How NCLT Chennai's order may restrain the freedom of creditors' panel

Since its inception, the Insolvency and Bankruptcy Code (IBC) has been hailed as a monumental reform that would help tackle the problem of bad loans plaguing the Indian financial system.

Part of the code’s appeal was that it minimised the role of the state and the judiciary in the insolvency process. Instead, it provided space for financial creditors to take commercial decisions by introducing a time-bound transparent price-discovery process for bad loans between buyers and creditors.

Going by a recent order of the NCLT Chennai bench, in the case of Ashok Magnetics Limited, this critical aspect of the code is likely to be reviewed.

In its order, the tribunal has directed the “head offices” of the members of the committee of creditors (CoCs) to work out “standard operating procedures” to be followed by members of the CoCs for “determining the suitability and viability of resolution plans so that affairs of the CoCs can be regulated under the IBC regime for which the banking division of the Ministry of finance must be consulted”.

As currently there are no regulations determining the working of CoCs under the IBC and its operational freedom in a key pillar of the insolvency process, this order could have far-reaching ramifications.

“There are no prescribed guidelines/standards which the CoC is required to follow, while rejecting a resolution plan, even though the plan may otherwise be compliant with the requirements of IBC,” Anush Raajan, joint partner at Lakshmikumaran & Sridharan attorneys.

“However, this absence of guidelines has allowed CoC members to arbitrarily reject proposals that are otherwise valid under the IBC and in some cases run counter to the very purpose of the IBC, that is maximum recovery to the creditors while keeping the business alive,” he adds.

Now, ideally if the net present value of a firm’s future cash flows is greater than its liquidation value, it would make sense for the CoC to accept the resolution plan whose value is greater than the estimated liquidation amount. However, in many instances this has not been the case.

Data from the Insolvency and Bankruptcy Board of India (IBBI) shows that as of September 2018, 212 cases have gone into liquidation. However, in 30 of these, the resolution value was greater than the liquidation value. This implies that in all these cases, the CoC decided to liquidate the firm, which would entail taking a greater haircut, rather than accept a higher offer by bidders.

Now, one could argue that driven by commercial interests, CoCs are best placed to make decisions. But as the NCLT order in this case suggests, it is possible that other issues may have outweighed commercial decisions.

One could also argue that if guidelines are framed to regulate the functioning of the CoCs it would ensure a relatively smoother and uniform functioning as members of COCs would know their obligation with respect to consideration of resolution applications and what the law expects of them.

“In some cases, the matters get escalated when the Adjudicating Authority (NCLT) or the Appellant Authority (NCLAT) is called to decide if the decision of CoC is valid or not. However, this can be prevented if guidelines are issued by the Regulator (IBBI) prescribing a bare minimum set of consideration that the CoC must follow before valid, viable resolution plans are rejected,” says Raajan.

“These guidelines are likely to bring a balance between the interests of financial creditor and the interests of the promoters/company to resolve the debts and restore operations. At present, minus such guidelines, the balance between resolution and liquidation is amiss,” he adds.

“Given that the Code is evolving in nature, while the direction to CoC to work out a ‘Standard Operating Procedure’ could help in maturing the working of the CoC, it would also be equally better to provide some judicial guidance in setting the basic rules of the game for CoC in this regard,” says Diwakar Maheshwari, dispute resolution partner, Khaitan & Co.

But as operational freedom of CoCs is critical to the insolvency process functioning, some fear that this order, coupled with recent amendments, may end up derailing this nascent process.

“Amendments to the IBC do not reflect the original philosophy of minimisation of the role of the state and judiciary. Instead, they have increased state and judicial involvement. Section 29A is a classic example. It has single-handedly generated enough litigation, helping the judiciary reclaim its lost turf,” says Pratik Datta, a researcher at the National Institute of Public Finance and Policy.

“Now, the judiciary is asking for more state involvement. For instance, NCLT Chennai has recently suggested that the state should lay down standard operating procedure for the CoC. Therefore, it seems like we are slowly creeping back to the pre-IBC regime of more and more state and judicial involvement in the insolvency process,” he adds. 

Last week, the Supreme Court is reported to have observed that operational creditors should get a say in CoCs and should also get voting rights proportional to the debt owed to them.