• Dakshita Chopra

Mandatory Pre-Insolvency Restructuring: The Next Step in the Evolution of Our Insolvency Ecosystem

[Dakshita is an Associate at Chambers of Senior Advocate Sanjay Sen.]


Amidst mounting non-performing assets and a spate of largely unsuccessful laws for debt recovery, the Insolvency and Bankruptcy Code (IBC) was enacted in 2016. It was touted as the most ambitious economic legislation of India with the hope that it will yield a shorter timeframe for resolution and lower losses in recovery of debt. In the last five years, the IBC has fallen short of expectations. As noted by the Parliamentary Standing Committee on Finance in its 32nd Report, 71% of the cases have been pending with the National Company Law Tribunal (NCLT) for more than 180 days and creditors have had to accept haircuts as large as 95% of the debt.


Speedy resolution is preferred under the IBC, as delays not only erode the value of the company but also make it more likely that the resolution process will result in liquidation. While it is certainly imperative to bolster judicial infrastructure by increasing the number of specially trained judges, it would be more prudent to reduce the workload of the courts by encouraging early intervention at a pre-insolvency stage and preventing company failure to begin with. A parallel approach through out-of-court early restructuring similar to pre-litigation mediation could be institutionalised in the IBC itself such that the NCLT acts as a court of last resort if the company is forced into insolvency. In the context of the insolvency procedure under IBC, M.S. Sahoo, former chairperson of Insolvency and Bankruptcy Board of India has himself opined that “in the long run, the best use of the IBC would be not using it at all. That would be the ultimate corporate governance.”


Framework for a Pre-Insolvency Restructuring Mechanism


While negotiations towards a voluntary scheme of arrangement (SoA) are permitted under the Companies Act as a debt restructuring tool for both solvent and insolvent companies, it seems to be on the path to obsolescence. The unpopularity of SoA is perhaps owing to factors like excessive court intervention which leads to a protracted restructuring process, shaking the confidence of the parties and freedom of holdouts by recalcitrant creditors. The Indian insolvency regime would benefit from reviving the SoA mechanism by retaining the overarching theme of out of court debt restructuring and taking guidance from the form and substance of the EU Directive on Preventing Restructuring Frameworks (EU Directive) using a four-pronged approach.


First, at present, Section 138 of the Companies Act 2013 (Companies Act) is silent on the contours of the duties of internal auditors, leaving scope for laxity. The internal auditors, can in fact, play a crucial role in pinning down a crisis situation. Certain indicators like a) the absence of ‘regular and systemic business operations’ for the current financial year b) late payments – statutory or otherwise and/or c) debt service and liquidity ratios should trigger a duty to warn the management or require an interim auditor’s report. This must be formally instituted in the Companies Act to enable prompt identification of early signs of distress and facilitate early restructuring, independent of the corporate insolvency resolution process, to remediate the same.


Second, for adoption of the restructuring plan, a supermajority vote by all the creditors without any classification should be preferred. A simplified procedure like this will avoid time consuming litigation against artificial distinctions between classes and hierarchisation of creditors belonging to the same class. It would also overcome a shortcoming of the SoA, which, as per Section 230 of the Companies Act, requires the approval of 75% of each class of creditors, risking holdouts by those who comprise a majority in a particular class, thereby stalling the scheme. Additionally, the classification requirement has come under the scanner for difficulties in identifying a class which has been discussed by the Bombay High Court in State Bank of India and others v. Altstom Power Boilers.


Third, rather than adding more layers to the extant administrative machinery, the ‘Resolution Professionals’, who are responsible for conducting the Corporate Insolvency Resolution Process under Section 23 of the IBC, can be tasked with assisting the stressed companies during restructuring negotiations. After adoption of the restructuring plan by supermajority vote of all creditors, the final implementation should be made contingent only on the confirmation of the Resolution Professional without the need for court sanction. The Resolution Professional would have maintained oversight on the procedure, informed decision making by the creditors and safeguarded minority rights, rendering another round of scrutiny by the courts redundant. Akin to Section 34 of the Arbitration and Conciliation Act 1996, a limited provision of appeal to the High Court may be permitted in certain specific circumstances in the interest of fairness and equity. For instance, when the restructuring plan envisages additional lending as opposed to just rescheduling of debt and when it entails loss of employment.


Finally, the negotiations as part of the pre-insolvency restructuring should be kept confidential and publicity should be avoided. Since the SoA process is marked with court intervention at almost every stage, it is impractical to expect it to be confidential. Unfortunately, in India, the stigma attached with admitting that a company is in financial distress, makes them hesitant to pursue damage control at an early stage. As a result, they kick the can down the road until the company enters insolvency. Erosion in the value of its assets along the way eventually proves detrimental to the creditors who suffer deep losses in recovery of debt. Confidentiality of the process will also ensure that the debtor is able to negotiate freely, without adversely impacting their relationship with other financial partners and even their market reputation.


Why Should Corporate Debtors Not be Left to their Own Devices During Financial Uncertainty?


While the SoA is a voluntary mechanism, statutorily mandating stressed companies to resort to an early restructuring procedures as outlined above is necessary in light of two reasons that stem from the economic climate of the country. First, Indian companies are characterized by concentrated ownership, wherein the promoter exercises management and board control. Research has now established that such centralization of power may spell doom during a “downward spiral” as the top management tends to adopt a conservative stance by resisting change.


Second, MSME operational creditors, that form the economic backbone of the country, are lower down in the waterfall mechanism and thus, may prefer an out of court settlement with their debtors who are on the brink of insolvency rather than threatening them with the IBC. This especially holds true after the judgment of the Supreme Court in Committee of Creditors of Essar Steel India Limited v. Satish Kumar Gupta which clearly stipulates that IBC is binding for all claims - whether financial or non-financial as the overarching aim is resolution of the entity not recovery of debt. Operational creditors cannot by choice opt out of the IBC and contract for arbitration in the event of insolvency. However, debtor companies may take advantage of this vulnerability and not heed to operational creditor’s requests of an early resolution unless compelled to do so by the law.


Conclusion


In sum, a pre-insolvency restructuring process will arrest the flow of cases to the NCLT, giving it the latitude to concentrate on more arduous ones and disposing them speedily. Early crisis detection and exploration of restructuring options will also preserve the value of the company, being mutually beneficial for both debtors and creditors.This will not only restore the faith in the IBC but also align the Indian regime to similar developments that are taking place in this realm internationally.

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