Road to insolvency resolution

Mint, November 26, 2015 (with Richa Roy)

The current corporate insolvency resolution framework in India fares poorly in terms of timeliness and costs of proceedings. The longer the time taken, the more the erosion in realizable value of assets and the lower the recovery rate—the ultimate parameter for evaluating the strength and efficiency of an insolvency framework. Inordinate delays in resolution arise from a lack of clarity regarding legal provisions, an overburdened judiciary, information asymmetry faced by creditors, absence of well-defined timelines stipulated in the law and an overall weak enforcement mechanism. Institutions that should support the resolution process such as dedicated tribunals, official liquidators and credit bureaus are severely capacity-constrained. All these culminate in a recovery rate of roughly 20% of the value of debt—among the lowest in the world. Bankruptcy reforms in India must therefore focus on minimizing delays.

The Insolvency and Bankruptcy Code (IBC) proposed by the Bankruptcy Law Reforms Committee (BLRC) addresses the timeliness issue by stipulating a strict timeline of 180 days for insolvency resolution and limiting judicial determination at the trigger stage. Triggering the insolvency process in India [under the Sick Industrial Companies (Special Provisions) Act (SICA) or Companies Act] currently involves judicial judgement. Under IBC, the insolvency resolution process (IRP) can be triggered at the first instance of default, requiring the adjudicating authority to merely confirm the existence of default. This will aid early detection and resolution of stress and also avoid clogging judicial bandwidth at the trigger stage. Also a default only triggers a resolution process, and not liquidation. This is unlike the extant situation where winding up proceedings can be triggered on account of a default of Rs.500, resulting in courts undertaking full hearings at the admission stage and causing delays.

The 180-day timeline is not an implausible one for several reasons. Across the world, firms in distress start conversations about their financial troubles with stakeholders much before initiating formal proceedings. Court-supervised resolution procedures are filed when out-of-court negotiations fail to generate desired outcomes. In the post-IBC regime, if IRP is triggered, it is assumed that the debtor has already undertaken out-of-court negotiations with the stakeholders concerned about possible reorganization avenues to keep the firm as a going concern, and has not arrived at a solution. Triggering IRP is hence considered a last-course effort after sufficient preparation and deliberation.

Once IRP is triggered, it offers a calm period during which a moratorium is imposed on debt recovery actions and existing or new lawsuits against the debtor. During this phase, all creditors come together to collectively assess the viability of the firm and vote on proposed resolution plans, within a well-defined framework of rules enforced by an insolvency professional (IP). The IP takes over management of the firm to prevent potential asset stripping and to continue operations of the firm as a going concern. The likelihood of a moratorium being misused and dilatory tactics applied by promoters is minimal because the debtor loses control. Also there is a credible threat of liquidation should the defined timeframe of 180 days lapse without 75% of the creditors’ committee consenting on a resolution plan.

In view of the above, completing the final round of conversation between the debtor and creditors within 180 days to resolve temporary insolvency as against structural breakdown is not infeasible.

Once the creditors’ committee approves a resolution plan, the adjudicating authority reviews the plan not from a commercial perspective but against touchstones of conformity with applicable laws and repayment of interim finance (on priority) and operational creditors. This will free up judicial bandwidth to focus on critical issues of justice, such as compliance with procedural requirements, overseeing the IP and adjudicating on voidable transactions and potential penalties against management and promoters.

Delays in the resolution process also result from opacity of creditors’ claims and related information. The system of information utilities (IUs) proposed by the IBC and the BLRC report will store all financial transactions between a firm and its financial creditors. This should significantly assist the IP in assessing veracity of claims, thereby saving valuable time.

It is important to underscore here the centrality of the institutional pillars upon which the entire edifice of IBC stands. While the draft bill contains provisions to reduce delays and improve efficiency of resolution, the de facto outcomes in terms of effective and timely functioning of the process are contingent upon building the supporting infrastructure. This includes developing a new class of IPs to conduct the resolution process in a time-bound and disciplined manner, an extensive network of IUs vital for reducing information asymmetry and speeding up the process of initiating IRP and collecting claims, a well-functioning regulator to govern the operations of IPs and IUs as also issuing delegated legislation and finally, an effective adjudicating infrastructure replete with a well-laid-out appeals mechanism.

For the IBC to deliver the desired economic outcome of high recovery rate, a robust implementation plan for building the aforesaid institutions and creating state capacity is essential to complement the enactment of the draft bill. None of these will happen overnight.

It will take time for firms and all stakeholders to get familiar with the new system and to understand the new rules of the game.

