The Securities and Exchange Board of India, or Sebi, has liberalised the norms for banks to convert their holding of companies' debt into equity. Earlier, there was a 10 per cent cap on the conversion and the market regulator had laid down the formula for the price: the average share price of the previous 30 days or the previous six months, whichever was higher. By doing away with these two restrictions, it is assumed that the banks will be able to convert their stressed debt into equity more easily and fairly. Perhaps the conversion done in the case of Kingfisher Airlines was weighing on the regulator's mind and that's why the earlier formula has been done away with. In November 2010, a consortium of banks had exercised this option and the price they paid, as calculated by the Sebi formula, was 61 per cent higher than the share price at that time. In the days that followed, the share price of the beleaguered airline fell further. As was only to be expected, the banks drew a lot of flak for this decision. The new norms will now stipulate that the banks should negotiate the price with the companies whose debts are to be converted into equity.
The gains from this are fairly straightforward: the banks will get the opportunity to bring down the non-performing assets on their books and the companies will have easier cash flows. But it is fraught with challenges as well. To begin with, there is little evidence to suggest that conversion of debt into equity alone can help a badly managed company turn around. Kingfisher Airlines was grounded two years after the banks came on board as shareholders. Further, the price of conversion will invariably be contested, now that the Sebi formula has been done away with. As it happens, the share prices of companies with stressed balance sheets are trading low, which could give the banks a large chunk of their equity capital if they choose to exercise the option. Not many Indian promoters would be prepared to live with that. It could lead to widespread bitterness in the business community. It also remains to be seen if the banks have the bandwidth to play the role of an active shareholder, unless they decide to become a passive one. It is a valid question to ask if it is the job of the banks to run companies or whether they have the requisite management skills to play such a role.
The biggest challenge will arise when the banks decide to sell their stakes. This runs the risk of destabilising a company's management. As a result, many of these exits are likely to be contested in the courts. Given that the courts are already bursting at the seams with a huge pile-up of pending cases, it is likely that these matters will drag on for a long time. If the conversion scheme has to work smoothly, it is essential for the government to first unclog the courts through necessary judicial reforms. This is true also for the promised new bankruptcy law. In the end, the delicate decisions accompanying the unwinding of bad debt require more judicial capacity, not just different rules.
