by Renuka Sane and Adam FeibelmanIt has been five years since the Insolvency and Bankruptcy Code (IBC) was enacted by Parliament and notified by the Central Government, a period of development that was abruptly halted by the Covid-19 pandemic. In general, the creation and implementation of the IBC was an impressive institutional development and a beneficial financial sector reform. As with so many aspects of society, however, the economic effects of the Covid-19 pandemic has highlighted some structural limitations of the system and has suggested ways that it might be improved going forward.
The IBC was generally designed and enacted to help promote the development of credit markets in the country and to improve the environment for foreign investors. But there was also a pressing motivation for the IBC: to help resolve a crisis with non-performing assets in the country’s banking system. This crisis was primarily caused by two unfortunate and related features of the Indian economy and credit markets. First, too many debtor firms were able to opportunistically game the legal and financial systems and evade debt enforcement. And second, banks did not have incentives to realize losses from their debtor firms and were often more inclined to extend and “evergreen” their loans. Over the years, to address the results of these problems, the RBI had initiated several schemes for banks and their borrowers to conduct debt restructuring. But these ended up being used by banks to keep loan loss provisions low, and not to resolve stressed assets. The RBI acknowledged these underlying problems in constituting a formal “Asset Quality Review (AQR)” programme in April 2015.
Furthermore, these RBI programmes did not apply to other classes of creditors, who were only authorized to use general mechanisms such as SICA, SARFAESI, and BIFR. These regimes represented a fragmented framework for resolving corporate financial distress, beset with delays, and unable to provide a quick resolution for all manner of default. They tended to be debtor-friendly, allowing defaulting debtors to maintain control over their firms and reorganize even when their businesses were faltering. Thus, the pre-IBC system – if it could called such – was widely viewed as dysfunctional and had generally failed over the years to help or force bank creditors clear their non-performing loans or to promote efficient restructurings or liquidations.
Thus, the main goal in designing the IBC was to provide creditors with a more reliable and efficient way to enforce their claims against debtors. The IBC put creditors – especially “financial” creditors – in charge of most of the important decision-making within the system. Under the Code, any creditor can initiate a case against a defaulting debtor; owners and managers of the debtor firm are then displaced by a resolution professional; and financial creditors get to vote on plans for resolution.
As many others have observed with justifiable admiration, the Code was designed, enacted, and implemented within an astonishing short amount of time. Within a year of its enactment, the Insolvency and Bankruptcy Board of India (IBBI) had started discharging its functions, and an ecosystem of insolvency professionals, lawyers, tribunals, judges, and other stakeholders had started utilizing and performing their functions in that system. Most notably, within a year of enactment, the RBI required banks to initiate insolvency proceedings against debtors representing the country’s largest NPA’s, which sent some of the largest, most intractably troubled industrial firms to the nascent system. These came to be known as the RBI-12, and accounted for almost 25% of the total NPAs in the banking system.
IBC Functioning: By The Numbers
As of March 2021, a total of 4376 corporate insolvencies had been initiated under the IBC. Most of these (41%) have been firms in the manufacturing sector, followed by real estate (20%). Of the cases completed to date, 1277 have led to liquidation of the firms, and 348 have led to successful resolution plans. But most of those liquidations were cases that had been ongoing in the pre-existing system when the IBC was enacted; of newly initiated cases, the number of liquidations and resolutions are roughly equal. The resolution plans have yielded an average of recovery of 40% for financial creditors, although this number reflects a great deal of variation in recoveries in particular cases. The IBC has also managed to keep the costs of the process low – they were, on average 0.92% of liquidation value and 0.49% of resolution value. According to RBI, proceeds from resolutions under the IBC accounted for more than half of recoveries of stressed assets in the banking system in 2018-19.
While the IBC has been a major institutional achievement, the system had been falling short of some of its express goals in the period before the Covid-19 pandemic. Policymakers had voiced concerns, for example, that the rate of liquidations is higher than hoped; recoveries for creditors in many cases have been lower than hoped; and the timelines set by the law for various actions had proven difficult to meet. Of the ongoing IRPs as of March 31, 2021, 79% have taken more than the statutorily mandated 270 days. Nearly half of the largest cases triggered at the direction of the RBI in 2017 are still ongoing, and these represent a significant portion of the NPA’s in the banking system. Delays throughout the system are due, in part, to the failure to date to create a robust system of information utilities, which were designed under the Code to provide timely and reliable information about credit relationships and defaults. The absence of these information utilities means that threshold factual disputes are slowing progress in many cases.
