The Insolvency and Bankruptcy Code of 2016 (IBC) is a good law since it lowers stress for businesses, limited liability partnerships, sole proprietorships, and partnership firms, as well as individuals. However, the discussion here is confined to businesses because the IBC's rules related to people, with the exception of personal guarantors to corporate creditors, have yet to take effect. Although there are noteworthy outliers, it is based on generalizations.
A corporation may be stressed for a variety of reasons, some of which are under its control and others that are beyond its control, such as being unable to repay a loan on time, suggesting that it has fewer assets than claims against it. When a company's assets are insufficient, basic economics teaches us that an individual creditor's claim may be compatible with its assets, but the claims of all creditors combined may not. In such a case, creditors may hurry to collect their claims before others, resulting in a run on the company's assets. They recoup on a first-come, first-served basis until the company's assets are depleted, thus killing it. This is a game with a bad outcome.
The IBC allows for reorganization to avoid a value-diminishing run on the firm. Through a market procedure, it tries to save the firm if its business is viable or close it if it is unviable. The firm is reorganized as a going concern in the event of a rescue. Creditors' claims are reorganized, and they may be paid immediately or over time. In the event of a company's closure, the company's assets are liquidated, and the proceeds are allocated to creditors according to the priority rule. Financial creditors are entrusted with the duty of reorganization under the IBC since they have the capacity and desire to restructure their claims. They are more likely to save a firm with a going concern surplus, which matches the company's and financial creditors' interests, making it a win-win situation.
If the firm does not have sufficient assets, financial creditors may not be able to recover all of their claims if the company is rescued. In ordinary terminology, such scarcity is referred to as a haircut. Ghotaringa Minerals Limited and Orchid Healthcare Private Limited made headlines around a year ago. They owed creditors a total of Rs 8,163 crore and had no assets when they went through the IBC procedure. There was no need to shave. In comparison, certain situations (Binani Cements) have resulted in a zero haircut as well as the company's rescue.
Perhaps a more pertinent issue is why does the IBC procedure result in a zero haircut in one case and a 100 percent haircut in the other? The nature of the firm, business cycles, market emotions, and marketing effort are all elements to consider. However, it is crucial to know at when a point in the stress cycle the firm joins the IBC process. The IBC process may result in a substantial haircut or perhaps liquidation if the firm has been ill for years and its assets have dwindled dramatically. The firms that were rescued through the IBC procedure through March 2021 had assets worth on average 22% of the amount owed to creditors when they joined the process. This indicates that the creditors were facing a 78 percent haircut from the start. One-third of these were non-operational businesses. The IBC process not only saved these businesses, but it also lowered financial creditors' haircut to 61%.
The total claims minus the amount of realization/amount of claims are sometimes referred to as a haircut. However, this phrasing could not capture the whole storey. The sum that would be realised from equity holdings post-resolution, as well as via the reversal of avoidance transactions and the bankruptcy resolution of guarantors — personal and corporate — is frequently excluded from the realization. It also excludes any gains or losses earned in other accounts (recovery of about Rs 8,000 crore incidentals to the resolution of Essar). NPA, which may be entirely wiped off, and interest on such NPA are frequently included in the claim amount. It might contain both loans and guarantees for such debts. The numerator is understated, while the denominator is overstated, implying a higher haircut.
Should a haircut be considered in terms of creditor claims or accessible assets? The former is unlikely to be accurate, as statements are frequently exaggerated. The latter makes more sense since the market values a firm based on what it brings to the table rather than what it owes to creditors. The IBC maximizes the value of current assets, not ones that may or may not have existed previously. The IBC permits and facilitates market forces to address stress as a going concern, where resolution applicants compete to give the greatest value, which fits the expectations of financial creditors who have numerous choices for recovery as well as resolution. The firm is liquidated if the greatest value given by the market is not acceptable to creditors.
In addition to saving the firm, the IBC realizes the maximum proportion of the available choices for creditors. It is a tool in the hands of stakeholders to be utilized at the appropriate moment, in the appropriate situation, and in the appropriate manner. They should employ it in the early stages of a crisis, when the company's worth is nearly intact, and close the process swiftly before the value declines further, in order to minimize or even avoid haircuts. The haircuts could be appealing to the sight after the pre-IBC legacy problems are dealt with, as "current" stress situations are dealt with.
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