Corporate bankruptcy resolution: juxtaposing the US and India

March 2020 | EXPERT BRIEFING | BANKRUPTCY & RESTRUCTURING

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The Indian Bankruptcy Code (IBC) is a recent creation. The insolvency resolution process in India previously involved the simultaneous operation of multiple statutory instruments. These included: (i) the Sick Industrial Companies Act, 1985; (ii) the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002; (iii) the Recovery of Debt Due to Banks and Financial Institutions Act, 1993; and (iv) the Companies Act, 2013.

Broadly, these statutes provided for a disparate process of debt restructuring, and asset seizure and realisation in order to facilitate the satisfaction of outstanding debts. However, a plethora of legislation dealing with insolvency and liquidation led to confusion in the legal system, and there was a grave necessity to overhaul the insolvency regime. All of these multiple legal avenues, and a hamstrung court system, led to a huge pile-up of non-performing assets in India, and creditors waiting years to recover their money.

The Bankruptcy Code is an effort to comprehensively reform the fragmented corporate insolvency framework, to allow credit to flow more freely in India and to instil investor faith in the speedy disposal of their claims. The Code consolidates existing laws relating to the insolvency of corporate entities and individuals into a single legislation. The Code has unified the law relating to the enforcement of creditors’ statutory rights and streamlined the way a debtor company can sustain its debt without extinguishing the rights of creditors.

The main intent of the Indian Bankruptcy Code 2016 seems to have been ‘recovery type resolutions’, and this remains the case. The problem began with debt funding sources not keeping up with the funding requirements of a booming economy, particularly in capital-intensive industries such as infrastructure, real estate, capital goods and commodities. In the absence of any other source of financing, issuers turned to banks, some private but most publicly owned – and these could not be more inappropriate for the required type of funding. Empirical market evidence of this is reflected in the big spread of trading multiples among Indian banks – from private sector banks which do not lend on long-tenure projects, to government-owned banks that do. The mandated capability gap in assessment and post-disbursal monitoring by government-owned banks has become very clear; following the IBC regime, hopefully the stage is set for better allocators of debt in the market.

In addition to the mismatch between the asset liability profiles of the capital-intensive assets involved, matters were not helped by the mechanics of the debt sanctioning process. First, debt was often ‘gold plated’ at the project appraisal stage. Second, mechanisms were typically included by which the original sponsor was able to generate multiple times its original equity commitment, long before the project itself even saw the light of the day. Third, once the debt requirements of a project exceeded the sponsor’s capacity (even at ambitious forecasts), invariably the working capital gap funding requirements were sacrificed, so without the ability to fund suppliers and employees, the bulk of projects were dead by the time they were ready. Finally, large infrastructure projects or commodity processing plants were predicated on business cases that relied on a government-assured input of fuel supply or land acquisition support, which never materialised.

Bankruptcies in India have become a real value-discovery process. Gold plating and working capital ‘short-change’ correct themselves through the ‘recovery’ percentages of legacy debt. Lax equity raises standards in ‘hot’ market phases.

Alongside the introduction of the IBC, fundamental changes to the business ecosystem are needed for the process to become truly open and democratic. There must be contract enforceability, especially when the government is a counterpart. The larger bankruptcies in India have come about as a result of counterparties failing to meet their contract conditions without any consequences. Large facilities have been set up with promises of government input that does not come through, delays in regulatory approvals or even non-payment of dues. Judicial intervention has also resulted in delays or complete loss of the business case.

There is possibly no other jurisdiction on global investors’ radar where the bankruptcy and restructuring framework is so dependent on government for multiple aspects of business.

Under the IBC itself, excluding parties who have a right to submit a resolution plan is by definition “undemocratic”, and goes against debtor-in-possession (DIP) restructuring principles. To avoid the moral conundrum of ‘promoters’ acquiring their assets on the cheap through the ‘back door’, the right governance principles need to be in place to oversee credit appraisal and fund usage, and mechanisms need to be introduced to reverse fraudulent conveyance.

The IBC may not perfect but taking the best option off the table is not the best move to make. Contrast this with the orderly state of play in a US bankruptcy and restructuring scenario. Conceptually, the US framework puts the claim holders into three buckets: equity holders, secured creditors and unsecured creditors.

First, we have equity holders which have gambled on the company’s upside and lost. Logically, this group should go empty-handed. This principle is true for the both the US and Indian regime, but, practically, equity holders and management often do not go empty-handed. In India, large owner-managers have often made back the money they put in multiple times over by the time a project is anywhere near bankruptcy . In the US, the same phenomenon manifests itself just before a Chapter 11 filing, when management issue large bonuses to themselves, apparently as compensation for operating in a ‘high risk’ environment.

Second, we have secured creditors which are supposed to conduct a robust credit appraisal process, evaluating and factoring in the robustness of the business plan. In both the US and India, secured lenders have priority over other creditors. In the US, lower-valued outstanding collateral is added to the secured pool, and the balance goes into the unsecured pool. In India, the entire process is about recovery for secured lenders.

Third, we have unsecured creditors which are supposed to take a balanced risk and reward position. In the US, as part of a distressed company’s reorganisation, unsecured creditors are expected to become the new owners of the company and, therefore, have a key role in shaping how the company emerges from bankruptcy. This is where there is a serious discord between the US and India regimes. In India, an operational creditor has little or no role to play and even less control of their own destiny.

These differences manifest themselves in the constitution of the committee that plays a key role in the bankruptcy process. In the US, the unsecured creditors committee (UCC) is typically comprised of five or seven of the largest unsecured creditors chosen by the Office of the United States Trustee under the US Department of Justice (DOJ). Selection is based on a personal interview of the unsecured creditors’ representative. In India, there is the Committee of Creditors (CoC). Typically, every secured lender makes its way into the CoC. The CoC formation process is led by the lead bankers who choose their advisers and an insolvency professional (IP) to lead the CoC process.

Corporate bankruptcy provision in India clearly has some way to go before it even begins to approach the maturity of its US counterpart. That said, the creation of the IBC, while undeniably imperfect at present, is a significant step in the right direction for the bankruptcy resolution process in India.

Rahul Saikia is a chief strategy officer at FDC Limited. He can be contacted by email: rahul_saikia@hotmail.com.

Rahul Saikia

FDC Limited