MODULE 4: BASICS OF DEBT SECURITIES AND PROJECT FINANCE Class Notes: Banking and Finance Law UpGrad Blended LLM Programme (2022) Faculty Instructor: Prof. Shuchi SinhaDEBT SECURITIES - OVERVIEW What are Debt Securities? + An instrument of debt executed by the issuer company acknowledging its obligation to repay the sum at a specified rate and usually also carrying an interest. It is one of the methods of raising the debt capital of the company. + They are like a certificate of loan evidencing the fact that the company is liable to pay a specified amount (usually with interest) ~ the amount of loan generally corresponds to the issue price of such debt security, + Current Indian market ~ Bonds and Debentures — most commonly seen debt securities.+ Example: When a company issues a debenture, the investors that purchase the debenture are effectively lenders that provide the company with debt financing. So, if a person buys a debenture having a maturity of 5 years, issued by company X at the issue price of Rs. 100 with a coupon rate of 5% p.a — that means that this investor has given a loan of Rs. 100 to company X and accordingly, the company will: + Firstly, pay an interest on this loan (this is the coupon rate, which is 5% pa) and + Secondly, on maturity, will have to pay back the principal amount, which is Rs.100 (*maturity” — also referred to in terms of the Redemption Date, essentially means the completion of tenure or life of this type of loan), + If the issuer company goes into insolvency / bankruptcy, debenture holders, being a category of lenders, have a higher claim on any liquidated assets than shareholders. For example, Section 53 (Distribution of Assets) of the Insolvency and Bankruptey Code, 2016 (“IBC”), which provides for the priority of payments in the event of liquidation, puts the claims of creditors (both secured and unsecured) above those of equity shareholders. + Further, the definition of “financial debt” at Section 5(8) of IBC provides that such term “means a debt along with interest, if any, which is disbursed against the consideration for the time value of money and includes”... “(¢) any amount raised pursuant to any note purchase facility or the issue of bonds, notes, debentures, loan stock or any similar instrument; ... [ ]”*+ Debentures are issued in accordance with the “terms of issuance” of the debt security (this may be included with the debenture certificate) — this includes the contractual details for the debt finance such as, repayment of the principal sum on a date upon maturity of the debentures with the payment of interest at a rate which is also specified. * Such obligations to their debt security holders are also reflected in the financial statements of the company.Debt securities — a safer investment? * Debt securities, particularly secured ones, are seen to have an implicit level of safety s because they impose an obligation that the principal amount is returned to the lender (ie. the holder of the bond or debentures) - at the maturity date or alternatively can be earned back by that lender upon the sale of the security. + Classification/ rating of debt securities — issuers undertake such classification at their cost (particularly required for listed debt securities), and it serves as an important tool for investors 10 make the decision to purchase them. Rating takes into account various factors, including issuer's operational efficiency, level of ‘technological development, financials,’ competence and effectiveness of management, past record of debt servicing, etc. * In India, there are a number of credit ratings agencies that are regulated by the SEBI under the SEBI (Credit Rating Agencies) Regulations, 1999 (last amended on August 3, 2021). A list of such registered agencies can be viewed at + For example, AAA rated bond or debenture — will be deemed as one with very low risk of failure to pay coupon rate or redeem the security by the issuer. * As a practical matter, to sweeten the deal and raise demand for less highly rated securities, it is often scen that the riskier the bond/debenture, the higher its coupon rate or return yield (conversely, the better rated securities tend to be low yield or low coupon rate securities).WHAT ARE BONDS? + Bonds are included within the definition of debentures under the Companies Act, 2013. + Section 2(30) of Companies Act, 2013 provides th: “debenture” includes debenture stock, bonds or any other instrument of a company evidencing a debt, whether constituting a charge on the assets of the company or not; [Provided that— (a) the instruments referred to in Chapter II-D of the Reserve Bank of India Act, 1934; and (b) such other instrument, as may be prescribed by the Central Government in consultation with the Reserve Bank of India, issued by a company, shall not be treated as debenture; ] + A debenture (also including bonds) is simply a financial instrument through which the issuer (e.g. the borrower company) raises finance through the debt route. + In Module 3 we discussed the benefits of equity vs debt financing for the borrower ~ similar benefits would apply to debt financing through bonds and debentures.COMMON FEATURES OF DEBENTURES AND BONDS [contd. in next slide] = Secured or Unsecured — just as in the case of any other type of loans similar to the discourse in Module 3. * Short Term or Long Term ~ thus, there are bonds having maturity as low as 90 days while there are NCDs with maturity of 10 or 15 years or even government bonds with longer maturity in the market.