Decoding the Code

IBC, 2016, lays down a roadmap for beleaguered companies

The Indian banking system is plagued by asset quality pressures. Headwinds in capital-intensive sectors, including infrastructure, have led to high slippages and non-performing asset (NPA) levels. Despite multiple restructuring mechanisms being put in place, recovery remains a challenge. Although the magnitude of stressed loans is already known, much is yet to be seen in terms of resolution and recovery. High stress continues in sectors such as power, construction, and iron and steel, mainly due to regulatory hurdles and the weak financial profile of borrowers. There has been a lack of consensus between lenders and promoters which has delayed decision-making and has resulted in limited success of restructuring schemes. The newly introduced Insolvency and Bankruptcy Code (IBC), 2016, seeks to address the NPA issue by bringing in a consolidated legal framework to deal with defaults by companies and partnership firms in a time-bound manner. The provisions of the code have been enforced from August 5, 2016 to June 14, 2017, and the code supersedes all extant insolvency laws.

As per CRISIL estimates, gross NPAs of banks are expected to inch up from Rs 8 trillion (as on March 31, 2017) to Rs 9.5 trillion (as on March 31, 2018). Although slippages remain elevated, they are expected to decline marginally in the current fiscal year (2017-18) on account of the recognition of stress by banks, who have now become more cautious while lending to infrastructure companies. The NPAs recovered by public sector banks through various mechanisms such as Lok Adalats, Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI), etc., have been low, with recovery rates hovering at 10-15 per cent. Similarly, for asset reconstruction companies (ARCs), the redemption ratio of security receipts has been declining since 2014 on account of banks’ unwillingness to take large haircuts and low capital availability with ARCs to turn around stressed assets.

Introduction and key features of the IBC

Till now, there were multiple laws dealing with insolvency and bankruptcy cases. The overlapping jurisdiction of laws and the lack of clarity in their provisions made the entire resolution process complex, time consuming, fragmented and expensive with low recovery rates. The IBC was therefore introduced to ensure that decisions are taken in a time-bound manner. The code will apply to companies, partnerships, limited liability partnerships, individuals and any other body specified by the central government. The enactment of the IBC will shift the debtor-creditor dynamics from “debtor under possession” to “creditor in control”.

As of August 2017, 247 cases have been admitted to the National Company Law Tribunal (NCLT) for resolution. Of these, 39 per cent have been filed by operational creditors, 33 per cent by financial creditors and the remaining 28 per cent by companies themselves. During January-August 2017, the maximum number of cases (124) was filed during the July-August period.

The IBC has set up the following institutional framework: the Insolvency and Bankruptcy Board of India (IBBI), insolvency professional agencies, insolvency resolution professionals (IRPs), information utilities, and adjudicating authorities. The code provides for three types of applicants who can trigger the corporate insolvency resolution process – financial creditors, operational creditors and corporate applicants.

Two separate tribunals have been recommended under the IBC – the NCLT for companies and limited liability partnership firms and debt recovery tribunals (DRTs) for individuals and partnerships. The code requires an insolvency resolution process for a period of 180 days (extendable by 90 days) when a default takes place.

Experience with current debt restructuring schemes

In the initial years after its launch, the corporate debt restructuring (CDR) scheme had its share of success. However, with the surge in the number of stalled infrastructure projects, the scheme became less responsive to the rising stress. The revival rate was quite low – as many as 30 per cent of the cases approved for CDR slipped into NPAs. Thereafter, a slew of restructuring schemes was introduced to address the NPA issue. These were the joint lenders’ forum (JLF) corrective action plan, 5/25 restructuring, the strategic debt restructuring (SDR) scheme, and the Scheme for Sustainable Structuring of Stressed Assets (S4A), all of which met with limited success.

Small banks have limited say under the JLF corrective action plan leading to inter-creditor disputes. The 5/25 restructuring scheme was introduced with the aim of providing banks respite with respect to asset-liability management (ALM). The scheme provided for flexible terms for loans by aligning repayment schedules with project cash flows. However, protecting the net present value of loans while elongating the repayment tenure became a challenge. Also, the coverage of this scheme was limited only to operational projects.

Under the SDR scheme, the revival or takeover of an entity within the stipulated 18 months has been difficult to manage. Further, valuation mismatches have stymied the restructuring process as banks are not comfortable with taking steep discounts. Meanwhile, the S4A suffers from various gaps – it does not factor in future cash flows in determining sustainable debt, lacks flexibility in pricing and tenure adjustment, and requires high provisioning by banks. A key area of concern for investors with respect to the scheme is the treatment of the unsustainable part (Part B) of a debt.

Legal implications of the code

  • The process of insolvency is now controlled by creditors (through IRPs) instead of debtors.
  • Prior to filing an insolvency case, a financial creditor is not required to give any notice to the company, as opposed to the 21 days’ notice that had to be given earlier.
  • Management is vested with IRPs with the obligation to run the business as a “going concern” and work in coordination with the committee of creditors towards a resolution, if feasible.
  • The resolution plan needs to be approved by 75 per cent of the financial creditors and subsequently approved by the NCLT.
  • Winding up of a firm due to a default in payment is not permitted. Restructuring has to be explored before liquidation. If more than 75 per cent of the financial creditors do not agree on restructuring, only then does the company go into liquidation.
  • Once the restructuring plan has been sanctioned by the NCLT, it becomes binding on all the creditors and stakeholders.
  • Failure to arrive at or implement the resolution plan would result in liquidation.
  • Interim funding for day-to-day operations is permissible and will hold priority under the resolution plan or liquidation.
  • A director can be made personally liable to contribute to the corporate debtor’s assets if prior to the insolvency commencement date the director knew or ought to have known that there was no reasonable prospect of avoiding the commencement of the corporate insolvency resolution process (CIRP); and if the director did not exercise due diligence in minimising the potential loss to the company’s creditors.

