Let’s just say it never happened:Considerations for faster economic recovery –what banks, companies and regulators can do

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ContentsIntroduction 03

Isolate the impact of COVID-19 on businesses 04

Categorise businesses based on their viability post COVID-19 05

Consider a two-step approach 06

Implementing the two-step approach 08

Support by businesses 09

Actions for the government 10

Actions for the RBI 11

Closing remarks 12

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India is under lockdown to minimise the spread of COVID-19 and businesses (except those engaged in essential goods and services) have paused their operations. Given the enormity of the crisis, businesses and communities are equally participating in shouldering the burden, alongside the government, to prevent a systemic breakdown. Whilst revenues have come to a grinding halt, salaries and wages and other costs continue to ensure that people are not deprived of their means to livelihood and that the business sustains as a going concern. These are essential “COVID Crisis Investments” made by businesses and the government in the fight against the pandemic.

There are concerns that once business resumes, the disruption caused due to this pandemic could lead to a systemic failure impacting companies and the banking system as a result of a steep decline in asset quality, and a string of covenant breaches and defaults.

Is there a way to wish away the virus, at least financially? Could we park on the side the losses and liabilities incurred due to the virus and deal with them in small measures over an extended period? Can we simulate a normal scenario for businesses with long-term sustainability to ensure their continuance?

This document discusses whether it is possible to isolate the effect of the COVID-19 crisis on businesses and defines actions, which if taken, can restrict or mitigate the impact on businesses by spreading it over a longer time horizon. This would include allowing viable businesses, if required, to obtain additional financing, and simplifying the restructuring process for other businesses to ensure that we do not end up in a situation of a systemic lockdown of the banking system.

Introduction

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Negative impact on profitability and liquidity metrics due to losses incurred during the primary impact period of COVID-19 needs to be segregated to identify businesses that continue to remain viable with some support.

Businesses may be allowed to capitalise the COVID Crisis Investment (defined as excess of operating costs including non-cash and finance costs, over revenues during the primary impact period), its subsequent amortisation over a period of five years, and its treatment as special deferred expenditure as part of long-term sources until fully amortised.

Isolate the impact of COVID-19 on businesses

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In the past, banks typically found it hard to categorise accounts as it involved a significant level of judgement and responsibility. A simple and systematic approach has been proposed to enable the categorisation for this purpose based on their business sustainability so that a targeted approach may be taken to provide relief in an objective manner to rightful recipients.

Category A (sustainable businesses) – This would include businesses that would be healthy, after excluding the impact of the crisis, and project forward as sustainable with support in the form of additional liquidity and some augmenting of the balance sheet. Businesses whose rating, after adjusting for the COVID Crisis Investment made by it and the potential Crisis Liquidity Bridge assumed to have been disbursed by banks, is lower by not more than two notches of their last rating and more than RP4 would be included in this category.

Category B (potentially sustainable businesses) – Businesses that have the potential to be healthy but require support beyond additional liquidity and augmentation of the balance sheet, in the form of restructuring of their existing liabilities, would fall in this category. Businesses whose rating, after the proposed restructuring and adjusting for the COVID crisis investment made and the potential Crisis Liquidity Bridge assumed to have been disbursed by the banks, is lower by not more than two notches of the last rating and more than RP4 would be included in this category. For these businesses, a resolution through restructuring may be possible with or without current management.

Category C (unsustainable businesses) – Businesses that after COVID-19 are unsustainable or where the promoter’s integrity/capability is doubtful would fall in this category. Banks may consider preserving or nurturing such assets until the market stablises. After that, they can seek to monetise, or where required, take immediate action in terms of IBC, enforcement of security, etc.

Proposed categorisation, based on the pre-defined criteria, should not be subject to scrutiny in the future for efficient implementation. Further, banks may continue classifying the accounts in line with currently applicable guidelines (standard, SMA1, SMA2, etc.). Only an adjustment on account of COVID crisis investment and crisis liquidity bridge will be carried out to continue with the current classification (standard, SMA1, SMA2, etc.).

