Sunday, November 8, 2015

Ushering in a New Corporate Bankruptcy Regime for India

[The following guest post is contributed by Vinod Kothari of Vinod Kothari & Co.]

The Bankruptcy Laws Reforms Committee (“BLRC”) headed by Dr. T. K. Viswanathan recently submitted its final report (“Final Report”) to the Ministry of Finance. Before this, an interim report (“Interim Report”) was submitted earlier in February 2015. While the Interim Report merely recommended some amendments to the existing scheme of resolution of sickness under the Companies Act 2013 and some additional measures, the Final Report goes on to suggest a comprehensive Insolvency and Bankruptcy Bill, 2015 complete with the institutional framework, eligibility for applying for resolution, moratorium provisions, interim and final administration of entities during administration, liquidation, priorities, and the like.

A Flawed Insolvency Regime

The recommendation of a comprehensive self-contained bankruptcy code for India is a huge step towards cleaning up the clutter that bankruptcy and resolution laws in India are currently in. Presently, there is no comprehensive code for handling business failures in India – we have been working spasmodically to enact the Sick Industrial Companies Act, 1985 (“SICA”) way back during the era of industrial sickness, to grant special rights to banks for recovery of debts via the Recovery of Debts Due to Banks or Financial Institutions Act, 1993 for non-judicial recovery of assets, via the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”), and special measures for repayment of debentures under the Companies Act. In the meantime, the basic framework for bankruptcy of companies under winding up provisions under the Companies Act, 1956 has remained unchanged over last nearly six decades, and the framework for personal insolvency has remained unchanged over nearly an entire century!

Not only is the present scene a mosaic of many pieces, but even worse the pieces do not fit with each other at all. Winding up is a holistic remedy – looking at the business as a whole, taking a view whether the business can be revived, and if the business cannot be revived, then taking the business down the liquidation path, distributing its assets on a fair and equitable basis. On the contrary, enforcement of security interests by creditors is based on a “might is right” principle – a creditor is obviously concerned with its own dues rather than the interests of other stakeholders in the business – other lenders, creditors, workers, and others whose livelihood depends on the business.

SICA, framed on the recommendations of the Tiwari Committee, was based on Chapter 11 of the US Bankruptcy Code, and was aimed at reviving a business if the business was still viable. In practice, the moratorium provisions of SICA were widely used to prolong defaults without attracting any creditor action. While revival might have been the central theme of SICA, it became a safe harbour for defaulters, thus creating the landscape for the SARFAESI Act. The SARFAESI Act, purporting to base itself on Article 9 of the Uniform Commercial Code (“UCC”) in the US was based entirely on creditor-driven enforcement of security interests. Amendments introduced by the SARFAESI Act into SICA made SICA virtually irrelevant if the creditors had enforced security interests or sold their assets to an asset reconstruction company (“ARC”). This measure, apparently a reaction to the tactics used by defaulters to use SICA as the shied to ward off creditor action, served to be a complete contrast to any possibility of revival, because nothing would be left in a unit to revive if its core assets had been repossessed by lenders already.

The ARC business, clearly a by-product of the SARFAESI Act and in a broader sense a unique business model to India, is also based on the “might is right” principle, where the ARC aggregates loans by various lenders to increase its might.

In short, the equitability principle in which insolvency laws are rooted all over the world is rarely seen on the Indian scene as of now.

This is for the legal framework; but the way the failure of big business in India is currently managed is by of informal framework –the Corporate Debt Restructuring (“CDR”), Joint Lenders Forum (“JLF”) and the Strategic Debt Restructuring (“SDR”), all of which are based on guidelines issued by the Reserve Bank of India (“RBI”). It is these frameworks currently handling much of Rs 2,67,000 crore non-performing loans in the Indian financial system. SARFAESI has mostly been successful in evicting homeowners from their residential houses for defaulting on their installments; as for big business, most of it continues to chug on under the CDR arrangements, with bankers trying to save their revenue statements converting loans into equity.

