India experienced a major structural change with the enactment of the Insolvency and Bankruptcy Code, 2016 (‘IBC’). On some measures, thelaw has been quite successful. For instance, the overall recovery rate for stressed assets under the pre-IBC regime in 2015-16 was 10.3%, while the recovery rate under IBC in 2017-18 was 49.6%. India's ranking under the World Bank's Doing Business report for Resolving Insolvency has also risen sharply from 136 to 103, attracting international attention.
In spite of these achievements, the IBC has raised serious concerns. By September 2018, only 20% of the cases admitted under IBC were successfully resolved. 80% ended up in liquidation. Consequently, there are apprehensions that the IBC suffers from liquidation bias. Additionally, there are concerns that the IBC unfairly discriminates against operational creditors. This issue gained prominence during the insolvency of Jaypee Infratech Ltd., a real estate company whose unsecured home buyers were initially left without any effective remedy. Even the constitutionality of the law itself faced serious challenge before the Supreme Court of India in Swiss Ribbons Pvt. Ltd. v. Union of India on this issue.
In view of these contemporary challenges, my working paper, Value destruction and wealth transfer under the Insolvency and Bankruptcy Code, 2016, shows that many of these challenges could be conceptually classified into two categories - the value destruction problem and the wealth transfer problem. The paper uses the law and economics literature on insolvency to identify the sources of these two problems within the IBC.
A well-designed insolvency law should help in correctly determining if an insolvent business is suffering from financial distress or economic distress. A business is financially distressed when the total value of its debt exceeds its present value. Insolvency law should facilitate going-concern sale or restructuring of such businesses. But a financially distressed business could also suffer from economic distress - the present value of the business could be less than the total value of the assets of the business, were they to be broken up and sold separately. In such cases, insolvency law should facilitate liquidation. In contrast, a poorly designed insolvency law could inadvertently push a merely financially distressed business into liquidation, causing value destruction. Value destruction could also happen due to delayed restructuring. I refer to these as Value Destruction Problems (VDP).
The IBC classifies creditors into financial and operational creditors. The decision as to the future of an insolvent company under the IBC is left to a Committee of Creditors (‘CoC’) comprising only the financial creditors of the company. Operational creditors do not have any vote on the CoC. The financial creditors on the CoC may by 66% vote by value decide whether to continue the business or to liquidate it. I argue that secured financial creditors comprising the super-majority (i.e. 66%) in the CoC may prefer to liquidate even a merely financially distressed business in certain circumstances. If the present value of their expected returns from continuing the financially distressed business is less than their pay-off in immediate liquidation, they are likely to prefer liquidation, although sustaining the business may have fetched a better overall outcome. This could be one potential source of value destruction under IBC.
Further, the IBC does not provide for pre-insolvency restructuring. A company which is reasonably likely to default on its debt obligations in the near future cannot use the statutory moratorium and the cramdown provisions in IBC for a restructuring. Alternatively, pre-insolvency debt restructuring through a scheme under Companies Act, 2013 would neither offer the benefit of a statutory moratorium, nor would cross-class cramdown be possible. Overall, under the current Indian legal framework, pre-insolvency restructuring is far more difficult to execute than post-insolvency restructuring through IBC. This may delay restructuring of financially distressed companies, enhancing value destruction.
When an insolvency law provides cramdown powers to majority claimants to facilitate restructuring, it raises the possibility of wealth transfer. Majority claimants in control of the restructuring may be able to advantage or disadvantage different groups of beneficiaries by structuring of the securities, contract rights or other property received by each. They could even abuse this control to derive disproportionate private benefits, by transferring wealth away from the dissenting minority claimants through the restructuring plan. I refer to these as Wealth Transfer Problems (‘WTP’).
Insolvency laws provide various tools to address WTP. First, the law could require a restructuring plan to ensure that dissenting creditors are not worse off than what they would have been if the next best alternative was chosen. Since restructuring makes sense only if an insolvent business is financially distressed but not economically distressed, the next best alternative should be a going concern sale and not break-up liquidation. Consequently, the restructuring plan should at least provide going concern liquidation value to dissenting creditors. Second, the law could provide for judicial supervision to ensure that restructuring plans are ‘fair’ and do not cause wealth transfer.
Restructuring, being a hypothetical sale of the debtor's business to the claimants of the debtor, requires that some finite notional value be placed on the business of the debtor. Therefore, restructuring requires a valuation benchmark. No such problem arises in a going concern sale for cash to a third party after a proper marketing exercise. Consequently, no such valuation benchmark is necessary for a sale transaction. However, the IBC uses the liquidation value benchmark to protect operational creditors in both restructuring as well as sale transactions. This creates opportunities for wealth transfer from operational creditors in sale transactions under the IBC.
Even for restructurings, the IBC provides for liquidation value benchmark to protect only operational creditors but not dissenting financial creditors (since October 5, 2018). Moreover, where such protection is available, the law uses break-up ‘liquidation value’ instead of going concern ‘liquidation value’. These create opportunities for wealth transfer from operational creditors as well as dissenting financial creditors in restructuring transactions.
Indian policymakers did not envisage judicial supervision as a check against potential wealth transfer through resolution plans. Consequently, the IBC does not provide any explicit power to the National Company Law Tribunal (‘NCLT’) to review the ‘fairness’ of a resolution plan. However, in practice, the National Company Law Appellate Tribunal (‘NCLAT’) has done exactly that in the Sirpur Paper Mill case (para 9) and the Binani case (para 48). In an attempt to address WTP in these cases, NCLAT prohibited discrimination of operational as well as dissenting financial creditors through resolution plans. This, however, does not resolve the problem.
Indian policymakers need to revisit some of the fundamental legislative design choices embedded within the IBC to successfully address the very sources of the Value Destruction Problem and the Wealth Transfer Problem.
Pratik Datta is a Researcher at the National Institute of Public Finance and Policy, New Delhi.