Now is a perfect time to introduce a composite code for the resolution of financial service providers, following a series of high-profile incidents in this area, writes Mohit Shukla

Editor’s note: Large banking and financial companies such as Yes Bank, IL&FS, DHFL and others have experienced serious trouble in the recent past, damaging public trust in the financial system. These events have been widely reported.

 

The possible aftermath of COVID-19 is being discussed avidly, and the house is not entirely unanimous as to the degree of doom, and the span of time for recovery, but the mood remains largely sombre. India’s government, too, has focused on fiscal and economic stimuli, including regulatory measures for segments of the financial sector.

With these, will a series of failures in India be in the offing? The hope is that there will not be, or at least, it will be contained. But what instrumentality is best placed to provide for a well-managed handling of situations when a rescue is not otherwise available?

India’s Insolvency and Bankruptcy Code, 2016 (IBC), consolidated and updated various legal provisions aiming to provide for the orderly reorganization, resolution and liquidation of corporations, as well as deal with bankruptcy.

The IBC was intended to be comprehensive, with a finite timeframe and a clear roadmap, and, with regard to corporate insolvency, to provide confidence and clarity to international and domestic businesses as to how matters may pan out once a company enters insolvency. At about the same time, the country also prepared a separate code, the Financial Resolution and Deposit Insurance Bill, 2017 (FRDI Bill), for the resolution of financial services providers.

While the code was hailed for what it offered, it was also criticized for perceived shortcomings. It was subjected to what is described as the “settling-in” phase for new and significant law. In this time, it has seen constitutional challenge, a flurry of amendments necessitated by constituent behaviour, rapid judicial finality to tribunal and appellate interpretation, rule setting and rule tweaking. The belief has persisted that this code will definitely establish and demonstrate that it is for the greater good.

The code’s twin – the FRDI Bill – set out a schematic to monitor banks, insurers and other financial sector entities, to resolve them, merge them, transfer assets and liabilities, and, in the final eventuality, liquidate them in an orderly fashion, and all of this within a fixed timeframe.

This, too, was an attempt to consolidate and update the law, but it remained still-born as debate around it swirled with respect to whether the proposed bail-in was a good or bad thing for depositors. Questions were also raised on whether the proposed recovery and resolution plans were too onerous, whether the global nature of companies needed a globally-natured response, and how that was to be addressed.

On account of apprehensions relating to provisions like the use of the bail-in instrument to resolve a failing bank, the adequacy of deposit insurance cover, the perceived need to substantially revive insurance limits, and the application of a resolution framework for public sector banks – and as resolution of these issues would require examination and reconsideration – the government decided to withdraw the bill from parliament in 2017, and took the proposed legislation back to the drawing board, where it has remained to date.

BALLOONING OF BAD DEBT

Interestingly, over the same period of time, India has witnessed a substantial bad-debt balloon in the banking system for various reasons including alleged window-dressing, ever-greening of non-performing assets, and fraud – the uncovering, as it were, of a systemic malaise.

Significant corporates, as their underpinnings were rattled by the market, economic and commercial changes, and liquidity constraints, were also subjected to the resolution process under the IBC (including by reason of a regulatory mandate to banks in an effort to cleanse balance sheets of non-performing assets), adding to the stress but creating credit opportunities as well.

To add to this, a shockwave went through the system with the sudden collapse in September 2018 of the very large entity in the infrastructure development and finance space, one with an immensely significant group balance sheet, large dues to banks, mutual funds, pension funds and many other constituents, and with no hope at the time of recovery in sight.

In the same month, this also led to a seemingly entirely unconnected wobble at the significant housing finance company, and suddenly there was more emphatic anxiety among a number of significant systemically important non-banking finance companies and groups.

As far as the public sector banks are concerned, the government had to look at significant re-capitalization in this period, a curbing of asset growth, directionally focusing on reduction of non-performing assets, and rationalizing the number of banks through the merger of weak banks with stronger ones.

As far as private sector banks and even co-operative banks are concerned, the banking regulator demonstrated the will for corrective action, and change where it was required, to uphold governance, protect depositors, and stem the tide of bad news.

The entity in the infrastructure business had immense significance as an institution, but it also had an equally immense balance sheet and dues. With the speed at which matters came to a head after the dramatic slide in ratings, the government sought a temporary moratorium on legal proceedings in an application under the provisions of the Companies Act.

This was solely an effort to stave off what could have become an extremely chaotic and disorderly situation, both in terms of a planned putting together of the pieces and focus on salvage, and in terms of the risk to appetite for Indian credit, liquidity and funding.

