Though the Insolvency and Bankruptcy Code is a welcome step in the development of modern bankruptcy laws, it gives more power to creditors than debtors, forcing the latter to sell assets at diminished value
By Sanjiv Bhatia
The continuous entry and exit of companies is a natural feature of free market economies. When a productive entity fails, there is a cost to society, and bankruptcy laws are required to protect the contractual rights of interested parties and to allow for the orderly liquidation of the firm’s assets to maximise its value.
A good bankruptcy law has to balance several objectives. It has to protect the rights of creditors and other stakeholders—essential to the development of stable credit markets—and prevent the premature liquidation of viable firms—essential to risk-taking and entrepreneurship that drives economic growth.
There are two kinds of bankruptcy laws. In liquidation bankruptcies, also known as “creditor in control” laws, debtors must surrender their property, which is subsequently sold, and the proceeds distributed to creditors. In return, all debts are permanently discharged. In reorganisation bankruptcy laws, also referred to as “debtors in possession” laws, debtors are allowed to keep their property, but must agree to a reorganisation and repayment plan. In return, the court provides a moratorium on creditor claims to allow the debtor time to reorganise and rehabilitate.
The 2015 World Bank Ease of Doing Business Index ranked India 135th out of 190 countries on ease of resolving insolvency. Insolvency resolution in India took 4.3 years on an average, compared with the UK (one year), the US (1.5 years) and South Africa (two years).
To consolidate the vast array of fragmented and often conflicting laws on insolvency, the government passed the Insolvency and Bankruptcy Code (IBC) in May 2016. The salient feature of this law was a paradigm shift from a “debtor in possession” to “creditor in control” regime. In effect, the law now gives greater power and leverage to creditors than debtors. There is now increased pressure on debtors as any whiff of insolvency could trigger a change in corporate control.
Many developed countries have shied away from creditor-in-control laws as they increase the risk associated with borrowing and inhibit business owners from borrowing. Even an otherwise sound business can go through periods of revenue and profit stress due to macroeconomic and industry-specific factors—the real estate sector in India is a good example of this. Even if a company’s debt is small in relation to its market value, creditors could force the sale of all its assets, often at diminished values.
This is especially painful for small and medium-sized businesses where the owner-promoters have a lot of personal goodwill invested in the firm.
Academic studies have shown that economic activity is affected in countries with bankruptcy laws that increase the risk of borrowing.
A major thrust of most bankruptcy laws is to prevent wanton destruction of the value of a distressed firm. Insolvency laws in most countries differentiate between “financially distressed” firms and “economically distressed” firms.
A financially distressed company may be an otherwise viable company (producing goods and services that society wants), but for a multitude of reasons is currently unable to service its debt. Such companies are more valuable if their assets are kept together as a functioning unit rather than sold off on a piecemeal basis. The value of such a firm can be preserved by restructuring its debt or selling parts of it. Pushing viable businesses into liquidation, instead of allowing for successful restructuring, destroys their value and imposes unnecessary cost on all its stakeholders.
The Indian Bankruptcy Code (IBC) has been written to cure a legacy of unscrupulous promoters who successfully gamed a moribund judicial system to create endless delays and legal tangles to keep creditors at bay. The current banking crisis is partially the result of a long history of unscrupulous borrowing. The focus of the bankruptcy law is, therefore, on providing relief to creditors and not necessarily on preserving the market value of financially distressed companies. “The defaulter’s paradise is lost,” noted the Supreme Court in a recent ruling on the constitutionality of the IBC, clearly suggesting that the focus of the law was to protect creditors (especially financial creditors) from unscrupulous defaulters.
The IBC mandates the resolution of insolvency within 180 days (extendable by 90 days if a majority of creditors agree) and allows creditors to initiate the process. This bias in the IBC towards creditor-driven insolvency resolution could push companies into liquidation and destroy their market value. Insolvency resolution under the new law relies on the vote of financial creditors whose interest in recovering their claims (and cutting losses) may predispose them to sell off the company’s assets rather than evaluate the risk of restructuring it and allowing existing debtors to continue operating it. Data from the Insolvency and Bankruptcy Board of India confirms this—almost 80 percent of the cases admitted for insolvency resolution since the enactment of the law have resulted in liquidation.
