What critics of Insolvency and Bankruptcy Code get wrong about the recovery model

Any belief that the Insolvency and Bankruptcy Code has not performed better than the erstwhile mechanisms of recovery is not supported by facts.

Representational image of Indian currency notes | Photo: Dhiraj Singh | Bloomberg

The Insolvency and Bankruptcy Code has completed five years. Critics of the IBC have focussed mainly on two issues: a) large write-offs of loans by the banks; and b) undue losses to stakeholders like employees and minority shareholders.

On both these issues, fears and allegations that the IBC has been a failure are not supported by facts or rationale. Let us see why these are misplaced beliefs.

Large write-offs of loans by banks

The job of creditors is to generate a return in exchange for the risk arising from the disbursement of loans. So,unless it is too high, loss on loans is not an unusual incident. There are two dimensions of analysing if the magnitude of loan loss is too high. One is to measure the amount of loss in proportion to the amount of investment, often known as credit cost. This helps us understand whether the creditor is undertaking a profitable lending business vis-à-vis alternative uses of capital. The other dimension is to check if the creditor’s particular approach for recovery of dues helps in a lower loan loss.

Most critics focus on the second dimension, that is, whether the IBC is a better recovery mechanism compared to others like Debt Recovery tribunal (DRT) or Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. This is a fair question to ask.

Before answering this, however, one should note that the role of IBC begins with the admission of a corporate debtor into the IBC process. The efficiency of recovery should be measured by the value recovered post the insolvency resolution process as a proportion of the enterprise or liquidation value of the corporate debtor at the time of admission into IBC. Often, analysts use book value of debt as the denominator, which is misleading. The real value of debt is usually significantly lower than its book value by the time the IBC process begins.

Now, let us look at some data. As per the Reserve Bank of India (RBI)’s Report on Trend and Progress of Banking in India 2019-20, as a percentage of claims, scheduled commercial banks have recovered 45.5 per cent of the amount through the IBC for the financial year 2019-20. This is higher than the recovery under other modes and legislations such as the Lok Adalats, DRTs and the SARFAESI Act, 2002.

Here’s another metric. As cited in the March 2021 report of the Insolvency and Bankruptcy Board of India (IBBI), the final realisation by the claimants, as a proportion of the liquidation value (at the time of admission to the IBC process), ranged from 115 per cent to 387 per cent for nine out of 12 large accounts in the first set of insolvent corporate debtors. While the comparative figures for the other modes of recovery are not available with the author, it is reasonable to infer that recoveries under the IBC would be higher than under other modes.

Thus, any belief that the IBC has not performed better than the erstwhile mechanisms of recovery is not supported by facts. It is also not a surprising conclusion since the process followed under the IBC is more market-driven and faster than others.

This does not mean that the recovery process through the IBC is perfect. The Code needs refinement on multiple aspects. Just like other mechanisms, the IBC too operates in a corporate and legal system, which suffers from major systemic deficiencies. Our legal processes are slow, and many of our corporate laws and policies promote adverse behaviour. It is worth pondering how the value of the assets of a defaulting corporate debtor deteriorates so fast as to leave little value for the creditors, by the time any recovery mechanism begins. Unless these issues are corrected, the IBC, in itself, cannot lead to dramatic results.

Undue losses to other stakeholders

The stated objective of the IBC is maximisation of value of assets of corporations (under insolvency), to promote entrepreneurship, availability of credit, and balance the interests of all the stakeholders.

In the case of solvent firms, the maximisation of the value of assets benefits the shareholders, and in insolvent firms, it benefits the creditors. This means that at any given point of time, the objective benefits only one class of financiers. So, balancing the interests would mean one class sacrificing its rightful interests for the benefit of the other. Why would any stakeholder voluntarily suffer a loss in a commercial and free market scenario?

The framework of corporate finance is well understood and adopted by the stakeholders when a firm is clearly solvent or insolvent. However, a firm is definitively solvent or insolvent only In legal terms. In the opinion of the capital markets, there is also a grey area. Capital market participants assign a probability to every legally solvent firm becoming insolvent and every legally insolvent firm becoming solvent again.

Let us say that a firm, D, has just been admitted as being insolvent by the National Company Law Tribunal (NCLT). For the markets, there is still some hope for D’s recovery and it becoming “more” solvent. This is evident from the fact that the shares of legally insolvent firms also quote at non-zero values. However, this also often leads to irrational expectations in the minds of certain stakeholders, partly out of ignorance on the difference between hope and legal right. Legally, a shareholder should expect zero value till the creditor is fully repaid. But markets survive on hopes and hence, the shareholder expects some value for their shares. This divergence leads to anomalies that are, at times, exploited.

