18 January, 2017
The Indian Insolvency and Bankruptcy Code 2016 ("Code") introduces a completely new insolvency and resolution regime for India. In this briefing, we provide an in-depth analysis of some of the issues raised by the final drafting and concerns that the Code presents when compared to our international experience.
Key provisions of the new Code – both the Act and accompanying rules and regulations – applicable to Indian companies, limited liability partnerships and other entities incorporated with limited liability came into effect in November and December 2016 (an overview of these provisions can be found in a previous article here).
The process of preparation, drafting and implementation of the Code was much faster than anyone expected, and is tangible evidence of the Government’s commitment to improving the ease of doing business in the country and freeing up the Indian capital markets.
As the Government has amply demonstrated by its recent implementation of demonetisation, it is prepared to bring in
measures which may be unpopular with some, and which in their implementation could be criticised, but which are designed to improve the economic outlook.
The Code is not perfect, and will need to be refined over time, just as our own legislation has been in the years since the UK undertook a radical overhaul of its own insolvency law in the mid 1980’s. It is easy to find holes, lack of clarity and perhaps even scope for challenge of the Code, but we consider it a very viable framework to build on and one which will, over time, prove to have been a critical step forward in upgrading the country’s legal infrastructure. As the Bankruptcy Law Reform Committee ("BLRC") itself has noted in its reports, the reform was long overdue and the pre-existing regime no longer fit for purpose in today’s rapidly changing world. The Code is brought forward in the light of the need to attract and facilitate foreign investment as well as the rapid rescue and turnaround of viable domestic businesses overburdened with unsustainable debt and a lack of transparency as to their true underlying economics.
Much of a descriptive nature has been written of late by lawyers, accountants and professionals seeking to explain the new law. In contrast, in this note we aim to be more analytical and provide commentary on some key provisions of the Code and related rules and regulations applicable to corporate persons. We do so with a view to encouraging positive debate and review, and from the perspective of professionals experienced in the field of finance, restructuring, turnaround and insolvency. Perhaps most importantly we combine that with almost twenty years' experience advising both domestic and foreign parties of every description who are doing business in India and with Indian counterparties.
We offer these thoughts in some trepidation. We are not qualified to advise on Indian law and nor do we purport to do so; we defer to those much more experienced and better qualified in that regard. We are also commenting on new and completely untested provisions. They will evolve. The BLRC itself intended they should be malleable and be refined over time.
At time of writing we understand that only one case has come before the NCLT, and that has apparently not gone to plan. When we were in Mumbai in December 2016 the general view of most participants in the market was that they would refrain from availing the new legislation until a number of test cases had gone through the system. We are in a critical period therefore when there is little precedent and much to play for in using the legislation for its intended purpose.
The new law is for good reason based upon our own UK insolvency law (in particular the administration process) but does not follow it in detail. The new provisions have been thoughtfully and deliberately adapted to suit the unique context, which we absolutely recognise.
In this note we are going to comment on particular provisions and structure those comments in roughly chronological order, following the process set out in the Code. We have not by any means identified every comment which could be made, or spotted every problem that could arise in practice, but we are highlighting matters we think of early significance and which we believe will need to be at the forefront of the mind when professionals, market participants and the judiciary are using and giving effect to the law in its early days. Our hope and intention is that there should be constructive debate and informed implementation of the law such that early precedents are consistent with its manifest intended purpose and reinforce its application in the furtherance of the underlying objectives which have brought it about.
2. Triggering the resolution process
There is now a clear and objective trigger to commence the resolution process (which is always a precursor to actual liquidation) under the Code. The trigger is a non-payment default – subject to a very low monetary threshold. The trigger can be pulled by any person who is owed money by a corporate debtor (whether or not that person is owed the unpaid amount).
This is a cash flow insolvency process and there is no parallel balance sheet insolvency test (ie there is no ability to commence insolvency proceedings absent a payment default if on the balance of probabilities, the company’s liabilities, including prospective and contingent liabilities, will exceed its assets as and when they eventually fall due). This is unusual when compared with other insolvency regimes, but was a deliberate decision by the BLRC.
This is also something of a hair trigger; already our discussions with market participants in India and abroad amply demonstrate the real possibility that someone with nothing (or very little) to lose could apply to the NCLT (the relevant court/adjudicatory body) for the resolution process to begin in anticipation that the consequential nuisance value and leverage to be gained (the consequences of an application and the resolution process commencing are severe for all parties) could create value where there would otherwise be none.
