Challenges in the Transition to the New Insolvency and Bankruptcy Code

The Wire, December 15, 2016 (with Anjali Sharma)

The Insolvency and Bankruptcy Code, 2016 (IBC) replaces a fragmented legal framework and a broken institutional set-up that has been delivering poor outcomes for years for creditors and distressed businesses seeking an exit. Currently, corporate insolvency and debt recovery cases are being dealt with under various laws and forums. In a previous article, we had argued that almost all of these are now eligible to be initiated as new cases under the IBC. However, this will create a massive burden for the nascent institutional infrastructure that is being rushed to operationalise the IBC. In this article, we analyse some of the challenges of transitioning existing cases to the new law.

The IBC offers a time-bound resolution process aimed at maximising the value of a distressed business. This will benefit not just the creditor and debtor companies, but also the overall economy because capital and productive resources will get redeployed relatively quickly. To meet the objectives of timeliness and value maximisation, the IBC proposes a new institutional set-up comprising four critical pillars:

1. A robust and efficient adjudicating authority to hear the cases.
2. A regulated profession of insolvency professionals (IPs) to manage the insolvency and bankruptcy cases.
3. A regulated competitive industry of information utilities (IUs) to reduce information asymmetries in the insolvency resolution process.
4. A regulator – the Insolvency and Bankruptcy Board of India (IBBI) – to perform legislative, executive and quasi-judicial functions with respect to the IPs, and IUs and draft regulations for the resolution procedures under IBC.

Steps are currently underway to set up this institutional infrastructure. The National Company Law Tribunal (NCLT) has been notified as the adjudicating authority for the corporate insolvency and bankruptcy cases. The IBBI has been constituted and has started building capacity. The regulatory framework for IPs and IPAs is in place and some IPs and IPAs have already been registered by the IBBI. It may take some time for new IUs to get registered but even without the IUs in place, the provisions of the IBC related to the Corporate Insolvency Resolution Process (CIRP) and liquidation have been notified. While the former has been operational from December 1, 2016, liquidation provisions will come into force from December 15, 2016. Clearly, the speed of implementation has been prioritised leaving the institutional set-up to develop in parallel to the functioning of the law.

Challenges in implementation

The NCLT will face the biggest challenge in the process of transitioning existing cases to the IBC. The NCLT currently has 11 benches with 16 judicial members and seven technical members among them. Its mandate includes hearing cases earlier dealt with by the Company Law Board (CLB) under the Companies Act 2013, in addition to cases under the IBC. As of March 2015, there were around 4,200 pending CLB cases. All of these will now be transferred to the NCLT. In addition, the CLB receives around 4,000 new cases every year. Now these will have to be dealt with by NCLT. With the IBC provisions on CIRP becoming operational and the provisions on liquidation expected to be notified soon, all the 4,500 winding-up cases pending at the high courts as of March 2015 are also likely to get transferred to the NCLT. Our analysis shows that corporate recovery cases at the debt recovery tribunals (DRTs) and the rehabilitation cases at the Board for Industrial and Financial Reconstruction (BIFR) are eligible to be initiated as new IBC cases.

Therefore, given its limited capacity, how will the NCLT deal with fresh IBC cases, added to which will be the case load from the CLB, the high courts, the BIFR and potentially the DRT? Unless its adjudication capacity is enhanced, the NCLT will fail to hear and dispose cases in a timely manner from the start. For the IBC cases, this could mean the inability of the NCLT to adhere to the 180-day timeline that is the duration of the CIRP. This has earlier been seen in the case of DRTs too. DRTs were intended to dispose of recovery cases in 180 days, but given capacity issues and pendency, often the first hearing for a case takes place after 180 days. The 180-day timeline represents the core design intent of the IBC – rapid resolution of insolvency to maximise recovery. If this is compromised due to capacity constraints, the effectiveness of the IBC will get diluted.

