To Maximize the Value of Distressed Firms, Insolvency and Bankruptcy Code Needs More Reform
The Insolvency and Bankruptcy Code (IBC) has ushered in a new era in dealing with corporate insolvency and bankruptcy in India.
The code was to provide the necessary framework for orderly negotiation between lenders and borrowers in order to preserve the economic value of a business enterprise. And when the company represents a bankrupt company, the code is supposed to facilitate the orderly and speedy liquidation of such a company.
Unlike previous insolvency regulations that were in effect in India, such as the Sick Industrial Companies Act (SICA) and the Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act (SARFAESI), 2002, etc. – which granted privileges to certain groups of creditors to initiate insolvency proceedings against debtors – IBC facilitates the participation of all key stakeholders involved.
Also unlike regulations that dealt with sick businesses, the IBC calls for prompt resolution of insolvency without wasting a company’s business value through delayed proceedings.
In addition to a legal framework for faster and more efficient insolvency resolution, the IBC has also led to the development of a new ecosystem with several key elements that are essential to a vibrant market economy. The ecosystem includes regulated insolvency professionals, who manage the assets of the debtor company during bankruptcy, Insolvency Information Utilities, which provides information for bankruptcy-related decisions, and the Insolvency Bankruptcy Board of India, who oversees the insolvency process by acting as a regulator. .
IBC and results
Four years after the promulgation of the IBC, much has been accomplished. IBC has dramatically improved the debt collection rate for companies in India. Before IBC, banks had to depend on various legal mechanisms such as Debt Collection Courts (DRT) and SARFAESI Law etc. which made collection expensive, inefficient and time consuming. The existence of several pieces of legislation was known to allow unscrupulous promoters to exploit lenders.
In September 2020, out of the nearly 4,000 cases admitted, more than 50% of cases were resolved. Among the settled cases, there are more than a hundred cases pending before the Council for Financial and Industrial Reconstruction (BIFR). Thanks to the IBC, financial creditors are able to collect around 42% of their debts.
According to a Reserve Bank of India (RBI) report, almost half of the collections made in fiscal year 2018-19 were through IBC. The corresponding figure for the 2019-2020 financial year is approximately 61%.
Obviously, the IBC was able to achieve an insolvency resolution in a much shorter time frame. The average time taken under the IBC is almost a year, compared to around four years under previous regimes. The IBC is also successful in removing businesses from unscrupulous promoters who were ineffective, as they now face an increased threat of losing control of their businesses through the actions of creditors.
A key agenda for the future
As the IBC has successfully ushered in a new era in India’s bankruptcy resolution history and improved the country’s business friendliness quotient, this should only be seen as the first right step. It needs several reforms to strengthen its supporting role in the capital formation and economic growth of the country.
The ideal outcome of an effective IBC goes beyond higher recovery by lenders, as it is supposed to maximize the value of businesses facing bankruptcy proceedings. Faced with such an ideal, statistics so far suggest that IBC still has a long way to go. First, a large majority of cases resolved under the IBC have paved the way for the liquidation of the business rather than its restructuring.
Second, the average time taken for resolution also greatly exceeded the time limit set by the code. It is possible that several factors, including the late start of restructuring and the slowing economy, contributed to the less than desirable outcome of the CBI. However, to achieve the goal of maximizing the value of distressed firms, it must adopt a path of continuous reform.
One of the main reform programs required in the IBC is the inclusion of a provision for a debtor-in-performance bankruptcy process. The IBC has transformed the bankruptcy process in India from “debtor in possession” to “creditor in control” to deal with stray and manipulative promoters. Nonetheless, once unscrupulous promoters leave the scene, a significant portion of insolvent businesses in a free economy are real failures triggered by business and economic uncertainties.
The debtor-in-manager bankruptcy process would be more efficient for companies that find themselves in difficulty for reasons other than negligence or incompetence of the management in place, compared to a creditor-monitor process.
Under the debtor-in-manager bankruptcy resolution, the promoters would be allowed to continue operating the business. The process could largely follow the Chapter 11 bankruptcy code in the United States. The Chapter 11 process allows companies to rework their debt obligations while continuing to operate, when debtors submit a restructuring plan in the best interests of creditors. This is especially important given the increasing frequency and ferocity of external shocks such as the COVID-19 pandemic, severe commodity price cycles and frequent global financial crises.
In such cases, the current promoters are probably the most competent entities to manage the business to maximize the cash flow of the business as the creditors committee. Adding a debtor-in-owner process would make the IBC the user-friendliness it so badly needs to deal with true non-crony defaults.
The prepackaged resolution on MSME insolvency introduced in April 2021 is a welcome step in this direction. The Debtor Favorable Insolvency Resolution process which facilitates the initiation of the bankruptcy process prior to default aims to minimize disruption to the business of MSME debtors.
Another major concern regarding the IBC concerns the disempowerment of operational creditors. It has been argued that the higher recovery rates obtained by financial creditors are at the expense of operational creditors. This would be particularly damaging to the financial soundness of MSME suppliers. Despite the recent amendment, the code still needs to strike a healthier balance between operational creditors and financial creditors.
Then there are other reforms that are still needed to strengthen the effectiveness of the existing IBC process. It is important to upgrade the forensic infrastructure that supports the IBC to ensure that the timeline set for the process is adhered to, as it is a key factor in preserving the economic value of the business.
The number of judicial officers and insolvency professionals is quite limited to manage large-scale bankruptcies which can emerge from economic shocks such as the current pandemic. In addition, there is also an urgent need to deepen the stressed asset market. Without a strong investor base for turnaround assets at the end of the IBC process, we would not be able to improve ultimate recovery rates.
Joshy Jacob is Associate Professor at the Indian Institute of Management in Ahmedabad.