Saturday, July 11, 2015

Subordinated debentures – A Capital Supporting Instrument

[The following guest post is contributed by Vinita Nair of Vinod Kothari & Co. The author may be contacted at]

Non Banking Financial Companies (NBFCs) in India are always seeking sources of raising funds. Capital is costly and therefore NBFCs rely more on public funds. Public funds as defined under the Systemically Important Non-Banking Financial (Non-Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2015 (the “2015 Directions”) include funds raised directly or indirectly through public deposits, commercial papers, debentures, inter-corporate deposits and bank finance but excludes funds raised by issue of instruments compulsorily convertible into equity shares within a period not exceeding 5 years from the date of issue.

Debentures can be classified into various types based on several parameters viz. transferability, convertibility, tenure, public participation, security, seniority, coupon and rate of return. On the basis of seniority, debentures can be classified as Senior debt and Subordinated debt. Subordinated debt is even included for meeting regulatory capital requirements.

This post discusses the statutory provisions for subordinated debt, features, rights of subordinated debt holders as reflected in the information memorandum of NBFCs/ Banks issuing and listing the same and international practice.

Statutory provisions for issuance of Subordinated debt by NBFCs and Banks in India

Subordinated debentures, as evident from the expression, are subordinated to other debt of the Company. Subordinated debt has been defined under the 2015 Directors means

“an instrument, which is fully paid up, is unsecured and is subordinated to the claims of other creditors and is free from restrictive clauses and is not redeemable at the instance of the holder or without the consent of the supervisory authority of the non-banking financial company. The book value of such instrument shall be subjected to discounting as provided hereunder:
Remaining Maturity of the instruments                                               Rate of discount

(a) Upto one year                                                                                100 per cent
(b) More than one year but upto two years                                         80 per cent
(c) More than two years but upto three years                                     60 per cent
(d) More than three years but upto four years                                    40 per cent
(e) More than four years but upto five years                                      20 per cent

to the extent such discounted value does not exceed fifty per cent of Tier I capital.”

Companies are not permitted to issue unsecured debentures under provisions of Companies Act, 2013 except to exempted categories under Companies (Acceptance of Deposits) Rules, 2014. NBFCs were, however, permitted even under Non-Banking Financial (Non Deposit Accepting or Holding) Companies Prudential Norms (Reserve Bank) Directions, 2007 to issue subordinated debt. Pursuant to issuance of Guidelines on Private Placement of non-convertible debentures (“NCDs”) (maturity more than 1 year) by NBFCs by Reserve Bank of India (“RBI”) on 20 February 2015, NBFCs have been permitted to issue unsecured debentures subject to minimum subscription of Rs. 1 crore per investor. Thus, in addition to subordinated debt, NBFCs can raise funds by issue of unsecured NCDs subject to compliance of the prescribed guidelines.

Indian banks, until September 2009 were permitted to raise lower Tier II subordinated bonds without special features such as Call and Step up options. On a review of international practices in this regard, it was decided by RBI to permit banks to issue subordinated debt as Tier II capital with call and step-up options subject to conditions specified in the Notification No. RBI/2009-10/147 DBOD.No.BP.BC. 38 /21.01.002/2009-10 dated September 7, 2009. The bonds should have a minimum maturity of 5 years. However if the bonds are issued in the last quarter of the financial year, i.e. from 1st January to 31st March, they should have a minimum tenure of sixty-three months.

Features of subordinated debt

In the order of ranking of priority of claims, in case of a company being wound up, the claim of subordinated debt is settled before that of preference and equity shares. In case of NBFCs, subordinated debt is included as Tier II capital along with preference shares, perpetual debt instruments, hybrid debt instruments etc.

Subordinated debt provides a support to capital and can be utilized by companies for paying senior debt. In case of default by issuer company in paying coupons of subordinated debt, the debt holders can make the bonds due and payable. Clauses pertaining to claiming of liquidated damages or initiating action for attachment of assets or cashflows as available after taking care of interest of senior lenders and creditors can also be included. However, understanding the purpose of subordinated debt, providing right to sub debt holders to proceed against the company by filing petition for liquidation may not seem appropriate. We have perused the information memorandum filed by NBFCs/ Banks with stock exchanges for details regarding rights of subordinated debt holders, events of default and remedies in case of event of default and generalized the observations as set out below.

Events of Default


Failure on the part of a bank to forthwith satisfy all or any part of payments in relation to the bonds when it becomes due (i.e. making payment of any installment of interest or repayment of principal amount of the Bonds on the respective due dates) (except in case of regulatory requirements prescribed under Applicable RBI Regulations), shall constitute an Event of Default for the purpose of the Issue.