Experience abroad has been that funds will see this as a value opportunity and seek the opportunity to purchase claims for no other purpose. In a country where litigation has been used so often as a tactical weapon this risk must be real.
Though having no apparent discretion under the Code as currently drafted we consider that the NCLT may wish to take a stance in relation to claims of an unmeritorious vexatious or purely wrecking nature, and that modification of the Code may in due course provide for some discretion when the adjudicatory authority is considering whether to admit an application for the resolution process to begin or allow for challenge by the debtor.
We consider it highly likely that financial creditors will react to the hair trigger nature of the right to apply for a resolution process – and particularly the fact that any payment default can be relied upon by any creditor – by taking a stricter view also of cross default, cross acceleration and particularly materiality thresholds in debt documentation.
3. Information Utilities
It is intended that in reasonably short order there will be comprehensive credit information logged in the information utilities which will objectively evidence a non-payment or the existence of security interests, and which can be accessed by the creditor community at large.
Such transparency is daunting. It is to foreign eyes staggering that such comprehensive information can be reliably gathered, maintained, kept current and accessed but more importantly when implemented there will be no place for the recalcitrant payer to hide, and this will represent an enormous cultural change for the better.
We understand that the capacity to achieve this objective does exist in India today, and that steps are being taken to achieve it. Pending its full implementation, evidencing non-payment (especially non-payment to a third party) will be more laborious and is likely to result in some delays in the processing of applications triggering a resolution process.
Nonetheless it is intended that in the long term the NCLT should not look into the whys and wherefores of non-payment, or get dragged into disputes as to amounts due, but rather, provided clear and objective evidence is produced to it, admit an application (provided of course the non-payment has not been immediately rectified within the short time window available to do that).
Those seeking to commence the resolution process will therefore be well advised to keep clear, objective and verifiable records and indeed to be very careful (and seek appropriate advice) as to terms of correspondence and other dealings with debtors.
In due course, when information is readily available through the information utilities as to what has to be paid when, and whether it is still outstanding, the financial community in particular will need to be much tighter in its approval and documentation of waivers, extensions of payment dates and so on for these will need to be properly recorded with the information utilities. Borrowers too will need to be diligent in making sure their creditors make the needful updates to records.
This transparency is welcome to the foreign investor and creditor community; hitherto it has felt at a significant disadvantage to the domestic lenders in particular and ignorant as to exact details of payments and due dates. Waivers and extensions have been granted, and defaults occurred, without necessarily being readily discoverable, but this will no longer be the case
This is a very welcome change and a dramatic improvement from our perspective.
4. The commencement of insolvency as a reference point
At various places in the legislation, rules and regulations which comprise the Code, the “commencement of insolvency” is a point of time which is referred to for different purposes.
It is the time at which the NCLT admits the application and thereby begins the resolution process and the clock starts ticking.
It is when the moratorium on enforcement action commences (which is intended to permit time and space for the creditors to assess the viability of all or part of an enterprise and to implement a resolution plan if one can be agreed).
It is also the point in time as at which claims are valued. Claims are valued in part to assess the liquidation value attributable if no resolution plan can be agreed but also to determine the votes on the creditors' committee (which is constituted and convened after the application triggering a resolution process is admitted-see further below).
Financial creditors will no doubt wish to maximise their claims as at that time by accelerating their debt. And foreign creditors in particular will need to be fully aware of the affairs of their debtors and be prepared to act quickly. It is in our view highly likely that acceleration rights in English law governed debt documentation (notably the LMA and APLMA based agreements) will be tightened up and that acceleration may even be made automatic (as it is for similar reasons in US style documents or transactions involving US obligors already) for the protection of financial creditors.
Trade and other non-financial operational creditors who have a bargaining position may also seek to entitle themselves to shorten credit terms and/or immediate payment on the commencement of insolvency.
Joint venture parties (as to which subject we make more detailed comments below) will consider carefully what could happen if their Indian counterparty becomes subject to the resolution process and again may put a new emphasis on termination rights, and may in some circumstances consider making them automatic.
5. Who are the resolution professionals?
A key part of the application for a resolution process is the appointment of a resolution professional, who must belong to a recognised agency.
