Why Is The Corporate Insolvency Code In India Imperative Today?
The Insolvency and Bankruptcy Code, 2016 (the Code) is, undoubtedly, a significant reform. The speed at which the legislation was enacted and then subsequently, the supporting rules and regulations have been developed has surprised many.
How have banks dealt with stress commercially in the past?
Joint Lenders Forum (JLF)/Corporate Debt Restructuring (CDR)
Traditionally, banks have preferred to restructure the debt of stressed borrowers through the CDR or JLF mechanisms. While the CDR mechanism was used extensively, the objective seems to have been to provide temporary relief to the borrower rather than making active efforts to revive businesses. CDRs have met with limited success (only 17% exits as of June 2016) in reviving stressed assets due to poor evaluation of business viability and the lack of effective monitoring.
Strategic Debt Restructuring (SDR)
Until the introduction of the SDR in June 2015, the Reserve Bank of India (RBI) had largely stayed away from devising a mechanism that enabled the banks/lenders to play a direct role in the turnaround of stressed borrowers. SDR is a tool for lenders to acquire majority ownership in a borrower by converting a part of the outstanding loan (including overdue interest) into equity. At a later date, it can transfer the control to a new promoter. The SDR scheme (along with variations introduced in February 2016) provides banks significant relaxation from the RBI income recognition and asset classification norms.
Most importantly, SDR aimed to provide the lenders an option to initiate a comprehensive turnaround by taking control; giving them a fair shot at reviving these companies by partnering with a more capable promoter. There has been limited will, though, from banks to take on management of companies through the SDR route. Along with an apprehension that the existing legal system would not allow a change of management to take place smoothly, banks were sceptical of lack of protection from existing and imminent litigations. Lack of willingness of the banks to "right size" the debt and provide the "new" buyer with an appropriate capital structure to turnaround the assets has also impacted the success of SDR.
Scheme for Sustainable Structuring of Stressed Assets (S4A)
The lack of a positive response to SDR from banks have led the RBI to devise other measures such as S4A in June 2016. S4A is a reversal from the 'creditor in control' stance taken by the RBI. Under S4A, control remains with the existing promoter as long as 50% of their debt is "sustainable." While the efficacy of the S4A is yet to be evaluated, it has found limited eligibility as it prescribes a short-term cash-flow visibility and does not allow change in repayment terms. Even as these challenges are being addressed, the lack of emphasis on a comprehensive turnaround could possibly result in the problem just being postponed.
Corporate stress needs a quick and decisive revival strategy rather than an indefinite deferral of the problem. If comprehensive turnaround plans had been implemented in a timely manner, the size of the problem could have been mitigated. Limited will from lenders to engender such a strategy and a judicial framework that did not entirely support them have hampered the efforts in this direction.
The current judicial framework
Until the Code, there was no single legislation that governed corporate insolvency and bankruptcy proceedings in India. Lenders had limited muscle when faced with default and promoters stayed in control. Only one element of a bankruptcy framework has been put into place to a limited extent, banks are able to repossess fixed assets which were pledged with them. According to the Bankruptcy Law Reforms Committee (BLRC), "Corporate bankruptcy and insolvency is covered in a complex of multiple laws, some for collective action and some for debt recovery. These are:
- Companies Act, 2013 – Chapter on collective insolvency resolution by way of restructuring, rehabilitation, or reorganisation of entities registered under the Act. Adjudication is by the NCLT. This chapter has not been notified.
- Companies Act, 1956 – deals with winding up of companies. No separate provisions for restructuring except through Mergers & Acquisitions (M&A) and voluntary compromise. Adjudication is under the jurisdiction of the High Court.
- SICA, 1985 – deals with restructuring of distressed 'industrial' firms. Under this Act, the Board of Industrial and Financial Reconstruction (BIFR) assesses the viability of the industrial company, and refers an unviable company to the High Court for liquidation. SICA 1985 stands repealed, but the repealing enactment is yet to be notified."
The significant number of legislations and the complex interplay between them have made the recovery of debts cumbersome for lenders. Different acts define the powers of lenders and borrowers in the case of an insolvency. The lack of clarity on jurisdiction and lack of commercial understanding have allowed stakeholders to manipulate the situation and stall progress.
Apart from Prime Minister Narendra Modi's commitment that India will be among the top 50 countries in terms of ease of doing business within three years, the Code acquired urgency because of the following reasons:
The average life of cases recommended for restructuring in 2002 was 7 years and the average life of cases recommended for winding up to the court was 6.5 years1. Even as of October 31, 2015, only about 955 (out of 4,636) and 163 (out of 545) cases of court and voluntary winding up were resolved within 5 years. A significant number of such cases were pending for more than 20 years – 1,274 and 205 respectively2.
In this environment, the outcomes are poor. For instance, the average time taken for insolvency proceedings in India is about 4.3 years, while it is only 1.7 years in high income OECD countries. The recovery rate (cents on the dollar) is 71.9 in high-income OECD countries as opposed to 25.7 in India.
Therefore, there is an immediate need to overhaul the insolvency framework.
How can the Code help?
The Code makes a clear distinction between insolvency and bankruptcy - the former is a short-term inability to meet liabilities during the normal course of business, while the latter is a longer term view on the business. As all businesses cannot succeed, it is perfectly normal for some businesses to fail, making it important to emphasise on corrective action.
The Code amply clarifies that insolvency or bankruptcy is a commercial issue, backed by law to enforce transparency and objectivity. It is not another law behind which the inevitable can be delayed.
As per the BLRC, the Code set out the following objectives to resolve insolvency and bankruptcy:
- Low time to resolution.
- Higher recovery.
- Higher levels of debt financing across a wide variety of debt instruments.
The Code ensures certainty in the process, including what constitutes insolvency, the processes to be followed to resolve the insolvency, and the process to resolve bankruptcy once it has been determined.
Such a framework can incentivize all stakeholders to behave rationally in negotiations towards determination of viability, or in bankruptcy resolution. In turn, this will result in shorter recovery timeframes and better recovery, and greater certainty on lenders' rights leading to the development of a robust corporate debt market and unlocking the flow of capital.
1 Arvind Panagariya, India: The Emerging Giant, Oxford University Press, 2008.
2 Report of the Joint Parliamentary Committee on Insolvency Code, 2016, p76-77 citing data from Department of Financial Services.
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