Categorise businesses based on their viability post COVID-19

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Step 1: Balance sheet correction – Moving the COVID-19 impact from the P&L account to the balance sheetMove the impact of the COVID Crisis Investment made by businesses, on a quarterly (or monthly) basis, from the profit and loss (P&L) account to the balance sheet. It would now appear as an investment/asset in lieu of cash/liquidity erosion. This capitalisation and subsequent amortisation over a period could help bring the financial ratios and business metrics back to normal gradually.

To enable this, a specific COVID-19 dispensation may be introduced as an amendment to the accounting standards and Companies Act, 2013, by the Ministry of Corporate Affairs (MCA) or the Institute of Chartered Accountants of India (ICAI). This could also help with compliance and provide a guidance for statutory and internal audit purposes. This investment can then be amortised over a period of five years to write off its impact on the business.

Step 2: Liquidity correctionFor businesses that continue to be viable, after adjusting for the COVID Crisis Investment made by it and the potential crisis liquidity bridge assumed to have been disbursed by banks, additional funding could be provided to restore businesses and towards working capital requirements. Potentially viable businesses may require additional support in the form of restructuring of their existing liabilities. For companies that are not found viable, corrective actions could be considered on a case-by-case basis by banks.

The RBI and banks should come up with a policy (or a special dispensation) to require consideration of revised profitability situation of businesses after making adjustments on account of COVID crisis investment.

Testing for lending covenants or financial analysis for the purpose of ratings, etc., should also be for a period excluding the primary impact period of COVID-19 during the financial year for a normalised analysis. For this purpose, audited financial statements may report accounts after capitalising the COVID Crisis Investment, hence limiting its impact on the company’s P&L account.

Banks may be advised to consider additional liquidity support to businesses in the form of a Crisis Liquidity Bridge funding (up to COVID Crisis Investment) on the basis of internal categorisation process (as elaborated in the previous section).

Consider a two-step approach

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Resolution for sustainable businesses (category A)

Resolution for potentially sustainable businesses (category B)

Resolution for unsustainable businesses (category C)

Banks/NBFCs/financial institutions to disburse crisis liquidity bridge to category A businesses within timelines upon approval of such funding by its single-window clearance committee of the processing bank.

Amendment to the Prudential Framework for the Resolution of Stressed Assets dated 7 June 2019, to require its recommendations to be considered in conjunction with the impact of the potential crisis liquidity bridge, which matches the COVID crisis investment by the company.

In addition, the RBI may come up with a new framework for assets affected by the crisis and permit resolutions as proposed in the subsequent parts of this note.

In this category, businesses are not sustainable, the viability is uncertain, or the long-term viability cannot be established.

The following options are available for lenders:

Hold and work out: Where finding a buyer in the current environment is challenging, banks may consider nurturing the asset and selling at the right time (not longer than two years later). Banks can look to appoint professional management and even provide some funding or working capital to the extent where there is a commercial rationale and required for value maximisation.

Sale: Where banks believe that sale of the assets, including those at a deep discount, is the best option, they should be permitted to sell and account for any loss over a period of 2–3 years to avoid a sudden impact on banks’ books. One of the pre-conditions to the sale should be a proper price discovery process. Currently applicable guidelines relating to the sale of assets/loans shall continue to apply, except for proposed amortisation of losses over an extended period.

Insolvency: Additionally, where banks believe that there is no good option in the foreseeable future or they believe that the case is complex and an insolvency process could be the best option, banks should refer the matter to IBC. This would be subject to moratorium, if any, imposed by the government on initiation of insolvency process in light of the crisis.

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A limited review of the information provided by companies seeking additional funding can be undertaken by its statutory auditor within three working days with a view to validate the quantum of the COVID Crisis Investment. While the COVID-19 crisis is ongoing and it is not possible to await the full impact of the crisis to play out prior to providing the impacted businesses the required relief, the following is proposed:

Implementing the two-step approach

Those businesses that have a surplus on account of the revenues over costs in a particular quarter would be deemed to have zero COVID Crisis Investment for that particular quarter.

