Indian Insolvency Law

CREDIT AVAILABILITY

Every supplier of funds wishes to invest in a balanced portfolio while every firm wishes to build a balanced capital structure in sync with their objective functions. A market economy makes it possible, where the portfolio and the capital structure have a balanced combination of debt and equity as well as of different variants of debt and equity. The state intervention generally strengthens the rights of suppliers of funds and thereby reduces risks for them, leading to a higher supply of capital at a lower cost. This promotes capital formation. If, however, the intervention strengthens rights of one set of suppliers of funds vis-à-vis those of others, the supply of funds from one source may increase, while supply from other sources, as well as overall supply, may reduce. Where creditors have relatively weaker rights as compared to equity suppliers, market hesitates to supply credit. This limits supply of credit, and consequently, the firm and the economy forego the benefits of capital gearing. State intervention should balance the rights and powers of the suppliers of different types of funds, yielding a balanced capital structure for firms.

RESOURCE UTILIZATION

Mainstream economic thought believes that at any point in time, human wants are unlimited while the resources to satisfy them are limited. The central economic problem, therefore, is the inadequacy of resources vis-à-vis ever-increasing, unlimited wants. Mainstream legal thought believes that as a person moves from a natural state to an economic state, it loses some degree of freedom. The central legal problem, therefore, is the lack of freedom to pursue economic interests meaningfully. Thus, there are twin inadequacies of limited resources and freedom. Resources have alternative uses, and firms pursue self-interests. An economy thrives when the self-interested firms have the maximum possible freedom to shift resources to more efficient uses continuously and seamlessly. There are occasions when the resources at the disposal of a firm are underutilized, as compared to other firms in the industry. The state intervention should facilitate optimum utilization of resources at all times by preventing the use of resources below the optimum potential, ensuring efficient use of resources within the firm or releasing unutilized or underutilized resources for other uses, through the closure of the firm.

ENTREPRENEURSHIP

A company has indefinite life by law. There is, however, a continuous threat to its life from the ‘market’. It experiences financial stress to start with, which, if not addressed in time, converts to economic stress, eventually leading to its death. The average life of S&P 500 companies has reportedly reduced from 90 years to 18 years over the last century. While the state intervention should facilitate the death of an unviable company, it must rescue a viable company well in time. Death of a viable company would mean loss of organizational value, and the creation of a similar company would take considerable time.

A business should continue as long as it is efficient and exit otherwise. The state intervention should facilitate the exit of an inefficient business to enable the larger economic ecosystem to reallocate resources seamlessly from such businesses to efficient ones. The cost of impeded exit, that is, the cost to keep failing business alive, is prohibitive (GOI, 2016). The process of creative destruction should drive out failing, unviable businesses continuously. This is a sine qua non of an efficient, effective and efficacious market economy. Joseph Schumpeter described this market process as creative destruction. He suggested: Capitalist reality is first and last a process of change. It is sometimes the case that a business, which is not efficient, can be made efficient with a change of the entrepreneur or persons in charge of the business. For this change, entrepreneurs need to be provided with easy entry and exit opportunities from the markets (Schumpeter, 2003). If it is onerous for an entrepreneur to exit a business, he would not be starting it. The state intervention should enable entrepreneurs to get in and get out of business with ease and release them form genuine business failures. The greatest successes come from having the freedom to fail (YouTube, 2017). In Silicon Valley, touted as the global centre of entrepreneurialism, the notion of ‘failing is succeeding’ has ingrained itself such that entrepreneurs, who may have gone through one or more business bankruptcies, are looked up to with honour.

IMPORTANCE OF INSOLVENCY LAW

Given the above set of central issues facing an economy, we proceed to present the role of insolvency and bankruptcy law, in the form of effective state intervention, in the larger milieu of economic legislation to serve as a forerunner for enhanced economic growth.

