Insolvency Law: Financial Assets Should Be Taken Out Of The Moratorium Umbrella

On initiation of a corporate insolvency resolution process against a company under the Insolvency and Bankruptcy Code, the National Company Law Tribunal imposes a moratorium in relation to the insolvent company. Section 14 of the IBC, which deals with the moratorium, prohibits any alienation of assets of the company during the CIRP period; stays the continuation and institution of any legal proceedings; and prevents secured creditors from enforcing any security interest created over the assets of the company. In this regard, the IBC mirrors the ‘automatic stay’ imposed under Chapter 11 of the U.S. Bankruptcy Code and the moratorium imposed under the Insolvency Act of the United Kingdom.

There is sound rationale for introducing a moratorium in an insolvency scenario. Insolvency is essentially a collective remedy against a defaulting entity which ensues for the benefit of all creditors.

• The moratorium ensures that individual creditors are prevented from unilaterally initiating enforcement action which could defeat a holistic restructuring of the company.
• Secondly, it ensures that the company has control over its operating assets to be able to continue transacting as a going concern.
• Thirdly, it gives acquirers certainty over the assets which can potentially be taken over leading to better price discovery and better-informed bids.

Scope Of The Moratorium – Special Case For Financial Assets

However, the scope of the moratorium under Section 14 of the IBC is very expansive and requires reconsideration. The moratorium goes beyond prohibiting enforcement over tangible assets (such as land, plant and machinery, stock in trade and inventory) and non-financial intangible assets (such as intellectual property rights). The moratorium also restricts enforcement against liquid financial assets such as shares, units in managed funds, commodities, derivatives and any other form of capital market traded assets.

For instance, one such financing structure is the provision of margin loans which entails the provision of credit to companies where the advances are secured by a portfolio of financial assets pledged by the borrower itself or by its group entities. The value of the pledged financial assets is required at all times to have a certain predetermined level which is ascertained on a continuous ‘mark to market’ basis. A key feature in the credit analysis of margin lending is the ability of the borrower to borrow funds on the security of the financial assets it holds. If the value of the pledged financial assets declines below a certain level, the margin lending institution will make a ‘margin call’ directing the borrower to top up the margin to the predetermined level failing which it may enforce the pledge by selling the financial assets to recover the sums outstanding under the advance.

Section 14 as it currently operates is likely to disrupt the market for margin lending since the moratorium restricts enforcing and selling the margin provided as security. Banks, financial institutions, NBFCs, and FPIs provide significant credit to corporates across the spectrum – from small and medium enterprises to large conglomerates on the back of margin lending structures.

Margin lending is an example of only one financing structure which will be irreparably impaired by Section 14 of the IBC. There are several other complex and specialised products which rely heavily on the ability to enforce security interests on financial assets expeditiously and inexpensively in conducting their credit analysis.

Policy Justification For Exempting Financial Assets From Operation Of Moratorium

There is a strong policy justification to treat financial assets as a distinct class of security interest. Legal certainty as to the effectiveness of arrangements created with financial assets as the security interest is critical to the stability, integrity, and efficiency of the financial markets. Counterparties and stock exchanges would often not even be aware of whether the security being traded is subject to a moratorium. The costs of monitoring which financial asset is subject to a moratorium on an ongoing basis are likely to be costly and cumbersome. On the other hand, any breach of the moratorium attracts criminal penalties under the IBC and capital market players will be subject to significant liability if they inadvertently end up dealing with financial assets belonging to an insolvent entity.

In particular, an approach which provides a safe harbour for financial assets will protect against systemic risk. In times of financial crisis, systemically important financial institutions will need the ability to rapidly enforce security over liquid financial assets to preserve value and prevent erosion of net worth. Secondly, a safe harbour is likely to enhance the availability of credit.

A legitimate concern against any safe harbour against the moratorium is that it will lead to depletion of assets of the company and will impede the company’s ability to run its operations as a going concern. However, the nature of financial assets is such that unlike land, inventory, plant or machinery, they do not contribute towards the day to day operations of the distressed company. Therefore, allowing enforcement of security interests over financial assets will not hamper the company’s ability to achieve a turnaround during the CIRP period. Further, bidders are also likely to be attracted to the company due to its core business operations and not on the basis of the company’s liquid investment portfolio. If a safe harbour is introduced, bidders will simply revise their bids to take into account the lower valuation of the enterprise – but will not be fundamentally dissuaded from bidding.

