The Union ministry of finance has called bankers for a “retreat” to help prepare a blueprint for banking sector reforms. The prime minister will attend the brain-storming session on the second and concluding day. Everything is on the table: Consolidation and restructuring, risk profiling and recovery, HR, technology, even financial inclusion. One more item should be added to the agenda: Corporate debt.
Excess debt that companies take is a cause for worry. A recent study by India Ratings showed that the aggregate debt of the 500 largest corporate borrowers is R28.76 lakh crore, which accounts for 73% of the total bank lending to industry, services and export sectors. Of this, ‘stress’ cases account for R3.917 lakh crore and the ‘vulnerable’ another R2.546 lakh crore.
Why are companies allowed to borrow so much? It is because banks (and shareholders) never can tell how much a company will borrow since regulations regarding borrowing limits continue to remain opaque under both The Companies Act 2013 and the amended Clause 49 of the Listing Agreement.
Borrowing limits are covered under Section 180(1)(c) of the Companies Act 2013. Under this Section, the board of the directors of a public company shall not borrow moneys, together with the moneys already borrowed by the company (apart from “temporary loans” obtained from the company’s bankers in the ordinary course of business), in excess of the aggregate of the paid-up capital and free reserves of the company, unless it is approved by the shareholders. Temporary loans are loans repayable on demand or within six months from the date of the loan such as short-term, cash credit arrangements, the discounting of bills and the issue of other short-term loans of a seasonal character, but does not include loans raised for the purpose of financial expenditure of a capital nature.
There are three main issues that impact lenders.
First, the total quantum of debt that the company plans to raise is unclear. Under this section, a company needs to approach shareholders for an approval of borrowing limit only where long-term loans (largely related to capital expenditure) are likely to exceed the company’s net-worth (paid-up share capital plus free reserves). Short-term loans can be raised without shareholder approval and without setting an upper limit.
Therefore, it is impossible for shareholder and lenders to assess the total level of debt that the company plans to raise and its potential impact on credit protection measures as well as earnings per share (EPS).
A company recently sought shareholder approval to approve a borrowing limit of R3,000 crore, over and above its net-worth of R1,220 crore. This suggested that the borrowing limit would be R4,220 crore. However the company’s ‘rated’ bank facilities (predominantly working capital loans and non-funds based facilities) already aggregated R5,500 crore. Therefore, with this resolution, the company’s total debt could increase to over R9,700 crore.
Second, companies can borrow for subsidiaries without requiring shareholder approval. The requirement of shareholder approval to set a borrowing limit applies only directly-held companies. So, a subsidiary would take approval from the holding company (and who is to know when and under what circumstances that happens), while the holding company would need approval from its direct shareholders. Therefore, owners/shareholders of the holding company do not have a say in the level of debt raised by the subsidiaries. Companies can raise an unlimited quantum of debt for their unlisted subsidiaries. Therefore, at a consolidated level, a company may have a much weaker debt protection measure. Several businesses, particularly those in the infrastructure and construction space, operate through a series of subsidiaries. Therefore, understanding a company’s consolidated debt level is critical for both lenders and shareholders.
Recently, a company proposed a resolution to set its borrowing limit at R10,000 crore. On a standalone basis, the company’s debt/equity ratio has hovered around 1.5x in the recent past, which would give the impression that the company raised debt judiciously. But, consolidated debt/equity levels were double, at over 3x, on March 31, 2014. The company had raised debt through unlisted subsidiaries. Therefore, approving the borrowing limit of R10,000 crore would further exacerbate the company’s already weak credit protection measures at the consolidated level.
Three, borrowing limits remain in perpetuity, until they are changed. Unlike most approvals under the Companies Act 2013, borrowing limits do not have any expiry date. These limits stay with the company until they are changed. Therefore, once the resolution is approved, a company can raise the entire amount of debt in future without having to approach shareholders. This can have precarious consequences. Note that the Securities and Exchange Board of India (Sebi) has specified a one-year validity for all resolutions relating to equity-raising.
As per an analysis, the borrowing resolutions presented to shareholders during the 2014 proxy season have been without any details explaining why the money is needed. While companies do need some flexibility to raise funds to manage their operations, some have leveraged the full scope of ambiguity by asking shareholders to approve borrowing limits that the company may not even exhaust over the next decade. Others have asked for rolling limits—a finite amount of debt, over and above the net-worth. Therefore, as the company’s net-worth increases, so does its borrowing limits.
To ensure that businesses are run conservatively—and the integrity of the banking system maintained—some fixes are needed, that lie with both the ministry of corporate affairs and Sebi. These include:
*Borrowings limits, when presented to shareholders for a vote, must be absolute limits (not rolling limits linked to net-worth), and must comprise both long-term and short-term limits (including credit limits). The company must also provide clarity on the quantum of borrowing limits that are likely to be non-fund based in nature
*Companies must be required to present broad details of the plan and purpose of raising the debt
*Companies must also be required to disclose the quantum of consolidated and standalone gross debt and net debt outstanding as on the date of the notice and each quarter-end
*Regulations must set an expiry date for borrowing limits. Companies must approach shareholders periodically for an approval of borrowing limits. While this is a one-year window in the case of equity, it may be a rolling three-year window for borrowing limits
Bankers need to deliberate and address issues like who owns the company, how is the board and its CEO appointed, and whether India has the best-in-class bankruptcy laws, and if not, how can it get it. But in all this, we must not forget the biggest risk remains credit-risk. This must be contained.
By Amit Tandon
The author is the founder and MD, Institutional Investor Advisory Services India Limited