The Supreme Court judgment in the Essar Steel case has restored the primacy of the committee of creditors (CoC), settling the contentious issue of the distribution of funds between creditors. While the judgment solidifies one of the tenets of the IBC (Insolvency and Bankruptcy Code), does it pave the way for smoother functioning of the resolution process? And does it alter the incentive structure for various stakeholders that have complicated the process so far?
Let’s take a step back. The introduction of the IBC marked a structural change in the resolution architecture in India. The shift to a time-bound resolution process — meant to facilitate the quick exit of firms — was a tool to help tackle the bad loan problem. But despite its obvious strengths, various stakeholders seem to have recalibrated their approach towards dealing with the problem of bad loans through the IBC process. There are several indications to this effect. Under Urjit Patel, the RBI took a more forceful approach to resolving bad loans through the IBC process. Its various lists directing banks to take specific companies through the process were a clear indication of its intent. But, under the new leadership, there appears to have been an institutional rethink on the approach to resolving bad loans. The June 7 circular on the resolution of stressed assets signals this change in stance.
Even certain sections of the ruling dispensation appear to have reconsidered their approach towards resolving bad loans. Initially, the IBC was touted as a game changer in dealing with bad loans. But, a few weeks ago, the minister of state for finance, signaling the shift in stance, said there should be an attempt to resolve stressed assets outside the IBC as it would help banks and the business community.
Amongst banks, too, scepticism about the process appears to have crept in. Rather than taking companies to the NCLT, banks now appear to be in favour of resolving the bigger cases outside the IBC process.
Several factors have prompted this shift. First, delays in the resolution of cases, and endless litigation have dampened enthusiasm for the process. Of the 1,497 cases that are currently going through the resolution process, 36 per cent have crossed 270 days, while another 22 per cent have crossed 180 days. As a time-bound resolution process was one of the most appealing aspects of IBC, such delays create little incentive for stakeholders to opt for this process.
Second, barring a few cases, the recovery rates have not have been along expected lines. Part of the problem is that recovery rates tend to be pro-cyclical. During high growth phases, businesses tend to be inclined to bid more for assets as expectations for higher returns are baked in.
One sees this trend under SARFAESI too. In the initial few years after the law was enacted, recovery rates were low, but as growth picked, and as the system stabilised, so did recovery rates. Recovery rates touched a high of 61 per cent in 2007-08, trending downwards thereafter as growth slowed. Over the 10-year period from 2003-04 to 2012-13, the recovery rates under SARFAESI averaged around 33 per cent.
In comparison, the recovery rate under IBC currently stands at 41 per cent. But, this also needs to be qualified. The higher recovery rates are driven partly by the resolution of steel companies during a period that coincided with high global steel prices. Even Arcelor Mittal’s bid for Essar Steel was made during this period. Excluding steel companies would significantly lower the recovery rates.
A slowing economy, coupled with an over-leveraged corporate sector, has reduced appetite for assets stuck in the NCLT. Not only have recovery rates been low in the cases resolved, but more than half of the cases closed so far have ended up in liquidation as there have been no buyers. In such a scenario, as banks would have to take huge haircuts, in both resolution and liquidation, there is little incentive to resolve bad loans through IBC.
Third, lack of clear precedents has complicated matters. For investors, it was hardly possible to calculate expected returns on their investment with any degree of certainty. Fourth, instances such as the enforcement directorate attaching property, as in the case of Bhushan Power and Steel, have further disincentivised buyers.
The judgment in the Essar steel case addresses one of these concerns. The Court has done away with the uncertainty surrounding the distribution of claims. This is a positive step for creditors who otherwise faced uncertainty. But, more needs to be done to ensure smoother functioning of the code.
For one, the provisioning norms for bad loans should be made more stringent to ensure banks have strong incentives to take companies through this process and not postpone the decision, hoping to restructure the loan outside IBC.
Second, relaxing the 330-day deadline will further dampen enthusiasm. The idea of having a time-bound process was to put pressure on the CoC to ensure speedy resolution. Delays in either taking the company to NCLT or in the resolution process destroys enterprise value. This decision must be reviewed.
Third, the government should establish the supremacy of IBC to ensure that assets are not allowed to be attached once they have been admitted. Under Section 53 of the law, amounts due to the central government rank below those of secured and unsecured creditors. This hierarchy needs to be respected.
There also needs to be clarity on the role of promoters. While barring all promoters from bidding was a harsh step, there needs to be consistency of approach. Allowing them to participate in liquidation but not in the resolution process would be inconsistent. Unless, of course, there has been a considered view that promoters, barring wilful defaulters, should be allowed back in, although now it is possible only through the backdoor. Addressing these issues would go a long way in ensuring that IBC is the preferred option for dealing with bad loans rather than being the last resort.
This article first appeared in the print edition on November 20, 2019 under the title ‘Reset the Code’. Write to the author at firstname.lastname@example.org.