The Rationale and Design of a Sound Insolvency and Bankruptcy Law

The Bankruptcy Law Reforms Committee (BLRC) submitted a report on the Rationale and Design of an Insolvency and Bankruptcy Code in November, 2015. The Committee was chaired by Mr. TK Viswanathan and 14 other prominent members. The report enunciates about the reforms made to the financial sector which has transformed the way of economic thinking in relation to equity, currency and commodity market. The key factor that holds back the credit market is the mechanism for resolving insolvency, or the failure of a borrower (debtor) to make good his repayment promises to the lender (creditor), notes the Report.

The BLRC Report proposed the introduction of a Comprehensive Code on Insolvency and Bankruptcy which provides for a comprehensive reform, covering all aspects of insolvency and bankruptcy along with an aim for a time bound resolution mechanism in order to maximise the value of assets of all stakeholders. It is aimed to be efficient, cost effective, procedure driven and handled by properly trained insolvency professionals.

The Report underscores the following important aspects:
(A) Requisites of a sound law on Insolvency and Bankruptcy
(B) Discussion regarding the “erstwhile regime” qua bankruptcy
(C) Criticism and shortcomings of the “erstwhile regime” qua bankruptcy
(D) Principles guiding the new Bankruptcy Code
(E) Recommendations of the Committee
(F) Benefits from the reforms of the Bankruptcy process

The Report provides the requisites of a sound law on bankruptcy.
Firstly, improved handling of conflicts between creditors and debtor becomes crucial when the law has to be strengthened in terms of creditor possession, control and supremacy over the debtors.
Secondly, the avoidance of destruction of value i.e. the value of the creditors and stakeholders also holds much importance read in line with the objects of the Code. A sound legal process also provides flexibility for parties to arrive at the most efficient solution to maximise value during negotiations. If the enterprise is insolvent, the payment failure implies a loss which must be borne by some of the parties involved. Across a restructuring of liabilities, and in the hands of a new management team and a new set of owners, some of this organisational capital can be protected. The objective of the bankruptcy process is to create a platform for negotiation between creditors and external financiers which can create the possibility of such rearrangements.
Thirdly, under a weak insolvency regime, the stereotype of promoters of defaulting entities generates two strands of thinking: (a) the idea that all default involves malfeasance and (b) the idea that promoters should be held personally financially responsible for defaults of the firms that they control. Considering facts like, “some businesses will always go wrong” and understanding ideas which promulgates that the “control of a company is not a divine right”, a line is ought to be drawn between malfeasance and business failure. This would facilitate the boosting of morale of honest debtors and penalise those who are mala fide.

The Report discusses the erstwhile regime and elaborates the same as below:
• The Presidency Towns Insolvency Act, 1909, covered the insolvency of individuals and of partnerships and associations of individuals in the three erstwhile Presidency towns of Chennai, Kolkata and Mumbai. The Provincial Insolvency Act 1920, is the insolvency law for individuals in areas other than the Presidency towns, deals with insolvency of individuals, including individuals as proprietors. Section 3(1) of the Provincial Insolvency Act, 1920, allows the State Government to empower subordinate courts to hear insolvency petitions, with district courts acting as the court of appeal.
• Companies are registered under the Companies Act, 2013, Limited liability partnerships are registered under the Limited Liability Partnership Act, 2008, The Micro, Small and Medium Enterprise Development Act, 2006, registers Micro, Small and Medium Enterprise (MSMEs) but does not have provisions for resolving insolvencies. Partnership firms are registered under the Indian Partnerships Act, 1932, which is administered by the Ministry of Corporate Affairs. But, like for sole proprietorships, insolvency and bankruptcy resolution of partnership firms is treated the same as under individual insolvency and bankruptcy law.
• The Recovery of Debt Due to Banks and Financial Institutions Act (RDDBFI Act) 1993 gives banks and a specified set of financial institutions greater powers to recover collateral at default. The law provides for the establishment of special Debt Recovery Tribunals (DRTs) to enforce debt recovery by these institutions only. The law also provides for the Debt Recovery Appellate Tribunals (DRATs) as the appellate forum.
• Under certain specified conditions, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) 2002 enables secured creditors to take possession of collateral without requiring the involvement of a court or tribunal. This law provides for actions by secured creditors to take precedence over a reference by a debtor to Board of Industrial and Financial Reconstruction (BIRF). The Debt Recovery Tribunal (DRT) is the forum for appeals against such recovery.
• The law for rescue and rehabilitation remains the Sick Industrial Companies (Special Provisions) Act (SICA), 1985, although it applies exclusively to industrial companies. Under SICA, a specialised Board of Industrial and Financial Reconstruction (BIFR) assesses the viability of the industrial company. Once it has been assessed to be unviable, BIFR refers the company to the High Court for liquidation. The SICA was repealed in 2003, but the repealing act could not be notified as the National Company Law Tribunal (NCLT) proposed by a 2002 amendment to the Companies Act, 1956 got entangled in litigation.