The second concern related to the NCLT is regarding the case law that develops under the IBC. Given that it is a new law, the procedures and common practices under it need to develop independently from the case laws under the pre-IBC regime. Since the first cases that come to the IBC are likely to be the existing ones, the initial case law that develops under IBC will reflect the context of these cases. The behaviour of creditors, debtors, auditors, lawyers, valuers, liquidators are all steeped in the old case laws under the Companies Act 1956, the Sick Industrial Companies Act 1985 (SICA), the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 and the like. This will change only when the IBC gets perfected as a law and its institutional infrastructure reaches its capacity, allowing the NCLT to focus on upholding the design and objective of the IBC over all priors that exist. For this, the IPs, the IUs, the NCLT and the IBBI all need to be properly set up and functioning in a manner envisaged by the IBC.

IPs form the backbone of the IBC. Their role requires a fine balancing act, given that they are in charge of managing the debtor company and are accountable to the committee of creditors and the adjudicating authority for their actions. To ensure that the IPs perform their role without any misfeasance, well-defined entry barriers to the profession must be designed and the IPs must be closely regulated by the IBBI. A qualification examination has been proposed to get registered as IPs. This is modelled after the best practices of other jurisdictions such as Canada and the UK that have a well-functioning industry of IPs.

The IBBI, however, has now licensed the first batch of IPs only on the basis of their professional experience. Given the speed with which the law is being implemented, this seems to be the only option till the infrastructure for conducting the examination is set up. IPs registered in the first round also need to be prepared to handle the complexities of the existing cases. The IBBI needs to have adequate capacity to monitor the IPs and ensure that malpractice and fraud do not seep into the profession in the early days. For this, the IBBI needs to ramp up its human resources and its IT capability and build a far greater level of preparedness than it is at, right now.

The lack of IU infrastructure is going to be another challenge. Under the IBC, a CIRP can be triggered only when a default by the debtor company has taken place. In the IBC design, the IU enables a quicker initiation of cases by providing access to irrefutable and transparent evidence of the default. At present, winding up petitions under the Companies Act, 1956 and cases under SICA take around one to two years to get admitted. The situation is marginally better at the DRTs, where the Bankers Books Evidence Act allows bank books’ to be treated as primary evidence in cases. Even then there are delays in establishing the existence of a debt and default.

In absence of IUs, the IBBI is required to specify the evidence of default that can be used to trigger an IBC case. This can cause inordinate delays especially if the NCLT gets involved in evaluating whether a default has indeed taken place. Under the IBC design, IUs also facilitate the formation of the creditors’ committee within 14 days from the date of registration of a case. All information regarding the creditors’ claims needed by an IP to form the committee can be easily collected from the IUs.

It is therefore likely that in absence of IUs, initiating a case as well as forming the creditors’ committee will take far longer than envisaged in the IBC design. This will make it difficult to meet the 180-day timeline for completing the CIRP, giving rise to two possible outcomes. First, the delay in forming the creditors’ committee will reduce the time available to agree on a resolution plan. If the committee cannot agree on a resolution plan within the specified time limit, the NCLT will order the liquidation of the company. Secondly, the NCLT may exercise its judicial discretion and extend the CIRP beyond the time limit specified in the law. Both these outcomes have negative consequences. The former creates a liquidation bias in CIRP while the latter compromises the fundamental design of time-bound resolution in the IBC.

The manner in which the IBC is currently being implemented seems to focus more on expeditiously operationalising the law rather than effectively implementing it. These concerns, if not addressed suitably, will defeat the purpose of enacting a new insolvency law to improve the recovery rate in order to promote the development of credit markets and entrepreneurship.

Will it work?

The IBC is an important reform for India and its successful implementation depends on meticulous transition planning. The first cases coming to the IBC are likely to be the existing corporate insolvency cases. Four steps are needed to ensure that these do not impact the design and effectiveness of the IBC in an adverse manner.

The capability of the NCLT needs to be developed with adequate project planning. This could mean a special bench designated only for the IBC cases, scaled to the expected IBC case load and trained in dealing with commercial matters including the complexities of the existing cases. The NCLT needs to ensure that for any case coming to the IBC, whatever be its priors, the IBC provisions are followed without any exception. If the NCLT is built like a conventional Indian tribunal, it can develop a multi-year backlog very soon.

