There are some important lessons to draw from the insolvency proceedings of the largest Indian auto-grade steel manufacturer Bhushan Steel.
--BY KAMESH SUBRAMANIAN AND H SUCHANDRA MUNDUL
There are numerous articles, blogs and write ups that are already present on why Bhushan Steel went into bankruptcy and what ensued after that. The attempt here is to give a consolidated picture of when the debt crisis started, what was the trigger that forced RBI to take a hard look at the way banks were treating their NPA’s and what prompted the Central Government to create the Insolvency and Bankruptcy code (IBC) in India.
The Steel industry in India in tandem with the global trend has been suffering for the last few years. Many players in this industry have been suffering to a great extent as the demand for their products have dipped. These players were not even able to generate sufficient cash to service their borrowings from banks and financial institutions. We have chosen Bhushan Steel as a case in point to discuss how and when the financial difficulties of Bhushan Steel started and what ensued later.
Bhushan Steel’s stock price had soared to a record of INR 508.9 in November-11-2013. Little did the company know that its stock would take a massive beating merely days later. The incident was the blast furnace explosion at its Odisha Plant on Nov 13 2013. Within less than a year, the company’s share price had fallen by more than 70 percent to INR 112. This was not the beginning of the company’s troubles. Their troubles had begun well before 2013 and the blast furnace incident only served to further intensify the difficulties.
The company’s problems began in 2010-11, post the completion of its first phase of expansion. Nearly three fourths of its capacity expansion had been funded by debt, leading to the company’s debt doubling to INR 15,433 crores over a short span of two years. Moreover the company’s debt maturity profile took a significant turn for the worse from 2010-11.
Short-term debt which in prior years was a miniscule portion of its total debt, showed a considerable increase 2010-11 onwards. Another cause for concern was the poor cash conversion ratio of the company when its profits were growing at a healthy rate. The question that arises here is why? While its operating profits grew at a brisk CAGR of 30 percent from 2008-11, its operating cash flows were only around 50 percent of its total operating profits. During the years of high revenue and profit growth, Bhushan Steel had minimal cash and short-term investments. It was highly dependent on cash generated from operations and additional net borrowings to meet its debt repayment obligations. Again a warning sign that all was not hunky dory as the company claimed.
At the time of completion of capacity expansion, global steel prices were on a massive downward spiral. Steel prices had fallen from a peak of USD 1,265/tonne in 2008 to USD 300/tonne in 2012. The huge decline in steel prices was partially offset by the massive capacity expansion undertaken by the company during the period. When there is a steep decline in steel prices, revenues tumble. In lieu of that, margins will also take a hit as the raw material cost may or may not follow the same trend as the steel prices. In layman terms, margin is (SP-CP)/CP. Thus, if the company has already utilised most of its capacity, it won’t have the privilege of limiting the losses to even some extent. The example below shows the effect of decline in steel prices in both scenarios.
Revenues had grown at a CAGR of 24 percent and operating and net margins had increased by around 7 percent and 1 percent respectively during the period (2008-12) At the close of FY-2012, the company’s financials was faring well, as evidenced by its healthy interest coverage ratio of 3. While volatile, the cash conversion ratio (Operating cash as % of operating profits) was showing an overall upward trend.
However given the downtrend in the steel industry, the desirable strategy would have been for the company to consolidate rather than further expand its operations. Bhushan Steel defied conventional logic and went ahead with its second phase of expansion from FY-2012. Surprisingly, Equity markets were rewarding companies with aggressive expansion plans while ignoring the risks related to these.
Hence, despite the huge amount of debt already sitting on its books Bhushan steel further borrowed to finance its second phase of expansion in its Odisha plant. The stock market was enthused by the company’s aggressive expansion plans, leading to its shares touching an all-time high of 508.9 (split adjusted) in November 2013. However, this dream run on the bourses was severely affected post the explosion at a blast furnace in its Odisha plant. The company was soon ordered by the Odisha State Pollution Control Board to shut down its blast furnace. It was almost after a period of six months that the company could resume operations in its Odisha plant. It also led to the escalation of its financial difficulties and debt obligations. This was just the beginning of the seemingly endless spiral, which ultimately led the company to bankruptcy.
