Thursday, July 18, 2019

The birth pangs of India's IBC continues

I had blogged earlier here, here, here, and here about the challenges facing the fledgling Insolvency and Bankruptcy Code (IBC) due to competitive litigation by competing creditors and buyers.

Last week the National Company Law Appellate Tribunal (NCLAT) dismissed a plea challenging Arcelor Mittal's elgibility to buy Essal Steel India Ltd. The latter had argued that the bid was ineligible under Section 29A of the IBC, whereby bidders cannot be connected to other defaulting parties. The NCLAT ruled that this was already settled by the Supreme Court earlier on 4 October, 2018 and therefore cannot be re-litigated.

It also ruled that its operational creditors, consisting of vendors and suppliers, were to be treated in an "equitable manner" with secured financial creditors at the time of settling claims. It ruled that lenders and operational creditors would get 60.7 per cent of their outstanding claims and proportionately share the Rs 42,000 crore that Arcelor Mittal has offered to pay. The resolution plan, approved by the Committee of Creditors (CoC) which does not contain the operational creditors, had proposed a small share to operational creditors and 92.5 per cent to financial creditors.

This ruling equating different creditors effectively makes secured, unsecured, and operational creditors on a par. Secured creditors have understandably expressed their concern and are planning to appeal before the Supreme Court. It also discourages banks from taking companies to IBC and prefer liquidation which would only destroy value. 

This interpretation by NCLAT is in keeping with the practice of imposing judges' subjective preferences and values in judicial pronouncements. Latha Venkatesh summarises the problem nicely. This on the IL&FS case,
In the IL&FS case, the NCLT has indicated that provident funds, even if they are not secured or senior creditors, should be given their dues at par with or even over secured creditors because the beneficiaries of these funds are more vulnerable due to their age. In the Essar Steel case, the NCLAT set aside the distribution that the committee of creditors (the CoC) put forth. The CoC, in keeping with clause 30 (2b) of the Insolvency Code, gave 10 percent to the operational creditors and kept 90 percent for themselves, i.e the secured creditors. The NCLAT cancelled this plan and ordered the CoC to give 40 percent to the operational creditors on the ground that the CoC and the NCLAT are bound by a higher law of fairness. The Clause 30 (2)(b) of the IBC says that operational creditors need to be given liquidation value, and once the CoC gives a plan that satisfies this clause the NCLT, under Section 31 “shall” accept the CoC’s plan.
Let us cut through the legalese, to where the two cases meet. The IBC and commercial law, in general, are predicated on the premise that those creditors, who have given loans in exchange for a collateral or security, should be paid before those who have given unsecured loans. The difference is reflected in the interest rates. World over, secured loans attract lower interest rates while unsecured loans bear a higher interest. This is because low risk in secured credit gets a low return, while unsecured loans are high risk and hence get a higher return. This fundamental principle of commercial law has gotten dislodged in the above two cases.
In the IL&FS case, the tribunal is moved by sentiment towards one group of lenders. But such a judgement can hurt the entire economy and cause untold misery to the entire country. If the fund manager of the provident fund has been reckless and subscribed to debentures that are substandard, while bankers have been smart enough to “secure” their credit, the mere fact that the PFs beneficiaries are more vulnerable cannot be used to override the rights of secured creditors. If this became law (as all precedents do), then the concept of secured credit will be undermined and all banks will give only unsecured credit and charge high rates to make up for the risk. Bankers may go a step further and even demand that if a project needs their loans, the borrower must promise never to take loans from provident funds.
And this on the Essar Steel case,
Here, the NCLAT has done two things which may upset the economic applecart.

1) The IBC has given more powers to the CoC to draw up a resolution plan since they are the biggest lenders and their help is needed for the future survival of the company. The CoC is directed by the IBC to follow a prescribed waterfall: first the legal dues to employees, then secured creditors after 10 percent liquidation value to operational creditors. The NCLT was intended to ensure the process has been followed, not substitute its commercial judgement in place of the CoC’s. By setting aside the position of the CoC, the Essar judgement can destroy the entire edifice of the IBC, since creditors and the resolution applicant will be willing to go ahead with a plan to rescue a company only if it makes commercial sense to them...
2) The Essar Steel judgement of the NCLAT also in a way gives almost as much importance to the operational creditors as to secured creditors. Like in the IL&FS case, this can jeopardise the entire credit system in the country, with all creditors preferring to give unsecured loans at high interest rates, thus grinding all economic activity to a halt. The law gives operational creditors liquidation value with a reason. An operational creditor is only exposed to one production cycle and, if not paid, the creditor stops supplying. The secured financial creditors, viz the bankers have taken a risk on the company for many years, betting its plant will be set up and bear profit over time. Commercial law, everywhere, gives such creditors more powers. Else, no one will fund expansion plans or greenfield projects. Some experts have argued that in many small companies operational creditors bear the entire risk in the form of suppliers credit and hence they need to be given a fair share when the stressed company is sold. They have a point which perhaps needs to be addressed. However, while addressing operational creditors, the law needs to note that in many cases operational creditors are related parties: In Essar Steels case, over 20 operational creditors are group companies. If the NCLATs order becomes law, then all promoters, who see their companies in danger of going into IBC, may quickly create bogus operational credits with group companies. The NCLAT's judgement can thus lead to perverse developments that hurt the larger good.
I had blogged earlier highlighting that among the biggest concerns about the success of the IBC came from the judiciary. This is only the latest example of how judicial activism or kritarchy of the wrong kind can have damaging consequences in distorting incentives and imperilling the effectiveness of public policy.

Fortunately, despite these intemperate decisions, like with the GST, the Ministry of Corporate Affairs seems to be swift in reacting effectively to such emergent scenarios. The Union Cabinet yesterday has passed several amendments to the IBC with the objective of addressing the problems that have emerged from the likes of Essar Steel case and attendant court judgements.

The amendments aimed at speeding the bankruptcy resolution process include enforcement of a strict 330-day timeline for the insolvency resolution process, including the time taken for legal challenges (the courts had started excluding this time in the 270 day time limit given under the Code for approval of the resolution plan); upholding secured creditors' priority right on the sale or liquidation proceeds; making clear the rights of financial (who have not voted in favour of a rescue plan) and operational creditors; specifying that the resolution arrived at the IBC is binding on central, state and local governments etc.

This is a good example of the iterative approach to ensuring effective implementation of complex regulations and commissioning of large projects. As I have written earlier, I am very impressed by the vigilance exercised by the Ministry of Corporate Affairs over the past two years of IBC and the swiftness with which it has stepped in on multiple occasions to address emergent failings/flaws exposed in the legislation and its regulations.

Someone should write a case study on the implementation of the IBC Act. It can be a rare good illustration of high quality state capacity, and yet another example of how corporate India and the judiciary loses no opportunity to distort every new law that comes their way.


Unknown said...

in the particular instances you had blogged on, it seems that the problem is more with NCLT and NCLAT rather than with companies, per se. So, can they be blamed for gaming the law, in these two instances?

Urbanomics said...

Thanks Anon. Correct. I have amended the last line in the article accordingly. While in this instance discussed here, it is the judiciary which has been responsible for subversion, the Section 29A issue has been an instance of corporate litigations.