Analyzing the proposed mandate of SEBI for Large Corporates

[Kartikey Kanojiya]

Kartikey is a 5th year student of Institute of Law, Nirma University

Introduction

Securities and Exchange Board of India (SEBI) by virtue of the consultation paper released on 20^th of July proposed an idea whereby they will be making it mandatory for the Large Corporates to raise 1/4^th (25%) of their finance through bond markets only. This idea was first proposed by Mr. Arun Jaitley, finance minister of India, during the budget session speech of 2018-2019. He said “SEBI will consider mandating, beginning with Large Corporates to raise 1/4^th of the financial need through debt market only.”[1]Subsequently, SEBI took up this issue and finally released a consultation paper. In this article the author analyzes the feasibility of the proposed mandate of raising 25% of finance through bond market only.

Applicability

By virtue of this paper, the mandate will be applicable only to Large Corporates, which have been defined as:

Any entity whose outstanding borrowing is more than 100 Crores;
Has a credit rating of AA and above;
An entity which intends to finance itself with long-term borrowings (Long term is defined here as any period above 1 year) and;
Has listed its securities on any of the stock exchange.

The mandate will be applicable from April 1, 2019 on all the Large Corporates who as on 31^st March of any financial year fulfills all four conditions mentioned above. Thus, if any entity as on March 31 of a financial year is identified as Large Corporate then from the next financial year i.e. from April 1, the mandate will be applicable. However, Scheduled Commercial banks as mentioned in Schedule 2 of the Reserve Bank of India Act, 1934 are exempted from this mandate.[2]

Compliance Mechanism

Under the compliance mechanism it says that the large corporate shall inform the stock exchange about the same. It also creates two blocks of compliances. The First block constitutes first two years of implementation and the second block constitutes the third and fourth year of implementation.

Under First block i.e. first and second year of implementation, there is a process of comply and explain whereby, the Large Corporates will try to fulfill the requirements but if they fail to do so they have to explain the reasons for the failure in writing to the authority. Under second block i.e. third and fourth year of implementation it is mandatory for the Large Corporates to meet the mandate and if they fail to do so a penalty of 0.2% to 0.3% of the shortfall will be levied on them. [3]

Analysis

Trend of Bank v. Bond financing in India.

If we look at the prevailing finance market in India, then there is a shift in the borrowing practices followed by the corporates. The data from financial year 2012-13 to 2016-17 i.e. data of 5 financial years shows that the trend line of bond financing is going upwards while the same of bank financing is sloping downwards. In future the trend of Bond Financing will increase because of the enactment of Insolvency and Bankruptcy Code, 2016. If we look at the preference which is given to the bond holders, then they are placed above the government and thus making it easy for the bond holders to recover during the liquidation period even before tax recovery.[4]

General benefits of Bond Financing

Better Borrowing terms:

When a company goes for loan financing the rate of interest is already fixed but in the Bond financing the company can fix the interest keeping in mind the market conditions prevailing during the time and the predicted future of the company. This flexibility gives company an edge to go for Bond Financing.[5]

Covenants and Restrictions:

When a company goes for loan financing there may be a time where the lender puts some restriction such as that borrower cannot make any material change in the company without the affirmative vote of the creditor and thus making it difficult for the company to enter into any arrangement. In bond financing the only liability the bond issuer has is to repay the principle amount at the time of maturity and to pay interest as per the agreed terms. The bond holders do not get any control in the company as compared to the loan lender.[6]

Non Dilution in the shareholding of the present shareholders:

As and when new shares are issued to raise finance the shareholding of the present shareholder depletes because of the infusion of the shareholders. For example, I had 25% share in the company and thus, a material stake in the governance matters of the company but due to issuance of new shares and new shareholders entering the company my shareholding is reduced to 20% thus, making my clout in the governance of the company less. This is not the case with bond financing.

Preference during the liquidation:

After the enactment of Insolvency and Bankruptcy Code, 2016 the preference is given to the bondholders, and they are placed above the government and thus making it easy for the bond holders to recover during the liquidation period. This is a positive step to attract the the investors.[7]

Disadvantages of Bond Financing

Long and Complicated process:

To issue bonds in the market SEBI (Issue and Listing of debt securities regulations), 2008 (“regulations”) are to be followed which makes it a complex process. As per the regulations, merchant bankers are to be appointed which also makes it financially difficult as compared to loan financing.

Early Repayment:

In bond financing the main issues is of repayment. Even if a company has money after some time they cannot pay the debt and settle it. In Bond financing there is no mechanism of early repayment of the claim and final setoff is done between the company and the bond holder. On the other side, in loan financing the money can be paid back soon after taking loan and there is no bar for doing the same except for a penalty which is levied upon the borrower.

