Tales of Insolvency: Seven-Year (GL)ITCH

The new Bankruptcy Code led to stupendous successes, fantastical failures, and dozens of amendments since it was introduced in 2016. The story is replete with several summits and setbacks The new Bankruptcy Code led to stupendous successes, fantastical failures, and dozens of amendments since it was introduced in 2016. The story is replete with several summits and setbacks
By Alam Srinivas
  • IIM study focuses on outcomes related to ruined firms after they were taken over by new owners under the so-called resolution process
  • Post-resolution, e insolvent firm combined sales grew by 75%, employee expenses were up 50%, total assets increased by 50%, and Capex zoomed by 130%
  • Most MSMEs, depend on their bigger corporate brothers for survival. If their claims remain unpaid in case of bankruptcies, they are doomed
  • Revived firms post-bankruptcy exhibited increased debt, implying new owners secured substantial loans despite reduced costs and creditor recoveries

EVERY law is either hyped to contend it is the best, or looked at with suspicion as one that requires major changes. Two recent reports on the Indian Insolvency and Bankruptcy Code (IBC) reached seemingly contradictory conclusions. In August 2023, IIM (A), a leading B-School, said that busted firms revived under the Code “significantly improved their performance…. Specifically, we find that these firms’ profitability, liquidity, activity, and turnover ratios have improved….” It added that the performance of resuscitated firms were as good as profitable peers from the same industry, as also firms of similar sizes.
In May 2023, the Insolvency Law Committee suggested wide-ranging changes to the Code. It wanted to address crucial issues like unusual delays in dealing with insolvent firms and irrational and random behaviour of financial creditors that had overriding and overwhelming powers to recuperate liquidated companies. The Law Committee based some of its suggestions on a scathing report (August 2021) by a Parliamentary Standing Committee, which pointed out glaring holes in the law.

The IIM study hinted at the possibility that the Indian Insolvency and Bankruptcy Code needed a review. Of the 542 companies it surveyed, it found the average recovery rate of loans and other claims was 33.2%, or an overall haircut of 66.8%, which is more than twice the first figure. Of the 33.2%, financial creditors, or lenders, got 38.5% of their outstandings, and operational ones received a lower 23.8%. But these figures were at variance with those of the Insolvency and Bankruptcy Board of India

Ironically, a closer look shows that the IIM study and Law Committee report do not necessarily talk at cross purposes. When put under a microscope, IIM focuses on outcomes related to ruined firms after they were taken over by new owners (or original promoters in extremely rare cases) under the so-called resolution process. The Law Committee and Parliamentary Committee were more worried about the procedure, and benefits or losses to financial creditors that lent tens of thousands of crores to bankrupt firms. The Law Committee looked at the workings of the Code, and IIM at its future consequences. Both used different lenses and looked at different events, motives, and evidence.

More importantly, since IIM’s study was majorly quantitative, with a limited qualitative survey thrown in, it contained inherent ambiguities and incongruities. Many of its inferences can be questioned, even disputed, if seen in the light of the correct context. At the same time, it seems perplexing that the Law Committee reached similar deductions as the Parliamentary Committee, but two years later. If the evidence that the Code required changes was staring into the faces of Parliamentarians, why did it take so long for it to dawn upon bankers, former judges, lawyers, and other legal and financial experts?

BARBERS AT THE CORPORATE GATES

The most controversial issue highlighted by the Parliamentary Committee related to haircuts. No, the latter is not a term related to your favourite salon, but a jargon. It indicates loan cuts that financial creditors who lend money, as opposed to operational creditors (suppliers, employees, and government authorities) who are owed money, take during a resolution process. Under IBC, applicants can submit plans to pay existing loans and invest more to revitalise a sick company. Generally, whoever agrees to pay the highest percentage of the existing debt to financial lenders gets to own and manage the bankrupt firm.

Business partners discussing documents and ideas at meeting. Benefit-sharing, Business success.

Parliamentary Committee observed that loan recovery rates were abysmally low “with haircuts as much as 95%”. The lenders received a mere 5% of the existing loans in some cases. The Committee felt that this was a “deviation from the original objectives of the Code intended by Parliament,” which included maximisation of the value of assets of bankrupt firms, or high payment of loans. It suggested that the “design and the implementation of the Code as it has evolved needs to be revisited,” and there should be a “thorough evaluation of the extent of fulfilment of these (original) aims and objectives.”

