BackAn alternative mechanism to flatten the bankruptcy curve
India needs a resolution framework in the wake of the six-month suspension on bankruptcy filings under the IBC to prevent a build-up of stress in the financial system.This is also critical to prevent an inevitable deluge of bankruptcies after the lockdown.
PremiumAn ordinance to suspend fresh filings under the Insolvency and Bankruptcy Code (IBC) by any category of creditors or even the corporate debtor for a period of six months is now imminent. This is required to obviate the likelihood of multiple businesses facing financial fragility being pushed through the insolvency process. Excessive insolvency filings would clog the National Company Law Tribunal (NCLT), and cause the erosion of enterprise capital as well as possible liquidation of viable businesses. Professor Mark Roe at Harvard Law School, while speaking on the possibility of clogged bankruptcy courts, said that this could lead to a further stagnation of business, investments and hiring. A 2018 study conducted in the US showed that clogged bankruptcy courts result in lower recoveries for creditors; more liquidation of smaller firms; longer bankruptcy processes for larger firms. This mirrors India’s experience. This study was conducted at a time a time when the number of cases was falling—the effects may get amplified during a crisis.
Any suspension of filings must be undertaken concurrently with the strengthening of alternative means for the resolution of stress; permitting all creditors of stressed businesses to participate in the restructuring and for the framework to be binding on all stakeholders. The absence of such a framework would lead to severe moral hazard issues, which must be acknowledged in any relief granted in the covid-19 crisis. Without a robust debt resolution framework, there could be a severe build-up of stress in the financial system, which could cause financial instability.
Nobel laureate Joseph Stiglitz recently highlighted the specter of “systemic bankruptcies" that could lead to a debt gridlock. A systemic problem, therefore, demands a system-wide, cohesive and coordinated response by all financial regulators. The Reserve Bank of India (RBI) permits the resolution of the stress of borrowers from banks and non-banking financial companies through its Stressed Asset Directions. Resolution under this framework is attempted prior to undertaking formal insolvency proceedings. Its criticality is accentuated during a crisis like this. Businesses increasingly have diverse and disaggregated creditors, given the stated policy objective of both the Securities and Exchange Board of India (Sebi) and RBI to increase funding through the corporate bond route. Where there is a diverse, heterogeneous set of creditors, some of whom are not bound by the Stressed Asset Directions, there is no common platform to agree on the resolution plan and bind creditors. In such instances, arriving at a collective resolution to prevent holdouts and arbitrage by individual lenders requires regulatory coordination to make a resolution framework applicable to a wider universe of creditors and binding to all stakeholders.
Sebi has recognized the need for a different regime for stressed companies to facilitate resolution, and has put out a consultation paper on possible exemptions for pricing and open offer requirements for such companies. This is a welcome first step. It can be supplemented by initiating a collective pre-packed resolution process involving Sebi-regulated and other entities.
The thrust of a resolution process should be to find a collective solution rather than enforce piecemeal individual action. Accordingly, a framework is needed that recognizes a resolution arrived at between multiple regulated creditors. Before giving legal sanctity to such a resolution, it can be tested on certain defined parameters such as (a) will it yield more value than individual enforcement/liquidation, (b) does it address the interests of all stakeholders (c) does the process meet the norms of transparency and maximizing value. Such a plan must be made binding on all. This prevents creditors from writing down other categories of creditors, when they may have relinquished the right to exercise individual enforcement action. A collective process will also prevent individual bondholders from rushing to the courts for the discharge of security or to restrain rating downgrades, which regulators have been seeking recently. Other jurisdictions are considering similar proposals—the UK secretary for business, energy and industrial strategy announced on 28 March that a “restructuring vehicle" that binds all creditors is being worked upon.
The Insolvency and Bankruptcy Board of India had similarly mooted a proposal for a pre-packed framework exactly a year ago. This may be an idea whose time has come. Pre-packed insolvency may follow on the continuum from resolution or restructuring proceedings undertaken consensually or under the aegis of the Stressed Asset Directions/regulatory guidance. Once creditor approval thresholds have been “stitched together" a pre-packed scheme may be used to provide fast-track NCLT approval. This will serve to bind all stakeholders, including shareholders, employees, operational creditors and third parties.
This will also permit more flexibility in the resolution process as against some of the prescriptive requirements included in the IBC. While these were included for the sanctity of the process, they come with significant costs, which especially overburden small and medium enterprises. In the US, studies have shown the costs of going through Chapter 11 can be up to 30 % of the estate of the company. Minimizing transaction costs and preserving value is especially crucial during a crisis. Concerns about transparency may be mitigated by establishing an independent body similar to the “Prepack Pool" in the UK, which provides an opinion on the sale of assets to connected persons.
It is clear that there cannot be “bankruptcy as usual" in response to the current crisis, to borrow from Professor David Skeel of the University of Pennsylvania Law School. Augmenting out-of-court restructuring processes is central to preventing the inevitable deluge of bankruptcies after the great lockdown. This may be the salve and salvo required to flatten the bankruptcy curve.
The authors are partners at Cyril Amarchand Mangaldas
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