In the early months of the Covid-19 pandemic, the Indian government and regulators took a number of dramatic steps to address its financial and economic effects. The RBI, for example, allowed for a general loan repayment moratorium and eased requirements for classifying defaulted loans.Regarding the IBC in particular, shortly after the strict lockdown of March 2020, the IBBI increased the threshold for (pre-pandemic) defaults that made debtors eligible for insolvency from one lakh rupees (roughly $1,500) to one crore rupees (roughly $150,000). At that time, the IBBI also announced that the strict timelines for the restructuring process under the Code would be paused during the pandemic. On June 5, 2020, the Central Government issued an amendment to the Code instituting a moratorium on IBC cases based on defaults during the pandemic.
That moratorium was extended twice and formally ended in March of this year, just before the second wave of Covid-19 cases ground life in the country to a halt again. The primary rationales given for the moratorium were the limits on judicial capacity during the pandemic and concern that there would not be a sufficient number of resolution applicants (i.e., bidders for insolvent firms), leading to widespread and inefficient liquidation of firms in the system. Notably, the moratorium also covered debtor-initiated insolvencies. The moratorium notwithstanding, there were roughly 200 corporate insolvencies initiated last year against firms that were eligible due to pre-pandemic defaults. This represented a sizeable fraction of the number of filings from the previous, non-pandemic year.
It has not gone unnoticed that, while other countries have adopted pandemic-related modifications of their insolvency and bankruptcy regimes, India was alone in essentially shuttering the IBC for firms affected by the pandemic. This meant that the IBC was totally sidelined as part of the response to economic and financial crisis. To be sure, insolvency and bankruptcy law is only one potential tool in the overall set of responses needed to address a crisis such as the current one. But as we have seen in other countries, it can play a beneficial and sometimes crucial role in resolving or restructuring firms that face financial distress due to – or in the midst of – an external economic shock. There was clearly a need for such a tool or mechanism as a result of the effects of the pandemic; instead of utilizing the IBC, the RBI created a completely new consensual restructuring scheme.
The need for a moratorium of the IBC during the pandemic and the ad hoc RBI restructuring scheme reflect some general limitations in the function of IBC as it has developed. It has highlighted, for example, that the IBC was simply not designed or implemented to promote voluntary restructuring of otherwise viable firms with financial problems. This was due to numerous factors, perhaps most notably a skepticism of defaulting firms and loss-averse banks borne of the practical experience. Discouragement of voluntary and negotiated restructuring is built in to the system through features such as the ability of any creditor to trigger an insolvency upon a modest default, the fact owners and managers are displaced from the affairs of their firms once a case is initiated, and that owners of many firms are precluded from continuing as owners after restructuring. It has been exacerbated by the fact that the system has become exclusively a process for auctioning off firms and liquidating those firms that cannot be successfully purchased out of the system.
Some of these attributes of the system were intended in the original design, but others have emerged through amendment or practice. For example, the insolvency process under the IBC has come to require that resolution plans be exclusively in form of bids to purchase the firm. And the process has become overly focused on the overall price of “resolution” bids as compared to the actual plans for restructuring those firms’ business models and capital structure or to the distribution of proceeds among creditors. There is a general understanding among bank creditors that they should accept the highest bid rather than assess operational or management plans for firms. The Code as initially designed did not require either. Vesting decision-making authority in creditors was based on an assumption that they would be in the best position to choose plans that made the best business sense. Furthermore, the Code as initially enacted clearly allowed for the possibility that debtors would be able to offer resolution plans for their own firms – if the debtor’s plan made most commercial sense, they would be allowed to regain control of their firms. This fact is evident in the subsequent decision to amend the Code to prohibit some owners – those defined as wilful defaulters or who have recently non-performing accounts – from being “resolution applicants” under the Code and, thus, unable to make a bid for their firms.
Applying The Fixes
There are reasons to believe that these structural limitations of the IBC will be continue to hobble the system in the short- to medium-term in the aftermath of the pandemic. There is a growing realization that the IBC moratorium and other recent policies have effectively been kicking the can of financial distress down the road. Debts owed by firms and individuals throughout the country have not been forgiven but made temporarily unenforceable; many debtors will be emerging from the pandemic in a deep financial hole. This is exactly the type of scenario – widespread debt overhang among debtors who are otherwise returning to viability – for which a formal and efficient restructuring tool could be beneficial at both the micro and macro levels. But even in the longer term, a system that is effectively unavailable for firms that could benefit from voluntary restructurings is simply missing an important cog.
