The Insolvency and Bankruptcy Code (Amendment) Act, 2019 has moved towards recognizing the absolute priority rule (APR). This rule suggests that in an insolvency resolution, the claims of a class of creditors must be paid in full before any junior class of creditors may receive or retain any property in satisfaction of their claims, unless the more senior class consents to such a departure.
APR originated in the US about a century ago. Since then, many American insolvency scholars have criticized the APR and suggested various alternatives. One important alternative is the relative priority rule (RPR).
The American Bankruptcy Institute (ABI) has recently considered eliminating the APR in favour of the RPR. In this context, we explain the primary economic function of the RPR, and analyze which rule is better suited for India’s fledgling insolvency regime.
To appreciate the difference between the APR and RPR, a simple hypothetical example is convenient. Imagine a financially distressed company with two creditors. The senior creditor made a loan of ₹150 and the junior creditor made a loan of ₹50. Also, assume that if the business of the company is continued, there are two equally probable possibilities after one year – in good state, the business would be worth ₹200, and in bad state, it would be worth nothing. Assuming the discount rate to be zero, the present value of the business would be (200)(0.5) + (0)(0.5) = ₹100. The APR and RPR provide different ways for distributing this value among the creditors.
Applying the APR, the senior creditor must be paid in full before the junior creditor receives any value. Consequently, in this case, the entire present value of ₹100 should go to the senior creditor, and the junior creditor should get nothing. However, after one year, if the good state actually materialises, the business would be worth ₹200. In that case, even after satisfying the senior debt of ₹150, the junior debt of ₹50 could also be satisfied. However, the APR would have destroyed the junior creditor’s right to this future value. In short, by collapsing all future possibilities into the present value, the APR destroys the potential value in the junior creditor’s claim.
In contrast, the RPR helps protect this potential value in the junior creditor’s claim. It keeps the future possibilities open by issuing a call option to the junior creditor. This option could be exercised after one year at the strike price of ₹150 (face value of senior debt). In other words, after one year, the junior creditor has a right, but not an obligation, to buy out the business from the senior creditor for ₹150.
Consequently, if the good state materialises, the junior creditor could simply buy out the business worth ₹200 for only ₹150, thus gaining ₹50 – its full claim amount. In bad state, the option would be worthless.
In practice, the junior creditor may not be in a position to wait for one year to exercise the option. Instead, it may wish to cash out the value of the call option during the resolution. At the time of resolution, the value of the call option would be ₹(50)(0.5) + (0)(0.5) = ₹25. Therefore, under the RPR, the junior creditor would be entitled to ₹25, while the senior creditor would be entitled to the ₹75.
Now, it would be useful to understand whether the APR or RPR is better suited to the Insolvency and Bankruptcy Code, 2016 (IBC). First, the main advantage of the APR is its simplicity. The same cannot be said of the RPR, because it involves complicated option valuation. Disputes could arise regarding the strike price and strike date. This may increase litigation risk and judicial discretion, which would be counterproductive to efficient resolutions under the IBC.
Second, the IBC is geared more towards going concern sale of a distressed business. In such sales, potential third-party buyers would ideally want to purchase the distressed business free and clear of all existing liabilities. Consequently, it may not be possible to follow the RPR and issue call options to junior creditors in third-party sales under the IBC.
Third, the RPR is more suitable for restructuring transactions. In such cases, the existing claimants simply put a new capital structure in place without a market sale. As a result, the main concern in a restructuring is how to allocate securities in the restructured business among the various claimants. Here, issuing call options to junior creditors may be a feasible solution.
In India, restructurings are more likely to happen pre-IBC under the Reserve Bank of India’s Prudential Framework for Resolution of Stressed Assets. Therefore, the RPR may be practical at that stage. In light of these, it is submitted that the APR is better-suited for IBC resolutions, while the RPR may be considered for pre-IBC restructuring.
Pratik Datta is a senior research fellow, and Varun Marwah is a research fellow at Shardul Amarchand Mangaldas & Co. Shardul S Shroff, executive chairman and national practice head – insolvency & bankruptcy at the firm, also contributed to this article.
Shardul Amarchand Mangaldas & Co
Amarchand Towers, 216 Okhla Industrial Estate
Phase III, New Delhi, 110020, India
Tel: +91 99586 96900
Email: [email protected]
Email: [email protected]
Email: [email protected]