Debenture holders must approve any move by a company to enter into a merger or acquisition () — this new mandate has been markets regulator Sebi’s response to some non-banking financial companies (NBFCs) in distress staging assorted mergers to get out of their mess, possibly harming the welfare of debenture holders. This is completely wrong. It mixes up the risk-reward payoff for providers of risk capital, that is, equity, with that of the providers of debt capital. The right solution is for Sebi to improve the conditions under which an NBFC can issue debentures and insist on better transparency as to its current and prospective financial health while issuing bonds, while also improving the market for corporate control in India.
Sebi’s Master Circular of 18 November 2021 introduced the new requirement among the list of documents to be submitted to the National Company Law Tribunal by a listed entity intending to carry out an arrangement (a merger or acquisition, in the jargon): No Objection Certificate (NOC) from the lending banks/financial institutions/debenture trustees. This was followed up with a further clarifying circular on 1 February 2022. It says that NOC must be from not less than 75% of the secured creditors in value. It goes on to say that “this Circular shall be applicable for all the schemes filed with the stock exchanges after Nov 16, 2021″.
There is a reason why there are different types of capital in the total amount of funds used by the company to create new value. Equity capital carries with it the highest level of risk, should the company malperform, but also has the reward of ownership and claim to the value created by the company after meeting its costs such as interest on borrowed capital, tax, depreciation and amortization, that is, gross profits net of these costs. If the company generates intellectual property and powerful brands, their value is embedded in the company’s overall valuation and that accrues to equity holders. This is reflected in the share price and the shareholder’s ability to pledge those shares and raise money against them. There is no cap on the reward that could accrue to equity holders by way of surplus after meeting all costs from the value generated by the company. However, if the company goes under, the capital will be wiped out and the shareholders would be the biggest losers, with no claim on the value realized from resolving the assets of the bankrupt company until all creditors, statutory bodies to which the company owes money and workers are paid off.
Debt capital offers a different mix of risk and reward. Debt holders have the first claim on the value the company generates. Debt servicing costs are treated as an expense, which takes away from the surplus that can be counted as profits. However, this return is capped at the rate specified while debt is raised. If the company goes under, debtholders have the first claim on the proceeds of sale or liquidation of the failed company. Debt holders have no claims on the intangible value created by the company, except when the company fails and all its properties are put up for sale, at which time, they have the first claim. Secured creditors have higher rights as compared to unsecured creditors.
Merger, sale, amalgamation or winding up of a company is an act of ownership. The owner has the responsibility to use the proceeds to pay off the owner’s outstanding dues. But the company’s obligation to debtholders continues to rest on the company and it is the statutory obligation of the company’s post-merger/acquisition shareholders and the management they entrust to run the company to meet that obligation. It makes no sense to give debtholders rights similar to an owner’s in the matter of mergers and acquisitions. This strikes against the basic distinction between equity capital and debt capital and the different mixes of risk and reward associated with each type of capital.
But what about protecting the interests of debtholders? This is to be achieved by making clear the financial implications of taking on additional debt at the time of raising fresh debt. Debt-issuing companies are rated as to their creditworthiness by professional rating agencies. This rating process has to become more thorough and transparent. Those who invest in company debentures need to have clarity on the state of the company’s finances, its business plans and so, the likelihood of the fresh capital raised as debt being serviced.
Sebi’s job is to clean up this process of creating visibility, for the sake of investors, as to a company’s finances, business plans, execution capability and management credibility. That calls for better regulation of companies and the rating agencies, including better ways to prevent companies from going around shopping for ratings.
A functional market for corporate control is key to ensuring optimal use of capital, and terminating suboptimal corporate by takeover, so that the company is now run by a different set of managers, who have invested to realise their ambition of getting more value out of the same company. By making mergers and acquisitions ever more difficult, Sebi is weakening rather than improving the market for corporate control in India. That will eventually harm providers of debt capital as well.