The bankruptcy code does not guarantee efficient resolution

RBI has been commended for acting to refer big-ticket firms for resolution under the code

The Insolvency and Bankruptcy Code has been variously credited as being “game-changing”, “excellent” and as being able to “save the lenders” since its enactment. It will face its first real test now that the Reserve Bank of India (RBI), acting on powers recently conferred upon it, has drawn up a list of 12 borrowers for banks to resolve under the bankruptcy code.

However, it is important to remind ourselves of the structural issues with the public sector banks that led to the non-performing assets (NPAs) crisis in the first place.

The lack of human capital in the public sector to assess credit risk, the improperly aligned incentive structure and the absence of discipline imposed by the capital markets because of the sovereign ownership of the shares remain. The best of resolution mechanisms will not have solutions to these bottlenecks.
 

Coming back to the bankruptcy code, once the National Company Law Tribunal (NCLT) admits an application filed by the lenders, a moratorium will issue foreclosing any creditor action against the company for the duration of the insolvency resolution process.  A resolution professional will assume control of the management of the corporate debtor, displacing the current incumbents. A creditors’ committee will also be formed comprising the financial creditors.

The resolution professional will manage the company under the supervision of the creditors’ committee, proposing plans to reduce the debt burden on the company. The creditors’ committee will vote on such resolution plans. If the resolution plan is accepted by the creditors holding not less than 75 per cent of the debt, the plan is implemented and the company exits the insolvency resolution process. But the code provides that if there is no resolution within 270 days from the date of commencement of the process, the company shall liquidate.
 

The RBI has been commended for quickly acting on its powers to refer big-ticket firms for resolution under the code. It is important to note this by no means guarantees efficient resolution. For example, borrowing from the UK, the code proposed the idea of an insolvency resolution professional to manage the company while under resolution. An resolution professional coming in cold from outside the company will, even in the best of cases, face a steep learning curve about the nuts and bolts of the entity. This issue was highlighted in a recent NCLAT case in the matter of Starlog Enterprises.
 

The resolution professional, appointed upon displacing the management, could not speedily process the payments due to a material contractor and the contract was terminated. Furthermore, the code mandates installing the resolution professional but stops short of permitting the resolution professional control over the affairs of the subsidiary. The resolution professional appointed in Starlog was materially hampered in executing his responsibilities owing to that constraint.  Finally, the resolution professional was constrained to manage the company even as human assets were bolting out of the door as is evident from the order of the NCLAT in the case. Key employees may jump ship and the resolution professional (unlike the owners) will not have the social bond to enable retention.

Then there is the question of strict timelines. In JK Jute versus Surendra Trading the NCLAT ruled that the time limit of 14 days prescribed for passing orders for rejection or admission of applications was directory, not mandatory. A company in distress is a melting ice-cube and the asset value can dissipate quickly. As such, the NCLAT should have read the provision as mandatory. Interpretation of Section 9 as directory will affect genuine cases of distress as they may be taken up with less promptness than would be if the time period were mandatory.  
 

Aside from these process issues, empirical studies conducted on the UK bankruptcy regime reveal that while adoption of the “administration” model--broadly on the lines of the resolution professional model the code adopts--resulted in higher realisations, it also correspondingly increased costs of bankruptcy and thus did not materially improve creditor recoveries. So we should be circumspect about expecting banks to get decent yields through the process.

Madhav Lal is executive director, Bharti Institute of Public Policy, Indian School of Business, while Mandar Kagade is a policy analyst at ISB