Insolvency and Bankruptcy in India: Weaknesses in present law and proposed reforms.

The current Indian bankruptcy regime is highly fragmented, implemented by multiple judicial forums resulting in a lack of clarity and certainty in jurisdiction.  There is no single law that deals with corporate insolvency and bankruptcy; there are rather, several statutes that deal with debt recovery (the RDDBFI Act, 1993 and the SARFAESI Act, 2002); with the “revival and rehabilitation” of “sick” industrial companies (the Sick Industrial Companies Act, 1985 (“SICA”)), the liquidation of companies (the Companies Act, 1956).  In addition, Banks have recourse to the corporate debt restructuring (CDR) and joint lenders forum (JLF) mechanism for resolving stressed consortium loans. 
 
Each of these suffer from limitations on issues ranging from applicability, objective and effectiveness.  The RDDBI Act and SARFAESI apply only to banks ad not to foreign banks and non-bank lenders (increasingly important sources of funding for business of in India); they are also aimed at debt recovery rather than assessment of an enterprise as a going concern.  The SICA applies only to industrial companies as borrowers (when India is increasing a services-led economy).  CDR and JLF also apply only to regulated banks and non-banking finance companies and are meant as banking regulation to give capital relief rather than address insolvency in a systemic manner. 
 
Ravi (2015) demonstrates that this patchwork of laws applicable to different stakeholders results in the current system being unable to achieve the fundamental principles of any insolvency law regime- certainty in the law, predictability in outcomes and timely resolution of insolvency.  There are several proceedings on the same matter that happen in parallel, decisions are often appealed, stayed or overturned by multiple judicial forums having concurrent or overlapping jurisdiction.  There is no clarity on whether the right of a secured creditor who has initiated recovery under SARFAESI will prevail, or that of unsecured creditors who initiated winding-up under the Companies Act or that of the company who may trigger proceedings under the SICA.  This is in addition to issues of judicial capacity.
 
Substantive issues exist with even the initiation of insolvency or winding up process.  SICA, for instance is triggered when more than half a company’s networth has eroded.  Already much too late, research has shown that Board for Industrial and Financial Reconstruction (BIFR) and High Courts are reluctant to liquidate unviable companies.  In Kristin van Zwieten’s paper titled: Corporate rescue in India: the influence of the courts, she examined over a thousand cases from a range of courts to demonstrate that the BIFR and the High Courts often acknowledge that a company cannot continue and repay its debts and yet keep it going, unwilling to liquidate it, fearing loss of jobs and labour unrest. 
 
Ironically, the trigger for winding up a company is too low – a default of INR 500.  This effect becomes too late as Courts do a full hearing on merits at the admission stage itself, dragging on proceedings and limiting the efficacy. 
 
Creditors, especially the non-bank ones do not have access to a mechanism to assess the viability of an enterprise and systematically addressing the problem, without the threat of other proceedings initiated by the debtor or other creditors torpedoing them. 
 
Even when proceedings are triggered, the debtor’s existing management retains control thereby creating the risk of asset stripping.  Under SARFAESI, creditors are empowered to take over the management of a company in a limited manner- only that part of the company that is connected to the secured asset.  Also the potential liability to creditors is high, so this is rarely invoked.  Again, there is no corresponding provision for non-banks. 
 
There is no linearity of proceedings.  Under SICA, even if the BIFR recommends liquidation, a reference is made to the High Court, who would reexamine the recommendation; potentially even reverse it.
 
With an aim to address the aforesaid problems, provide for quicker recovery, allow unviable business to shut down, empower all stripes of creditors and preserve and redeploy capital for more productive uses, the Ministry of Finance formed the Bankruptcy Law Reform Committee which submitted its report and a draft Insolvency and Bankruptcy Code (“IBC”) in November 2015.  The IBC was tabled in the Lok Sabha on 21 December 2015.  With the proposed IBC, the labyrinth of extant Indian laws dealing with corporate insolvency are being replaced by a single comprehensive law that (a) empowers all creditors-secured, unsecured, domestic, international financial and operational to trigger resolution (b) enables resolution process to start at earliest sign of financial distress (c) provides a single forum overseeing all insolvency and liquidation proceedings, (d) enables a calm period where other proceedings do not derail existing ones, (e) replaces existing management during insolvency proceedings while keeping the enterprise as a going concern, (f) offers finite time limit within which debtor’s viability can be assessed and (g) under bankruptcy, lays out a linear liquidation mechanism. 
 
Some of the key features of the insolvency resolution process (“IRP”) and liquidation under the IBC have been discussed hereafter. 
 
