This article has been written by Ashapurna Roy pursuing a Startup Generalist & Virtual Assistant Training Program from Skill Arbitrage.

This article has been edited and published by Shashwat Kaushik.

Introduction

The direct proportionality and positive correlation between economic freedom and growth is well established in economic literature. Businesses generate goods and services, thereby stimulating consumer spending, regulating demand and supply, creating employment opportunities, and fostering innovations in technology. The result is an increase in economic output and Gross Domestic Product (“GDP”) for the country. Therefore, establishing an optimal external environment for businesses to flourish is a sine-qua-non for all economies. The legal framework within which businesses function plays a crucial role in determining their success. In particular, businesses need freedom at three stages, namely,

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  • Freedom of entry (no restrictions on entry to the market, i.e., to start a new business),
  • Freedom of competition (ability to sustain and grow business operations under the aegis of free market), and lastly,
  • Freedom of exit (no barriers to exit from the market, i.e., to wind-up the business).

Freedom of exit is perhaps the most significant as it facilitates the exit of unproductive or insolvent firms, liberating limited resources for more efficient market users, thereby bolstering market efficiency. A sound bankruptcy law enhances freedom of exit by providing a time-bound, transparent, and cost-effective mechanism for resolving distressed assets. The Insolvency and Bankruptcy Code, 2016 (“IBC/Code”) which came into force on May 28, 2016, is a comprehensive piece of legislation enacted to consolidate and amend the legal charter for insolvency and bankruptcy in India.

The enactment of the Code marked a watershed moment in Indian corporate legislative history by providing for reorganisation and insolvency resolution of corporate persons, partnership firms and individuals in a time bound manner for maximisation of the value of the assets of such persons, to promote entrepreneurship, availability of credit and balance the interests of all the stakeholders, including alteration in the order of priority of payment of government dues and to establish an Insolvency and Bankruptcy Board of India. In upholding the constitutionality of the IBC in the landmark case of Swiss Ribbons Private Limited and Another vs. Union of   India and Others (2019), the Supreme Court observed that the primary objective of the IBC is the reorganisation and insolvency resolution of the corporate debtor in a time-bound manner. In Binani Industries Ltd. vs. Bank of Baroda & Another [CA (AT) (Ins) 82/2018 & Others], the NCLAT emphasised the order of objectives of the IBC as follows, first order objective of the IBC is resolution; the second order objective is maximisation of the value of the assets of the firm; and the third order objectives are promoting entrepreneurship, availability of credit, and balancing the interests of stakeholders. This order is given sacrosanct value under the Code.

The legal milieu

Prior to the enactment of the IBC, Indian insolvency and bankruptcy laws were multiple and fragmented. The winding-up of companies was regulated by the Companies Act, 1956 and thereafter by the amended Companies Act, 2013. However, their provisions were quickly found to be inadequate. Winding-up proceedings could only be initiated after the company had defaulted on repayment of its debts, leaving no scope for rehabilitation or reorganisation of the company while in distress. The liquidation process was also long and cumbersome for the creditors. The Sick Industrial Companies (Special Provisions) Act, 1985 (“SICA”), prescribed for the determination and implementation of remedial measures for the revival of “sick” companies. However, the SICA was applicable only to industrial enterprises, led to considerable misuse of the prescribed moratorium to the detriment of creditors and was otherwise unable to fulfil its legislative intent. Among the debt recovery and security enforcement mechanisms available to financial institutions are the Recovery of Debts due to Banks and Financial Institutions Act, 1993 (“DRT Act”) and the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”), which sometimes took decades to enforce Non-Performing Asset (“NPA”) recoveries.

The sub-par bankruptcy laws of the country were ensnared in debtor-in-control modus- operandi, affording loopholes misused by defaulters to exploit credit institutions and destabilise the credit market. Moreover, the multiplicity of insolvency laws and enforcement authorities and the complexity of implementation mechanisms caused arbitrary delays. Prolonged litigation, exacting both time and money, further discouraged long term lending and stifled investor confidence in the market. In addition, the ballooning NPA portfolio of banks since the 2000s has been eroding bank profits and capital and constricting their ability to lend. This led to a credit crunch, limiting access to credit for businesses and individuals, thereby dampening investment and consumption, both key drivers of economic growth. The urgent need of the hour was progressive legislation balancing both creditor and debtor interests while establishing formal rules to enhance efficiency ex-ante, interim and ex-post. Born out of this necessity, under the guidance of the Bankruptcy Law Reforms Committee (“BLRC”), was the IBC, which introduced the necessary shift to a creditor-in-control insolvency regime aimed at reducing the cost of debt, improving credit supply, and encouraging long term loans.

