The Insolvency and Bankruptcy Code has begun to transform the Indian NPA resolution process and its credit culture Ani Follow Apr 21, 2018 · 17 min read

April 16th, 2018, Mumbai (Mint): Debt-laden Uttam Galva Steels Ltd on Monday offered to repay its creditors in full, after its previous offer to pay ~Rs.29bn as a One Time Settlement for ~Rs.69bn debt to the banking consortium was rejected by SBI. The steelmaker also sought time to arrange the funds.

April 17th, 2018, Mumbai (Mint): Electrosteel Steels first from RBI’s dirty dozen to exit bankruptcy. NCLT cleared the resolution plan of Electrosteel Steels Ltd, approved by the Committee of Creditors (CoC) with a voting share of 100% , submitted by Vedanta

April 20th, 2018, Mumbai (Mint): NCLT puts ArcelorMittal, Numetal back in the race for Essar Steel. NCLT Ahmedabad has set aside Essar Steel IRP’s decision to disqualify the first round of bidding and extended by a month the deadline for filing a debt resolution plan of ~Rs.526bn. Vedanta has emerged as the strong third bidder in second round of bidding.

April 20th, 2018, Kolkata (Mint): UltraTech Cement is willing to pay ~Rs80bn for Binani Cement if NCLT orders liquidation and will raise its offer by Rs.5bn if any firm matches its bid. Competing bid from Dalmia Cement-Bain Capital-Piramal Enterprises consortium stands at ~Rs.69bn, up from ~Rs.63bn bid initially. Financial lenders won’t have to bear any haircut on this resolution. Operational creditors have thrown their weight behind the UltraTech bid since their claims are better served in that bid.

The above cases, among others, highlight the legislatively driven transformational changes sweeping the ownership patterns in Corporate India. Never before have errant promoters been subject to the loss of assets upon defaulting on their financial obligations.

The newscycle will be dominated by the debt resolution process of the various stressed corporates over next two years. But FY19 will be an intense “newscycle year” as political parties are likely to increase the decibel levels surrounding these developments in the runup to the 2019 elections.

To cut through the noise, it will be imperative to understand why the transformational legislation — The Insolvency and Bankruptcy Code, 2016 (Code) — was required and connect the dots of the newscycle to the underlying logic of the legislation.

An enterprise may underperform or fail for a variety of reasons. Mostly it is on account of competition from more efficient firms which drive out the inefficient businesses out of the market place. At times, such underperformance can also be traced to design flaws of the business model, faulty execution, economic downturn, or even wilful/ malafide intent. Reasons notwithstanding, failure has a multiplier effect on the business environment and, therefore, needs to be addressed expeditiously.

The Insolvency and Bankruptcy Code, 2016 (Code) is transformational change in the way such resolutions have happened in India. It structurally alters the mechanism to address honest failures and encourages the freedom to exit. It is one of the most transformative third generation economic reforms to have been undertaken in India.

Facilitating Exit is as important as facilitating Entry

Markets based economy needs freedom at three stages of an entrepreneurial venture — Stage of Entry (Freedom to enter a business), Stage of Continuance (as a Going Concern and Free to Compete) and Stage of Closure (freedom to exit in case of unviability).

This process enables — Emergence of new competitive firms; their ability to remain in business till they remain competitive, and make way for newer entrants when they lose their competiveness. This freedom is essential for efficient allocation of the resources within the economy. It is well established that economic freedom and economic performance have high positive correlation. Countries having high level of economic freedom generally out-perform the countries with not-so-high level of economic freedom.

The underlying theme of economic reforms since early 90s has been granting freedom of business by altering or repealing the debilitating legislations. Essentially, the modifications and enactments of various economic legislations have expanded the “who, what and how to do” list for businesses which have sought to expand the contours of economic freedom and address market failures.

Economic Reforms — What was missing?

The reforms process began with “facilitating entry” by dismantling the license permit-quota Raj. Stage 1 included creation of rules authoring the State to regulate the market for provision of goods and services — a mindset change from the State providing the same. Legislations and creation of regulatory bodies such as SEBI under the Securities and Exchange Board of India Act, 1992 happened during this stage.

