Bankruptcy code reforms must be handled with special caution

Relevance: Improving the Insolvency and bankruptcy law.

Synopsis: Rather than focussing too much on haircuts and debt recovery, IBC should focus on maximization of value, as intended originally. Few suggestions for reforming the Insolvency and Bankruptcy Code (IBC), 2016.

Background

• A parliamentary standing committee has called for an overhaul of the Insolvency and Bankruptcy Code (IBC), 2016.
• The major concern has been over large haircuts and a high rate of liquidation.
  • A haircut refers to the lower-than-market value placed on an asset being used as collateral for a loan.
• While the suggestion to overhaul the law is welcome, it is important to understand the root cause of the problem and address the same.

Too much focus on haricuts

While assessing the effectiveness of the Code, too much emphasis has been laid on haircuts, which is often seen as the only determinant of its success. This approach is wrong due to the following reasons:

• The IBC is not responsible for large haircuts. This is the result of losses in enterprise value. Why should the market pay ₹1,000 for an asset that is worth only ₹100 by the time it comes under IBC?
• Fixing a limit on a haircut is like asking the market to pay a minimum of, say, ₹1,000 for an asset which is worth merely ₹100.
• Nothing except market forces should determine the haircut that creditors must take on their dues.

Should haircuts be fixed?

No. Fixing any benchmark for haircuts will have two harmful effects:

• Firstly, it will incentivize banks to extend riskier loans, as they would be assured of getting a minimum proportion of their dues back.
• Secondly, it will discourage prospective bids for assets, as their market value may not be worth the minimum proposed. This will push companies further towards liquidation. This, in turn, will be terrible for the economy, which is already grappling with high non-performing assets and high unemployment.

Debt recovery was never the objective of this law. The primary objective of the IBC is maximization of value. Even, the Banking Law Reform Committee had noted that value should be determined by net present value calculations.

Recovery should be measured only against the value that’s left in the company on the day it becomes an IBC case.

Suggestion/Measures

1]. There is a need to revamp the judicial infrastructure.

• The law must provide a strict timeline for the National Company Law Tribunal (NCLT) to look into insolvency matters.
• The court should also be given legislative guidance on how its powers are to be used, so that there are no judicial delays.

2]. Create a fresh cadre of insolvency and restructuring professionals

• Currently, the work of insolvency professionals is overregulated and most of their energy is wasted on compliance fulfilment. They should be given training on the operational turnaround of stressed companies.

3]. The regulatory regime governing insolvency professionals should encourage pragmatism and business risk-taking.

• It should incentivize ethical conduct. For this, the entry barrier for these professionals should be raised, with focused training imparted at a younger age.

4]. There is a dire need to develop a market for stressed assets so that sales are not a challenge.

• India’s stressed asset market, which is estimated at $115 billion, presents a large opportunity for investors through the IBC process as well as out-of-court alternatives.
• The regulatory regime should allow the entry of global capital to this space and strengthen the process based on best practices observed in better developed stressed-asset markets.

5]. The participation of asset reconstruction companies in insolvency resolutions should be encouraged and not prohibited.

6]. Sixth, the success of any business regulation rests on the effectiveness of the court system. The role of courts should be limited, while their effectiveness and capacity are enhanced.

Terms to know:

• IBC