Hence, the Parliamentary Committee wanted “greater clarity” to strengthen creditors’ rights, and enhance payment of loans, “considering the disproportionately large and unsustainable ‘haircuts’ taken by the financial creditors over the years.” One of the options: since the Code had “fairly matured,” it would be better to have a “benchmark for the quantum of ‘haircut’, comparable to global standards.” In other words, there should be a ceiling on lenders’ claims that can be foregone, or a minimum percentage of the loan amount that a new successful applicant paid in a resolution process.

Under IBC, a bankruptcy court also commented on the “extraordinary” haircuts of 90% and above. It made suggestions, which included: the approval of the shareholders of financial lenders, many of whom are listed banks or financial institutions, if the haircut was beyond a certain percentage; and the approval of the shareholders of the successful applicant, which took over a busted firm after agreeing to pay a certain portion of existing loans. The second was in line with other corporate laws that mandated a firm to take shareholders’ approvals for mergers, demergers, takeovers, and acquisitions.

DO NOT QUESTION THE LENDERS

Both the courts and the Parliamentary Committee realised that the issue of haircuts could not be addressed without relevant amendments to the existing Code. This was because the Supreme Court had set several precedents. The apex court categorically stated that the “commercial wisdom” of the Committee of Creditors (CoC), which comprised specific financial lenders in each bankruptcy case, was paramount, and could not be legally questioned by any court. As per the language of the Code, legislators had consciously and deliberately not provided any grounds to challenge the decisions of CoCs.
Only financial lenders, who formed part of the CoC, could decide the haircut in each case. No one else, including courts, could interfere with the decision. This was the legislators’ intention, and it was stated in the report of the Banking Law Reforms Committee (2016). The latter said that there was only one correct forum to decide the fate of a bankrupt firm – CoC. The negotiations could happen between it and the debtor (insolvent firm), with the final decision vested with the CoC. This was upheld by the Supreme Court, which reasserted that the CoC was fully aware of the viability of a bankrupt firm, and the feasibility of the plan submitted by the successful resolution applicant.

Parliamentary Committee observed that loan recovery rates were abysmally low “with haircuts as much as 95%”. The lenders received a mere 5% of the existing loans in some cases. The Committee felt that this was a “deviation from the original objectives of the Code intended by Parliament,” which included maximisation of the value of assets of bankrupt firms, or high payment of loans

Although it gave a positive edge to loans-related statistics, the IIM study hinted at the possibility that the Code needed a review. Of the 542 companies it surveyed, it found the average recovery rate of loans and other claims was 33.2%, or an overall haircut of 66.8%, which is more than twice the first figure. Of the 33.2%, financial creditors, or lenders, got 38.5% of their outstandings, and operational ones received a lower 23.8%. But these figures were at variance with those of the Insolvency and Bankruptcy Board of India, the regulator as per the Code, especially for operational creditors (11.28%).

Surprisingly, the segment with the highest recovery for financial creditors was hotels and restaurants, followed by construction, automotive repair + household and personal goods + wholesale trade, and real estate + renting. The one with the lowest rate was public utility (electricity, gas, and water supply), followed by financial intermediation, agriculture + hunting + forestry, and manufacturing. The report added, “Interestingly, the highest recovery rates are not for asset-heavy industries but rather for asset-light industries with substantial intangible assets. It also highlights the importance of an auction to realise the going concern value of an entity.”

Indirectly, the IIM conclusion on auction negates and dilutes the confidence placed on “commercial wisdom” of CoC. If auction seems to be the right way to minimise haircut, and maximise the value of a bankrupt asset, then the logical insight is that financial lenders do not have the capability to assess and judge how much the asset is worth.
What they realise is possibly lower than the market value. This is because the successful applicant for, and new owner of, a debtor firm with huge assets agrees to pay a lower amount, as a percentage of existing loans, than the one who takes over an asset-light firm.

BLACK MAYBE THE NEW RED

Of the 550 companies in the database, IIM considered 431, excluding those in the financial services segment, and whose data was missing. In the three years after the resolution process was complete, and the insolvent firm was taken over by a new owner, combined sales grew by 75%, employee expenses were up 50%, total assets increased by 50%, and Capex (capital expenditure) zoomed by 130%. Most importantly, the market cap of listed firms skyrocketed from Rs 200,000 crore to Rs 600,000 crore in the same period. While net margins remained negative, operating margins were in the black.