Lacunae under the code

  • Given the number of transferred applications (from a high court, the Board for Industrial and Financial Reconstruction, etc.) along with freshly filed ones, it would not be wrong to speculate that the NCLT may develop a multi-year backlog very soon. The NCLT has only 11 benches which will be completely inadequate to deal with such a huge number of disputes.
  • Given the pendency and disposal rate of DRTs, their current capacity may be inadequate to take up the additional role envisaged under the code.
  • The code creates a provision for an Insolvency and Bankruptcy Fund, but it fails to specify the manner in which the funds will be used.
  • There is a  lack of qualified IRPs to run large companies, particularly in the infrastructure sector. IRPs are professionals who are trained chartered accountants, company secretaries and cost accountants, and may fail to understand the practicalities of running a business and the risks involved in it.
  • The code prescribes no timelines for the disposal of appeals lying with the National Company Law Appellate Tribunal (NCLAT). Therefore, the ultimate resolution could still be a long-drawn-out process.
  • The minimum single default for triggering insolvency proceedings is merely Rs 100,000. This can be a menace, as even an employee might knock the doors of the adjudicating authority for non-payment or late payment of salary.
  • What constitutes the “existence of a dispute” with respect to an operational creditor – whether the dispute exists as soon as an operational creditor files an insolvency case or when the corporate debtor responds to it.
  • There is resistance from large companies to allow IRPs to run the business.
  • No mechanism is provided for going after the foreign assets of a corporate debtor.
  • There may be conflict between two special statutes, for instance, the Real Estate (Regulation and Development) Act, 2016, vis-à-vis the IBC, 2016.
  • The code is silent on the treatment of consumer advances – whether to classify them under financial debt or under operational debt.

Implementation issues

One of the most routine issues faced by IRPs is how to deal with suppliers and contractors who constitute operational creditors. IRPs have to ensure that the past dues of all the operational creditors are cleared, as they might threaten to halt work. Another issue which needs to be highlighted is the lack of support from the existing management due to which IRPs have to seek NCLT orders. This takes up a lot of time of the IRPs who are required to adhere to strict timelines under the code.

For a beleaguered company which requires working capital, interim finance plays an important role. Lenders are extremely reluctant to provide interim finance to a company already under the insolvency process. Without the availability of working capital, it is difficult for IRPs to run the company. This is another issue faced by IRPs in the day-to-day running of a company.

A key challenge faced is the difficulty in finding a strategic buyer for the underlying asset/company, particularly for mid-sized units. Other issues include seeking approval of shareholders for capital write-off/fresh issue, and the lack of clarity with respect to the liability of the guarantors. Also, a dearth of active distressed asset funds has contributed to the slow NPA resolution process.

Recently, the NCLAT has passed a judgment that the provisions of the Limitation Act, 1963, will not apply to the IBC, 2016, which means that a time-barred debt can be used as a basis for initiating the insolvency of a company. However, the NCLAT also maintains that delays and

laches could be a ground for rejection. This raises a key concern whether limitation will apply while admitting debt during the CIRP. Under the earlier Companies Act, the liquidator did not admit time-barred debts. Given the NCLAT judgment, it is yet to be seen how this aspect will be dealt with by IRPs during the CIRP.

Conclusion

The IBC is deemed a transformational law as it will aid in speedy resolution and allow the market discovery of assets. The code has created fear among promoters of the possibility of liquidation of their business or a takeover of management. It has brought about a significant change in the mindset of promoters, in the sense that they are considering filing for bankruptcy themselves.

In absolute terms, the recovery rate is not expected to show a remarkable increase under the IBC; however, in present value terms, the rate may improve. The code should not be misunderstood to be a tool for recovery  in place of the DRT and the SARFAESI; instead, it provides for a resolution plan for the revival and rehabilitation of debt-laden companies. The IBC, rather than being viewed as a substitute, should be seen as complementary to existing debt restructuring schemes.

Lenders are not really gung-ho about the code, as can be seen from the recent cases filed before the NCLT. Most of the cases have been filed by operational creditors, with only 64 cases being filed by financial creditors (including banks and financial institutions).

The correct strategy for rehabilitation would be that the promoters and lenders work together to revive the underlying asset rather than li-quidating it. Strategic buyers, including ARCs and special situation funds, must be identified prior to filing for insolvency. There should be qualified IRPs with sector-specific expertise and knowledge to run the business of infrastructure companies. Also, checks and balances must be in place for ensuring that IRPs discharge their duties to the best of their abilities.

There are a lot of merger and acquisition (M&A) opportunities under the code. In the twilight period before the start of the CIRP, any M&A transaction which is significantly undervalued can be set aside or the buyer can be asked to pay the market price. Therefore, the onus to carry out due diligence to know if there are any payment defaults by the company is on the investor. Also, the IRP can sell unencumbered assets of the company during the moratorium period, provided the book value of assets sold in aggregate does not exceed 10 per cent of the total claims and that the committee of creditors has approved the asset sale.

The code is a critical step in the right direction in providing an umbrella legislation for laws relating to bankruptcy, liquidation and insolvency resolution, concerning both individuals/firms and corporate entities. The idea behind the code is to boost foreign direct investment in the country by improving India’s score and ranking in the Ease of Doing Business Index. Adequate institutional capacity is essential to ensure that the IBC does not suffer from the predicament of earlier reform attempts.

(Based on a recent India Infrastructure conference on Insolvency and Bankruptcy Code, 2016)

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