The January 25 Supreme Court judgment on the constitutional validity of India’s fledgling insolvency law in its “entirety” is a booster dose for the lenders who are left with no choice but to clean up the financial system of the mound of toxic assets, accumulated over past few years through poor appraisal of projects, reckless lending and indifferent monitoring. This, along with the National Company Law Appellate Tribunal (NCLAT) ruling in the last week of December on a personal guarantor’s rights, will perk up the moribund insolvency law, which promises a lot but has not delivered much, with smart corporate defaulters tirelessly putting up bumps on the road of bad loan recovery. Since it came into force in August 2016, there have been quite a few amendments to the Insolvency and Bankruptcy Code (IBC) and a series of court cases, making it a work in progress. The latest couple of judgments have brought in a lot of clarity and ensured that things will move faster from now on. ICICI Bank Ltd filed the first case under the new law against a steel products maker which had a Rs 955-crore debt in September 2016. It could recover a minuscule amount. Since then, the amount of recovery has had its ups and downs, but the most depressing fact is the snail’s pace at which the insolvency cases have been dealt with. So far, at least 10,000 cases have been filed but there are just 13 benches of the National Company Law Tribunal (NCLT) that hear such cases. Any default above Rs 1,00,000 can be dragged to NCLT by financial creditors, operational creditors, and even corporate borrowers. Woefully inadequate infrastructure is one of the many reasons why a case is not settled within 180 days, or even 270 days, as stipulated by the law. Insolvency process and progress The Reserve Bank of India (RBI) in June 2017 had listed 12 defaulters against whom it wanted immediate bankruptcy proceedings to be invoked. This was followed up by another list of 28 defaulters in August 2017. These companies account for half of over Rs 10-trillion bad debt in the Indian banking system. Once a defaulter is identified, a committee of the creditors (CoC) appoints one resolution professional (RP) to supervise the case. In the next stage, the information memorandum is prepared and the so-called expression of interest is sought from prospective bidders. After checking the eligibility of the bidders and evaluating the bids, the CoC goes to NCLT. This is the process but when it comes to implementation, things are not so simple. The critical issues that complicate things are the following: # The CoC — a body of financial creditors — always chooses the interest of its ilk, such as banks and bond holders, over operational creditors like suppliers of capital goods, original equipment manufacturers, maintenance vendors, employees and tax authorities. So, operational creditors feel shortchanged. # There have also been disputes over the rights of guarantors. # Then, should the promoters of a defaulting company or parties related to them be allowed to make a bid for the assets up for sale? Section 29(A) of the amended law disqualifies many, including a defaulter, to bid for the assets auctioned. (This particular clause was brought in through an amendment to keep at bay crony-capitalists who do not service bank loans but step in to reclaim the assets when they run the risk of losing their corporate empire.) The latest judgments have addressed these issues clinically. Operational creditors argued that the IBC doesn’t differentiate (or, in legal parlance, make an “intelligible differentia”) between a financial creditor and an operational creditor, and hence it violates Article 14 of Indian Constitution on equality before the law. Operational creditors provide services to corporate India and they have the right to initiate insolvency proceedings if a company defaults in its payments, but the law does not allow them to participate in the resolution process, conducted through the CoC. Debt, equality and rights The barring of promoters from bidding for their own companies was also challenged, saying it was against the fundamental rights of promoters of a company. (Incidentally, the Ruias, the promoters of Essar Steel Ltd, offered to repay 100 per cent of its debt after UK’s Arcelor Mittal won the formal bidding process for the company.) The bunch of petitions also included those challenging the 12 February 2018 RBI circular which had directed lenders to invoke the insolvency law against defaulters in the power, steel and textiles sectors. This will be dealt with separately but the court has upheld the Constitutional validity of the law. According to the court, financial creditors are very different from operational creditors. “…A financial debt is a debt together with interest, if any, which is disbursed against the consideration for time value of money…. (The) ‘operational debt’ (in contrast) would include a claim in respect of the provision of goods or services, including employment, or a debt in respect of payment of dues arising under any law and payable to the government or any local authority.” What is “intelligible differentia”? Simply put, most financial creditors, particularly banks and financial institutions, are secured creditors but operational creditors are unsecured. Financial creditors lend term loans and working capital while contracts with operational creditors are for supply of goods and services. Typically, financial contracts involve large sums of money even though the number of operational creditors could be far higher. There is a repayment schedule for a financial creditor and, in case of a default, the lender can recall a loan but the contracts with operational creditors do not have such stipulations. The dispute resolution forums for the two sets are also different. Violation of contracts with operational creditors generally leads to arbitrations for dispute resolution while financial debts to lenders are well documented and verifiable. The Supreme Court has also made it clear that RPs do not have any adjudicatory powers — they have administrative as opposed to quasi-judicial powers.