We understand that three agencies are now recognised (the insolvency agencies set up by the professional bodies for chartered accountants, cost accountants and company secretaries in India) and a number (by now in excess of 1,000) of individuals that are enrolled with these agencies have been licensed and are able to take on appointments.
The resolution professionals will be running the businesses in respect of which they are appointed. They will face daunting challenges gathering the information required to reliably assess financial viability and prepare a resolution plan or evaluate the resolution plans submitted to them, but equally will likely have little experience running the subject businesses until some years have passed. Equally it is fair to say that many candidates for appointment will have little experience of this new approach to insolvency.
It has been said to us this will be a weakness of the new system; while the intention is that promoters be forced to step back from their companies so that resolution can occur without their involvement, the reality of many businesses (especially SME’s) is that only the promoter can run them. Wider management is often weak or undeveloped and there is, as yet, very little professional management that can be parachuted in to a failing company alongside or instead of the promoter influenced current team. This can only change over time; it is encouraging that a number of funds we know of have actually built experienced asset management teams and there is no reason to think this will not improve. It is certainly no reason to adjust the legislation or criticise it.
Another comment which we have heard is this; even if the promoter can be made to step back, and decent independent management installed, there are countless possible sabotage and subterfuge options available in many Indian businesses which will undermine a successful resolution process. We well understand this observation too, but again it is no reason to hold back from supporting and seeking to implement the new process; only by doing so will change slowly be possible such that these experiences reduce and become the exception rather than the perceived rule.
6. The National Company Law Tribunal (NCLT)
The NCLT is new; and like everyone else inexperienced in the operation and effect of the Code. They are on a steep learning curve and facing undoubted challenges (the statutory timeframes for a start). However they will deserve nothing but support and encouragement to apply the law, especially those parts which are more outline, or where there are gaps, ambiguities or inconsistencies, in a commercial and common sense manner so as to achieve the objectives for which it was framed.
In the UK we have often heard the view expressed that there will be undoubted scope to challenge the new law almost every step of the way. Keen minds will be seeking to further divergent interests and the adjudicatory authorities will have their work cut out dealing with this. We would encourage the government to react speedily with clarifications, supplement and amendments as required if it turns out the tribunal and appellate body are in need of reinforcement in this endeavour, and we suggest an early consultation process with all the relevant stakeholders to ensure that the legislators are fully aware of and informed about any emergent weaknesses real time.
7. The creditors' committee
The creditors’ committee envisaged by the Code is a creature of statute and regulation, which is a marked contrast to the way creditors’ committees are generally established and function in other mature economies.
We are used to the creditors with most at stake establishing the creditors' committee, at first informally and then to a degree by contract, and for it to function as a body representative of the wider creditor group. The aim is the same, which is to quickly assess viability and to agree a way forward, but there are very significant differences between our experience and the way the Code has legislated the creditors' committee is to operate.
In our view this part of the Code will need to be adjusted relatively soon in light of experience to make sure that the committee is not manipulated so as to allow disproportionate influence to, or to disproportionately disadvantage, particular creditors or groups of creditors.
Our first observation is that the creditors' committee comprises all financial creditors (ie financiers) irrespective of their relative weight. In other words they are all treated as one class. Their votes appear to be pro rata to what they are owed at the commencement of insolvency whether or not their likely recovery rates are the same for example, by being secured or unsecured or the subject of intercreditor arrangements.
The consequence is that a secured creditor owed US$100K with a healthy loan to value-of-security ratio will have the same number of votes as an unsecured lender owed the same amount who cannot expect more than a small percentage recovery in a liquidation, and the same number of votes as a subordinated lender (other than an intra- group lender) of the same amount who ought to expect nothing. This is strange especially as the resolution plan expressly contemplates that a 75% majority of the entire creditor group could adjust the terms of all debt (including the secured lender – there seems no express protection for its headroom).
In other words the relative value of different classes of debt is not recognised at the moment by the Code, but we suggest it should be. Depending on the facts of a particular case it is quite possible as the Code currently stands that a low value (ie low or no percentage recovery debt) could be used (or transferred to someone else for them to use) to influence the resolution plan, its approval or rejection purely in order to be bought out by those wishing to achieve an alternative outcome. Some would argue this is no more than capitalism at work; but we consider it at odds with what is intended by the Code and therefore put it on the table for discussion.
