by Ajay Shah and Bhargavi Zaveri.
M. C. Govardhana Rangan and Satish John have an article in the Economic Times where they describe selective default by Amtek Auto to some bondholders but not to others. We have been aware of this problem for a while now: it appears that when a firm gets into trouble, it undertakes a `soft default' where powerful investors get paid while less powerful investors are not. Sometimes what firms seem to do is respond to stress by paying out different bond holders with different delays, which is also a form of default.
Securities markets are about arms-length investing. The investor looks at public domain information about the issuer, at the rules of the game as articulated in securities law, and makes the decision to buy or sell. The investor should need to have no human relationships into the game, or possess political power or influence.
When the cashflows that emanate from a security depend on who the investor is, this is not arms-length investing; it is not a securities market.
Selective default clouds our databases about default, and makes it more difficult to analyse credit risk in the future. In a well functioning financial system, we should observe a binary event of default or non-default associated with each date of cashflow for a bond. With selective default, the information set becomes enormously complicated: the information set of interest is the list of bondholders who were paid and the date on which the payment was made. None of this is visible in the public domain. Enormous energy is expended by market participants in obtaining gossip about these questions of fact. Ordinarily, bonds are a superior way for society to organise loans for borrowing above a certain size, but the productivity gains are lost when expensive finance practitioners waste their time on information gathering about default.
At a philosophical level, the equal treatment of every security is fundamental to the concept of a securities market, much like the concept of equal treatment in the eyes of the State is essential to liberal democracy (e.g. as is done by Art. 14 of the Constitution of India).
Under present Parliamentary law, there is no equal treatment clause which imposes the burden of fair play upon issuers of securities.
There is a complicated landscape of subordinate legislation which has scattered references to the principle of fair treatment of holders of a class of securities. However, it is not clear whether a selective default is a violation on account of unequal treatment of investors.
SEBI has recently come out with Listing Obligations and Disclosure Requirements Regulations, 2015, which explicitly have an equal treatment clause for shareholders. The regulation of listed debt instruments is now folded into this single regulation. Given that equitable treatment has been embodied as a general overarching principle in these Regulations, we hope the principle will be applied to a class of securityholders (and not be restricted to holders of equity).
Under a sensible bankruptcy code, paying some bondholders would not help, as the bondholders that you have not paid would go to a court and trigger an efficient bankruptcy process. Hence, there is no incentive to undertake selective default.
Under the present law also, a bankruptcy process may be triggered by a creditor to whom it has become obvious that the company is going to default. However, given the costs associated with initiating and taking a bankruptcy petition through, it makes sense for a bond holder to await a settlement than to resort to a lengthy winding up process which guarantees little chance of recovery. Hence, the present institutional infrastructure for bankruptcy is a causal ingredient for the phenomenon of selective default.
Beyond bankruptcy, the issue of equitable treatment of security holders deserves to be treated under a securities law. Under a sensible securities law, issuers would be obliged to treat all security holders equally. This is a deep concept which goes beyond default into corporate governance. As an example, in version 1.1 of the Indian Financial Code, S.217 says:
Once this legal foundation is laid, we would require a well functioning `debenture trustee' institution to represent the dispersed bondholders and vigilantly protect their rights, of which equal treatment is a core right.
Today, the SEBI (Debenture Trustee) Regulations allow debenture trustees to discriminate amongst their clients on ethical or commercial considerations. This virtually allows a debenture trustee to pick and choose amongst its beneficiaries and is contrary to the principles of fiduciary responsibility. This is low-hanging fruit which SEBI needs to revisit. The incentive structures for debenture trustees is another area which needs systematic reform.
The depositories have the full list of bondholders and the characteristics of the bonds that were promised. We can envision a regulation which mandates that issuers pay bond holders only through a an electronic system, that is operated by information utilities such as depositories. So, once a bond becomes redeemable as per its terms, the issuer is compelled to pay those who choose to redeem only through a single large electronic transfer of cash to the system, who would send out thousands of electronic payments to such bondholders. On one hand, this yields greater efficiency in the processing of payments. Objective data would come out into the public domain about the precise nature of default which took place, if any. This would help alert debenture trustees and help them do their job better.
The very presence of such an arrangement would constrain issuers to behave better.
M. C. Govardhana Rangan and Satish John have an article in the Economic Times where they describe selective default by Amtek Auto to some bondholders but not to others. We have been aware of this problem for a while now: it appears that when a firm gets into trouble, it undertakes a `soft default' where powerful investors get paid while less powerful investors are not. Sometimes what firms seem to do is respond to stress by paying out different bond holders with different delays, which is also a form of default.
This undermines the very concept of the securities market
Securities markets are about arms-length investing. The investor looks at public domain information about the issuer, at the rules of the game as articulated in securities law, and makes the decision to buy or sell. The investor should need to have no human relationships into the game, or possess political power or influence.
