Since August 31, 2017, alarm bells have been ringing in banks and non-banking financial companies that provide margin financing and share-backed financing to various promoter groups. The interim order of the Supreme Court restricting the holding companies of Malvinder and Shivinder Singh from selling the shares of Fortis Healthcare and preventing certain banks from enforcing their pledge on these shares has left the lending community dumbfounded.
Margin financing and share-backed financing is very popular with promoter groups who borrow money usually for investments, refinancing group debt or general corporate purposes by offering security over shares they own in listed companies. Promoters generally have an obligation to maintain a certain collateral cover based on the value of the underlying pledged shares and have to pledge additional shares if the collateral cover falls below the pre-agreed threshold.
Lenders also typically have a right to sell the pledged shares in case of a fall in the collateral cover or the occurrence of certain pre-defined events. Lenders are comfortable offering such a loan product to promoters purely on the basis that the underlying pledged shares are freely trade-able and they will be able to promptly sell the pledged shares on the stock market if things go belly up. However, the recent order of the Supreme Court does not bode well for them as it prevents the lenders from enforcing their security and erodes the fundamental assumption underlying their loans.
Without getting into the merits of this Supreme Court order, the lending community needs to be more vigilant going forward when providing such margin or share-backed loans. In fact, now would be a good time for them to reconsider some points that should be borne in mind when granting such loans.
A crucial aspect is for the lenders to undertake a thorough legal due diligence on the promoter entities that are borrowing the loans and all the entities that are providing the pledge (in case there are multiple entities pledging their shares for the margin / share-backed loan). The due diligence should certainly include a diligence of the corporate documents and authorisations, shareholder agreements and lending documents. If the diligence exercise reveals that consents from any third parties (shareholders, lenders or others) are required for the borrowing or creation of the pledge, it would be prudent and advisable to obtain such consents before raising the debt or pledging the shares. If such consents are not obtained in advance, the risk of any actions by such third parties thwarting any pledge enforcement cannot be ruled out.
Further, the legal due diligence should also encompass a scrutiny of any ongoing disputes that the borrower or security providers are engaged in or any potential disputes threatened against them. It is important for lenders to understand why such disputes are in existence or threatened and what potential liabilities will ensue on the borrower or security provider if the outcome is not in their favour.
For instance, if an insolvency petition has already been filed by a creditor against the pledgor under the Insolvency and Bankruptcy Code, 2016 (IBC) at the time the loan is being provided, then the lender runs a risk of such insolvency petition being admitted and a moratorium being granted on any disposal or enforcement of security on the assets of the pledgor.
This will restrict the enforcement of the pledge of shares created by the pledgor for such loan and, therefore, it may be advisable for the lender to wait and watch rather than provide the loan.
It is also important for lenders to ascertain that the borrower or pledgor has sufficient unencumbered shares available to top up the pledge if the collateral cover falls below the pre-agreed thresholds. The loan documentation should oblige the borrower to maintain sufficient unencumbered shares to meet this condition.
Further, in addition to the customary representations, covenants and events of default, the loan documentation should provide for sufficient safeguards that enable the lenders to enforce their security in a timely manner in advance of any adverse action being taken. For example, the loan documentation could provide for enforcement of the pledge on commencement of a material dispute rather than receipt of a judgement or order.
It is also incumbent on the lenders to closely monitor the progress of the pledgors and the entities whose shares have been pledged. Monitoring should include any sale of shares or further pledges created by the pledgers (based on filings with stock exchanges, review of periodic Demat statements or certifications from independent third parties) to ensure that such sales or pledges in favour of third parties does not adversely affect their loan terms.
Lenders should also regularly keep track of any insolvency petitions filed under the IBC against the pledgor or any of the pledged companies. Petitions against the former could impact pledge enforcement as mentioned above, and against the latter could adversely impact the value of the shares pledged. Appropriate information covenants should also be included in the loan documentation which obligates the pledgor to notify the lenders in such events take place.
While the lending community awaits with bated breath on whether the Supreme Court will have a change of heart when it deals the matter in due course, in the interim, implementing some of the above points as part of the credit appraisal, documentation and monitoring processes can only benefit lenders in the long term.(The writer is a banking and finance partner at J Sagar Associates. Views expressed are personal.)