On May 17, 2020, the Indian Finance Minister announced a one-year suspension on the initiation of new proceedings under the Insolvency and Bankruptcy Code 2016 (‘IBC’), stating that an ordinance amending the IBC to this effect would soon be notified. The exact form that these amendments will take is not yet known, except that they appear to be a suspension on the initiation of insolvency proceedings by financial creditors and operational creditors as well as by the corporate debtor. The amendments are also expected to include a new resolution framework for medium and small enterprises and exclude debts related to COVID-19 from the definition of defaults under the IBC. In parallel, there has been talk of strengthening pre-IBC resolution mechanisms as well as introducing pre-packaged insolvencies (‘pre-packs’) as a fast track resolution process under the IBC, possibly as an alternative to the standard corporate insolvency resolution process (‘CIRP’) currently contemplated under the statute.
The rationale behind the suspension of the initiation of IBC proceedings is well known. Several countries, including Australia, the United Kingdom, Spain and Germany, have announced temporary suspensions and relaxations of their insolvency and bankruptcy laws to give companies some breathing room to deal with the devastating economic impact of COVID-19 on most businesses. There is an expectation that payment defaults have and will increase drastically, and the Indian Government does not want firms to be forced into insolvency for factors that are universal and beyond their control. In addition, even if a debtor were admitted into IBC proceedings, we may see many more liquidations than resolutions at this time, as third-party bidders might be reluctant to bid for distressed assets in light of the risks and uncertainty around the pandemic and its economic impact.
At the same time, there appears to be an implicit acknowledgment that a blanket suspension of the initiation of IBC proceedings without any alternative mechanism for resolution of distress could led to rapid depletion in asset value and huge losses for a number of stakeholders. This has led to numerous discussions on strengthening pre-IBC restructuring options and pre-packs. Currently, there is no clarity on whether a regulatory framework for pre-packs under the IBC, if introduced, would operate while a suspension of the ability to initiate other CIRPs is in place and how this would work in practice. In this post, I consider some factors worth keeping in mind if pre-packs are to be introduced into the IBC framework.
What are Pre-packs?
A resolution of a distressed company’s debt can be done either through an out-of-court restructuring plan where debtor and creditors agree on a consensual resolution or through the formal insolvency process provided under the IBC. For out-of-court restructurings, there is no commonly accepted market practice in India, although there are some circulars issued by the Reserve Bank of India, including the June 2019 circular for ‘Prudential Framework for Resolution of Stressed Assets’, that provide a framework for the resolution of large accounts. An out-of-court resolution gives parties the flexibility to arrive at a plan best suited to the circumstances, without the constraints of any specific legal process or framework. If a consensus between debtor and creditors can be reached, an out-of-court resolution can be completed within a shorter time period, at lower cost and with less disruption to the debtor’s business than what a typical insolvency proceeding would entail.
However, the significant disadvantage of an out-of-court resolution is that it only binds those who have explicitly consented to it. Further, an out-of-court resolution would not give the debtor regulatory benefits (such as, for example, exemptions from securities laws) that are available to those going through the formal insolvency process. In the Indian context, an out-of-court restructuring would typically exclude operational creditors and would also leave the door open for claims by any creditors who do not consent to the resolution plan.
A pre-pack seeks to provide the advantages of an out-of-court resolution in terms of time, costs and flexibility, while ensuring that the resolution plan is binding on all stakeholders. Pursuant to a pre-packaged insolvency, the debtor and financial creditors can agree to a resolution plan prior to making an application for insolvency, though the specific process and point in time when the pre-pack enters the formal insolvency system varies across jurisdictions. The resolution plan that has been pre-agreed among creditors will then need to be formally approved through the process provided for under the applicable insolvency law, thereby giving the plan the statutory backing required to bind all stakeholders. Pre-packs emerged as a market driven response to the need for faster resolution and are very popular in the UK and the US. In the Indian context, however, various amendments would be required to enable a pre-pack as the current framework for the corporate insolvency resolution process (‘CIRP’) under the IBC does not permit one.
Pre-packs as a Response to COVID-19
The advantages of a pre-pack in terms of time and costs and minimal disruption to the debtor’s business make it a helpful alternative for companies facing financial distress as a result of the COVID-19 pandemic as the time spent in the formal IBC process can be significantly reduced. In addition to these advantages, it would also ease the burden on tribunals as a pre-pack would most likely require fewer filings and court time than a typical CIRP. These are good reasons to bring pre-packs into the Indian insolvency framework for the COVID-19 era and beyond. It is, however, important to keep in mind a few factors, including the inherent limitations of pre-packs, when designing a framework for pre-packs in India.