While all these sporadic and uncoordinated forays of law making continued, committees and working groups over decades have been talking about reforming bankruptcy laws in India. The trail goes back at least as early as 1964 when the 26th Report of the Law Commission recommended reform of personal insolvency laws and suggested a new Insolvency Bill to consolidate the extant two separate insolvency laws. Obviously, this report has not been acted upon to date. The Tiwari Committee’s report, based on whose recommendations SICA was drafted and finally enacted has been referred to above.

In 1999, the Government appointed V B Eradi Committee specifically from the viewpoint of corporate bankruptcy. The Committee revealed some startling facts – that the average time taken in winding up matters was 11 years pan-India, and in the Eastern Region, it took on an average 25 years to resolve a bankruptcy. The idea of the National Company Law Tribunal (“NCLT”) was born, inclusively, out of the recommendations of the Eradi Committee. Accordingly, the Companies Act was amended in 2002 – it is a sad reflection on Indian law-making that the provisions pertaining to shifting of winding up to the NCLT, enacted by the Parliament in 2002, have not been enforced for over 13 years, and if the BLRC recommendations are indeed accepted, the law made in 2002 will die, still born, though having lived in incubator for 13 long years.

In 2001, the N L Mitra Committee report recommended a comprehensive bankruptcy code –nothing was done to implement any of the Mitra Committee recommendations until the Companies Act, 2013 was enacted, based largely on the recommendations of the J J Irani Committee, which adopted the Mitra Committee recommendation for changing the basis of insolvency from “inability to pay” to “failure to pay”. Of course, the provisions of the Companies Act, 2013 on corporate insolvency are yet to be enforced, as the NCLT is yet to be constituted.

Major recommendations of the BLRC

- Scope of applicability

- The law is to cover insolvencies of “corporate persons” (covering companies, limited liability partnerships (“LLPs”), and all other entities having limited liability), as also individuals, firms etc.

- While the law is admittedly a code for insolvent companies, it covers liquidation of solvent companies as well, and thereby, serves as a complete code on liquidation of companies.

- Institutional framework

- Insolvency and Bankruptcy Board of India: the primary functions of the Board will include registration of insolvency professionals, insolvency institutions, information utilities, provide guidelines on the conduct of bankruptcy resolution, etc.

- Adjudicating Authority (“AA”): the AA is the primary quasi-judicial body presiding over the entire process of bankruptcy. 

- In case of corporate persons, the NCLT will be the AA.

- In case of other persons, the Debt Recovery Tribunal (“DRT”) will be the AA.

- Insolvency professionals: may be practically read as administrators (pre liquidation stage) and liquidators (post liquidation order) – who have role to play in both insolvency, liquidation and resolution. The following are the insolvency professionals:

- Interim resolution professional – immediately on admission of an insolvency resolution process.

- Final resolution professional  - on appointment by the Committee of Creditors.

- Liquidator – on commencement of liquidation proceedings. Typically, the final resolution professional will act as liquidator, unless replaced by the AA.

- Resolution applicant: the entity that prepares a resolution plan.

- Information utilities: the information utilities will be storing financial information – this may be seen as electronic filing of defaults, security interests. There will obviously be an overlap with present filing of defaults with someone like CIBIL, security interests with the Companies Act, etc., which may be eventually resolved.

- Manner of filing for bankruptcy in case of corporate persons

- The “corporate insolvency resolution process” may be initiated on:

- application by a financial creditor, meaning a creditor for financial facility (which is a broadly worded expression including financial lease and hire purchase transactions, which are treated as financial transactions under applicable accounting standards);

- application by an operational creditor, meaning a creditor other than a financial creditor;

- application by the corporate debtor himself, that is, company itself.

