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The RBI Scheme for Sustainable Structuring of Stressed Assets (S4A)

THE BMR VIEW

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INTRODUCTION

The Reserve Bank of India guidelines on the Scheme for Sustainable Structuring of Stressed Assets (S4A), is the latest salvo in the battle against India’s ballooning and unwieldly NPA (Non-Performing Assets / Bad Loans) problem. This follows assessments from a section of economists, financial commentators, bankers and analysts who have been clamoring for more than just the existing provisions, to resolve the issue of stressed assets and troubled projects across the financial landscape in India. Like all new things which have captured imaginations, this scheme has been bestowed with its own moniker - S4A. It is interesting to note, that within a month of its release, the banking fraternity has leveraged the S4A to initiate big ticket NPA cleanups like HCC, Alok Industries and a few others who have been mentioned in media reports. That being said, there is limited exposure to the details and implications of this scheme, for the NPA landscape. This is important, since a number of banks, investors and interested parties are in the process of formulating S4A action plans. It is also unclear how this scheme will play out in combination with other schemes, provisions, laws and regulations which have been enacted over the past decade.

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It is estimated that this year will see the overall stressed advances in the INR 800,000 – INR 900,000 crore range. This may be a far more relevant estimate as compared to total NPA (Non-Performing Assets) level which is currently pegged at INR 600,000 crores, as stressed asset levels are usually better at showcasing the extent of the problem at hand. As per the RBI, the GNPA (gross non-performing asset) ratio might rise to 8.5 per cent by March 2017 from 7.6 per cent in March 2016. Needless to say, none of these are encouraging signs for times to come.

Gross NPAs for Indian Banks

24 23 26 27 30 32 35 37 45 55

228 227 235 251 273 278 296 314 405

540 252 251 261 278 303 311 331 351

449

595

Dec 2013 Mar 2014 June 2014 Sep 2014 Dec 2014 Mar 2015 June 2015 Sep 2015 Dec 2015 Mar 2016

Private Banks

Financial Stability Report, June 2016 – Reserve Bank of India

Public Sector Banks Total NPAs

It is expected, that the S4A, will be an improvement on the efforts being made to manage the current slippages of NPAs. However, certain bankers & analysts continue to raise concerns around increasing ‘moral hazards’ as there exists an element, of extension of timelines towards the recognition of an eventual bad loan under the existing management. Hence, there may be certain parallels with the infamous CDR scheme. In this paper, we attempt to look at the operational details of the scheme along with the implications, benefits & areas of focus, to exploit the relevant opportunities on offer.

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S4A SCheme OveRvIew2.

The stated purpose of various schemes introduced by RBI, over the last few years, is to strengthen the lenders’ ability to deal with stressed assets and to provide an avenue for reworking the financial structure of entities facing genuine difficulties.

With the S4A scheme, the RBI has made provisions, for a certain set of lenders & business owners, who are struggling with stressed large projects which have commenced commercial operations, but face external or macro-economic issues. The underlying structure of the scheme is aligned to the ‘Framework for revitalising distressed assets in the economy’ (Released by the RBI in 2014) and incorporates enhanced timelines for recognition of stressed loans by offering an opportunity to resolve them by way of sale, refurbishment, recapitalization, support or a combination.

The last 3 years, now known as the ‘Rajan era’ at RBI, have seen an acceleration in the NPA clean-up undertaken by the banks. This has been achieved by recognizing NPAs and stressed accounts in the first place, setting up SMA reporting, getting the banks to take the hit with NPA provisions (leading to bad financial results for large banks) and regular release of tools on incentivizing resolution. Schemes such as SDR, 5:25, S4A and the Bankruptcy & Insolvency Code, incorporate various facilities to extend timelines for recognition of bad loans by giving lenders & debtors the ability to enhance, revitalize or restructure operations/businesses while opening opportunities for investors & ARCs. However, concerns remain, such as the process for removal of management, timelines for on-ground execution, cooperation by the borrowers for a comprehensive assessment & due diligence as well as how regulatory/relevant bodies deal with resolution failures. In addition, investors and ARCs have raised issues associated with the practicalities around changing the management, relationship with lenders/JLF and legal implications for the sale and active management of the business.