First, as the key advantage of pre-packs is the flexibility it gives debtor and creditors, it is important that pre-packs are not overregulated. Countries such as the UK, where pre-packs are very common, do not have an explicit statutory framework for pre-packs, except indirectly through the regulation of insolvency practitioners. As discussed above, while amendments to the IBC will be needed to enable pre-packs, regulation governing pre-packs should not be overly prescriptive, as the idea is not to create a mini-CIRP before the actual IBC filing. Ideally, the IBC amendments and any regulations should be restricted to providing an enabling framework for pre-packs, process related regulations for bringing in a pre-packaged plan into the formal IBC process and mechanisms for curtailing possible misuse of pre-packs (discussed below).
Second, pre-packs will not work in all cases as they presuppose a degree of cooperation between debtor and creditors as well as among creditors. Unlike in a CIRP, the promoters will continue to be in control of the business during pre-pack discussions and if they do not cooperate with creditors in providing information, a pre-pack may be doomed from the start. Similarly, pre-packs are likely to fail in cases where there are a large number of highly dispersed creditors with disparate interests, making it difficult for them to come together. Thus, while pre-packs should certainly be permitted, making them a replacement to CIRPs is likely to backfire. Ultimately, the creditors should be able to decide if a pre-pack or a CIRP is best suited for a particular debtor.
Third, a major concern with pre-packs is the potential lack of transparency in the process of arriving at a pre-agreed resolution as pre-pack discussions are usually confidential and do not involve an open bidding process. This is the other side of the advantages of a pre-pack in terms of flexibility and speed. The lack of transparency can result in potential abuse of the pre-pack process if a debtor was to reach an arrangement with a handful of financial creditors, without providing adequate protection and information to other stakeholders, including operational creditors. It is, of course, the case that a resolution plan arrived at through a pre-pack would ultimately have to comply with the same requirements as any other resolution plan under the IBC in order to be approved by the tribunal. However, the difference in a pre-pack is that the debtor had control over the business for a large part of the negotiations period and the resolution professional (ie, insolvency practitioner) would not have as much oversight on the process of arriving at a resolution plan. As a result, issues such as fraud or preference transactions might be much harder to unearth in the case of pre-packs, which in turn could adversely impact operational creditors as well as smaller financial creditors. The independent Graham Review Report into Prepack Administration of June 2014 noted that the ‘lack of transparency disenfranchises creditors, especially unsecured creditors particularly where the purchase is being made by a connected party.’
The lack of transparency that is inherent in the pre-pack process must be countered by providing adequate protection to operational creditors. Operational creditors would already be hit particularly hard by the moratorium on the initiation of IBC proceedings as they have often used the possibility of filing an insolvency application under section 9 of the IBC to ensure that debtors meet their payment obligations. Rendering this tool for instilling some discipline in payment obligations unavailable will affect the (already impaired) financial condition of operational creditors as well as their ability to pay salaries to their employees and their own creditors. In the case of pre-packs, as operational creditors will have very little visibility over the initial process until the IBC filing, the pre-pack framework must provide a reasonable timeframe for operational creditors to file claims and raise any objections to the plan, as well as guidelines on providing a respectable percentage of recovery for operational creditors vis-à-vis financial creditors.
Another concern stemming from the lack of transparency in the pre-pack process is that it might give rise to a lot of process-related litigation. There has already been much litigation around IBC proceedings by all stakeholders and this has contributed to delays in resolutions. The pre-pack regulatory framework would have to walk a tightrope, balancing the need for transparency and due process, while not opening the floodgates to further litigation and delays.
An important measure of success of any insolvency law, including the IBC, is the quantum of cases that can be resolved without coming into the formal insolvency process at all. Out-of-court resolutions, pre-packs and CIRPs are all part of a continuum of avenues for resolution of distress and the COVID-19 induced crisis might indeed be an opportunity to strengthen pre-IBC resolution mechanisms and introduce pre-packs into the IBC toolkit. However, the regulatory framework for pre-packs in India needs to be carefully thought out and, even if introduced, cannot serve as a replacement for the typical resolution process under the IBC.
Aparna Ravi is a Delhi-based lawyer and a Partner at Samvad Partners. The views expressed here are personal.