Thereafter, the company shall apply for funding, on a quarterly basis, if required, to the lead bank of the consortium or the largest lender to the company (the "Processing Bank"), as the case may be.

The Processing Bank could then, with the assistance of suitable external experts, if required, carry out an internal rating exercise—within seven days of receipt of the application—to evaluate whether a Crisis Liquidity Bridge amount would help the company run as (a) a sustainable business or (b) a potentially sustainable business or (c) would not be able to prevent it from being unsustainable.

The Processing Bank can form a committee to enable single-window reviews and clearances of such Crisis Liquidity Bridge funding. If approved, the amount of the Crisis Liquidity Bridge shall be disbursed by Indian banks, NBFCs, and financial institutions in proportion to their debt exposure within three working days of approval, unless the processing bank decides to disburse the entire amount itself.

Over the course of the disbursement, companies may be required to submit quarterly or half-yearly audited accounts to revalidate the COVID Crisis Investment. Internal ratings by banks could be revalidated by subsequent ratings carried out, within two quarters of disbursement of the Crisis Liquidity Bridge, by a third-party rating agency.

Statutory auditor of businesses to confirm provisional COVID Crisis Investment for each quarter starting 1 April 2020 within seven working days of the quarter ending

At the end of the second month of each quarter, the government to announce whether COVID Crisis Investment will be permissible for the current quarter

Investment from each quarter to be provisionally reviewed and provided for in the business’ balance sheet

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Businesses classified under Category A would need to support the bank’s decision to closely monitor business operations and cash flows.

For businesses classified under Category B, control provisions could be similar to the powers provided under the IBC, i.e., lenders should be able to appoint a CFO/CRO/director who shall report to them and have control over the company’s cash flows. The CFO/CRO/director should also have a veto power to prevent the promoter’s decisions (such as giving loans to group companies, additional investments, and expansions), which may be detrimental to lenders’ interests. Deviations from the control or operating protocol could lead to lenders initiating insolvency.

For businesses in Category C, a significant level of management decision making would be directed by banks, with the support of experts/external professionals. The bank representation would have complete operational and financial control on the business.

Support by businesses

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The government may consider providing sovereign guarantee/support to bonds issued by banks to raise funds for the Crisis Liquidity Bridge. The government may also provide guarantee to lending banks for the Crisis Liquidity Bridge provided by them to each qualifying company for the bank’s benefit against any loss/default on account of the Crisis Liquidity Bridge. This can collateralise the loan extended and eliminate the need for any additional security creation against the company’s assets or by means of personal guarantees of promoters for the express disbursement of the Crisis Liquidity Bridge. Income of banks/NBFCs/FIs from the Crisis Liquidity Bridge may be exempted from tax or taxed at a substantially lower rate for the next two years.

The government may consider amending The Fiscal Responsibility and Budget Management Act, 20031 and general financial rules to facilitate the provision of the aforementioned guarantee beyond annual limits and relaxation in associated conditions as may be required. To help banks, a short-term solution to secure additional funding could be the issuance of certificates of dues payable by the government (such as tax refunds), with specific provisions made for recognising such a certification as due security.

The government could come up with industry-/sector-specific concessions to support the economy. These concessions may include an additional corpus of funds to be routed through the SIDBI for equity contribution for restructuring proposals. The government may also allow the entire COVID Crisis Investment as a tax-deductible expense during the relevant financial year of the primary impact period.

The government is also working on setting up a process for pre-pack insolvencies, i.e., cases where the resolution is agreed upon before declaring a company insolvent. This should be introduced immediately and can be used as a method of parking assets into the bad bank.

Actions for government to consider

01. https://dea.gov.in/sites/default/files/FRBM%20Act%202003%20and%20FRBM%20Rules%202004.pdf

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The RBI may consider providing limited support to banks through the following considerations:

Suspend fresh ratings for a period of three quarters from the date of publication of a notification, making effective tenets of this proposal. Further, direct rating agencies can adjust for the COVID Crisis Investment and the Crisis Liquidity Bridge to monitor the current and assess future ratings.

