Behind the Bankruptcy Act and Why Moral Hazard Makes Shareholders Feel Cheated

For long, a joke which was close to reality when it came to the Banking Sector was

“If you owe the bank £100, that’s your problem. If you owe the bank £100m, that’s the bank’s problem”

When equity holders in Electrosteel Steels Ltd were liquidated to the extent of close to wiping out the existing value of their holdings, it came as a surprise for a few analysts who were of the belief that all said and done, equity holders will not be negatively impacted. In fact, many came to believe that investing in the companies which were in the bankruptcy court at NCLT can be bought, given that they will be resolved and companies will be back on the growth path.

Aside: NCLT is the National Company Law Tribunal – a court which decides on things like mergers and demergers and all that. Recently, with the new Bankruptcy act, there’s a process called Corporate Insolvency, where companies that can’t pay back their loans are “resolved”. The resolution process involves getting bids from potential acquirers and then letting the creditors decide which one is good, arbitrated by a resolution professional. Should take around 9 months to clear.

Economics 101 says that Equity has the last claim when it comes to bankruptcy. Only after every other claimant on the assets of the company has been fulfilled would equity get whatever was left to be distributed.

This is not new or not individual to India but is the process that is followed worldwide. But first, a background.

Resolution is not Liquidation

NCLT has a two-step process to try and resolve the situation. In stage one, they try to auction the firm to the bidder who promises to pay a value which is much higher than the liquidation value of the firm.

If the bids are too low or non-existent, it moves with the stage two of the process, i.e., liquidation.

When a firm goes through Liquidation, there is a clear understanding that the equity holders will lose out everything since the company post the process will no longer be in existence.

But there has been a lot of confusion about companies which shall get bought out in the auction and how the existing share-holders are treated.

Fixing A Business Problem

Most of the companies that have entered NCLT Bankruptcy aren’t bad businesses to start with. With the right management and flow of funds, they can be resurrected to their former glory. A key reason for many to have failed has more to do with being over burdened with debt resulting in inability to organize working capital which in turn resulted in lower outputs than what was sustainable. In some cases, there has also been mismanagement and perhaps siphoning away of the debt, by tactics like gold plating capex, or by diverting revenue to group companies and so on.

Steel companies such as Electrosteel / Bhushan Steel and Essar Steel fell prey to the cyclical variation of steel price. Reduce debt today and the company is likely to become profitable.

But resurrection is not free and the new buyers need to pump in substantial amounts of money to enable the company to get back to green. And why will any investor invest significant sums if it doesn’t fetch him oversized returns he expects for the risks he is taking?

The Process

Debt restructuring is not a new idea. Chapter 11 of US is famous for the number of companies who have used the law to restructure their companies. For too long though, India had no such law.

The Indian Bankruptcy Act is modelled after Chapter 11 and Chapter 7 of the United States Bankruptcy Act. The main intention behind Chapter 11 and the Insolvency and Bankruptcy Code, 2016 is to create a way to revive a business to run by selling it to a new promoter. This new buyer will add more capital and so on, and the lenders will write off some of the debt they are owed.

If resolution fails or National Company Law Tribunal is unable to find a outcome within 270 days from the day the company is referred, the next outcome is to Liquidate the company. Sell all its assets, give proceeds to the lenders and shut everything down. (Like US Chapter 7)

The key difference is: companies in the US can work out a deal with its creditors while being under Chapter 11. In India, once a company enters into the Insolvency Resolution process, the management is barred from negotiations unless all outstanding dues are cleared.

The company is run by the Resolution Professional (appointed by the banks who’re owed money) from the day NCLT accepts the application to the day the Resolution plan is approved. This ensures that once a company enters NCLT, operations don’t get impeded or assets stripped due to control exercised by now former management.

In other words, unless the company’s management can find a way to pony up the amount required to be part of the bidding process, they stand to lose ownership of the company.

For way too long a time, small defaulters saw their assets taken over and sold, while large borrowers got more money even when they were in no position to repay the earlier loans. The new bankruptcy act levels that field.

The Moral Hazard For Current Shareholders

Shareholders of the company have a problem. They know there’s too much debt. But if someone “forgives” the debt, the company will be profitable. And as shareholders, they should see a good return. Or should they?