Stage 2 of the reforms was focused on enhancing the freedom of doing business with enactment of legislations like the Competition Act, 2002. It promoted the freedom to do business, while also safeguarding the freedom of all interested players to do so. Concomitantly, to ensure a level playing field, the state owned enterprises were treated at par with private enterprises under the competition law.

While the freedom to enter and operate has been facilitated, the ability and freedom to close down businesses and exit was still missing in the ecosystem which has been impairing the functioning of the markets driven economy. This inability has manifested in the burgeoning Non Performing Accounts (NPA) crisis in the Indian banking system. As balance sheets get saddled with NPAs, the risk appetite of bankers reduces which constrains the flow of credit even to the healthy and productive parts of the economy.

Non-Performing Assets — What lies beneath?

A firm becomes an NPA for a bank when its ability to service the debt is impaired or if it fails. These failures manifest in default in repayment obligations as mismatches between cash inflows and outflows get accentuated. There can be variety of reasons for why a firm may fail or underperform to deliver as expected — faulty conceptualization of business, inefficient execution of business, change of business environment, or even willful /malafide intentions in some cases. Regardless, the failure impacts the economy in multitudes of ways and hence needs to be addressed expeditiously.

Defaults due to liquidity crunch and/or impaired solvency are legitimate outcomes of business operations for reasons cited earlier. It is erroneous to club and equate all defaults with scams or malafide intent. And thus, all defaults don’t necessarily warrant the closure of business, which destroys organizational capacity and capital.

Globally, there are mechanisms to resolve insolvency in an orderly manner. The absence of a comprehensive mechanism in India has denied effective recourse to lenders to recover their debt which translates into reduced lending. The reduced availability of finance and ineffective recovery mechanisms push up the risk premiums and thereby the cost of capital thus putting in question the viability of many projects. Paradoxically, by allowing freedom to enter and to compete but not to exit has resulted in higher inefficiencies in the system with the presence of ineffective zombie entities.

Ease of Doing Business — How does India stack up?

Exiting a venture, if need be through insolvency resolution, is a critical aspect that businesses consider before starting a venture. Two variables are important in this resolution — Time for Closure and Recovery Rates. According to the World Bank’s Ease of Doing Business Index in 2016, insolvency resolution in India took 4.3 years on an average.

India compares unfavourably compared to other economies. Time taken to resolve cases in courts and confusion due to a lack of clarity about the insolvency process are two primary reasons for such unfavourable rankings. The second order effect of this delay manifests in lower recovery rates on resolution.

The Insolvency and Bankruptcy Code 2016 is an effort to rectify the system by providing for a time-bound insolvency resolution process within a 180-day period (extendable by 90 days).

Pre IBC Debt Resolution — No Clear Debt Default Resolution Mechanism

The legislative as well as the institutional mechanism for dealing with debt default and insolvencies has lagged global standards — be it for individual or for corporates.

For individuals insolvency resolution the applicable laws are almost a century old — the Presidential Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920.

For corporate or non-individual insolvency resolution, the laws facilitating the recoveries for creditors were governed either by the Indian Contract Act, 1872 or through special laws such as the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Through SARFAESI Act, 2002, only limited elements of bankruptcy framework have been put into place to a limited extent — banks are able to repossess fixed assets which were pledged to them.

According to the Bankruptcy Law Reforms Committee (BLRC), a complex maze of multiple legislations govern the corporate bankruptcy and insolvency — some for collective action and some for debt recovery.

1. Companies Act, 2013: A chapter deals with collective insolvency resolution by way of restructuring, rehabilitation, or reorganization of entities registered under the Act.

2. Companies Act, 1956: Deals with winding up of companies. No separate provisions for restructuring except through M&A and voluntary compromise.

3. SICA, 1985: Board of Industrial and Financial Reconstruction (BIFR) assesses the viability of an Industrial company and refers an unviable company to the High Court for liquidation. SICA 1985 stands repealed w.e.f. 25 November 2016.

The result of legislative ambiguity

The legislative as well as the institutional mechanism for dealing with debt defaults and insolvency have not had desired outcomes. Actions through the SICA Act, 1985 and the winding up provisions of the Companies Act, 1956 haven’t aided the recoveries for lenders as per expectations and haven’t helped the necessary restructuring of debt laden firms.