Decoding the code

The IBC provides a two-pronged strategy for corporate debtors (“CDs”) facing insolvency, namely, the Corporate Insolvency Resolution Process (“CIRP”) and Liquidation. On the occurrence of default by a CD, a financial creditor, operational creditor, or the CD itself may initiate CIRP before the adjudicating authority, which is the National Company Law Tribunal (“NCLT”) having jurisdiction. Upon commencement of the resolution process, the powers of the board of directors of the CD were suspended and vested in an Insolvency Professional (“IP”). The IP functions under the overall control and supervision of the Committee of Creditors (“CoC”), which generally comprises the financial creditors of the CD. The CoC proposes the resolution plan for the CD. The objective of the CIRP is to preserve and increase the pool of assets of the CD for the collective benefit of the creditors and other stakeholders. Hence, a moratorium or “calm period,” is provided against individual or collective legal actions against the CD for the duration of the CIRP. If the CIRP fails, liquidation proceedings for the CD will commence.

A deterrence to defaults

The IBC has played a vital role in overhauling India’s archaic insolvency laws. In the first year of its commencement, IBC enabled banks to recover 49.60% of bad loans through either resolution or liquidation. The table below signifies the recovery rate of banks through various channels over the years.

Since the provisions of CIRP came into force in 2016, a total of 4946 CIRPs have commenced by the end of December 2021. 2527 CIRPs were initiated by operational creditors, 2111 by financial creditors and 304 by CDs. Out of the total cases that have been closed, around 47% (1514 cases) have been ordered for liquidation. While the data indicates a high percentage of closures under liquidation, on deeper analysis, it is observed that out of the total liquidation cases, 76% were referred from the erstwhile BIFR regime, with most of such cases being default accounts for over a decade and mostly defunct for years. Refer the table below for further details.

The IBC has accelerated asset enforcement through liquidation. Besides, it can be readily seen that the remaining 53% of cases are those that are either successfully resolved through resolution plan approval or by way of withdrawal or settlement, which indicates a healthy level of performance by the Code. Further, till December 2021, 19,803 applications for initiation of CIRPs with a total underlying default of ₹ 6.1 lakh crore were resolved before admission. Gone are the days when defaulters would misuse and manipulate the ambiguities in the law to delay repayment to creditors. The IBC fosters a credit environment that dissuades promoters from operating below an optimum level of proficiency.

Third pillar of economic freedom

A cornerstone of a competitive and dynamic market is the ease of entry and exit afforded to firms. Barriers to exit weaken market discipline as economic resources such as labour, capital, and assets continue to stagnate in unproductive firms, impeding entry of efficient firms into the market. The IBC provides an integrated “one-stop-shop” insolvency resolution mechanism, giving impetus to the process of ‘creative destruction’. The theory of creative destruction, formulated by economist Joseph Schumpeter, postulates the departure of obsolete or non-competitive businesses as necessary for reallocation of the scarce factors of production to more innovative and efficient firms. Productivity and economic growth are augmented by the utilitarian allocation of resources to successful ventures. By establishing itself as the third pillar of economic freedom (i.e., freedom of exit), the IBC strengthens the market selection process, facilitating the timely exit of non-viable firms and the restructuring of viable firms to preserve value.

Early detection and prevention

To cure the information asymmetry plaguing the Indian credit market, the IBC proposed a regulated information industry in the guise of Information Utility (“IU”). A major milestone towards that end was the establishment of the National E-Governance Services Limited (“NeSL”) in 2017 as India’s first IU. The IUs act as repositories of authenticated financial information on debts and debtors. The information is disseminated for use by institutional creditors in the form of Credit Facility Report (“CFR”). When a default in loan repayment occurs, it is reported to the IU, which then presents the information for verification of the debtor. The debtor is provided three opportunities to repay the debt and cure the default, failing which information about the default is circulated among other creditors.