It is critical that the winding-up cases that come to NCLT are disposed of separately from the IBC cases and their outcomes in no way impact the IBC case laws. The capacity of the IBBI needs to be brought to scale as quickly as possible so that no malpractices or adverse priors develop in the IP practice and the entry barriers to the profession need to be implemented in accordance with the law. India has a long history of failure in the regulation of professions. The regulatory system for IPs must be designed to avoid creating yet another failed profession. Finally, the IUs need to be operationalised. In their absence, the IBBI needs to specify clear guidelines that enable the timely admission and disposal of the existing cases. This means a rapid creation of regulatory capacity in terms of people, processes and information technology systems.

Adequate institutional capacity is essential to ensure that the IBC does not suffer from the predicament of earlier reform attempts such as the DRTs. Doing all of these needs time and needs proper planning. Rushing through the implementation of the new law may serve to improve India’s ranking in World Bank’s ‘Doing Business’ report but may not result in a de facto improvement of the insolvency resolution framework, thereby defeating the very purpose of the IBC.

Demonetisation Will Likely Lead to a Protracted Economic Slowdown

The Wire, December 12, 2016 (with Radhika Pandey)

In most emerging economies, an important driver of GDP growth is investment demand. In India, private sector investment has been sluggish for consecutive quarters over the last two years. The principal driver of GDP growth in India in recent times has been private consumption demand, which contributes 60% to the GDP.

The announcement by the government on November 8 to ban the Rs 500 and Rs 1000 currency notes is a monetary contraction that will translate into a massive negative shock for consumption demand. As more and more firms start feeling the pressure of declining demand, investment will get adversely affected. The combination of a slowdown in consumption and investment may result in a fall in GDP growth rate lasting beyond two quarters.

GDP growth rate was estimated at 7.3% in the July-September quarter of 2016-17. The marginal increase from 7.1% in the April-June quarter was primarily driven by agriculture, construction and the services sector. Ironically, these sectors are now likely to bear the brunt of the currency-ban shock. Year-on-year manufacturing growth rate has declined from 9.1% in the previous quarter to 7.1%. In the July-September quarter investment demand contracted by 5.6%, resulting in a large negative contribution to the GDP.

In general, private sector activity in the economy has been weak in the recent quarters. The state of the economy prior to the announcement of the currency ban is essential because it highlights the structural weaknesses in the economy that may worsen as a result of this shock and aggravate the economic slowdown.

Cash in the economy

Estimates suggest that the reduction in GDP could be somewhere between to 330 basis points. Given the widespread reliance on cash, the actual impact could be bigger. The following highlight the dependence of the Indian economy on cash:

• India is amongst the most cash-intensive economies in the world with a cash-GDP ratio of 12%. The same ratio in its peer economies such as Brazil and South Korea is one-third of India,

• Cash in circulation to private consumption ratio in India is 20%,

• Card transactions account for 4% of the personal consumption expenditure.

In such a cash-dependent economy, all of a sudden around 86% of the cash supply has been rendered useless. This has effectively imposed a tight constraint on real economic activity. This constraint will initially be felt most acutely in the cash-intensive sectors such as agriculture, construction, gems and jewellery, textile, trade, transportation and real estate as well as in the activities in the vast informal sector of the country.

Beyond the initial impact, the shock from demonetisation is likely to set off a domino effect that will impinge on activities far removed from the cash-intensive sectors. This impact may result in a protracted economic slowdown going beyond the current financial year.

It is likely that firms and households will innovate in an attempt to get around the cash constraint. Formal financial services will provide support to those who have access to them. Firms in the retail business that utilise the formal financial services will face a rise in demand as consumers shift from the cash economy to the digital economy. These innovations will dampen the effects of the shock to some extent, however, they cannot act as much of a cushion in an economy which is so overwhelmingly dependent on cash. So, even if the share of digital transactions doubles, it would still represent only a small portion of the transactions in the economy.

Will the economy rebound after a short period of distress?

While some initial data has already started signalling a slowdown, experts opine that the slowdown in the next two quarters would be temporary and would be followed by a quick and strong period of rebound. They conjecture that as the expected benefits of the currency ban start kicking in and as the cash supply in the economy gets replenished, normalcy will be restored.