It is very welcome that foreign financial creditors are enfranchised on the creditors' committee; this is a huge step forward which should be welcomed, as are points such as that noteholders can be represented through their trustee.
We perceive potential disadvantages to a system which requires the participation of all financial creditors. As noted above some may have only a small stake and little economic interest in the outcome. Systems and procedures must quickly be established to enable them to stand back if they desire (perhaps through proxy or nominee appointment, or even by waiving their entitlement to participate) and again this seems to us an area for pragmatism to override the dangers of non-participation (for example could a resolution plan be otherwise challenged if not all financial creditors participated on the committee even though required to do so?).
We have commented before that the distinction at various places in the Code between financial and operational creditors is not consistent with law and practice in other jurisdictions. It is truly difficult to work out whether this is more than a theoretical issue, and we know the BLRC considered this point and that there are arguments both ways. To us there is no legal distinction between a claim under a loan and a claim under a supply contract, especially if the supply contract allows time for payment (ie credit); it seems odd to say that financial creditors are voting members on the creditors’ committee when operational creditors (who are fundamental to the ongoing viability of the resolution process and the long term survival of the business) have only limited rights to attend through representatives other than in businesses that only have operational creditors, which is in our experience is unusual in the Indian context.
We think this could be argued both ways though because, de facto, we believe the operational creditors will use their bargaining position (as they are likely fundamental to the possibility of the business continuing during the formulation, agreement and implementation of a resolution plan) to protect their interests versus those of the financial creditor community.
It is possible that some operational creditors could argue to recharacterise their claims as financial debt (eg if supplying on credit) or even acquire low or no value financial debt from unsecured creditors with nothing to gain so
as to get a vote but much remains to be seen and this seems to us to be an area to be monitored, perhaps adjusted in the medium term, but of little immediate concern.
8. The position of secured creditors (including those funding during a resolution process)
We have noted above that the protection of a secured creditor’s position appears on the face of it weaker than we would anticipate.
Set against that we are of course aware that many Indian companies have very significant levels of secured debt relative to unsecured, a very large share of their assets subject to security and therefore that the secured creditors of most Indian companies will in fact have significant influence so as to protect their interests when considering a resolution plan.
The rights of secured creditors can however be adjusted by the approval of a resolution plan, their headroom (ie surplus security over secured debt) does not seem to be protected and indeed it is possible that (if the headroom is more than the secured debt) it can be fully used to support super senior borrowing to fund a resolution process.
This will be of greater concern to domestic creditors than foreign, since it is still the case that foreign creditors cannot avail security enforcement rights available to domestic lenders under the SARFAESI Act (despite the recent amendments to that Act, it still does not seem to us to mesh perfectly with the Code and level the playing field for domestic and foreign lenders). However the foreign experience has been that where a pre insolvency debt restructuring is agreed (with a view to avoiding an insolvency process as such) it will create a security over the whole of the assets and undertaking of a debtor for the benefit of all creditors in an agreed priority and waterfall. It seems that such an arrangement (which has to be a sensible tool to have available) can be unpicked during a resolution process in India which therefore will in fact mitigate against restructurings designed to keep a debtor out of insolvency proceedings and perhaps drive it into a resolution process.
We have been asked about this very question; banks are concerned about the sanctity of their pre insolvency funding of distressed companies through priority security and related intercreditor agreements. Such arrangements might be consensually achieved through existing RBI created mechanisms (JLF, SDR, S4A) which seem to be continuing parallel with the Code, and quite sensibly seem to be intended to co-exist and be available for resolving pre insolvent issues and potentially avoiding insolvency proceedings per se.
We believe there are arguments that would avail for the protection of secured lenders in such a position, but it would seem sensible to avoid them if possible by an early re-examination and clarification of this point.
That said, if there is surplus security available it should if at all possible be released to allow resolution and/ or rescue funding on a super senior basis. This is, we believe, what lies behind the ability of a resolution professional to realise secured assets without consent of the secured lender, and to effectively cash collateralise the debt and make use of the surplus.
We suggest another point for clarification is whether or not a dissenting financial creditor is paid out at liquidation value in order to allow a resolution plan to proceed; if that is indeed intended the realisation of security for rescue funding becomes doubly important.
