Banks, non-banking financial companies, debt funds and companies are increasingly using the route of private placement of listed and unlisted non-convertible debentures (NCDs) to raise funds from players such as pension funds, insurance companies, foreign portfolio investors and mutual funds to retire debt and for on-lending. However, this route is beset with legal and regulatory challenges, some of which are outlined below.
RBI approval: Creation of security over immovable property in favour of a foreign lender requires prior approval of the Reserve Bank of India (RBI) under the Foreign Exchange Management (Acquisition and transfer of immovable property in India) Regulations, 2000. This poses a challenge in structuring the security package.
Classification as “deposits”: Under the Companies Act, 2013, bonds or debentures issued by a company must be secured by a first charge or a charge ranking pari passu with the first charge on the tangible assets of the company. Any subsequent charge is considered as a deposit, and optionally convertible debentures are also now considered as deposits. However, compulsorily convertible bonds or debentures convertible within five years are exempted from the definition of deposits.
Contractual restrictions: Step-in rights of the existing lenders of the borrower company may require the security package to be structured either by way of substitution of rights in favour of the NCD holders or by way of a charge over the immovable property.
Industrial zoning restrictions: India’s urban development authorities lease parcels of land to industrial enterprises restricting their right to create any security interest on the leased land without the authority’s prior approval. Such approvals are usually discretionary and pose both structuring and timeline challenges.
Stamp duty issues: High rates and lack of uniformity in levy of stamp duty pose a challenge for security creation.
Enforcement timelines: The remedies under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002, and the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, for fast-track disposal of enforcement proceedings are not available to other NCD investors. They would need to resort to time-consuming civil law remedies. Post-decree execution proceedings in India are a nightmare creating further challenges to the enforcement of security interest.
Insolvency proceedings: Section 14(1)(c) of the Insolvency and Bankruptcy Code, 2016, provides for placing a moratorium on the debtor’s operations during the insolvency resolution process. During this “calm period”, no judicial proceedings for recovery, enforcement of security interest, sale or transfer of assets, or termination of essential contracts can take place against the debtor. This restricts the right of the NCD holders to enforce their security.
Inadequate penal provisions: Section 138 of the Negotiable Instruments Act, 1881, does not prescribe a strong deterrent for dishonour of a cheque.
Security cover: Under the Companies Act, a company can issue secured debentures only upon creation of a charge on its assets or immovable properties having sufficient value for redemption of such debentures. This requirement with respect to adequacy of security poses a challenge for companies with an asset light model. Further, debentures secured by way of share pledges are not recognized as “secured debentures” in terms of rule 18(1)(d)(i) of the Companies (Share Capital and Debentures) Rules, 2014, which further weakens the security package.
Asset quality and valuation: The Indian real estate market is volatile space in which the valuation of assets is not range bound. Being an unregulated market, the degree of credit risk is higher for real estate assets than other asset classes. Although the transaction documentation typically provides for maintaining adequate security from the borrower, there is no assurance that the value of the security will remain adequate to secure the redemption of the NCDs.
Public offer norms: The issuer company is required to strictly comply with the private placement guidelines provided under the Companies Act for private placement of NCDs, which can be issued to a maximum of 200 people per financial year. In case of breach such placement would be construed as a “public offer” under the act, leading to onerous compliances. However, many issuers of NCDs take a different position on what constitutes “public”, thereby leaving scope for debate on whether an issue is valid.
It is the time for the regulators and the government to focus on making the legal framework for debt instruments simpler and enforceable for ensuring a challenge-free debt market.
Rajesh Begur is the managing partner at ARA LAW, a first-generation law firm with offices in Mumbai and Bengaluru.