* An interesting note / faetoid: a specific type of debt security is permitted by RBI and particularly used by banks to shore up their Tier I eapital (Additional Tier” or “AT-I” Capital as preseribed under the Basel Norms, which are without any specified maturity ~ these are refered to as Innovative Perpetual Debt Instruments (IPI) Perpetual Debt Instruments (PDI) and in common parlance as “perpetual bonds”. They tend 10 ‘only have a “call option” after a fixed number of years ‘Such perpetual bonds have been in the news revently as on March 10, 2021, SEBI issued a circular requiring the maturity of such bonds to be deemed as 100 years for purposes of valuation. However, this directive was addressed by the Finance Ministry, which reportedly requested SEBI inter alia: “Considering the capital needs of banks going forward and the need to source the same from the capital markets, itis requested that the revised capital norms to treat all perpetual bonds as 100-year tenor be withdrawn,.". However, Association of Mutual funds in India (AMED), a self-regulatory organisation and a trade body, representing the mutual fund industry, sided with SEBI. SEBI subsequently agreed to have this requirement come into effect only in 2023. Ina statement, SEBI noted thatthe deemed residual maturity of Basel II additional tier-1 (AT-1) bonds will be 10 years until March 31, 2022. It also mentioned that the maturity period will be increased to 20 and 30 years over the subsequent six-month period, From April 2023 onwards, the residual maturity of AT-1 bonds will become 100 years from the date of issuance of the bond. (**as per news reports]= Coupon Rate or Zero Coupon — Debt securities with or without interest (coupon rate) payable. = Discounted or Full Price — Discounted simply means that the bond or debenture is being sold at a price below its issue price. > Practically speaking, zero coupon bonds or debentures would tend to also be discounted bonds or debentures. > Example, if a company were to offer a 60-day maturity zero coupon bond at its issue price of Rs. 100, it may not find many takers ~ but if zero coupon rate is combined with a discounted price, it would make it worthwhile for investors to subscribe to it. For example, if the same 60- day maturity zero coupon bond is offered by its issuer at a discounted price of Rs. 95, but would be redeemed at the actual price of Rs 100 after 60 days. In this case, the investor makes a profit / return based on the difference between the discounted price it is purchased at and the full price it is redeemed at. Thus, you will tend to see zero coupon rate bonds or debentures also being discounted bonds or debentures,= Bearing Fixed Rate or Floating Rate interest — Like any other types of loans, the coupon rate of such debt securities can be fixed rate or floating * Convertible or Non-convertible ~ Such debt securities could be partly or fully convertible into other types of securities, including equity shares at certain pre-agreed times that will be specified in the terms of such debt security. In such case, the issuer will continue to treat is as a debt instrument until the time of conversion. + Have a Put Option or Call Option — See examples below to provide an overview of how such options attach to debt securities Example (Call Option): If Company X issues bonds with a call option, it gives the iss X an option to call back the bond before its maturity (after a specified time period — e.g.: 3 years / 5 years etc. — as per the terms of such bonds) by paying back the principal amount.> A “put option” in a debt security, e.g.: a bond, gives the bond holder the right to enforce repayment of the principal amount before the maturity period. Such a Bond can thus be “PUT” to the issuer at certain pre-agreed points of time in accordance with their terms of issuance. > This can be an attractive flexibility to a debt security and the issuer may embed a put option in the terms of the debt security to entice the prospective investors to purchase the bond or to give some additional feature which offers a benefit to the purchaser to balance out some not- so-attractive features. * Be issued via Private placement or Public offer — Similar to equity shares, debt securities can be issued to the public at large via a public offer as well as on a private placement basis to a select group of investors. > However, in the case of debt securities, debentures, bonds etc. issued on a private placement basis can be then listed on the stock exchange without undertaking any public offer.