Its net profits dived by more than 90 percent from INR 909 crores in FY-2012-13 to INR 62 crores in FY-2013-14. The company was in serious financial trouble and unable to repay its debts. Taking a cue from the same, its share price declined by more than 70 percent to INR 112, within less than a year.
Things came to a head for the company in 2014. The Vice Chairman and Managing Director Neural Singal was arrested by the CBI for allegedly offering to bribe the Chairman and Managing director of Syndicate Bank for enhancement of credit limits. By then, Bhushan Steel was already on the verge of drowning in its debts. It owed around INR 40,000 Crores to 51 banks, with SBI topping the list.
The only way the company could service its existing debt obligations was to borrow further. It was either that or appeal to the banks for restructuring the loans. An article in The Hindu Business Line reads, " ‘As referred in the news, on 15th December 2014, RBI announced a scheme for long-term restructuring of loans in line with cash flows. The joint lenders forums have agreed to extend the loans of BSL (Bhushan Steel Ltd) for tenure of 25 years under the said scheme. However, the respective authorities of the banks have to approve the scheme, which is under process with the respective banks,’ the company had said in a BSE filing on Friday”.
Bhushan Steel further said that the company has received sanctions from some banks only. However, the “sanction from rest of the banks are still awaited". Despite this breather, at the close of FY-2015, the total debt of the company was INR 45,000 crore on an equity of INR 5,600 crores, leading to a debt-equity ratio of 8:1. The company started defaulting on its debts from FY-2016.
Why did Bhushan Steel go into IBC?
The Indian Bankruptcy Code here forth referred to as IBC, came into existence in 2016. The grounds on why Bhushan Steel went into bankruptcy have two parts. The first and foremost is the macroeconomic events that lead to the creation of the Indian Bankruptcy code. On taking a close look at the functioning of the Indian industries, it found that NPA’s were rapidly becoming a threat. This led to the tightening of norms by RBI along with stringent action by the MOF. The second reason was Bhushan Steel’s finances. The company’s financials were already in the doldrums and there are articles, which date back to 2014, where the lead consortium bankers had raised serious concerns about the way it was being managed. They had even suggested a third party management to oversee the day-to-day operations.
As per RBI data, the gross NPAs as percentage of gross advances of banks significantly increased from 5.1 percent in September 2015 to 9.1 percent in 2016. Stressed assets which consist of NPAs and restructured loans and write offs moved up from 11.3 percent in 2015 to 12.3 percent in 2016. NPAs and stressed assets significantly increased post the asset quality review of RBI in December 2015. The asset quality review forced the banks to take a hard look at their stressed accounts and stop ever greening them to avoid classifying them as NPAs.
The huge NPAs forced the government to take action. The IBC Act was notified in 2016. In addition to the IBC Act, the banking regulation act was amended to increase the powers of the RBI over the resolution of stressed assets. Two sections were inserted- namely 35 AA and 35 AB. While 35AA empowered the RBI to direct banks to initiate the IBC in case of default, 35AB allowed the RBI to issue directives to banks over resolution of stressed assets.
Pursuant to the two new sections (35 AA and 35 AB), the RBI directed the banks to initiate insolvency proceedings against the 12 companies. To avoid accusations of bias, the RBI picked the 12 companies with the largest NPAs, which was referred to as the ‘dirty dozen’.
The list was dominated by big companies in the steel and infrastructure sectors and estimated to represent around a quarter of the total NPAs of the banking sector. Prominent companies in the dirty dozen are Bhushan Steel, LancoInfratech, Alok Industries, Electrosteel and Essar Steel. Bhushan Steel alone had around INR 45,000 crore of unserviceable debt.
Why did IBC come into existence?
Prior to IBC, there were several restructuring schemes and statutory acts to deal with NPAs. The key restructuring schemes were: CDR (Corporate Debt Restructuring), SDR (Strategic Debt Restructuring) and S4A (Scheme for Sustainable Structuring of Stressed Assets.
CDR involved modifying the principal and interest repayments to provide relief to the borrower. CDR’s had limited success (* only 17 percent resolutions as of 2016), since it provided only temporary relief to the borrower and there was no long-term plan for the turnaround of the business. Due to the limited success of CDRs, SDRs were introduced by RBI in 2015. SDRs enabled banks to revive troubled companies by becoming majority stakeholders in them through conversion of debt into equity. However SDRs too had limited impact, since banks were reluctant to take control of companies on account of lack of enabling legal provisions.
