Why the IBC process is often falling short

Thirteen companies of the Dhoot family-owned Videocon Group owed ₹64,838.63 crore to banks and other operational creditors. As per the approved resolution plan, Twin Star Technologies will pay ₹2,962.02 crore to the creditors, which amounts to a little over 4% of the outstanding amount. This means that the banks and other creditors will take a haircut of close to 96%. In simple English, close to 96% of what the Videocon Group owed to its creditors will not be recovered.

This is just the latest in a string of cases that have resulted in poor recoveries. Naturally, his has led to many experts questioning whether the Insolvency and Bankruptcy Code (IBC), which started working in early 2017, has been effective. In the past, the lenders have had to take a haircut of 83% in the case of Alok Industries, where the amount recovered due to the resolution plan stood at ₹5,052 crore—against the ₹29,523 crore that was owed. In case of Reliance Infratel, the haircut amounted to a little less than 90%, with only ₹4235.78 crore of the ₹41,055.38 crore that was owed to financial creditors—largely banks—being recovered.

On the flip side, if a retail borrower misses out on even a single EMI payment, banks unleash their legal and not-so-legal system on them. What explains this dichotomy?

The IBC came into existence in May 2016. Between then and March 2021, a total of 4,376 companies have been admitted into the corporate insolvency resolution process (CIRP). Of the total, 2,653 CIRPs have been closed. However, only 348 companies have ended up with an approved resolution plan.

A resolution plan can entail a variety of options, including everything from a change in management or product portfolio to the restructuring of the organization or its business model and even an alteration in the repayment schedule of the defaulted loan. But from the resolution plans that have been executed up until now, we can clearly see that the committee of creditors, which includes the banks, mostly prefer to sell the defaulting company to another entity and recover whatever portion of the defaulted loan that it can. Of the 348 companies which have ended up with resolution plans, the rate of recovery as of March 2021 stood at 39.3%. Of the ₹5.16 trillion owed to financial creditors, only ₹2.03 trillion has been recovered. Also, the 39.3% recovery rate is primarily due to two big recoveries—the sale of Bhushan Steel and Essar Steel to Bamnipal Steel and Arcelor Mittal India, respectively.

The total defaults amounted to ₹1.05 trillion, of which ₹76,589 crore was recovered. If we subtract these two cases from the overall figure, the rate of recovery for the remaining 346 companies falls to 30.7%. This means that if we leave out the resolution of the two biggest defaults, for every rupee that has been defaulted on, only around 31 paisa was recovered.

Best available mechanism

But how does the situation look if we compare it to other recovery methods that have been in place before the IBC came into force. The other methods are Lok Adalats, Debt Recovery Tribunals (DRTs) and the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest (SARFAESI) Act. The rate of recovery in the case of the Lok Adalat stands at a measly 5.1% between 2012-13 and 2019-20. When it comes to the DRTs and the SARFAESI Act, the rate of recovery stood at 6.1% and 21%, respectively. The rate of recovery for the IBC between 2017-18 and 2019-20 stood at around 46%, including the resolution of the two biggest recoveries. Even after excluding the biggest recoveries, the rate of recovery under IBC is much more than the other methods. Of course, this comes with the corollary that the rate of recovery is better only when a defaulting company entering the CIRP ends up with a resolution plan.

What about firms that don’t end up with one? Of the 2,653 closed CIRPs, at least 1,277 firms, around 48.1%, have ended up with an order for liquidation. Liquidation means selling the company piece by piece, asset by asset. As per the January-March 2021 newsletter of the Insolvency and Bankruptcy Board of India (IBBI), of the 1,277 firms where liquidation was ordered, data for 1,272 firms was available. The total outstanding amount in these cases was ₹6.47 trillion. But the assets on the ground were valued at only ₹46,000 crore.

Liquidation also takes time. As of December 2020, around 69% of the liquidations had been going on for a period of more than one year; 26% of them for a period of more than two years. Of these firms, the biggest is ABG Shipyard, with outstanding dues of ₹15,500 crore. The liquidation was ordered in May 2019.

This explains to a large extent why banks are ready to take a haircut on loans, given that they know that if the firm goes into liquidation, they are unlikely to get much and will also be stuck with the process for a while. Take the case of the Videocon Group. The liquidation value of the assets of the group was ₹2,568.13 crore. The lenders obviously knew this and settled for ₹2,962.02 crore. What does not help is that India barely has a distressed asset market.

