This article has been written by Bhabya Rani, pursuing a Diploma in General Corporate Practice: Transactions, Governance and Disputes from LawSikho.
Table of Contents
During the dusk of 2019, a number of people in China started searching online for specific symptoms regarding health. This was an outbreak of pandemic (COVID-19) which soon took over the whole world. This had several impacts on business operations and trade which triggered a major corporate solvency crisis. Steps were taken by the government including introduction of relief packages for supporting the economy.
As we know, the government of India temporarily suspended section 7, 9 and 10 of Insolvency and Bankruptcy Code, 2016 (“IBC”) as part of the economic relief package to support the economy. This was to avoid any fresh insolvency petition against companies for a year. So, Covid-19 debts were kept outside the purview of IBC. Latest amendment ordinance, The Insolvency and Bankruptcy Code, Ordinance, 2020, introduced section 10 (A) and 66 (3). Section 66(3) for the protection of partner/director of a corporate debtor from any liability in case any default occurs when Corporate Insolvency Resolution Process (“CIRP”) gets suspended u/s 10A of IBC; also regulation 40 C was introduced in IBBI Regulation, 2016, for providing exemption from the lockdown period.
Challenges faced by economy
The challenge mainly arose due to the uncertain nature of Covid-19 pandemic and its economic consequences. Pandemic led towards sudden supply shock as the previous method of production became impossible in a lot of cases and consumption pattern also changed due to various associated restrictions. Thereby, losses were faced by the companies and urgent liquidity was needed for its continuity. Consumers have limited their expenditure to essential products and services only in this situation. This consistent shock globally disrupted the supply chain as the initial outbreak in China led to plant closures and supply shortage.
The unsure prediction of difficulty regarding duration and path of recovery after the pandemic, and differentiation between the permanent or structural changes and temporary changes in demand, made it difficult to determine the long term viability of enterprises during the pandemic. Even, there is a difference between the propagation mechanism, financial players, and financial context from those seen in the 2008 global financial crisis faced by the world. The coronavirus crisis has directly hit the balance sheet of firms in the real economy, with the potential risk of spread to balance sheets of banks. The presence of more diverse, alternative private capital sources are expert and capable for non-traditional investments through private fund structure which led to the growth of private equity and debt globally which outpaced global GDP growth of 51% between 2017-2019.
The hardest hit sectors in India include civil aviation, tourism, cultural sector etc. Manufacturing sector, agriculture and transport are also struggling. Most MSMEs are on the verge of shutting down.
Need of legal amendments
There is a need for a change in the bankruptcy code or introduction of new restructuring schemes because the businesses and firms are struggling. Many businesses in India are fundamentally sound but their balance sheet is unsound which unveils the unsuitability of the bankruptcy code of India for situations like Covid-19. There is a clear need for reform in insolvency code or introduction of new schemes which would facilitate contractual debt restructurings without the use of bankruptcy procedures in this crisis. Currently, it is very difficult to fix the solvency crisis through normal market operations, without harming the global economy.
The existing liquidity-focused policy measures by the government are insufficient. The support provided is inadequately targeted, which fails to sufficiently tailor the policy response to the problems of different firms. The excessive credit provisions risks overburdening of firms which promotes insufficient use of resources. Direct government decision making is excessively used and private sector expertise is used sub-optimally which could be a better direct support. This level of public spending by the government would be unsuitable over the potential duration of the ongoing crisis.
The legislation must focus primarily on –
- Better targeted credit to support firms- Policies of the government should seek to encourage appropriate lending. Target of the credit programme should be the firms that are fundamentally sound and could afford further debt.
- The infusion of equity or similar investment should be encouraged- Policy response to encourage borrowing has further added debt burden to a corporate sector. Equity and equity-like instruments help in funding companies and insulate them from shocks to their revenue streams, unlike loan which increases fragility in the balance sheet.
- Restructuring bankruptcy procedure- The way to preserve the concern value of business is preferably to a punitive approach in a bankruptcy system that destroys value is by improving restructuring and bankruptcy procedure, enabling restructuring of the balance sheet of viable but solvency-challenged businesses. There is a need for improvement to encourage speedy and cheap exchanges of debt for equity and the restructuring of loan terms and conditions or other similar actions.
- Preventive measure for future pandemic- to prepare the government and corporate sector for future pandemic, one potential tool can be government-backed business interruption insurance against pandemic risk.
Amendments in IBC
Section 10 (A) included in IBC provides that no application u/s 7, 9 and 10 of the IBC shall be filed against a corporate debtor for any default which has been committed on or after 25th march 2020. Further, new ordinance has a proviso which states that ‘no application shall ever be filed against a corporate debtor during this period i.e., from 25th March 2020 till the suspended period. For avoiding any confusion, the ordinance specifically states that any application filed against a corporate debtor prior to the period of 25th March 2020 shall be held maintainable.
As we know, ordinances like this play an important role in safeguarding the economy of a country from any type of domino effect occurring because of force majeure events like- Covid-19; it leaves more room for diverse interpretations for a lot of issues at hand. This is really needed when there is uncertainty and no predictions can be made.
