Covid-19: Making A Bankruptcy Law Work In A PandemicBloombergQuintOpinion
The union cabinet has reportedly cleared a proposal to suspend the Insolvency and Bankruptcy Code, 2016, for six months, which may be extended to 12 months. Before this announcement, there was a clamour for a blanket suspension of the IBC in anticipation of a large number of IBC filings in respect of firms that face severe distress due to the lockdown. This fear was exacerbated by the possibility of a large number of liquidations resulting from such filings.
We argue that a blanket suspension of the IBC will harm the very firms that such suspension seeks to protect, and firms that can be restructured under this law may get pushed to liquidation. An understanding of the purpose of bankruptcy laws—often dismissed as a theoretical or academic exercise—is critical to see why this would be the case. It is, however, likely that the implementation of the law in its current form might pose insurmountable challenges. We make a case for taking some measures to mitigate such challenges, without resorting to a blanket suspension of the law.
Why A Bankruptcy Law Helps Now
A bankruptcy law is helpful right now as it allows a distressed debtor to restructure all its liabilities under the shelter of the law. In the absence of a bankruptcy law, each creditor will likely maximise its self-interest by acting in ways that harm the interests of the debtor and all other creditors. For example, a secured creditor may choose to liquidate its security, which may result in overall sub-optimal recoveries for the other creditors.
A piecemeal sale of a secured asset may imply sub-optimal recovery for the secured creditor as well.
The law preempts self maximising conduct in two ways. First, as soon as the law is invoked, it gives the debtor and the creditors the benefit of a moratorium, aptly referred to in several other jurisdictions as a ‘calm period’. Second, during the calm period, the law compels all the creditors to collectively come to the negotiating table and consider the options before them.
The negotiation between the collective body of creditors is driven by an understanding of whether the debtor is undergoing ‘financial distress’ or ‘economic distress’, nuanced concepts that are well explained in the 2015 report of the Bankruptcy Law Reforms Commission. If the creditors identify it as financial distress, it implies that the firm is viable, but has the wrong financial structure, typically excessive debt. Here, the most optimal approach for most creditors is to restructure the debt so that the firm survives as a going concern and all the creditors benefit from the otherwise viable business model of the firm. This may be done by allowing the firm to be taken over by new management, new shareholders or the creditors themselves. If it is the latter, it implies that the firm is fundamentally unviable. In such cases, no restructuring helps and the most efficient decision is to liquidate the company.
A bankruptcy law facilities this decision making.
From the debtor’s perspective, a bankruptcy law allows the debtor to “reset its bargain” with the creditors under the shadow of the law. From the perspective of creditors, it assures transparency on the terms of the bargain offered to every other creditor and equality for similarly placed creditors. Bankruptcy laws are time-tested solutions that have been used by several large firms, such as Delta and Chrysler, to emerge healthier in times of extreme distress.
Closer home, the IBC has allowed the restructuring of several large NPA accounts such as Bhushan Steel, Essar Steel and Alok Industries. There is no reason why the same framework will not work for large firms now.
While it appears that the IBC is proposed to be suspended in its entirety, advantages could still be obtained if Section 10, which allows the debtor to voluntarily file under the IBC, were to be kept operational.
Three practical difficulties may arise in the implementation of the IBC during these times.
Small firms versus large firms
First, a review of the literature suggests that while bankruptcy laws work well in crises-times for large firms, they might not work well in the case of small firms. This is because of several reasons such as all-encompassing liens on the small firm’s assets, the costs of the proceeding and the disruption caused by the insolvency process that diverts the attention of the promoter-manager from running the business.
The government has already increased the threshold of default required for triggering bankruptcy from Rs 1 lakh to Rs 1 crore. While this may reduce the number of small firms that are brought under the IBC, several businesses in India continue to run as sole proprietorships and unincorporated partnership firms which can be resolved under the provisions of the IBC dealing with personal insolvency.
As counter-intuitive as it may be, this warrants notifying the provisions of the IBC pertaining to personal insolvency.
These provisions would give much-needed relief to such businesses in the form of structured negotiations, a calm period and timebound repayment plans. In the absence of this relief, these businesses are likely to die a slow death anyway.
Interim financing and recapitalisation
Second, irrespective of the size of the firm, a big challenge would be to keep it as a going concern even as the creditors negotiate among themselves. Interim financing has been given a super-priority status in the liquidation waterfall under the IBC.
Bearing this in mind, the economic package that the government has proposed should include a provision for a fund that provides interim financing to firms that take the formal route of insolvency to restructure their debts.
For firms that do get restructured, the resolution plan could provide for repayment of this loan to the government over a period of time. For firms that get liquidated, the government would get a super priority to the extent of the interim finance provided by it. Here, it is important that the government does not select individual firms, but set out criteria for determining the firms eligible for interim financing.
It is also important for the government to create such a fund as a part of a fiscal stimulus package and not wait for the banking system to provide interim financing. The banking system is currently gripped with very high-risk aversion and will not provide such funding even when there is plenty of liquidity. We are seeing similar behavior already. However, to encourage the creditors to also participate in this restructuring process, the RBI could make contingent any forbearance it provides to the creditors on their participation in the restructuring process.
In 2014, then RBI governor Raghuram Rajan spoke “of a country where we have many sick companies but no sick promoters”. In 2020, this may indeed work to our advantage in the short-term from hereon. For a bulk of the mid-sized firms, it is possible that the promoter may have the necessary means to recapitalise her business. In such cases, we must ensure that the law does not present any impediment to allowing the promoter to do so.
Towards this end, provisions such as Section 29A of the IBC, which prevent willful defaulters and its associates from presenting resolution plans must be relaxed, even if temporarily so.
While this relaxation has been made for SMEs under an exception crafted under the law, there is value in considering such relaxation on a temporary basis for all corporate debtors, for it may well spur unexpected revivals.
The third challenge to the implementation of the IBC is the judicial capacity required for dealing with IBC cases. The problems associated with low judicial capacity will likely aggravate the pain of these proceedings. There are two broad ways of easing the burden of the NCLT.
First, it is useful to explore the levers available in a bankruptcy framework for minimizing its role in IBC cases. This may involve taking measures such as lowering the litigation arising from section 29A and developing a framework for pre-packaged insolvencies, which are essentially pre-negotiated agreements between creditors and the debtor, requiring a one-time approval of the NCLT.
Second, an urgent study must be commissioned to understand the stages of the IBC which consume the maximum resources of the NCLT. For example, a week-long study of 400 odd cases undertaken by the Finance Research Group, shows that the maximum number of adjournments were sought for filing additional documents, such as affidavits, rejoinders and vakalatnamas. This is a parallel effort that will require to be pursued rigorously with the objective of identifying the specific aspects of the NCLT process and the administrative infrastructure that needs to be supported.
At a time where financial distress may overwhelm us, we must not disarm ourselves of a useful legal instrument to systematically deal with distress. By suspending the IBC in its entirety for six months, the government is seeking to achieve a rather short-term goal of ‘soothing sentiments’. Instead, a more long-term approach warrants nuanced relaxations from the parts of the law prone to litigation and notifying long-defunct portions of the law so that small businesses can use them to their advantage. Most importantly, there is a desperate need to shake-off the stigma associated with bankruptcy and instead use the framework to bring larger gains to society.
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.