The S4A has been formulated as an optional framework for the resolution of large stressed accounts and has been introduced as an enabling tool to further the purpose of the Strategic Debt Restructuring Scheme (SDR). The basic premise is based on the determination of sustainable debt level of a stressed borrower and segregation of the debt into sustainable debt (Part A) and equity or equivalent instruments (Part B). The key difference between SDR and S4A lies in that while the former prescribes a change in existing promoters, S4A allows a resolution plan to be

executed without such a change. These provisions should, in theory, allow the borrower to continue servicing Part A from existing cash flows while allowing the lenders to look at restructuring and resolving Part B of the loan. This however, does come with its share of legal & practical limitations, which have been discussed in detail in this paper.

It is important to note, that S4A has been developed keeping in mind those big ticket projects, which may have

a. Certain inherent value and cash flows

b. Promoters who have managed the business with the appropriate intent, standards and ethical arrangements

c. Unable to pay loans due to factors beyond their control

d. Have redeeming features to interest investors and agencies

Considering the structure and guidelines, this scheme seems to have been built, keeping in mind certain sectors which have showcased capital intensive requirements and may have lagged due to macro-economic factors rather than internal inadequacies. With the change due at the helm of RBI, it remains to be seen how the S4A will play out.

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DeTAIlS Of The S4A SCheme

Name

Scheme for Sustainable Structuring of Stressed Assets (S4A)

Regulator

Reserve Bank of India (RBI)

Date

13 June 2016

Overview

The basic premise is based on the determination & servicing of sustainable debt level of a stressed borrower and segregation of the debt into sustainable debt (Part A) and equity or equivalent instruments (Part B)

Lenders

a. The Joint Lending Forum (JLF)/consortium, will determine the debt segregation

b. Agree on a plan for rectification

c. Provisions to the extent of 20% of the total outstanding amount or 40% of the amount of debt that is seen as unsustainable, whichever is higher

Pre-Requisites

a. Applicable for projects with an aggregate exposure of above INR 500 Cr.

b. Commercial operations should have been initiated

c. Promoters to continue active management if not implicated in the forensic review

d. Agreement on resolution plan & Part A debt by the JLF

e. Overseeing Committee (OC) constituted by the Indian Banks’ Association (IBA) to act as advisory body

Resolution Plan | Part A

a. Sustainable level of debt, serviceable by current free cash flows

b. Sustainable debt should be no less than 50% of current funded liabilities

c. Agreed upon by a minimum of 75% of lenders by value & 50% by number of JLF

d. No fresh moratorium to be granted on interest or principle repayments

e. No reduction in interest rate or repayment schedule

f. Security cover to be the same, if not more than Part A

Resolution Plan | Part B

a. Difference between the aggregate outstanding debt from all sources & Part A

b. Converted into either equity or redeemable cumulative optionally preference shares

c. Promoters may continue to hold shares to exercise control over the borrowing entity

d. Lenders may choose to convert a portion of Part B into optionally convertible debentures

Current Promoters

a. Under an ideal scenario, no change in management is envisioned

b. Promoters may continue to hold enough shares to exercise control

c. Dilute shareholdings in at least the same proportion as that of part B to total existing debt

d. Promoters to provide a personal guarantee to the JLF/Consortium for the Part A amount

e. Resolution plan & control rights structured to ensure sale of firm or company is not possible without approval & sharing the upside with lenders (if any) towards loss in Part B

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Change in Management

a. Current promoters may be replaced with new promoters under the SDR scheme

b. Replacement based on Prudential Norms on Change in Ownership of Borrowing entities

c. Lenders may acquire majority shareholding and change management to a professional agency/management

