The forthcoming regime of corporate debt restructuring –CDR may be more lethal, and borrowers may only shudder at the prospects of their account having to be restructured

The RBI’s just-released discussion paper on  Early Recognition of Financial Distress, Prompt Steps for Resolution and Fair Recovery for Lenders: Framework for Revitalising Distressed Assets in the Economy is, right perceived, a frank admission of the mammoth problem that Indian banking industry is currently sitting on – the spectre of lots of actual and potential non-performing assets (NPAs). Actual NPAs may still be manageable, but the potential NPAs may be a huge problem.

The discussion paper was described as a carrot and stick, but on balance, it is more of a stick against the borrower, rather than any carrot. The forthcoming regime of restructuring of corporate debt may be more lethal, and borrowers may only shudder at the prospects of their account having to be restructured.

The following are main proposals of the RBI:

Special Mention Accounts

The Discussion Paper proposes that in addition to non-performing or substandard accounts, banks will identify a new category of Special Mention Accounts, called SMA. SMA itself is further classed into 3 classes – SMA-NF, SMA-1 and SMA-2. While classification into SMA-NF is based on non-financial information such as sales/operating profits dropping by 40% or more, return of three or more cheques over a period of 30 days, and so on, SMA-1 is based on principal/interest overdues of 31-60 days, and SMA-2 based on principal/interest overdues of 61-90 days.

The RBI will set up a Central Repository of Information on Large Credits (CRILC) – an entity to keep track of “large credits”. The RBI’s definition of “large credits” is not really large, as accounts with a fund and non-fund exposure of Rs5 crore, and current accounts with an outstanding balance of Rs1 crore will be covered by the CRILC system. Where an account reaches SMA-2 status, banks and larger NBFCs (systematically important NBFCs) will report the account to CRILC.

Joint Lender’s Forum

The reporting of an account to CRILC by more than one bank/NBFC will also trigger the formation of a Joint Lenders’ Forum, if the total fund-based and non-fund based exposure is of a size of Rs100 crore or above. Banks/NBFC do have the option of forming a JLF even for exposures of less than Rs100 crore. The JLF will work under a JLF agreement, either under the leadership of the consortium leader, or the lender having maximum exposure, and will try to work around ways to ensure that the borrower comes out of the stress.

Corrective action plan

The JLF will frame the corrective action plan (CAP). The CAP may include case-specific solution to the problem – rectification, recovery or restructuring. Rectification is the corrective action taken by the borrower, without either a restructuring or recovery action. If the JLF comes to a view that additional equity investment may have to be brought in to keep the account performing, the JLF may prevail upon the borrower to do so.

The next alternative is restructuring. This seems to be the replica of the existing CDR mechanism, and one of the downsides of the Discussion Paper is that duplicates the CDR mechanism with the JLF mechanism. Restructuring under the JLF works exactly on the same basis as in case of CDR – with an inter-creditor agreement, debtor-creditor agreement, recovery of sacrifice, non-disposal of assets by the promoters, and a stand-still clause whereby the lenders agree not to take any coercive recovery action during a certain period. Presumably, all lenders will anyway be a part of the JLF – hence, subjecting the restructuring to a decision by the CDR Cell seems to be further burdening the already-burdened CDR framework.

Not only has the Discussion Paper retained the overlapping roles of the JLF and the CDR cell, it has mandated an independent evaluation committee, called IEC, to assess the techno-economic viability of CDR proposals involving debts of Rs500 crore and above.

If restructuring fails, recovery follows. The JLF may decide upon the best and most effective recovery action. The recovery action is to be decided by a vote of creditors forming 75% in value, or 60% in number.

The JLF has a time-bound brief.  It has a maximum time frame of 60 days for finalising and signing off on the corrective action plan.

Sting attached to corporate debt restructuring

Corporate debt restructuring may, henceforth, not just be a breather to the company – it may come with coercive covenants such as transfer of promoters’ equity to the lenders, lenders causing issue of shares to themselves to the extent of their sacrifice, and so on. In essence, we may be back to the era of “convertibility clause” where lenders could cause their loans to be converted into equity and thus dilute the stakes of the promoters. The RBI sites the principle of skin-in-the-game to justify the forced sale or dilution of promoters’ equity – how would conversion of a loan or loan sacrifice into equity ensure any skin-in-the-game on the part of the promoter is not coming clear at all. On the contrary, when a loan is converted into equity, the very obligation to repay the loans gets erased.

Hang the auditor

The current regulatory mood of hanging the auditor, when things go wrong with a borrower, seems to prevail upon the RBI in the Discussion paper as well. The discussion paper says that banks must strictly adhere to RBI instructions about filing complaints against auditors where auditors seem to have engaged in falsification of accounts, stock statement or end-use statement etc. However, it does not seem to trust the disciplinary mechanism of the ICAI. It says, even while the disciplinary proceedings before ICAI are pending, the names of the CA firms against whom many complaints have been received from different banks may be flagged for information of all banks. Banks should consider this aspect before assigning any work to them. The names may also be shared with other regulators/MCA/CAG for information. In essence, the auditor is penalised by the banking system merely based on complaint, and not based on actual establishment of a case of breach of discipline by the auditor.

Strengthening the ARCs and the DRTs

The two of the legal institutions currently available to banks for coercive recovery action are – sale of NPAs to asset reconstruction companies (ARCs), or recovery action through debt recovery tribunals (DRTs). The discussion paper proposes several reforms of the current regulatory framework applicable to ARCs as well as DRTs.