Corporate Guarantees: Ensuring Enforcement Is as Important as Fixing the Rules
Last week, the Securities and Exchange Board of India (SEBI) took a step towards closing the divergence between its rules and those of the Reserve Bank of India (RBI) on ‘support structures’ by way of personal guarantees, letters of comfort (LoCs) and letters of undertaking, which allow companies to claim a higher credit rating. The market regulator has asked credit rating agencies (CRAs) for information on companies whose “ratings are propped up with promoter or parent guarantees and pledge of shares. The capital market regulator has also sought details on companies which have been refusing, often for years, to share data with rating firms,” says The Economic Times (ET).
Although SEBI has only called for data, the action is part of regulatory tightening process that began after several corporate horses had already bolted. The long list of companies that enjoyed high ratings based on fudged audits, promoter guarantees/LoC include big names such as Infrastructure Leasing & Financial Services (IL&FS), Anil Ambani group, Essar group companies (beyond Essar Steel), Dewan Housing Finance Ltd (DHFL), Videocon, Bhushan group, Punj Lloyd, IVRCL, etc.
While bank defaults are socialised through bailouts, individuals who invest in bonds and debentures are badly hit and have lost over Rs25,000 crore since 2018. CRAs suddenly downgraded AA and AAA rated companies to default rating, leaving retail investors with dud paper. CRAs have escaped with barely a slap on the wrist as the apex court and appellate bodies failed to grasp the fiduciary role and liability of credit rating when CRAs downgrade a highly secure investment to junk status overnight. Investors have little hope of recovery or suing for compensation in our slow and expensive legal system. On the other hand, banks and promoters, whose collusion led to large-scale defaults, have escaped accountability.
Scourge of Hidden Guarantees
Companies use personal guarantees by promoters or LoCs/letters of undertaking from profitable group companies to obtain a higher credit rating and lower their cost of borrowing. In March 2021, three years after the collapse of IL&FS, the standing committee of parliament asked RBI and SEBI to review the credit rating framework to ensure greater disclosure, including the extent of ‘promoter support, linkages with subsidiaries and liquidity position to meet near-term payment obligations,’ to provide a clearer picture about the entity. The report did not bother to tabulate the enormous corporate guarantees that had been accepted by public sector banks (PSBs) from leading industrialists without assets to back them or create enforceable legal agreements.
For instance, a clutch of PSBs had accepted a personal guarantee of Rs13,000 crore by Prashant and Ravi Ruia of the Essar group (DRT Ahmedabad 652 of 2018) against loans to a barely known company called Essar Investments. This is separate from the personal guarantees that the duo had issued to Essar Steel which was taken over by Arcelor Mittal. The Ruias claimed in court that they hardly had any personal assets to make good the guarantee.
Similarly, PSBs had accepted personal guarantees of over Rs11,500 crore from the Dhoot brothers of Videocon, when the entire group is not able to command that price in bankruptcy proceedings. Forget Indian lenders, even Chinese Banks struggled to invoke personal guarantees of Anil Ambani on their loan of over US$700mn (million).
RBI’s April 2022 Instructions
In April 2022 ( NotificationUser.aspx?Mode=0&Id=12276), RBI tightened the rules on guarantees and co-acceptances by banks, making it clear that such guarantees could lead to enhanced credit ratings only if there are enforceable and have strict timelines on invocation of guarantees. Although RBI’s April instructions are a step in the right direction, their implementation in letter and spirit will be the challenge.
For one, banks may continue to find ways to avoid compliance. The former chairman of a leading PSB tells me that eager bankers, looking for secure lending opportunities, often, accept dodgy LoCs or un-enforceable bank guarantees in order to book business. These are as good as unsecured loans, he says, and ought to be treated as such.
He cites the international case of HSBC vs Jurong Engineering where an appellate court rejected the enforceability of an LoC saying that it was not binding in nature, because the wording did not create a legally binding obligation in favour of the bank. Unless RBI issues a model LoC or guarantee agreement, it would be no surprise if banks, in collusion with corporates, continue to accept badly drafted agreements that create no legal obligation.