Provide interim liquidity to banks through reduced CRR for a longer duration to fund the Crisis Liquidity Bridge for various qualifying companies.

Allow issuing bonds by banks to the RBI/public at large to raise funds equivalent to the Crisis Liquidity Bridge provided to various qualifying companies by banks, and return the additional liquidity they had used during the CRR relaxation.

Facilitate structuring of banks and segregation of accounts into good bank and bad bank.

Amend the Prudential Framework for the Resolution of Stressed Assets dated 7 June 2019, to require its recommendations to be considered in conjunction with the impact of the potential crisis liquidity bridge, which matches the COVID Crisis Investment by the company. In addition, the RBI may come up with a new framework for assets affected by the crisis and permit resolutions.

Allow a special treatment of bonds in banks’ balance sheets that are issued for the crisis liquidity bridge support to be extended through a special account created in every bank.

COVID Crisis Investment may also be made applicable for listed bonds, and its amortisation recognised and allowed by SEBI.

Actions for RBI to consider

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We recognise that banks will be under significant pressure to disburse funds to businesses. However, the large scale of lending envisaged should not push banks towards becoming inviable. To allow banks to concentrate on their core business of lending, categories B and C accounts can be carved out into another vehicle, which can issue paper to banks and allow amortisation of period. Lenders can identify the holdings that are worth less than their previous estimates and should park them separately with a separate capital structure.

Further, a ”bad bank” can be carved out to insulate healthy banking institutions. The bad bank should also be allowed to house the ownership of asset for which, no adequate value was received under an IBC or the Swiss challenge process. The accounts managed by the bad bank should have viability studies carried out and be extensively monitored.

The crux of managing a crisis well is close coordination and swift action—both of these aspects will be required to help businesses revive their operations and minimise the impact of COVID-19. At the same time, the banking sector should use this opportunity to initiate radical changes under enabling amendments by the RBI and the finance ministry.

Closing remarks

Deloitte refers to one or more of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee (“DTTL”), its network of member firms, and their related entities. DTTL and each of its member firms are legally separate and independent entities. DTTL (also referred to as “Deloitte Global”) does not provide services to clients. Please see www.deloitte.com/about for a more detailed description of DTTL and its member firms. This material is prepared by Deloitte Touche Tohmatsu India LLP (DTTILLP). This material (including any information contained in it) is intended to provide general information on a particular subject(s) and is not an exhaustive treatment of such subject(s) or a substitute to obtaining professional services or advice. This material may contain information sourced from publicly available information or other third party sources. DTTILLP does not independently verify any such sources and is not responsible for any loss whatsoever caused due to reliance placed on information sourced from such sources. None of DTTILLP, Deloitte Touche Tohmatsu Limited, its member firms, or their related entities (collectively, the “Deloitte Network”) is, by means of this material, rendering any kind of investment, legal or other professional advice or services. You should seek specific advice of the relevant professional(s) for these kind of services. This material or information is not intended to be relied upon as the sole basis for any decision which may affect you or your business. Before making any decision or taking any action that might affect your personal finances or business, you should consult a qualified professional adviser. No entity in the Deloitte Network shall be responsible for any loss whatsoever sustained by any person or entity by reason of access to, use of or reliance on, this material. By using this material or any information contained in it, the user accepts this entire notice and terms of use. ©2020 Deloitte Touche Tohmatsu India LLP. Member of Deloitte Touche Tohmatsu Limited

Uday BhansaliPresidentFinancial AdvisoryDeloitte Touche Tohmatsu India LLPudaybhansali@deloitte.com

Rajesh R AgarwalPartnerFinancial AdvisoryDeloitte Touche Tohmatsu India LLPrragarwal@deloitte.com

Sumit KhannaPartner, Leader Corporate Finance and Restructuring Services Financial Advisory, Deloitte Touche Tohmatsu India LLPsumitkhanna@deloitte.com

Kaustubh MittalDirectorFinancial AdvisoryDeloitte Touche Tohmatsu India LLPkmittal@deloitte.com

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