= Listed or Unlisted — Debt Securities can be listed or unlisted (similar to equity shares). = Legal Not >The regulatory regime for listing of equity shares and debt securities is separate and companies are not mandatorily required to become “listed companies” (whose shares are available for trading in the stock exchange) to list their debt securities and they can also do so via the “private placement” route. > An additional route for listing of debt securities - “Private placement” route whereby no public offer is made, and debentures or bonds issued privately can be listed on the exchanges afer a private investor has purchased them,GOVT. ISSUED SECURITIES IN INDIAN MARKETS - OVERVIEW WHAT IS A G-SEC? = A Government Security (G-Sec) is a tradeable instrument issued by the Central Government or the State Governments that acknowledges the Government's debt obligation, * Such securities may be short term (usually called treasury bills, with original maturities of less than one year) or long term (usually called Government bonds or dated securities with original maturity of one year or more) = In India, the Central Government issues both, treasury bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). = G-Secs are deemed to carry practically no risk of default and, hence, are called risk-free gilt- edged instruments.KEY TYPES OF G-SECS INCLUDE: * Treasury Bills (T-Bills): this are short term (91, 182 or 364 days tenures), zero coupon, discounted bills issued by the government to meet short term financing needs. Cash Management Bills (CMBs): these are similar to T-bills but issued for tenures of less than 91 days for temporary gaps in government’s financing needs. Dated Government Securities: these are long term bonds with coupon payments at fixed periods (usually half-yearly) and tenure may be as long as 40 years, State Government Loans (SDLs): these are dated securities issued by the State Government having long tenure with coupon payments at similar intervals, Apart from central and state governments, local governments and government owned public utilities & enterprises /PSUs can also issue bondsNON — GOVERNMENT ISSUE OF DEBT SECURITIES - OVERVIEW = These include debt securities issued by private entities and companies (i.e., those that are not government owned or controlled) = In the non-governmental debt securities market, the commonly seen instrument is debentures. + Example — In 2021, Shriram Transport Finance Company Limited reported issuance and allotment of secured, listed, Non-convertible debentures (“NCDs”) of the face value of Rs10 lakh each on a private placement basis in 2 lots, aggregating to approximately Rs 1800 crores. = Also in 2021, DLF Cyber City Developers Ltd. raised Rs 1,000 crore through private placement of listed, secured NCDs at 6.7% annual fixed coupon maturing in September 2024. = Itmay be noted that there is no blanket rule regarding which categories of entities undertake is of bonds v debentures: a number of public sector companies and entities also issue debentures, while non-public sector companies may also issue bonds. = However, in recent times, it has been generally noticed in the market a tendency that non-public sector companies often opt for issuance of non-convertible debentures or “NCDs” as the preferred debt security. = Thus, the form of instrument often seen as being issued by this sector tends to be debentures that are: non-convertible, secured, issued on a private placement basis, and listed post issuance.+ Some Key Laws for secured NCDs issued on private placement basis and then listed include 1 The Companies Act, 2013 — Sections 71 (which prescribes requirements for issuance of debentures by companies) & 42 (which covers issuance of securities as private placement), 2 Rule 18 of the Companies (Share Capital and Debentures) Rules, 2014, which prescribes further requirements in respect of debentures to be issued by a company, including rules for issuance of secured debentures. 3 SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 SEBI’s Operational Circular for issue and listing of Non-convertible Securities, Securitised Debt Instruments, Security Receipts, Municipal Debt Securities and Commercial Paper (August 2021) SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 SEBI (Debenture Trustees) Regulations, 1993 SEBI (Prohibition of Insider Trading) Regulations, 2015. SEBI Circular on Electronic Book Mechanism for issuance of debt securities on_ private placement basis (also, NB: BSE and NSE have their own Operating Guidelines for their Electronic Bidding Platform).NB: Apart from the above, depending on saws (i) _ the sector of the issuer company, (ii) the category of investor, e.g.: a non-resident investor as a Foreign Portfolio Investor and (iii) specific features of the deal, various other statutes and regulations may also apply.Recent Changes