SUSTAINABLE STRUCTURING OF STRESSED ASSETS - STRIKING A BALANCE
27 June 2016
With continuing uncertainty in the economy and increasing number of bad loans declared by the banks and financial institutions in India in the last few quarters, the Reserve Bank of India (RBI) on 13 June 2016, unveiled the Scheme for Sustainable Structuring of Stressed Assets (S4A Scheme). The S4A Scheme is aimed at deep financial restructuring of projects having a chance at sustained revival as well as strengthening the lender’s ability to deal with such stressed assets. Primarily, the S4A Scheme focusses on facilitating the resolution of large accounts by allowing banks to take equity in stressed companies and permitting them to split total loans of struggling companies into sustainable and unsustainable baskets, based on the cash flows of the projects. The move is intended to help restore the flow of credit to crucial sectors such as infrastructure and iron and steel, among others, to reduce the stress on the balance sheet of companies and to ease the burden of bad loans across banks. Under this regime, banks will be allowed to rework stressed loans under the oversight of an external agency, thereby ensuring transparency while also protecting bankers from undue scrutiny of investigative agencies. In situations where the revival scheme is successfully implemented, the banks having taken the equity risk would also stand to benefit from the appreciation in the value of the enterprise as a reward for the forbearance upfront.
Determination of Sustainable Debt for Restructuring : For an account to be eligible for restructuring under the S4A Scheme, the aggregate exposure of all institutional lenders in the account should exceed INR 500 crore (including rupee loans, foreign currency loans/external commercial borrowings) and the project should have commenced its commercial operations. In addition to this, the debt outstanding is also required to meet the test of sustainability (discussed below), introduced by the RBI under the S4A Scheme.
The Test of Sustainability: For a debt level to be deemed sustainable, the Joint Lender’s Forum (JLF)/Consortium of lenders/bank must conclude through an independent techno-economic viability analysis (TEV), that the present outstanding debt (funded as well as non-funded) is capable of being serviced by the current cash flows of the company, over the same tenor as that of the existing facilities and such outstanding debt should not present less than 50% of the current funded liabilities.
Bifurcation of the outstanding debt into sustainable debt and equity/quasi-equity instruments: The S4A Scheme provides for a bifurcation of the outstanding debt into sustainable debt and balance debt which would be converted into equity/quasi-equity instruments which is expected to provide upside to lenders when a borrower turns around. This shall be done by the JLF/consortium/bank after an independent TEV by dividing the current dues into Part A and Part B:
Part A would include the level of debt (including fresh funds required to be sanctioned within next six months and non-funded credit facilities that will crystallise within the next 6 months) that can be serviced within the respective residual maturities of existing debt through the current cash flows of the company as well as expected cash flows from the prospective level of operations, within the next 6 (six) months.
For this purpose, free cash flows (i.e., cash flow from operations minus committed capital expenditure) available for servicing debt would be taken into consideration. In case of more than one debt facility, the maturity profile of each facility would be that which exists on the date of finalising the resolution plan. For the purpose of determining the level of debt that can be serviced, the assessed free cash flow would be allocated to servicing each existing debt facility in the order in which its servicing falls due. The level of debt so determined is referred to as Part A under the S4A Scheme which cannot be lower than 50% of the current funded facilities of the company.
The difference between the aggregate current outstanding debt from all sources and Part A would be reckoned as Part B under the S4A Scheme. The debt under Part B would be converted into equity/redeemable cumulative optionally convertible preference shares. However, in cases where the resolution plan does not involve change in promoters, banks will have the option of converting a portion of Part B into optionally convertible debentures.
One of the benefits under the S4A Scheme is that it ensures that such bifurcation of debt does not dilute the security position of lenders. Even after bifurcation, Part A portion of the debt would continue to have at least the same amount of security cover as it had available before the resolution.