Exit barriers may be economic, strategic or emotional, which keep firms in the business even when they are not in the best of financial health. Such exit barriers do not allow distressed firms to exit impeding efficient allocation of limited resources of an economy. This also hinders technological progress precluding new technologies to replace the old. Easy exit procedures are imperative to encourage entrepreneurship. Laws which trap businesses in lengthy court proceedings or impose penal provisions on bankruptcy muzzle risk-taking entrepreneurship (Porter, 1976).

One of the considerations for an exit by a corporate is also the availability of an efficient insolvency regime in a country. Effective insolvency regimes, while coming into play at the end of the business life cycle, have an overwhelming impact on the commencement of the cycle, ensuring the willingness of banks and investors to lend and that of entrepreneurs to enter the market, taking some amount of risk. An effective insolvency law can provide a much-needed orderly process for the reorganization or liquidation of insolvent entities. It provides comfort in the form of a safety net for business activity by offering mechanisms for rescue or value, maximizing exit from the business. An effective system for insolvency and business exit must be able to timely distinguish between those firms that can be saved and those that must exit fast.

A good insolvency regime should inhibit the premature liquidation of sustainable businesses. It should also discourage lenders from issuing high-risk loans, and managers and shareholders from taking imprudent loans and making other reckless financial decisions (Djankov et al., 2008). A firm suffering from poor management choices or a temporary economic downturn can still be turned around. When this happens, all stakeholders benefit. Creditors can recover a larger part of their investment; more employees keep their jobs, and the network of suppliers and customers is preserved. Studies show that effective reforms of creditor rights are associated with lower costs of credit, increased access to credit, improved creditor recovery and strengthened job preservation (Klapper & Clasessens et al., 2002; Neira, 2019). If at the end of insolvency proceedings, creditors can recover most of their investments, they can continue reinvesting in firms and improving companies’ access to credit. Similarly, if a bankruptcy regime respects the absolute priority of claims, secured creditors can continue lending and confidence in the bankruptcy system is maintained (Armour et al., 2015; Djankov, 2009).

While the importance of a well-functioning insolvency resolution framework is well recognized, different countries have approached it differently, such that there is no single, internationally accepted regulatory framework for organizing an efficient insolvency resolution process. These differences stem from differences in the underlying economic context, legal traditions, institutional structures and political economy of a nation. Furthermore, insolvency laws have witnessed evolution over long times based on the changing needs of the stakeholders (Sharma & Sengupta, 2015).

INSOLVENCY AND BANKRUPTCY LAW IN INDIA

The reforms in India, in the 1990s, focused on freedom of entry. It ushered in liberalization, privatization and globalization. It dismantled the license-permit-quota Raj ¹ when discretionary license gave way to an entitlement of registration. It allowed firms meeting the eligibility requirements to raise resources, without requiring any specific approval from the state, to facilitate freedom of entry. The reforms in the 2000s focused on creating a free and fair market competition. It moved away from the control of monopoly of firms to promote competition among firms at the marketplace. Size or dominance, per se, was no longer considered bad, but its abuse was. The reforms provided a level playing field and competitive neutrality and prohibited firms from restricting the freedom of other firms to do business.

The index of economic freedom, which measures the degree to which the policies and institutions of an economy are supportive of economic freedom, has substantially improved for India since the 1990s. The outcome has been astounding. The average growth rate in the post-reforms period since 1992 has been more than double than that in the pre-reforms period. Today, India is the fastest growing, trillion dollar economy and the sixth largest in the world. The Indian economy moved from socialism with limited entry to marketism without exit, leading to substantial cost of impended exit (GOI, 2016).

Given that the resources are scarce, and failures are not unusual in a dynamic market economy, India needed a codified and structured market mechanism to put the underutilized resources to more efficient uses continuously and free entrepreneurs from failure. The significance of this mechanism can be gauged from the fact that it was the absence of the same which led to some sick private sector enterprises to be taken over the government and nationalized sectors in the1960s and the 1970s.