The short answer is: No.

When someone writes off debt they are owed, they should effectively buy shares of this entity. You may not owe me this much money, but I will take a part of your equity for my effort in writing it down. If a company owes Rs. 10,000 cr. in debt, and a buyer is only willing to pay Rs. 2500 cr. back, then the difference is not just “gone”. As a lender I would rather convert it into equity and take that much ownership in the company, worth Rs. 7500 cr.

Then, I might own 80% of the company by myself. The company will then issue a humongous amount of new shares to a new buyer, who will pump in money as equity, so that the new owner now owns nearly all (say 90%+) of the company.

Effectively, 90% of the company is owned by a new promoter, and of the rest, 3/4th is owned by banks (or financial lenders). Only the remaining tiny amount of shares is owned by existing shareholders. This is such a tiny amount that even if the company were to revive the current shareholders will see nothing.

This should have always been the case.

The Bad Way In The Past

But in the past India has mollycoddled equity investors. Wockhardt borrowed money from FIIs and then couldn’t pay back. It forced lenders to write down the debt – effectively saying, you gave us 100, but we’ll only return 35. Most CDR schemes were similar – they would “forgive” debt but not convert the forgiven amount into equity.

Which meant that debt people just said it’s okay for us to lose that money; let’s move on. But equity shareholders got no downside! Now, the same company, with lower debt, carried on to being more profitable, and none of that upside was seen by the lenders themselves, who forgave the debt.

What should have happened is that debt holders should have gotten themselves big chunks of the company, so that they could get at least a part of the recovery that the company would go through.

But there were good reasons for that – SEBI didn’t allow an issue of shares unless all shareholders approved. And sometimes the debt was so high that lenders would end up buying more than 26% of a company, which triggers SEBI Open offer regulations (everyone else can sell to the banks for the same price, which the banks may not want). Plus SEBI doesn’t allow anyone to buy more than 75% of a company. And then RBI had rules that disallowed any bank from owning more than 10% in a company. So debt conversion to equity was frowned upon – they just forgave the debt.

The moral hazard: equity shareholders now think they are isolated from debt restructuring.

But things have changed.

The new act sees these problems and, in the new bankruptcy law:

• RBI has eased up and allowed banks to own more stake in companies
• SEBI has ditched the takeover regulation for a 26%+ acquisition
• SEBI has said it will remove any hurdles like the 75% promoter rule or any other disclosure requirements
• The act itself needs no shareholder approval of anything in a bankruptcy

The old rules no longer apply – and the lenders can convert to equity, own a significant chunk, and sell even more shares to a new promoter.

This changes the structure – now equity holders can be diluted, and diluted a lot. But there’s another thing:

The Promoter’s Moral Hazard

The old fraud idea was simple.

• Take lots of loans.
• Don’t pay them back.
• Go to Corporate Debt Restructuring and what not.
• Tell the banks you’ll pay 60% less.
• Banks say ok. What choice do they have? 40% versus zero. And liquidation can take years.
• Continue to run the company as a promoter and no dilution in equity.

And repeat, as many times as possible. (With due credit to the Ruia group for the inspiration)

But things here too have changed.

The Bankruptcy law now tells banks simply: Get rid of the promoter. Meaning, don’t let him, or his relatives, buy the company back after you take a hit. So promoters can’t even bid even though they know the company well enough. Unless they do one thing: pay back the loans they owe.

The idea is that if a promoter feels that he’s going to lose his company, he might suddenly find the money to pay back.

And indeed, this has happened in some cases. In Uttam Galva, a defaulter where the promoter was ArcelorMittal, the dues to banks were bad loans. Arcelor Mittal, however, is considering paying off the loans to avoid them being disqualified from bidding for other companies in the bankruptcy process.

Existing Shareholders: Is Bankruptcy a boon or bane?

Coming back to the main topic: should the current shareholders of these bankrupt companies worry?

We say Yes. We have said this in two past posts:

• Companies may survive, shareholders still lose: Monnet Ispat Edition
• Banks take a hit, shareholders a bigger hit: Electrosteels Steels Edition

This makes it amply clear that the dilution means that current shareholders have little upside.