The National Company Law Tribunal (NCLT) declined this request on the basis that there was no provision in the law for such a moratorium, prompting an urgent appellate application. The National Company Law Appellate Tribunal (NCLAT), confronted with the enormity and the significance of the issue, passed an order not only granting a stay on institution and continuation of legal proceedings, but also temporarily suspended acceleration, by creditors and the exercise by creditors, of the right of set-off.

This was on the basis that the appellate body could pass an appropriate interim order under the Companies Act similar to an order of moratorium under the IBC for resolution of the problems faced by an entity in a time-bound manner, for maximization of value of assets, to promote entrepreneurship, availability of credit, and to balance the interests of all the stakeholders, and, in case of failure of resolution, pass an appropriate order of liquidation.

STAVING OFF POTENTIAL CHAOS

While this order sparked considerable debate and some muted protest as to its basis, it held ground, and the moratorium originally sought for three months lasted for well over a year, and perhaps, unclear though its antecedents may have been in terms of supporting law, and passed as it was on the basis of exercise of discretionary powers, it served its purpose of sensibly staving off much potential chaos and havoc. As to whether such powers will be invoked in the future, the answer is probably not.

Matters may have proceeded differently had there been a law in place for the resolution of financial institutions at the time, or if the government had the window of time to work with the sectoral regulator to use the inherent powers to extend the provisions of the code to financial entities. This would have been preferred in lieu of the discretion, and an ad hoc process that had to be applied to a very peculiar and complex matter.

That the IBC was applied subsequently for the housing finance company is probably the result of some lessons learned, as well as because in its case there was time for planning and execution, and this application should now largely serve as the template for such institutions.

In this latter instance, using inherent powers under the IBC, the government issued rules as a generic framework for insolvency and liquidation proceedings of defined systemically important financial service providers other than banks (with a provision for separate notification for such providers that are not systemically important, and will be dealt with under the IBC in the same manner as companies would).

In such instances, it will be the regulator who will make the application, and there is provision for the supersession of the board of directors, the appointment of an administrator, and an interim moratorium, with clarity as regards continuity of business and the segregation of third-party assets.

That brings us to the recent situation, when the well-known private sector bank seemed to be at the point of imminent collapse from the burden of non-performing assets, ratings downgrades, and the inability to conclude an arrangement for equity infusion. In exercise of its powers under banking regulation law, the banking sector regulator, in March 2020, in consultation with the government, superseded the bank’s board of directors to quickly restore depositors’ confidence in the bank – including by putting in place a scheme for reconstruction or amalgamation, and appointed an administrator.

In addition, the government issued orders in exercise of powers under the same law, to impose a limited-term moratorium, stayed litigation and other action, the authorities proceeded swiftly to notify a scheme of reconstruction for the bank, and the moratorium ended prior to its term. One can praise the speed of action, as it prevented disorder and loss of confidence, and one can be unclear, too, as to whether the speed allowed adequate time for all stakeholders to be considered duly and fairly.

MANAGING THUS FAR

It can be argued that, in a time when the need for a comprehensive framework for the orderly resolution of banks and all manner of other financial services entities was most needed, we nevertheless appeared to have done quite well in its absence, with a combination of use of discretion, application of inherent powers otherwise available under the IBC, and powers available to the banking regulator, and to the government, under the extant banking law.

One might also be persuaded that since the IBC provides for application to financial services providers, comprehensive regulations under the IBC code should suffice, and perhaps that may indeed be so, with a separate law unnecessary. However, the entire objective of framing a composite and comprehensive law in any form is to bring disparate pieces together, avoid the requirement for cross-referencing, to rationalize provisions, and to provide a clear framework and timelines.

This will also remove the potential for any possible subjectivity and conflicts of interest, inject transparency and independence, and remove the possibility for surprises, even welcome ones. These are all important elements that create confidence in the process, and also provide all stakeholders with the ability to timely and proportionately engage, address their interests, and remain aware and informed of developments through the process.

This is why a composite code for the resolution and liquidation of financial services providers, including banks, is necessary, whether it be in the form of a separate substantive code, or as an adjunct to the code.

It may become even more relevant for a strong, standard and uniform process to be in place to mitigate other unforeseen shocks to the system, especially those that may reveal themselves in the aftermath of the COVID-19 pandemic, as well as pre-empting a complete failure of institutions.

And while the suspension of operation of the code for a period of time, by reason of the pandemic, is a response to stave off wider potential distress, it may be useful to also look to other measures to address that matter, with frameworks such as the code continuing to address what they were established to do. In challenging times such as these though, that may be easier said than done.

Mohit Shukla is managing director and head of legal at Barclays India, and lead for government and regulatory relations. The views expressed by the author are personal and not that of the organization.