- In case of financial creditors, the basis of filing is the fact of a default to any financial creditor. This drastically changes the basis of the current provisions of “sickness” under the Companies Act, which is based on default to a majority in value of the creditors. In addition, the only fact on which the application for insolvency will be admitted is the fact of a default, established from the records of the information utility.

- In case of operational creditors, if there is no dispute about a debt (there is a process for dispute too), then, if the claim is not paid within 10 days, the creditor may initiate insolvency process. This largely creates a level-playing field between secured and unsecured creditors.

- The law puts a very tight timeline of just 180 days for completing the resolution process.

- Moratorium

- One of the most important features of a bankruptcy law is the grant of moratorium during which creditor action will remain stayed, while the bankruptcy court takes a view on the possibility of rehabilitation. In the chapter on Sick Companies under the Companies Act 2013, there is no provision for automatic moratorium – it merely empowers the NCLT to grant a moratorium up to 120 days.

- The Code [clause 13] talks about a mandatory moratorium – thereby, it serves almost like the automatic moratorium under global bankruptcy laws. The moratorium will continue throughout the completion of the resolution process – which is 180 days as mentioned above. However, if in the meantime, the creditors’ committee resolves to approve liquidation of the entity, then the moratorium will cease to have effect.

- Explicitly, the moratorium before liquidation applies to enforcement of security interests under SARFAESI Act as well [clause 14 (1) (c)].

- A moratorium also applies when an order for liquidation has been passed by the AA. [clause 33 (6)]

- Interim administration, Committee of Creditors and final administration: these provisions are similar to the existing process of winding up of companies, except for much tighter timelines.

Steps in corporate insolvency resolution process

Timelines (in days)
Filing of insolvency application
AA shall communicate admission or rejection of insolvency application
Moratorium and advertisement of admission of insolvency resolution process
Before appointing an IRP, AA shall declare a moratorium
AA shall appoint an interim resolution professional (IRP)
(X+2) + 2
Tenure of an IRP shall cease to exist
(X+2) + 2 + 14
Constitution of Committee of Creditors
(X+2) + 2 + 14
Appointment of final resolution professional 
(X+2) + 2 + 14
Preparation of resolution plan by resolution applicant

Submission of resolution plan duly approved by the committee of creditors to the AA

If resolution plan approved – the moratorium shall cease to have effect
(X+2) + 180
If resolution plan rejected - Initiation of liquidation – this is the culmination of the resolution process, if the entity is not getting revived, but heading for liquidation
(X+2) + 180
The corporate insolvency resolution process shall be completed
(X+2) + 180
The process can be extended
(X+2) + 180 +90

Steps in corporate liquidation process

- Initiation of the liquidation process, based on either the recommendations of the resolution plan, or failure to submit the plan within the maximum time period permitted, or based on a vote of the Creditors’ Committee – clause 33

- Appointment of liquidator  - clause 34

- Formation of liquidation trust – clause 36. This provision is indeed very significant as it defines the reach of the so-called “liquidation estate”. That is to say, to the extent assets of the corporate debtor form part of the liquidation trust, the assets will be distributed by the liquidator in the manner of priorities laid in the law, and individual claimants or those claiming to have any special rights on such assets will have to form part of the liquidation process. 

- Important inclusions in the liquidation trust are:

- All assets and interests as evidenced in the balance sheet of the corporate debtor: this issue will continue to cause confusion as it relies on accounting principles which are quite often not aligned with legal title. For example, under IFRS, several securitisation transactions or sale of financial assets do not go off the balance sheets. This may put to question the “true sale” character of several securitisation transactions.

- Important exclusions are:

- Third party assets, including

- Trust assets, that is, assets whereof the corporate debtor is merely a trustee

- Bailment assets – thereby, leased assets will be excluded from liquidation trust but it may be argued that in case of financial leases, as the assets are on the balance sheet, at least the right to use will be an asset, unless the right to use gets terminated by virtue of the bankruptcy event.

- Transactions where there is no transfer of title but merely a right to use.

