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Insolvency Bankruptcy Code - Is it really a game changer?

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Chandra Sekhar Dec 5, 20171 Response

Background:

 

The insolvency & Bankruptcy code (IBC) was passed by Lok Sabha on 5th May 2016. It received the consent of the president of India on 28th May 2016. However, the provisions of CIRP (Corporate Insolvency Resolution Process) have come into effect under IBC only from 1st December 2016. The difference between insolvency and bankruptcy is that insolvency is short term inability to meet liabilities whereas bankruptcy is a long term inability to meet liabilities. Before we understand if it is a game changer or not, let us get a hang on what made the government go for a new IBC in the first place.

 

Some of the statistics which indicate the performance of earlier bankruptcy code are alarming. For instance, the average time take for insolvency proceedings in India is about 4.3 years compared to only 1.7 years in high income OECD (Organization for Economic Co-operation & Development) countries. Similarly, the recovery rate is 71.9 cents for every dollar of debt in high income OECD countries as opposed to recovery of 25.7 cents for every dollar in India is not at all acceptable. The numbers stand as a mirror to the dismal performance of earlier insolvency and bankruptcy code.

 

Flaws of earlier code:

With the above data points no one would be surprised to know that India was ranked at 135 in resolving insolvency. In order to improve the recovery rate and reduce the time taken for insolvency proceedings, one should understand the causes for such an intolerable performance of earlier code.

 

As per the provisions of earlier code, corporate insolvency law comes under companies act and the individual insolvency act comes under two old acts: provisional towns insolvency act and presidential towns insolvency act. Though the two acts dealing with individual insolvency are having similar content, they differ in their territorial jurisdiction. The Presidential towns insolvency act, 1909 applies in presidency towns namely Kolkata, Mumbai and Chennai. The provincial towns insolvency act, 1920 applies to all provinces of India. Such difference in territorial jurisdiction is clearly irrelevant to current Independent India and are completely repealed in the new IBC. Moreover, district courts are responsible for dealing with insolvency petitions leading to larger time delay.

 

The delay is much more pronounced in the case of corporate insolvency due to interplay of several factors. First of all, the law dealing with corporate insolvency is very cumbersome. Liquidation/insolvency process essentially encompasses aspects of recovery, revival, reconstruction and winding up. However, no separate unified insolvency code covering all these in one place is present. Therefore the process is complicated, time consuming and ineffective. There were 4 major legislations related to corporate insolvency namely Companies Act 1956, Sick Industrial Companies (Special Provisions) Act, 1985 (SICA), Securitization and Reconstruction of Financial Assets and Enforcement of security interest (SARFAESI) act, 2002 and Recovery of debts due to Banks and Financial institutions act, 1993.

 

Secondly, the rate of recovery is prohibitively low for creditors to file petition against corporate debtors. The Board for Industrial and Financial Reconstruction set up under the provisions of SICA is responsible for determining the sickness of industrial companies and a company is declared sick if at the end of financial year it accumulates losses equal to or exceeding 50% of its average net worth in the immediately preceding 4 financial years. The corporate insolvency liquidation process used to take 10 to 20 years. It provides the debtors with ample time for indulging in siphoning off and stripping of assets. All these factors compounded and resulted in recovery rate of a meagre 25.7 cents per dollar. Though the government had earlier come up with SARFAESI act to mitigate the issues of SICA and BIFR, it was applicable only for banks and financial institutions keeping the private creditors still at bay.

 

Provisions of new IBC:

The new IBC does not involve courts in the insolvency resolution process. Petitions for corporate insolvency goes to NCLT (National Companies Law Tribunal) and petitions related to individual and partnership firms’ insolvency will be handled by DRT (Debt Recovery Tribunal). The new IBC has laid provisions to set up Insolvency and Bankruptcy Board of India (IBBI) for promoting transparency and governance in administration of the code. The debt recovery, especially for corporate firms is a two stage process.

 

Stage 1 – Insolvency Resolution Process:

 

A financial creditor (for a defaulted financial debt) or an operational creditor (for an unpaid operational debt) can initiate IRP against a corporate debtor at the NCLT. On adjudication by NCLT, the committee of creditors (CoC) formed with financial creditors as members with voting rights in proportion of the credit provided, will appoint insolvency professions (IPs). These IPs are licensed professionals enrolled by Insolvency Resolution Agencies (IRAs) which are professional bodies registered by IBBI.

 

In order to speed up the process, a moratorium period of 180 days is provided for the IPs to come up with a resolution under the guidance of CoC and it can be extended by 90 days under special circumstances. If the resolution secures 75% of favourable voting, it will be binding on all creditors (both financial and operational) and debtors. Though the operational creditors do not have the voting rights, they will be permitted to attend the meetings of CoC if their outstanding credit is above certain threshold. Anyone can submit a resolution proposal, but it must necessarily provide payment of operational debts to the extent of the liquidation waterfall.

Insolvency Bankruptcy Ecosystem

Stage 2 – Liquidation:

 

Order to liquidate the assets will be passed by NCLT in the following scenarios:

  • The Corporate Insolvency Resolution process ends and no sign of recovery
  • No resolution plan is submitted to NCLT
  • Plan submitted is not approved by NCLT
  • CoC decides to liquidate
  • Implementation of plan is not in accordance with the resolution submitted

Game Changing Provisions of IBC,2016:

The code imposes a jail term of 5 years if the firm indulges in asset stripping within 12 months before default. This provision mitigates the issue of lesser loan recovery due to siphoning off and stripping of assets.

 

The new IBC provides the right to initiate the process even if the default is in respect to debt provided by another lender. Unlike the earlier code, the test of insolvency is not erosion of the net worth but the default of a loan (operational or financial) above a certain threshold. This will shift the test of insolvency from balance sheet to cash flow statements. It helps in identifying potential companies for bankruptcy before huge damage is done.

 

In contrast to the earlier code, the central & state government dues will get lesser priority than the unsecured loans. The code also pushes for setting up of the information utilities like rating agencies for helping the unsecured lenders in making an intelligent choice. These provisions will lead to greater flow of funds into corporate bonds from the venture capitalists and private equity players.

 

The bankers and financial institutions benefit from the new insolvency resolution process which is based on “creditor in control” model unlike the earlier “debtor in control” model. This will help the banks in cleaning up of their balance sheets by providing them the opportunity to reduce the baggage of non-performing assets (NPAs).

 

In keeping with the broad philosophy that insolvency resolution must be commercially and professionally driven rather than court driven, the role of adjudicating authorities is limited to ensuring due process rather than adjudicating on the merits of the insolvency petition.

 

In essence, the IBC is sending a message that big failures are acceptable in a market economy.

  • Varun
    Varun Chawla

    Extremely well written and informative. I really like how you have structured this from start and the way you end this. It acts as a very useful primer to understand IBC and why it is needed.