Insolvency Laws in India: Need For Immediate Reforms

Asking someone what regulators can do to improve the business momentum?  

While answering the question one will always have a long to tell about, the norms, which can promote entrepreneurship, foster competition and innovation, encourage connectivity with other economies, and create an environment in which objectives become clearer and can be achieved in an easier way.      

If the same guy will study about India, he will definitely going to be impressed, by counting all those measures, the Indian regulators have taken and which are reflecting in India’s high level output and trade, effective demand, rise in income and employment and in expansion of credit, the Indian economy has generated in recent past.

The reforms, which have been made in last couple of years, have impacted business growth in various ways: allowing better laws for investors & minority’s protection, minimal government intervention, E- governance, easier licensing, smoother inbound-outbound Investment norms, and enhanced disclosures etc have done exciting job to promote the business environment.

The Macro indicators like growing forex reserves, under control inflation, and an impressive growth and profitability achieved by Indian corporates, to the rest of the world, have given  all reasons to be jealous of India.

But let’s wait a little, and have a relook.  Behind this story, the coin has another side, which is hidden and not so brighter.

A close look, of the Balance-Sheets of various Indian Corporates, provides gloomy pictures; the risk associated with the debts taken is increasing day by day.

Let’s have a look on a news, based on an RBI report, which was published in an India’s leading daily newspaper:

“……………..a detailed analysis of the performance of non-government non-financial listed companies during the period from 2011-12 to 2013-14 (latest available) indicated that the strain observed in the beginning of the period continue to cause concerns, the reserve bank has said.

·         4635 (23.8%) turned out be week

·         61557 (24.1%) private companies were about to week,

·         32.1% is the share of bank borrowings of the weak public companies in total bank borrowings of the group,

·         32.5%  is the share of weak private limited companies in total bank borrowings,

·         10.4% is the overall impact on account of assumed default by week companies out of total bank credits of banks

·         7.3% is the impact in case if assumed impact of weakness in debt servicing capacity of companies on bank credit (share of bank credit in total credit of banks)

·         The share of debt of weak companies was 27.3% of total debt.

·         The leveraged weak companies were 2.4% in the sample and accounted for 11.8% of the share of total debt

·         The number of firms and shares in total debt for weak as well as leveraged weak firms increased in 2014-15, but decline marginally in the H1FY2015-16.

·         19.4% is the share of companies negative networth (termed as leveraged companies)  in September 2015, higher that 18.4% was a year ago

·         15.3% is the proportion of high leveraged companies

·         5.1% is the gross NPA of Banks as percentage of gross advances in 2015 up from previous data i.e. 4.6%

This phenomenon has nothing unnatural; failure is inevitable in a free enterprise system. It happens worldwide. The Burst of IT boom and the Sub Prime Crises have resulted into the failures of some of the biggest Software companies, Banks, Financial Institutions and other Corporations. The recent crises, in Europe, the slowdown in China, threatened western Asia, slow going development in Japan is affecting Balance sheets of Business Houses worldwide.

We were also part of these cyclones and felt the storm in form of sudden pause on Information Technology Boom, struggles in Infrastructure & Airline segments, stress felt by the Banks due to the increase in Non-Preforming Assets. In our own country the story of Satyam and Kingfisher is also not very old.   

But what is worrying, in India, is that, unlike in developed world the business failure is not taken as natural event. The lack of clear system for liquidation events, results into prolong legal dilemma and ultimately into severe losses for investors and lenders.

Needless to mention that it is imperative for India, to have the better Bankruptcy Law, enacted on the principle of efficiency, can provide effective resolution system to preserve the residual enterprise and can deliver justice in a timeframe manner for liquidation events, a law, which can give an honest debtor a "fresh start" in life, by relieving him of most debts and allowing repayment to creditors in an orderly manner.

Something like referred on US court website:

 “Bankruptcy helps people who can no longer pay their debts get a fresh start by liquidating assets to pay their debts or by creating a repayment plan. Bankruptcy laws also protect financially troubled businesses“

Existing Legal Framework Governing Bankruptcy in India:

Unlike in US or in some other developed economy, India does not have a composite law to deal with Bankruptcy, but different-different enactments are there to deal with various portion of it. A brief of some of those laws are as mentioned here under:

Constitutional Provisions:

Article 246, seventh schedule, which divides power between center and state governments to make laws on various aspects of insolvency, says as under:

Sick Industrial Companies (Special Provisions) Act, 1985 (SICA):

Except Chapter XIX of Companies Act, 2013 and Chapter V Companies Act, 1956, if we talk about solvency practices, SICA is the single law in our country.

