Bad loan resolution: Fixing a hole
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The battle lines are drawn. On one side are the Reserve Bank of India (RBI) and state-owned lenders that have borne the brunt of India’s bad-loan problem. On the other are 12 big defaulters who owe the banks a collective Rs1.78 trillion—about a quarter of the bad loans choking the Indian banking system. The arena is the National Company Law Tribunal (NCLT), where India’s newest bad loan resolution tool—the Insolvency and Bankruptcy Code (IBC)—is being put to the test.
The process of resolving the bad loan problem gained impetus on 5 May when the Indian government notified an ordinance empowering the central bank to intervene directly to coax banks into resolving bad-loan cases. Previously, RBI had no role to play in resolving individual bad-loan cases.
RBI followed it up by forming an internal advisory panel that analysed the top 500 defaulters and winnowed the list down to 12 large ones that should be hauled to the bankruptcy court first. RBI applied an objective criterion: Companies to which banks had a total exposure of at least Rs5,000 crore, and where 60% had turned into bad loans as of 31 March 2016, were the chosen dozen. Banks were given six months to resolve the loans owed by the remaining 488 defaulters through other means; if they failed, these, too, would be dragged to the NCLT.
Nine out of 12 cases are already being heard at the company law tribunal. All 12 firms didn’t respond to emails and text messages seeking comment.
The Rs10 trillion problem
RBI’s directive to cut the Gordian knot of bad loans has been a long time in coming. The Indian banking system has been crumbling under the weight of Rs10 trillion in stressed assets (including Rs7.8 trillion of bad loans and Rs2.2 trillion of restructured loans) that have piled up over almost half a decade. After the 2008-09 global financial crisis, there was a push in lending to infrastructure and capital goods sectors. But as economic growth faltered, demand slowed and capacity idled, crimping the ability of firms to service their debt. Indeed, most of the big 12 defaulters belong to the metals sector, particularly iron and steel, or infrastructure and capital goods, as the chart alongside shows.
“So many things happened—dumping took place, global economic slowdown, there were interventions of courts, agitation against land acquisition. These issues accumulated into a bigger problem,” said R. Subramaniakumar, managing director and chief executive officer at Indian Overseas Bank.
For the banking system, the rise in bad loans led to higher provisions, which wiped away profits and necessitated more capital infusion. But fresh capital hasn’t been forthcoming for state-owned banks, with the government on a fiscal consolidation path and trying to control its deficits. With many state-owned lenders’ capital barely able to cover for these loans and provisioning, lending has slowed to a trickle. In 2016-17, banks’ share in the flow of funds to the commercial sector dipped to 38%, according to RBI’s June financial stability report. While economic growth has picked up, investment demand is yet to recover and the bad loan additions are likely to continue, albeit at a slower pace. The International Monetary Fund estimates Indian banks need another three years to complete provisioning.
In this backdrop, RBI devised many mechanisms over the years to solve the bad loan problem. Initially, it allowed forbearance on loans, resuscitating a tool first used in 2001 called corporate debt restructuring. Then it unveiled something called strategic debt restructuring (SDR) wherein banks were allowed to convert debt into equity and change the management of defaulting firms. For infrastructure firms in particular, a so-called 5/25 scheme allowed banks to extend long-term loans of 20-25 years to match the cash flow of projects, while refinancing them every five or seven years. Then, it introduced the scheme for sustainable structuring of stressed assets (S4A) which allowed banks to bifurcate debt into sustainable and unsustainable parts; the first part would be serviced by current cash flows and the remaining restructured. But all these failed to make a dent in the bad loan problem. At the same time, help arrived in the form of IBC, which had just been notified.
The bankruptcy law
India has had a plethora of laws and institutions to enable creditors to recover loans. But the multiplicity of loans meant that these often came in the way of each other as defaulters filed multiple petitions in different judicial bodies such as the company law board, debt recovery tribunals and high courts. It can be summed up in one damning statistic from a 2014 World Bank report; it took an average four years to resolve a bad loan case in India compared with 10 months in Singapore and one year in the UK.
The bankruptcy law, which was passed by Parliament in May 2016, kicked in from December, superseding other existing laws. It came as a shot in the arm for creditors. An important aspect of the new law is that unlike the earlier ones, it leaves the creditors in control of a company, lawyers say. It also lays down a strict timeline for resolving stressed assets, thus preventing a deterioration in the economic value of these assets.
“It was a much awaited reform that we needed. This was a demand from bankers for a long time that we need a bankruptcy law and it is in the best interest of lenders, borrowers and the economy as a whole. In any capitalist society, it is the survival of the fittest and you have to find ways and means,” said Rajnish Kumar, managing director of State Bank of India (SBI).
NCLT, the judicial body overseeing the entire process, will take 14 days to either reject or accept an insolvency plea filed by financial or operational creditors. After an application is admitted, the tribunal will appoint an insolvency resolution professional (IRP)to come up with a resolution plan within 180 days, extendable by 90 days. During this time, the board of the company would be suspended, the promoters would not have a say in functioning of the company, but the IRP would be supported by the management for day-to-day operations. If a case cannot be resolved in 270 days, the firm would go for liquidation.