to Legal & Regulatory Framework + The key change to the regulatory framework came about when on 9th August 2021, through Notification no. SEBI/LAD-NRO/GN/2021/3, SEBI, merged and repealed 2_ erstwhile regulations, namely SEBI (Issue & Listing of Debt Securities) Regulations, 2008 (“ILDS Regulations”) and SEBI (Issue & Listing of Non-Convertible Redeemable Preference Shares) Regulations, 2013. + The ILDS Regulations had up to this date been the key regulation governing listed NCDs/ bonds etc., whether on a private placement basis or by way of a public offer. However, they stand repealed and: + The SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 (“Debt Listing Regs 2021”) are now the applicable regulations. + On August 10, SEBI also issued its: Operational Circular for issue and listing of Non-convertible Securities, Securitised Debt Instruments, Security Receipts, Municipal Debt Securities and Commercial Paper.In September 2021, SEBI introduced amendments to Listing Obligations and Disclosure Requirements (LODR) Regulations, 2015. One aspect of these amendments is to align references of various terms under LODR to the recently introduced Debt Listing Regs 2021. Further, through these amendments, SEBI has now extended some provisions that were previously applicable only to equity listed entities to certain high value debt listed entities (i.e., those which have listed their non-convertible debt securities with an outstanding value of Rs 500 crore and above). Further, the existing compliances under Chapter V of LODR, applicable to all entities that have issued listed non-convertible debt securities, have been enhanced and made more frequent with clearer timelines for making such disclosures. These amendments make the new requirements on ‘comply or explain’ basis till March 31, 2023, after which compliance will be mandatory. Additionally, SEBI on October 8, 2020, also issued an amendment to the SEBI (Debenture Trustees) Regulations — aimed to enhance and make more efficient the role of the debenture trustee (DT) in investor protection, Further to the above, there have been some other amendments to the law including inter alia that SEBI vide its circular dated November 3, 2020, has issued guidelines on creation of security in respect of listed debt securities and due diligence to be undertaken by DTs.Recent Changes to Legal & Regulatory Framework - 2022 On April 11, 2022, SEBI amended / modified the rules pertaining to debenture trustee norms (vide the SEBI (Debenture Trustees) (Amendment) Regulations, 2022), apart from the issue and listing of non- convertible securities norms and also the LODR, according to three separate notifications issued by SEBI. Under these notifications, among other changes, SEBI has altered the rules to align the framework and terminology with respect to ‘security cover’ wherein the term ‘asset cover” has been substituted with term ‘security cover’ in debenture trustee rules and LODR norms. Another change is that SEBI has redrafted rules prescribing the maintenance of security cover sufficient to discharge both principal and interest thereon. Further, SEBI has rationalised the disclosure requirement with regard to credit ratings and put in place the requirement of a due diligence certificate for unsecured debt securities in the (Issue and Listing of Non-Convertible Securities) rules. Source: tps. sehi goin Tegallrepulations‘pr-2022 sebi-ssue-andlsting-of-non-convertible-securtes-amendment-epulatons= 2022_57986,b4ml hhupsi/www sobi gov inTegaregulations/apr-2022 2022_57988,himl hupsi-www sebi gov in/egal/regulations/apr-2022/sebi-debenture-trusces-amendment-epulatons-2022_$7987.html ng-obligaions-andiselosure-requirements-thin-amendment-regulations-PROJECT FINANCE Project Finance refers to financing the development of a project or exploitation of a right- typically a large project in the infrastructure, power, energy, oil extraction and similar sectors (referred to as the ‘Project’), where the bulk of capital is provided by way of long-term debt and all amounts due under the loan are paid with the revenue cash-flows of the project itself. Unlike in the Corporate loan scenario (which includes bilateral term loans as discussed earlier), the borrower in a project finance arrangement does not repay the loan from its own funds. so enormous differences in scale, value and tenure of the loan as all of these tend to be project finance, given the nature of the projects being financed. There are a very large Examples Of Project Finance Deals — + Nagpur Mumbai Super Communication Expressway Limited, which borrowed about USD 4 billion from a group of banks. = Ada ower (Jharkhand) Limited which borrowed approx. USD 1.2 billion for a thermal power project. + HPCL-Mittal Energy's 18 million metric tonne per annum petrochemicals complex. of estimated USD 2 billion.In practical terms, Project Finance is ~ long-term financing of large, long-gestation and highly capital-intensive projects, where the