We, however, argue that reviving the real economy and getting it back on a high growth track could be a much more difficult and time-consuming process.

A continued shortage of cash is already forcing consumers to postpone their purchases, especially of non-essential goods and services. There have been reports of a decline in footfall in shopping malls and retail outlets have reported a sharp drop in sales over the last month.

In an environment of uncertainty, it is natural for economic agents to behave cautiously. Two kinds of currency have now emerged – cash and deposits. While people are able to convert cash into deposits, going the other way round is more difficult due to the administrative restrictions imposed by the government on withdrawals along with the unavailability of sufficient usable banknotes even a month after the demonetisation.

Given the widespread uncertainty about more restrictive withdrawal limits being imposed and about the time taken by banks and ATMs to disburse the new notes, it is likely that households will hoard whatever cash they are able to obtain instead of spending it. This tendency to build up precautionary savings could continue for a while even after the money supply is restored. This will exert an additional downward pressure on consumption demand.

The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold, i.e. MV=PY, where M is the money supply, V is the velocity of circulation of money, P is the price level and Y denotes output.

The currency ban has reduced the money supply drastically. As people hold back consumption and hoard cash, the velocity of circulation will fall. This means both P and Y have to decrease commensurately in order to restore equilibrium in the system. Estimates suggest that it may take six to eight months for the new currency notes to fully come back into circulation. The time taken to restore money supply may reduce the velocity of circulation for an even longer period, thereby resulting in a protracted GDP contraction.

Long-term impact

A stable, sophisticated economy is one where economic agents are able to take risks as well as make long-term plans. This includes private businesses, financial investors and households. A major shock like the currency ban disrupts the overall stability of the economy. The continuous change of rules almost on a daily basis further adds to the uncertainty. Since November 8, the government has changed rules related to the currency ban over 20 times and the RBI has released more than 15 sets of frequently asked questions to clarify this change in rules. These actions create an environment of unpredictability and in such an environment, firms and households hold back their investment and consumption plans. This further puts a brake on real economic activity and it is likely that even after the currency notes are back in circulation, the brakes stay on or are only gradually lifted.

One segment of the real economy that could be severely hit by demonetisation is the medium, small and micro enterprises (MSME) sector. This sector plays a pivotal role in the economy, contributing about 8% to the GDP, 45% to the total manufacturing output and 40% to the total exports from the country. Given the reliance of the sector on cash, especially for the small and micro enterprises, and the cost of compliance with regulations in the formal sector, some of these firms may not remain viable or solvent in the changed environment.

Some of these firms that were already struggling to meet their interest payments amidst the business cycle downturn over the past few years, may now tip over and become bankrupt as a result of the liquidity crunch. Once businesses start failing, valuable organisational capital gets eroded. Irrespective of how quickly money is put back into circulation again, some of these losses could be irreversible, thereby inflicting long-lasting damage on the growth of this sector.

The initial contractionary effect on the sale of goods and services will negatively impact business investment at a time when private sector investment is already sluggish.

The revival of private sector investment requires a sustained flow of credit. Bank credit to the corporate sector has remained tepid over the last few months. Analysis shows that despite banks receiving a large volume of deposits since November 8, their ability to make fresh loans remains limited. In addition to this, if a large number of firms in the MSME sector default on their loans, this will exacerbate the existing non-performing asset (NPA) problem of the banks. This, in turn, may further affect their capacity to extend credit given their already precarious capital adequacy position. These developments coupled with the heightened macroeconomic instability triggered by the currency ban do not augur well for the private investment scenario.

Another long-term impact of the shock may result from the negative wealth effect on consumption demand. For example, the real estate sector is likely to take a severe hit due to the currency ban since a large percentage of the transactions in this sector have traditionally been cash-based. As real estate prices start falling due to the liquidity crunch, people who had invested their savings in real estate will experience wealth erosion and may cut back on future consumption plans. This is likely to impose a lingering effect on aggregate demand.

