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.

Update 1 (15.11.2019)

The Supreme Court appears to have brought a closure to the litigation surrounding Arcelor Mittal's purchase of Essar Steel for $5.8 bn. Livemint reports,

The Supreme Court allowed Arcelor to pay creditors for Essar Steel India Ltd. and scrapped a bankruptcy appellate tribunal’s order that had given secured and unsecured lenders equal right over the sale proceeds, a three-judge bench headed by Justice Rohinton F. Nariman ruled Friday. “There is no principal of equality between secured and unsecured creditors," Justice Nariman said while reading out the judgment in court. Bankruptcy courts don’t have a say in deciding the distribution of funds between creditors. They can only examine the legality of the resolution plan approved by the panel of lenders of an insolvent company, the court ruled.

The case was admitted into the NCLT in August 2017. In October 2018, the Committee of Creditors approved Arcelor Mittal's bid. The NCLT too approved it in March 2019. However, the NCLAT ruled that secured and unsecured creditors have equal rights. This is a good summary.

Update 2 (23.11.2019)

Ishan Bakshi makes the argument that IBC should be the preferred option for resolution of bad loans, and not the last resort, and makes some suggestions in that regard,

For one, the provisioning norms for bad loans should be made more stringent to ensure banks have strong incentives to take companies through this process and not postpone the decision, hoping to restructure the loan outside IBC. Second, relaxing the 330-day deadline will further dampen enthusiasm. The idea of having a time-bound process was to put pressure on the CoC to ensure speedy resolution. Delays in either taking the company to NCLT or in the resolution process destroys enterprise value. This decision must be reviewed. Third, the government should establish the supremacy of IBC to ensure that assets are not allowed to be attached once they have been admitted. Under Section 53 of the law, amounts due to the central government rank below those of secured and unsecured creditors. This hierarchy needs to be respected.  

There also needs to be clarity on the role of promoters. While barring all promoters from bidding was a harsh step, there needs to be consistency of approach. Allowing them to participate in liquidation but not in the resolution process would be inconsistent. Unless, of course, there has been a considered view that promoters, barring wilful defaulters, should be allowed back in, although now it is possible only through the backdoor. Addressing these issues would go a long way in ensuring that IBC is the preferred option for dealing with bad loans rather than being the last resort.

This on delays is a reason why creditors are losing their hope with IBC,

Of the 1,497 cases that are currently going through the resolution process, 36 per cent have crossed 270 days, while another 22 per cent have crossed 180 days. As a time-bound resolution process was one of the most appealing aspects of IBC, such delays create little incentive for stakeholders to opt for this process.

Update 3 (28.11.2019)

Soumya Kanti Ghosh has this analysis of the IBC where he suggests raising the threshold for applicability of IBC, limiting liquidation etc.

Update 4 (16.12.2019)

Aravind Panagariya and Rajeev Mantri write,

According to ratings agency Crisil, during 2018-19, financial creditors recovered 42.8% of the Rs 2.53 trillion amount claimed under IBC. This represents a marked improvement over the dwindling pre-IBC recovery rates of 31%, 24%, 22% and 18% in 2010-11, 2011-12, 2012-13 and 2013-14 respectively. Critically, Crisil reported that the average time taken for resolution has declined from 3.5-4 years to 326 days for the 94 cases resolved under IBC as of March 31, 2019.

And the latest on the progress of IBC,

Of the 2,542 corporate insolvency cases filed between December 1, 2016 and September 30, 2019, about 156 have ended in approval of resolution plans — a mere 15 per cent, according to latest data released by the Insolvency and Bankruptcy Board of India (IBBI). In the current fiscal, as many as 1,037 cases of corporate insolvency have been admitted by various benches of National Company Law Tribunal (NCLT) across India until September 30 — an increase of 51.6 per cent over the corresponding period last year. However, a meagre 76 resolution plans have been approved in the current fiscal, while the number of companies which have either been liquidated or are headed at liquidation stands at 351 — which is one-third of the total number of insolvency cases filed until September 30... In the past three years, the number of companies which have been sent for liquidation — either due to lack of feasible resolution plans or absence of any resolution plans whatsoever — stand at 587. These include big ticket names such as Adhunik Metaliks, Khaitan Electricals, and Orchid Health Care Private, among others. The IBBI, however, defended the number in its latest data newsletter and said that nearly 427 of the companies which underwent liquidation were earlier with the BIFR and or defunct.

As of September 2019, 535 companies have spent more than 270 days, waiting to get resolved. In August this year, the Centre had introduced an amendment to increase the deadline to 330 days, but said that the corporate insolvency resolution process (CIRP) shall mandatorily be completed within this time. “This would include extension of time as well as any exclusion of time on account of legal proceedings,” the government had then said. The Supreme Court, however, while delivering the judgment in the Essar Steel insolvency case, relaxed the criteria of “mandatorily” resolving the CIRP within 330 day, allowing the possibility of extending it beyond even that if need be.

More here on the strain faced by the NCLT benches.

Update 5 (24.12.2019)

Very good account of the early days of the IBC.

Update 6 (14.03.2020)

MS Sahoo critiques the critics of IBC and puts its performance in perspective,

Two hundred companies had been rescued till December 2019 through resolution plans. They owed Rs 4 lakh crore to creditors. However, the realisable value of the assets available with them, when they entered the IBC process, was only Rs 0.8 lakh crore. The IBC maximises the value of the existing assets, not of the assets which do not exist. Under the IBC, the creditors recovered Rs 1.6 lakh crore, about 200 per cent of the realisable value of these companies. Hypothetically, any other option of recovery or liquidation would have recovered, at best, Rs 100 minus the cost of recovery/liquidation, while the creditors recovered Rs 200 under IBC. The excess recovery of Rs100 is a bonus from the IBC. Despite the recovery of 200 per cent of the realisable value, the financial creditors had to take a haircut of 57 per cent as compared to their claims. This only reflects the extent of value erosion that had taken place when the companies entered the IBC process. Nevertheless, as compared to other options, bank are recovering much better through IBC, as per RBI data.

On liquidation being the norm,

There is a myth that although the IBC process has rescued 200 companies, it has sent 800 companies for liquidation. The number of companies getting into liquidation is thus four times that of the companies being rescued. Numbers, however, to be seen in context. The companies rescued had assets valued at Rs 0.8 lakh crore, while the companies referred for liquidation had assets valued at Rs 0.2 lakh crore when they entered the IBC process. Thus, in value terms, assets that have been rescued are four times those sent for liquidation. It is important to note that of the companies rescued, one-third were either defunct or under BIFR, and of the companies sent for liquidation, three-fourths were either defunct or under BIFR.

The point he makes about companies waiting till the last moment before availing IBC as a reason for many liquidations is important.