Systemic change:
Hits and misses of India’s bankruptcy reforms code

India’s Insolvency and Bankruptcy Code (IBC) has had a carrot-and-stick effect: making companies serious about governance and bringing stuck capital back into the economy. Recovery rate under IBC has improved from 25 per cent to 43 per cent and the cost of resolution has reduced from 9 per cent of the balance sheet to just 0.5 per cent, according to one estimate. The Supreme Court sometimes overrules the IBC ecosystem and operational creditors feel slighted for not being considered at part with financial creditors. It’s work in progress, but the system is working.

Abhishek Waghmare, Business Standard
24th December

Steel matters: it's used in a host of products, from automobiles to houses. In 2019, two of India’s biggest steelmakers changed hands. Tata Steel acquired Bhushan Steel for nearly Rs 35,000 crore in May, and ArcelorMittal and Nippon Steel together acquired Essar Steel for Rs 42,000 crore in December. The deals kept India’s steel supply running.

The company takeovers would have been cumbersome but for the Insolvency and Bankruptcy Code (IBC), a three-year old legislation that has transformed insolvency management in India. Bhushan and Essar were the biggest resolutions from a list of 12 companies identified by the Reserve Bank of India (RBI) in 2019.

Lenders, or financial creditors (FCs), took a 37 per cent haircut (63 per cent realisation of asset value) for Bhushan Steel. The Essar Steel resolution yielded FCs a staggering 90 per cent of their claims, taking the haircut down to 10 per cent.

That would not have happened unless a host of agencies--the government, bodies established under the IBC, and the Supreme Court--had not intervened. That has been the story of IBC: creditors and applicants managing their disagreements inside and outside the resolution process, the Supreme Court sometimes overruling the IBC ecosystem, and financial creditors being ranked higher than operational ones.

A complex set of debates and arguments, claims, bids and successive bids is still shaping up the IBC process. It is a success story in the making but one that is throwing up challenges at each step.

Recovery rate under IBC has improved from 25 per cent to 43 per cent and the cost of resolution has reduced from 9 per cent of the balance sheet to just 0.5 per cent, writes M S Sahoo, chairman of Insolvency and Bankruptcy Board of India (IBBI), in a compendium on IBC released earlier this year.

How IBC works, and helps

IBC has reduced the average resolution time to about a year, compared to five years under the previous regime. Yet, Essar Steel resolution took 805 days--the delay happening because the Ruias, the former promoters, attempted to bid or the company, and challenges by operational creditors.

It facilitates establishing a contract between two or multiple parties with the oversight of the state, helps build consensus and brings stuck capital back into the economy. Industry credit in India is almost stagnant, with greenfield investments even in absolute terms at near-record lows. Overall growth in bank credit has fallen back to 8 per cent as 2019 ends.

The IBC, in its essence, aims to bring industry credit growth back to double digits. It’s creditor-friendly, in contrast to the debtor-friendly or creditor-and-debtor at par regimes before.

When a resolution process starts, financial creditors such as banks and non-banking financial companies (NBFCs) take precedence in the Committee of Creditors (CoC). This has been one of the most contesting debates under the IBC to date. The distribution of claims made by all classes of creditors are debated in the CoC.

The contest has been between financial and operational creditors, with the former claiming primacy and the latter expressing their right over fair share in the resolved/liquidated value.

“FCs have long-term interest in the company’s performance while OCs is interested in being paid, regardless of whether the company is liquidated or continues as a new entity,” says Shubhashis Gangopadhyay, research director at India Development Foundation, in an edited volume on IBC published by the IBBI.

Creditors in contest

The primacy of FCs was underlined in the Essar Steel case—a development most experts have welcomed. “In the case when the FCs have different contractual rights than the OCs, they are never in the same position. The Code [IBC] does recognise this and does not let treat different classes of creditors in the same manner,” says Shreya Prakash, senior resident fellow at the Vidhi Centre for Legal Policy.

However, the asymmetry in voting rights puts OCs at the mercy of the FCs, says Gangopadhyay.

Insolvency professional Sumant Batra, too, warns against the secondary treatment of OCs. “Due to this, many service providers now are unwilling to provide services to an ailing company with the same vigour as they used to. They fear that if the company becomes insolvent, they will lose out the most,” Batra says.

This has hurt credit culture to some extent at the level of OCs, he said, asserting that the concept of financial creditor is unique only to India.

“Globally, the distinction is secured vs unsecured creditors, wherein the former gets top priority, irrespective of whether the debt is operational or financial,” Batra says. Secured FCs get primacy over unsecured FCs in the current IBC model.

Now the CoC, made up of FCs and OCs (or their representatives) discusses and decides the way money should be distributed after an applicant filed a bid. According to law, only financial creditors get to vote in CoC decisions and operational creditors don't. Further, share of different FCs to the failing company is an important factor in deciding the rightful share of a particular FC in the offer made.

There have been some key instances where the NCLT and NCLAT have judged the OCs and FCs impartially, using their adjudicating power to return a particular resolution plan. The reasoning given mostly adheres to the norms of natural justice, applying which tends to give OCs a bigger share in the pie.

However, the Supreme Court has time and again reiterated in these cases that the commercial wisdom of CoC should have primacy in the resolution process. It is somewhat akin to the dictum: let the big fish decide who gets what.