Recently, the constitutionality of the IBC was challenged on three grounds. A PIL was filed by aggrieved homeowners who, as unsecured creditors, were left without a remedy during the insolvency of several real estate companies. They challenged the constitutionality of the preference given to financial creditors over operational creditors, citing the fundamental right to equality under Article 14 of the Constitution. The Supreme Court dismissed the Article 14 argument, stating that there was a difference in the relative importance of financial creditors because repayment of debt allows the capital to be re-injected into the economy and is vital for economic growth.
The preference given to financial creditors is troubling, given the judicial system’s dismal record on enforcing contracts. Operational creditors, while not direct lenders of money to the company, provide goods on credit and these contractual arrangements can often be more useful to a business than bank debt. But enforcing these unsecured contracts in Indian courts is a long and hard process which often leaves operational creditors without remedy. It is time for the judicial system to step up and expedite the enforcement of contracts. Similar to the time-bound insolvency resolution in the IBC, all contract disputes must be settled in court within 180 days. It is essential to pair judicial efficiency with a good bankruptcy law to create an effective financial system. Studies have shown that if enforcement of contracts is strong, debtors and creditors try to avoid risky behaviour, thereby reducing the chances of financial distress and bankruptcy.
The second challenge to the IBC was against the broad sweep of Section 29A, which bars not just the existing promoters but also individuals or entities “related” to them from attempting to take over the ailing company. These provisions are intended to ensure that errant promoters do not game the system by claiming debt relief and then repurchasing the company (at a lower price) through the resolution process. The petitioners had argued that such a blanket ban does not distinguish between unscrupulous promoters and those who can’t pay their debt for other reasons (a poor economy, for example). They argued that this provision violates Article 14 of the Constitution by treating “unequals as equals”. The Supreme Court rejected the argument that Section 29A of the IBC violates Article 14, and clarified that the definition of a related person would mean only persons connected with the business activity of the insolvent company.
The third challenge was to Section 12A of the IBC which requires 90 percent of the Committee of Creditors (CoC) to approve the withdrawal of an insolvency petition filed against a corporate debtor. It was argued that this Section gives tremendous power to the CoC to reject legitimate settlements between creditors and corporate debtors. The Supreme Court again ruled against the petitioners, observing that the figure of 90 percent is the domain of legislative policy, and in the absence of anything to show that it is arbitrary the Court would not encroach upon the domain of the legislature.
The verdict will have an impact on some significant insolvency cases such as that of Essar Steel. The debt-laden company was put up for sale under the IBC, and all the lenders approved Arcelor Mittal’s bid of Rs 42,000 crore for the company’s assets. Essar Group’s promoters, the Ruia family, realising that the economic value of the firm was higher than Arcelor’s bid, have since sought to regain control by pledging to repay the entire amount of Rs 54,000 crore that is owed. Under Section 12A of the IBC, the Ruias might be able to regain control if they can convince 90 percent of the lenders to withdraw the insolvency petition. But Arcelor Mittal is arguing that Section 29A of the IBC prevents the errant promoters (Ruias) from regaining control of the company.
The Essar Steel case is an excellent example of the wealth transfer that occurs in bankruptcy laws that favour creditors. It is clear that the enterprise value of Essar Steel exceeds Rs 54,000 crore, but its major creditor, State Bank of India (SBI), doesn’t care. The SBI wants its Rs 15,000 crore back, and the sooner the company is sold, the faster the bank can recover its money. Being on the CoC, the bank can influence the sale of Essar to Arcelor even if it results in a transfer of wealth from minority creditors and existing shareholders (the Ruias) to Arcelor.
Despite some shortcomings, the IBC is an excellent first step in the development of a set of modern bankruptcy laws in the country. Over time, changes need to be drafted to ensure proper resource allocation, efficiency and stability, as well as equality and fairness.
—The writer is a financial economist and founder, contractwithindia.com