(a) The issuer does not pay, on the due date, any amount payable pursuant to any of the Transaction Documents;

(b) If the issuer voluntarily or compulsorily goes into liquidation or ever has a receiver appointed in respect of its assets or refers itself to the Board for Industrial and Financial Reconstruction or under any other law providing protection as a relief undertaking;

(c) If the issuer commences a voluntary proceeding under any applicable bankruptcy, insolvency, winding up or other similar law now or hereafter in effect, or admits inability to pay its respective debts as they fall due, or consents to the entry of an order for relief in an involuntary proceeding under any such law, or consents to the appointment of or the taking of possession by a receiver, liquidator, assignee (or similar official) for any or a substantial part of its respective property;

(d) If a petition is filed for the winding up of the issuer and the same is admitted, and such petition is not dismissed or stayed within a period of 30 (thirty) days of such petition being admitted;

 (e) Breach of any representations and/or warranties or covenants contained in this Deed or any other Transaction Document, which is detrimental to the interest of the Debenture Holders in the discretion of the Debenture Trustee (acting on the instructions of the Majority Debenture Holders) or any such representations and/or warranties are found to be untrue, misleading or incorrect, when made or deemed to be made;

(f) Any material adverse event, as defined in the Transaction Documents.

As evident from above, any representation or warranty, general covenants should be carefully worded to avoid any undue or unreasonable trigger of any default clause. Representations and warranties should not be such that unduly interferes with the management of the issuer company – e.g. issuer company defaults on any agreement or in violation of its articles of association. Such violation should not result in triggering acceleration and repayment of the subordinated debt.

Remedies in case of event of default


The Bondholders shall have no rights to accelerate the repayment of future scheduled payments (coupon or principal) except in bankruptcy and liquidation. This is mandated in Para 1.7 of Annex 5 of Master Circular – Basel III Capital Regulations. Further, Annex 16 of the said Master Circular contains criteria for loss absorption through conversion / writeoff of all non-common equity regulatory capital instruments at the point of non-viability.

The terms and conditions of all non-common equity Tier 1 and Tier 2 capital instruments issued by banks in India must have a provision that requires such instruments, at the option of RBI, to either be written off or converted into common equity upon the occurrence of the trigger event, called the ‘Point of Non-Viability (PONV) Trigger’ stipulated below: The PONV Trigger event is the earlier of:

a. a decision that a conversion or write-off, without which the firm would become non-viable, is necessary, as determined RBI; and

b. the decision to make a public sector injection of capital, or equivalent support, without which the firm would have become non-viable, as determined by the relevant authority. Such a decision would invariably imply that the write-off or issuance of any new shares as a result of conversion or consequent upon the trigger event must occur prior to any public sector injection of capital so that the capital provided by the public sector is not diluted.


Upon the occurrence of any of the Events of Default, the Trustees shall on instructions from majority Debenture holder(s), declare the amounts outstanding to be due and payable forthwith. Debenture holders will have the right to accelerate the repayment/ redemption of debentures along with all outstanding dues including interest and demand immediate repayment of the principal. Further, the Debenture Trustee shall have other recourse as provided for in the transaction documents.

International Practice

Office of the Comptroller of the Currency, US department of treasury issued guidelines for subordinated debt on April 3, 2015. The guidelines require banks to comply with applicable OCC rules and federal and state securities law. In Canada, Office of Superintendent’s (OSFI) guidelines pertaining to Subordinated Debt are observed.

With respect to remedies in case of event of default, as observed from one the disclosure document from CIMB Bank, in case of event of default being triggered, the Trustee may institute such proceedings as it chooses to enforce the obligations of the Issuer under the Trust Deed and/or institute proceedings for the winding up of the Issuer, provided that the Trustee shall have no right to accelerate payment of the indebtedness in the case of a default in the performance of any covenant of the Issuer under the Trust Deed. However, in case of other countries the remedies include making the note due and payable forthwith and that too only in the event of a receivership, insolvency, liquidation or similar proceeding of Bank.

Non Viable Contingent Capital ( NVCC)

These subordinated debt get converted into common equity upon a trigger event.  The multiplier is used for determining the number of shares to be issued. Royal Bank of Canada has already made issuances of NVCC. For OSFI, the federal financial institution regulator, two circumstances can bring about a trigger event:

a) when it announces that the financial institution “has ceased or is about to cease being viable”, and that conversion of the conversion of the contingent instrument “will restore or maintain viability,” and;

b) the financial institution “has or will” accept a capital injection from the government, “without which the firm would cease to be viable.”

Further, as per FIIG research paper, any new subordinated debt issuances in Australia made post January, 2013 have clauses viz. Non-viability clause, contingent capital conversion clause, step up clause and expectation to call.


Subordinated debt is surely a capital-supporting instrument. NBFCs making issuances of the same should be careful in framing the covenants and remedies in case of events of default and should take into consideration best practice followed internationally.

According to RBI estimates, public and private sector banks will together need additional capital of Rs 5 lakh crore to comply with Basel III regulations. Of this, the equity capital requirement will be Rs 1.75 trillion and the non-equity portion will be Rs 3.25 trillion. Banks will also gradually increase issuance of subordinated debt.

- Vinita Nair

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