[S Sivakumar is a fifth-year student at Tamil Nadu National Law University, Tiruchirappalli.]
The Securities and Exchange Board of India (SEBI) on 26 November 2018 introduced a framework for implementing the budget announcement of 2018-19 which mandated one fourth of the financial needs of large entities to be mandatorily met from the debt market. The primary objective behind this framework was to address the excessive reliance of corporates on banks for corporate funding and to uplift the corporate bond market in India. The framework inter alia provides for detailed guidelines as to its applicability, disclosure requirements of large corporates, responsibilities of stock exchanges, details of progression of operationalizing the framework over a period of three years, penalty for violations and format for disclosures. The research focusses on analyzing the present framework on the mandatory issue of debt securities by large corporates and highlighting core issues which remain unanswered even today.
Statement of Problem
Identifying the source of finance, undertaking a financing decision or deciding the capital structure of a company are all within the discretion and prudence of the management of the company. SEBI through its framework has given a very short progression period for diversion from other sources of finance to compulsory issue of debt securities for 25% of the incremental borrowings; the failure to comply with the aforesaid mandate would lead to imposition of penalties. There are a number of problems in the framework which includes the mandatory conversion of source of finance, provision of penalty and other issues concerning inclusion of unsupported borrowings and exclusion of external commercial borrowings from the framework and other incidental matters.
SEBI Framework on Mandatory Issue of Debt Securities
The framework for mandatory issue of debt securities by large corporates came into effect from 1 April 2019 for the entities following financial year and 1 January 2020 for entities following the calendar year. This framework applies to all listed entities which have any of the specified securities, debt securities or non-convertible redeemable preference shares listed in a recognised stock exchange in line with the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 and have an outstanding long-term borrowing of INR 100 crores or more with a maturity period of more than a year and a credit rating of AA and above in case of unsupported bank borrowing or vanilla bonds of an entity which have no structuring support. This framework also particularly excluded the applicability to scheduled commercial banks.
All entities which fulfil the aforesaid criteria are categorised as ‘large corporates’ and they have been mandated under this framework to not raise less than 25% of the total incremental borrowing by virtue of issue of debt securities during the financial year subsequent to which they were identified as ‘larger corporates’. ‘Incremental borrowing’ refers to those borrowings whose maturity is more than a year, irrespective of whether use of such borrowings is for repayment, refinancing or otherwise, but it does not include external commercial borrowing and inter corporate loans between the parent and subsidiary companies.
The initial requirement of compliance of these requirements is on an annual basis. In the event of shortfall or inability to perform the aforesaid compliances, the entity shall provide an explanation to the stock exchanges on why it was unable to meet such shortfall for the first two years. From the financial year 2020 i.e., third year, the mandatory requirement of incremental borrowing from debt securities by large corporates have to be met over a continual block of two years unlike the initial years. However, in the event of shortfall at the end of the block of two years, the company that has such shortfall shall pay a monetary fine of 0.2% of the shortfall to the stock exchange.
Key Issues and Challenges in the Present Framework
The first and foremost issue concerning this framework is the scheme of mandatory conversion from other sources of financing to that of issue of debt securities. The framework initially begins with the approach of ‘comply or explain’, meaning either comply with the requirements stated in the framework or provide an explanation for such non-compliance. However, after two years, i.e., from financial year 2020, the framework provides for the levy of monetary fine in the event of non-compliance or shortfall which makes it mandatory for the ‘large corporates’ to adhere to the requirements instead of a voluntary scheme which is desirable.
Importantly, the decision concerning the financing option for the company is a management decision taken by financial managers with prudence, commercial reasons and principled approach with the approval of the board of directors. SEBI has said that it has issued this circular in furtherance of its powers and mandate under Section 11(1) of the SEBI Act 1992. However, despite the vast and broad powers for regulation of securities market vested with SEBI, it is still a regulatory over-reach to dictate the choice of finance that a company should opt for and the proportion of such finance in the total capital structure of such company.
The framework provides that the debt instruments of the entities shall have a credit rating of AA and above primarily to ensure serviceability of debt instrument which leads to increased demand and investor protection. However, it does not guarantee investors of complete protection as we have witnessed in the infamous collapse and default of IL&FS and Essel Bonds where many mutual funds and financial institutions had huge exposures. The shift of corporate funding from banks and financial institution to the corporate bond market would perhaps relieve stress from banks, reduce non-performing assets and focus on priority sector lending, partly also because of the fact that even unsupported borrowings which are not secured through collateral assets are also being considered for eligibility under this framework. Therefore, the risk is not mitigated but just transferred from one bearer to the other.
The objective behind excluding external commercial borrowing from the ambit of this framework in terms of the requirement of INR 100 crores outstanding borrowings was to differentiate a debt borrowed from other sources of finance that affect the transition from corporate funding via banks to debt securities and borrowings from outside the country from other sources that do not have a direct impact on the objective behind the framework. However, inclusion of such funds under this framework would have resulted in greater number of entities moving towards the corporate bond market in India instead of the scope for deliberate shift to external sources to circumvent the framework.
Lastly, large corporates may volunteer to bear the mild monetary fine of 0.2% of the shortfall if the cost of raising such finance through issue of debt securities is greater than that of the monetary fine. This is primarily because the issue of debt securities will encapsulate increased cost as to regulatory compliances, issue management and other procedures and formalities as compared to loan financing which is relatively cheaper. This is despite the fact that SEBI has waived the requirement of security deposit in case of issue of debt instruments to make it more attractive and less cumbersome.
Suggestions and Recommendations
The statistics pertaining to bond financing and bank financing provides us with the insight that there has been a considerable shift towards bond market as a share of total corporate credit. The corporate bond market gained from 37% in 2012-13 to 51% in 2016-17 even before the present framework was introduced. Hence, we need to re-evaluate whether we need a mandatory framework for borrowings by large corporates or a guideline which is soft in nature to provide enough leeway for voluntary transition.
To prevent loopholes, the other possible approach should have been to envisage a threshold above which there needs to be use of corporate bond market for fulfilling financing needs instead of the proportion alone being specified. This will allow us to address a situation where entities are evasive when the cost of financing such debt is higher than the monetary fine. Also, the applicability provides for the existence of long-term borrowings which have a maturity period of more than a year. We should consider increasing the maturity period as the bond market in general is for long-term fund requirements and 'more than a year' could relatively be a very small period for corporates to move to this framework. The operationalizing of the Insolvency and Bankruptcy Code 2016 also has helped in a way in addressing the apprehensions of default risk by placing them above government dues in the waterfall arrangement in order of priority paving the way for further deepening of corporate bond market.
Conclusion
SEBI has brought this framework prescribing mandatory issue of debt securities by large corporate with the right intention and effort. The primary objective is to recalibrate the focus from banks to debt securities for corporate funding to relieve the stress from the banks for the development of the corporate debt market in India. However, the framework can be described as a double-edged sword with a few hits and misses. While this framework may lead to some transformation of the bond market, the companies do not get to gain as much as the market does itself. The review of the framework with the reconsideration and incorporation of the suggestions provided for the key issues and challenges would give a renewed outlook for the development of bond market. Nevertheless, in the broader context of reforming the corporate debt market, this is a beginning in the right direction.