No more bankruptcies?

In today's Finshots, we talk about the Insolvency & Bankruptcy Code and the government's plan to suspend the act for a period of 6 months.

The Story

Every time a bank lends money to a corporate entity, there’s a tacit understanding that the owner/promoter will act in good faith — that they will do everything in their power to pay back in full.

In the event that repayment is near impossible, the promoter will liquidate the company, and pay back what’s left.

This is the corporate code of honour.

However, before 2016, the equation was a tad bit different. In the old days, defaulters often pressurized banks to extend repayment periods and take large haircuts. Meaning they tried to get banks to settle for only a fraction of the original loan amount while retaining full control of their company.

In the event of resistance, corporates often threatened to take the matter to court. And the uncertainty involved in waiting for the courts to offer a final settlement often prompted banks to cede ground and settle with the defaulter.

I mean who wants to keep paying endless legal bills and wait for an eternity, right?

So most banks simply let promoters have their way and this emboldened them further to willfully default on their payments so long as they were convinced the balance of power remained with them.

So in 2016, lawmakers finally passed the Insolvency and Bankruptcy Code, 2016 (IBC) to provide for a legal framework that banks could use to take defaulting companies to task.

The premise is simple — first, it puts a time limit of 330 days within which lenders have to agree on a resolution plan i.e. decide if they can salvage the business by offering some extra leeway or if the company ought to be dissolved with all the assets put up for sale. And if the business is liquidated, the proceeds are then divided between the lenders in an equitable manner.

Nice!!!

The IBC also allows the consortium of creditors (lenders) to sidestep the promoter (by appointing a resolution professional) and manage the company until the insolvency proceedings are complete.

In summary, lenders now have every reason to find a resolution plan because they know they’d have to settle for pennies if they waited for the company to be dissolved. And owners of defaulting companies have every reason to settle because if they don’t, they lose control of their most prized possessions. A win-win for all parties involved. No more endless legal battles. No more bad loans.

However, IBC hasn’t really been a runaway success. Resolutions still take time. Promoters continue to get away and the bad loan problem continues to plague financial institutions.

But that’s not the point of this story. The point here is that with the lockdown in place thousands of small and medium enterprises are finding it extremely hard to keep meeting their repayments. And if they were to default on their payments right now, banks can drag them to bankruptcy court (NCLT), no questions asked. Imagine what happens then?

We will have thousands of cases of potential bankruptcies all lined up at the same time and the courts will be overwhelmed. So the government tried to prevent this eventuality by raising the threshold limit for invoking insolvency proceedings from Rs. 1 lakh to 1 crore. Meaning unless you’re a bank that’s looking at unpaid dues to the tune of 1 Cr., you can’t take these companies to court.

But as more firms started seeking protection against such proceedings, the government had to turn it up a notch. So now, we have reports suggesting that the union cabinet cleared a proposal to suspend certain sections of the IBC for a period of 6 months.

Meaning the banks can’t take you to bankruptcy court. Your suppliers (who you owe), can’t take you to bankruptcy court. And even you can’t voluntarily admit yourself to bankruptcy court.

While obviously this offers businesses some respite, there are definite downsides here as well. For one, if you can’t admit yourself to bankruptcy court, it’s quite possible that a bank may simply choose to sell your collateral (in the event you don’t pay up); thereby, prioritizing its self-interest leaving other lenders high and dry.

Consider for instance a bankrupt airline company. So long as the company stays intact, with all the planes, the airport slots, the buildings, and other intangibles; the consortium of creditors (with IBC) can find a buyer and negotiate a large settlement offer and redistribute the proceeds equitably. However, if individual creditors choose to adopt a piecemeal solution (without IBC), the planes will go to one buyer. The buildings will go to somebody else. And you won’t be able to optimize the total recoverable value.

Also, there’s another concern. What happens to your suppliers — your operational creditors? Since you can now get away with not paying them in full, how are they supposed to survive? Especially considering they have little legal recourse without the IBC.

Well, these are difficult questions and obviously the government needs to consider its options before initiating a blanket ban on IBC. But until then, all we can do is hope — that this too shall pass.

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