CONVERSION OF CREDIT INTO EQUITY

The business can only start after the appropriate amount of capital. The capital can be raised through Financial Institutions and other Creditors by issuing:

If companies fails to repay its debt, then the government allows it to convert their debt into equity. Both public as well as private companies are eligible for the said conversion.

As per Section 62(3)[3] of Companies Act, 2013, the loan will be converted to share capital by fulfilling below:

  • Approve terms of loan by passing special resolution and filing E-form MGT-14 within 30 days.
  • Pass board resolution for conversion& filing E form PAS-3 within 30 days.
  • Issue share certificate by passing Board resolution and filing MGT-14.

Public companies are facing more issues as compared to private companies, such as:

Public Company Private Company
The existing shareholders may not agree in the General Meetingbecause theirvoting rights will be diluted. Easily agreed in the General Meeting because they are not concerned with the voting rights.
Concerned more with the percentage of holdings. Concerned more with the existence of business.
Convincing the shareholder for approval is a big task No such issues will arise.

 

The ways of conversion of credit into equity as per RBI regulations:

Corporate Debt Restructuring(CDR) Mechanism[4] Strategic Debt Restructuring(SDR) Scheme[5]
Announced by RBI in 2001 In June 2015
Eligibility Criteria:
·         More than one Creditor.

·         Debt of 10 Cr. or more.

·         Consent of lenders representing 75% debt (in value).

·         Debtor-Creditor/Inter-Creditor Agreement.

·         Done by consortium of lending institution known as Joint Lenders Forum (JLF).

·         Not applicable to single lender.

Covers all categories of assets in the books of creditors. Covers assets which have been restructured by CDR or any other restructuring exercise.
Restructuring the existing debt by increasing the repayment period or by reducing the rate of interest or by granting of fresh loans Provides for conversion of debt into equity by the lenders.
Three tier structure which includes CDR Cell, Empowered Group and a Standing Forum. Lenders form a Joint Lenders Forum to decide on the conversion of debt into equity
It is a voluntary non-statutory system based on the agreements. Statutory system but exempts from the SEBI guidelines to make an open offer.

 

The SDR scheme has been introduced with the hope that it can speedily resolve the case and will also benefit the parties as well as government.

 

SEBI & RBI GUIDELINES:

The Securities and Exchange Board of India (SEBI), has liberalised the norms for banks to convert their holding of company’s debt into equity. Earlier, there was a 10% cap on the conversion and the price had lead down by average share price of:

  • Previous 30 days or Previous 6 months (whichever is higher)

By doing away with these restrictions, it is assumed that the banks will be able to convert their stressed debt into equity more easily and fairly.

If the shares are listed in stock exchange, then the company should comply with following regulations:

 

Shares are listed in Stock Exchange[6]

 

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Conversion of ECB into equity[7]:

ECB stands for External Commercial Borrowings, which is the source of raising fund from the international market. Generally the lenders are the holding company or existing shareholders which can also be repaid by issuing the equity of the company (borrower).

Procedure:

As per FEMA Act, conversion is permitted subject to following conditions:

  • The activity of the company is covered under Automatic Route under FDI or govt. approval for foreign equity participation.
  • After conversion the holding is within the sectoral cap.
  • Pricing of shares is defined as per SEBI regulation for listing companies and DCF (Discounted Cash Flow) method for unlisted companies.
  • Compliance with the other provisions of other laws applicable.

The following can also be allowed for conversion[8]:

  1. Lump-sum fee, technical know-how fee, royalty due for payment subject to pricing guidelines of RBI/SEBI and compliance with applicable tax laws.
  2. SEZs are permitted against import of Capital Goods subject to valuation done by Committee.
  3. Import of capital goods/machinery/equipment (excluding second-hand machinery) by compliance with following conditions:
  • Import should be in accordance with export/import policy notified by Directorate General of Foreign Trade (DGFT) and FEMA regulations.
  • Independent valuation of goods from the independent valuer of the foreign country along with documents issued by custom authorities towards assessment of fair value of such imports.
  • Application should clearly indicate the beneficial ownership and identity of the Importer Company as well as overseas entity.
  • Applications should be made within 180 days from the date of shipment of goods.

 

  1. Payment of all dues which are covered under automatic route:

 

  • Import of raw material/ semi-finished
  • Finished goods/ capital goods
  • Services related payments such as advisory fees, legal fees, import/ export commission, investment banking fees, underwriting commission, information technology related payment, brokerage, expat salaries etc.
  • Dividend to foreign shareholders or interest to foreign debenture holders.

