Revised regulations on due diligence for listed debentures

By Sawant Singh, Aditya Bhargava and Sristi Yadav, Phoenix Legal
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In November 2020, the Securities and Exchange Board of India (SEBI) issued a circular on due diligence to be carried out by debenture trustees on security for listed debentures. The circular prescribed additional obligations and compliance requirements for trustees and issuers of secured debentures. The implementation of this circular was brought forward to 1 April 2021.

Sawant Singh,Phoenix Legal
Sawant Singh
Partner
Phoenix Legal

While the SEBI (Issue and Listing of Debt Securities) Regulations, 2008, and the SEBI (Debenture Trustees) Regulations, 1993, require due diligence for security for listed debentures, the circular prescribes more detailed and enhanced requirements. It now requires issuers to provide greater information and documents to the trustee regarding assets to be charged to secure debentures. These include details of existing charges, title search reports, consent from existing charge holders, and undertakings from issuers on whether the assets to be charged are unencumbered or are already charged. Trustees can also ask for additional information in relation to the creation and perfection of any security.

The circular takes an expansive regulatory approach on personal and corporate guarantees, which now have to be supported by enhanced documentation. An issuer must provide details of the guarantor, the financial information and assets of the guarantor, consents, conditions, and details of any previous guarantees provided. For pledges of securities, statements and undertakings from depository participants are required.

The circular requires trustees to verify that assets on which issuers intend to create security are free from encumbrances, or that consents have been obtained from existing charge holders. If such consents have to be obtained by the issuer, the trustee must verify that they have been validly obtained. Trustees must inform existing charge holders of the proposed security creation and seek their comments or objections. Where personal or corporate guarantees or any other form of security are provided, the trustee must verify filings made to any authorities and obtain certification from statutory auditors or chartered accountants to confirm the ability of the guarantors to provide the guarantees. The terms and conditions of due diligence must be set out in the agreement to be executed between the trustee and the issuer.

Aditya Bhargava,Phoenix Legal
Aditya Bhargava
Partner
Phoenix Legal

The trustee must prepare or obtain reports and certifications, including valuation reports, title search reports, and asset cover certificates, and independently assess whether the assets to be charged adequately secure the debentures. Once the consents required for the creation of a security have been obtained, and the appropriate disclosure of the security and other covenants in the offer document have been made, the trustee may issue a due diligence certificate in the format prescribed in the circular. This certificate has to be disclosed in the offer document.

While SEBI regulations give the impression that security can be created within 90 days after the issue of listed debentures, the circular appears to require security to be created upfront to the satisfaction of the trustee before the application for listing. This is a curious step as it may raise jurisprudential questions on possible conflicts in the circular and SEBI regulations, and may consequently also result in judicial challenges on the validity of the circular.

The circular appears to be a reaction to the recent turmoil affecting certain non-banking financial companies, and questions raised on fundraising and security creation. However, the relatively harsh measures introduced by the circular have raised eyebrows. Some stakeholders believe that while such measures are appropriate for debentures offered to the public and retail investors, these may be counterproductive for privately placed debentures, which are generally offered to institutional investors and rely on freedom of contract and nimble execution. The circular appears to address through regulation matters that should instead be a part of best practices and sound risk management. While the circular is an investor friendly step, it may need to be re-evaluated if it results in constricting the issues of listed debentures.

Sawant Singh and Aditya Bhargava are partners at Phoenix Legal. Sristi Yadav, an associate, also contributed to this article.

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