This led RBI to bring in the S4A scheme in 2016. The key difference between SDRs and S4A was that S4A enabled the present promoters to remain in control, provided that more than 50 percent of the company’s debt was sustainable debt. Sustainable debt is debt where the principal value could be repaid based on the current cash flows. S4A too failed since it not only allowed promoters to remain in control but it also did not have any sustainable recovery plans.
SICA (Sick Industrial Companies Act) and SARFAESI (Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002) were the acts related to NPAs and distressed industrial firms. These acts also failed to deliver since they did not specify any timeline for resolution thereby causing the resolution process to drag on for years.
The inability of these restructuring schemes and acts to make a dent in India’s NPA crisis led to the introduction of the IBC in 2016. The existing acts such as SICA and SAFAESI were merged under the IBC, once it came into existence. IBC significantly differs from other acts in specifying a time bound resolution and transferring control from the debtor to an independent resolution professional on the occurrence of a bankruptcy event. Important points of difference between prior acts and IBC are summarised below.
The diagrammatic representation of the process is shown below.
Priority of Payment of Dues:
Another important point of difference between the IBC and prior acts is the priority of payment of dues in the event of liquidation of the company. Unlike prior acts, dues to the government rank much lower in the priority list. Under IBC, post insolvency process costs, the claims of workmen and employees, all creditors (secured/unsecured, financial/operational) would need to be settled prior to the payment of dues owed to the government.
IBC, which provides a comprehensive framework from filing of applications to completion of resolution plans, can be broken down into four phases.
Phase 1: Filing of Insolvency Petitions
A financial or operational creditor can file an insolvency petition with the NCLT (National Company Law Tribunal) when there is a default by those covered under the insolvency act of an amount equivalent or greater than INR 1 lakh. Financial creditors are those to whom a debt is owed. Operational creditors are those who are owed money on account of provision of goods or services.
Phase 2: Admission/Rejection of Application
The NCLT would have to accept or reject the insolvency application within 14 days of receipt of the same. The primary grounds for rejection of the insolvency application would be dispute over the due amount, inability to verify the due amount or the operational creditor not serving proper notice. Post admission of the application, the NCLT would appoint an IRP (Interim Resolution Professional) and make a public announcement about the corporate insolvency process. Admission of the application would lead to an immediate moratorium of claims against the company and transfer of control from the current management to the IRP. The IRP would also verify the claims submitted by the creditors and constitute a committee of creditors. The committee of creditors would consist of all the financial creditors of the company.
The IRP would run the day to day affairs of the company and require the concurrence of the committee of creditors before taking a major decision. The committee of creditors would also require the approval of those holding 75% or more of their voting rights to take any decision. Voting rights would accrue to a financial creditor based on the proportion of total debt owed to financial creditors held by them.
Phase 3: Bidding Process, Submission and Acceptance of Resolution Plan
The committee of creditors would appoint a Resolution Professional (RP). Prospective suitors for the company would need to submit their resolution plan to the resolution professional. The resolution plan would primarily provide details on the total consideration that would be paid to the creditors in lieu of their existing debt and the infusion of equity if any. The total consideration offered to the creditors offered by the bidders cannot be lower than the liquidation value of the company. The resolution plan would need to be approved by the committee of creditors (financial creditors holding 75 percent or more of the voting rights). Post approval by the committee of creditors, the resolution plan would then need to be approved by the NCLT.
It is pertinent to note that as per the provisions of the IBC, the company would go into liquidation in case the resolution plan is not approved by the COC (committee of creditors) and NCLT within a period of 180 days from the date of admission of the application by the NCLT. The 180 days timeline can be extended by a maximum of 90 days, subject to the approval of the NCLT. An important provision in IBC is section 29(A) that bars promoters of defaulting companies from bidding for companies under IBC.
(Kamesh Subramanian, CA, CFA, is Senior Manager at Standard Chartered GBS and H Suchandra Mundul, MBA Finance, is Associate Manager at Standard Chartered GBS.)
Note: This is the first of the three parts of the article.