The following statistics highlight the acuteness of the problem for the lenders. According to Ernst and Young, the average life of cases recommended for restructuring in 2002 was 7 years while the average life of cases recommended for winding up to the court was 6.5 years. As of Oct-15, ~ 955 (out of 4,636) court cases were resolved while ~163 (out of 545) cases of voluntarily winding up had been resolved within a span of 5 years. The number of cases pending for more than 20 years for the same categories was 1,274 and 205, respectively.

The unsynchronized and numerous legislations with their complex interplay had resulted in debt recovery being a cumbersome process for lenders. The rights of borrowers and the powers of lenders in the case of insolvency are governed by different legislations. The various ambiguities in the legislative and the jurisdiction impair the commercial understanding among the stakeholders which acts as a fertile ground for manipulation and stalling the progress of resolutions.

A poor record of recovery and resolution has hampered the confidence of the lending community in the legal cycle thus resulting in the lenders being risk averse which in manifests either in reduced access to finance and/or higher cost of capital.

These structural constraints have weighed on the development of corporate bond markets in India which are efficient in sniffing out the potential problems and pricing them in the bond prices thereby enforcing corrective actions well in time than letting those problems fester. Small size of corporate bond markets means that the share of banks in the secured credit is the largest component of the credit market in India.

Need to Consolidate

The key endeavour of Insolvency and Bankruptcy Code (IBC) is to consolidate into a single legislation the multiple laws relating to insolvency of companies, other limited liability entities, unlimited liability partnerships and individuals, which were contained in a dispersed manner across a number of legislations. This consolidation is expected to provide greater legislative clarity and facilitate the application of consistent and coherent provisions to different stakeholders affected by business failure or inability to pay debt.

The central idea of IBC is that when a firm defaults on its debt, the control of the firm must shift from the shareholders/promoters to a Committee of Creditors, who has to evaluate proposals within 180 days from various players about reviving the company or taking it into liquidation. When decisions are taken in a time-bound manner, there is a greater chance that the firm can be saved as a going concern. Under the SICA regime, the inordinate delays often proved to be value destructive.

The Foundational Pillars

The IBC provides a comprehensive and robust regime at par with global standards and even better in some aspects. The key thrust areas of IBC are:

(i) Dealing with all aspects of insolvency and bankruptcy of all kinds of persons;

(ii) Separating the commercial aspects and judicial aspects of Insolvency and Bankruptcy proceedings from adjudicating authorities to decide the matters within their domain expeditiously;

(iii) Moving away from erosion of net worth to a more objective default in payment for initiation of the insolvency process;

(iv) Moving away from the ‘debtor-in-possession’ regime to a ‘creditors-in-control’ regime where creditors decide matters with the assistance of insolvency professionals;

(v) Providing collective mechanism to resolve insolvency rather than recovery of loan by a creditor.

(vi) Achieving insolvency resolution in a time bound manner and empowers the stakeholders to complete transactions in time.

The Insolvency and Bankruptcy Code has at its foundations, a four pillars supported institutional infrastructure:

Pillar 1 — The Insolvency Professionals: IPs will assist the stakeholders in the conduct of insolvency and bankruptcy process.

Pillar 2 — Information Utilities: A new industry which will store, process and make available the information required to conduct various transactions under the Code efficiently and expeditiously.

Pillar 3 — Adjudicating Authorities: NCLT and DRT will adjudicate on the insolvency and bankruptcy proceedings for corporates and individuals respectively and their appellate bodies would accordingly be NCLAT and DRAT.

Pillar 4 — Regulator: The Insolvency and Bankruptcy Board of India will have the role of regulatory over-sight over the Insolvency Professionals, Insolvency Professional Agencies and Information Utilities and writes regulations to govern various transactions under the Code.

Source: Ministry of Finance

How does the process work?

The Insolvency and Bankruptcy Code sets to rest an era of confusion and ambiguity. It has defined and streamlined the resolution/ liquidation process.

After a default in debt servicing, the control over the debtor’s assets moves to the creditors. During this period, the Code also provides immunity to debtors from the claims of creditors. This is essential to ensure an uninterrupted resolution process.

