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How can the proposed code lead towards a robust bankruptcy framework

Why a new code and what’s wrong with the prevailing framework?

Today when a firm runs into trouble, typically creditors take the legal recourse and follow a court process (through a Debt Recovery Tribunal or a court-appointed Official Liquidator) to recover their dues. The secured lenders (typically banks) possess the additional tool of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (Sarfaesi) to enforce collateral and initiate recovery. We also had the Sick Industrial Companies Act (SICA) and the Board for Industrial and Financial Reconstruction (BIFR), which were restricted to industrial units and have largely been ineffective due to their inherent shortcomings.

Historically, the above options have been: (1) excessively long-drawn (partly because of the burdened resources of the courts); and (2) devoid of any collective action among the creditors (limited to restricted collective action in out-of-court mechanisms like CDR/JLF, that too only among the banks).

In the entire process, the asset/business value gets destroyed rapidly as the firm runs out of resources to continue operations. This ultimately leads to much lower recovery rates than potentially achievable in a scenario where there is a robust framework which ensures timely resolution and a collective process for liquidation.

Under the recently introduced Strategic Debt Restructuring (SDR) framework by RBI, the control gets transferred to debt holders from equity holders on default. This is a positive step in the direction of paving way for a robust bankruptcy framework. However, as an SDR mechanism does not fully amend legislation especially under the Companies Act and other laws, the measure is at times not as effective as intended.

What does a sound bankruptcy law promise to deliver?

A developed bankruptcy law essentially provides a transparent and predictable process to be followed by the debtor and creditors during insolvency; enables a collective effort to preserve value with fairness to all stakeholders; and is a time-bound process to reach definitive conclusions on closing or continuing the business. This is enabled through information sharing between debtors and creditors, a time-bound resolution, and one law to deal with bankruptcy as against multiple acts at present. At its heart, it suggests a commercial resolution without burdening the courts excessively. It would result in a better business environment and ease in debt rising.

What are the key features in the proposed code that will essentially lead towards a robust bankruptcy framework?
* Consolidating legislative framework: This aspires for a unified code to resolve all insolvencies in order to ensure greater legal clarity and make the resolution process for individuals as well as enterprises more synchronous.
* Assessing viability at an early stage: The code emphasises that the legislature is not meant to make business decisions and viability is purely a matter of negotiation between the debtor and the creditor. This will help in striking a balance between liquidation and reorganisation.
* Providing a calm period to stay all claims: The provision for temporary immunity to ensure interim focus on ascertaining realistic business potential in order to resolve insolvency and also limit inter-creditor conflicts.
* Symmetry of information between creditors and debtor: An emphasis on availability and access to essential information by all creditors.
* Respect rights of all creditors: Impartial law, acknowledging all classes of creditors to play a vital role in the insolvency process.
* Clarity on ownership and control after default: Transfer of control to creditors on default.
* Empowering insolvency professionals (IPs): This will help in preserving value and time.

What could be the challenges?

Broadly, the challenges that might arise during implementation of the framework would either be of operational nature or will comprise of legal/systemic challenges.

As far as operational challenges are concerned, they would arise while setting up the Board for Insolvency and Bankruptcy (Regulator), or while setting up of all the processes, IP exams, setting up of information utility, etc, ensuring support from all stakeholders (especially the promoters) and financing during the calm period. Who will finance, under what terms, what will be the safeguards to protect, etc, will be some of the questions that will have to be addressed.


Whereas legal or systemic challenges would comprise of getting the law approved in Parliament, weak implementation history of similar laws introduced in the past, no existing set-up for the tribunal (CLT)/adjudication infrastructure, lack of experienced judges in dealing with insolvency cases, lack of clarity on overriding power in case of conflict with existing laws, legal options with promoter if he/she is unwilling to cooperate.

Which are the areas that need refinement/improvement in the proposed framework?

The BLRC report does not include a lot of procedural details as the committee believed that it needs to evolve with practice and much of the nitty-gritties of the law will be drafted by a regulator.

Definitely, there are certain aspects that the code may look to refine or the future regulator may want to detail going forward. Some of the key aspects should include:
* Credit committee composition: Currently, credit committee to comprise of only financial creditors. However, operation creditors to be paid out first. This may lead to conflict between the two creditor classes.
* New financial arrangement: If business is found to be viable, possibility of a new financial arrangement between the debtor and the creditor is envisaged in the code. However, the contours of the new arrangement with the lenders and treatment of the new finance arrangement from asset classification and provisioning perspective can be clarified.
* Waterfall priority: Central and state government liabilities will be placed below creditors’ claims to ensure lender confidence continues. It may be clarified if this means that employee PF liabilities will get a lower priority. This is important to understand as it directly affects the employee compensation and welfare. Also, one may need to assess if this, potentially, would lead to huge write-offs by statutory bodies.
* Two-year history: For ascertaining malfeasance, two years of history to be checked for diversion. What if the diversion happened more than two years ago?
* Promoter buyback: Promoters have the option to buyback the company at a certain price, with a certain debt restructuring. This has to be contemplated further to avoid the bankruptcy tool from becoming an instrument to be exploited to reduce debt and increase equity value going forward.

The author is partner & national leader, Financial Services, EY India

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First published on: 29-12-2015 at 00:25 IST