Should the promoter (owner) of an insolvent company be allowed to buy back its assets or business through another company at a steep discount? This question has been at the heart of contemporary reforms in Indian insolvency laws since the controversial Essar case.
Essar Steel went into insolvency after defaulting on its loan repayments. During its insolvency resolution, the promoter - Essar Group – that was in the control of the defaulter, tried buying back Essar Steel’s business by bidding as a resolution applicant under Insolvency and Bankruptcy Code, 2016 (IBC). This incident sparked a heated debate. Some commentators cried foul and advocated outright ban on such promoter buy-backs, while others urged caution against such a ban. In this backdrop, the President of India recently promulgated an ordinance amending the IBC to effectively restrict such promoter buy-backs.
Essar's strategy was akin to ‘phoenixing’ - the practice whereby the management of a company puts it into resolution or liquidation solely to buy the same business back and set up a new ‘phoenix’ company in the same or similar business, shorn of the debts of the old company. The Bankruptcy Law Reforms Committee (BLRC) had envisaged the possibility of phoenixing in India. But it did not elaborate on the moral hazard inherent in such practice. Neither did the IBC specifically address it. The Essar episode has now nudged the Indian government to effectively restrict phoenixing. Although well-intentioned, we argue that the ordinance may in certain cases impact bona fide phoenixing, diluting the principle of limited liability. We propose a more balanced approach to address Indian policymakers' concerns about phoenixing.
Phoenixing as consequence of limited liability
Limited liability is a fundamental principle of modern corporate law. It insulates shareholders from the risk of business failure of the company. The liability of each shareholder is limited to their individual subscribed share capital. When a creditor lends to such a company, it implicitly agrees that on failure of the company, it will have recourse only to the company's assets. The shareholders will not be personally liable. Therefore, on failure of a limited liability company, shareholders (including promoters) have a right to move on and form a new company in the same business. And like any other bidder, their new phoenix company should be able to bid for the business or assets of the old insolvent company and try rebuild the business. Consequently, phoenixing is an inevitable consequence of limited liability.
Moral hazard implications
Phoenixing however reveals a unique moral hazard problem with limited liability. Promoters of a limited liability company could deliberately force it into insolvency in order to buy back its business or assets at a reduced price, while taking advantage of limited liability to avoid their responsibility to repay the debts of the company, including tax dues. Such abusive phoenixing would compromise creditors' rights, increase cost of capital, and hurt the development of credit market. Precise state intervention is necessary to address this market failure without prohibiting bona fide phoenixing.
The Essar case for the first time introduced Indian policymakers to the moral hazard implications of ‘phoenixing’. To address this, the newly inserted section 29A ex ante excludes various persons from phoenixing. These include:
- promoters of companies which have an account legally classified as non-performing asset and have failed to repay the amount within one year from such classification;
- persons who have executed an enforceable guarantee in favour of a creditor, in respect of a corporate debtor under insolvency resolution or liquidation;
- promoters of companies which have indulged in preferential transactions or undervalued transaction or fraudulent transaction in respect of which an order has been made by the Adjudicating Authority under this Code.
As to (1), a company could have taken a loan and then failed to repay it because of genuine financial or economic distress. Consequently, the loan could have been classified as non-performing. Even after one year of such classification, the company may not have recovered from the distress. This would mean that category (1) would ex ante, from the time of the re-classification, exclude promoters of such a company from phoenixing.
Promoters often give personal guarantees to creditors for loans taken by their company. Such a company may subsequently experience genuine financial or economic distress and enter into insolvency. Category (2) would ex ante exclude such promoters from phoenixing.
In establishing a preferential transaction (section 42) or undervalued transaction (section 45), the IBC does not require any mala fide intent on the part of the corporate debtor or its promoters. An innocuous commercial arrangement without any mala fide intent to defraud creditors could still qualify as a preferential or undervalued transaction under the IBC. Yet, category (3) ex ante excludes promoters of such a company from bona fide phoenixing.