- Assets placed as collateral with financial debtors, that are subject to netting under multilateral or clearing contracts – thereby giving protection to such derivatives as are settled by multi-lateral clearing. The provision seems to have been picked from international jurisdictions, but multilateral clearing is not currently in vogue in India.

- Assets of subsidiaries – while shares held in the subsidiary form part of the liquidation trust, the assets do not.

- Collection of creditors claims within 21 days of the commencement of liquidation, and verification of claims – clause 38-41. Clause 42 also includes elaborate provisions about voidable transfers and undue preferences, incorporating several safe harbours for bona fide transactions against “clawback” rights of a bankruptcy court. Under existing law, the court simply has powers to preserve bona fide transactions – the Bill gives several such transactions which are protected from any clawback. In addition to this, there are usual provisions for undervalued transactions, fraudulent transfers, etc. There is seemingly a new provision pertaining to avoidance of “extortionate credit” contracts, entered into within 2 years before the commencement of insolvency process [clause 50-52].

- Realisation of debt by secured creditors [clause 53]: This very important section incorporates the classic principle understood over the decades in India – that a secured creditor may either relinquish security interest and force his claim on the overall liquidation trust assets, or may opt to realise security interest outside the winding up process. Clause 53 (4) permits the secured creditor to realise security interest according to such law as may be applicable – thereby preserving the process of self-help realisation under the SARFAESI Act. However, there will be reference to the liquidator for the purpose of the liquidator identifying the asset. This section, however, brings a very important balance in the process of repossession outside the liquidation process under SARFAESI Act, by requiring the secured creditor to return the excess realised by him to the liquidator. Thereby, the liquidator also becomes an interested party in the process of sale of secured assets under SARFAESI Act, throwing greater burden on the creditors in being more transparent in the conduct of the sale.

- Distribution of assets by the liquidator [clause 54]. Most interestingly, clause 54 starts with a non-obstante clause, giving this section supremacy over conflicting provisions of a vast number of Central and State laws. There have been several rulings of the courts, including the apex court, on conflict of laws pertaining to claims of the state creditors over assets of companies in winding up. Hopefully, this section, being a dedicated section pertaining to distribution of assets on liquidation, will operate as a special law, and will resolve the cacophony currently existing in the matter. In fact, state dues come at number 5 in the rung. One disturbing point is the provision in clause 54 (2) which seeks to disregard contractual arrangements between claimants of a single class. Usually, in capital market transactions, there are several classes of preference created among creditors – for example, super senior, senior, subordinated, etc. Clause 54 (2) may be interpreted to disregard these priorities as “contractual arrangements”.

- Application for dissolution [clause 54 (4)].

- Order for dissolution [clause 54 (5)].

Fast track resolution

As a notable feature of the Bill, the Bill proposes a fast track resolution process, intended to be completed within 90 days, as opposed to the 180 days’ time for a normal process. The fast track process will be applicable for corporate debtors of a particular class, or having assets or income up to such level as may be notified by the Central Government. Essentially the process seems to be targeting small companies.

Voluntary liquidation

It would have been a pity if the process of liquidation under the Code was to be reserved only for defaulting companies, since voluntary winding up of healthy companies in India currently takes enormously long time and, surprisingly, all attention has been to the speed of incorporating companies, not winding them up. Thus, a healthy company, based on a declaration of solvency, may pass a special resolution to liquidate itself. At least 2/3rds of the creditors in value must also support the members’ resolution. The rest of the liquidation mechanics under the Bill will apply to a voluntary winding up as well.

NCLT to mind its timelines

One of the highlight points of the Code is timely completion of the liquidation process. Since most delays take place due to protracted time before the Benches, clause 64 will keep the benches of NCLT and NCLAT serious about timely disposal of matters. Theses sections enact that where the NCLT or NCLAT does not dispose of the matter within the time limits, the president of the forum shall record the reasons for not doing so.

- Vinod Kothari

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