NCLT currently has 14 benches in 11 locations with 25 members. Its mandate includes hearing cases earlier dealt with by the Company Law Board (CLB) under the Companies Act 2013, in addition to cases under IBC, with a proposal to add pleas against the Competition Commission of India (CCI), the antitrust regulator. A 6 April dated National Institute of Public Finance and Policy report says NCLT needs 69 benches to deal with its existing case load and 80 benches in the next five years. Currently, the Ahmedabad bench in the western Indian state of Gujarat is hearing petitions against Essar Steel Ltd and Alok Industries Ltd, a textile company. Creditors have taken auto parts maker Amtek Auto Ltd to the Chandigarh bench and Electrosteel Steels Ltd to Kolkata. In many of these cases, at the time of writing, NCLT is still deciding whether to admit the petition or not. “This move definitely gives an even playing field for discussions between bankers and promoters but it is not a panacea for the NPA (non-performing asset) issue for banks,” said Manisha Shroff, a partner at law firm Khaitan and Co. “NCLT may not have enough manpower or infrastructure to deal with the mountain of already identified cases and the hopes of a fast resolution are not realistic. Effective implementation is key to the success of IBC.”
Apart from infrastructure, the second concern relates to the case law that develops under IBC. Within six months of the code being operational, cases have emerged which have either expanded the scope of the bankruptcy code or given new interpretations to provisions covering issues such as what constitutes a dispute, how are principles of natural justice applied, and the applicability of timelines.
For instance, the National Company Law Appellate Tribunal (NCLAT) in one case ruled that the 14-day timeline for rejecting or admitting a case under the IBC was directive: that means courts do not have to necessarily adhere to this timeline. In another case, it directed that NCLT “adopt a cautious approach in admitting insolvency application by ensuring adherence to the principles of natural justice”.
In the six months since IBC came into force, financial institutions have been just testing the waters with smaller cases. Ahead of the government’s ordinance, only about 100 cases were being heard under IBC and they were mainly petitions by operational creditors (such as suppliers).
“Largely I believe banks are going about it the right way—preparing internal policies and procedures; training and awareness sessions for relevant staff; and creating panels of insolvency professionals, etc. The low number of filings made by financial institutions to NCLT till date indicate banks are not jumping into this without a plan,” said Ashish Chhawchharia, a partner at Grant Thornton Advisory Pvt. Ltd.
“IBC is a tool, not a solution and has to be used wisely to procure the best results. Though not the intended objective, we understand there are large numbers of cases where operational creditors are using IBC as a debt recovery tool,” he added.
The Essar case
Indeed, the first big challenge among the 12 defaulters’ list came not at NCLT but at the Gujarat high court when Essar Steel challenged RBI’s authority to direct banks.
In early July, Essar filed a petition objecting to RBI classifying it with the 11 other defaulters and called the central bank’s decision arbitrary and discriminatory. Essar’s contention was that the firm had been discussing a debt restructuring plan with its lenders for at least six months. It said the firm had paid Rs3,400-odd crore of dues to banks in the year to March 2017 and added that ceding control of the firm to an insolvency resolution professional could result in deterioration of its operations. In particular, it pointed to an RBI press statement that said these dozen cases “will be accorded priority at NCLT”.
On Monday, 17 July, the court refused to grant relief to the steel maker. In an 83-page order, justice S.G. Shah said a bank can initiate proceedings under IBC even without a direction from RBI. The order said concerns raised by Essar should be heard by NCLT. However, the court also rapped RBI on the knuckles, noting that it “has to be careful while issuing press releases; it must be in consonance with the constitutional mandates, based upon sound principles of law, but in any case should not be in the form of advice, guidelines or directions to judicial or quasi judicial authorities in any manner whatsoever.”
Nevertheless, that clears the deck for banks to go ahead with the bankruptcy process. “Chances of resolution become dim if we delay,” said Kumar of SBI. “As bankers, we would love it if 180 days is the outer limit (for bad-loan resolution). It is in everybody's interest that resolution happens faster. Otherwise, there is a loss of economic value.”
The road ahead
Once petitions are admitted under IBC, the firm comes under the control of an IRP. As a class, IRPs are largely untested. With IBC in full swing, chartered accountants and company secretaries are rushing to get themselves certified as IRPs, but the experience of dealing with, say, a large infrastructure firm, is different.
Secondly, promoters are also stepping down from board roles, or adding management roles to stay close to the action once the insolvency resolution process kicks off. In the past month, board members from Amtek Auto, Bhushan Steel Ltd and Era Infra Engineering Ltd have all added management roles. “ IRPs are not equipped to run firms and businesses and while the resolution process is ongoing, a complete change in management of the firm would have the opposite effect. It is being seen that CEOs and IRPs in this interim period are working together so that there is no further depletion of value of the company during the resolution process,” said Shroff of Khaitan.
Another concern for banks is the so-called hair-cuts, or sacrifices they would need to make on amounts due to them, and losses they will need to bear during resolution at a time when they are starved of capital.
“Resolving these large accounts in 6-9 months will entail high provisions. Currently, banks have not made adequate provisions on these accounts. High provisions and interest rate reversal will, therefore, have an impact on banks' profitability going forward,” said Karthik Srinivasan, senior vice-president at rating agency ICRA Ltd.
Ratings agency India Ratings and Research estimates Indian banks need to provide a bare minimum Rs18,000 crore additionally to meet provisioning for these 12 accounts. This accounts for about 25% of estimated profits of the banking industry in the current fiscal, the ratings agency said on Tuesday, 18 July.
Leave aside these problems, what’s on test is the Indian banking system’s ability to arrive at a successful resolution of bad loans, as opposed to liquidation of defaulters.
“The proof of concept (of IBC) is when you are able to get a resolution plan, not if the process results in only liquidation. That has to happen in 270 days; there’s no choice,” said Shardul Shroff, executive chairman of law firm Shardul Amarchand Mangaldas, which is representing SBI against Essar Steel.