Value destruction and wealth transfer under IBC

by Pratik Datta.

India experienced a major structural change with the enactment of the Insolvency and Bankruptcy Code, 2016 (IBC). Since its enactment, India's ranking under the Insolvency head in the World Bank Group's Doing Business report has sharply risen from 136 to 103, attracting international attention. Yet, as per IBBI data, till end of September 2018, only 20% of the cases admitted were successfully resolved under IBC, while 80% ended up in liquidation. And now, even the constitutionality of IBC is under serious challenge before the Supreme Court of India for discriminating against operational creditors.

In view of these contemporary challenges facing IBC, my paper titled Value destruction and wealth transfer under the Insolvency and Bankruptcy Code, 2016 argues that many of these challenges fall within two conceptual categories - the value destruction problem and the wealth transfer problem. The paper uses the law and economics literature on insolvency to identify the potential sources of these two problems within the IBC.

Value Destruction Problem (VDP)

A well-designed insolvency law should help in correctly determining if an insolvent business is suffering from financial distress or economic distress. A business is financially distressed when total value of its debt exceeds its net present value. Insolvency law should facilitate a going-concern sale or restructuring of a merely financially distressed business. But a financially distressed business could also suffer from economic distress - the net present value of the business could be less than the total value of the assets of the business were they to be broken up from the business and sold separately (break-up `liquidation value'). In such cases, insolvency law should facilitate liquidation, whether through a going-concern sale or a break-up sale.

A poorly designed insolvency law could inadvertently push a merely financially distressed business into liquidation, causing value destruction. Value destruction could also happen due to delayed restructuring. I refer to these as Value Destruction Problem (VDP).

IBC suffers from VDP

VDP could arise under IBC. Secured financial creditors comprising the super-majority (i.e. 66%) in the Committee of Creditors (CoC) may not necessarily have the right incentives to sustain a merely financially distressed, but not economically distressed, company. This is because the secured creditors are not entitled to going concern surplus. Instead, such creditors are likely to have a stronger incentive to immediately liquidate the financially distressed company and realise the liquidation value, thus destroying the going concern surplus of the company.

To illustrate, let's consider a hypothetical example. Suppose a company has two types of creditors - secured financial creditors and unsecured operational trade creditors. It owes USD100 to its secured financial creditors, USD30 to its unsecured operational trade creditors, and the liquidation value ('L') of the company is USD90. If the company is continued as a going concern for next 6 months, there is a 0.5 probability that in good state ('G') it will be worth USD200 and a 0.5 probability that in bad state ('B') it will be worth USD40. In other words, if the company is continued for the next 6 months, the expected going concern value of the company would be USD (0.5).(200) + (0.5).(40) = USD120. Assuming discount rate to be zero (for simplicity), since the net present value (USD120) is higher than the liquidation value (USD90), the company is not economically distressed. It is only in financial distress because the total debt of the company (USD130) exceeds its net present value (USD120). Therefore, the value maximising option would be to keep the company going, so that both the financial and operational creditors can recover a total of USD120 as against only USD90 if the company is liquidated.

However, if things go well and after 6 months the company is actually worth USD200, the secured financial creditors will still get only USD100, the value of debt owed to them. On the other hand, if things go badly and after 6 months the company is actually worth USD40, they will get the entire USD40. Therefore, the expected return for secured financial creditors would be USD (0.5).(100) + (0.5).(40) = USD70 - much lesser than what they would get in liquidation (USD90). Therefore, the secured financial creditors comprising the CoC would rationally prefer to liquidate the company for USD90, although ideally the company should have been sustained to get USD120. Looked at from this perspective, IBC suffers from VDP.

	L	G	B	E(v)
FCs	90	100	40	70
OC	0	30	0	15
Sh. H.	0	70	0	35
Company's value	90	200	40	120

Wealth Transfer Problem (WTP)

When insolvency law provides cramdown powers to majority claimants to facilitate restructuring, it raises the possibility of abuse. Majority claimants in control over the restructuring of the corporate debtor may be able to advantage or disadvantage different groups of beneficiaries by structuring of the securities, contract rights or other property received by each. They could even abuse this control to derive disproportionate private benefits by transferring wealth away from the dissenting minority claimants through the restructuring plan. Wealth transfer could also happen if valuation of the corporate debtor is left to one particular class of creditors. Senior creditors have an incentive to undervalue the company's business, while junior creditors have an incentive to overvalue it. I refer to these as Wealth Transfer Problem (WTP).

IBC suffers from WTP

The IBC empowers majority financial creditors with 66% vote by value in the CoC to impose a resolution plan on the dissenting minority financial creditors as well as the non-voting operational creditors. However, it does not provide proportionate protection to dissenting financial creditors. Till October 5, 2018, IBC regulations required the resolution plan to identify specific sources of funds to pay the `liquidation value' due to dissenting financial creditors. On October 5, 2018, this minimum protection was removed. Therefore, currently there is no specific provision under the statute or regulations to protect dissenting financial creditors from potential wealth transfer by abusive use of cramdown powers by majority financial creditors.

Further, the IBC overlooks a basic distinction between restructuring and going concern sales. Restructuring, being a hypothetical sale of the corporate debtor's business to the claimants of the corporate debtor, some finite notional value has to be placed on the business of the corporate debtor. Therefore, restructuring requires a valuation benchmark, according to which the rights of each claimant in the restructured business has to be determined. No such problem arises in a going concern sale for cash to a third party after proper marketing exercise. Consequently, no such valuation benchmark is necessary for a sale transaction. However, the IBC uses the liquidation valuation benchmark to protect operational creditors in both restructuring as well as sale transactions. This creates opportunities for wealth transfer from operational creditors in sale transactions under IBC.

To illustrate, assume that a corporate debtor has entered insolvency resolution process under the IBC. It has a going concern value of USD130 and break-up `liquidation value' of USD110. The face value of debts owed to its financial creditors is USD100 and to its operational creditors is USD30. If the company is liquidated on break-up basis, then the financial creditors would get USD100 and the operational creditors would get only USD10. However, if the company is sold for cash to a third party at going concern value, then the financial creditors could get USD100 and USD30 will be left over. Applying the creditor protection rules under the IBC, the financial creditors could approve a resolution plan that provides only the break-up liquidation amount (USD10) to the operational creditors and the remaining USD20 to the lower claimaints like shareholders. This would effectively amount to a wealth transfer from the operational creditors. Looked at from this perspective, IBC suffers from WTP.

Conclusion

Recently, the NCLAT in the Binani case tried to solve the WTP by taking an extreme position. It held (para 48) that a resolution plan must not discriminate against dissenting financial creditors or non-voting operational creditors. This broad non-discrimination principle developed by NCLAT is problematic. It could be misused by out-of-the-money minority financial creditors or non-voting operational creditors to engage in hold-up strategies to extract a better deal for themselves, causing wealth transfer from the majority financial creditors. Additionally, an increase in hold-up costs and coordination costs could in turn result in value destruction. It is rather ironic that in a bid to resolve the WTP under IBC, the Binani ruling could end up creating avenues for further WTP as well as VDP.

Solving the contemporary challenges emanating from the VDP and the WTP under IBC would require deeper policy thinking. Indian policymakers need to take into account the root causes of these problems, as highlighted in this paper. Ultimately, the fundamental legislative design choices underlying IBC may need to be revisited.

 

Pratik Datta is a Researcher at the National Institute of Public Finance and Policy.