The Sick Industrial Companies (Special Provisions) Act, 1985 was enacted by the Government of India with the view to make special provisions for securing time detection of sick and potentially sick companies which own the “industrial undertakings”.

“Industrial Undertaking” means any undertaking pertaining to a scheduled industry carried on in one or more factories by any company but does not include an ancillary industrial undertaking and a small scale industrial undertaking.

The Act makes provisions for the purpose of Board of experts to determine speedily and preventive, measures, which are necessarily to be taken and enforced expeditiously in relation to sick companies. 

It divides sick companies into two criteria:

(a)  Sick Companies: an industrial company (being a company registered for not less than five years and employing fifty or above workmen), which has at the end of any financial year accumulated losses equal to or exceeding its entire net worth;

(b)  Potentially Sick Companies: An industrial company of which accumulated losses, at the end of any financial year, have resulted in erosion of fifty per cent, or more of its peak net worth during the immediately preceding four financial years.

Net worth has been defined as the sum total of the paid up capital and free reserves.

SICA mandates that when an industrial company become a sick industrial company, the Board of Directors of the said company shall, within sixty days from the date of finalization of the duly audited accounts of the company for the financial year as at the end of which a company has become a sick industrial company, make a reference to the Board for Industrial and Financial Reconstruction (BIFR) for determination of the measures which shall be adopted with respect to the company. However, if the Board of Directors has sufficient reasons even before finalization of accounts to form an opinion that the company has become a sick industrial company, it shall, within sixty days after it has formed such opinion, make a reference to the BIFR.

It also requires that an industrial company of which accumulated losses, as at the end of any financial year, have resulted in erosion of fifty per cent, or more of its peak net worth during the immediately preceding four financial years to intimate to the Board for Industrial and Financial Reconstruction (BIFR) with respect to the financial position of the company.

Where the BIFR comes to the conclusion that it is not possible to revive the company and that it is just and equitable that the company should be wound up, it shall record and forward its opinion to the concerned High Court, on the basis of which the Court, may order winding up of the company and may proceed and cause to proceed with the winding up of the sick industrial company in accordance with the provisions of the Companies Act, 1956.

The formal involvement of Courts under SICA is possible for

(i) Judicial review of the decisions of the BIFR or AAIFR by the High Courts and the Supreme Court; and

(ii) Issuance of winding up orders by the High Court on the basis of a liquidation opinion from the BIFR.

SICA is basically a remedial Law:

Moreover, SICA is basically and predominantly remedial and ameliorative in so far as it empowers the quasi-judicial body, Board for Industrial and Financial Reconstruction to make appropriate measures for revival and rehabilitation of potentially viable sick industrial companies and for liquidation of non-viable companies.

However, its operation is always a matter of question to provide a timely rescue mechanism for sick industrial companies where it takes about several years for a sick industrial company to be revived after BIFR proceedings.

Packages provided under SICA are often become matter of court proceedings and leads to an ineffective conclusion. It is argued that the informational advantage that managers’ possessed, coupled with control over the rescue process would enable them to carry out such measures and the costs of failure (leading to liquidation) would largely be borne by creditors.  Critiques also allege that in addition, SICA can provide delay tactics to get concessions from creditors.

If we ignore all those criticism, even then with all its limited scope because SICA applies only to those companies which are industrial companies, it is quite clear that a big number of institutions, which are not the industrial undertakings, can’t get shelter of SICA. 

SICA allows that even a single institutional creditor can veto a scheme for rescue and can make whole efforts futile.

Companies Act 1956:

Chapter V, of the Companies Act 1956, which is yet in force, provides a mechanism by which corporate can enter into a scheme of arrangement or a compromise with its creditors and members. Powers given under this chapter are very wide and allow a company to have legitimate arrangement with 3/4^th majority of court, without complying other provisions given in the act, under the supervision of High Court.

Unlike SICA, it covers all companies, and not just industrial ones, and can be initiated at any point of time, even without waiting for any sign of distress (reduction of networth etc.).

As the applicant, don’t need to have any proof of insolvency, it allows to have such timely action well in advance.

Further, unlike the SICA where a single institutional creditor can veto a scheme for rescue, the requirement of obtaining only (special) majority creditor approval.

