India’s Insolvency and Bankruptcy Code has been operational for more than a year but how does it stand up to critical analysis? Shardul S Shroff offers an assessment
In May 2016, India enacted the Insolvency and Bankruptcy Code, 2016 as a major legal reform. The code is not fully effective. The sections of the code that deal with insolvency of companies were notified on 1 December 2016, but the sections of the code that deal with the bankruptcy of individuals are yet to be made effective.
One year is not adequate time to examine the efficacy of a legislation. Nevertheless, the past year has been eventful, specifically because:
- The banks suffering from a huge cache of non-performing assets did not initiate proceedings on their own to take benefit of the code, and India’s central bank had to issue directors to the banks to initiate insolvency proceedings against 12 large defaulters with aggregate non-performing assets worth 25% of the gross non-performing assets in India’s banking system; and
- The application of the code to real situations has brought to light several practical difficulties, some of which can be remedied only through an amendment to the code.
Suspension of board of directors
In order to trigger insolvency proceedings, a creditor can make an application to the National Company Law Tribunal (NCLT). When the NCLT admits the application, it appoints a resolution professional (RP) on an interim basis, who is later confirmed or replaced. Once the RP is appointed, the board of directors of the company in insolvency stands suspended, and the powers of the board vest in the RP. The RP has unrestricted powers to manage the company, except that the RP needs the approval of the Committee of Creditors (COC) for deciding certain specified matters.
Suspension of the board and its substitution by the RP has resulted in several practical difficulties. The RP, being an individual, often finds it difficult to manage a company that is new to him/her, and effectively replace the directors. In addition, sometimes one individual is appointed as RP in more than one company.
In the initial cases of insolvency, RPs have been generally outsourcing their responsibilities and entering into consulting/advisory agreements with the organizations to which they are appointed. In addition to the issue of conflict of interest, this raises multiple questions, specifically whether an RP can outsource its statutory responsibilities, and can those responsibilities be performed by someone who may not be qualified to become an RP.
The Insolvency and Bankruptcy Board of India (the regulator under the code) has recently issued several circulars to regulate the conduct of RPs, with the most recent circular issued on 16 January 2018 to require disclosures by the RP and its advisors to address the issues of conflict of interest. However, a lasting solution would be to amend the code and provide for a more robust mechanism for substitution of the board of directors. Illustratively, in case of large companies, instead of one individual an entity could be appointed as an RP. In addition, there should be a prohibition on an individual from accepting appointment as an RP in more than one company, and outsourcing statutory responsibilities.
No end date for resolution process
The code has a much publicized timeline of 180 days (extendable once, by up to 90 days). However, this timeline is for submission of a COC-approved revival plan (a resolution plan) with the NCLT. There is no timeline for the NCLT to approve a resolution plan.
This results in several practical problems. There is no certainty in term of time, as the NCLT can take any amount of time. This may result in problems for funding for the insolvency company during the interim period. In addition, the tenure of the RP ends upon expiry of 180 days (as extended), and there is no express stipulation in the code regarding management of the company in the interim period.
At present, resolution plans provide for different mechanisms for management of a company between expiry of 180 days (as extended) and approval of the NCLT, or receipt of other regulatory approvals. An effective solution would be to not leave the management in the interim period to the resolution plan, and amend the code to extend the tenure of the RP until an approved resolution plan is implemented.
There are at least two instances of handover of management under the code. First, when the board is suspended and the RP takes over, and second, when the RP vacates his/her position and the new board takes over.
At present the code does not specify a well-defined mechanism for handover in either case, and there are apprehensions that in the future the new board may find it difficult to gather data for the prior periods. In addition, it may be difficult for the new board to draw up and sign off the accounts for the period prior to appointment of the new board, when the RP was managing the company.
There must be an express obligation to the handover, and a well-defined mechanism listing various activities to complete a handover, including handover of the records, title deeds and property. One of the mandatory handover activities ought to be drawing up accounts, and also audit of such accounts by the statutory auditors, for which the person in management at the relevant must extend co-operation.
Liability, approvals and contracts
Insolvency resolution hinges on a fresh start, and an important aspect of a fresh start is the ability to place a limit on past liability. The code does contain provisions that allow a resolution plan to provide for a limitation of liability, but these provisions are not set out in clear terms. What is lacking in the code is an express and unambiguous provision that imposes a clear limitation of liability with respect to all claims prior to approval of a resolution plan, except in accordance with the resolution plan. Such claims may be under a contract, or towards any regulatory authority. Relatedly, the code should also contain express provisions regarding treatment of contracts to which the company is a party.
In addition, implementation of a resolution plan often requires an approval from other regulatory authorities, such as an approval of certain combinations from the Competition Commission of India, or an approval for transfer of mineral concessions. At present, the code empowers the NCLT to approve a resolution plan, and confirms that it will be binding on all stakeholders, without expressly dealing with the issue of regulatory approvals. If this issue is relevant, as in if a resolution plan cannot be implemented due to lack of a regulatory approval, it is likely to lead to mandatory liquidation of a company in insolvency.
Operational and other creditors
The code classifies creditors into three categories: financial creditors; operational creditors; and other creditors. Financial creditors are banks, non-banking financial companies and financial institutions who have lent money against time value; operational creditors are those who have supplied goods and services, and include government dues and labour dues; and those who don’t fall in either category are other creditors.
The COC comprises only the financial creditors who take all decisions, with a 75% majority, based on their outstanding debt. Operational creditors cannot become members of the COC and consequently can’t vote. This approach has resulted in fears that the financial creditors will focus on their recovery and not payments to other classes of creditors, or revival of the company in insolvency.
The rationale for not providing voting rights to operational creditors was that they would receive a priority payment of liquidation value against their operational debt. In practice, liquidation value is often not sufficient to support payment to operational creditors, as secured creditors are entitled to priority payment from the liquidation value.
Depending on the implementation of the code and selections made by the COC, there may be a need to amend the code to safeguard the rights of the operational creditors and other creditors.
Due diligence, information access
Insolvency resolution process under the code is similar to an acquisition process through competitive bidding, where a resolution applicant (a bidder) submits a resolution plan (bid), and the COC has to select one amongst the several resolution plans based on evaluation criteria.
However, the code does not mandate a detailed due diligence on the company in insolvency, and in absence of a statutory mandate, RPs have been permitting limited due diligence.
The inability to conduct a detailed due diligence, a lack of indemnities, and no express limitation of past liabilities may result in muted price discovery and suppress the value that an acquirer would have assigned.
A statutory obligation to provide access for implementing a due diligence (subject to confidentiality), and an overall limitation of liability, would result in a better price discovery.
The way forward
The code is a radical departure from the law that existed in India for insolvency and bankruptcy, and its implementation so far has resulted in large companies, previously deemed invincible, forced into insolvency. It is expected that the code will be an efficient tool, not just for insolvency, but also to check reckless borrowing, as borrowers will now be cognizant of a real possibility of losing control of their company if they default.
The issues and challenges described above are teething problems that may be easily cured through amendments to the code. The government of India is keen to ensure that the code is efficiently implemented, and it is therefore likely that these issues will be resolved soon.
The author is the executive chairman of Shardul Amarchand Mangaldas and is the national practice head for insolvency and bankruptcy practice at the firm.