Default is a state of insolvency potentially leading to the failure of the enterprise and consequent liquidation, which needs to be prevented. If liquidation is not possible, there needs to be resolution:

(a) For the firm as a going concern, as closure of the firm destroys organizational capacity and capital;

(b) At the earliest, preferably after the first default itself, to prevent it from ballooning into an unresolvable case;

(‘c) In a time bound manner as undue delay prolongs the organizational inefficiencies leading to erosion of capital thereby making resolution difficult;

(d) By stakeholders who have a claim against the firm; and

Achieving these objectives is possible only if the insolvency resolution and other transactions are completed in a time bound manner which is a distinguishing of the IBC from the erstwhile legislations.

IBC mandates the completion of Corporate Insolvency Resolution Process (CIRP) within a period of 180 days with a one-time extension up to 90 days by the NCLT with 3/4th of the Creditors approving the plan. All insolvency resolutions may not entail a similar level of complexity and thus could be resolved sooner. Accordingly, IBC provides for a fast track process for certain categories where the resolution process needs to be completed within 90 days, with provision for one time extension up to 45 days.

The importance of “Timeline”

The “timeline” is one of the most important constructs of the IBC and hence it is important to understand its significance. When a debtor (enterprise) defaults, it is because it is financially stressed and hence requires resolution to strengthen his financial position.

During the CIRP period, an insolvency professional manages the operations of the corporate as a going concern and there is uncertainty about ownership and control of the corporate, post resolution. Prolonged uncertainty on this account will likely diminish organizational capital making resolution difficult and could eventually lead to liquidation of the firm at distressed valuation. The CIRP, therefore, needs to be completed as quickly as possible as, not later than 180 days.

The timeline for CIRP needs to be evaluated from these perspectives:

(i) Enough incentives for the stakeholders to adhere to the time line to complete the CIRP early to avoid liquidation. Hence, the entire process has been kept under their control to ensure implementation of the resolution plan.

(ii) Presence of qualified, competent and empowered professionals — Insolvency Professionals — who drive the process. The provision of calm period ensures continuity of the process under CIRP and also interim finance.

(iii) Information Utilities would provide relevant information required for CIRP expeditiously.

As the system processes many number of CIRPs over a period of time, the processes would get standardized and streamlined leading to, what is known in some jurisdictions, a Prepack — where a stakeholder triggers the process only when it is reasonably ready with a resolution plan and closes it soon thereafter.

The Insolvency Resolution Process — Key Stages

NPA Cleanup: The underlying objective

One of the chief reasons why the Government has undertaken the structural legislative reforms is to address the unsustainable levels of banking NPAs which are proving to be a major headwind for the Indian economy. The NPAs in balance sheet have made bankers risk averse and credit constraints are prolonging the upturn in the investment cycle since last few years.

To further the legislative agenda and add enhance the enforceability of the IBC, in May-17, the Government amended the Banking Regulations Act to accelerate resolution of the Rs15.2 trillion of Stressed Assets clogging the Indian banking system.

The three key measures incorporated are:

I. Authorize the RBI to issue directions to banks to initiate insolvency proceedings against defaulters under the bankruptcy code;

II. RBI can issue directions to banks for resolution of stressed assets on its own accord;

III. RBI may form committees with members it can choose to appoint to advise banks on resolution of stressed assets.

How is IBC Progressing on the ground?

This amendment has stepped up activity in NCLT as numbers of cases being referred to have increased. Earlier banks were hesitant to invoke the IBC due to future potential political fallout. But with RBI now directing the banks to undertake the balance sheet clean up by initiating the insolvency proceedings, the transparent and market-determined approach is bearing fruit.

As the number of admissions is rising, so is the ecosystem for asset resolution beginning to evolve. An enabling operational environment is evolving for collaboration among Banks, ARCs, Private Equity, Asset Management Companies and the Insolvency Professionals. The incentives for various players in the value chain are driven by measures like 100% FDI in ARCs, Pass through Status to ARC Trusts for Income Tax purposes, Stamp Duty exemption, Allowing trading in Security Receipts, etc.

The demand for IPs has been very strong and anecdotal indications suggest that IPs and other related infrastructure is stretched to timely finish cases on time. Given the near term infrastructural bottlenecks, it is reasonable to expect an increase in timeline for resolutions.

One of the key findings from the evolving data suggests that many companies (1/3rd of the total admissions so far) are referring themselves to the NCLT for insolvency proceedings. Also, 42% of cases referred are by Operational Creditors. Financial creditors, having strongest claim seniority as per IBC, have filed 23% of the overall admissions so far.

