It has long proved difficult to deal with financially distressed companies in India. One of the main reasons is the many tools available to the existing management of a company to prevent an external creditor from taking control over the company. On June 8, the Reserve Bank of India (RBI) issued a circular introducing new measures that should provide help to lenders struggling to cope with the mountain of bad debt owed by Indian corporates.

The Strategic Debt Restructuring Scheme (SDRS) which the RBI has now introduced allows banks to convert their outstanding loans into a majority equity stake in a defaulting company if the company fails to honour its debt commitments agreed under a restructuring plan. It is expected the SDRS will enhance the bargaining power of banks during debt restructuring negotiations and ensure better compliance among borrowers with their restructuring plans.

The SDRS

Allowing loans to be converted into shares will now be a precondition in all debt restructuring deals in India. If a borrower is unable to achieve the viability milestones stipulated in the restructuring package, the Joint Lenders Forum (a committee formed by all the lenders of a borrower) will be required to review the accounts of the borrower and decide, within 30 days after reviewing the account, whether to invoke the SDRS. The SDRS needs to be approved by 75 percent of creditors by value and 60 percent of creditors in number.

After loans are converted into equity, the Joint Lenders Forum must collectively hold at least 51 percent of the shares issued by the borrower. Any conversion of shares due to the execution of the SDRS will be exempted from regulatory ceilings and restrictions on capital market exposures, and such conversion will not be treated as an “investment-in-associate” under applicable accounting standards. The Joint Lenders Forum will closely monitor the company, and if needed, replace the existing management with new independent management.

The option to replace the existing management with new management could act as a deterrent for wilful defaulters and create a sense of fear amongst borrowers, possibly resulting in better credit compliance and responsible management. This could create awareness amongst borrowers that mismanagement could even lead to them losing control over their own entity, therefore ensuring a better corporate governance structure in the company. At this stage, it should be noted that there is a significant number of challenges that new promoters face on acquiring a financially-distressed company. Bringing the financially troubled company out of its present situation and achieving a new successful strategic turnaround could prove to be a difficult task for the new directors. A significant challenge would be to build and sustain operating cash flow in such troubled entities. Another difficulty that such companies could face is paying off the creditors of the newly acquired entity. The company may also not be in a position to satisfy any post-completion indemnification claims that may arise. Non-compliance by distressed companies with applicable laws and the consequent statutory liabilities can pose problems for the new directors.

The circular provides that the Joint Lenders Forum should divest their new equity stake to a new promoter as soon as possible. The new promoter must acquire at least 51 percent of the shares. In sectors where a ceiling is imposed on foreign investment, the foreign new promoter must acquire at least 26 percent of the equity capital or up to the applicable foreign investment limit, whichever is higher. In such a scenario, where the new promoter is unable to hold 51 percent of the paid equity capital due to the applicable foreign investment restrictions, the banks will have to be satisfied that with this equity stake, the new non-resident promoter will have to control the management of the company by putting in place necessary contractual mechanisms in case of unlisted distressed companies.

Implications of the SDRS

The existing debt restructuring process in India currently favours the promoters. It is generally very difficult for external creditors to take control of a defaulting company. The SDRS will be a useful tool to pressure wilful defaulters. It is expected to instil a real sense of concern among promoters that they risk losing control over their company if they fail to meet the milestones in their restructuring plan.

Banks in India have generally welcomed the introduction of the SDRS and regard it as an effective measure to deal with wilful defaulters. However we anticipate that there will initially be reluctance by banks to step in and take over control of a company until they have developed the internal expertise and technical know-how to manage large enterprises. This could well represent an opportunity for professional debt advisors to support lenders along with specialist interim directors, provided director liability issues can be successfully navigated.

Sandeep Mehta