How will IBC 2016 deal with existing bank NPAs?

by Rajeswari Sengupta and Anjali Sharma.

The Insolvency and Bankruptcy Code, 2016 (IBC) is an important reform for India. It is also one that has witnessed one of the fastest legislative and implementation processes. The report of Bankruptcy Law Reforms Committee (BLRC), set up to design and propose the law, was submitted in November 2015. By May 2016, the law was passed by Parliament and received Presidential assent. October and November 2016, saw a lot of action from the government on implementation and finally on 30th November 2016, the sections of the law dealing with the corporate Insolvency Resolution Process (IRP) were notified.

All along, the public and policy discourse on IBC has been intertwined with the non-performing asset (NPA) problem of the banking sector, specially on account of loans to firms (link, link, link). NPAs of banks, specially the public sector banks (PSBs), have been a cause of concern. In a statement to the Rajya Sabha in May, 2016, the government reported that bad loans to firms accounted for 56% of the NPAs of PSBs.

Since the RBI initiated the `asset quality review' at banks, reported NPAs have reached alarming levels. In June, 2016, gross NPAs of listed banks stood at Rs. 6.7 trillion or 9.1% of their advances, a jump from 4.3% of advances in March 2015. This increase is mainly on account of reclassification of corporate loans, that were hitherto classified as standard, to NPAs. The proximity of a banking crisis has helped hasten the processes that led up to the IBC. In this case, now that IBC is in motion, we should ask how much of a difference this will make to the banking crisis.

Impact of IBC on bank NPAs

The overall question about the impact of IBC for the banking crisis contains two related issues:

1. Are existing corporate NPA cases eligible to come under IBC?

2. How will the IBC solve the existing NPA cases in terms of recovering value?

Are the existing corporate NPA cases eligible to come under IBC?

Banks' corporate NPA cases are of three types:

1. Those where banks have initiated legal action against the debtor for recovery of dues, under the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDBFI) and the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI).

2. Those where banks, or some non-bank lenders, or the corporate debtor itself has sought legal action for collective resolution of insolvency, either under the Sick Industrial Companies Act, 1985 (SICA) or under the winding-up provisions of the Companies Act, 1956 (CA 56).

3. Those where banks have chosen to restructure corporate debt under RBI's Corporate Debt Restructuring (CDR), Strategic Debt Restructuring (SDR) or similar mechanisms.

For the cases under SICA pending at the Board for Industrial and Financial Reconstruction (BIFR) and Appellate Authority for Industrial and Financial Reconstruction (AAIFR), the Eighth Schedule of IBC explicitly provides for an abatement of the existing cases with an option to re-initiate them as new cases under IBC, within a period of 180 days.

For cases on all other forums, legal or regulatory, the IBC is silent on their status. We believe that there is no legal impediment to DRT cases being initiated as new cases under the IBC. Similarly, even winding-up cases pending in High Courts admitted under the Companies Act, 1956 (the winding-up sections of Companies Act, 2013 were not notified and are now replaced by the IBC provisions) are eligible to be initiated as fresh IBC cases. CDR and SDR cases are also eligible as possible cases under the IBC, given that IBC as a law will prevail over CDR and SDR, which are regulatory mechanisms.

Only one type of winding-up case is ineligible for IBC: where a High Court has granted a stay on other legal proceedings being initiated while the winding-up petition is being heard.

This means that most of the 4,500 winding-up by Court cases, the 1,200 BIFR/AAIFR cases, the corporate loan recovery cases under DRT and the 430 failed and pending CDR cases, can effectively now come to the National Company Law Tribunal (NCLT), which is the adjudicating authority for corporate insolvency cases under section 60 of IBC.

This has major implications for the implementation of the IBC. If NCLT is built like a conventional Indian tribunal, within a few weeks, it can develop a multi-year backlog. It is important to bring sound project planning into implementing NCLT.

Will eligible cases come to IBC?

After the notification of IBC, two scenarios are possible:

Scenario 1: Status quo continues and the existing cases, despite being eligible under IBC, stay where they are. This could be because the incentives of banks may not be aligned with the time bound resolution that IBC offers. If errors in bank regulation allow a bank to weakly provision for a case that lingers in court for years, while the recovery rate expected through IRP is low, banks have an incentive to postpone bad news and not initiate the IRP.

Scenario 2: Section 6 of the IBC empowers all kinds of creditors -- financial and operational, bank and non-bank -- to initiate corporate insolvency cases. It prescribes a simple test for a creditor seeking to initiate a case: Has the corporate debtor defaulted on an undisputed debt? If this test is met, any creditor can initiate an IRP under Sections 7 to 9. This is different from the earlier laws that only empowered some classes of creditors (mainly banks and financial institutions) to trigger a recovery or a resolution action. Once an IRP is initiated, its outcome will affect all creditors of the defaulting firm.

Under Section 12(1) of IBC, the corporate IRP must be completed within a period of 180 days, with only the one-time 90 day extension. So even if banks themselves may not initiate corporate IRP cases under the IBC, non-bank creditors, who earlier did not have recourse to a resolution mechanism or whose cases are facing long pendency at other forums without any resolution in sight, will most likely initiate an IRP. Once an IRP is initiated, banks will have no choice but to participate in the process. Hence, we believe that even though the regulation of banks may be faulty, initiation of IRP will take place on a large scale for existing NPAs. This is one of the gains of shifting the legal and institutional machinery of insolvency out of the banking regulator to the Ministry of Company Affairs.

What happens to existing cases when IRP is initiated under IBC?