We therefore echo the calls of a growing group of commentators to make the IBC system more amenable to restructurings generally and voluntary restructurings in particular. We appreciate that many knowledgeable observers worry that relaxing the creditor-oriented nature of the IBC will simply open the door to all of the problems that existed under SICA and other pre-IBC regimes. We share that worry. But recalibrating the IBC can be done without returning to the status quo ante. There are various ways to make the system more serviceable for viable firms that need restructuring without making it unmanageably debtor-friendly and while also maintaining the IBC as a useful tool for resolving unviable firms. The new regulations allowing for MSME’s to obtain pre-packaged insolvencies exemplify a cautious and promising step in this direction. The process was clearly designed to provide a route for owners and managers to voluntarily utilize the IBC as a restructuring tool. Among other things, it enables owners and managers of MSME’s – even those who would otherwise be barred by section 29(a) from bidding on the firm in a normal insolvency process – to institute a reorganization while continuing to operate and own the firm, depending on the approval of two-thirds of their financial creditors.
The impact of the pre-pack option itself will be limited. For one thing, it only applies to certain MSME’s. And structurally, it requires a debtor firm to reach an agreement up front with two thirds of its financial creditors to initiate the process, without providing the debtor any additional leverage to motivate those creditors to agree. But, as others have noted, this innovation could provide a partial blueprint for modifying the insolvency process under the Code for other debtors. The key components of this blueprint include allowing owners and managers to remain in control of their firms; giving debtor firms a limited, circumscribed chance to propose resolution plans and seek creditor approval; and relaxing rules against letting promoters continue to be the owners of firms that go through the system. Such changes need not return us to the perils of SICA if creditors can still initiate an insolvency; if they retain the exclusive power to approve resolution plans; and if tribunals can review debtors’ proposed plans for feasibility. If debtors are allowed to continue to control their firms in insolvency, they should be subject to meaningful oversight and a plausible threat of displacement. And promoters could be required to contribute new capital to be allowed to continue as owners of their restructured firms, as is the case in other jurisdictions.
Changes Outside The IBC
For the IBC to promote voluntary and negotiated restructurings and to function more effectively in general, however, also depends on some critical changes in the broader financial system and the regulatory environment. For one thing, banks must make progress in developing both an inclination and the expertise to evaluate and negotiate restructuring arrangements with their debtors. This depends in some part on relaxing some of the skepticism in the financial system and in society about promoters and the causes of financial distress. While many promoters will act opportunistically and mismanage affairs, many of them will face financial distress due to external shocks and honest mistakes. For them, a restructuring tool could help return their firms to viability.
But it also depends on changes in the banking regulatory environment, which currently hampers development in this direction in various ways. It often encourages mechanistic, overly cautious approaches to addressing non-performing assets, and it fails to provide sufficient incentives to banks to be both assertive and flexible in their relationships with borrowers in distress. For example, bank employees – both public and private –are considered public servants under the Prevention of Corruption Act (POCA). As a result, they face perceived legal risks in the judgments they make about restructuring loans. In such a position, it is easier to mechanistically choose among bids rather than engage in complex negotiations with borrowers. A more consequential regulatory failure is that the RBI does not force banks to aggressively write down stressed debt. Such forbearance offers banks no incentives to attempt to address their borrowers’ distress before they need to enter the IBC and before firm value has evaporated; in fact, it effectively encourages them to engage in the ever-greening of loans that has fueled the NPA crisis.
Changes in these kinds of background legal and regulatory approaches could help improve the incentives of banks, the main creditors in the Indian economy, to be more proactive in restructuring loans (and taking necessary losses) where appropriate. That, in turn, could motivate banks to develop more expertise in restructurings and turnarounds, making it more likely that the IBC, with some of the institutional reforms described above, could serve as a useful tool for voluntary and negotiated reorganizations. Banks and firms may nonetheless still often delay and avoid employing the insolvency system, but operational creditors have the ability to initiate cases, and they have proven that they are willing to do so. If debtor firms are allowed an exclusive period to propose resolution plans, it is worth considering whether operational creditors should also be given the right to vote on those plans. Doing so might further improve the incentives of bank (and other financial) creditors to reach negotiated outcomes.
One Last Thing
As a final note, we believe it is also time to notify the Code’s provisions that apply to personal debtors. The economic and financial effects of the pandemic are creating the same hazards of over-indebtedness for individuals and households as for firms. In fact, there is evidence that lending to households has increased significantly in recent months. As consumer credit plays an increasingly important role in the Indian economy and society, there is a structural need for a process to deal with consumer over-indebtedness. But the need to recalibrate the system to make it less creditor-oriented is even more important in this context. The consequences of an involuntary insolvency for individuals can be debilitating, leading to significant social costs and deterring productive borrowing. Giving creditors the unconstrained power to approve – and thus to effectively dictate the terms of – debtors’ repayment plans will surely make the insolvency process forbidding for debtors, who will be especially hesitant to employ the system even when it is clearly in their interest, and in the social interest, for them to do so.
(This article first appeared in Bloomberg Quint, 23 July, 2021)