Let us look at the same data, with subjective parameters, and relevant context. It is logical that the market cap of firms, whose stocks quoted at rock-bottom prices and at massive discounts (50-90%; Rs 1-5 for a share whose face value was Rs 10), catapulted several times once they came out of insolvency, and were on a possible profitable path. Since investors reflect future returns – profits in the next 2-3 years – in current stock prices, it is inevitable for such stocks to climb up several times. The fact that the market cap of ex-bankrupted listed firms went up only three times is disturbing, and not encouraging.

Both net and operating margins were up in the post-resolution period. But a look at the graphs that show the progress of these figures between T-3 (three years before the firms went into the insolvency process) and T+3 (three years after the new owners took over), is illuminating. The sharpest increases, more so for operating margin, were during the resolution process. That is when firms were managed by outside professionals appointed under the Code, with advice from CoCs. During T+3, the average operating margin plateaued, and the upward movement of the net margin slowed down.

Similar trends were true for other profitability ratios such as profit after tax/assets, EBITDA (earnings before interest, depreciation, and tax)/assets, EBITDA/sales, and ROCE (return on capital employed). One can contend that these upward, positive, drifts indicate that the ratios and margins of bankrupt firms were so low before they were referred for resolution process under the Code that an upsurge was a near-certainty. This was reflected when they were managed by resolution professionals before the new owners. In effect, any decent management could have turned out their fortunes.

What is intriguing is that the average debt of the firms with successful revival plans was higher than the figure before they went bankrupt. What this implies is that despite huge haircuts, with recoveries of 33.2% for financial and operational creditors, new owners took on huge fresh loans to finance their investments. IIM thinks this is a positive trend. The report states that it indicates that “firms were able to raise significant debt financing in the post-resolution period.” But what is the purpose of IBC – to free up credit that can go to more deserving corporate borrowers, or to the same bankrupt ones?

IRRATIONAL AND RANDOM BEHAVIOUR

In its report, the Parliamentary Committee noted that the earlier era of “defaulters paradise” was over. This enabled “much higher recoveries (despite huge haircuts),” and brought down the “cost of borrowing.” The fear of the Code forced borrowers to settle disputes “before the formal resolution process begins.” This is reflected in lower NPAs (non-performing assets), and better ease of doing business rankings. Yet, the Committee seemed frustrated by delays. It noted that 71% of the cases were pending with the lowest and relevant bankruptcy court, the National Company Law Tribunal (NCLT), for over six months.

classic style restaurant with tables and chairs

A crucial reason for this scenario was the way that CoCs dealt with resolution applicants or bidders. The Code specifies timelines for submission of plans, and their acceptance or rejection by the creditors, or CoCs. But experience showed that new applicants cropped up, and submitted new bids after deadlines, even as CoCs evaluated existing plans. “These (new) bidders typically wait for the H1 bidder to become public, and they then seek to exceed this bid through an unsolicited offer that is submitted after the specified deadline. Currently, the CoCs have significant discretion in accepting late and unsolicited resolution plans,” felt the Parliamentary Committee.

Courts allowed late offers to justify one of the Code’s objectives, i.e., to maximise the value of assets. If fresh unsolicited offers were better than earlier ones, there was some justification in evaluating them. On the flip side, they worked against earlier applicants, who abided by the deadlines. They disrupted and delayed the process. Hence, there was a need to fix timelines. The Law Committee agreed that existing regulations need to be changed to “lay down a mechanism for reviewing late submissions of (or revision to) resolution plans.” The Code may be amended to give this “due sanctity.”

While this may smoothen the workings of CoCs, there were other issues that delayed the process. As noted by the Parliamentary Committee, and accepted by the Law Committee, members sent by financial lenders to represent them at CoCs were neither “adequately apprised” nor “adequately empowered” to make decisions. At present, the “conduct and decision-making of the CoC is not subject to any regulations, instructions, guidelines, etc. of the IBBI,” stated the Law Committee. As suggested by the Parliamentary Committee, it felt that IBBI needs to “issue guidelines providing the standard of conduct of the CoC.”