Needless to say, the IU has reduced the bank’s dependency on debtors for information. The availability of timely financial information improves credit appraisal, i.e., assessment of the creditworthiness of borrowers prior to the grant of credit facilities, as well as monitoring of the repayment behaviour of existing borrowers. Special Mention Accounts (“SMAs”), which are a classification used by banks to identify loan accounts displaying signs of initial stress but have not been classified as NPAs as per Reserve Bank of India (“RBI”) Prudential Norms, can be meticulously monitored to provide opportunity for stress resolution. This ensures minimal value erosion of the underlying assets of the enterprise due to mismanagement or default of the CD. Timely remedial actions can prevent potential slippages into NPAs. Thus, the integration of IUs within the insolvency resolution ecosystem enhances early warning mechanisms for creditors, enabling them to tackle financial distress proactively and facilitating the appropriate resolution or restructuring strategy of the CD as a going concern.

A creditor-centric approach

The IBC represents a paradigm shift from debtor-in-possession to creditor-in-control insolvency resolution mechanism, which has been instrumental in shaping the credit culture of the country. The erstwhile bankruptcy laws promoted a debtor-friendly regime, allowing the defaulting CD to secure a moratorium order and force write-downs on debt repayment. Retaining management in the hands of the defaulting CD led to protracted legal battles and frustrating efforts by creditors including banks, to realise payment of dues. The Code provides for the takeover of control of the management of the CD by its creditors. The creditors, represented by the CoC, and the IP, wield enormous powers of reorganisation, restructuring, and liquidation of the CD. This ensures the revival and continuation of the CD by protecting it from its own mismanagement and liquidation. The supremacy of the creditor-centric approach of IBC was emphasised by the Supreme Court in the case of Innovative Industries Ltd. vs. ICICI Bank (2017), wherein the Court rejected a challenge to the insolvency proceedings on grounds of limitation mounted by the corporate debtor and ruled in favour of the financial creditor. In K. Sashidhar vs. Indian Overseas Bank & Ors. (2019), the Supreme Court acknowledged the commercial wisdom of the CoC, which has been given paramount importance under the IBC for ensuring completion of the resolution process within the timelines prescribed under the IBC. In Essar Steel India Limited vs. Satish Kumar Gupta & Ors. (2020), the Supreme Court held that the NCLT and NCLAT must not trespass upon a commercial decision of the CoC. The decision of how much and what to pay the creditors lies with the CoC, which must reflect three parameters of maximising value of the assets of the CD, balancing the interests of all stakeholders, and ensuring that the CD is kept as a going concern during CIRP. As such, the decision of the CoC in approving or rejecting a resolution plan has been granted primacy by making it non-justiciable.

One of the cardinal principles of commercial law and the bedrock of commercial transactions is the sanctity of legal contracts. This implies legal protection and a framework for the execution of binding contracts. The sacredness of contractual obligations imparts stability to the economic system and dictates that inter-se contractual rights of secured financial creditors must be accorded priority in the event of insolvency. Further, unless the value of securities and collateral held by secured creditors is conserved during CIRP, institutional lenders would be disincentivised from offering low-cost loans, impacting availability of credit in the market. The circulation of low-cost credit promotes entrepreneurship ex-ante, necessitating protection of the contractual integrity of pre-insolvency rights and collaterals of secured creditors. This creditor-tilted approach towards insolvency resolution and liquidation generates revenue through rehabilitation of the sick CD, improves quality and access to credit, and instills enhanced fiscal and credit discipline ex-post.

Credit culture and investor confidence

Credit culture encompasses a set of policies, principles, management behaviours, and philosophies within an organisation or society governing the extension of credit, in particular relating to borrowing, lending, risk assessment, and debt management. A robust credit culture ensures a steady stream of affordable credit to business enterprises, timely servicing of loans by debtors as per agreed interest rates and committed resources for sound risk management. If corporate sickness and NPAs are not addressed in a timely manner, the ability of lenders to effectively allocate resources for businesses will be hindered. Lending will contract, the cost of credit will surge, and aggregate output and employment will plumet, leading to an economic slump.

A multitude of studies have indicated strong causal relations between high creditor protection and a higher recovery rate, a higher credit supply and lower interest rates. By establishing a clear and predictable framework for insolvency resolution, the IBC improves debtor-creditor relations and promotes a healthy credit culture. It encourages borrowers to honour their debt obligations and discourages strategic defaults by imposing consequences for non-compliance (such as loss of control of the company). This fosters a more disciplined approach to borrowing and lending, thereby improving the overall quality of credit in the market. As observed by the Supreme Court in the case of Swiss Ribbons Private Limited, once the resolution plan commences, the CD can repay its debts, which promotes the credit market. As the CD benefits from the resolution, the interests of all stakeholders are looked after.