Several attempts were made to provide legal and institutional machinery for dealing with a debt default. However, these had not kept pace with the changes in the Indian economy. While provisions for recovery action by creditors were available through the Indian Contract Act, 1872, special laws such as the Recovery of Debts and Bankruptcy Act, 1993 and the Securitization and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002, they did not yield desired outcomes. Further, action through the Sick Industrial Companies (Special Provisions) Act, 1985 and the winding-up provisions under the Companies Act, 1956 were not proving to be very helpful for either recovery by lenders or restructuring of firms. The laws dealing with individual insolvency, namely the Presidential Towns Insolvency Act, 1909 and the Provincial Insolvency Act, 1920 were also archaic and not suitable to the changing needs of the time. This hampered confidence of lenders and consequently, the debt market. While secured credit from banks was a predominant form of credit, the corporate debt market was yet to develop (GOI, 2016).

ENACTMENT OF THE INSOLVENCY AND BANKRUPTCY CODE, 2016

In the backdrop of these rather unsuccessful experiments, the stressed assets in the banking system reached unacceptably high levels by the end of 2015. By September 2016, it reached about 9 per cent of gross loans of all banks and 12 per cent of gross loans of public sector banks, which accounted for more than 80 per cent of total non-performing assets (NPA). On the corporate side, major companies were operating with an interest coverage ratio of less than 1, implying an inability to service debt obligations. Thus, what emerged is popularly referred to as the Twin Balance Sheet problem where both the banks and the corporates were reeling under the stress of bad loans.

It was amidst this state in 2016 that the Insolvency and Bankruptcy Code, 2016 (Code) was enacted on 28 May 2016, which reformed the existing institutional structure for insolvency and bankruptcy resolution and replaced the erstwhile regime with a modern and well-structured law. The objective of the Code is to consolidate and amend the laws relating to reorganization and insolvency resolution of corporate persons, partnership firms and individuals in a time-bound manner for maximization of value of assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders. The Code consolidates laws on insolvency and applies to companies, limited liability partnership firms, other body corporates, personal guarantors, partnership firms, proprietorship firms and individuals. ² It establishes a linear, collective process which is binding on the debtor, creditor and all other stakeholders. In the case of corporate insolvency, it provides creditors with a chance to assess the viability of the corporate debtor (CD). A corporate insolvency resolution process (CIRP) under the Code ends up with a resolution plan rehabilitating the failing CD or commencement of liquidation of the CD. Individual insolvency proceedings can proceed either through a fresh start process that results in the write-off of qualifying debts or through the insolvency resolution process, which would provide debtors with a chance to negotiate payments. A bankruptcy process, entailing sale of the assets of the debtor, can arise on failure of the insolvency resolution process. ³

India did not have any prior experience of a law for insolvency resolution that was proactive, incentive-compliant, market-led and time-bound. Many institutions required for the implementation of a modern and robust insolvency regime did not exist. The Code and the reform envisaged under the Code was, in many ways, an experiment in economic legislation. The swiftness of the enactment and implementation of the code probably has no parallel inside or outside the country.

The Code addresses four fundamental concerns of the erstwhile corporate insolvency regime:

The enterprise value of the firm reduces exponentially with time, as prolonged uncertainty about its ownership and control and general apprehension surrounding insolvency may make the possibility of resolution remote. The Code mandates closure of resolution process in a time-bound manner to preserve the value.

A key innovation of the Code is the four pillars of institutional infrastructure that it establishes. First of these pillars is a class of regulated persons, that is, Insolvency Professionals (IPs). They play a key role in the efficient working of the insolvency, liquidation and bankruptcy processes. The second pillar is a new industry of the Information Utilities (IUs). These store facts about lenders and terms of lending in electronic databases and eliminate delays and disputes about facts when default does take place. The third is the AA, namely the National Company Law Tribunal (NCLT) acting as the forum where corporate insolvency is heard and Debt Recovery Appellate Tribunal where individual insolvencies are heard. The fourth pillar is the regulator, namely the Insolvency and Bankruptcy Board of India (IBBI) which has regulatory oversight over the processes and professionals under the Code.

PROGRESS SO FAR

The entire regulatory framework and ecosystem for corporate insolvency resolution was put in place by the end of 2016, and debtors and creditors started using the Code for resolution. The Code added resolution to the choice set of banks to tackle the menace of NPAs. A bank can choose between resolution and recovery, and it has many options for resolution as well as recovery. Resolution under the Code is not an addition to its recovery menu.

