Insolvency Haircuts: Treating Symptom Will Not Cure The Disease
A recent report by the Parliamentary Standing Committee on Finance has made some observations on the current insolvency regime that deserve serious attention.
The Committee observed that the Insolvency and Bankruptcy Code, 2016 is one of the most transformative laws next to GST legislated by the current government. However, while examining if the code has remained true to its original purpose, the Committee noted the six amendments to the Code may have digressed from the basic design of the statute. Among the many recommendations it makes are a haircut quantum benchmark, self-regulation of resolution professionals, code of conduct for the committee of creditors. The authors believe some of these critiques and solutions are misplaced.
The proposal to introduce a benchmark for the quantum of haircuts, the gap between what lenders are owed and what they receive in insolvency resolution, is regressive and against the interest of the market. It is at best prescriptive for an otherwise market-driven outcome. This may undo other bold measures that the government has taken. Bankruptcy law must enshrine business failure as a normal and legitimate part of the working of the market economy.
The Bankruptcy Law Reform Committee noted that recovery should be measured in Net Present Value terms. A haircut is calculated against the debt owed to creditors. It is important to note that the debt size of a company does not represent its ‘true value’. All that the insolvency law can do is to enable the creditors to extract maximum value from the company as on the insolvency commencement date.
Take for instance a company that has availed a loan of Rs 1,000 to set up a manufacturing facility of “x” capacity. However, current demand for the company’s product is 20% of “x”. Resultantly, over the next few years, the company begins to default on loan repayment. On the day the insolvency petition is admitted, the company is left with a value of Rs 100. In such a case, will the investor view the company as worth Rs 1,000 or Rs 100?
Assuming the creditors realise only Rs 100 from the insolvency process, that amounts to a haircut of 90%. Steep, yes. But, the root cause of this large haircut is reckless lending and lack of loan monitoring and not the IBC.
If necessary, lenders could examine the business for preferred or fraudulent transactions which go beyond personal guarantees. If confirmed, despite enterprise recoveries, there is a recourse to promoters. Where such transactions cannot be established, it should be viewed as a normal business failure and hence acceptable.
In any case, the Reserve Bank of India in a report has mentioned that IBC recovery has been 45.5% whereas lenders have been able to recover 26.7% of the amount involved through Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002.
The World Bank Report 2019 released resolving insolvency score, to determine the present value of the amount recovered by creditors. The data below taken from the World Bank report shows that India’s performance has been encouraging compared to other countries.
The Real Problem(s)
One must not forget that the IBC has lived through five years of underdeveloped infrastructure. The National Company Law Tribunal and appellate tribunal (NCLAT) are swamped with cases. As per official data, as many as 19,844 cases were pending before the NCLT as on July 31, 2020. Of these, 12,438 cases were under IBC.
The NCLT has become an Achilles’ Heel for the Code - causing maximum delay and many times passing errant orders such as in case of DHFL. The Standing Committee has rightly observed that there is need to focus on capacity building of the courts and committee of creditors.
While there has been much focus on regulating insolvency professionals, sometimes to the extent of micromanaging them, there is not enough recognition of the lack of competencies among others -- in terms of resolution mindset and discipline regarding timelines, which is extremely critical.
Whilst the courts grant frequent, and at times frivolous stays which delay the process, committees of creditors need senior level representatives to take difficult calls on resolution on a timely basis.
Meanwhile, insolvency professionals are encumbered with heavy procedural oversight which takes away the focus from resolution and the hurts the risk-taking approach of IPs. A self-regulatory regime, if any, should be such designed that it controls the mischief and at the same time encourages those with entrepreneurial mindset.
Another concern of the Standing Committee—that fresh graduates may become IPs—may be genuine but has yet to play out in reality. None have as yet turned IP and it is unlikely creditors or courts would entrust businesses to them. Having said that, these fresh graduates undergo specialist training for two years and have proven skills. They may not handle independent cases but can play a vital role in the insolvency ecosystem.
Having said all of the above, certain Committee recommendations such as enabling piecemeal sale of businesses, self-regulatory body for insolvency professionals, better competencies at the NCLT and special training for judges, are all welcome. AS are observations regarding better staffing of tribunals and long-pending vacancies.
As India lays the foundations of a mature market economy, it is important that the regulatory regime Is designed in a manner that allows businesses to take risks.
A bankruptcy regime is a framework that resolves stress on a timely basis. The policy focus should be on curing the disease and not the symptoms. The disease here is increasing stress in banks and that needs many solutions - ranging from checks on reckless lending, a more robust debt market to a stronger market for stressed assets, fewer regulatory barriers such as Section 29A (which may have served a limited purpose but is also the source of much litigation and hence delays) and allowing asset reconstruction companies to participate as resolution applicants.
Insolvency is not the result of a failed process of law but failed business decisions. Why blame IBC for failed business? A haircut threshold will create wrong incentives - banks may undertake more reckless lending if assured a minimum payout.
Abizer Diwanji is Head of Financial Services at EY and Neeti Shikha is Head of the Centre for Insolvency & Bankruptcy at the Indian Institute of Corporate Affairs.
The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.