Friday, November 17, 2017

Don't rush to ban promoters from the IBC process

by Adam Feibelman and Renuka Sane.

There is speculation that the Government will amend the Insolvency and Bankruptcy Code to prohibit promoters from bidding on their firms in the insolvency process. This is to avoid letting owners of an insolvent firm effectively repurchase their firm or its assets at a discount after shedding debts that the firm had incurred under their control. The objective is to also ensure that lenders do not persist with ever-greening their loans when there may be no collective financial justification for doing so.

We appreciate the appeal of such a rule, especially when cases of dramatic promoter malfeasance and mismanagement, and ever-greening of loans by banks are fresh in our minds and all too common. But we worry that the change proposed by the Government would sacrifice potentially beneficial aspects of the Code to avoid something that can be dealt with through more modest reforms, some of which can be done through regulations and would not require reform of the Code. In fact, the Insolvency and Bankruptcy Board of India (IBBI) has already taken the step of amending its rules to ensure that promoters proposing turnaround plans for their sinking companies will be subjected to a stringent test of creditworthiness and credibility.

All promoters are not the same

It is true that promoters who run their businesses into the ditch through fraud or mismanagement should probably not be able to employ the IBC in concert with aligned creditors to simply shed their obligations and continue on their merry way.

But many firms run by honest and competent promoters end up in
financial distress due to factors beyond their control or that they could not reasonably be expected to have anticipated. Others will have made avoidable but forgivable mistakes.

The Code makes it very easy to force such firms into insolvency - a single default on a single debt suffices. In such an event, scrupulous and competent promoters may get permanently excluded from participating in their firms going forward if the reform under consideration is adopted. This might disincentivise good promoters from entering into businesses in the first place or from borrowing in arms-length transactions, either of which would impede the culture of entrepreneurship and the environment for start-ups that the government wishes to encourage.

This has consequences for the broader system

If this were only a question of the potentially harsh treatment of those promoters who are neither incompetent nor unscrupulous, we might consider that this could be an unfortunate but necessary aspect of the new insolvency and bankruptcy system. Law often imposes some unpleasantness in the service of avoiding greater harm.

But excluding such promoters from their reorganized firms will
predictably externalize losses on others and on the broader system. Promoters are often in the best position to turn their firms around, and occasionally they are essential to that outcome. In other words, excluding promoters from the process will make it harder to reorganize some firms that have experienced insolvency or financial distress, something that is hard enough to do with access to all available human resources.

Perhaps even worse, in a situation where creditors themselves
prefer to have the promoters continue to be involved with a firm that is in financial distress, they might avoid using the new insolvency system at all, or dismiss cases strategically, undermining the scope and effectiveness of the new Code.

Potential solutions

A rule excluding promoters from potential bidders in the insolvency process is not even necessary to achieve its purpose of protecting the system from unscrupulous or incompetent promoters. If the concern is that some promoters will effectively collude with creditors to take advantage of the new system to take their firms back after shedding debts, or that the inclusion of promoters in the bidding process will discourage or scare away other potential bidders, there are other ways of addressing such threats.

The US bankruptcy system, for example, has addressed this problem by allowing preexisting shareholders to have a stake in a reorganized firm if they put in new value equivalent to their new stake and if the reorganization plan was open to other potential bidders. Additionally, if a class of creditors objects to the plan, the presiding bankruptcy court must determine that the reorganization plan involving the preexisting shareholder is neither unfair nor discriminatory to the objecting class. These rules are not without controversy in the US, but they reflect a reasonable approach to constraining shareholders' participating in reorganized firms without banning them from doing so altogether.

Protections of this kind could easily be incorporated into India's new insolvency and bankruptcy system. Promoters could be allowed to submit bids, for example, only if an independent resolution professional is assigned to the case by the Insolvency and Bankruptcy Board. The resolution professional and the NCLT could be required to ensure that the promoters put up new value equivalent to their stake in the reorganized firm and strictly review other aspects of the resolution plan and the process of its approval by the creditors committee.

Conclusion

The new Code was designed to give creditors significantly more
power in relation to their debtors in deciding when to initiate
insolvency cases and what happens to debtors within the system. This system is thus built on the logic that creditors as a group know what is in their best interest and that it is possible to protect smaller creditors in the process. If policymakers are not comfortable letting creditors decide whether the promoters should participate in their reorganized firms, this suggests a lack of confidence in the new system and the various actors and institutions that operate it.

To date, the new system has performed surprisingly well, given the huge challenges that faced it upon inception. It seems too early to let a lack of confidence erode the basic approach and potentially undermine the ability of the new system to restructure firms that will have significant going concern value when their promoters stay involved. Furthermore, because it is easier under the Code for any creditor to force a firm into insolvency much sooner than before, it is also possible that the underlying problem of fraudulent and unscrupulous promoters will lessen over time. The recent steps taken by the IBBI are in the right direction, and it seems sensible to wait and see if they are sufficient as the new system matures.

Adam Feibelmen is a Professor of Law at Tulane University, he was a visiting scholar at National Law School of India University, Bangalore, and the Center for Law and Policy Research in 2016. Renuka Sane is faculty at the National Institute of Public Finance and Policy.

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