Defaults And Distrust
Markets
The Essar Steel Saga
Our first story this week was a dive deep into Essar Steel's
debt saga and why it took 800 days to finally reach a resolution.
When large corporates fail to pay up, you
would expect banks to immediately take them to task and force a resolution.
However, before 2016, the equation was a tad
bit different. In the old days, defaulters often pressurized banks to
extend repayment periods and take large haircuts i.e. get the banks to settle
for only a fraction of the original loan amount while retaining full control of
their company. In the event of resistance, corporates often threatened to take the matter to court. And the uncertainty involved in waiting for the
courts to rule on the matter often prompted banks to cede ground and settle
with the defaulter.
In fact, this emboldened many corporates to willfully default
on their payments
so long as they were convinced
the balance of power remained with them. Outside of hurting banking culture in
this country, it created many other distortions. As the Bankruptcy Law Reforms
Committee (2015) succinctly put it
“When creditors (lenders) know that
they have weak rights resulting in a low recovery rate, they are averse to
lend. Hence, lending in India is concentrated in a few large companies that
have a low probability of failure."
So you can see why we needed to tip the scales
here. And tip the scales we did.
In 2016, lawmakers finally passed the Insolvency and Bankruptcy Code, 2016 (IBC) to
provide for a legal framework that banks could use to take defaulting companies
to task. This was a watershed moment for two reasons. One, it put a time limit
of 180 days (extendable by a further 90 days) within which lenders had to agree
to a resolution plan i.e. figuring out repayment terms. Two, in the event that
nobody could agree on specific terms,
the company was to be dissolved with all the assets put up for sale. The proceeds would then
be divided among the lenders in an equitable manner.
In summary, lenders now had every reason to
find a resolution plan because they knew they’d have to settle for pennies if
they waited for the company to be dissolved. And owners of defaulting companies had every reason to settle because
if they didn’t, they would now lose all control of their most prized
possessions. A win-win for all parties involved. No more courts, No more
endless legal battles. No more bad loans.
At least, that was the plan.
And soon enough, the Reserve Bank of India
sprung into action. It identified 12 large borrowers who had failed to pay
their dues and Essar Steel figured very prominently in this list. The company
owed banks a whopping 43,000 crores and
another 11,000 crores to its suppliers and vendors. And in June 2017, SBI and
Standard Chartered Bank took Essar to NCLT — a special type of court
responsible for dealing with bankruptcy/insolvency proceedings under the IBC.
The court admitted their plea and the
lenders got together to draft a resolution plan. Their idea was simple. Invite
bids for a takeover of Essar
Steel and see who’s willing
to pay the most. Once the final bid
is accepted, they could decide how to split the proceeds.
And this is when things took a very
interesting turn. At first two companies expressed interest to buy Essar. ArcelorMittal, the world’s largest
steel producer and Numetal, a joint venture between Rewant Ruia — son of
Essar co-founder Ravi Ruia — and Russia’s VTB Bank.
Unfortunately, both bids were quashed. The
reason — Sec 29A. Under the IBC a special provision barred
companies with unpaid
dues from participating in the process. ArcelorMittal had some unpaid
loans on their books. Rewant Ruia had associations with Essar Steel ( a company
with over 50,000 crores of debt). So both companies were disqualified.
Eventually, Revant Ruia left the JV and
Numetal bid for Essar without the Ruia connection. ArcelorMittal followed suit,
by clearing their dues and tabling a fresh bid. After some back and forth
including trips to the Supreme Court Arcelor Mittal won the bidding war with a
42,000 crore offer. Now at this point in time it's important to note that, Essar
tried to scuttle
the deal by making another
offer that included
paying off the entire 54,000
crore loan burden.
“Forget
the IBC, Forget the NCLT. Let's just settle, eh?”
However, the committee of lenders deliberating
the resolution chose to ignore all of this and accepted the ArcelorMittal
offer.
Why you ask? Because ArcelorMittal had already offered
bank guarantees and put up a lot of the money on the table to signal their intent. They were serious
about this thing. Essar, on the other hand, made no real disclosures on how they were planning
to raise 50,000 crores. So
yeah, ArcelorMittal for the win.
The last problem was distribution. How do you split the
proceeds and who gets how much?
