SEBI’s restriction on wilful defaulters – Assessing its impact on M&A transactions & fund-raising
Madhur Kohli, Associate Partner (Khaitan & Co)
Arjun Bhagi, Associate
Not very long ago the nation had awakened to the humongous write-off of bad loans by Indian banks. The banks are looking for ways and means to tackle the bad debt in the markets, and one of the many methods being applied is the declaration of defaulting promoters and entities as ‘wilful defaulters’. RBI already has guidelines in place to ensure that further bank finance is not available to a unit that is categorized as a ‘wilful defaulter’. Surprisingly, while such borrowers were prevented from accessing the financial markets, there was a weak law in existence to prevent such borrowers from raising funds from the capital markets. SEBI has recently made an attempt to plug this loophole. By way of amendments brought to five regulations [SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009; SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011; SEBI (Issue and Listing of Debt Securities) Regulations, 2008; SEBI (Issue and Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013; and SEBI (Intermediaries) Regulations, 2008], SEBI has imposed restrictions on ‘wilful defaulters’ from accessing the capital markets. These changes have come into effect from 25 May 2016, and will govern any public raising activity or takeover taking place after this date.
The amendments draw the definition of ‘wilful default’ from RBI. A ‘wilful default’ would be deemed to have occurred, as per the RBI Master Circular on Wilful Defaulters, if any of the following events is noted in relation to a unit (individuals, juristic persons and all other forms of business enterprises):- (i) the unit has defaulted in meeting its payment/ repayment obligations to the lender even when it has the capacity to honour the said obligations; (ii) the unit has defaulted in meeting its payment/ repayment obligations to the lender and has not utilised the finance from the lender for the specific purposes for which finance was availed of but has diverted the funds for other purposes; (iii) the unit has defaulted in meeting its payment/ repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilised for the specific purpose for which finance was availed of, nor are the funds available with the unit in the form of other assets; or (iv) the unit has defaulted in meeting its payment/ repayment obligations to the lender and has also disposed off or removed the movable fixed assets or immovable property given by him or it for the purpose of securing a term loan without the knowledge of the bank/ lender.
Prior to these amendments, the restriction on accessing securities markets was imposed on only such ‘wilful defaulters’ who were issuing convertible debt instruments. SEBI has expanded the scope of this restriction, and now a person declared as a ‘wilful defaulter’ is restricted from raising funds by public issue of equity, debt and preference shares. While a company will be restricted from accessing securities market if it is categorized as a ‘wilful defaulter’, such restriction is also extended to a company whose promoter or director is declared as a ‘wilful defaulter’.
SEBI has left a small window for a listed company, (which itself is or whose promoter(s)/ director(s) has been declared as ‘wilful defaulter’), to raise money by way of rights issue or private placement to qualified institutional buyers. The regulator has nevertheless imposed rigorous disclosures requirements on such defaulting companies in order to safeguard the interests of existing shareholders.
On the public M&A circuit, the SEBI amendments now prohibit a ‘wilful defaulter’ from making an open offer. A ‘wilful defaulter’ is further restrained from entering into any transaction that would attract the obligation to make a public announcement of an open offer. The only exception carved out is in instances where the company makes counter offers to combat a hostile takeover.
SEBI will also now consider absence of categorization as a ‘wilful defaulter’ as a criteria for grant of certification to prospective intermediaries.
These amendments are a welcome move by SEBI. Furthermore, keeping rights issue out of the purview of prohibition will certainly help companies in tiding through troubled times with financial assistance from existing shareholders. Importantly, the SEBI amendments have ushered in the backdrop of a significant change made by RBI to the Master Circular on Wilful Defaulters. Gujarat High Court in the Ionic Metalliks case held the Master Circular on Wilful Defaulters to be ultra vires and violative of Article 19 of Constitution of India in so far as made applicable to all directors of company. All directors cannot be held liable for the default in repayment of the loan which might be for reasons beyond the control of such directors. This provision in the circular shatters the concept of a company being a separate legal identity distinct from its directors. The circular paints all directors with the same brush. An element of arbitrariness is found in such policy decision. To this limited extent the court held that the Master Circular is violative of Article 19(1)(g) of the Constitution of India.
RBI immediately responded with modification of the master circular in January 2015, and created a special carve out for non-whole time directors (nominee/independent directors) to exclude them from the ambit from ‘wilful defaulter’. The modified master circular states that a non-whole time director will be considered ‘wilful defaulter’ in only such “rare cases” when it is conclusively established that he was actively aware of the fact of ‘wilful default’ of the borrowing company or that he had consented to/connived in the willful default. Non-whole time directors, who hold majority seats on the boards of listed/ to be listed companies, owe their comfort to RBI in these times when SEBI has firmly decided to clamp down on ‘wilful defaulters’.
However, the amendments come with their own set of teething issues. The amendments have the potential to affect public M&As. Transactions across all stages will have to be unwound, if the acquirer is a declared ‘wilful defaulter’. Sellers will have to do additional diligence on the buyer to ascertain if they are categorized, or are susceptible to be categorized a ‘wilful defaulter’ in the near future. Ongoing transactions will be re-assessed in light of the new prohibitions on ‘wilful defaulters’, and this may take off some steam from the public M&A market.
It is also to note that the diligence scope for lawyers and bankers will further expand. Furthermore, it is still unclear when a borrower, who has repaid his debts, will be officially removed from the category of ‘wilful defaulter’. This determination is crucial for the concerned company to access the capital markets. Systemic delays and inconsistencies will be a major cause of worry for the market players. SEBI does not have a mechanism to monitor ‘wilful defaulters’, and will have to continue reliance on the data maintained by banks and financial institutions.
RBI requires banks and financial institutions to submit the list of accounts of wilful defaulters of Rs. 25 lakh and above on a monthly basis or more frequent basis to all the four credit information companies. Credit information companies like CIBIL are then expected to make this information available to other banks and financial institutions. The catch, however, is that information made available pertains to only such wilful defaulters who have defaulted on amounts of Rs 25 lakh and above. The SEBI amendments, on the other hand, intend to restrict all wilful defaulters from accessing capital markets, irrespective of the underlying default amounts. This appears to be a lacunae in the present system.
It is amply clear that the working relationship and free flow of information amongst SEBI, RBI and banks will eventually determine the success of the SEBI amendments. Nevertheless, SEBI’s recent move will certainly play its part in ring fencing and damage control in these troubled times of mounting bad debt.