But it overlooks the crucial requirements of a rescue mechanism- a long-drawn-out procedure, too expensive and complicated cannot be effective, at least where speed and urgency is needed.  

The late decision-making, either intentional or non-intentional, by a creditor or a group of creditors, regarding the scheme/compromise can affect the scheme adversely.

The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002:

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002, allows banks and financial institutions to auction properties (residential and commercial) when borrowers fail to repay their loans. It enables banks to reduce their non-performing assets (NPAs) by adopting measures for recovery or reconstruction. If a borrower defaults on repayment of his/her home loan for six months at stretch, banks give him/her a certain period to regularize the repayment, that is, start repaying. On failure to do so, banks declare the loan an NPA and auction it to recover the debt.

Majorly it’s a loan recovery law and cannot be equated with Insolvency/bankruptcy laws.

DRTs (Debt recovery tribunal) and CDR (Corporate Debt Restructuring mechanism):

The Corporate Debt Restructuring mechanism, as envisaged in the RBI circulars on the subject, aims to provide a forum for corporate debt restructuring for viable businesses in financial distress outside the court/tribunal driven legal processes. Whereas the court-supervised scheme of arrangement procedure provides a formal route to the restructuring of any or all of a company’s debts through a court, the CDR tool aims to facilitate the restructuring of debts owed to a class of creditors (institutional creditors) using essentially contractual means. Only debtors availing credit facilities from more than one bank with an outstanding total debt of INR 10 crore or more are eligible for such restructuring.

Companies Act, 2013:

The Companies Act 2013 (Chapter XXI of Companies Act, 2013, which is yet to come into effect, permits a secured creditor or the company to make a reference to the NCLT for declaring the company to be a sick company if it is unable to pay/secure/compound the debt when a demand for payment has been made by secured creditors representing 50% or more of the outstanding amount of debt within thirty days of the service of notice of demand,

Reference may also be made by the Central or State Governments, the RBI, a public financial institution, a State level institution or a scheduled bank if it has sufficient reasons to believe that a company has become sick.

Thus, typically, the triggers for making a reference to the NCLT for determination of ‘sickness’ of the company are:

(i) non-payment of 50% or more of the outstanding amount of debt when a statutory demand has been made; or

(ii) belief that the company has become sick. As per the draft NCLT rules, a ‘sick company’ is defined to mean and include “a company, which has failed to pay the debt of its secured creditors within 30 days of the notice of demand or to secure or compound it to the reasonable satisfaction of the secured creditors as per section 253 of the Act”

Thus, the insolvency provisions in the new Companies Act are undoubtedly a step in the right direction, since they bring about greater transparency in the issues concerning the liquidation of Companies.  These comprehensive legislations would also ensure greater clarity for investors, both Indian as well as of foreign origin, which are willing to invest in the Indian Securities Market. Chapter XXI of Companies Act, 2013 provides a much improvised mechanism in various senses than SICA and Companies Act, 1956.  But some changes brought by the act can be subject to review. For example:

(i) What is the basis/need to have a limit of “50% or more of the outstanding amount of debt”? Shouldn’t it be any amount if have clear/sufficient reason to believe that the company is not in a position to repay/secure the money.

(ii)   The law is silent if power is being misused by applicant as a pressure tactic?

(iii)  If debtor wants to have suo moto proceedings, then what will be the process?

(iv)Creditors don’t have right to appoint company administrator?

(v)  A clearer process needs to be for cross country insolvency problems.

Recently the government of India has, taken some initiatives by forming a committee to evaluate the winding up/insolvency practices in India.  Their recommendations may have far reaching impact, if implemented carefully, such as timed way of solving cases, establishment of special courts (replacement of BIFR with NCLT) and introduction insolvency professionals.  

If we carefully examine, Indian Insolvency system must be amended by emphasizing following areas to make it effective:

Advance assessment of the probability of default:

Lenders not only want to know the value of the loans that they have made but they also need to know the risk that they are incurring. Some rely on the judgments of ratings services, some on their individual self-developed parameters. As on date there isn’t any fixed formula by which a firms paying capability can be judged, though key numbers such as debt ratios, earning to interest, book value of assets, expected returns can give a fair idea about the financial worthiness.  

The present criteria, which allow, for having the safeguard measures at a stage when the company has already defaulted on 50% of its outstanding debt, makes it difficult for timely and effective revival.

Early identification of financial distress and possible remedial measures, which can be taken in respect there to, is very important so that steps could be taken to revive the ailing companies.

