Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation. This blog is currently suspended.

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Thu, 09 Apr 2020

A new chapter in the Insolvency and Bankruptcy Code

When India adopted the Insolvency and Bankruptcy Code (IBC) in 2016, it was clear that it was a transitional, stopgap arrangement, and that after the urgent goals of the IBC were met, there would be a need for a more comprehensive and fairer law (I have blogged about this many times, most recently a year ago). Covid-19 has however accelerated this timeline and made it necessary to make urgent modifications in the IBC even before its old goals have been fully achieved.

The pressing goals that led to the enactment of the IBC were two:

  1. A bailout of the Indian financial sector (mainly the banking system) which was (and still is) reeling under a massive burden of bad loans. This goal was accomplished in part by expropriating operational creditors.

  2. Ousting dishonest promoters who had run their companies to the ground but who were allowed in the pre-IBC regime to remain in control of their businesses. This goal was accomplished by handing over control of the company to a committee of creditors who might not know how to run the business, but could at least keep the promoters out.

Covid-19 is leading to a drastically different situation where an even more pressing goal is coming to the fore: rebuilding businesses that have been devastated by the crisis. To accomplish this new overriding goal, we will have to rethink the mechanisms that the IBC created to achieve its original short term goals.

Expropriating operational creditors

As mentioned above, the bailout of the banking system was accomplished by expropriating the non financial (operating) creditors of the company. This expropriation was accomplished by two legal provisions:

It is amazing how such a massive expropriation was achieved without any resistance. The reason is that the financial sector was well organized, and the financial sector regulators as well as the sovereign itself (as the owner of a large part of the banking system) were all batting for them. Operational creditors were unorganized and were not even paying attention. It was only when home buyers realized that they were mere operational creditors of some insolvent real estate developers that they woke up and screamed; the backlash from this segment was so strong that home buyers had to be quickly accommodated by an explanation hastily grafted onto Section 2(8)(f) of the IBC. Other operational creditors continue to remain in the lurch.

Such an expropriation of operational creditors does not happen elsewhere in the world. Right now, for example, we are witnessing the bankruptcy of one of the largest electricity companies in the US, Pacific Gas and Electric Company (PG&E). The bankruptcy arose because of PG&E’s potentially massive liabilities from certain catastrophic wildlife fires allegedly caused by its equipment. The bankruptcy proceedings of PG&E are being driven by the wildfire victims (who, as tort creditors, would count as operational creditors under IBC), while the financial creditors have been relegated to the backseat.

The expropriation of operational creditors under the IBC will be a disaster in the aftermath of the Covid-19 crisis in India. The disruption caused by social distancing and subsequent lockdown means that most businesses are under acute stress, and are unable to pay their suppliers or their lenders. To prevent complete economic meltdown, we need companies to continue to sell on credit to their customers while old bills remain unpaid. That is the only way that the going concern value of these businesses can be preserved. The cruel twist of the IBC is that if the suppliers do so, the mega bank will come along and steal the entire going concern value that the operational creditors have created and preserved. There is an urgent need to give trade creditors their due to prevent a massive economic contagion in which firms that fail drag their suppliers down with them, and they drag their suppliers down and so on.

Committee of creditors

Until the IBC came along, Indian businesses were well protected from their lenders by mechanisms like the BIFR. There was consensus that this needed to be changed, and ousting dishonest promoters was an important goal of the IBC. The problem was that the Indian judicial system was and is plagued by excessive delays. It was therefore thought that putting the courts in charge will in effect leave the promoters in charge. So the IBC put a Committee of Creditors in charge of the company during the entire resolution process with a tight timeline to either find a buyer for the whole business or to liquidate it.

Since there was general agreement that many of the defaulting promoters were in fact dishonest, this arrangement made sense. A crooked management would be siphoning off money from the business at every opportunity, and ousting them would actually help preserve value even if the creditors or the resolution professionals that they hire were not very good at running the business.

Covid-19 changes this drastically because businesses will be failing for no fault of theirs. Often the incumbent management would not only be honest but also competent. Throwing them out is a stupid thing to do even for the creditors who are trying to maximize their take. In the extremely challenging post-Covid environment, it would take the most skilled management to rebuild the business. The idea that a bunch of people can do this with no knowledge at all of the industry in question is just laughable. The consequence of handing over the business to the committee of creditors would be a sure prescription for destroying all value. It would ruin not only the employees and other stakeholders but even the lenders themselves who would recover a pittance in a firesale of the assets at a time when other lenders are liquidating similar companies in the same industry.

Some people have suggested suspending the filing of insolvency petitions under the IBC for a few months to prevent such a perverse outcome. They forget that an insolvency petition actually protects the debtor because it carries with it a moratorium on enforcement of debt. Without such a moratorium, most companies will be swamped by enforcement actions by secured creditors. Moreover, without a moratorium, any default will allow counterparties to terminate contracts, and this would be the death knell of the business. What we need is a new chapter in the IBC that allows a Debtor in Possession (DIP) insolvency regime for companies that get into difficulty not due to mismanagement but due to external factors (economy wide or industry wide problems).

In other words, India needs a world class bankruptcy regime in short order. In the rest of the world, we see bankrupt airlines operating flights normally while a bankruptcy court is figuring out how to restructure its debt. Similarly, telecom firms file for bankruptcy while continue to serve their customers without interruption. Steel mills continue to run while the bankruptcy proceedings are going on. The reason this does not happen in India is that we designed a stopgap bankruptcy code which did not envisage any of this. The time has come to remedy this shortcoming.

The way forward

I think we need to quickly add a new chapter to the IBC that allows an insolvency resolution process with the following feature:

Initially, this chapter can be limited to Covid-19 bankruptcies, but over time, it could be extended to other “no-fault” bankruptcies.

Posted at 22:03 on Thu, 09 Apr 2020     0 comments     permanent link