FinMin turns down Sebi's plan to do away with debenture redemption reserve

Sebi proposed to the Department of Economic Affairs (DEA) last month that the DRR rule be reviewed, saying it was not favourable for the development of the corporate bond market

The finance ministry has rejected the Securities and Exchange Board of India’s (Sebi’s) proposal to do away with the requirement of the debenture redemption reserve (DRR) — a provision mandating both listed and unlisted companies to set aside 25 per cent of their profits for protection of bond investors in case of a default. Financial institutions such as banks and non-banking financial companies are, however, exempted from this requirement if funds are raised through a private placement. 

The markets regulator proposed to the Department of Economic Affairs (DEA) last month that the DRR rule be reviewed, saying it was not favourable for the development of the corporate bond market. Sebi cited certain anomalies that were raising the cost of issuance by 18 per cent, particularly for infrastructure and manufacturing companies. In its proposal to the DEA, Sebi cited a study it had conducted on the costs involved in the issue of corporate bonds and measures that can be taken to diversify the issuer and investor base. 

According to the Sebi study, around 90 per cent of the issuances happen in the credit rating bucket of AA or above. Further, corporate bond issuances are done primarily through the private placement route, of which almost 60-70 per cent of the issues are done by financial sector entities. 

The private sector and non-financial entities constitute only 20 per cent of the total issuances, with the remaining being state-owned firms. 

Sebi highlighted that the gap between the financial and private sector issuances was due to the exemption given to financial institutions, with most of them raising funds through a private placement and that there was no level playing field for other sectors. 

Sebi also said the DRR requirement was increasing the cost of issuance for non-financial companies, which was up to 18 per cent for infrastructure and manufacturing companies.

In its response, the DEA said the actual cost was not that high, and that Sebi should relook at it. If required, Sebi could refer the matter to its committee on disclosures and accounting standards for further examination. 

“The debenture reserve is on the liability side of the balance sheet and does not actually add any cost to the issuing company. There is no negative implications, except that this 25 per cent cannot be used for the payment of dividend,” the DEA told Sebi.

The DEA further said wealth creation for shareholders drove investor interest rather than distribution of dividend. In fact, cost is associated with the creation of 15 per cent reserve one year prior to maturity. Therefore, Sebi’s calculation of cost appears to be on the higher side and needs to relooked, it added. 

The DRR mechanism under the Companies Act was created to protect investors against the possibility of default by a company. Under the rule, a company is required to create the reserve account out of its profits available for payment of dividend and the said amount shall not be utilised by the firm except for the redemption of debentures. Also, each company on or before April 30, needs to invest 15 per cent of the debentures maturing during the year in bank deposits or government securities. 

According to Sebi, if the requirement of the DRR is dispensed with, it may facilitate more non-financial sector companies to access bond markets for their financing needs. The DRR can be created only by profit-making companies, whereas companies which have accrued losses are more likely to default and will not be able to create the DRR, Sebi said in its proposal, adding that the creation of the DRR may not serve to protect the interest of investors as envisaged. 

During the discussion on the proposal, the DEA also sought Ministry of Corporate Affairs (MCA) officials’ opinion about the rationale of keeping the DRR provisioning for the debt securities. The MCA said the DRR was for investor protection and giving certainty to them in terms of redemption of the debt securities. The MCA also cited the provisions of the Insolvency and Bankruptcy Code under which creditors with outstanding of Rs 1 lakh and above can only take the matter to bankruptcy proceedings and not the small investors who are below Rs 1 lakh. 

Sebi, on its part, had said there were already several provisions for investor protection in the Sebi Act and others, besides there being stringent compliances in place for the issuance of the debenture by borrowers.