One of the most ambitious pieces of legislation created by the incumbent government is the Insolvency and Bankruptcy Code, 2016 (IBC). The legislation, as well as detailed rules have been finalised in record time. The Insolvency and Bankruptcy Board of India (IBBI) was set up on October 1, 2016, under the IBC. As its website states, "It is a unique regulator: regulates a profession as well as transactions. It has regulatory oversight over the Insolvency Professionals, Insolvency Professional Agencies and Information Utilities. It writes and enforces rules for transactions, namely, corporate insolvency resolution, corporate liquidation, individual insolvency resolution and individual bankruptcy under the Code." As we approach the first anniversary of IBBI, legal challenges have already been made against the first resolution plan approved by the National Company Law Tribunal (NCLT). The Supreme Court has also pitched in on another matter (Jaypee Infratech), which threatens to derail time-bound resolution envisaged as a key feature of the Code. Despite these challenges, it is hoped that the Code will help make resolution of bankruptcies speedier and free up financial and other resources for better utilisation.
A historical tour of stressed asset resolution
Until the IBC, multiple legislations governed bankruptcies. These are as follows:
- Companies Act, 2013 - Chapter on collective insolvency: Resolution by way of restructuring, rehabilitation or reorganisation of entities registered under the Act
- Companies Act, 1956: Deals with winding up of companies
- SICA, 1985 (now repealed): Deals with restructuring of distressed 'Industrial' firms. The Board of Industrial and Financial Reconstruction (BIFR) assesses the viability of the industrial company.
- Recovery of Debts Due to Banks & Financial Institutions Act, 1993 (RDDB Act)
- Securitisation & Reconstruction of Financial Assets & Enforcement of Security Interest Act, 2002 (SARFAESI)
The multiplicity of regulations, lack of adequate resolution infrastructure and shenanigans of borrowers using regulatory arbitrage to delay outcomes meant that the average life of insolvency proceedings in India was 4.3 years, with a recovery rate of 25 per cent as opposed to almost 72 per cent in some OECD countries.
Features of the Code
The Code marks a shift in defining bankruptcy from the balance sheet (is the net worth positive?) to cash-flow (can the company meet its payment obligations). It also shifts the control of the company once the resolution process is underway from the management to the creditors. The Code defines a framework of new entities that constitute the infrastructure for the Code.
A key feature of the Code is a time-bound resolution framework. Cases are to be resolved within six months with a maximum extension of another 90 days. Coupled with a reduced scope for judicial intervention, it is hoped that the process will be more effective than what exists currently.
Two legal cases are already testing the Code. In the first, Edelweiss Asset Reconstruction Company (EARC) has challenged the first ever resolution award of NCLT from its Hyderabad bench. EARC alleges that the restructuring company, through a legal subterfuge, managed to get its proxy the deciding vote in the Committee of Creditors. Consequently, the resolution award that meant lenders would take a 94 per cent haircut on their loans was not reflective of the views of independent lenders. They also allege that the resolution professional displayed bias by not acting on their complaint. NCLAT has accepted the matter for hearing.
In another case - that of Jaypee Infratech - Supreme Court has intervened at the behest of property investors. These property buyers have not received their promised real estate and now stand as unsecured creditors. In the event of liquidation, it is feared that after paying secured creditors, who are higher in the waterfall of distribution of liquidation proceeds, there will not be anything left for the putative flat owners to recover their investments. After initially stalling the process under the Code, the Court modified its order to let the company come under the control of the 'resolution professional'. We now wait to see how the conflict between home-owner rights and that of secured lenders will be balanced by the Court.
An alternative solution
The cases above illustrate the key problem in the current structure resolution, which is modelled on Chapter 11 of the US Bankruptcy Code. In essence, the Code seeks to answer two questions: who will get what amongst the different classes of investors (secured, unsecured, operational creditors, equity holders) and what to do with the company (continue, sell off, shut down, etc.). A paper published in January 1994 in the Washington University Law Review sought to create a new procedure to solve this problem. The authors named it the AHM Procedure after the papers co-authors (Aghion, Hart, Moore). The procedure seeks to align the interests of the competing classes of investors by converting them all into a homogeneous class of shareholders who then vote on what to do with the company.
Let us assume that there is a single class of creditors for a company whose debt adds to 'D'. Debt holders would convert debt to equity in proportion of their debt (the original shareholders are wiped out). The original shareholders then get the right to buy out the new shareholders (earlier debtors) and restore their holding at the value of D. If offered, the new shareholders are required to sell. Obviously, if the old shareholders estimate that a 'going concern' is more valuable than D, they will exercise the option. If not, new shareholders may decide to liquidate assets and pay themselves.
This is like 'promoters' bringing in new money to buy off debt. However, here, not all new shareholders may be bought out or not all their equity would be bought out.
This can be generalised to many classes of creditors, where each lower level has the right to buy out the equity of the higher claim holder by paying the debt off. Once the shareholding is stable, the new shareholders put the company's future to vote. A strong advantage of this method is the lack of need for an 'adjudicator' - decisions are made by the people who are most effected. This reduces that need for qualified professionals while also restraining judicial over-reach.
Clearly, the last has not been heard on the resolution issue. What is important is that a very serious attempt has been made to expedite its resolution. Ironically, a faster resolution will also likely imply a bigger dent in lenders books. Perhaps corporate lenders need to brace for another spike in provisions for non-performing assets.