Asset Classification & Provisioning

a. When change of promoter takes place, these will be as per SDR or ‘Outside SDR’ scheme, as applicable

b. For same promoters, asset classification to be at standstill for 90 days from decision date (reference date)

c. If resolution plan is unimplemented post 90 days, classification aligns to extant asset classification norms

d. Account to be treated as standard, if it is as such on reference date and relevant provisions are made

e. Account To be treated as NPA, if it is as such on reference data. Part A & B classified/provisioned as NPA

f. Part A & B may be upgraded to standard post 1 year of satisfactory performance

g. For existing moratorium, upgrade to be subject to performance and may happen post 1 year of the longest moratorium term

h. If Part A slips into NPA, account to be classified appropriately and provisions made

i. Provisions on account of difference between book & fair value of Part B, if considered in excess of minimum provisions prescribed, shall ideally be made at min 25% each quarter, for 4 quarters

Allied Requirements

a. Techno-Economic Viability (TEV) Study

b. Forensic Or Fraud Review

c. Due Diligence – Tax, Financial, Legal, Compliance etc.

d. Resolution Plan

e. MIS/Reporting mechanism

f. Joint Lending Forum (JLF)

Limitations

a. Applied to only operational projects

b. No rescheduling of original tenure or change in interest rates of repayment of debt

c. Projects with over INR 500 Cr. outstanding advances

d. Sustainable debt under this scheme to be over 50% of total aggregate loans

e. Provisioning of 20% of total debt or 40% of Part B, whichever is higher

End Goal

a. No change in management unlike under SDR

b. Chance to turn-around bad projects

c.Equity & equivalent instruments to provide upside to lenders

d. Once Part B debt is converted to equity, banks can sell their stake to a new owner

The resolution plan will be prepared by credible professional agencies in order to make sure that entire exercise is carried out in a prudent and transparent manner. An Overseeing Committee (OC) comprising of eminent experts will be set up by the Indian Banks Association (IBA) in consultation with the RBI. The committee will independently review

the process involved in preparation of the resolution plan under the S4A. The IBA will collect a fee from the lenders as a prescribed percentage of the outstanding debt to the consortium/JLF/bank and create a corpus fund to meet the expenses of the OC.

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While this scheme has been introduced with an aim of furthering the clean-up and reinvigoration of stressed assets for the Indian economy, there are notable and far reaching implications.

It is interesting to note that similar to most RBI guidelines releases, the S4A is rich in detail but short on laying out the broader picture on expectations, projections and outcomes. However, we now have the benefit of 8-10 weeks of post scheme release activity, discussions with industry leaders and the guiding ‘RBI framework for revitalizing distressed assets in the economy’ to bring to light, certain noted issues.

1. S4A and Current promoters: The scheme has been created for those projects where the current management is deemed as appropriate and capable, to manage the affairs under the corrective action plan (CAF).

2. Techno-Economic Viability Report: The TEV has always been a pre-requisite for stressed asset restructuring. However with current timelines & norms, the comprehensiveness of a TEV based assessment of the business, its realities and core fundamentals have become even more critical. This is especially since, certain critical failures of restructuring in the past (especially under CDR) had its origins in this stage.

3. Forensic Review and Sale of Assets: In addition to the TEV, a forensic review has become a critical pre-requisite under various schemes introduced by the RBI (as well as under the Bankruptcy & Insolvency Code, 2016). This is because the outcome of this report will determine certain rules of engagement and applicability, regarding the resolution plan & change in management. However, the real implication may be related to the desired sale of acquired equity & assets

by lenders, to ARCs, Investors and AIFs, as they may want assurances related to the extent & quality of management control & inherent business/project value.

4. Hunt for the right projects: The S4A scheme has led to an intensive hunt for commercially operational but distressed projects i.e. the ideal targets. While this has been given impetus by lenders, debtors & regulatory agencies for now, increasingly a number of ARCs and Investors are hoping to identify these targets, even before they formally enter the distressed zone. Certain projects are being considered by investors even though their classification is standard, since research & market information have indicated critical performance red flags.

5. Delaying the Pain: A whole host of schemes aimed at resolving NPAs have been structured, so as to extend the timelines, towards complete recognition of bad loans on books and offer lenders the opportunity to make amends. In itself, this is laudable and necessary. However, certain parallels with the failed CDR scheme are inevitable (and have been drawn already) as the sheer quantum of stressed loans and the current macro-economic scenario, may mean that most of these assets will ultimately have to be recognized as bad loans. This is a real possibility, unless the market is appropriately motivated and incentivized to invest and take up these assets. While such market conditions, may be the stated intent of the authorities, it is far from the current reality.