The long lasting nature of the economic slowdown may also result from the ripple effects spreading across the entire real economy. It is well understood by now that the large informal sector accounting for 80% of the country’s employment and 45% of the GDP will be disproportionately affected by the liquidity crunch because of its inherent dependence on cash. While the share of the informal sector is estimated at ‘only’ 45%, this hardly means that majority of the economy will be insulated from the shock. A reason for that is that firms are interlinked in production. The production and sale of a good require a long chain of transactions, many of which involve cash.

If just one link in this chain breaks down, there will be problems. For example, one tends to imagine that exports will not be affected, because exports generally involve bank transactions and not cash. But that is only true at the final stage. At the earlier stages, cash can be quite important, for example, in the textile sector where many of the activities are carried out in small workshops and are cash-dependent. If a large number of these workshops start shutting down because of liquidity constraints and a decline in sales revenues, the entire supply chain in the textile sector will get disrupted. Even if the new notes come back into circulation in a few months’ time, this kind of real economic disruption may last much longer.

All these point to the possibility that once GDP growth starts falling, it may take several quarters before the economy gets back on track again.

Conclusion

The impact of the contractionary demand shock triggered by the November 8 currency ban will gradually radiate from cash-intensive activities to virtually every sector of the economy. This will lower the GDP growth. The resurgence in growth may prove to be a challenge and may take longer than expected in an already sluggish investment scenario. Given the magnitude of the shock and the channels through which economic activity may get disrupted for close to a year, if not more, it is surprising that the RBI estimated the impact on growth to be limited and transitory as announced in its recent monetary policy review meeting.

It may be worthwhile to ask, had the currency ban announcement not been made, how would the economy have progressed? Before November 8, India’s GDP was growing roughly at 7%, primarily boosted by growth in consumption expenditure. Private investment activity has been weak. Banks have been saddled with NPAs and till now no well-defined policy measure has been devised to resolve the problem and boost credit off-take in the economy. Demand for corporate credit has been stagnant for several quarters and an overleveraged corporate sector has been refraining from initiating new investment projects.

During this time, the singular objective of the government should have been to adopt structural reforms to stimulate GDP and achieve a high and sustainable growth rate. Generating jobs to absorb the demographic dividend while it lasts should have been another policy priority. Instead of prioritising these objectives, the government announced a measure that has in fact dealt a severe negative blow to the overall economy.

The associated policy uncertainty is contributing to macroeconomic instability. Arguably, this is the last thing that was needed now given the pervasive weakness in the credit and investment climate. Policymaking over the next couple of quarters is likely to get hijacked by this single event in order to ameliorate a potential economic damage. All this is very costly both in terms of the time spent and the resources used up in first delivering the shock and then in restoring normalcy.

The longer the time taken to normalise the situation, the deeper will be the damage inflicted upon the real economy, and some of the damage caused may end up being irreversible. Perhaps a year later it would be worthwhile to ask whether the costs in terms of a protracted economic slowdown were worth the benefits arising from this move.

How will IBC 2016 deal with existing bank NPAs?

How will IBC 2016 deal with existing bank NPAs? The Leap Blog, December 5, 2016 (with Anjali Sharma).

Demonetisation needs a Parliamentary law to be fool-proof

Demonetisation needs a Parliamentary law to be fool-proof The Leap Blog, December 1, 2016 (with Pratik Datta).

What does the currency ban mean for banks?

Mint, December 1, 2016 (with Anjali Sharma)

The withdrawal of Rs500 and Rs1,000 notes on 8 November has changed the composition of money supply in the economy. A large part of what was currency in circulation is now coming to banks as deposits. The sudden inflow of deposits has given rise to speculation about how these will be utilised by the banks. There are reports that banks will increase lending. Some have suggested that banks’ non-performing asset (NPA) problems will get alleviated. This is not correct. Our analysis suggests that: (1) banks are not in a position to significantly increase lending, (2) their net interest income (NII) may fall over the next few quarters, worsening their capital position, and (3) their NPA situation may get worse, further adding to their capital woes.

Close to 86% of the currency in circulation, amounting to roughly Rs14 trillion, was withdrawn overnight. By 13 November, Rs5.1 trillion out of this had been deposited in the banking system and Rs0.3 trillion had been exchanged over the counter. A large part of the remaining Rs9 trillion will get deposited in banks now that the exchange of old notes has been discontinued. At the same time frictions such as withdrawal limits on bank deposits, logistical constraints of re-stocking ATMs, banks’ capacity constraints in dealing with the surge in transaction volumes imply that it may take several months for the currency in circulation to even come close to its pre-8 November level.