When the cashflows that emanate from a security depend on who the investor is, this is not arms-length investing; it is not a securities market.
Selective default clouds our databases about default, and makes it more difficult to analyse credit risk in the future. In a well functioning financial system, we should observe a binary event of default or non-default associated with each date of cashflow for a bond. With selective default, the information set becomes enormously complicated: the information set of interest is the list of bondholders who were paid and the date on which the payment was made. None of this is visible in the public domain. Enormous energy is expended by market participants in obtaining gossip about these questions of fact. Ordinarily, bonds are a superior way for society to organise loans for borrowing above a certain size, but the productivity gains are lost when expensive finance practitioners waste their time on information gathering about default.
At a philosophical level, the equal treatment of every security is fundamental to the concept of a securities market, much like the concept of equal treatment in the eyes of the State is essential to liberal democracy (e.g. as is done by Art. 14 of the Constitution of India).
The approach of present law towards equal treatment
Under present Parliamentary law, there is no equal treatment clause which imposes the burden of fair play upon issuers of securities.
There is a complicated landscape of subordinate legislation which has scattered references to the principle of fair treatment of holders of a class of securities. However, it is not clear whether a selective default is a violation on account of unequal treatment of investors.
SEBI has recently come out with Listing Obligations and Disclosure Requirements Regulations, 2015, which explicitly have an equal treatment clause for shareholders. The regulation of listed debt instruments is now folded into this single regulation. Given that equitable treatment has been embodied as a general overarching principle in these Regulations, we hope the principle will be applied to a class of securityholders (and not be restricted to holders of equity).
Fixing the legal foundations
Under a sensible bankruptcy code, paying some bondholders would not help, as the bondholders that you have not paid would go to a court and trigger an efficient bankruptcy process. Hence, there is no incentive to undertake selective default.
Under the present law also, a bankruptcy process may be triggered by a creditor to whom it has become obvious that the company is going to default. However, given the costs associated with initiating and taking a bankruptcy petition through, it makes sense for a bond holder to await a settlement than to resort to a lengthy winding up process which guarantees little chance of recovery. Hence, the present institutional infrastructure for bankruptcy is a causal ingredient for the phenomenon of selective default.
Beyond bankruptcy, the issue of equitable treatment of security holders deserves to be treated under a securities law. Under a sensible securities law, issuers would be obliged to treat all security holders equally. This is a deep concept which goes beyond default into corporate governance. As an example, in version 1.1 of the Indian Financial Code, S.217 says:
(1) Every issuer making a public offering has an obligation to ... (c) have in place systems of governance and processes to ensure that the issuer does not discriminate between the owners of a class of securities of the issuer;
Once this legal foundation is laid, we would require a well functioning `debenture trustee' institution to represent the dispersed bondholders and vigilantly protect their rights, of which equal treatment is a core right.
Today, the SEBI (Debenture Trustee) Regulations allow debenture trustees to discriminate amongst their clients on ethical or commercial considerations. This virtually allows a debenture trustee to pick and choose amongst its beneficiaries and is contrary to the principles of fiduciary responsibility. This is low-hanging fruit which SEBI needs to revisit. The incentive structures for debenture trustees is another area which needs systematic reform.
One approach to constructing sound market infrastructure
The depositories have the full list of bondholders and the characteristics of the bonds that were promised. We can envision a regulation which mandates that issuers pay bond holders only through a an electronic system, that is operated by information utilities such as depositories. So, once a bond becomes redeemable as per its terms, the issuer is compelled to pay those who choose to redeem only through a single large electronic transfer of cash to the system, who would send out thousands of electronic payments to such bondholders. On one hand, this yields greater efficiency in the processing of payments. Objective data would come out into the public domain about the precise nature of default which took place, if any. This would help alert debenture trustees and help them do their job better.
The very presence of such an arrangement would constrain issuers to behave better.
Excellent article and I got enlightened about my presumption that all are equal in the eyes of the issue. I hope with the new guidelines atleast in listed debt this gets enforced
ReplyDeleteThanks for this interesting piece. Would you say there is a role for cross default clauses (both across different tranches of the same offering and across different bond issues by the same issuer) in engendering equal payouts organically rather than/in addition to regulation?
ReplyDeleteYou're right that cross-default provisions are quite standard. The Amtek Bond agreement also had them. There are two problems with the way cross-default rights pan out in India. First, the information relating to default doesn't get disseminated efficiently and early enough. That means that those who can take advantage of a cross-default provision are not able to do so. Second, we're seeing even under IBC which has cross-default trigger rights, people are not (yet) using them to trigger when a debtor commits a default to another creditor.
DeleteIt is unclear if cross-default provisions will resolve the problem of preferential pay-outs, which I think, relates more to the conduct of the issuer.