4 min read.Updated: 14 Dec 2020, 09:05 PM ISTRohit Prasad,Yogesh B. Mathur
Truly functional markets for ailing debt could yield resolutions well before harsh provisions go into force
The Insolvency and Bankruptcy Code (IBC) introduced a much-needed bankruptcy law to India. Over the years, through a process of government intervention, concurrent regulatory action and adjudication in courts, the law and underlying regulations have been proactively interpreted and modified to respond to market needs. In the process, jurisprudence has morphed progressively towards establishing the primacy of commercial considerations in a bankruptcy event.
However, the overall economic environment exerts a material influence on the efficacy of such measures. In a buoyant economy, optimistic expectations would result in a high proportion of fresh starts with a clean slate. However, in an economy with depressed expectations, bankrupt companies would be assumed to be unredeemable, even when viable, and consigned to liquidation. Hence, the calls for softer bankruptcy laws during macroeconomic downturns.
In India, post covid-19, the operation of the bankruptcy law has been suspended and there is a moratorium on the repayment of dues. Once the moratorium is over, a 2-year period for the restructuring of debt has been provided. Despite these measures, it is quite possible that there will be increased pressure on the IBC after the resumption of its operation. According to a recent forecast by the International Monetary Fund, India’s economy is expected to contract by 10.3% in 2020-21, the sharpest fall among emerging markets and developing countries, and the third steepest decline overall. Even before covid, only a small percentage of distressed companies were revived under the IBC process. Given the current economic stress, the IBC stands in imminent danger of being seen as a final resting place for liquidation, rather than a spa for revival.
Hence, the need of the hour is to strengthen processes for the resolution of distressed debt operating in a pre-bankruptcy phase, and thereby help companies avoid the label of being bankrupt. This can be done to two ways. First, by strengthening the hands of banks, so they can negotiate partial repayment packages on a commercial basis without fear of reprisal by vigilance authorities. Undoubtedly, this will also need to be accompanied by capital markets action by commercial banks. But, further, we also need well developed markets for distressed debt fuelled by private capital (with carefully designed restrictions on foreign capital in the case of strategic assets). This entails ensuring that distressed debt can be sold to those equipped to derive value, as well as various ways of securitization and transfer of economic interests to facilitate the revival process.
This market exists in our country today, albeit in a somewhat moribund state. Asset Reconstruction Companies (ARCs) created under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act of 2002 are allowed to buy distressed debt with a combination of cash and securities via an auction mechanism. But they are hobbled by a poorly designed auction format that virtually mandates a 100% cash deal. Further, there are stifling regulations on the source and structure of capital raised. This results in a situation where deal values would either get inflated under unrealistic expectations, or deals would dry up, placing before us the prospect either of a bubble or a dead market.
A possible enabler of market activity is allowing ARCs to buy distressed debt in the pre-non-performing-asset (NPA) stage. Recall, the market for stressed assets in India consists of an upstream market comprising accounts that have been identified as ‘Special Mention Accounts’ (SMAs) for the purpose of early stress discovery, and a downstream market for NPAs where the payment of dues has been delayed for greater than a minimum threshold of days. A bankruptcy event is triggered if NPAs remain unresolved for 180/270 days.
ARCs are only allowed to buy NPAs and invest in the parent company after such a purchase has occurred. In a downturn, the label of ‘NPA’ exerts a chilling effect on company value, in much the same way as the declaration of bankruptcy does. This results in good companies having to file for bankruptcy. The solution is to enable rescue packages at the SMA stage by allowing ARCs to bid for such assets. Such a move will benefit the stressed company, the ARC, and also the market for NPAs.
While the Reserve Bank of India (RBI) did give indications that it was considering the enablement of increased debt sales, no definitive action has been forthcoming so far. The limited and hesitant moves in this direction by RBI and bankers reflect a business mindset that we must shed. This is a mindset that views the acceptance of partial payments of dues by lenders as unethical, and the incidence of business distress as a result only of bad karma on the part of promoters. In some instances, there has been reason to take such a view on account of malfeasance, be it by lenders or promoters, and of collusion among them. But to treat this as a settled fact of life would create serious roadblocks in our plans for economic recovery in the face of a raging pandemic.
Many economists have warned of an imminent avalanche of NPAs and bankruptcies. Relying on the IBC alone represents a strategy that is ‘too little, too late’. We must catch the problem early by ensuring that SMAs do not become NPAs, and NPAs do not trigger bankruptcy. The focus must shift to upstream markets for distressed debt.
Rohit Prasad & Yogesh B. Mathur are, respectively, professor at MDI Gurgaon, and senior adviser-restructuring and former CFO at several major Indian/international groups.