This move would enhance the FDI flow in the country and also conserve foreign exchange outflow. Besides, it would spare funds for Indian companies, which can be used for other domestic purposes and reduce its working capital requirements. However, issue of equity shares against fund payables would have a dilution impact on existing shareholders of the company and would need to be appropriately dealt with.

 Kingfisher Airlines Case[9]:

The conversion of debt into equity has also been made in the case of Kingfisher Airlines by banks but the conversion has been mostly difficult due to regulatory and legal issues.

In November 2010, a consortium of banks had exercised this option and the price they paid, as calculated by the SEBI formula, was 61 per cent higher than the share price at that time. In the days that followed, the share price of the beleaguered airline fell further. As was only to be expected, the banks drew a lot of flak for this decision.

The new norms will now stipulate that the banks should negotiate the price with the companies whose debts are to be converted into equity.The gains from this are fairly straightforward. In this the banks will get the opportunity to bring down the non-performing assets on their books and the companies will have easier cash flows. But it is fraught with challenges as well.

To begin with, there is little evidence to suggest that conversion of debt into equity alone can help a badly managed company turn around. Kingfisher Airlines was grounded two years after the banks came on board as shareholders. Further, the price of conversion will invariably be contested, now that the SEBI formula has been done away with. As it happens, the share prices of companies with stressed balance sheets are trading low, which could give the banks a large chunk of their equity capital if they choose to exercise the option. It also remains to be seen if the banks have the bandwidth to play the role of an active shareholder, unless they decide to become a passive one. It is a valid question to ask if it is the job of the banks to run companies or whether they have the requisite management skills to play such a role.

The biggest challenge will arise when the banks decide to sell their stakes.As a result, many of these exits are likely to be contested in the courts. Given that the courts are already bursting at the seams with a huge pile-up of pending cases, it is likely that these matters will drag on for a long time. If the conversion scheme has to work smoothly, it is essential for the government to first unclog the courts through necessary judicial reforms. This is true also for the promised new bankruptcy law. In the end, the delicate decisions accompanying the unwinding of bad debt require more judicial capacity, not just different rules.

Analysis:

The company can utilise the CDR mechanism as it is a non-statutory procedure which is only based on Debtor-Creditor/Inter-Creditor Agreement. If the share price of the company constantly got reduced then thebankers cannot go under this mechanism as it will increase the liability to run the business. The CDR mechanism can be beneficial only when the shares are traded at a decent price in the market otherwise running of business becomes the liability of bankers.

Electro Steel Group Case[10]:

In the present case, the Electro Steel was unable to pay the debt to their lenders. The board has taken on record the strategic debt restructuring package approved by its lenders.

In filing with the BSE, the company and its lenders had agreed to convert Rs.2507 of debt into equity. The company holds an EGM to seek shareholder’s approval for the SDR scheme.

The company has debt of over Rs.9500 Cr. on its books and the bankers have been finding it difficult to recover the amount and they also don’t get the suitable buyer to take over these stressed assets.

Analysis;

By applying SDR scheme the company becomes able to convert the portion of its debt into equity which anyhow reduces the burden of the organisation.

 Conclusion:

A debt into equity conversion is an advantage for both i.e. debtors and creditors to avoid insolvency of the business. There are methods which can be adopted to curb the problem of repayment of loan.

Every method has their own benefits and drawbacks but all of them enable the debtor to avoid insolvency and continue to trade. In simple terms “substitution of previous commitments with new commitments”

 

[1]A stock or any other security representing an ownership interest.

[2]Debt is an amount of money borrowed by one party from another.

[3] If a company takes loan on the term that loan will be converted into share capital and such an option have been approved before raising of loan by special resolution, subscribed capital can be increased.

[4] CDR Master Circular-updated on April 29, 2015

[5] RBI Notification June 8, 2015

[6]SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009 (“ICDR”) & SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 (“SAST”)

[7] Master Circular No. 12/2013-14 on ECB and Trade Credit

[8] Master Circular No.15/2014-15 on Foreign Investment in India

[9]Business Standard March 26, 2015

[10]Economic Times June 14, 2016


AUTHOR

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Sachin Bajpai Associate @ SAPAA.  He did  BA. LLB from Bharati Vidyapeeth’s New Law College, Pune and wanted to excel in Tax and other Corporate Laws. He is fun loving, love to travel, riding bike and wanted to explore the world.

 


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Disclaimer:  The views and opinions expressed in this article are those of the authors. All data and information provided on this site is for informational purposes only. sapaa.in makes no representations as to accuracy, completeness, correctness or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use.