Alternative modes of financing are imperative for businesses to thrive. In this context, non-convertible debentures (NCDs) have become an accepted route for raising financing by Indian corporates, especially in situations where funding from banks and non-banking finance companies is unavailable. In fact, CRISIL expects that the supply of corporate bonds in the domestic market could double to ₹65 lakh crore-₹70 lakh crore by fiscal 2025.
The Securities and Exchange Board of India (SEBI) regulates the issuance of privately placed NCDs, which are to be listed on a stock exchange, and the Reserve Bank of India (RBI) regulates the investment in NCDs by foreign investors. Investors prefer listed NCDs issued by Indian corporates because these provide them the ability to enforce security under the SARFAESI Act (which tends to be faster than enforcement through the court procedure).
On November 3, 2020, SEBI issued a circular on “Creation of Security in issuance of listed debt securities and ‘due diligence’ by debenture trustee(s)”. The circular, which came into effect from April 1, 2021, provides that an issuer of NCDs (that are proposed to be listed) needs to obtain consents for the creation of security from its existing lenders as a prerequisite to the issue of the said NCDs and, further, that such security is created prior to making the listing application to stock exchanges. By another circular, SEBI has prescribed that the NCDs are required to be listed within four trading days from the issue closure. This effectively necessitates creation of security for the NCDs either prior to, or immediately upon, the issue of the NCDs. While the intent behind the circular is commendable, given that it will protect investor interests, at a practical level this regulatory change has unintended implications.
We set out some of the potential challenges.
Refinancing of debt: In a typical refinancing transaction, new debt is raised to repay an existing debt, and the new debt is often secured by assets that were earlier provided as security for the existing debt. Usually, existing lenders are reluctant to release or share the given security before they are fully repaid. Further, after repayment, the process of security release may take a few weeks, depending on internal functioning and the type of security. As a result, it is common in India for security to be created for the new lender a few weeks or months after the existing debt is repaid. The new requirements make it unviable to raise funds through listed NCDs for several refinancing deals. Consequently, corporates may default on debts that cannot be refinanced or may be forced to borrow unsecured debt at higher interest rates.
Acquisition finance: Financing acquisition of shares of a target using NCDs has also become challenging. Acquisition finance is generally secured by the shares of the target company and, in some cases, also by the assets of the target. Such security cannot be created until the acquirer (i.e., the issuer of NCDs) controls the target. In some cases, the financing may need to be raised in advance to show that funds are committed and as proof of deal certainty. Further, in the case of public M&A deals, which entail a mandatory takeover offer, the earliest that primary shares, or control, may be acquired is 21 days after the detailed public statement.
Further, in cases where the acquirer is a foreign owned and controlled company in India (FOCC), the only route available to raise debt for the acquisition of an Indian company is by issuing NCDs to FPIs, given that leveraging in the Indian market for downstream investment is prohibited. These conflicting scenarios are not conducive to fulfil the circular’s requirements for creating the security as a prerequisite to registering the listing application.
Asset finance: Issuing NCDs to finance a specific asset that is intended to be provided as security for the NCD issue is also challenging in view of the new security timelines. It will usually take some time to make payment and acquire the asset before security can be created on it.
Requirement to obtain consent as a prerequisite: Obtaining consents from existing lenders as a precondition to the issue of NCDs may turn out to be a herculean task in several cases. There is merit in obtaining these consents if the existing lenders are going to continue their tenure and not be refinanced from the NCD proceeds. However, where existing lenders expect to be refinanced in full, they seldom provide any consent for the creation of security upfront, and borrowers are loathe to approach them, given the likely delay in the refinancing process.
As discussed above, the circular could pose challenges for the privately placed NCD market. Infrastructure companies are one of the largest groups of issuers that use the NCD route for their business needs and to refinance existing bank debt. Further, INVITs and REITs have been permitted to raise NCDs with the objective of spurring infrastructure and real estate growth in the country. These investment vehicles will typically issue NCDs to either repay existing debt at the project levels or acquire new projects that are likely to be secured by the project level assets or shares. Such entities will now find it difficult to tap the listed NCD market.
SEBI can draw comfort from the fact that the investors in privately placed NCDs are either institutional investors or high net worth investors who, unlike retail investors, are more sophisticated and experienced in analysing the risks involved. To draw a parallel, the RBI does not mandate banks or financial institutions to ensure the security for the loans extended by them is created as a precondition to funding or immediately after the funding. This is left to the commercial agreement between the lender and the borrower.
To avoid issuers shying away from the listed NCD route, here are a few suggestions:
An automatic penal interest can become payable by the issuer to the NCD holders (which they cannot waive) if the security is not created within an outer timeline (for example, six months after the issue).
If an issuer defaults in creating the security interest within a pre-agreed timeline (other than due to force majeure events), they may be held liable to pay a penalty to SEBI or be debarred from listing NCDs for a prescribed period of time.
Specific risk factors indicating the risk in security creation as a condition subsequent should be set out on the cover page of the offer document.
The mandatory requirement to obtain lender consent and create security before the listing application is made should not apply if the original investment per investor is above a certain threshold. In fact, in case of alternative investment funds, while SEBI has prescribed a model format for a private placement memorandum, it does not have to be followed where the investment per investor in the fund is beyond a certain amount.
To protect retail investors who indirectly invest in NCDs (such as investors in the schemes of mutual funds), mutual funds may be permitted to purchase the secured NCDs only after the security is created.
The time period for listing may be increased beyond four days to provide sufficient time to create security after the NCDs are issued and before listing.
SEBI’s intention to protect the interests of investors is laudable. A balanced approach will ensure investors and issuers are not deprived of the NCD route as a viable means of financing and will stimulate a vibrant debt market.
Views are personal. The authors are partners at J. Sagar Associates.