The maintainability issue with respect to the applications filed and pending prior to the date of its promulgation is not discussed in this ordinance. However, this was resolved in the case of Arrow line Organic Products Private Limited V. M/s Rockwell Industries Limited, IA/341/2020 by NCLT Chennai bench, where it was held that “the ordinance shall have retrospective applicability to all applications irrespective of their date u/s 7, 9 and 10 of IBC.” This judgement is contradictory to the order passed by NCLT Kolkata, in Foseco India Limited V. Om Boseco Rail Products Limited, CP (IB) No. 1735/KB/2019 where it was held that “the ordinance will not have retrospective applicability in the absence of a specific mention.”
Cumulative implications of amendments
The amendment clearly specifies that no application under section 7, 9 or 10 can be filed for a period of 6 months for any default occurring after 25th march. The application must be within the threshold of Rs. 1 crore. This shows the intent of low value realization of assets. This amendment can aid MSMEs but can hurt them as well. Dues owned by major corporations to MSMEs are usually less than Rs. 1 crore. So, with this amendment the MSMEs wouldn’t be able to drag these major corporations to NCLT even for recovery of their debt. Though, this amendment will protect the MSMEs from being dragged to NCLT by major corporations. This will have a long term impact on MSMEs in realizing their debt as this threshold is permanent as per notification.
The ordinance of June 5 amendment, based on ‘One size fit all’ approach as sector-wise distinction is not considered. Some of the sectors are facing the impact of Covid-19 but certain sectors like- medical and essential services are doing usual business. Suspension of provisions in the code initiating the CIRF altogether is not proper. There must have been a provision specific for the entities which have defaulted solely on account of pandemic.
Future policy development recommendation
Let’s further explore the four legal amendments that the legislature must focus on, as pointed earlier in this article.
- Better targeted credit programs as there is a need for policies which encourage appropriate lending. Target of the credit programme should be the firms which are fundamentally sound and could afford further debt. This can be done by decreasing the guarantee percentage; guarantee against extreme negative outcomes on loan portfolios instead of individual loans; encouraging a wider range of credit spreads to allow more risk- sensitive pricing; use stricter minimum credit underwriting standards. This will help in binding resources without generating corresponding economic value. For example– Germany introduced a new fully guaranteed loan programme to support SMEs on April 6, 2020 which offers SMEs loans up to € 800,000 with a full guarantee and 3% interest. Similar programmes are introduced in the US and Australia as well.
- The infusion of equity or similar investment should be encouraged- Policy response to encourage borrowing has further added debt burden to a corporate sector. Loans increase fragility in the balance sheet of a company so, equity and equity-like instruments are a better option for funding companies and insulate them from shocks to their revenue streams. Incentives should be taken by the government to harness the expertise of private sector investors and encourage investment as long term equity funds. But, the government may take lead independently if private expertise is not present or the government has an option of private investors as passive participants. This can be done by converting loans backed by government into equity or equity like instruments; and nationalised companies or take significant government stakes. For example– Singapore introduces a Special Situation Fund for Start-ups to leverage domestic and international private capital expertise, with government co-investment on one-to-one basis, via convertible debt. Related programmes are functioning in the UK and US as well.
- The way to preserve the concern value of business is preferably to a punitive approach in a bankruptcy system that destroys value by improving restructuring and bankruptcy procedure, enabling restructuring of the balance sheet of viable but solvency-challenged businesses. There is a need for improvement to encourage speedy and cheap exchanges of debt for equity and the restructuring of loan terms and conditions or other similar actions. This problem arises due to bias towards liquidation over restructuring which amplifies the issue. The government can deal with problems by-
- Establishing temporary processes that facilitate and enforce speedy resolution between existing stakeholders of the firm through the power of cramming up or down the resolution decision.
- The temporary resolution system needs to be favourable for handling significant flows of restructuring, and, as such, will have to adhere to clear process and judgement criteria.
- As we know, members of the board of directors face personal liability for voting to pursue bankruptcy or formal restructuring which can be an important obstade to voluntary restructurings. So, consideration should be made by the government for limiting personal liability to encourage boards of directors to pursue timely restructurings as a part of temporary action.
- Preventive measure for future pandemic- To prepare the government and corporate sector for future pandemic, one potential tool can be government-backed business interruption insurance against pandemic risk. Cover to provide first layer support to prevent viable firms from going under in a pandemic could provide more certainty to business and their leaders about finances of affected firms. Government could either provide insurance or reinsurance to the insurers. Though, reinsurances by the government would be a better use of the private sector’s distribution and administration expertise than the government acting directly as an insurer.
This pandemic will have a long term impact on the world economy. It started with a corporate liability crisis that may turn into a solvency crisis in different sectors and individual firms in the country. It was necessary to focus on liquidity in the beginning. With increasing pressure on the fiscal capacity of governments, there is a need for nuanced policy response to a growing corporate solvency crisis.
As resources are finite and the costs of the pandemic large, governments will have to make tough decisions keeping specific priorities in mind. There is a need for targeted measures focused on those firms that need more support and taking other steps to support the economy through businesses, providing support to the corporate sector in the most efficient and effective way to protect living standards in the country and to prepare ground for long term economic resilience.
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