Unlike the liquidator, the RPs cannot act, in most circumstances, without the approval of the CoC, which enjoys the power to replace one resolution professional with another, by a two-thirds majority. Simply put, the RPs are only a facilitator of the resolution process and their administrative functions are overseen by the CoC. Most importantly, the Supreme Court has also maintained the sanctity of Section 29A, which forbids existing promoters from bidding for assets with a clarification that the ‘related person’ not connected with the business of the activity of the resolution applicant cannot be disqualified. In other words, the mere fact that somebody happens to be a relative of an ineligible person cannot be good enough to oust such a person from bidding, if he is otherwise qualified. While the Supreme Court upheld the bar on promoters to come in as resolution applicants, the Section 12A route is still open for them. This section of IBC allows for a withdrawal of an insolvency application if 90 per cent of the creditors’ committee by voting share approves it. The NCLAT ruling that a personal guarantor’s right to subrogation against a corporate debtor can be taken away in a resolution plan under the IBC is an equally important development as it clarifies that a personal guarantor has no right to step into the shoes of a creditor of a defaulting company. Subrogation means the substitution of one person or group by another in respect of debt, accompanied by the transfer of any associated rights and duties. Under the Indian Contract Act, the liability of a guarantor and borrower is co-extensive. If a creditor recovers some amount from a borrower, the liability of the guarantor reduces proportionately and vice versa. The Contract Act also focuses on the right of subrogation for the benefit of guarantors — if a creditor recovers partial or full debt from the guarantor, the guarantor can step into the shoes of the creditor and recover this amount from the borrower at a later stage. The NCLAT order has denied this right to guarantors. The twilight zone of insolvency Why has it done so? Well, in many cases, the promoters are the guarantors and the insolvency law prohibits promoters from benefiting, directly or indirectly, from the resolution process. In the so-called twilight zone or the zone of insolvency, there is always a conflict between creditors and shareholders whose value should be protected. By denying the subrogation rights, the NCLAT has made it clear that risks for equity holders will always be higher than that of lenders. Indeed, all contentious issues have not been solved yet but these clarifications will definitely minimise the cost and time for liquidation and resolution of bad assets. Till now, none knows when the bidding process for an asset up for sale ends, as even losers can make fresh bids and new bidders can join the fray. Allowing new bids after sealing the process helps price discovery but it leads to inordinate delays and kills the sanctity of the process. Still, the judiciary seems to be more in favour of value maximisation than early resolution. So, what’s the solution? Well, let’s be realistic. Frankly, the 270-day resolution process is too aggressive and unrealistic. The ideal timeframe could be 18 months (12 months plus six) or around 550 days. Japan, which introduced the bankruptcy law in 2004, takes six months to settle a case and the recovery rate is close to 93 per cent. For the UK, which introduced it in 2002, the recovery rate is 88.6 per cent and settlement is done within a year, while the US, where insolvency law is 40 years old, takes 18 months to settle a case at a recovery rate of 80.4 per cent. These still are early days in India but after the latest developments, IBC will certainly speed up the recovery, even as banks will continue to use it as a threat while settling the score outside it. The battle line is firmly drawn now and smaller irritants will not blur the big picture of the great Indian asset sale any more. As someone has recently said, it’s paradise lost for errant Indian promoters.
- The Insolvency and Bankruptcy Code (IBC) came into force in August 2016. It was expected to pave the way for banks to recover billions of dollars from bankrupt firms mired in litigation.
- So far, 10,000 cases have been filed but there are just 13 benches of the National Company Law Tribunal that hear insolvency cases.
- Inadequate infrastructure is one of the many reasons that have led to cases not being settled within the mandated 180 days, or even 270 days.
- The Supreme Court in January rejected petitions challenging the IBC, including a rule that bans owners of insolvent firms from bidding to buy back assets auctioned as part of bankruptcy proceedings.
The columnist, a consulting editor with Business Standard, is an author and senior advisor to Jana Small Finance Bank Ltd
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