Independency and Non-inclination towards any party

Various reports support the claim that the Indian laws, which allow a party to intentionally delay the process, can be used as a tool to safeguard against the legitimate claim by the counter parties. There must have mechanism to identify genuine claims and get it differentiated from colored one.

The handling of conflicts between creditors and debtors, avoid destruction of value, distinguish malfeasance vis-a-vis business failure and clearly allocate losses in macroeconomic downturns.

Limited time frame vs. Judicial intervention

A report of World Bank says that:

“creditors in India recover about 25.7 cents on the dollar in the 4.3 years that it takes to resolve insolvency, World Bank data show, compared with 80.4 cents in the U.S. after less than half of that time. This inability, to collect on dues, has played a key factor to lock up funds at banks. As on date the stressed assets are at the highest level in more than a decade.”

“A delayed justice is no justice”. The biggest criticism against existing Indian system is that it allows delay of several years and ultimately made the whole efforts at least ineffective. Indian law makers have readymade solution for it, to form special Courts/Tribunal/Benches.

But, what about the appellate procedure?  If an appeal can be made against the order of special Courts/Tribunal/Benches in the normal courts, the story will remain the same.

In a situation where one forum decides on matters relating to the rights of the creditor, while another decides on those relating to the rights of the debtor, the decisions are readily appealed against and either stayed or overturned in a higher court. Ideally, if economic value is indeed to be preserved, there must be a single forum that hears both sides of the case and make a judgment based on both.

According to report written by current RBI governor Raghuram Rajan, because the ossified laws in India allow, it is quite possible to roll over debt and result is that the average time taken to close a business in India is 10 years, compared with 1.7 years in China.  This report also highlights abysmally low asset recovery rates in India—12% at the end of a bankruptcy process compared with China’s 36%. 

Before proposing any new or old regulatory systems, relationship which it is going to have with general courts also needs to be examined.

Mere limiting a time frame is not going work unless decisions given, process agreed by the parties and any affirmation if needed from the court has been defined in a proper manner.

Transition provision:

A major challenge faced by the lenders at this stage is how to repair their cracked balance sheets. This question remains unanswered even with new Companies Act, 2013. It is unclear with respect to the existing stock of bad loans, where recovery from corporations pending for several years. It’s not clear how it can apply to existing cases.

Special provision for certain category of applicant

Insolvency is not the demand of mere corporate but it should cover each kind of business entities. The Companies Act, talks about winding up of unregistered companies also. With rise of MSME’s, LLP’s and other firms, and other kind of ventures it is inevitable to have such provisions.

Do we really need the new kind of Professionals?

The recommendation by expert panel, set up for reviewing exiting framework has called for introduction a new class of professionals who dealt with insolvency practices. Although most of the time, even in this article I have supported for a special kind of judicial benches, but even then it is the industry experts along with existing managers, due to its own specific experience, can be in a better place to manage such kind of situation.

Promoter vs. Distressed Company:

First thing we read about a company is that it is a distinct entity from its shareholders. The Indian Bankruptcy laws haven’t differentiated the liability if any of special kind, the promoter possess in case of a liquidation events; sometimes it may results into a wealthy promoter vs distressed lenders/investors and after that a long, time consuming legal process. 

Removal of multiple dilemmas, existing laws are posing 

The laws have several dilemmas; here one can go to jail for failing to repay just 500 rupees (Presidency Towns Insolvency Act, 1909), but simultaneously under what passes for insolvency protection for companies, firms need to wait until at least half of their value is wiped out before seeking any help from regulator’s side.

Start Afresh:

There will always be booms and busts and the classic never-say-die attitude that law makers are sitting on it, will do little only.

There are lots of talks about ups and downs, on a bad day; we may tend to come across headlines screaming about the billions that have been bled out of the value of investments in one day. But it is rare to come across headlines raving about the billions that have been wiped on in a rally. But yes it is possible and real.

Starting afresh is a natural right an individual possesses, and ideally a business entity must also be allowed to have it. Needless to mention, the lack of clear laws not only discourage new entrants, enhanced fear of failures but also create blockage in easy flow of investment/borrowing, and a clearer time bound efficient system must have to be in place.

Ashish Panday

Guest Author Ashish is Member of ICSI & Graduate in Economics. He is associated with M/s Uniserve Knowledge Foundation (ÜKF") in his capacity as Head of Legal & Secretarial Committee.