The Code has created a cohesive and comprehensive ecosystem that cements the processes and the service providers together towards the achievement of its objectives. With the enactment of the Code, India has witnessed the birth of two professions, namely insolvency profession and valuation profession, that have professionalized insolvency services. The Code has opened unlimited possibilities of resolution, including merger, amalgamation and restructuring of any kind, which often requires professional help. This has created markets for services of IPs, IPAs, registered valuers (RVs), registered valuers organisations (RVOs), insolvency professional entities (IPEs) and IUs and expanded the scope of services of advocates, accountants and other professionals. There are presently around 3,000 IPs, 3 IPAs, 69 IPEs, 3,030 RVs and 12 RVOs. The Code has also created markets for education and capacity building of these professionals.

Debtors and creditors alike are utilizing the provisions of the Code. Till March 2020, about 3,700 corporates, including some with very large NPAs, have been admitted into CIRP. About 1,135 CIRPs have completed the process either by yielding resolution plans or by ending up with orders for liquidation. A total of 312 processes have been closed on appeal or review or settled, and 157 have been withdrawn. Another 669 firms have commenced voluntary liquidation. Rich jurisprudence has developed. The government has been proactively addressing the issues that come up in the implementation of the reform. Since its enactment in 2016, the Code has been amended four times, within a short period, mainly to streamline the processes and address any emerging deficiencies.

KEY OUTCOMES

An assessment of the design of an insolvency regime can be guided by a measurement of the effectiveness, efficiency and efficacy of the insolvency procedures (Garrido et al., 2019). Effectiveness of an insolvency regime can be ascertained by measuring the extent to which an insolvency system achieves its intended objectives. Looking at this measure about the objectives of the Code, the results are quite visible. One of the key goals of the Code is the maximization of value of assets of the CD in financial distress while it is undergoing a CIRP. The Code enables this by requiring the creditors to make a collective endeavour to revive the failing CD and improve utilization of the resources at its disposal. If revival is not possible, the Code releases resources for other efficient uses. In either case, the value of the assets of the CD improves. It prevents depletion of value by enabling early initiation of the process for revival and expeditious conclusion of the process. In fact, the CD would be tempted to initiate process early to minimize potential loss to creditors. The Code mandates the Resolution Professional (RP) and the liquidator to determine if the CD has been subject to irregular transactions, such as preferential, or fraudulent, or undervalued, or extortionate transactions in the past, and if so, he is obliged to file an application with the AA for appropriate directions. This exercise not only helps recover lost value for the stakeholders but also deters the management from indulging in such transactions. This will cleanse the corporate governance and improve the confidence of stakeholders.

The Code attempts to meet its other objective of promoting entrepreneurship by reducing the incidence of failure, by incentivizing prevention of failure, rescuing failing businesses, wherever possible and releasing resources from failed businesses wherever required. It enables an honest entrepreneur to make an orderly exit if his enterprise fails despite his best of intentions and efforts. Thus, the possibility of failure does not hold up an entrepreneur from commencing a business or implementing a new idea.

Efficiency parameter measures the extent to which the insolvency system achieves its objectives with the minimum use of resources. It measures the relationship between inputs and outputs. In effect, an efficient system would translate into a quick resolution of financial distress with maximum recovery and minimum costs. The recovery rate under an insolvency procedure is a function of time, cost and outcome. The Code provides a timeline of 330 days to conclude a CIRP. Probably, no other regime in the world mandates a time-bound resolution. This push has meant that proceedings under the Code take on average about 350 days, including time spent on litigation, in contrast with the previous regime where processes took about 4.3 years. The insolvency resolution process cost has been reduced immensely from the levels of about 9 per cent of the estate value under the previous insolvency framework.

In a matter of over 3 years, approximately 25,000 cases have been filed under the Code, of which around 3,000 cases have been admitted. A total of 221 cases have yielded resolutions, and 914 resulted in liquidation. About 2,170 cases were undergoing CIRP as on 31 March 2020.