From non-performing to performing

Mint, November 25, 2015 (with Richa Roy)

The ministry of finance recently released the draft Insolvency and Bankruptcy Code (IBC), proposed by the Bankruptcy Law Reforms Committee. The government of India greeted this bill as among its biggest and most crucial reforms. To a person unconnected with finance, it may be unclear why this is important or what ails the current framework. A well-functioning insolvency resolution framework is fundamental for dealing with business failures that inevitably occur in any economy. Additionally, an effective insolvency resolution process is one tool, among others, for banks and other creditors to address low recovery rates.

This is particularly relevant for India where economic growth is contingent upon the financial health of the banking sector. Banks in India face acute problems of asset quality. Perceiving that laws did not sufficiently empower secured creditors to activate recovery by seizing security, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, and Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, were enacted to facilitate the enforcement of security by banks and financial institutions.

Asset reconstruction companies were constituted under SARFAESI to buy bad debts from banks and recover from defaulters. Domestic banks also have recourse to corporate debt restructuring and joint lenders forum mechanism to resolve stress in consortium loans.

None of these initiatives seems to have helped. Gross non-performing assets (NPAs) as percentage of total advances went up from 3.4% in March 2013 to 4.45% in March 2015. The picture is grimmer when volume of restructured assets is also considered in stressed advances. As a percentage of total advances, overall stressed advances increased from 9.2% to 10.9% between 2013 and 2015. Average recovery rate for secured debt is as low as 20%. One factor responsible for all this is a weak legal framework for resolving failure. Once debts go bad, creditors’ ability to realize value is predicated on a robust insolvency resolution mechanism.

Accumulation of bad debts in bank balance sheets has systemic risk implications for the entire economy. As capital gets tied up in provisioning for bad debts, banks get inhibited from extending fresh credit, slowing down the real sector. Absence of a well-functioning insolvency framework that protects creditors’ rights also thwarts the development of alternative lenders, such as corporate bond market. There are admittedly other issues systemic to the banking system and capital market that compound these problems. However, an insolvency law focused on preserving viable businesses as going concerns and liquidating unviable ones is the cornerstone of a mature financial system and India urgently needs one.

Aparna Ravi highlights in a paper titled The Indian insolvency regime in practice—an analysis of insolvency and debt recovery proceedings that the current framework in India is highly fragmented with decisions frequently stayed or overturned by judicial forums having overlapping jurisdiction. There is no clarity on whether the right of secured creditors initiating recovery under SARFAESI will prevail, or unsecured creditors initiating winding-up under the Companies Act or the company triggering proceedings under the Sick Industrial Companies (Special Provisions) Act, 1985, (SICA).

Substantive issues exist with even initiation of insolvency resolution or the process of winding up. SICA is triggered when more than half a company’s net worth has eroded. In Kristin van Zwieten’s paper titled: Corporate rescue in India: the influence of the courts, she examined over a thousand cases from a range of courts to demonstrate that the Board for Industrial and Financial Reconstruction (BIFR) and the high courts are reluctant to liquidate unviable companies. Ironically, the trigger for winding up a company is too low. The default is Rs.500. Courts, therefore, do a full hearing on merits at admission stage itself, limiting efficacy. Creditors, especially non-banks, do not have access to a mechanism to assess the viability of an enterprise and address the problem, without the threat of other proceedings initiated by the debtor or other creditors torpedoing them. Even when proceedings are triggered, debtor’s existing management retains control, thereby creating the risk of asset stripping.

Under SARFAESI, creditors are empowered to take over management of a company but only that part of the company connected to the secured asset. Since potential liability to creditors is high, this is rarely invoked. There is no corresponding provision for non-banks. There is also no linearity of proceedings. Under SICA, even if BIFR recommends liquidation, a reference is made to the high court, which would re-examine the recommendation and might even reverse it.

With the proposed IBC, the labyrinth of extant Indian laws dealing with corporate insolvency are being replaced by a single comprehensive law that (a) empowers all creditors—secured, unsecured, financial and operational to trigger resolution, (b) enables the resolution process to start at the earliest sign of financial distress, (c) provides a single forum overseeing all insolvency and liquidation proceedings, (d) enables a calm period where other proceedings do not derail existing ones, (e) replaces existing management during insolvency proceedings while keeping the enterprise as a going concern, (f) offers a finite time limit within which debtor’s viability can be assessed and (g) under bankruptcy, lays out a linear liquidation mechanism.

The proposed framework strengthens creditors, without discrimination. While this will not necessarily be a magic bullet that will make the mass of NPAs vanish from bank balance sheets, it can facilitate better recovery and faster closure of troubled assets. IBC will prevent new loans from getting added to existing stock of NPAs. It will aid development of alternative debt securities, spread the risk of corporate failure across larger sets of creditors, and lead to the double benefit of lower systemic risk as well as deeper debt finance for a rapidly growing economy of entrepreneurs.

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