Valuation of Part B instruments: The S4A Scheme contemplates that the valuation of the equity shares should be marked to market at least on a weekly basis (preferably on a daily basis). For equity shares which are not listed on any stock exchange or for which current quotations are not available, should be valued at the lowest value using either:
the “break–up value” method – which is determined from the company’s latest audited balance sheet (without considering ‘revaluation reserves’). In case the latest audited balance sheet is not available, the shares should be valued at INR 1 per company; or
the ‘discounted cash flow method (DCF method)’, under which the discount factor is the actual interest rate charged to the borrower plus 3%, subject to floor of 14%.
Separately, the valuation for the redeemable cumulative optionally convertible preference shares/optionally convertible debentures should be on the Discounted Cash Flow (DCF) method, to be valued with a discount rate of a minimum mark up of 1.5% over the weighted average actual interest rate charged to the borrower by the lenders. Where there are preference dividends in arrears, the value determined as per the DCF method should be further discounted by at least 10% for year of such arrears (for example, 15% if the arrears are for one year and 25% if the arrears are for 2 years).
The Resolution Plan : The resolution plan under the S4A Scheme contemplates a bar on any fresh moratorium being granted or extensions in the repayment schedule for repayments of Part A of the debt or reduction in the interest rates for servicing Part A of the debt (when compared to the pre-resolution conditions). Separately, under the resolution plan, Part B would get converted into equity/quasi-equity instruments.
Where the resolution plan does not involve change in the existing promoters or where the existing promoters have been permitted to operate and manage the company as minority owner, the lenders need to ensure that the existing promoters dilute their shareholdings by way of conversion of debt to equity or sale of certain portion of the promoter’s equity to the lenders, at least in the same proportion as that of Part B to the total dues of the lenders. Additionally, under the S4A Scheme, a personal guarantee of the promoters are mandatory, at least up to the amount of Part A.
Post-Resolution Ownership of Borrowing entity : One of the key features of the S4A Scheme is that it allows multiple options in relation to the post-resolution ownership of the borrower, that is:
the current promoter of the borrower may continue to hold majority of the shares/controlling interest in the borrower (other than in cases where a malfeasance on part of the promoter has been established);
the current promoter may be replaced with a new promoter, in one of the following ways:
through conversion of part of the debt into equity under the strategic debt restructuring (SDR) mechanism (which needs to be sold to a new promoter subsequently); or
in the manner set out under the Prudential Norms on Change in Ownership of Borrowing Entities;
in the event the lenders decide to acquire the majority shareholding of the borrower under the SDR mechanism, they may either permit the present management of the borrower to continue or appoint external agencies/professionals under an operate and manage contract to control the management of the borrower.
Asset Classification and Provisioning : The S4A Scheme provides for two situations to be considered during Asset Classification and Provisioning:
In the event there is a change in the existing promoter of the borrower, the asset classification and provisioning requirement would be as per the SDR scheme or ‘outside SDR’ scheme, as applicable;
In case there is no change of promoter, asset classification as on the date of lender’s decision to resolve the account under the S4A (Reference Date) will continue for a period of 90 (ninety) days from this date. This standstill period of 90 days is aimed at enabling the JLF/consortium banks to formulate and implement the resolution plan within such standstill period. If the resolution is not implemented within this period, the asset classification will be as per the extant asset classification norms, assuming there was no such ‘stand-still’;
It may be relevant to note that for a ‘Standard’ account (as on the Reference Date), the entire outstanding (both Part A and Part B) would remain Standard subject to provisions made upfront by the lenders being at least the higher of 40 percent of the amount held in part B or 20 percent of the aggregate outstanding (sum of Part A and part B);
However, for accounts which are classified as non-performing assets on the Reference Date, the entire outstanding (both Part A and part B) shall continue to be classified and provided for as a non-performing asset as per IRAC norms. After a period one year of satisfactory performance of Part A loans, the Lenders have an option to upgrade Part A and Part B to ‘Standard’. In case of any pre-existing moratorium in the account, the lenders would be permitted to make such upgrade after the completion of one year from the longest moratorium period and subject to satisfactory performance of Part A debt. However, lenders will continue to mark to market Part B instruments as per the prescribed norms under the S4A Scheme;
Through the resolution plan set out under S4A Scheme, the ultimate objective is to ensure that the promoters do not sell the company/firm without the prior approval of lenders and without sharing the upside, if any, with the lenders towards loss in Part B. Further, if Part A debt subsequently slips into the NPA category, such account would be classified with slippage in category with reference to the classification applicable on the Reference Date and necessary provisions should be made immediately;
Where a bank/NBFC/AIFI chooses to make the prescribed provisions/write downs over more than one quarter and this results in the full provisioning/write down remaining to be made as on the close of a financial year, banks/NBFCs/AIFIs should debit the reserves other than the one created in terms of Section 17(2) of the Banking Regulation Act 1949 (Other Reserves) by the amount remaining un-provided/not written down at the end of the financial year, by credit to specific provisions. However, banks/NBFCs/AIFIs would have to proportionately reverse the debits to the Other Reserves and complete the provisioning/write down by debiting profit and loss account, in the subsequent quarters of the next financial year. Banks would have to make suitable disclosures in Notes to Accounts with regard to the quantum of provision made during the year under this S4A Scheme and the quantum of unamortised provisions debited to ‘other reserves’ as at the end of the year.