Here’s the real example of how it will work. The Electrosteel resolution.

How Electrosteel Steels Will Resolve

Vedanta won the bid for Electrosteel Steels.  Thanks to Vedanta being listed on the London Stock Exchange, we can now get some insights with regard to the process. Here’s their full document on the process of transition.

Here’s the situation :

• Electrosteel Steels has 240 cr. of shares outstanding.
• It also has over 14,100 cr. due to creditors.
• It is bankrupt.

Vedanta will now take over the company. Like this:

• First, Rs. 7600 cr. of the debt will be converted to shares at a rich price of Rs. 10 per share (current market price is Rs. 1.5, so this looks rich indeed)
• That means 750 crore more shares will be issued to bankers.
• Now bankers have 760 cr. shares, current shareholders 240 cr. shares.
• Bankers effectively own 76% of the company.

Now the dilution.

• Electrosteel will then “consolidate” shares – and give you one new share for 50 old shares.
• That means the total of 1000 cr. shares will become 20 cr. new shares.
• Of this, around 15 cr. shares are with banks
• Remaining 5 cr. shares are with existing shareholders.

Then the buying in:

• Electrosteel will then get a fresh investment of Rs. 1800 cr. from Vedanta.
• At a price of Rs. 10 per new share. Remember one new share = 50 of the current shares. Effectively, the current share is valued at Rs. 0.2.
• So now, there are 180 cr new shares with Vedanta. (90%)
• And there are 15 cr. shares with banks. (7.6%)
• And there are 5 cr. shares with current shareholders. (2.4%)

Then the returning of the bank money:

• Banks get back Rs. 5320 cr.
• Part of this is the 1800 cr. Vedanta has put in as equity
• Another part is Rs. 3500 cr.+ that Vedanta gives the company as debt.

That’s not all.

• Vedanta will delist Electrosteel steels from NSE and BSE.
• Shareholders will be paid as per an evaluation matrix. In all probability this is Rs. 10 per new share, and that is equal to Rs. 0.2 per current share. 

Which means this: As an existing shareholder, you would not buy this at any level above Rs. 0.2 per share, or 20 paise per share.

Banks have to then take a loss of Rs. 9.8 per current share (remember they buy in at Rs. 10) which is like a Rs. 7500 cr. loss for them. But they do get some money back from Electrosteel.

But What About SEBI?

SEBI has to relax its regulations. Otherwise no one will bid.

Banks have to get some equity – however small – for their investments.

Even a company like Bhushan Steel is likely to see this. An Economic Times article (not verified) says that Bhushan will issue 120 cr. shares to Tata Steel for Rs. 180 cr. – valuing the current company at Rs. 1.5 per share. Further, it could buy up another 4500 cr. shares at Rs. 2 per share.

That would mean the current equity shareholders, holding just 22 cr. shares in total, will own less than 0.5% of the eventual company. Even if it were to be valued at Rs. 20,000 cr. later, the 0.5% means the current shareholders are collectively worth just Rs. 500 cr. – which is just about the current valuation of the company in the market.

And SEBI will have no restrictions on this – delisting, promoter ownership or dilution wise.

Existing Shareholders: Stay Away

I could summarize this entire article in one phrase: “Stay away, you’ll lose nearly all your money”.

But there are too many people who seem to want to buy and believe there is value in owning these companies today.

And it’s because of the past, the moral hazard where equity shareholders got away scot free when debt writedowns were taken, that these expectations exist.

Those circumstances have changed. You are no longer a ‘small, helpless retail investor”. You are supposed to understand and know these things when you buy in. Especially in companies that are, quite literally, bankrupt.

It may be better for SEBI to put these companies into a high-margin segment: where if you buy Rs. 100 worth of shares, Rs. 500 worth of margin is collected from you as long as you own these shares. And that you can’t “intraday” trade them – you have to buy only if you have the full money, and sell only if you already own them.

But while we wait for that to happen, we would encourage you to understand this process deeply, and why we believe there is no major value in the shares going forward.

Disclosure: We have no interest in any of the stocks mentioned above.