Tuesday, June 9, 2015

Lenders Empowered to Take Control over Distressed Firms

The Reserve Bank of India (RBI) yesterday conferred a significant power to banks to acquire control of borrower companies which fail to achieve prescribed milestones as part of their restructuring. Under this arrangement, the Joint Lenders’ Forum (or JLF, formed for the purpose of addressing distressed assets) may “convert the whole or part of the loan and interest outstanding into equity shares of the borrower company, so as to acquire majority shareholding in the company”. In other words, the lenders will collectively acquire legal control of the company as they are able to control the entire board by obtaining majority of equity shares in the company. RBI has also prescribed the mechanism for determining the price of conversion of the loan into equity. Earlier this year, the Securities and Exchange Board of India (SEBI) had also amended its regulations to remove constraints pertaining to issue of shares and also to takeovers so that such conversion of debt could occur smoothly.

RBI’s move empowers lenders of defaulting companies (where restructuring has failed) to exert greater pressure on borrower companies. Moreover, given the potential loss of control over their companies, the promoters will retain “skin in the game” and ensure that they take all measures for borrower companies to comply with loan terms and restructuring conditions. Generally, due to the moral hazard problems promoters could wash away their hands and let lenders hold the losses due to lack of repayment. However, the right now conferred upon lenders may have an impact on the conduct of the promoters as their apathetic attitude could cost them control over their companies.

At the same time, the benefits of this move to the lenders have to be seen in the light of risks and costs associated with it. First, when lenders obtain control over the company, it is natural for them to replace the current board and management with new ones so as to prevent the further downfall in the business and financial circumstances. But, lenders are not in the business of managing companies, and hence there could be questions on how lenders are able to measure up to these new demands.

Second, the idea of obtaining control is to ensure that companies do not experience further downslides and that they can be sold off to new acquirers. The proceeds of such sales could be utilized to discharge loans owed to the lenders. However, the ability of lenders to accomplish such sales depends on a number of imponderables such as liquidity for such businesses, market conditions, and several such matters. As pointed out in these reports (here and here), the sale of businesses, particularly distressed ones, can be a long-drawn process, and lenders must be willing to hold on to the companies and oversee their managements until then.

Third, it is possible that lenders may be foisted with risks and liabilities pertaining to the business, an aspect that is not evidently addressed in either RBI’s or SEBI’s efforts. For example, lenders as shareholders may have to bear losses and risks (or sometimes liabilities) in respect of activities of the borrower companies, thereby adding to the complications involved the process. It is not always likely that such risks can be passed on to a potential buyer of the company from the lenders. In practical terms, an open question relates to whether a buyer would be willing to buy a distressed company from the lenders on an “as-is where-is” basis without representations and warranties. The lenders would not be willing to provide representations and warranties since they have been exercising control only for a limited period of time. In any event, it is inconceivable that lenders would provide business-types representations and warranties to a prospective buyer.

In sum, while RBI’s move confers tremendous powers on lenders to take control over borrower companies in certain circumstances, it is not clear whether it will in fact be exercised given the numerous practical considerations. But, it is likely that the very existence of these powers with lenders may itself act as an incentive to borrowers to ensure compliance with terms and conditions imposed by the lenders.


2 comments:

Ramgovind K said...

Another issue is Director and KMP liability which the Lender nominees on the Board and Management of distressed firms will be subject to, which in turn will act as a further dis-incentive for lender employees from taking up such roles.

vswami said...

OFFHAND (TO SHARE OWN THOUGHTS, to provoke further deliberation from all concerned)
The significance of the concluding observations is not quite clear.
On the first blush, so far as could be readily seen, also as understood and visualized independently, the new proposed measures seem to have the main focus on lenders’ interests; and do not seem to have fully or otherwise taken cognizance of two very important aspects :
1. The borrower - firms–in- distress (and/or the lending banks / institutions) may have to go through, despite/apart from the SEBI’s amended regulations referred to, strictly comply with the other legal formalities, if any, as mandated / required by the company and/or any other applicable laws; and
2. the statutory dues , such as taxes, owed to the government , would, as unequivocally understood, have precedence over the ‘contractual’ obligations such as to lenders.
If so, if not without substance or merits, all concerned would do well to look through these and other relevant angles, to the end of ensuring that the mentioned measures do not fall foul or visited with fallout problems; and do not fail to prove as effective and as safe proof as warranted after ‘restructuring’.
In short, the most intriguing common sense point of doubt is this: Do not the RBI’s measures appear to have not realized that the significant powers to be vested with each lender / bank might lead to further complications and prolongation of the whole process, after all aimed at retrieving self and salvaging from the predicaments / utterly hopeless situation.
Over to law expects cum banking pundits at large!