Distinction between financial and operational creditors:The IBC makes a distinction between financial creditors (creditors, both secured and unsecured; who have extended credit for interest, rather than in exchange for the provision of goods and services) and operational creditors (creditors who have extended credit in exchange for goods and services).  This distinction is made in order to (a) treat both secured and unsecured creditors equally for initiating an insolvency resolution process and participating the decision making process; (b) empowering an operational creditor to trigger an insolvency resolution process, but not participate in the decision-making since they would be paid at least the liquidation value.  This seeks to rebalance the present position where secured lenders have far more power than unsecured lenders.  It is hoped that this will aid the development of alternative sources of credit such as the bond market. 
 
Trigger:The primary principle of IBC is to detect distress as soon as possible and resolve it (as against existing statutes where this is to early or too late.  To this end, it enables the insolvency resolution process to be triggered by the occurrence of a single default.  IBC prescribes penalties for false and frivolous triggers as a disincentive to creditors triggering IRP for extraneous reasons. 
 
Debtor Not In Control During IRP: A regulated insolvency professional is appointed and is empowered to run and manage the entity (when it is a going concern), and the assets of the entity during the process of an IRP.  This is to prevent the possibility of asset-stripping or siphoning during this IRP period.  IBC also provides for the suspended management of an entity to cooperate with the Resolution Professional. 
 
Moratorium:During an IRP, there is a time bound moratorium against debt recovery actions and any new cases filed against the debtor.  This helps assure creditors and the impugned debtor that the assets are protected while they negotiate and assess the viability of the entity. 
 
Business Decisions by a Creditor Committee:All decisions on matters of business will be taken by a committee of financial creditors.  The matters on which decisions can be taken by such committee include evaluating proposals to keep the entity as a going concern, decisions about the sale of business or units, retiring or restructuring of existing debt.  The debtor will be a non-voting member on such creditors’ committee, and will be invited to all meetings.  The decisions taken by the creditors’ committee will be by way of a majority of 75% of the creditors– reckoned by debt outstanding to each such creditor. 
 
No Prescriptions on Solutions to Resolve the Insolvency:IBC provides flexibility in manner in which the entity will be maintained as a going concern and such manner will be decided and voted on by the creditors’ committee.  Other than the majority vote of the creditors’ committee, the Resolution Professional is required to confirm to the Adjudicator that the final solution voted on by the creditors’ committee complies with the following three requirements:

1. the plan must explicitly require the repayment of any interim finance availed by the entity.  Further, costs of the IRP are required to be paid in priority over other payments;
2.  the plan must explicitly include payment to all creditors that are not members of the creditors’ committee, within a reasonable period after the solution is implemented; and
3. the plan must comply with existing laws applicable to the entity while implementing the solution. 

An Irreversible, Time-Bound Liquidation with Defined Payout Prioritization:In the eventcreditors cannot agree on a solution within a period of 180 days from the start of the proceedings, the Adjudicating Authority will automatically pass a liquidation order along with accompanying orders to: (a) appoint a liquidator; (b) move assets into a liquidation trust, which will be managed by the liquidator; and (c) to change the name of the entity reflected in the registration records to include the phrase “in-liquidation” to its original name.  Under the IBC, there is a clear responsibility of the liquidator, to maximise the value of the assets of the entity in the most efficient manner of disposal. 
 
Distribution Waterfall:As per the waterfall set out in the IBC, the costs of the IRP and liquidation have first priority, followed by secured creditors, who share second priority on a pari passu basis with dues owed to workmen for a defined period of 3 months.  Interestingly, unsecured financial creditors such as bondholders have higher priority over state dues.  This should also give stimulus to the bond.
 
This single comprehensive code with a simple, early trigger, timebound proceedings, linearity between insolvency and liquidation and clarity of priorities in liquidation should help overcome some of the existing weaknesses in the present framework. 

Richa Roy is a Senior Associate with AZB & Partners.  Her focal practice areas are banking and financial services, private equity and venture capital funds and foreign inward investment law. 

She has advised on the structuring and setting up of several funds and feeder structures investing in capital markets, real estate, private equity and other asset classes in India and drafted and negotiated key documentation in this regard, including subsequent investment by such funds.  She has advised on several diverse bank regulatory and securities law issues including relating to the offer of a large Indian bank’s private wealth management products in 50 countries across the world and helped set up a compliance program in this regard. 

Richa took her B.A.LLB (Hons.) from the National Law School of India University, Bangalore, in 2005 and began her career at ICICI Bank Limited, Mumbai, in the same year.  Since 2008 she has been with AZB & Partners.

Richa can be contacted on richa.roy@azbpartners.com