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India: Insolvency & Bankruptcy Code - Arrangement Or Functionality?

Summary

New bankruptcy law in India.

Functionality taking over form.

Focus on enhanced recovery for all stakeholders.

A debtor-creditor arrangement forms the basis of credit markets: An effective arrangement is critical to setting constructive market and investor expectations. The Insolvency and Bankruptcy Code (IBC), introduced in 2015, is an attempt to create a more modern legal resolution mechanism to attract investments in the distressed space in India. It is an attempt to create a comprehensive bankruptcy law to consolidate all existing resolution regimes. It is an attempt to create a creditor-friendly framework that resolves NPAs, maximizes value, and fosters entrepreneurship.

Prior to IBC, several insolvency initiatives and guidelines, such as Part VIA, Part VII and Chapter 391 of Companies Act, 1956; The Presidency Towns Insolvency Act, 1909; The Provincial Insolvency Act, 1920; SICA enacted BIFR; RDDBFI Act enacted DRT; and SARFAESI, were constructed for an effective debtor-creditor arrangement. However, these initiatives, unlike the IBC, focused on a narrow set of insolvency issues and did not recognize the need for an insolvency system that encompasses the needs of the various stakeholders, creditors – secured and unsecured, operational creditors, employees, management, and various restructuring advisors, in an array of interrelated systems.

In addition to enhanced recoveries for existing stakeholders, a resolution plan for a distressed firm must answer the critical question of an investor: Is there a realistic prospect of the company providing an acceptable return on fresh capital? Does the IBC facilitate a process that justifies the incremental investment risk? That new capital has a decent prospect of delivering a better outcome, for all concerned stakeholders than alternatives such as liquidation or a distressed sale? It is still too early in time, but the success of IBC will be constantly examined from these perspectives.

With a burden of checkered legacy from its predecessors, IBC does, however, try to address some critical issues:

a. It yields the conclusion that delay inhibits both recovery and optionality in distressed situations. The importance of timeliness in distressed situations cannot be overstated. Companies face industry cycles, high-cost input inflation, a temporary decline in revenues, or a severe liquidity crisis. The longer a firm stays in distress, the more likely human capital will leave, the more strained relationships with suppliers become, and the more lasting is the damage to goodwill of the firm. Consequently, the firm loses more business. A delay contributes to this vicious downward corporate spiral. Profitability erodes. Valuations drop. Recovery-prospects thin. If such situations continue for long, then liquidation becomes the only option.

The 180-day timeline, with the possibility of a 90-day extension, speeds up the insolvency process considerably. Finally, a resolution as a going-concern is desirable not only to the financial creditors but also to the employees of the firm.

b. It provides companies with the ability to access credit and investment to restore solvency, which is necessary to keep a viable company afloat. Such a lifeline can come in the form of interim-finance or additional investment from the resolution applicant. Interim finance is a super-priority (priming lien) secured debt that is available to companies under IBC. A company might need to avail interim finance to cover its payroll, or to instill confidence in its suppliers and customers. Although interim finance requires the consent of the COC, and they will agree to be primed because of the value of their collateral interest. Fresh capital or exit financing from a resolution applicant is necessary to restore a distressed business to normalcy.

c. It recognizes that an effective institutional and regulatory framework is essential to redress the shortcomings of previous initiatives. Institutional issues such as training for insolvency professionals and other stakeholders are regulated by the newly created Insolvency and Bankruptcy Board of India. Information utilities and tribunals support the corporate bankruptcy infrastructure in India.

A stronger framework and the ability to enforce insolvency procedures are consistent with robust creditors’ right systems. IBC improves on consistent judgments and transparent decision-making when compared to previous initiatives. Promoters and entities, who are willful defaulters and who seek to unduly influence the creditors, NCLT, RPs, or other stakeholders, are barred from submitting resolution plans for distressed assets.

A substantial deficiency of a bankruptcy code, including IBC, could be due to the weak implementation of regulations, or a chaotic institutional framework. Issues such as delayed admission to NCLT, or a lack of skilled resolution professionals and practitioners to presume over the distressed corporate entity during the 180-day period present a real risk to the functionality of IBC.

Much has been written about the arrangement that IBC proposes. NPA resolution, value maximization and capitalistic angles to the flavor of the code have been debated on with differing sets of views. However, an important aspect of the law, i.e. functionality is starting to take center stage, and the success and longevity of IBC depend more on function than on arrangement.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.