Haircuts and Settlements

Source: Business Standard 

Relevance: The insolvency and Bankruptcy Code (IBC) is an important mechanism to protect the economy from NPA and failed businesses. Any issue in this mechanism will act as a big hurdle in the economic development of the country.

Synopsis:

The Insolvency and Bankruptcy Code (IBC) allows for a system of haircuts and settlements. However, experts have expressed concerns over their misuse which demands a robust reformation of the IBC process. 

Background:

• India’s bankruptcy process under the Insolvency and Bankruptcy Code (IBC) is relatively new and should be seen as a work in progress.
• Experts have expressed concerns about the magnitude of haircuts that banks are taking under the IBC resolution process. Also, the system of one-time settlement (OTS) is harmful. 

Issue of Haircuts:

• In finance, a haircut refers to the reduction applied to the original loan amount during the insolvency resolution settlement.  
• Overall, haircuts have been in the 80 percent range. Banks have lost four-fifths of the money they have lent to companies that have entered the IBC process.
• Even the National Company Law Tribunal recently expressed surprise that Vedanta’s Anil Agarwal was “paying almost nothing” to take over Videocon Industries. 

Issue of One-time Settlement (OTS) Mechanism:

• Under IBC, 90 percent of the committee of creditors (CoC) can decide to give the firm back to the promoter. 
  • The recent OTS between the promoter of Siva Industries and Holdings Ltd and its creditors is one such example. The promoter paid Rs 500 crore against a Rs 5,000 crore loan and got back the firm.
• The mechanism is beneficial as:
  • It preserves capital and involves an agreement of the original lenders, 
  • It also takes the pressure off the tribunal, which is clogged up with cases.
• However, the OTS mechanism to settle cases can be open to subversion as the mechanism attracts minimum legal oversight.
  • The promoters could borrow money from banks, take it out of the company, and then use the OTS mechanism to have the banks take a massive haircut on the loans.

Way Ahead:

• Any further reform of the IBC process must take into account the basic motivation for its introduction: 
  • Firstly, to preserve the companies as far as possible.
  • Secondly, to ensure that capital is not wasted or locked up in legal proceedings.
  • Third, to introduce some market discipline in bank’s corporate lending.

The ideal solution is the development of an incentive-compatible banking sector that lends more carefully. But until public sector banking in India occupies a far smaller share of corporate lending, such incentive compatibility is a distant dream.

Read more – Brazen gaming of bankruptcy process on