This is all the more important today. A leading private banker says, after the government announced a 15% tax rate on new manufacturing, many existing companies are opting to set up new capacity in subsidiary companies to reduce their tax burden. The loans to these subsidiaries are backed by guarantees and comfort letters provided by the parent.
Secondly, the problem with information asymmetry and data sharing also lies at the doors of banks. Two decades after setting up credit information companies to collate data on individual, a public credit registry that will include all corporate borrowings and credit relationships is still a work-in-progress. Even though 90% of all ratings are for bank loans, banks do not cooperate when it comes to keeping data up-to-date nor do they report large defaults with alacrity.
Another serious issue is the non-cooperation of borrowers. CRAs have complained that nearly 15,000 companies have refused to furnish information required to update ratings of debentures as well as loans. These are mostly unlisted companies and their numbers will only increase as new subsidiaries crop up. Rating rules require a financial instrument to be rated throughout its lifetime. But, in the absence of information and cooperation, ratings cannot be accurate. The effort to shame them by reporting their recalcitrance has not helped and CRAs want permission to withdraw the ratings. SEBI is unwilling to permit this for debentures and banks are also reluctant to issue no-objection certificates for withdrawal of ratings. Unless regulators and key administrative ministries find a way to mandate compliance, merely tinkering with guidance and regulatory instructions will not help.
SEBI Needs To Act
SEBI’s call for data on rating propped by corporate guarantees is important; but eliminating regulatory arbitrage requires a lot more work, given the number of large defaults in the past four years. Removing the anomaly of permitting higher ratings on structured obligations (SOs) based on LoCs and corporate guarantees is only the first step. A senior banker says, “ever since credit ratings started in this country, the whole 'SO' concept was, by and large, deeply flawed.”
Moneylife columnist, R Balakrishnan, who has long years of experience with credit rating, says, “An SO is anything that changes the intrinsic credit rating of an instrument and has a separate symbol to denote that it is not a vanilla credit rating. This includes third-party guarantees by the parent and even external support and liquid collateral for credit enhancement or timely payments. The CRA decides what is an acceptable structure to permit enhanced ratings.”
Retail investors are indirectly exposed to SOs because mutual funds (MFs) and institutional investors have been allowed to turn into investment bankers and lenders in their quest for higher returns. “Of late, we are seeing instances where fund managers seem to be granting time to the issuer by re-scheduling payments. This effort has often failed and the CRA is held accountable for negligence of the fund manager,” says Mr Balakrishnan. We have also seen how fund managers dubiously colluded with corporates to hide the pledge of promoter holding. Mr Balakrishnan hopes that before the regulator steps in to ‘micro-manage’ rating, it should consider barring MFs from investing in structured instruments of unlisted entities. Improving the quality of credit ratings will require RBI and SEBI to get the public credit registry going, mandate better disclosures and ensure compliance. The buck stops with them.
Kamal Garg
3 months ago
It is a horrible mockery of the entire legal system of giving personal guarantees/letter of comforts, etc where the guarantor does not have where-with-all to honour his obligation and the entire banking sector conveniently accepts such doubtful and wrong worded/drafted PG/LoC. Few decades back, there was a system of giving BG against any issue/obligation and then, if the banks goes for enforceability of the BG, immediately the company would go to a court of law and obtains stay on the enforceability of the BG. The whole system was/is rotten and requires complete overhauling. How on earth, an ordinary investor is supposed to know the details and intricacies of such SO based market borrowings (in the form of public deposits/NCD, etc) when even seasoned and responsible bankers fail to carry out their duties sincerely.
3 months ago
SEBI and RBI have enough money to hire and recruit talent, but don't bother to do so, never mind upgrading IT infrastructure for data analysis. So, as long as the culture is old-school, predated on flimsy, incoherent, jumbled data and fining entities, nothing will change I'm afraid.
3 months ago
LoCs are used by some indiscrete bankers to help a client with temporary reprieve without due diligence over the accompanying invoice to the accommodation given under the LoC. As the tenure of LoC comes closer, either the firm would have met its obligation from its revenues or produces another LoC to buffet the old LC. This practice would stop only when the regulations for the issue of LoCs change and a standard format is introduced providing for regulatory rigidity.
3 months ago
A welcome initiative and good to see RBI and SEBI working in tandem on this.
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