The following observations are made on how the previous laws were ineffective and obsolete with regard to the contemporary requirements of the debt-ridden interphase:
Firstly, It is problematic that these different laws are implemented in different judicial fora. Cases that are decided at the tribunal/BIFR often come for review to the High Courts. This gives rise to two types of problems in implementation of the resolution framework. The first is the lack of clarity of jurisdiction as multiple forums for adjudication.
Secondly, One forum decides on matters relating to the rights of the creditor, while another decides on those relating to the rights of the debtor. This creates inconsistencies, confusion and delays. Further the decisions are readily appealed against and either stayed or overturned in a higher court.
Thirdly, The fora entrusted with adjudicating on matters relating to insolvency and bankruptcy may not have the business or financial expertise, information or bandwidth to decide on such matters. This leads to delays and extensions in arriving at an outcome, and increases the vulnerability to appeals of the outcome.
Fourthly, India being a common law country, is governed with reliance on the principle of stare decisis. Judicial precedent is set by “case laws” which helps in fleshing out the statutory laws. On the review of judgments, it was found that these are fragmented and contrary judgments and thus an environment of legislative and judicial uncertainty. World Bank (2014) reports that the average time to resolve insolvency is four years in India, compared to 0.8 years in Singapore and 1 year in London.

The Committee found the United Nations Commission on International Trade Law (UNCITRAL) Legislative Guide on Insolvency as a useful benchmark to base the design of the new Insolvency and Bankruptcy law for India. The principles of the new Code on insolvency in India are derived from three core features of (UNCITRAL) Legislative Guide on Insolvency:
Firstly, a linear process that both creditors and debtors follow when insolvency is triggered;
Secondly, a collective mechanism for resolving insolvency within a framework of equity and fairness to all stakeholders to preserve economic value in the process;
Thirdly, a time bound process either ends in keeping the firm as a going enterprise, or liquidates and distributes the assets to the various stakeholders.

• These features are common, and most well developed bankruptcy and insolvency resolutions share the same.
• These attributes ensure certainty in the process, starting from what constitutes insolvency, the processes to be followed to resolve the insolvency, or the process to resolve bankruptcy once it has been determined.
• Such a framework has to be implemented in its true essence so that it can incentivise all stakeholders to behave rationally.
• This will lead to speedy recovery and greater certainty about creditors rights in developing a corporate debt market.

The BLRC Report recommendations are as follows:
• A unified or a single code for all companies, firms, individuals, and partnerships.
• Both the corporate debtor and the creditor shall have the eligibility to trigger insolvency resolution process.
• A strong base for the setting up of Information Utilities (IU) to support efficient implementation, flow of systematic information, and maintaining a strong database to make available all the relevant information to all stakeholders.
• The Adjudicating Authority shall make sure that the procedures are adhered to by the parties
• The insolvency professionals are given the task of assessing the viability of the business
• Proposal to establish a regulator being the Insolvency and Bankruptcy Board of India (IBBI) which shall be efficient and malleable and shall be responsible for the procedural detailing.
• Resolution of stressed assets of a corporate debtor to Commence in two phases, one being the allotment of a calm period meaning a collective negotiation to rationally access the viability of an enterprise, and the other being bankruptcy as an outcome of insolvency resolution.

