IBC has better remedy than any other resolution of stressed assets

The 2016 Insolvency and Bankruptcy Code (IBC) is an excellent law since it reduces stress for businesses, limited liability partnerships, sole proprietorships, and partnership firms, as well as individuals. The discussion here is limited to corporations because the IBC's provisions affecting individuals, with the exception of personal guarantors to corporate creditors, have yet to take effect. There are notable outliers, but the data is based on generalisations.

A company might be stressed for a variety of reasons, some of which are under its control and others outside of it, such as being unable to repay a loan on time, implying that it has fewer assets than claims against it. Basic economics teaches us that when a company's assets are insufficient, an individual creditor's claim may be compatible with its assets, but the claims of all creditors combined may not. Creditors may rush to collect their claims before others in this situation, resulting in a run on the company's assets. They recuperate on a first-come, first-served basis until the company's assets are drained, putting the company out of business. This is a game that has a negative outcome.

UNDERSTANDING THE ROLE OF IBC 2016

For reasons sometimes a company may experience stress, that is, is unable to repay the debt in time implying that it has assets less than claims against it. So, when a company has inadequate assets, the claim of an individual creditor may be consistent with its assets while claims of all creditors put together may not. In such a situation, creditors may rush to recover their claims before others do, triggering a run on the company’s assets. The IBC provides for reorganisation that prevents a value-reducing run on the company. It aims to rescue the company if its business is viable or close it if its business is unviable, through a market process. Restructuring: The claims of creditors are restructured, which may be paid to them immediately or over time. In case of closure, the assets of the company are sold, and proceeds are distributed to creditors immediately as per the priority rule.

Reorganisation by the financial creditor: The IBC entrusts the responsibility of reorganisation to financial creditors as they have the capability and the willingness to restructure their claims.

The reorganisation is permitted under the IBC in order to avoid a value-diminishing run on the company. It aims to save the company if its business is viable or close it if it is unviable using a market procedure. In the event of a rescue, the company is reorganised as a going concern. Creditor claims are reorganised and may be paid in full or in instalments. The assets of a firm are liquidated in the case of its closure, and the proceeds are distributed to creditors according to the priority rule. Financial creditors, who have the ability and desire to restructure their claims, are entrusted with the reorganisation obligation under the IBC. They are more likely to save a company that has a going concern surplus, which aligns the interests of the company with its financial creditors, creating a win-win situation.

Financial creditors may not be able to recover all of their claims if the company is rescued if it has sufficient assets. Such scarcity is referred to as a haircut in common parlance. Around a year ago, Ghotaringa Minerals Limited and Orchid Healthcare Private Limited made the news. When they went through the IBC procedure, they owed creditors a total of Rs. 8,163 crore and had no assets. It was unnecessary to shave. In contrast, certain circumstances (Binani Cements) resulted in a zero haircut and the company's rescue.

Perhaps a more pressing question is why does the IBC process result in a zero percent haircut in one example and a 100% haircut in the other. Aspects to consider include the firm's character, business cycles, market sentiments, and marketing activity. However, knowing when a firm joins the IBC process at a specific point in the stress cycle is critical. If the company has been sick for years and its assets have shrunk considerably, the IBC process may result in a significant haircut or even liquidation. By March 2021, the enterprises that had been rescued through the IBC procedure had assets worth an average of 22% of the amount owing to creditors when they entered the process. This means the creditors were facing a 78 percent cut from the beginning. Non-operational enterprises made up one-third of the total. The IBC process not only protected these enterprises but also reduced the haircut to 61 percent for financial creditors.

A haircut is defined as the total claims less the amount of realization/amount of claims. This phrase, however, fell short of capturing the entire storey. The amount that would be recovered from equity holdings after the resolution, as well as from the reversal of avoidance transactions and the bankruptcy resolution of personal and corporate guarantors, is typically left out of the realisation. It also doesn't take into account any gains or losses made in other accounts (recovery of about Rs 8,000 crore incidentals to the resolution of Essar). NPAs that may be completely wiped out, as well as interest on such NPAs, are typically included in claim amounts. It is possible that it will include both loans and guarantees for such debt.

Should a haircut be taken into account in terms of creditor claims or available assets? The former is unlikely to be correct, as exaggerated statements are common. The latter makes more sense because the market values a company based on what it offers rather than what it owes creditors. The IBC aims to maximise the value of present assets rather than those that may or may not have existed in the past. The IBC allows and facilitates market forces to address stress as a going concern, where resolution applicants compete to provide the best value, which corresponds to the expectations of financial creditors who have a variety of recovery and resolution options. The firm is liquidated if the greatest value given by the market is not acceptable to creditors. 

WHY SO MUCH VARIATION IN HAIRCUTS?

