In recent times, advocates of the Insolvency and Bankruptcy Code (IBC) have relied on its intentions to steer the discussions about it. They have asserted that the IBC intends to effectively resolve distressed companies and safeguard the interest of all stakeholders. If it fails, then the company goes to liquidation. The bankruptcy law reforms committee (BLRC) envisioned the IBC as “a collective mechanism for resolving insolvency within a framework of equity and fairness to all stakeholders to preserve economic value in the process". We are a long way from ascertaining whether the process indeed upholds the objectives of fairness, collective resolution and equality—the three mainstays of an insolvency process.

Recovery or resolution?

The IBC sets out a simple proposition: Allow a prospective investor to save the distressed company through a resolution plan as long as it receives an adequate number of votes from financial creditors. M.S. Sahoo, the chairman of the Insolvency and Bankruptcy Board of India, said in an interview that the “privilege" of selecting a resolution plan for a distressed company has been given to financial creditors owing to their ability to take business decisions and create value. This underscores a view that only financial creditors are capable of assessing a plan to resolve a distressed company. This is a seemingly paradoxical proposition considering that, in most cases, it was on their watch that companies amassed debts over a prolonged period, without the banks exercising the tools available to them to take necessary action to recover their dues. A closer look at the IBC suggests that it has not fundamentally introduced any new powers of enforcement for creditors that were not available earlier, but has armed lenders with the additional privilege of deciding how best to revive the company.

Evolution of the IBC highlights how the scales are tilted in favour of financial creditors, because at the resolution stage, the immediate focus tends to be on debt payouts to lenders rather than on charting a course to get the company back on its feet. This payout is, in turn, guided by an evaluation matrix prepared by financial creditors with a focus on the amount of upfront and deferred payment that will be paid to them. In short, the resolution plan seems more like a recovery plan. As part of a resolution plan, the IBC also makes certain mandatory provisions that focus only on payouts to various creditors.

While both the BLRC report and the IBC proclaim that equity and fairness are the cornerstones of the insolvency process, there is no empirical evidence to demonstrate that the framework under the IBC will promise a truly “collective process" under which operational creditors and employees have a say, let alone an equal seat at the table. There are no guarantees that banks will not negotiate lower haircuts with prospective applicants and the sacrifice by other creditors will not be increased to this end. Furthermore, no one participant in the process has been tasked with the objective of keeping a watch on this risk. This is the starting point of a conflict of interest between voting creditors and other stakeholders.

Prisoner’s dilemma

The recent IBC amendment ordinance proposes that only 66% (as opposed to 75%) of the financial creditors are required to approve a resolution plan, with no substantial explanation for such change. This raises two problems.

First, lower aggregate percentages for approving a resolution plan mean greater control in the hands of a few creditors who can swing the voting on the resolution plan, thereby moving away from the objective of collective decision making.

Second, the IBC provides that any creditor who dissents with a resolution plan (provided the resolution plan gets the requisite votes) will be paid out before those who give their approval. This encourages voting creditors to pursue individual interests over the collective interest—even in cases where the outcome of pursuing the collective interest may yield better rewards individually. To illustrate, if the amount promised to each lender under the resolution plan is not significantly higher than the liquidation value payable to each lender (which is usually the case), a minority creditor who is reasonably certain that the plan will be passed may vote against the proposal or abstain. This will be in the hope that the plan will get passed by other creditors and the lender will then get his dues prior to the other lenders as a dissenting creditor. For such a lender, the option of voting in favour of a resolution plan which, in its view, is anyway going to be passed by the majority, is not as appealing—since, as an assenting creditor, the payout will be timed along with those of the majority creditors. This could result in each creditor second-guessing the other lenders’ decisions, and, based on that, deciding to vote collectively or to compete for an early payout.

There are other concerns, contradictions and oversights in the IBC. Just like any new legislation, it needs to evolve. Piecemeal, knee-jerk changes to the IBC may hamper such an evolution, as we are dealing with a statute that is also supposed to have a moral and social responsibility to take care of other stakeholders. The continuous shifting of principles may dilute the IBC’s desired effect.

Zubin Mehta and Amrita Sinha are banking and insolvency lawyers at Veritas Legal.

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