Once an IRP for a corporate debtor is admitted by the NCLT, according to Section 14 of IBC, an automatic moratorium comes into force for the duration of the IRP which is 180 days. During this period, all pending cases against the corporate debtor, whether at DRTs, Civil Courts, or High Courts, are stayed. Under section 21 of IBC, a Committee of Creditors (CoC) will be formed, comprising all the financial creditors of the company. Under section 30 of IBC, the CoC can approve a resolution plan for the company by a 75% super-majority vote by value. If a resolution plan gets approved by the CoC and the NCLT, all cases pending at other forums will have to abate and the resolution plan will get implemented.

If however, no resolution plan emerges or the CoC is unable to agree on a resolution plan within 180 days, the NCLT will pass a liquidation order under section 33(1) of IBC. Once a corporate debtor goes into liquidation, the only recovery possible will be through the liquidation process and all other recovery, rehabilitation or restructuring proceedings will abate. Under section 52 of IBC, secured creditors will be given a choice of pursuing liquidation on their own or as part of the collective liquidation proceedings.

Will the IBC solve NPAs in terms of recovering value?

This depends on what is meant by `solve'. If `solve' means somehow find the capital which will stave off the Indian banking crisis, the answer is No. The losses that have taken place in the past are money that banks have lost. Nothing can undo the loss. All that can be done is to rapidly recognise those losses and work out their implications for banks, which can be done through a combination of (a) IBC (b) Resolution Corporation and (c) Improvements in banking regulation.

The role of IBC in this is to remove delays in the bankruptcy process. The existing corporate resolution mechanisms have been plagued by delays. If and when these cases come to IBC, at least 3-4 years would have elapsed from the original event of default. In a recent article, Ghei and Roy, 2016 show evidence of a 4 year delay in the legal system in recognising corporate insolvency and a further 5 year delay in giving a final winding-up decision. This delay induces value destruction. Even if the IBC proceedings for such cases are completed within the stipulated 180 days, the recovered amount will only be a fraction of the original value of assets.

The World Bank Doing Business Report, 2017 (WBDB 2017) points out that a higher time to resolution is associated with a lower recovery rate. India takes an average of 4.3 years to resolve insolvency and has a recovery rate of 26 cents to the dollar. In comparison, South Asian economies take only 2.1 years to resolve cases and have a better recovery rate of 32.6 cents, despite having a lower score on the strength of the insolvency framework. Given that most existing NPA cases may have been pending at various forums for 3-4 years, the recoveries from their resolution within the IBC framework may not yield much more than the 25-30 cents to the dollar that the WBDB 2017 reports. In this case, the balance sheet of the bank has to bear the loss of 70-75 cents to the dollar.

Under section 33(1) of IBC, failure to reach a resolution in 180 days results in liquidation. This is a hard budget constraint, that brings pressure on banks to vote on possible resolution plans quickly. The track record of PSBs on jointly taking key decisions with respect to NPAs has been poor. Even in the RBI regulated forums such as CDR and the Joint Lenders Forum (JLF), the lack of coordination and delayed responses by banks have led to delays in approving restructuring plans. If these problems persist for cases that come to IBC, i.e. if banks do not change their behaviour when faced with IBC, the outcome will be liquidation. In general, liquidation induces larger value destruction as the organisational capital of a going concern is destroyed. This has been witnessed in cases like Kingfisher Airlines where lenders are unable to sell even real estate assets.

The IBC will only recover what value remains, either through resolution or through liquidation, and distribute it to creditors in a finite time frame, albeit a lot quicker than the existing forums. This by itself is a positive outcome for the credit markets because the value that is recovered can then be deployed more productively in the economy. However, this will disrupt the cover-up that has been going on in Indian banking.

Currently, the listed banks' reported NPAs are Rs. 6.7 trillion and 80% or Rs. 5.4 trillion of these are in the books of PSBs. The aggregate provision cover ratio of PSBs against these NPAs is around 45% (Source: Banking sector analyst's estimates). As an illustration, let us assume that 60% of these cases are corporate insolvency cases, let's assume that all of them come to the IBC for resolution and the recovery under the IBC is 30 cents to the dollar. Under these assumptions, the PSBs would have loan values of Rs. 1.8 trillion against which no provision is made, while their recovery would only be Rs. 1 trillion. This would mean an additional provision of Rs. 0.8 trillion for these banks.

For making these provisions PSBs will need additional capital. Already in 15 of the 27 PSBs, gross NPAs as a percentage of assets are close to or in excess of the capital to risk-weighted assets ratio (CRAR). Even if the IBC framework delivers a 180 day resolution of the existing NPA cases, it does not solve the capital adequacy problem of the banking system. This lack of capital is the reason why banks may not want to bring existing corporate NPAs to IBC to begin with. Keeping existing cases at forums such as CDR or SDR or the other RBI restructuring forums has, till now by design, given banks the ability to hide problems. Often, these mechanisms have been referred to as extend and pretend schemes.

One possibility is that when the existing NPA cases come to IBC, banks as financial creditors in the CoC will approve the CDR or the SDR plan as part of the resolution plan. For this they need to have the 75% voting power in the CoC. In cases where they fall short of the threshold vote, banks may not be able to agree on a resolution plan and in such cases, a liquidation becomes more imminent. Once liquidation is ordered, banks will have no choice but to make full provisions for the un-recovered dues from these firms.

Conclusion

Existing bank NPA cases pending at other forums are eligible to get initiated as new cases under the IBC. While IBC can solve an existing NPA case by providing a resolution outcome within a definitive time frame, recoveries are likely to reflect reality, i.e. yield large losses. The most that IBC can do is enable the reality to come out into the open; it cannot undo losses that have taken place in the past. This will lead to a new stage in the Indian banking crisis.

Rajeswari Sengupta is a researcher at the Indira Gandhi Institute of Development Research. Anjali Sharma is a researcher at the Finance Research Group at IGIDR.