Transparency, accountability, predictability, and legal and institutional mechanisms are fundamental to investment decisions. As a corollary to the development of a sound credit culture, the IBC enhances investor confidence by promoting the above qualities. This confidence is particularly important for attracting investment, both foreign and domestic and fostering the growth of corporate bond markets, as investors are reassured by the existence of an effective mechanism for debt recovery and resolution.

Resolution of non-performing assets (“npas”)

The IBC has been instrumental in addressing the issue of increasing NPAs in the Indian banking system. By facilitating the timely resolution of stressed assets, the IBC helps banks and financial institutions clean up their balance sheets and allocate capital more efficiently. This, in turn, enables lenders to recycle funds into productive lending activities, thereby stimulating credit growth. The banking sector NPAs in 2015-16 increased from ₹6,119 billion to ₹10,397. By the end of September 2021, the NPAs reduced to 6.90%, as can be observed from the table below.

Further, the table below shows that the amount recovered has been much higher than under any other method in 2019-20 and even for the period 2020-21 where there were restrictions on initiation of proceedings under IBC (due to the COVID pandemic), it accounted for almost 43% of the amount recovered, showing its success. The amount recovered as a percentage of the amount involved was 46.3% under IBC, higher by a very large margin as compared to other methods in 2019-20. In comparison, it was 17.4% under the SARFAESI Act, which had the second highest recovery rate. The same trend was true for the previous two years as well (2017-18 and 2018-19), although this was not so in 2020-21 largely due to the suspension of proceedings on account of the COVID-19 pandemic. This is a noteworthy achievement considering it has been less than eight years since the inception of the Code.

Personal guarantors

Legislative amendments and judicial reforms have played a significant role over the course of the past eight years in evolving the jurisprudential body of the IBC. Among the important ones is the enactment of the provisions in IBC relating to personal guarantors (“PGs”) to CDs in November 2019. The validity of this enactment was upheld by the apex court in the case of Lalit Kumar Jain vs. Union of India (2021). In this case, the Supreme Court held that to achieve the Code’s larger goal of reviving corporate entities, the PG’s right to recover the guarantee from the CD ceases to exist when the guarantee is invoked by a creditor. This was a major departure that greatly enhanced the rights of the creditors against guarantors and promoters, allowing creditors to initiate and maintain proceedings against both CD and its guarantors before the NCLT.

The path forward

As with any new legislation, the IBC also faces implementational challenges, especially regarding delay in admission of insolvency applications as well as the CIRP, greater recourse to liquidation over resolution, vacancy of NCLT and NCLAT benches, inadequate provisions for cross-border bankruptcy and group resolution procedures. Yet, it cannot be denied that over the eight years of its operation, the IBC has achieved several milestones in the form of improved loan recovery, increased out of court settlements, and debt restructuring of listed firms, compared to erstwhile modes of recovery. Being led by market driven and creditor-centric forces, the IBC has infused greater transparency in the resolution process and improved investor confidence, bringing about a perceptible transformation in the prevailing credit culture of the country.

The success of IBC has positively contributed, inter-alia, to remarkable improvement in India’s “Ease of Business” parameters. As per the World Bank’s latest “Doing Business” Report 2020, India’s overall ranking in the ease of doing business had jumped to 63 from its earlier rank of 142 in the year 2015. Additionally, through the consistent interpretation and application of the IBC, the judiciary stood as a bulwark against erosion of creditor’s rights, positively impacting debtor-creditor relationships and ensuring implementation of the spirit of the Code.

In the long run, it is crucial to analyse the IBC through the lens of its legislative intent, being, ex-ante efficient business and resource management through the incentivisation of low-cost credit and proactive monitoring of firm performance; interim efficiency by minimising insolvency costs and timelines; and ex-post efficiency by preserving the going concern value of the business & facilitating asset reallocation for the maximum welfare of stakeholders. To ensure optimum realisation of these objectives, the existing chinks in the system caused by disparity between the letter of law and practice ought to be resolved through periodic review and correctional measures. Further, to meet the challenges of changing market conditions, the IBC must pragmatically strengthen the existing insolvency framework to yield higher economic efficiency and growth.

References

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