Why India Urgently Needs An Efficient Bankruptcy Code

As the Bankruptcy Law Reform Committee submits its final report to Finance Minister Arun Jaitley, here is a look at why India urgently needs an efficient bankruptcy code.

Prime Minister Narendra Modi and finance minister Arun Jaitley have promised to make corporate rescues and exits less cumbersome by bringing in a bankruptcy code to deal with insolvencies. They have said the code, comparable with best around the world, will be introduced in this financial year.

Work on the code began in August 2014, when a high-level committee under the chairmanship of former law secretary T.K. Vishwanathan was set up to study the legal framework for corporate bankruptcy in India and recommended changes. The committee submitted its final report on Wednesday; it had an interim report in February 2015.. On the basis of these recommendations, the government is set to move a bill on the subject in the winter session of Parliament.

Why do we need such a code?

When a business fails and there is little hope of reviving it, it makes more sense to close it down and reassign resources to another venture. A speedy closure process saves companies time, effort and money. Most investors like an environment where it is easy to set up a business as well as to exit it if the venture does not succeed.

If it is a case of financial distress only, a well-managed restructuring of the company, a moratorium on repayment of loans and refinancing of debt can help revive the company. For revival as well as for winding up, an efficient institutional and legal mechanism is required, such that all stakeholders’ interests are adequately protected.

Closing down a sick company, liquidating its assets and paying off creditors can take several years – sometimes even a decade – in India. In the World Bank’s Ease of Doing Business 2015 rankings, India ranks 137 on the `resolving insolvencies’ parameter; China ranks 53.

Companies become sick for variety of reasons – a change in the business environment, contraction of demand for its products, competition from cheaper imports, change in technology and inability to pass on higher input costs to consumers. Often, the distress would have been caused by an inefficient management or frauds committed by promoters. Many of these companies could be rescued with a change in management. In some instances, a part of the business may be viable while the rest may be bleeding, and survival of the company would depend on closing down of that part of the business or selling it off its assets.

Credible corporate rescues – which attempt to give a distressed company a fresh lease of life through restructuring that may involve  closure or sale of part of a business, management change and moratorium on creditors’ demands – are rare in India.  Other mechanisms such as corporate debt restructuring and joint lender’s forum through which a sick company can be rehabilitated are more popular.

Corporate debt restructuring (CDR) allows viable businesses facing financial distress to restructure debts owed to institutional creditors without courts or tribunals getting into it. Only those companies that have taken loans from more than one bank with an outstanding of Rs 10 crore or more are eligible for such restructuring.

Joint lenders’ forum is meant for early identification of financial stress where the amount involved is Rs 100 crore or more and the principal or interest payment has been overdue for more than 60 days. The process involves restructuring of loan with the objective of preserving economic value of the underlying assets as well as the lenders’ loans.

Debt recast is relatively commonplace for larger businesses, especially if the promoters of the company wield a lot of clout. Sometimes it is part of a government-sanctioned scheme to provide relief to a specific sector.

What are the current provisions for dealing with sick companies?

Currently the Sick Industrial Companies (Special Provisions) Act, 1985 (SICA) is the only rescue law in force for industrial companies. However, this has mostly been ineffective.

For one, frequent adjournments delay proceedings of the Board for Industrial and Financial Restructuring (BIFR), a statutory body that administers SICA. BIFR decisions are routinely challenged in courts, although the whole idea of setting it up  was to limit judicial interference in the rehabilitation process. Even after proceedings are completed, reviving a sick industrial unit takes five to seven years.

Studies by different committees have noted other problems with the SICA-BIFR led rehabilitation packages – they failed to distinguish between cases suitable for rehabilitation and for winding up, and  they were pro-debtor and anti-creditor. More significantly, they allowed the current management to control the company during the rescue, which is seen to incentivise risky rescue measures. There were many instances where debtor companies abused SICA provisions to avoid repaying debt. Promoters were also known to siphon out whatever value remained in the company while proceedings were underway.

In 2002, the Companies Act, 1956 was amended to deal with insolvency of industrial corporate entities. The amendments sought to redefine sickness and allow the process of rehabilitation to kick in much before the company’s distress reached a difficult-to-redeem stage. The primary objective  was to make rehabilitation, liquidation or winding up of the distressed industrial units quicker and the process time-bound.

These amendments to the Act also entailed creation of a National Company Law Tribunal (NCLT) to replace the BIFR as well as repeal of the SICA. The NCLT was to be more than just a replacement for BIFR, it was to replace the Company Law Board as well as the companies benches of the high courts.

However, the constitution of the NCLT was challenged before the Supreme Court.. The Court, in 2010, upheld the constitutional validity of NCLT and the National Company Law Appellate Tribunal (NCLAT) and said transfer of the powers of the corporate benches of the high courts and the Company Law Board to the tribunal could be made only after certain defects in the law for setting them up were rectified. The apex court laid out qualifications and experience for those to be appointed as judicial and technical members of the tribunal and it wanted greater say for the judiciary in the committee set up to select members of the tribunals. The court felt these changes were required so as not to undermine the status and position of high courts. The directions of the apex court on remedying the situation were not completely incorporated either into the 1956 Companies Act or the new 2013 Act.

The NCLT has not been set up yet. So all aspects of rehabilitation of sick/potentially sick industrial companies continue under the SICA-BIFR regime.

In May 2015, the Supreme Court disposed of another set of challenges to the constitutional validity of the NCLT and NCLAT. However, it asked the government to incorporate its directions on the appointment of technical members and the constitution of the selection committee to ensure constitutional validity of the tribunals. The amendment bill to be moved by the government is expected to address these issues.

What shape could an insolvency code take?

An insolvency code needs to consider not just corporate insolvency, but also insolvencies of individuals, partnership firms, cooperatives and financial institutions.  However, the focus right now is on corporate insolvencies and legislative changes to deal with those.

The Vishwanathan committee had said, in its interim report, that existing laws for dealing with corporate insolvencies could be updated immediately without undermining the proposed code. It noted that many of the provisions of the Companies Act, 2013 on rescue and liquidation are relevant for the code. Given the government’s keenness to find quick resolutions for corporate insolvencies and also the fact that the legislative changes required have been identified, that is the path the government is expected to take in the coming winter session. The insolvency code, which the committee is expected to make recommendations on, may follow later.

One of the committee’s key recommendations is that “viability should be the most important (if not the only) consideration for allowing a company to be rescued.  Unviable insolvent companies should not be allowed to continue  functioning for extraneous considerations. Liquidation should not be seen as a measure of last resort for unviable businesses that have become insolvent – they should be liquidated as soon as possible to minimise the losses for all the stakeholders”.

It has also suggested several amendments to provisions of the Companies Act, 2013 relating to the NCLT, in order to make it an effective tribunal – not just in its functioning but also in implementation of its orders.

If Make in India has to be a success and India is to be seen as a place that is business friendly, the government needs to make peace with the judiciary by amending the Companies Act appropriately. That should be followed up with early constitution of the NCLT an NCLAT. In addition, work on the insolvency code should also get going in right earnest.