RBI has released two sets of list of corporates whose resolutions should be taken up on a priority basis. The first list of 12 NCLT referred accounts constitutes 20–30% of GNPAs while the second list constitutes 15–20% of GNPAs. Effective resolutions have started to commence with first set of initial results of the 12 NCLT referred accounts crystalizing by May-2018. The overall loan exposure both lists aggregates to (2.6+1.3) Rs.3.9trn.

Need for Change — The BRIC Evidence

With the Insolvency and Bankruptcy Code, 2016, the government has undertaken a radical restructuring of the bankruptcy regime in India. Apart from the near term focus of cleaning up banking balance sheets by resolving the NPA situation over next couple of years, the longer term vision is to encourage entrepreneurship and innovation as old inefficient businesses and capacities vacate the space and make way for newer, efficient and perhaps even innovative business models.

Failure of entrepreneurial ventures is part and parcel of a markets based economy, but at a macro and a policy level, how are such failures handled systemically in a swift and a time bound manner makes a difference. A quick debt resolution enables entrepreneurs as well as lenders to move forward without being burdened with past decisions. While there is sufficient global evidence from the developed nations supportive of the above argument, the experience of other BRIC nations also supports the same.

When the IBC process began with the first list, it was widely estimated among the Banking circles that in the first of cases, banks would have to take atleast 60% haircuts on their loan exposure to these names. The ensuing upturn in the steel cycle and the progress of bidding process, especially for those companies having good underlying operational assets, the estimated loss expectations have improved.

(i) Uttam Galva has agreed to pay in full earlier this week; (ii) lenders have no haircut in Binani Cements case; (iii) TATA Steel and Vedanta are likely to take control of Bhushan Steel and Electrosteel Steels respectively; (iv) the profile of bidders for Essar Steel assets is stronger than erstwhile promoters — Arcelor Mittal, JSW Steel, Vedanta.

Good quality assets have generated strong interest and bidding wars among better rated corporates. On the other hand, weaker underlying assets are not generating enough bidding interest and losses in these exposures will likely be to the tune of 85–90%. It may not be possible to resolve the insolvency in all cases and hence it is necessary to have a mechanism wherein the defunct firms with unsustainable businesses don’t encroach upon the valuable economic resources. The Economic Survey of 2015–16 has estimated the cost of such impended exits, with the opportunity cost of not allowing ‘creative destruction’ in an otherwise dynamic economy.

As the resolution cycle of the last credit cycle largely culminates by 2020, the ensuing new credit cycle will germinate on a much more fertile ground of improved credit culture whereby the lessons of IBC will check the propensity for willful defaults among borrowers. This should also lead to the deepening of the bond markets as the global experience shows and the commentary of Credit Rating Agencies indicates that they are already smelling the change in the air and preparing for the business opportunities.

With increased discipline in the system, the estimates of credit costs and loss given defaults (LGD) should also be significantly lower in the ensuing credit cycles than the past cycles which should lead to higher valuation multiples for corporate and public lenders in the forthcoming cycles vis-a-vis current multiples. The government should undertake privatization exercises, if politically feasible, during those times than at current depressed multiples for better monetization of assets.

The Insolvency and Bankruptcy Code, 2016 — A Snapshot

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References:

REPORT OF THE JOINT COMMITTEE ON THE INSOLVENCY AND BANKRUPTCY CODE, 2015

Insolvency and Bankruptcy Board of India www.ibbi.gov.in

National Company Law Tribunal www.nclt.gov.in

Monetary Management and Fiscal Intermediation http://www.ibbi.gov.in/echap03_vol2.pdf

180 Days for Resolution Process:; Too Long or too Short? http://www.ibbi.gov.in/IBBI_Newsletter_2017_Jan_March_FinalWeb.pdf

The Insolvency and Bankruptcy Code, 2016 builds the third pillar of economic freedom http://www.ibbi.gov.in/IBBI_Newsletter_Web.pdf

3 ways in which changes to Banking Act gives RBI more powers tackle NPAs http://www.livemint.com/Home-Page/yKWZGLqqM2NLT7uxpEMHcM/Govt-notifies-Banking-Regulations-Amendment-Ordinance.html