Suppose company D has assets worth Rs 120 going into the resolution process. The claims to the assets stand at Rs 100 for the creditors (including all classes) and Rs 20 for the shareholders.

The creditors receive multiple proposals to recover their outstanding dues of Rs 100 from D and finally choose the best one. The proposer, P, offers to bring in cash, Rs 50, out of which it pays off Rs 40 to the creditors, who accept a loss of Rs 60 on their investment. The remaining Rs 10 is used by P to buy fresh shares issued by D at an issue price, as per the proposal.

After resolution, the market price of the shares settle at a level such that the value of all outstanding shares is Rs 15. The old shareholders hold shares worth Rs 5, thereby suffering a loss of Rs 15 on their existing investment. The new shareholders holding Rs 10 worth of shares just bought the company. The new value of debt, after write-off of Rs 60, is Rs 40. The value of the firm is therefore Rs 55 — divided between the creditors (Rs 40), the old shareholders (Rs 5) and the new shareholders (Rs 10). Any gain to any one stakeholder must mean a loss to one or more of the other stakeholders.

As we observe in this case, the older shareholders suffer a loss in the value of their shares, if the market price of the shares fall during the process of resolution. This is often raised as an issue affecting the interests of minority shareholders. However, two facts must be kept in mind:

1. Shareholders have no residual claim in an insolvent company, which is unable to pay its creditors in full. If the firm D had actually become fully insolvent, the shareholders would have lost their money completely, and not partially. So, whatever value the shareholders own is only on account of hope that the new promoter will take the company away from insolvency.
2. Shareholders were, ex ante, aware of the dues owed by their company D to the creditors. They also knew of the poor state of business. Yet, they stayed with their stake in the company and therefore it has been a conscious decision to hold the shares, which led them to take the risk of insolvency, and potentially lose money.

A balancing act

The lack of awareness of the retail, or small, shareholders is cited as a reason for offering them a better deal in the resolution process. This is a weak argument in many ways.

First, there is little data to show that retail shareholders are irrational or have been duped by some party against their wishes. The latter is simply a case of cheating and the accused party should be charged to compensate the losing shareholders.

Second, if the retail shareholders are being compensated, they should also be willing to share their profits in case of any gains. But that does not happen.

Third, as shown in the above example, gains to one party can come only at the cost of another. Typically, creditors are expected to cede some of their share to other stakeholders. But that is neither fair nor justifiable. Creditors have, ex-ante, been promised a fixed amount of repayment. Any use of pressure, post resolution, to reduce creditors’ share would amount to a dilution of the primacy of contract.

Fourth, any artificial interference to influence the market-based process of determining the values of the firm, the debt, and the equity would lead to issues of moral hazard. If any class of market participants begin to believe that their returns have a significant upside but the risks are limited through support systems, they will participate beyond their risk appetite and game the system. We have seen such examples of losses to retail shareholders, including the default by the Unit Trust of India (UTI) on its flagship US-64 bond units and recently in the case of AT-1 bonds of Yes Bank.

Fifth, we should recognise the creditors as well as shareholders as the rightful providers of capital. If any one set of financiers is treated against the fundamental principles of markets and financing, that set of financiers will lose some incentive to provide finance to the firms. Unless it is desired as a macro-objective to reset the balance between the financiers, we should make our markets even more efficient and let them determine the expected returns and the risk levels for each set of the former.

Let us also evaluate the case of the employees who operate under employment contracts. In this case, changing the distribution norms under the waterfall mechanism under Section 38 of the IBC is an option worth examining. However, this should be preceded by a consideration as to whether employees are to be treated as superior to the creditors with regard to settlement of dues. There are trade-offs involved in such a decision. However, once it is decided either way, any temptation by the policy makers or courts to award ad-hoc benefits to either party should be resisted.

To sum it, the IBC has provided us with a framework that allows a market-determined process for distribution of the firm value between creditors and shareholders. The market process should be understood by all parties, and not be disturbed for the benefit of a limited set of stakeholders. It has further provided a waterfall mechanism for distribution between the creditors/shareholders and other stakeholders. This should be open for deliberations in view of the larger objectives, but not disturbed in an ad-hoc manner.

The author is Associate Professor, Finance, at Bhavan’s SP Jain Institute of Management and Research (SPJIMR). He tweets @hemantmanuj. Views are personal.

(Edited by Prashant Dixit)