The NCLT and National Company Law Appellate Tribunal, which have generally adhered strongly to the principles of natural justice (to put it loosely, a situation in which weaker claimants get stronger shares), but the SC has struck it down multiple times. The government, too, has promptly made changes in law.

For example, in the same Essar Steel case, the NCLAT had ordered a distribution of Rs 30,000 crore to the FCs, and nearly Rs 12,000 crore to the OCs. The SC overruled this order to pass on Rs 42,000 crore to the FCs, and less than Rs 3,000 crore to OCs.

As Ajit Ranade, chief economist at Aditya Birla, writes in the IBBI volume, the role of the state comes in while enforcing contracts between private parties when incentives change during and after the process. The SC judgments and subsequent swift government action have restored the primacy of commercial decision making of the CoC to safeguard market dynamics.

The market finds liquidation a legitimate and potent way to resolve stuck assets, but IBC regards it as a last resort. Every effort is being made in most cases to prevent liquidation.

IBBI chairman Sahoo maintains that the primary focus should be resolution, and that for a company to continue, ensuring that there is “no death by liquidation.” Market mechanism should come to the rescue of a failing company, resulting in “creative destruction.”

Batra, however, argues that though there is “erosion of value” in liquidation and the CoC is best placed to decide whether it is the best option.

In majority of the cases, the liquidation value has been higher than other resolution options, IBBI data shows.

But even if liquidation does not happen, liquidation value is extremely important to the IBC process. When either FCs or representatives of OCs dissent on the decision of the CoC, they still receive a share of the resolved value, and its quantum is equal to the liquidation value, as certified by a valuer.

The most important responsibility of the resolution professional is to constitute the CoC, which admits claims and decided on the distribution.

The resolution professional, however, acts as a pivot, and assesses claims, makes value judgement to some extent, while running the company, says Bharat Chugh, partner at law firm Luthra & Luthra.

But apart from these roles, experts feel that the RP should become more proactive in the IBC process, especially in the case of related party transactions.

“The prevalence of such transactions is on the rise, and the RP has all the powers to investigate, trace transactions, use forensic audits to arrive at conclusions. But the progress in this regard is a bit slower than expected,” a company law expert, who does not with to be identified, says.

The RP does not have adjudicating powers, but ends up deciding on a lot of things, says Chugh.

Fear of insolvency

A rule called Section 29A, added to the Code in 2018, bars promoters from bidding for their own company, or any related party to bid for an insolvent company to which it has connections. Existing promoters of a failing company are barred from bidding and taking back control.

The rule was introduced to help corporate governance standards, but many, such as State Bank of India chairman Rajnish Kumar, have said that it is being “stretched too far,” suggesting that there probably is merit in making some relaxations.

Section 29A has prompted many a corporate debtor to settle matters outside the IBC and run their companies productively again, says Shreya Prakash of the Vidhi Centre for Legal Policy.

IBC has prompted businesses to settle disputes outside the insolvency process, instilling fear of losses and insolvency.

Excessive importance of timeliness can be detrimental sometimes, but neglecting liquidation is worrisome too, says Batra.

He also suggests that the CoC should be able to freely decide on the viability of the company and the subsequent direction: resolution or liquidation. Avoiding liquidation at any cost proves costlier many a time, he says.

An effective bankruptcy ecosystem should ultimately improve in credit market efficiency. While IBC is on track to achieve the same, it is yet to show its strength in full might, experts concur.


Corporate Debtor (CD): The owners of a failing company

Financial Creditor (FC): Bank and non-bank financiers to the failing company, having voting rights in CoC

Operational Creditor (OC): Those who do not owe debt, but are linked to the company as employees or service providers. They have no voting rights in the CoC

Committee of Creditors (CoC): A panel of the members or representatives of the two types of creditors, with different rights and powers

Insolvency/Resolution Professional (RP): The person who takes charge of the management of a failing company till new owners take over

Claims: Assessment of exposure towards a failing company; these are admitted/rejected by RP

Resolution Applicant: The bidder who places a bid based on claims admitted and his own assessment of the sickness, viability

NCLT: National Company Law Tribunal, the primary law court under the company law in India, also the Adjudicating Authority under the Code

NCLAT: National Company Law Appellate Tribunal, the appeals court under company law

Liquidation: Rapid sale of assets of the company which causes loss of productivity and immediate turnout in cash

CIRP: Corporate Insolvency Resolution Process, that starts with admission of the case into NCLT, and ends either by withdrawal, resolution or liquidation

IBBI: Insolvency and Bankruptcy Board of India, the regulator under IBC (similar to how SEBI is financial markets regulator)

What happens under IBC

A corporate debtor or a lender to the company that is unable to pay a financial obligation, or an aggrieved service provider approaches the NCLT with a petition to push a failing company into a Corporate Insolvency Resolution Process (CIRP).

Petitioners hope to get good return on investment for the corporate debtor, interest and principal in the case of FCs and salaries, service charge and interest in the case of OCs.

A resolution professional (RP) takes over the failing company, accepts and assesses claims of interested bidders, submits them to the CoC for final decision making.

This decision can be challenged in the NCLT, appeal to which (if a competing bidder disagrees) can be made to the NCLAT, which can further be challenged in the Supreme Court, the final authority.

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