R Ravimohan: Lender's club

Lending documentation must be standardised to provide a clear process for debt resolution

For a variety of reasons a number of projects that were set up in the nineties had problems paying their contracted debt. One could fault inadequate assessments or follow-up on the part of the banks, or blame recalcitrant borrowers, but these are addressable issues.

Already the progressive banks have tighter risk-control measures. The law has also been considerably sharpened to help banks to foreclose their security.

However, the question of cooperation amongst the lenders in proceeding against a defaulting borrower in a coordinated and efficient manner remains a vexatious concern.

Especially since more categories of lenders are joining the game, it is important to foster a greater understanding of the debt-resolution mechanism to avoid unnecessary loss of time and money later.

It is interesting to trace a typical case of a borrower whose fortunes turn adverse. As the financial position of a borrower worsens, the more vigilant of the lenders silently work to reduce or eliminate their exposure to the case.

This is easier done if there is a way to sell down the exposure (through securitised debt) or by forcing the borrower to repay them in preference to other lenders.

The borrower does this to reduce the debt-servicing burden, without alerting the entire lenders' consortium and indeed the larger financial markets about its incipient financial difficulties.

However, as the news spreads to a larger circle of lenders, the company finds it easier to enter into a multilateral arrangement with lenders, rather than settling lenders on a bi-lateral basis.

This is because, first, it will not have the resources to deal with all the lenders simultaneously, and, second, by making it a common issue, the burden of resolution gets transferred to the lending comity.

Then the strategy of the borrower is to convince the lenders that its problems are temporary, and therefore it is in the lenders' interests to resolve the problem through debt relief, rather than through loan foreclosure.

Here comes the second point of friction between the remaining lenders, who are already smarting at the nimble-footed ex-lenders' exit from the problem loan case.

Lenders usually have a divergence of opinion of whether good money should be put behind bad money, and it takes a while for this round of restructuring to succeed.

The borrowers' financial condition usually worsens during this period of negotiation and inaction. Assuming the borrower's strategy of a debt rework succeeds, the intervening deterioration usually sets the stage for a weak, if any, recovery.

Depending on the clout and energy levels displayed by the lenders and borrowers, this stage often involves several rounds of restructuring where the borrower oscillates between defaulting and debt relief.

In those cases where the borrower is not able to recover its financial health, the stage eventually gets set for foreclosure, which again sees the next round of intense negotiations, often acrimonious, amongst the lenders.

After protracted legal measures, when eventually some recovery gets effected, the lenders usually war over the spoils. The whole process appears to make lenders suspicious of each other and weakens their common front against the borrowers.

It is quite possible that of late there is some improvement in these matters, and maybe many loans get resolved more amicably than the case presented above.

But there is a need for thinking about this issue in a systemic manner and not leaving it to be resolved by negotiations or arbitration. This would at the least save the lenders substantial time that is unnecessarily spent in legal wrangles and hopefully result in a more effective resolution of debt.

The pressure points in the inter-lending relationship occur in four clusters""preferential treatment for select lenders, consensus building on debt-resolution strategy, the timing of foreclosure, and priority of claims post recovery.

These problems are caused by a poor quality of documentation, non-standardisation of legal documents, litigious nature of property rights, incomplete disclosures of outstanding and impending debt, and indifferent compliance of registering charges of collateral by senior lenders.

An unsettled legal process on determining priorities of claims (especially with regard to the new evolving structured finance type lending) also leads to contention among the lenders.

Different regulatory norms for recognition and provision for bad loans and differing philosophies adopted by different lenders in applying and adhering to those also yield different perspectives on resolution mechanism and strategies.

Lastly, there is no or little agreement between various classes of lenders and indeed between lenders of the same class on the format, process, or leadership to be adopted during the resolution.

So what should be done by lenders going forward? Lending documentation must be standardised. This must provide a clear-cut process for debt resolution. One of the important provisions of this document is to assign leadership with authority to some body to effect the resolution.

Overseas, this is becoming known as common action clauses. Of course, it is easier said than done. One alternative is to have an interventionist regulator who will dictate the course of the resolution process.

BIFR was one step in this direction and hopefully the system has learnt that solutions found outside the system are unlikely to be helpful to any of the lenders.

Therefore, the lenders are way better off if they find a leading lender in the consortium based on its ability and integrity to effect a good, speedy resolution that is fair and equitable to all lenders. Ideally, one of the banks in the lenders' comity should be elected as leader.

Failing this, it would not be a bad idea for a few leaders to emerge and the rest of the lending community choosing to align with such lenders. Some bold and imaginative leadership needs to emerge amongst lenders.

It will be in the interests of the lending community to invest time and effort to get this leadership to agree prior to the lending arrangement than to suffer the hardship in the recovery period.

Over time, a few lenders will emerge as natural leaders, and debt resolution and recovery services could become an accepted fee-based activity.

There should be an online debt and collateral register that should reflect the right position of indebtedness. The regulators can play an important role in facilitating the creation of an online debt and collateral registry and in fostering effective and standard documentation.

Internal control across the lending community needs to be tightened in respect of documentation and diligence on registration of charges. Lenders must prefer a securitised lending mechanism to a loan asset, as exits are much easier.

Even if the asset is not booked directly as a bond or debenture, loans must be so documented to allow selldown as collateral debt obligation. This would allow the lender greater exit options.