Bonds are Worthless because of increase in the interest rate:

There exists an inverse relationship between interest rate of interest provided on bond and the price of the bond. Whenever the interest rate on the bond increases, price of the bond decreases and as a result the seller sustains loss.[8]

For instance If Mr. A purchased 10 bonds of Company A at 100 Rs/bond (face value) having interest of 5% per annum and the maturity date of the bond is after 10 years. Now Mr. A wants to sell the bonds after two years but within two years the rate of interest on the bond has increased to 10%, no one will buy Mr. A’s bonds because that buyer will be getting interest of 5% only as compared to 10% and thus Mr. A will have to sell the bonds at less price than the face value to make good for the buyer.

Recommendations

Better Liquidation laws:

If better preference is given to the investors during liquidation process the bond market will automatically increase and enactment of Insolvency and Bankruptcy code is one such positive step. The reason being, it’s easy for the bond holder to recover the money during liquidation.

Regulatory system

SEBI was given role of a regulator for the primary and secondary bond market. Thereafter, in 2007 SEBI came out with the guidelines for the issuance of bonds which made some reductions in the compliance which is to be followed by the companies issuing bond and some of them are as follows:

The company issuing bond now has to get the credit rating from just one credit rating agency as compared to two which was the case earlier.[9]
For the bond issuer to have more flexibility they now have the option of putting call option and put option etc. to make the issue flexible.[10]

3. A better credit rating system

The credit of the company depends on the credit rating given by the credit rating agencies and in India there are 6-7 registered credit rating agencies. The difficulty is at time when there are high fluctuations taking place in the market because high fluctuation makes it difficult for the credit rating agencies to rate the same because of unpredictability in the market.[11] In India the trend can be seen that agencies are rating it properly and this is also evident from the fact that all the AAA or AA credited companies have not defaulted while the lower once like BB or below have defaulted. This shows that the predictions are true but when it comes to high inflations in the market it’s a different situation. [12]

Governmental policies and demand

With the passing of Master Circular – Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) issued on July 01, 2011, the regulators made it mandatory for the banks to have 24% of their liabilities in gold, or governmental securities, which leave the non-governmental market out of scope and thus, there is a small consumer base available to the non-governmental issue as compared to governmental securities.[13]

Conclusion

It’s evident from the paper of SEBI that the regulator is trying to relive the stress from Banking sectors because of increasing defaults and the scams happening has put the banking sector into high pressure but making it mandatory for the Large Corporates to borrow finance from the bond market is not something very sound for the companies. It may be a positive step for the bond market but for companies they have to go through the length process of issuing bonds.

[1] SEBI Consultation paper 20^th July, 2018, Consultation Paper Designing a Framework for Enhanced Market Borrowings by large Corporates. https://www.sebi.gov.in/reports/reports/jul-2018/consultation-paper-for-designing-a-framework-for-enhanced-market-borrowings-by-large-corporates_39641.html.

[2] SEBI Consultation paper 20^th July, 2018, Consultation Paper Designing a Framework for Enhanced Market Borrowings by large Corporates, Clause 4.1, https://www.sebi.gov.in/reports/reports/jul-2018/consultation-paper-for-designing-a-framework-for-enhanced-market-borrowings-by-large-corporates_39641.html.

[3] SEBI Consultation paper 20^th July, 2018, Consultation Paper Designing a Framework for Enhanced Market Borrowings by large Corporates, Clause 4.4 (c), https://www.sebi.gov.in/reports/reports/jul-2018/consultation-paper-for-designing-a-framework-for-enhanced-market-borrowings-by-large-corporates_39641.html.

[4] https://www.chambersandpartners.com/article/903/the-insolvency-and-bankruptcy-code-2016—key-highlights. (last accessed on 10 September, 2018).

[5] The Motley Fools LLC [US], https://www.fool.com/knowledge-center/long-term-loans-vs-bonds.aspx.

[6] ibid

[7] Gayatri Athare Mohapatra, Summarizing the Insolvency and bankruptcy Code, 2016, http://www.indialaw.in/blog/blog/commercialcorporate/summarising-insolvency-bankruptcy-code-2016/.

[8] Mike Patton, Why Rising Interest Rates Are Bad For Bonds And What You Can Do About It

https://www.forbes.com/sites/mikepatton/2013/08/30/why-rising-interest-rates-are-bad-for-bonds-and-what-you-can-do-about-it/.

[9]SEBI (Disclosure and Investor Protection) Guidelines, 2000, https://www.sebi.gov.in/sebi_data/attachdocs/1290148750028.pdf

[10] ibid

[11] European Central Bank, Working papers No. 1208, March 2009, https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1028.pdf?2ea2476aec952dbf33b6a070fe38683c.

[12] Indian Institute of Management Bangalore, CORPORATE BOND MARKETS IN INDIA: A STUDY AND POLICY RECOMMENDATIONS. https://iimb.ac.in/research/sites/default/files/WP%20No.%20450.pdf.

[13] Munish personal RePEc Archive, Corporate Debt Market in India: Issues and Challenges, Rajeswari Sengupta and Vaibhav Anand, https://mpra.ub.uni-muenchen.de/53945/1/MPRA_paper_53945.pdf.