Efficacy is the measure of the extent to which there exists a connection or contribution of the insolvency system (sub-system) with higher-level systems like legal, economic and financial systems. The efficacy of the Code can be evaluated on the basis of the positive spillover effects of the Code on the stakeholders and various units of the economy in general. In this regard, the Code has had an impact on the credit market. The Code is also helping in resolving the NPA problem of the banking system. Some of the large cases of NPAs, such as Bhushan Steel, Electrosteel Steels, Alok Industries, Jyoti Structures Ltd and Monnet Ispat & Energy Ltd have been resolved, and financial creditors have realized their dues.

According to RBI’s Financial Stability Report (FSR) (RBI, 2019), the increased pace at which NPAs were recognized led to the NPA cycle peaking in March 2018. With most of the NPAs already recognized, the NPA cycle turned around with GNPA ratio declining to 9.3 per cent in September 2019.

Beyond realization for creditors and revival of firms, the Code has ushered in significant behavioural changes resulting in substantial recoveries for creditors outside the Code and improving the performance of firms. The credible threat of a resolution process that may shift the control and management of the firm away from existing promoters and managers, most probably, forever, is acting as a deterrent for the management and promoters of the firm from operating below the optimum level of efficiency. It is further motivating them to make the best efforts to avoid default. Further, it encourages the debtor to settle default with the creditor(s) at the earliest, preferably outside the Code. There have been several instances where debtors have settled their debts voluntarily or have settled debts after filing an application for CIRP with the AA, but before the application is admitted. There are also cases of settlements after an application is admitted. The Code has thus brought in significant behavioural changes and thereby redefined the debtor–creditor relationship. With the Code in place, non-repayment of loan is no more an option, and ownership of the firm is no more a divine right and equity is no more the only route to own a firm.

The Code is also instilling confidence among the stakeholders with respect to the financial system in general. As per the Systematic Risk Survey reported in the FSR of June 2019, about 50 per cent of the respondents felt that the prospects of the Indian banking sector are going to improve marginally in the next 1 year aided by the stabilization of the process under the Code which will also play a key role in enhancing the confidence in the domestic financial system. As the implementation of Code strengthens going forward, and framework for individual insolvency is also in place, it is expected that it would contribute immensely to government’s start-up initiatives.

RECOGNITIONS

Swift implementation of the Code got reflected in Ease of Doing Business. The World Bank’s Ease of Doing Business Report (DBR) has recognized India’s efforts at resolving insolvency easier. India’s ranking in resolving insolvency improved from 136 in the DBR for 2017 to 103 in the DBR for 2018. India further recorded a remarkable improvement in its ranking in the ‘resolving insolvency’ parameter, being placed at the 52nd position in the report released in October, 2019. India is now, by far, the best performer in South Asia in this parameter and does better than the average for Organisation for Economic Co-operation and Development (OECD) high-income economies,

MYTHS SURROUNDING THE CODE

When new legislation is enacted, the market hinges all its hope on the new law, hoping that it would resolve all market failures at the very first instance. As the new law is enforced, its intended outcomes take time to materialize on the ground. In the meanwhile, the market draws certain conclusions about the outcomes of the law based on a few initial results, which quickly metamorphose into popular myths. Three years into operation, while the Code has brought about several changes and its outcomes are quite discernible, there a few misconceptions about this new law which stem largely from the lack of complete understanding of the intent of the law and the processes involved. Some of these myths are attempted to be dispelled here.

CONCLUSION

The legal framework of insolvency and bankruptcy impacts a number of economic indicators such as credit growth, job preservation, employment creation and entrepreneurship and in turn, overall economic growth. It also causes behavioural changes in terms of affecting the willingness of investors, banks, companies and entrepreneurs to take risks. Each of the central economic issues pointed out at the outset of this article, can be said to be, in some form, addressed by the modern, comprehensive insolvency and bankruptcy law in the form of the Code. The implementation of Code has started demonstrating its results on each of these fronts, and as the new regime matures, further progress is likely to be visible.