To give an example, let’s say a company defaults on its loans and needs to be liquidated. The main asset of the firm is a factory with machines. For liquation to be effective, there ought to be a set of firms that are interested in these machines; middlemen are also required to connect the buyer and the seller; the final piece in the jigsaw are valuers who can determine the value of the machines, and transporters who can move them from one place to another. Then, there is also the case of Section 12A under the Code, which allows the defaulter and the creditors to close the insolvency case. This is being used as a loophole, with banks going in for a one-time settlement with defaulting promoters. In April, lenders led by IDBI Bank decided to take a haircut of more than 93% and settle an outstanding amount worth ₹4,863 crore with Siva Industries. Banks going for one-time settlements is another impact of hardly any recovery happening if a company goes into liquidation.

The pandemic effect

Interestingly, as mentioned earlier, the rate of recovery for firms that did end up with a resolution plan had stood at close to 46% as of March 2020. By March 2021, this had fallen to around 39.3%. Hence, 2020-21 was a bad year. Data from IBBI tells us that in 2020-21, of the total outstanding amount of ₹1.32 trillion, only around ₹25,944 crore was recovered—implying a recovery rate of 19.7%, or only around 20 paisa for every rupee of default.

What explains this? The answer lies in the fact that capacity utilization in Indian industry has been falling even before the covid-19 pandemic. As per the Reserve Bank of India (RBI), the capacity utilization of Indian industry as of December 2020, the latest available data, stood at 66.6%. In March 2019, it had stood at 76.1%. In other words, there is enough unused capacity, which is discouraging prospective buyers from bidding for firms that have defaulted on loans.

Also, the bankruptcy resolution process cannot go un-impacted by the state of the economy. In 2020-21, the Indian economy contracted by 7.3% in real terms. Another point that has become obvious over the last few years is that the IBC process is effective only when prospective buyers see value in a company. There has been some demand for firms in the steel sector. The same cannot be said about other sectors, such as textiles and power. This explains why loans defaulted on by Bhushan Steel and Essar Steel got good recovery rates, whereas the textile company Alok Industries did not. As Viral Acharya and Raghuram Rajan note in their paper titled Indian Banks: A Time to Reform? : “Given the excess capacity in some sectors (such as power), there may be assets that have little value today but are likely to be more valuable as the economy grows (e.g., power consumption would naturally rise over time). Rather than trying to operate power plants in the face of inadequate demand or liquidate them piecemeal, a better option might be to ‘mothball’ them till demand is adequate to re-open them." They further say that private entities might find it hard to mothball assets.

Hence, this is something that should be done by existing government entities like the National Thermal Power Corporation (NTPC) or a “professionally-managed national asset management bad bank (that) could be set up for warehousing and resolution/sale of these assets."

The way ahead

For a healthy rate of recovery, a defaulting firm must be put through the bankruptcy process as quickly as possible. Any dillydallying only leads to further destruction in the value of its assets. As economist Ajay Shah puts it in a recent column in the Business Standard:“A defaulted company is a melting ice cube"

Also, it is worth remembering that while the rate of recovery under IBC has fallen in 2020-21 and will take a hit again in 2021-22, it has at least put the fear of losing the firm in the minds of many promoters—something that was missing earlier. “The credible threat of the Code has changed the behaviour of debtors…Till March 2021, 17,305 applications for (the) initiation of CIRPs… having (an) underlying default of ₹5.33 trillion were resolved before their admission," said the IBBI newsletter quoted earlier.

Of course, this does not tell us how much of the ₹5.33 trillion was recovered. Given that hurdle, more transparency in bankruptcy and insolvency data is also needed. It is also worth recalling that IBC is trying to change bad habits that have held sway for many decades. And it’s going to take time to effect these changes. As Vijay Kelkar and Ajay Shah write in their book In Service of the Republic, public policy work is a test match and not an IPL. “The bulk of the gains from the bankruptcy reform come from modified behaviour of private persons, taking place in the shadow of the law. The threat of the law is expected to induce modified behaviour on the part of borrowers and lenders. This also takes time."

Now that leaves us with the question about the retail borrower, who feels the weight of the entire banking system even if he or she defaults on just one EMI payment, whereas industrialists who default on thousands of crores often get away with it. One may recall what the British economist John Maynard Keynes said many years back: “If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has (a problem)." The Economist, a few years ago, came up with the modern-day version of what Keynes had said: “If you owe your bank a billion pounds, everybody has a problem." Clearly, corporate loan defaults, which can cripple the entire financial system, are everybody’s problem. By extension, a well-functioning system that can address those loan defaults effectively is in everybody’s interest.

Vivek Kaul is the author of Bad Money