RBI’s Crackdown on Evergreening

Background

The Reserve Bank of India (RBI) recently issued a notification raising concerns arising from investments by entities regulated by it (Regulated Entities) in units of alternative investment funds (AIFs). The notification dated December 19, 2023 (Notification) aims to curb potential regulatory risks associated with the substitution of direct loan exposure of Regulated Entities with indirect exposure through AIF investments.

This was originally highlighted by the Securities and Exchange Board of India (SEBI) earlier this year in their consultation paper dated May 23, 2023, with respect to pro-rata and pari passu rights of investors of AIFs. SEBI observed that evergreening of loans leads to a lack of transparency for investors, much like the tranching of collateralised debt obligations did during the 2008 financial crisis.

Addressing the Problem: Key Provisions of the Notification

The RBI’s primary concern lies in the practice of “evergreening”, where Regulated Entities facing troubled loans park them in AIFs, which then invest in the same debtor companies, essentially recycling stressed assets and delaying their recognition as non-performing assets (NPAs). This creates an illusion of financial health while masking underlying risks.

The Notification outlines a three-pronged approach to address evergreening:

Prohibiting investments of Regulated Entities in AIFs with debtor exposure

Regulated Entities are barred from investing in AIF schemes that have direct or indirect investments in companies to which they have current or past loan exposure (within the preceding 12 months). This effectively cuts off the route for evergreening through AIFs.

Mandatory divestment or provisioning for existing investments

If an AIF scheme in which the Regulated Entity has already invested makes further downstream investments in such debtor company, the Regulated Entity must divest its AIF holdings within 30 days. Failure to do so within the prescribed time limit necessitates 100% provisioning on the investment, highlighting the significance of the RBI’s stance.

Regulated Entities which have already invested in AIFs having downstream investment in their debtors as on date are required to liquidate such investment within 30 days from the date of the Notification.

Stricter capital requirements for investments with “priority distribution model”

Certain AIF schemes follow a “priority distribution model” where senior class investors get priority in payments on account of sharing loss more than pro-rata to their holding in the AIF vis-à-vis junior class investors. Investments of Regulated Entities in the subordinated units of such AIFs will require full deductions from their capital funds. This discourages investments that prioritize AIF returns over borrower repayments, potentially mitigating risks associated with evergreening.

Comparison with Global Standards

The Notification shares striking parallels with the Volcker Rule, implemented in the aftermath of the 2008 financial crisis in the United States. Like the Volcker Rule, which aimed to prevent excessive risk-taking by banks, the Notification targets potential risks associated with indirect exposures through AIF investments. Both regulatory measures emphasize the importance of maintaining the integrity of financial institutions and curbing practices that could lead to systemic vulnerabilities. While the Volcker Rule primarily focused on restricting proprietary trading, the Notification, in a similar vein, seeks to mitigate risks arising from certain transactions.

Legal Implications

While the Notification’s long-term impact will depend on its enforcement and potential legal challenges, the direct consequence is likely to be a reduction in flow of funds to all AIFs in general, whether affiliated to Regulated Entities or otherwise, particularly those with substantial stressed assets. There would be immediate disinvestment pressure on AIFs, due to overlapped investments. Concerns are anticipated from Regulated Entities regarding the retrospective application of the 30-day divestment rule and the potential for increased provisioning requirements to impact their capital adequacy. The Notification underscores the regulator’s commitment to maintaining the integrity and stability of the financial system. As the AIF industry adapts to these new regulations, a more transparent and borrower-centric approach to debt resolution is likely to emerge, contributing to a more resilient financial system in India.

Contributed by Ms. Anushka Sinha, Associate