The courts too were responsible for the delays. NCLT took too much time to admit insolvency cases and clear resolution plans. NCLAT, the higher appellate body overturned NCLT’s orders. The reasons: heavy caseload before the benches of NCLT, cases filed by disgruntled resolution applicants, as well as creditors and other stakeholders, and attempts by successful bidders to modify their original plans, or withdraw them. While the apex court disallowed attempts to modify or withdraw plans, it agreed that “long delays… affect the subsequent implementation of the plan. These delays, if systemic and frequent, will have an undeniable impact on the commercial assessment that the parties undertake during the course of the negotiation.”

Surprisingly, the segment with the highest recovery for financial creditors was hotels and restaurants, followed by construction, automotive repair + household and personal goods + wholesale trade, and real estate + renting. The one with the lowest rate was public utility (electricity, gas, and water supply), followed by financial intermediation, agriculture + hunting + forestry, and manufacturing

Keeping these factors in mind, the Law Committee stated that amendments need to be made to the Code “to provide that the Adjudicating Authority (NCLT) has to approve or reject a resolution plan within 30 days of receiving it.” However, it did not elaborate on the Parliamentary Committee’s suggestions that NCLT judges had to be more experienced and trained. The latter was categorical that overturning of NCLT orders demonstrated that the “judgement quality has to be improved at the NCLT level. This can be improved by ensuring that NCLT Members are highly experienced and fully trained.”

OPERATIONS DISRUPTED : MSMES GUTTED

Way back in 2021, the MSME segment (micro, small, and medium enterprises) screamed ‘wolf’ several times, as it narrated the unintended consequences of IBC to the Parliamentary Committee. Its leading federation claimed that thanks to a few seminal orders by higher courts, including Supreme Court, the recoveries by operational creditors, a sizable number of whom were vendors and suppliers in the MSME sector, had plummeted. While the percentage of their recoveries as a percentage of claims was 49% earlier, or higher than financial creditors (42%), it sank to 14%.

This implied that the operational creditors, including MSMEs, took haircuts of 95-100% in the recent past to account for the overall decline. A major reason was the attitude of CoC members (financial creditors) who had a conflict of interest to maximize their gains at the expense of other creditors. The federation explained, “The only way you are able to get any recovery as an operational creditor… is if you (can) arm-twist the RP (resolution professional who manages a busted firm during the resolution process), you (can) arm-twist the CoC, and you hope and pray that you are an essential service supplier.”

Citing an important case of Jaypee Infratech, the federation said that everyone, including courts and the public, were worried about homebuyers, many of whom invested their life savings to buy a house being developed by the bankrupt realtor. But no one shed a tear for operational creditors, who got a mere Rs 500 crore out of their huge claims of Rs 20,000 crore, or just 2.5%. The recoveries by operational creditors remained low, even nil or 0% in many cases, in the period after the Parliamentary Committee report. This intensified after the apex court ruled that the decisions of CoCs were paramount, and courts could not interfere with them.

Several suggestions were offered to the Parliamentary Committee. One, 5% of the total amount to be paid by successful bidders can be kept aside, which will be sufficient to pay MSMEs. Two, the claims by MSMEs may be included in the costs related to the resolution process, or the expenses incurred during the time when a new owner was decided by courts. Finally, if nothing worked, the banks can be asked to lend against unrecovered claims of MSMEs. The desperate federation requested that “something needs to be done… because CoC (or financial creditors) is not going to do anything.”

The Parliamentary Committee suggested that the status of MSMEs as operational creditors “will need to be reconciled with the MSME Act, and the additional protection that MSMEs may require in these economic circumstances.” Most MSMEs, especially those that are located near large plants, depend on their bigger corporate brothers for survival. If their claims remain unpaid in case of bankruptcies, they are doomed. Clearly, if the essence of the Code is to revive insolvent companies, it cannot be its accidental after-effects to bankrupt existing healthy firms, especially those that are smaller in size. It is evident that the Code has played a stellar role to improve and ease the insolvency process in the country. This has encouraged investors, as also banks, to lend with more freedom without the fear of being saddled with unpaid and non-payable NPAs. However, there is more to be done. What the past seven years have taught is that the Code needs to keep evolving, not just through legal interpretations and court precedents, but through regular changes in the law. One cannot sit on past laurels, and ignore the existing challenges.

Alam Srinivas

Alam Srinivas is a business journalist with almost four decades of experience and has written for the Times of India, bbc.com, India Today, Outlook, and San Jose Mercury News. He is working on a new book on the benefits and pitfalls of the Indian Bankruptcy Code.

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