9. Foreign lenders under RBI policies and the Code
The RBI policies applicable to the restructuring and sale of distressed debt, including the JLF, SDR and S4A schemes are consensual and do not require the involvement of the foreign lenders once triggered (unlike the domestic lenders) as they are not RBI regulated. As a result those international lenders tend to stand outside those processes hampering their effectiveness where there is measurable foreign debt. From the foreign creditor perspective this is an unsatisfactory situation as the JLF, SDR or S4A processes may attempt to achieve an onshore solution that they do not consider desirable from their offshore perspective. The Code offers the offshore creditor a way to bring everyone to the table and undermine any ongoing onshore process but allowing that offshore creditor to trigger the resolution process if the conditions are met. RBI will clearly need to consider the viability of their existing mandated processes in the light of the Code.
10. Problems for JVs
We have alluded already to the likely concerns of foreign joint venture partners. They will doubtless analyse the operational/financial creditor distinction since they are likely to be naturally described as the former, and wish to understand whether the distinction is potentially prejudicial and, if so, how to mitigate their risk through documentation or structuring of the JV.
However there is a larger concern, which is the potential for the resolution professional to ignore or modify JV agreements.
There is no definition of what the Code means by joint venture, and we consider it sensible to assume that an all- encompassing approach will be taken that anything in the nature of a joint venture (a co investment, an agreement where equivalent but different assets or services are contributed to a commonly owned vehicle, arrangements for one party to supply to a co-owned vehicle etc.) is what is referred to. The obvious protection a foreign party might look for is a termination right (or even automatic termination in some circumstances) and crystallising claims as financial rather than operational as much as possible. It is too early to predict, and the factual permutations that could apply are so numerous, that we cannot at this stage do any more than highlight this as an area for further thought and consideration, and one which will no doubt be developing over coming months.
11. Provisioning for bad loans
Domestic creditors so far have been incentivised to use the JLF, SDR or S4A schemes of the RBI to benefit from a reduced provisioning treatment for the distressed or non-performing loans on their books (which are subject to different RBI categorisations depending on the period for which the debt has been overdue).
Clearly the triggering of a resolution process under the Code would undermine that approach in that the debtor is now subject to a clearly defined resolution process with a hard end date that may result in liquidation if consensus cannot be reached on the restructuring proposal. The RBI will need to consider how it treats the provisioning of loans subject to the Code resolution process and we would expect that it will result in domestic lenders having to make more significant discounting on a much faster basis than is currently the case.
12. Trading of distressed debt
One of the impediments to the development of a secondary distressed debt trading market in India to date has been the mismatch between lender expectations on valuations for distressed credits and the valuation given to that credit by any potential purchaser. This has been partly driven by the previous practice of the asset reconstruction companies ("ARCs"), the only secondary market players in this market up until now, of issuing security receipts for non-performing loan accounts transferred to them which did not result in a significant discount at face value; they were structured in such a way that the loan was effectively discounted by extending it out for a period that the net present value of the credit was significantly diminished, and the existing lenders remained in control of the underlying debt. However the RBI is seeking to discourage this practice by imposing higher provisioning requirements on banks in such cases.
As discussed above, under the Code any creditor can trigger a resolution process with respect to a defaulted debt of any creditor. This both undermines the effectiveness of the existing security receipt structure used by the ARCs, which we do not anticipate being able to be used going forward given the RBI's scrutiny, but also means that creditors will need to take a much more realistic view on valuations of non-performing loans. We anticipate that the Code will drive a move in such valuations in India to that which we see in western markets where the valuation is based upon the net asset value upon liquidation less winding up costs.
If debt begins to trade for a properly discounted cash consideration the range of market participants and scope for constructive resolution of distressed situations can only be enhanced. We well remember the caution with which this prospect was viewed in our own jurisdiction, but it has proved to be the case that the changes we saw have been for the better; we hope and believe the same will be true in India.
13. Concluding remarks
We are at an exciting point in the development of the Indian economy, and the Code represents a real opportunity for the law and legal infrastructure to make a unique contribution to that development.
In its early days, it is crucial for that contribution to have greatest effect that we all who have relevant experience should contribute to the debate and constructive development of the Code. We look forward to playing our part and welcome discussion of our thoughts and suggestions.
For further information, please contact:
Clive Barnard, Partner, Herbert Smith Freehills