Deposits are liabilities on a bank’s balance sheet, which they use to make loans and advances, which are their assets. However, in making these loans and advances, they have to adhere to two principles. The first is the principle of asset liability matching. This broadly means that short-term liabilities are used to generate short-term assets. If long-term loans are made using short-term deposits, banks are exposed to the risk of not being able to pay back when required or having to raise costly funds from the market to do so. The second is the principle of maintaining bank capital commensurate with the risk profile and quantum of loans made. These are according to Reserve Bank of India’s regulations and are in line with international standards set under Basel II.

First, in the current context, banks do not know how long these new deposits will stay on their books. So they can deploy these only in short-term assets. Second, the burgeoning NPAs of the banking system have significantly eroded their capital base and hence their ability to lend. In June, gross NPAs (GNPAs) of listed banks were Rs6.7 trillion or 9.1% of their advances. The 27 public sector banks (PSBs) account for 80% of these NPAs. In 15 of them, GNPAs as a percentage of advances are more than or close to the capital to risk weighted assets ratio (CRAR). Except for the State Bank of India and a few other PSBs, the CRAR headroom required to make new loans does not exist.

Given both these factors, banks will face constraints in using the new deposits to make new loans. There is also a question of demand for new loans. Corporate credit demand has been slow. The currency ban has imposed a big negative shock on consumption demand, which in turn may lead to businesses cutting back on their working capital requirement, at least in the next few quarters. This in turn will affect the demand for working capital loans.

If banks cannot make loans on these deposits, then they can either park them with RBI as reserves or invest them in government securities (G-secs). Banks would not prefer to park these deposits as reserves with the RBI beyond the cash reserve ratio (CRR) limit, because these reserves do not earn them any interest. They would prefer to invest the deposits in G-secs through the reverse-repo window. G-secs being sovereign bonds do not pose any capital requirements on banks, give them returns and allow them to match their asset liability profile.

The availability of G-secs in the market is determined by the borrowing programme of the government and is not easy to expand without raising fiscal concerns. This limits the supply of G-secs using which RBI can absorb the excess liquidity from the banks. There has been no announcement yet on the expansion of the supply of G-secs. This implies that with more incoming deposits, RBI will soon run out of G-secs that are needed to absorb the excess liquidity. This seems to be the case because RBI has now made it mandatory for banks to hold 100% CRR on incremental deposits. This announcement prevents banks from investing the incremental deposits in G-secs.

This does not augur well for banks. Their ability to make loans from the new deposits and earn income is already limited, for reasons discussed earlier. With the 100% incremental CRR requirement, the possibility of banks earning risk-free returns by investing the incremental deposits in G-secs is also removed now. Theoretically, one option with the banks is to lower the deposit rates. However, even after interest rates were deregulated, banks have not reduced deposit rates below the level of 4% that prevailed in the regulated regime. Lowering deposit rates below 4% may cause a public uproar and it is unlikely that banks will take this step. Given this, banks will have to service the cost of these fresh deposits without earning commensurate income on them. This will negatively have an impact on their NIIs and their profits, at least for the next two quarters, which in turn will cause further deterioration in their capital position.

Overall, the move to ban the Rs500 and Rs1,000 notes does not appear to be a positive one for the banking sector. They may not be in a position to significantly increase lending and their capital base may get worse. If economic activity slows down in the aftermath of the currency ban and corporate performance deteriorates, there may even be a spike in their NPAs, at least in the short term. In addition to this, bank branches all over the country have been struggling to deal with the massive transaction load that this move has placed on them. The normal banking business has been disrupted and bank employees have been occupied in dealing with exchange, deposits and withdrawals of currency. Yet the task is far from over and it is likely to keep them fully occupied till 30 December. At a time when the banking sector has been struggling to recover its bad loans and to find adequate capital to deal with provisioning challenges, this sudden shock may worsen the situation even further.