A better functioning bankruptcy process would yield benefits in numerous directions which were elaborated by the BLRC as follows:
• Misplaced emphasis on secured credit: At present, many lenders are comfortable giving loans against (some) collateral. The concept of looking at the cash flows of a company and giving loans against that is largely absent. This has created an emphasis on debt financing for firms who have fixed assets. Many important business opportunities, which do not have much tangible capital, tend to face financing constraints.
• Value destruction in corporate distress: When a firm has secured credit, and fails on its obligations, the erstwhile framework emphasised on secured creditors taking control of the assets which were pledged to them. This tends to disrupt the working of the company. The present framework do not allow for the possibility of protecting the firm as a going concern while protecting the cash flows of secured creditors.
• Poor environment for credit: While SARFAESI has given rights to creditors on secured credit, the overall recovery rates remain low particularly when measured on an NPV (Net Present Value) basis. This creates a bias in favour of lending to a small set of very safe borrowers, and an emphasis on using more equity financing which is expensive. This makes many projects unviable. Better access to credit for new entrepreneurs will create greater economic dynamism by increasing competition.
• Industrial disease: The lack of rapid resolution of corporate distress leads to slow multi-year processes of industrial disease. Bankruptcy reform would allow a faster process through which society would put capital and labour to work in a business, and rapidly change course when that business did not work. This will foster more risk taking and better use of capital. The capital and labour that is blocked in industrial disease will be reduced.
• Failure of auctions: At present, in many public sector settings, auctions tend to go wrong because some bidders propose values which are too low. The bidders know that in the absence of an efficient bankruptcy process, they will not be displaced from their concession agreement, and they will have the ability to renegotiate terms from a position of strength. An efficient bankruptcy code would yield a better answer: When a project gets into trouble, it would be resolved using the formal bankruptcy process.
• Corporate bond market development: The natural financing strategy in all countries is for large companies (e.g. the top 500 firms) to obtain all their debt financing from the bond market. This channel has been choked off in India, partly owing to the fact that corporate bond holders obtain particularly bad recovery rates under the present arrangements. Bankruptcy reform would yield higher recovery rates for corporate bond holders, and remove one barrier that impedes the corporate bond market. It is important to emphasise, however, that this is not the only barrier which holds back the corporate bond market.
The final report then goes on discussing the Design of the Code with various intricacies and focusing on the entire drafting instructions thereby given for the framework of the Code. The report gives a detailed and structured outline of the Code with thorough analysis of the same with respect to the need and construction of a sound insolvency law.

With the above background the Insolvency and Bankruptcy Code, 2016 was introduced. Since its inception, the Code has proved to be an effective mechanism for realization of viability of an enterprise by aiding the continuing of a business as a going concern rather than tagging it as failed business.

The Code has come a long way in changing the face of how the country deals with bad loans. The Government seems focused on remedying and updating the law, as is evident from the creation of the Insolvency Law Committees and the weight given to its recommendations and the subsequent amendments being introduced to the Code. There is a strong focus on plugging all loopholes in the existing framework and working towards implementing national as well as international best practices which would further facilitate smooth inflow and outflow of credit in the economy and boost up the confidence and morale of the investors.

It is interesting to note that since the provisions of Corporate Insolvency Resolution Process (CIRP) has come into force on 1st December, 2016, nearly 1500 cases have been admitted into the CIRP by the end of December, 2018. It is quite startling to note that in cases where resolution plan has been approved, realization by Financial Creditors in comparison to liquidation value of the corporate debtors was 249%, while the realization by them in comparison to their claims, was 90%. Also relevant to cite is the illustration of Bhushan Steel, the liquidation value3 amounted to 14,000 crore rupees, whereas the total amount of admitted claims stood at 56,000 crore rupees. However, the amount realized from the resolution plan was 35,571 crore rupees, thereby reducing the expected loss by more than half to 20,500 crore rupees (approx.). This itself speaks volumes of the success of the Code and the improving health of the banking sector.

The World Bank released its Ease of Doing Business Report (EoDBR) for the year 2019 in October 2018. In just one year, India has escalated its overall ranking from 100 to 77 among 190 countries. Under the “getting credit” parameter, India has substantially improved its ranking from 44 in 2017 Report to 29 in 2018 Report, and to 22 in 2019 Report. In sum, the Code is proving to be a great success and is a significant step towards improving the state of the Indian Economy.

This Article was first published here on TAXGURU.

By Puneet Agrawal, Partner, & Tejaswini Tripathy, Associate of ALA Legal, Advocates & Solicitors

GST Law India is a blog on GST and allied commercial laws managed by members of the law firm ALA Legal.