lender group’s decision to give the loan is based upon the projected cash flows of the project rather than the balance sheets of the borrower company or its sponsors (sponsors here would generally refer to its promoters). ‘A project financing structure — involves a promoter or sponsor entity (or a group of them), which has been awarded the right to develop the project in question, commonly referred to as “sponsors”, and for the financing, a consortium (group) of banks or other lending institutions that provide loans to the operation. A standard approach is that an independent legal entity is incorporated (often with a finite life) by the promoters/sponsors specifically and with a sole purpose of executing the project. One of the main tasks in a project finance negotiations is to mitigate and allocate the risks between the parties (“participants”). It may be noted that by its very nature, any project finance deal involves various risks, such as environmental risks, market risks, supply related risks, etc. Set out below is an indicative deal sequence illustrating a commonly observed type of project finance deal scenario. However, it may be noted that this is a type of deal sequence that is commonly observed for project finance, but is not a blanket rule / deal sequence and there may well be variations across specific project finance deals. [EXAMPLE OF / INDICATIVE DEAL SEQUENCE: SEE NEXT SLIDE]INDICATIVE PROJECT FINANCE DEAL (E.g.:) + As a first step, the sponsors would set up a special purpose entity with minimal capital, which would be the project company and this company would undertake the project. It would be this company (‘SPV’/ ‘Project Company’) that is also the borrower for the project financing loan. + In this manner, the sponsors seek to limit and enclose all liabilities for the project in a separate corporate entity, the SPV or Project Company - so that the assets of the Sponsors are not on the line against the loan, nor do the Sponsors have to repay it. This is referred to in project finance jargon as “ring-fencing” and the SPV is the entity in which such liability is ring- fenced (thus shielding the assets owned by a project sponsor from the detrimental effects of a possible project failure).Subsequently, the SPV would enter into contractual agreements with numerous other parties necessary to the project. The contracts form the framework for project viability and control the allocation of risks. There are various contracts are involved with a number of related parties, such as BOT (Build operate and transfer), BOO (Build own and operate, BT (Build and transfer), BDOT (Build, develop operate and transfer). The SPV would also enter into negotiations with the host government to obtain all requisite permits and authorizations, e.g. an oil or gas production licence, a mining concession, or a permit to build and operate a power plant.While in many countries, such loans are on a “non-recourse” basis with respect to the lenders (i.e., sponsors have no liability or responsibility to the lenders), in India it is more commonly observed that such deals tend to have partial or limited recourse project finance loans, where the sponsors have to take on certain contractual responsibilities and some risks are allocated to them by way of contract with the lenders. The overall project finance arrangement would incorporate various mechanisms for risk allocation between various Project participants through contracts. The structure of such deals is that the loan is primarily secured by the project assets and paid from project cash flow of the project once it becomes operational, rather than the assets or cash flow of the project company or from the general assets or creditworthiness of the project sponsors. The financing is typically secured by all of the project assets, including the various types of contracts relating to the contract (many of which generate revenues for the project). Project lenders are given a security interest on all of these assets and will also contractually take the right to assume control of a project (“Step-in Rights”, usually contained in a "Direct Agreement”) if the project company has difficulties complying with the loan terms.KEY FEATURES OF A PROJECT * Such projects are Long Term and have a very lengthy gestational period before they become even operational, let alone generate surplus revenues or profits * The SPV or Project Company is Highly Leveraged — i.e. the amount of debt is extremely high in comparison to its own funds (primarily represented by its equity capital base). * The project is extremely Capital Intensive and thus the financing of it requires relatively very high value loans.COMPARING AND CONTRASTING PROJECT FINANCE WITH CORPORATE LOANS (such as BILATERAL TERM LOANS) * Firstly, the borrower company in a corporate loan may be a multi-business or multi- purpose organisation that may undertake numerous streams of business, but the SPV in project finance is precisely that: a Special Purpose Vehicle and is incorporated solely for ihe single purpose of undertaking the project, * Secondly, the tenure of a corporate loan tends to be shorter than that of project finance loans. * Thirdly, lender supervision of borrower in a corporate loan is minimal. Loan agreements may provide some general principles for conducting the borrower's operations e.g: compliance with law / maintaining all required licenses etc. but, the lender is not concerned with the day to day running of the business as long as it gets all payments due at the prescribed times. However, given the nature of project finance, the risk of project failure and the high value of ihe loan, the lender group in such a transactions would have a very high degree of supervision on the running of the Project by the project company.DOCUMENTATION IN PROJECT FINANCE > Loan agreement, which can be by way of: i. Joint Loan Agreement (between SPV and all the lenders), or ii Common Terms Agreement (between SPV and all the lenders) + Bilateral Loan Agreements (SPV with each lender), > Sponsor Support Agreement, whereby certain responsibilities are allocated to the Sponsors, and Sponsors undertake various obligations in respect of the Project Company > Trust and Retention Account Agreement » Security Documents — note that apart from the standard documents like v Mortgage ¥ Hypothecation ¥ Pledge and further, the security documentation would be likely to include a ¥ Direct agreement (discussed further below)DOCUMENTATION IN PROJECT FINANCE — contd. As an additional note on security, the security package in a Project Finance arrangement usually expands greatly on that of a bilateral term loan and includes not just the immovable and movable property, shares of the SPV, all bank accounts and other such assets (commonly secured for corporate loans) but also — among other items — all the rights of project development awarded to the Sponsors and being exercised through the SPV as well as all approvals, licenses and other operating permits Intercreditor agreement: an agreement executed among all the lenders, setting out how they will lation to each other (as part of the lender group) and describing their tions with respect to each other in implementing the financing arrangements. It can include provisions specifying the manner in which a default may be declared, how the security will be enforced and proceeds applied among the lenders, the process to grant waivers, or to make amendments to the loan agreements and security documents. IN THE SLIDES TO FOLLOW, A BRIEF OVERVIEW OF CERTAIN DOCUMENTS THAT ARE SPECIFIC TO PROJECT FINANCE ARE PROVIDED:SPONSOR SUPPORT AGREEMENT: > Sponsor(s) are typically required to give undertakings to the lenders for the following: ® for non-divestment of equity in the project company * for making equity contributions to maintain the applicable Debt-Equity ratio in the Project Company = agreement to subordinate sponsor debt = infusion of capital in the project company to meet ‘cost-overrunTRUST AND RETENTION ACCOUNT AGREEMENT (TRA) * Cash flows of the Project Company are subject to TRA arrangement + All proceeds, equity contribution and/or all operational revenue received - deposited in the Trust and Retention Account, which is a bank account with various sub-accounts opened specially for this purpose + Funds are subject to “waterfall” for payments and utilized in established order of priorityDIRECT AGREEMENTS = Direct agreements contain a unique form of lender rights ~ and contain a unique set of rights under the Step-in provisions = “Step in” refers to the right of lenders in certain circumstances to step-in to the Project Company's shoes = However, this is usually subject to the approval of the Government’ Governmental Authority/ Regulatory Body that awarded the project to the Sponsor, as well as: = Consent of others signment from project counterparties such as suppliers, contractors and End Note: Thus, project finance is a distinct form of financing that has been developed for the financing of these specific types of projects and has a number of unique features, as briefly summarized above.END OF MODULE 4 CLASS NOTES NB: All persons referring to the contents of these Class Notes (‘notes’) (comprising 31 slides of this PPT) are advised to independently verify the same and to further check the legal position for any updates and/or amendments to law / practice: the contents of these notes are indicative and are to be used as a preliminary reference point for independent study by the students with whom it has been shared. The contents of these notes are not to be deemed as legal advice under any circumstances. These notes may be used purely for purposes of assisting students to organize and systematize their independent study and research on banking & finance law. These notes is not to be circulated beyond the student group to whom it has been provided without the permission of the course instructor (Prof. Shuchi Sinha).