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Monday, December 31, 2018

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 $100 to its secured financial creditors, $30 to its unsecured operational trade creditors, and the liquidation value ('L') of the company is $90. 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 $200 and a 0.5 probability that in bad state ('B') it will be worth $40. In other words, if the company is continued for the next 6 months, the expected going concern value of the company would be $ (0.5).(200) + (0.5).(40) = $120. Assuming discount rate to be zero (for simplicity), since the net present value ($120) is higher than the liquidation value ($90), the company is not economically distressed. It is only in financial distress because the total debt of the company ($130) exceeds its net present value ($120). 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 $120 as against only $90 if the company is liquidated.

However, if things go well and after 6 months the company is actually worth $200, the secured financial creditors will still get only $100, the value of debt owed to them. On the other hand, if things go badly and after 6 months the company is actually worth $40, they will get the entire $40. Therefore, the expected return for secured financial creditors would be $ (0.5).(100) + (0.5).(40) = $70 - much lesser than what they would get in liquidation ($90). Therefore, the secured financial creditors comprising the CoC would rationally prefer to liquidate the company for $90, although ideally the company should have been sustained to get $120. 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 $130 and break-up `liquidation value' of $110. The face value of debts owed to its financial creditors is $100 and to its operational creditors is $30. If the company is liquidated on break-up basis, then the financial creditors would get $100 and the operational creditors would get only $10. However, if the company is sold for cash to a third party at going concern value, then the financial creditors could get $100 and $30 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 ($10) to the operational creditors and the remaining $20 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.

2 comments:

  1. The case (via example) made to show possibility of VDP is too hypothetical and does not appear to be very true.

    The example is a very restrictive one. For example, look at the restrictive assumptions of the example:

    1) majority of the company is owned by bold holders (66%) and hence a cap on what they can get from liquidation or going concern

    2) The recovery rate of 70% (90/130) seem to be high enough

    3) the entire set of bond holders are assumed to be perfectly homogeneous in what they know. For example they all know that recovery rate equals 70%. Secondly, they all know the scenario probabilities and corresponding scenario values

    The case of VDP may not hold true if we have a more realistic case around recovery value and lack of homogeneous belief about future states of the world

    ReplyDelete
    Replies
    1. Thanks for your comment. Your version of assumption (1) is incorrect. The Committee of Creditors (CoC) of the insolvent company gets to decide the future of the company. If secured creditor(s) have 66% by value of financial debt in the company, they control the CoC. I don't see why this would be a rare occurrence in India. Also, if bondholders have imperfect information, that would increase coodination costs. Why are you assuming that higher coordination costs would reduce the probability of VD?

      Delete

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