Overseeing Committee : In order to ensure transparency in decision making, the RBI has introduced an advisory body called an Overseeing Committee, which will be constituted by the Indian Banks’ Association in consultation with the RBI and would comprise of eminent persons. The Overseeing Committee will be responsible for reviewing the processes involved in preparation of the resolution plan submitted to it by the JLF/consortium/bank and shall ensure that the provisions of the S4A Scheme has been complied with while preparing such resolution plan. The resolution plan, once ratified by the Overseeing Committee, would become binding on all lenders. However, the lenders would have the option to exit in accordance with the RBI guidelines on JLF and Corrective Action Plan.
In the wake of rising numbers in the gross non-performing assets in the country (which have gone up from Rs 4.38 trillion in December 2015 to Rs 5.8 trillion in March 2016), the RBI has introduced the S4A Scheme with an aim to provide further flexibility to banks to restructure the assets facing stress.
However, there are a few concerns which have arisen which may pose practical impediments while implementing the provisions of the S4A Scheme. For example, the S4A Scheme only includes completed projects, and not those under construction. Given that a lot of projects which have not yet achieved their commercial operations are under financial stress, the benefits of the S4A Scheme would not extend to such companies and in turn, the issue of bad debts in such companies would continue to be governed by the existing RBI regime on restructuring. Separately, although the S4A Scheme calls for splitting of debts into “sustainable” and “unsustainable”, if the “sustainable” debt is not accurately determined such that the enterprise remains unviable even post conversion, the equity risk of the enterprise would also be on the lenders and the converted equity may not fetch good returns for the lenders in the short to medium term.
Further, the S4A Scheme contemplates use of current cash flows of the company as a basis of ascertaining sustainable debt. Given that for a large number of stressed companies, the current cash flow levels are at a minimum requiring them to take constant working capital support, the provisions of the S4A Scheme may result in an accumulation of a higher amount of debt, without checking issues of mismanagement and thereby rewarding “under-performance”.
Having said that, the S4A Scheme has been introduced by the RBI in the aftermath of the SDR regime and unlike the SDR regime, under the S4A Scheme, banks would be to allow existing promoter to continue in the management even while being a minority shareholder. In addition, under the S4A Scheme, the lenders also have an option of holding optionally convertible debentures instead of equity, which might be more preferred option. Thus, this S4A Scheme is a welcome move by the RBI which offers a measure of relief to banks weighed down by bad loans and their stressed corporate clients, seeking to slow the build-up of sticky loans and, at the same time, ease the pressure on company balance sheets.
However, it remains to be seen if the lenders under the supervision of the Overseeing Committee would be able to strike a balance between assisting viable entities suffering from external problems in the economy and not letting forbearance being seen as an encouragement to under-performance.
Kumar Saurabh Singh (Partner), Rajeev Vidhani (Principal Associate) and Ahana Sinha (Senior Associate)
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