Covid-19 Impact: A Relief Strategy For Distressed Businesses Seeking IBC RestructuringBloombergQuintOpinion
In a previous article, we critiqued the government’s approval to suspend the Insolvency and Bankruptcy Code, 2016 in its entirety, and argued that permitting companies to restructure their debt under the shelter of the IBC would have more efficient outcomes. We also proposed that the government should set up a fund that provides interim finance to companies that choose the formal route of restructuring their debt under the IBC.
It is widely expected that the central government will announce a fiscal relief package to stimulate the economy and bring it back to normalcy as soon as possible. Estimates of the size of such a package have ranged from ~2 percent of GDP to as high as 10 percent of the GDP. In this article, we explain why a fund for providing interim finance to distressed companies that take the IBC route for restructuring, would be a more prudent relief strategy compared to several other ways of supporting distressed businesses in India.
We draw the tangible contours of such a fund and define what its governance structure, commencement and end, might look like. We also define the eligibility criteria for distressed businesses to avail interim finance from this fund.
Relief Strategies For Distressed Businesses
There are three ways in which any government can help distressed businesses in India.
The first option is to acquire and nationalise businesses. The second option is to give a low-cost loan to all businesses or a class of them. The third option is what the central government has reportedly decided to do, which is, guarantee the existing loans taken by a class of businesses and dictate banks to enhance credit to businesses.
The first option is a non-option given India’s previous experience with running nationalised businesses and its impact on competition. The other two options face unique challenges that may make them unworkable. The second option of saving every single distressed firm would be fiscally infeasible. Supporting only a class of firms necessarily involves the exercise of political discretion in the selection of firms and sectors. It allows the government to pick winners and losers. Picking sectors to salvage tantamounts to industrial planning, which often perpetuates sectors and firms that are fundamentally unviable. It also creates incentives to lobby the government for bail-out packages, which in turn, triggers a vicious circle of fear and favour.
So far as the creation of a creditor guarantee fund, it is unclear whether lenders, who are demonstrating very high risk aversion, will enthusiastically participate in lending to small and medium sized borrowers despite the government guarantee. The financial system will wait for the government to see the exact mechanics of the program and the manner in which they may recover the guaranteed amount from the government if the borrower were to default before rushing to participate in it. In any event, the credit guarantee program reportedly aims to cover the micro, small, and medium (MSME) companies. That will still leave large distressed firms looking for relief. What we propose here can work as a complement to this credit guarantee program.
Optimal Relief Strategy
An optimal relief strategy is one that targets saving firms which are fundamentally viable, but are unable to obtain funding from the market due to exogeneous shocks like the ongoing nationwide shutdown. This minimises the possibility of perpetuating zombie firms and targets scarce funding to firms that need it the most and have the best chance of being revived.
The design of a relief program must also guard against discretion and not allow the bureaucracy overseeing the program to pick and choose winners and losers.
Finally, the relief measure must eminently signal that it is a limited purpose and limited duration measure. These principles are not codified in law, but have been recognized as principles that have served us well over time (Casey and Posner (2016)).
Why Interim Finance As A Source Of Relief
When firms undergo a resolution process under the IBC, an interim management led by an insolvency professional takes over until the creditors agree upon a resolution plan or resolve to liquidate the firm. The primary objective of the IP is to keep the company a ‘going concern’ which means that the day-to-day operations of the company must go on while it is under the IBC process.
In order to keep the operations running, companies need access to credit for working capital. Raising such ‘interim finance’ presents a peculiar challenge. Existing lenders, who are a part of the bankruptcy resolution process, are generally reluctant to provide additional credit. New creditors are wary of lending to a company already under a bankruptcy process. Obtaining interim finance during a resolution process was a challenge even during the pre-pandemic days. Higher risk aversion will exacerbate this issue even further.
First, it creates the right incentives for businesses to take the formal route to restructure their businesses. The IBC builds in provisions for transparency and equality of treatment of all creditors, and we should want firms to use this route as opposed to preferential and backdoor settlements with creditors.
Second, interim finance enjoys priority in both resolution as well as liquidation. This implies that the government stands a good chance of recovering the loan whether or not the firm is restructured.
Third, a key safeguard in this scheme is that the IBC requires the creditors to approve the IP’s proposal to avail of interim finance for the day-to-day operations of the firm until they arrive at a resolution plan. Since the interim financier gets priority in payment, the other creditors are incentivised to allow the debtor to obtain interim finance only if there is a real chance that the business will eventually survive. Allowing the existing creditors to make the decision also ensures that the relief package is sector agnostic and the government does not pick winners and losers.
Fourth, by stepping in as an interim financier, the government does not get any say in running the operations or management of the firm. Moreover, since the government will be paid in priority to all other creditors by the design of the law, it does not get a say in the creditors’ committee as well.
Finally, once some interim financing is provided by such a government sponsored entity, the chances of revival of the firm improve significantly which would incentivise other private creditors to provide additional interim finance.
Construct Of The Interim Finance Facility
The government could sponsor the facility by providing the initial corpus from the fiscal relief package. It could invite other investors to contribute to the corpus. The facility could be ideally set up as a professionally managed fund, like the National Infrastructure Investment Fund. A separate professionally-managed asset management company could be created to manage the fund.
Some other key features of the facility would be as follows.
First, the explicit mandate of the fund would be to provide support to distressed firms through interim financing. As in every such exercise, the objective of the fund should not be to maximise profit, but to lend working capital to distressed firms under the IBC and recover the principal together with inflation-adjusted interest.
Second, the fund must have a well-defined deployment period (let’s say, two years) from the date of its launch. In the long term, our banking and credit system must develop products that cover funding needs for distressed firms. The law has already provided secured such lenders through a priority in payment and liquidation waterfall. If the banking system cannot provide such products despite the legal protection offered, it is perhaps time for the banking regulator to examine this issue from a market development perspective. Bail-out funds should not exist in perpetuity.
Third, all companies which opt for a formal debt restructuring under the IBC will be eligible for this form of bail-out. The only condition is that the existing creditors of the company must have explicitly approved the debtor to avail of this relief for interim financing.
Fourth, the amount of interim finance, its tenure, pricing and the covenants will all be standardised. The fund would offer a set of standard packages of varying size and maturity that the borrower would self select. This would ensure speed in disbursement and guard against the fund having to make commercial calls in the case of every borrower.
Finally, the fund should be able to hive the risk off its balance sheet by securitising the loans made, including to foreign investors. This would allow the government to recycle the funds.
The scheme that we propose in this article is similar to the loan scheme offered by the U.K. government to provide urgent liquidity support to small distressed businesses, popularly referred to as the ‘bounce-back loan scheme’. However, given India’s experience with incessant lending to undisciplined firms, contexualising this scheme to Indian circumstances warrants linking such relief to the businesses that subject themselves to formally restructuring their debts.
Bhargavi Zaveri is a senior researcher at the Finance Research Group. Harsh Vardhan is Executive-in-Residence at the Center for Financial Studies of the SP Jain Institute of Management Research.
The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.