ImplICATIONS 4.

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The ease and opportunities which this scheme brings to the banking and lending community has meant that there has been significant traction seen towards this scheme. Our research has determined that a number of organizations and lenders have been actively considering the S4A scheme post its announcement.

The lANDSCApe & ACTIvITIeS5.

Total debt Company name Sector

Jaiprakash Associates Infrastructure61,285

GMR Infrastructure and Power Ltd Power & Infrastructure42,202

Bhushan Steel Steel39,078

Essar Steel Steel34,928

Steel Authority of India (SAIL) Steel28,221

Jaiprakash Power Ventures Ltd Power27,218

GVK Power and Infrastructure Ltd Power & Infrastructure24,914

Alok Industries Textiles19,921

Adani Enterprises Infrastructure19,298

Suzlon Ltd Power15,362

Monnet Ispat Energy Ltd Power & Steel11,075

Electrosteel Steel10,235

HCC* Infrastructure9,340

IVRCL Ltd Infrastructure8,668

Jaypee Infratech Infrastructure6,769

Unitech Real Estate3,801

Visa Steel Steel3,094

Total Debt is in INR Crores. Figures have been taken from Consolidated statements (wherever relevant)* Research has been conducted across known media sources HCC has already initiated the process of rectification under the S4A scheme

Sectors

S4A has project specific applicability and looks at supporting those who have faced the brunt of macro-economic, supply-demand or cash-flow issues. Hence, projects in certain sectors may be considered most relevant. Based on our research we have found that stressed projects in sectors such as Iron & Steel, EPC, Infrastructure, Real Estate, Textiles & Power may be in the best position and will showcase willingness in considering this scheme as one of the tools to be leveraged. Projects which have demonstrated cash-flow mismatches, especially due to pending payments may be prime targets especially

since it is found that such payments are due from PSUs, government agencies and other stable customers.

Lenders

Banks & Financial Institutions would do well to start assessing their NPA & Stressed Asset positions, to motivate the relevant borrowers from actively considering their positions with regards to the projects which meet the necessary criteria. It is important to underline the criticality of agencies & catalysts, used for pre-requisites such as the TEV and forensic review, and their role in the development of the resolution plan by the JLF. In the past, expansive

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scope of work, aggressive timelines and limited budgets have negatively affected the final quality and outcome of these assessments. The RBI, has been particular in mentioning the criticality of these assessments, as they will determine, in many ways, the future course of action and application of schemes, management control, measures and resolution plan. In addition to this, lenders should also look at operationalizing, advanced analytics capabilities, MIS, Reporting & monitoring standards, to ensure that they have adequate oversight on critical operational, financial & administrative parameters. This will be critical for timely decisions, which may need to be taken, in the event that a change in course is deemed necessary.

Borrowers

Organizations who are currently faced with the prospect of high & unsustainable liabilities, should ideally take the first step towards assessing their projects in alignment with the S4A requirements. The guidelines envisage specific and limited timelines for each stage and assessment. In this regard, organizations would do well to ensure complete & absolute transparency in access and delivery of information for various assessments & reporting requirements. Though

this is a basic requirement, in the Indian context this usually becomes a huge bone of contention, especially when it comes to the forensic review and TEV. Inadequacies at this level may mean that resolution plans may not go through, either at the JLF or the OC stage. The scheme outline is such, that most timeline dependencies are lender agnostic but borrower specific. In this context, the OC may (in the future) recommend drastic fines or penal action to motivate organizations to provide the required cooperation, information and transparency of information.

Investors and Agencies (AIF & ARCs)

While the potential & opportunities may be extensive, investors today are wary of committing themselves to stressed asset investments, where the control of promoters may continue to exist. Most players plan to keep their eyes open and ears to the ground. But actual deals of equity sale, asset sale or transference of management control may take some time. Regulatory clarity, recognition of on-ground realities & the initial success of the first few cases will precede substantial market activity

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CONClUSION6.