Position Under European And English Law

A safe harbour for financial assets in a moratorium has been provided in other jurisdictions too. For instance, the UK Insolvency Act, 1986 via its Schedule B1 provides for an ‘administration procedure’ – which is a means of restructuring a distressed company and is comparable to the CIRP process under the IBC. Paragraph 43(2) of Schedule B1 of the Insolvency Act 1986 imposes a moratorium on any step taken to enforce security over the company’s property except with the consent of the administrator in the period during which the company is in an administration procedure.

The UK Moratorium was as expansive as the moratorium under Section 14 insofar as it applied to all secured assets including Financial Assets. The European Commission recognised the need to exempt Financial Assets from the operation of insolvency-related moratorium imposed under the domestic laws of several European jurisdictions. In an attempt to harmonise the domestic laws, the European Commission passed the ‘Financial Collateral Directive’ in 2002 (EU Directive 2002/47/EC).

The FCD was given effect to in the UK as domestic law, by way of the Financial Collateral Arrangements (No. 2) Regulations 2003. Amongst other reforms, the FCA Regulations modify UK insolvency rules by dis-applying the UK Moratorium on enforcement of security interests in Financial Assets.

As of today, an overwhelming majority of member states of the European Commission have adopted the FCD into domestic legislation. This has led to the modernising of national legal frameworks for Financial Assets, by removing a variety of difficulties in their efficient enforcement in insolvency situations. These difficulties principally arose due to the application of security rules developed historically for tangible personal property to intangible personal property such as intermediated securities and financial receivables.

Shares Held By Insolvent Promoter Companies

The moratorium imposed under Section 14 only encompasses all assets of the insolvency company. The principle of distinct legal personality of the shareholders from their investee companies implies that the shares held by the promoters or parent companies in the insolvent subsidiary company are not the subsidiary company’s, but belong to the promoters. The NCLT has also clarified that in the insolvency of a subsidiary there is no restriction on secured creditors from pursuing enforcement action against promoter’s or holding company’s assets. To that extent, there is no legal bar on lenders enforcing and realising share pledges granted in their favour from the parent or promoter of the insolvent entity even when the moratorium is in place.

If the promoter company is undergoing insolvency, then the lenders secured over the promoter company’s shares in its subsidiary will be barred from enforcement due to the moratorium imposed at the promoter level. There are legitimate concerns if a safe harbour is granted to allow enforcement or sale of promoter shares in the subsidiary. Such an exception from the moratorium may jeopardise the insolvency resolution of the promoter company since acquirers will not automatically stand to acquire the promoter company’s shares in its subsidiary. Given the prevalence of group companies in India which are vertically integrated for various commercial and synergistic purposes, potential bidders would be interested in acquiring a parent company only if it comes along with the material subsidiaries which are critical to the parent company’s ongoing operations. Further, the net worth and cash flow of the promoter company could be closely linked with its subsidiary.

To address this concern, a distinction must be made between securities held by a company as part of its corporate structure as opposed to securities held for purely investment purposes. The proposed provision of the safe harbour should only apply to financial assets held by the company for investment purposes. The moratorium under Setion14 should continue to prohibit enforcement or sale of significant shareholding of an insolvent entity in its group companies. This will ensure higher and certain bids from acquirers while preserving the right of lenders to quickly realise non-core liquid assets of the entity.

Suggestion For Reform

Section 14(3), IBC provides that the provisions of the moratorium shall not apply to such transactions as may be notified by the central government (i.e. the Ministry of Corporate Affairs) in consultation with any financial sector regulator. The intention of Parliament was to specifically confer on the central government the delegated power to exempt certain classes of transactions from the ambit of the moratorium. This delegated power allows the MCA to act nimbly in plugging any adverse market impact created by the moratorium without resorting to a parliamentary amendment to the IBC. Given the recent turmoil in financial markets with the NBFCs and debt funds staring at rating downgrades and corporate defaults, the MCA may in consultation with the RBI and SEBI consider if creating a safe harbour for financial assets in corporate insolvencies is likely to mitigate their losses.

Nilang Desai and Suharsh Sinha are Partners, Restructuring & Insolvency practice, at AZB & Partners.

The views expressed here are those of the authors and do not necessarily represent the views of BloombergQuint or its editorial team.