In all these three cases, the new ordinance could translate a genuine business failure or an inadvertent corporate action of a limited liability company into what could be characterised, in substance, as a personal liability for its promoters by ex ante excluding them from bona fide phoenixing. This could effectively dilute the principle of limited liability - a fundamental tenet of corporate law. It is therefore hardly surprising that several Indian promoters are preparing a legal challenge against the ordinance before the Indian Supreme Court. In this backdrop, we propose an alternative approach to tackle abusive phoenixing.
An alternative approach
Indian policymakers have a valid concern with the moral hazard implications of phoenixing. But relying primarily on ex ante exclusions to check abusive phoenixing will either render the law under-inclusive and ineffective or over-inclusive and prohibit bona fide phoenixing. Instead, a balanced middle path is necessary.
English law provides a useful template. It checks abusive phoenixing broadly in three ways. First, a narrow class of persons whose negative antecedents render them unfit to manage a company are ex ante excluded from phoenixing. For example, a person disqualified from being a company director cannot use phoenixing. Second, the law imposes various duties on the Insolvency Professional (IP) to make sales to previous owners and connected parties (connected party sales) more transparent. For instance, the Statement of Insolvency Practice (SIP) 16 requires the administrator to make various disclosures to the creditors' including the details of the connected party purchaser. Before selling assets of an insolvent company to any connected party, an independent valuation of the assets along with appropriate marketing exercise is expected. Third, the law provides connected parties interested in purchasing assets of an insolvent company the option to approach the Pre-Pack Pool and disclose details of the deal. The Pool comprises experienced business people who conduct independent scrutiny of such deals and opine on their commercial bona fide. A positive statement gives confidence to the creditors to approve a deal whose bona fide has been independently verified.
Indian law uses the first two approaches. While the ordinance provides for ex ante exclusions, the Insolvency and Bankruptcy Board of India (IBBI) has issued disclosure regulations for connected party sales. However, there is currently no mechanism for ex post independent third party review of connected party sales like the Pre-Pack Pool. We propose that IBBI should consider setting up a panel of independent Insolvency Professionals to review the commercial bona fide of connected party resolution plans on a voluntary basis.
In our proposed scheme, a promoter seeking to buy back his business during insolvency resolution through a ‘phoenix’ company would have the option of placing his resolution plan before an independent IP from the panel. If the IP issues a negative statement, the deal could still proceed. But the fact that a negative statement had been made would have to be referred to in the promoter’s resolution plan. A positive statement would also be referred to in the resolution plan, showing that the deal had received independent scrutiny. As approaching the panel would be voluntary, the resolution plan should also state if the promoter had chosen not to approach the IP panel. The fact that the promoter’s resolution plan is supported by an independent IP would give greater confidence to a creditors’ committee in considering whether to accept the plan. Similarly, the lack of such an independent assessment or a negative statement would likely make the resolution plan less attractive to the creditors, giving them a legitimate ground to refuse such an offer. Overall, this arrangement would make abusive phoenixing in the form of undervalue acquisitions more difficult, without unduly restricting bona fide phoenixing, where it is beneficial to the creditors.
Phoenixing is not inherently objectionable. Some forms of phoenixing are legitimate, but policymakers are justified in intervening to prevent abusive ‘phoenixing’. However, any such intervention must be precise and should not end up restricting bona fide phoenixing. The Indian ordinance, although well-intentioned, may prevent promoters from acquiring businesses through phoenixing even where it is in creditors’ interests for them to do so. A more balanced approach for India would be to retain a narrower set of ex ante exclusions and introduce a panel of independent insolvency professionals to review connected party resolution plans to make abusive phoenixing in the form of undervalue acquisitions more difficult.
We thank Kristin van Zwieten for useful discussions.
Pratik Datta is a Chevening Weidenfeld Hoffmann scholar at University of Oxford and Suharsh Sinha is a practising lawyer with AZB and Partners.