Where the company does not have adequate assets, realisation for financial creditors, through a rescue, may fall short of their claims known as a haircut. The IBC process yields a zero haircut (100% recovery of claimed amount) in one case and a 100 per cent haircut (i.e. 0% recovery) in another. Factors: It depends on several factors, including the nature of business, business cycles, market sentiments, and marketing effort. It critically depends on at what stage of stress, the company enters the IBC process. If the company has been sick for years, and its assets have depleted significantly, the IBC process may yield a huge haircut or even liquidation. A haircut is typically the total claims minus the amount of realisation/amount of the claims. But this formulation may not tell the complete story. The realisation often does not include the amount that would be realised from equity holding post-resolution, and through the reversal of avoidance transactions and the insolvency resolution of guarantors -personal and corporate. It also does not include realisations made in other accounts. The amount of claim often includes NPA, which may be completely written off, and the interest on such NPA. These understate the numerator and overstate the denominator, projecting a higher haircut.

SIGNIFICANCE OF IBC

A haircut should be seen in relation to the assets available and not in relation to the claims of creditors. The market offers value in relation to what a company brings to the table, not what it owes to creditors. 

VALUE MAXIMISATION

So, the IBC maximises the value of existing assets, not of assets that probably existed earlier. Market determined value: The IBC enables and facilitates market forces to resolve stress as a going concern. Resolution applicants, who have many options for investment, including in stressed companies, compete to offer the best value. If the best value offered by the market is not acceptable to creditors, the company is liquidated. 

MAXIMUM REALIZATION

In addition to rescuing the company, the IBC realises, of the available options for creditors, the highest in percentage terms

In addition to rescuing the company, the IBC ensures that creditors have the greatest number of options. It is a tool in the hands of stakeholders that should be used at the right time, in the right scenario, and in the right way. They should use it in the early phases of a crisis, when the company's value is practically intact, and close the process quickly before the value decreases further, to avoid haircuts. After the pre-IBC heritage issues are resolved, as well as "present" stress situations, the haircuts may be pleasing to the eye.

The Standing Committee on Finance’- MCA has issued a 32nd report titled ‘Implementation of IBC-pitfalls and solutions’ whereby it has recommended for a benchmark for the quantum of ‘haircut by Financial creditor to be comparable to global standards. The committee proposed the establishment of ‘Institute of Resolution Professionals’ to oversee and regulate the functioning of RPs. It also proposed more transparency in the appointment of RPs by the Committee of Creditors, the inclusion of a more flexible resolution plan, the Adoption of a cross-border insolvency framework, etc.

1. Quantum of hair-cut at par with global standards

The Committee found that a low recovery rate with 95% haircut and delay in the resolution process with more than 71% cases pending for more than 180 days deviates from the objective of the Code. The Committee recommended a benchmark for the quantum of “hair-cut” comparable to global standards.

2. Transparency in the appointment of RPs

The committee noted that during CIRP, the committee of creditors decides whether to continue with IRP as the RP or to replace the IRP with another RP without any guidelines. The committee suggested that IBBI should fame guidelines for the selection of the RPs by the CoC in a more transparent manner.

3. Establishment of ‘Institute of Resolution Professionals’

The Committee recommended putting in place a professional self-regulator like ICAI for RPs.  “An Institute of Resolution professionals may be established to oversee and regulate the functioning of Resolution Professionals so that there are appropriate standards and fair self-regulations,” the committee said.

4. Inclusion of flexible resolution plan

The committee highlighted that resolution professional currently doesn’t have flexibility with the IBC to dispose of the corporate defaulter across multiple bidders.  The Committee recommended that the IBC be amended to clarify that the resolution plan can be achieved through any of the means prescribed under regulation 37 of the CIRP Regulations.

5. Digitisation of IBC ecosystem

The committee recommended the NCLT and NCLAT should completely digitise their records and operations with provisions for a virtual hearing to get through the backlog and deal with the pending cases swiftly. “All available data should be in a machine-readable format. There should be a broader built-in consultation mechanism and an ecosystem for regular feedback on the performance of NCLT,” said the committee.

6. Pre-pack insolvency resolutions

The Committee recommended that the pre-pack framework may be gainfully employed while strictly adhering to the timelines to achieve swift and cost-effective resolutions. The committee recommended that a pre-pack resolution framework for corporates may be rolled out to aid the existing insolvency framework in facilitating quicker and more effective resolutions. Currency MSME are considered operational creditors and come after secured creditors in the ‘waterfall mechanism’.

7. Cross border insolvency

The committee recommends that the adoption of a cross-border Insolvency framework should be expedited as once the recommendations of the ‘cross border insolvency committee’ are adopted, the cross-border insolvency framework would go a long way in ensuring coordination and communication between jurisdictions to successfully address the resolution of the cross-border insolvency cases.

8. Strengthening home buyers

The Committee recommended that once a single homebuyer decided to initiate insolvency proceedings in NCLT, the real estate owner should be obligated to provide details of other home buyers of the project to the concerned home buyer so that he can mobilise 10% or 100 homebuyers. This move would safeguard the interest of the homebuyer.

What we come to understand finally is that this is a tool in the hands of stakeholders to be used at the right time, in the right case, in the right manner.