From non-performing to performing

A well-functioning insolvency resolution framework is fundamental for dealing with business failures

Photo: iStock
Photo: iStock

The ministry of finance recently released the draft Insolvency and Bankruptcy Code (IBC), proposed by the Bankruptcy Law Reforms Committee. The government of India greeted this bill as among its biggest and most crucial reforms. To a person unconnected with finance, it may be unclear why this is important or what ails the current framework. A well-functioning insolvency resolution framework is fundamental for dealing with business failures that inevitably occur in any economy. Additionally, an effective insolvency resolution process is one tool, among others, for banks and other creditors to address low recovery rates.

This is particularly relevant for India where economic growth is contingent upon the financial health of the banking sector. Banks in India face acute problems of asset quality. Perceiving that laws did not sufficiently empower secured creditors to activate recovery by seizing security, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993, and Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002, were enacted to facilitate the enforcement of security by banks and financial institutions.

Asset reconstruction companies were constituted under SARFAESI to buy bad debts from banks and recover from defaulters. Domestic banks also have recourse to corporate debt restructuring and joint lenders forum mechanism to resolve stress in consortium loans.

None of these initiatives seems to have helped. Gross non-performing assets (NPAs) as percentage of total advances went up from 3.4% in March 2013 to 4.45% in March 2015. The picture is grimmer when volume of restructured assets is also considered in stressed advances. As a percentage of total advances, overall stressed advances increased from 9.2% to 10.9% between 2013 and 2015. Average recovery rate for secured debt is as low as 20%. One factor responsible for all this is a weak legal framework for resolving failure. Once debts go bad, creditors’ ability to realize value is predicated on a robust insolvency resolution mechanism.

Accumulation of bad debts in bank balance sheets has systemic risk implications for the entire economy. As capital gets tied up in provisioning for bad debts, banks get inhibited from extending fresh credit, slowing down the real sector. Absence of a well-functioning insolvency framework that protects creditors’ rights also thwarts the development of alternative lenders, such as corporate bond market. There are admittedly other issues systemic to the banking system and capital market that compound these problems. However, an insolvency law focused on preserving viable businesses as going concerns and liquidating unviable ones is the cornerstone of a mature financial system and India urgently needs one.

Aparna Ravi highlights in a paper titled The Indian insolvency regime in practice—an analysis of insolvency and debt recovery proceedings that the current framework in India is highly fragmented with decisions frequently stayed or overturned by judicial forums having overlapping jurisdiction. There is no clarity on whether the right of secured creditors initiating recovery under SARFAESI will prevail, or unsecured creditors initiating winding-up under the Companies Act or the company triggering proceedings under the Sick Industrial Companies (Special Provisions) Act, 1985, (SICA).

Substantive issues exist with even initiation of insolvency resolution or the process of winding up. SICA is triggered when more than half a company’s net worth has eroded. In Kristin van Zwieten’s paper titled: Corporate rescue in India: the influence of the courts, she examined over a thousand cases from a range of courts to demonstrate that the Board for Industrial and Financial Reconstruction (BIFR) and the high courts are reluctant to liquidate unviable companies. Ironically, the trigger for winding up a company is too low. The default is Rs.500. Courts, therefore, do a full hearing on merits at admission stage itself, limiting efficacy. Creditors, especially non-banks, do not have access to a mechanism to assess the viability of an enterprise and address the problem, without the threat of other proceedings initiated by the debtor or other creditors torpedoing them. Even when proceedings are triggered, debtor’s existing management retains control, thereby creating the risk of asset stripping.

Under SARFAESI, creditors are empowered to take over management of a company but only that part of the company connected to the secured asset. Since potential liability to creditors is high, this is rarely invoked. There is no corresponding provision for non-banks. There is also no linearity of proceedings. Under SICA, even if BIFR recommends liquidation, a reference is made to the high court, which would re-examine the recommendation and might even reverse it.

With the proposed IBC, the labyrinth of extant Indian laws dealing with corporate insolvency are being replaced by a single comprehensive law that (a) empowers all creditors—secured, unsecured, financial and operational to trigger resolution, (b) enables the resolution process to start at the earliest sign of financial distress, (c) provides a single forum overseeing all insolvency and liquidation proceedings, (d) enables a calm period where other proceedings do not derail existing ones, (e) replaces existing management during insolvency proceedings while keeping the enterprise as a going concern, (f) offers a finite time limit within which debtor’s viability can be assessed and (g) under bankruptcy, lays out a linear liquidation mechanism.

The proposed framework strengthens creditors, without discrimination. While this will not necessarily be a magic bullet that will make the mass of NPAs vanish from bank balance sheets, it can facilitate better recovery and faster closure of troubled assets. IBC will prevent new loans from getting added to existing stock of NPAs. It will aid development of alternative debt securities, spread the risk of corporate failure across larger sets of creditors, and lead to the double benefit of lower systemic risk as well as deeper debt finance for a rapidly growing economy of entrepreneurs.

This is the first column of a two-part series.

Rajeswari Sengupta and Richa Roy are, respectively, assistant professor of economics at IGIDR, Mumbai, and banking and finance lawyer at AZB & Partners