September 11 2015
As of March 15 2015, the non-performing asset ratio of Indian banks is close to 4.45%, compared to 4.1% in March 2014. To give banks an additional tool to manage bad debts effectively, the Reserve Bank of India (RBI) introduced the Strategic Debt Restructuring Scheme in its June 8 2015 circular, under which banks may convert outstanding loan payments into equity shares through strategic debt restructuring if defaulting borrowers fail to achieve projected viability milestones set out under the restructuring package. Through the scheme, the RBI has emphasised that the general principle of restructuring requires shareholders to bear the first loss instead of debt holders. The RBI has observed that, in many cases of restructured debt, borrower companies remain under financial stress due to operational and managerial inefficiencies, despite substantial sacrifices made by the lending banks. In such cases, lenders should be able to change ownership and management.
Under the scheme, at the time of the initial restructuring, the joint lenders forum(1) must incorporate an option in the restructuring agreement to convert part of or the entire unpaid loan (including interest) into equity in the borrower.
If a majority(2) of the forum lenders believe that the borrower has failed to achieve the viability milestones or adhere to critical conditions, and that the account will be viable only by effecting a change in ownership, part of or the entire loan may be converted into equity. On exercise of this option, the lenders should collectively hold at least 51% of the equity shares of the borrower.(3)
The conversion of a loan into equity under the scheme will not be treated as a restructuring for participating lenders under asset classification and provision norms, and the existing asset classification of the account (as on the reference date) will continue for 18 months following the reference date. The reference date is the date on which the decision to exercise the strategic debt restructuring option is taken.
On conversion, the RBI has directed banks to divest their holdings in the equity of the borrower as soon as possible. If the banks divest their holdings in favour of a new sponsor,(4) the asset classification of the borrower's account may be upgraded to 'standard'; however, banks cannot reverse the provision held against the account until the outstanding loan is serviced per the terms of the repayment plan agreed between the banks and the new sponsor.
While on paper banks always had the option to convert an outstanding loan amount into equity in a company, in practice, due to several restrictions applicable to banks in respect of shareholding ceilings, the ability to deal in securities and capital market exposure norms, they could not effectively exercise this option. The scheme prescribes various regulatory exemptions for banks in order to allow them to exercise the conversion option, including as follows:
The scheme gives banks considerable power when dealing with non-cooperative promoters of borrower companies under financial stress, which has been a longstanding problem in the Indian financial sector. Lenders can now effectively assume ownership and control of the borrower and replace the promoter if the borrower's condition fails to improve after a restructuring.
However, the industry has also expressed reservations over a bank's ability to manage the operations of a borrower company effectively (after exercising the strategic debt restructuring conversion option) and find willing buyers for a stressed company. While the success of the scheme remains to be seen, it is a powerful tool for banks to manage their stressed accounts.
For further information please contact Shilpa Mankar Ahluwalia or Shubhangi Garg at Amarchand & Mangaldas & Suresh A Shroff & Co by telephone (+91 11 4159 0700) or email (email@example.com or firstname.lastname@example.org).
(1) The RBI's joint lenders forum system requires all scheduled commercial banks, certain specified financial institutions and certain specified non-banking financial companies to establish a common forum for lenders in order to formulate a corrective action plan to identify problem accounts early and restructure accounts that are considered viable in a timely manner, so that lenders can promptly recover or sell unviable accounts.
(3) Due to statutory restrictions under the Banking Regulation Act, 1949, each bank's individual holdings cannot exceed 30% of the total paid-up share capital of the company or 30% of its own paid-up share capital and reserves, whichever is less.
(4) The scheme has clarified that a new sponsor cannot be a person, entity, subsidiary or associate (domestic or overseas) of the existing sponsor or sponsor group. New sponsors should acquire at least 51% of the paid-up equity capital of the borrower. If the new sponsor is a non-resident and in sectors where the cap on foreign investment is less than 51%, it should own at least 26% of the paid-up equity capital or up to the applicable foreign investment limit and must control the management of the company.
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