Inter-Creditor Agreement framework set out by the Reserve Bank of India. The ICA follows RBI’s Jun. 7, 2019, circular that sets out terms on which stressed assets must be resolved by banks. As debentures are a security, and hence under jurisdiction of SEBI, debenture holders were not covered by the ICA. But the regulators have been in discussions to sort that out.

SEBI has listed the challenges faced by debenture holders in joining the ICA (via the debenture trustee). The big ones being

• Under the ICA lenders have a month after default to review the account, whereas a debenture trustee must give debenture holders notice of 21 days to receive consent for further action.
• The resolution plan agreed upon by the lenders under ICA may involve infusion of additional funds, conversion of debt to equity, transfer of the borrower’s assets... many of which may not be acceptable to debenture holders such as debt mutual funds.

Stating that debenture holders might often be at a disadvantage in the ICA-led resolution process, and that the Debt Recovery Tribunal may offer equal recourse, SEBI has proposed that debenture trustees join the Inter-Creditor Agreement but subject to certain conditions.

Approval from debenture holders is quite obviously a must. But SEBI has also listed other conditions that debenture trustees must incorporate in the ICA. Namely, that the debenture trustee should be free to exit the ICA with the same rights as if it never entered it, if

• the resolution plan is not in accordance with SEBI regulations.
• the resolution plan takes longer than 180 days to arrive at.
• any terms of the resolution plan are contravened by any other lender.

The other proposals in the discussion paper include

• rationalising process of seeking consent from debenture holders.
• creation of a recovery fund by the issuer to fund expenses towards recovery proceedings.
• additional disclosures by debenture trustees regarding issuer compliance, asset covers, defaults etc...
• public disclosure of all covenants by the issuer in the investment memorandum and other additional disclosures regarding side letters etc...
• standardisation of the debenture trust deed.

This discussion paper is long overdue. While only 2.3 percent of debenture issues have defaulted in the last five years, said SEBI quoting data from Trustee Association of India, most of the defaults have been secured debentures. Debenture trustees have been able to enforce the security only in 10 percent of the cases so far. NBFCs are among those that raise substantial funds via debentures. And debt mutual funds are big investors.