The S4A is at best, an evolutionary step forward and fills a specific need for a specific set of stressed assets. Our research indicates that it may, if operationalized in spirit & purpose, assist in the much required clean-up of sectors & projects with massive debts but redeemable qualities. It offers promoters an opportunity to resuscitate their businesses and service debt while requiring adequate sacrifices. It also allows for lenders and promoters to take the benefit of a potential upside in the future, post the successful implementation of the resolution plan.

However, it is a matter of concern that certain aspects of the scheme are similar to CDR. Industry experts have been unified in their views regarding the failure of CDR which essentially led to evergreening of loans, increase in NPAs, minimal ramifications for promoters and finally, extension of timelines for recognition of stressed assets. In a sense, regulators, bankers and law-makers had identified the cancerous development of NPAs, a decade ago. However, their treatment consisted of placebos and mismanaged schemes. It remains to be seen if S4A will be able to break away from this legacy.

Measures

Across a majority of stressed asset resolution cases, lenders, investors & stakeholders, have been unable to take the right decisions, make changes in resolution plans or give the right directives. The primary reason for this has been an absence of the relevant information & insights, to validate decisions & assertions. This is key to the success of any restructuring.

1. Deficiencies in Techo Economic Viability (TEV) will lead to failures: The emphasis on TEV is critical since inadequate coverage or limited assessment at this stage has led to a number of unsuccessful recasts in the past, especially under the CDR norms. Operational parameters, cash flows, soundness of business, capacity utilization and other factors need to be assessed, validated and factored in for Part A & B debt. Hence, gaps at this stage may lead to unmitigated issues going ahead, as there doesn’t seem to be a re-assessment provision, which may open a window for a second chance.

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2. Forensic Review to determine application of the scheme and involvement of promoters: This review is critical for all recasts, as the current norms and guidelines under SDR allow for the change of active management of businesses and projects under stress. The saying - ‘Never reinforce a failure’ has somewhat been lost in notable cases where a comprehensive forensic review has not been conducted which has led to failures due to unearthed frauds, inappropriate accounting or other reasons.. Assessment of potential issues, unethical behavior, management control, frauds and systems, are critical to decisions made in developing the resolution plan and in determining the need for changing promoters. The forensic review is a definitive requirement in the application of S4A norms, as the outcome of this may decide who exercises control over the stressed asset.

3. Analytics Support & Dashboards are critical for stakeholder confidence & successful recasts: Monitoring operations, financials & systems of the stressed assets & related entities, to track compliance with the resolution plan, expectations of

the JLF and state of Part A & B debt is important for classification and provisioning norms. Stakeholder expectations of stay well informed, will require the appropriate analytics, technology and reporting tools to track critical parameters of performance. This will enable the JLF/Lenders to take measures on asset classification& provisioning, since these are dependent on the performance of the project, progress against milestones & the MTM value of the Part B instruments. Continuous monitoring and timely actions are important follow-throughs for a successful recast.

S4A is meant for projects run with competency & faith, but facing bad times due to factors beyond the control of the promoters. However, it is our view that stakeholders & lenders will have to make the right judgements related to the execution of critical operational elements of the restructuring exercise (TEV, Forensic Review, Dashboards, Resolution Plans, Due-Diligence etc.) since the S4A scheme requires the management & promoters to stay on. In such cases, while faith and trust are necessary, they are not always adequate in the Indian context, to ensure success.

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Sarabjeet Singh Partner +91 124 669 5044sarabjeet.singh@bmradvisors.com

Sanjay Mehta Partner +91 124 669 5080sanjay.mehta@bmradvisors.com

Abhishek Bali Senior Vice President +91 124 669 5033abhishek.bali@bmradvisors.com

Connect with the team

We look forward to hearing your views on the Scheme for Sustainable Structuring of Stressed Assets (S4A) and how the scheme may affect your organization, reveal opportunities and have implications in the future. Please connect with our specialists and advisors, who have been involved in assessing, researching and developing practical applications, based on the S4A guidelines.