A level playing field for debtors and creditors
4 min read 14 Dec 2016, 03:04 AM ISTThe Insolvency and Bankruptcy Code, 2016 can make credit cheaper, its sources wider and engender corporate accountability
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The Insolvency and Bankruptcy Code, 2016 (IBC), which came into effect on 1 December, is arguably among the most fundamental reforms to have been implemented recently. Yet it is often obscured perhaps because of the technical details it contains. IBC has the potential to make credit cheaper, its sources wider and engender corporate accountability.
A research paper by Mahesh Uttamchandani, Antonia Menezes, John Armour and Kristin van Zwieten shows that strengthening the rights of creditors (even perhaps at the expense of debtors) can reduce the cost of credit and increase access to credit for the entire economy. Until the enactment of IBC, the rights of creditors were unclear and their application was unpredictable. India had a patchwork of laws that dealt with insolvency and resolution, which applied inconsistently to different categories of creditors. For instance, international creditors do not have the right to enforce their collateral under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Similarly, the Joint Lender’s Forum (JLF) mechanism created by the Reserve Bank of India doesn’t apply to international creditors. Operational and trade creditors had no right to initiate resolution proceedings.
Insolvency is at its heart a collective action problem—collective action by all creditors together could achieve better outcomes by jointly deciding on a borrower’s viability and path for resolution. However, because of differing and misaligned incentives (embedded in law), creditors act individually—secured creditors tend to enforce their security which can destroy value for all creditors, unsecured creditors such as bond-holders or trade creditors may file for liquidation, neither of which yields the value that decisive, coordinated action would.
To retain the collective character of insolvency, similarly placed creditors must be treated alike, as directed in the International Monetary Fund principles. IBC addresses this by creating a level-playing field for all stripes of creditors. Upon default, any creditor, whether secured or unsecured, domestic or foreign, financial or operational may initiate a resolution process. Conversely, no creditor may trigger direct liquidation. The initiation of a resolution process results in an automatic moratorium, which prevents secured creditors from enforcing collateral.
Crucially, all financial creditors have a seat at the table to negotiate the recast of the debt and the resolution plan. Giving previously disenfranchised unsecured creditors the right to participate and vote in such decision-making could also give an impetus to the corporate bond market.
Committees of creditors under the JLF have struggled to arrive at resolution decisions. IBC incentivizes quick decision-making by having an outer limit of 180 days for the resolution to be completed. The risk that certain lenders may stall proceedings is mitigated under IBC regulations. Approval of 75% of all creditors voting by value is required to pass any resolution plan. Dissenting creditors are crammed down by 75% of creditors but will be protected by a requirement that they are paid at least as much as they would have, had the company been liquidated.
This brings Indian law in line with international best practice. One of the World Bank’s Ease of Doing Business criteria for Resolving Insolvency (on which India ranks 136 of 185 countries) is that dissenting creditors must be repaid at least liquidation value. This amendment is not just de jure compliance with the World Bank criteria. The wisdom of accelerating decision-making and preventing hold-outs is widely recognized.
IBC could also help inculcate responsible behaviour by corporate borrowers. Promoters and management of a company usually have the best information regarding the financial situation of a company, and when they anticipate financial stress, information is concealed from creditors, and assets may be fraudulently transferred. Often companies continue to take on more debt in the knowledge that a default may be imminent. IBC introduces criminal penalties for such behaviour. An offence of “fraudulent trading" has been introduced for the first time. The promoters and management of the company may be made personally liable if it can be demonstrated that they were aware that the company was in a precarious financial situation and yet took on more debt. IBC also has provisions criminalizing the concealment of assets, falsification of accounts and defrauding creditors. Based on investigation ordered by creditors, if it is discovered that assets or property was fraudulently transferred from the company as far back as two years prior to the insolvency proceedings, these transactions may be reversed. Such provisions should act as a deterrent against corporate profligacy and recklessness.
There are other pieces of insolvency reform to be realized, including the implementation of the liquidation process (the linear next step following a failed resolution) and the set-up of institutional infrastructure (tribunals, trained professionals and information repositories) to support the speedy resolution envisaged in the IBC.
It has been rumoured that demonetization and the deposit of funds in banks will miraculously wipe out non-performing assets on bank balance sheets and stimulate fresh lending. The full implementation of the resolution and liquidation provisions of the IBC aided by robust institutions is a far better bet for that.
Richa Roy is a master of public policy candidate at the University of Oxford and was part of the committee formed to draft and implement the Insolvency and Bankruptcy Code, 2016.