The NCLAT (the appeals court above NCLT) issued a rather bizarre
order here. It said
that all types of lenders had to be treated equally and the proceeds would be distributed on this single premise.
Which means even if you are a lender who
offered money against collateral, you are just as good as some chap who loaned
out money without asking for any guarantees in return. The banks with the
collateral challenged this order and the Supreme Court decided it was
imperative that these banks be paid first. The rationale was simple. When banks
lend against collateral they offer a lower interest rate on the loan simply
because they’ll have the collateral just in case things go wrong. However,
according to the NCLAT
order, everybody is to be treated equally.
So why would banks ever offer
a low interest on a loan even if the borrower can back it with collateral? They probably won’t
and that would screw up the whole banking equation.
So better sense prevailed and after over 800
days of legal wrangling, the Essar Steel saga came to a close.
Markets
Game Over for DHFL
After many twists and turns, it seems as if the DHFL saga is finally
coming to a close. But before we get to the story here’s a quick recap
Back
in September 2018, DSP, a mutual fund house offloaded DHFL’s bonds at a discount. I know you’re not
following this. So here’s
a nice translation- DSP had loaned out considerable sums
of money to DHFL. And then one day there was an epiphany
it seems. They no longer
wanted to wait for
DHFL to pay them back. So they begged someone
else to take the burden off of them by offering a huge discount. They said this was routine.
But come on. Who are we
kidding right?
When news of the sale
spread, DHFL stock crashed 60%🔻. Everybody was now thinking “Why did DSP do it? What’s wrong
with DHFL? Is everything alright at DHFL? I am panicking now, please help!!!”
And
then all the banks and the fund houses that ever loaned
money to DHFL took a back seat and said “ Yeah…
This is bad. We probably have to take a hit as
well”
At the same time, there were also
allegations that the promoters (owners) of the company were siphoning funds to
enrich themselves. Eventually, though
the allegations fizzled out and the company went back to assuring investors
that they would never default on their payments.
Until they finally defaulted in June 2019.
It was at this point that the company
finally stated that it was going through substantial financial stress. It even
confessed that its ability to raise more money was considerably impaired and
its future existence, now doubtful.
So what
went wrong?
A root cause analysis will reveal that DHFL, much like other NBFCs was running what bankers call an “asset-liability mismatch”.
A housing finance company like DHFL disburses
loans that have repayment periods of about 20 years. Despite the unusually long
repayment periods, the loan is a rather safe bet. The company generates
reasonable interest income and if the consumer were to default on his payments,
DHFL will still have a house they could liquidate to help recoup a part of
their investment. So there is little concern on the lending side. It’s the
borrowing bit that’s slightly more complicated.
In an uber-competitive scenario, DHFL would
want to make an extra penny by trying to borrow at cheap rates. But borrowing at cheap rates comes with a caveat — You can’t take 20 years to pay back the loans. DHFL’s lenders will
gladly offer loans at lower interest rates if they promise to repay the loan
sooner. How soon? 3–6 months would be optimal.
But DHFL is poised to receive its funds over the course
of 20 years. How then could you expect it to pay back its dues within 3–6 months. This is a problem
referred to as the Asset Liability Mismatch.
But it has a rather simple workaround
nonetheless. DHFL borrows funds with short repayment periods by issuing a
contract note. In banking parlance, they call this a Commercial Paper (CP).
Once the repayment period is complete and the CP is due after 6 months, the
company simply issues a new set of commercial papers and borrows once again.
And again. And again. This way the company can keep “rolling over” funds to
meet their short-term obligations.
Now all this works exceedingly well until
there’s somebody on the sidelines willing to refinance your loans. But when
there’s no one willing to back you, that’s when things quickly spiral out of
control. First, it’s just one default. You promise to honor all your other
obligations. But almost instantaneously you find out that nobody wants to lend
to you anymore. You quickly
run out of cash. And before you know it, you’re defaulting almost every day.
Long story short, DHFL was running out of
time. And since they couldn’t reach a resolution plan with their lenders any
more, RBI decided to intervene yesterday. The plan now is to take DHFL to bankruptcy court and see if DHFL's
lenders can reach an
amicable resolution. If they don't, the company will be liquidated and the assets sold to the highest bidder. And until the lenders get paid in full, there's
little hope for the stock price to recover.