Rising Haircuts: A Death Knell for the IBC?

[Simran Lunagariya and Priyanshi Jain are fourth-year B.Com LL.B. (Hons.) students at Nirma University, Ahmedabad (Gujarat)]

A competent insolvency procedure assists creditors and corporate debtors (“CDs”) in recognizing whether the stressed company is approaching financial collapse and in finding an amicable solution for the same. To this end, it is important that the insolvency procedure is prompt, efficient, and impartial. In the Indian setting, the Insolvency and Bankruptcy Code, 2016 (“IBC”) is still attempting to achieve harmony between the aforementioned features, especially in securing good recovery rates. 

Huge haircuts have been observed in a few insolvency cases in recent times. Broader interests are affected since banks obtain their funds from the general public, whilst CDs obtain their funds from banks. While settling for very low recovery rates, the percentage of bad loans continues to grow without evidence of resolution or restructuring, or even recovery. One of the major contributors to escalating haircuts is the provision of One Time Settlement (“OTS”) through withdrawal of insolvency process under section 12A of the IBC. 

In this post, we will examine if growing haircuts contribute to the IBC’s failure to achieve its goals. To begin, we will explore the factors that have significantly contributed to increasing haircuts in relation to section 12A. Second, we seek to emphasize the negative repercussions of growing haircuts. Lastly, we will discuss possible solutions to the problem.

Unwrapping the Enigma around Increasing Haircut

Despite the fact that the IBC seeks to achieve its aims through prompt, efficient and impartial restructuring or resolution, there exists a significant contrast between the objectives and current occurrences principally due to increasing haircuts. This is for the following reasons:

Has Section 12A Failed to Walk the Talk?

Section 12A of the IBC states that if members representing 90% of the committee of creditors (“CoC”) collectively agree to withdraw the resolution plan in favour of an OTS, then such application is approved. This section is often abused by the CoCs to bargain for OTS at a significant haircut in order to get earnest money even after the CoCs have given their assent for the resolution plan. 

The CoCs often vote for the withdrawal applications for earnest money without considering the objective of the revival of the company.  Additionally, the law is not equipped to allow for a liquidation of the CD after the withdrawal. Also, such conduct is unjustified because considerable time is employed in the resolution process when the creditors concur for OTS under the aegis of Section 12A at huge haircuts. 

Furthermore, section 12A authorizes the adjudicating authority (“AA”) to allow for withdrawal applications after creditors holding 90% of the debt have given their assent. In the majority of the cases, the CoCs approval has been given paramount importance by the AA. However, the outlook of the National Company Law Tribunal (“NCLT”) in the case of Siva Industries has proved otherwise. In this case, the NCLT interrupted the autonomy of CoC in order to promote the overall objective of IBC. Furthermore, the bench clarified that withdrawal application under section 12A cannot be made in case of ambiguous terms of settlement on the part of CoC. Hence, this alludes to the need for conducting an evaluation of the CoC’s judgment and responsibility of the AA in deciding on OTS.

The ‘Infallible’ Commercial Wisdom of CoC – An Irony

The Supreme Court in various cases has affirmed that the commercial wisdom of the CoC cannot be questioned. In the case of Videocon Industries Limited, the successful resolution applicant decided to pay at a haircut of 99.28%. The NCLT Mumbai was distressed as the applicant was paying almost not even close to the liquidation value. The creditors often vote for the withdrawal applications in the greed of earnest money without considering the objective of the revival of the company. A question that remains unvoiced is whether the CoC is competent enough to understand the nitty-gritty of the resolution process. Therefore, whenever there is high slippage in debt recovery rate yielding huge haircuts, the court is not sufficiently empowered to draw a red line between judicial wisdom and commercial wisdom of CoC to judge whether the revival has taken place or not.

Moreover, absolute independence has been given by courts to the commercial wisdom of creditors. This has created an “overwhelming effect” on other objectives, including value maximization of assets and time-bound resolution process. The prevailing circumstances have proved to be reducing the probabilities of the revival of the stressed company. It is pertinent to consider that the role of the CoCs is very crucial in the entire insolvency process. In recent times, the creditors have forsaken reasonableness in handling their responsibilities.

Lack of Competence of New RPs vis-à-vis Valuation of Assets

The courts have often granted stay orders which delay the timeline for the time-bound resolution process. As a result, the CD’s value also decreases with an increase in time, giving rise to huge haircuts. Additionally, the unfair valuation of the assets of CD by the resolution applicant in the resolution process is leading to the erosion of the value of a CD in terms of time and preservation of assets. This effect can be attributed to the negligence and lack of knowledge on the part of new resolution professionals (“RP”). When inexperienced individuals are hired as RPs, their competency remains questioned when the stressed company, involving complex processes undergoes the corporate insolvency resolution process (“CIRP”). Also, according to a report, disciplinary action has been taken against 123 RPs out of 203 inspections so far.

As a result, huge haircuts and fraudulent promoters are encouraged, defeating the value maximization aspect. Therefore, ensuring the effectiveness of the already delayed resolution process with huge, entangled debts is not an easy task for RPs who are new to the game. 

Potential Considerations

Having stated all the above issues that arise with increasing haircuts, the recent trends suggest that huge haircuts are dampening the interests of all stakeholders. In that regard, few recommendations would include the following.

First, the invocation of section 12A would be justified only in the case where CoC is able to secure a better deal than the CD undergoing insolvency. When huge haircuts are observed in OTS, the relevance of section 12A gets questioned. The terminology used in section 12A clearly reiterates that the application is subject to approval by AA but, since the CoC’s commercial wisdom cannot be second-guessed, the AA gets compelled to approve the application if the said criteria of 90% approval have been fulfilled. This creates a dichotomy in the functioning of AA.  Therefore, the AA must be diligent enough to exercise their discretionary power whenever the autonomy of CoC is overpowering the interests of the revival of CD’s company, and to reject the withdrawal application accordingly. Moreover, such an exercise of power under section 12A shall not be construed as against the commercial wisdom of CoC, but interpreted harmoniously in order to achieve the greater motive of enacting IBC i.e., maximization of value and time-bound resolution process.

Second, at the outset of the Code, it has been iterated that the commercial wisdom of CoC brooks no interference. However, the code of conduct of CoC is a major challenge. Hence, two steps should be taken care of i.e., firstly, scrutinizing the intention, objective, and transparency of decision making of CoC. The IBC was enacted to protect CoC’s commercial wisdom vastly.  However, the evident inaccuracies in the recovery rate show that tougher rules are required. Thus, assuring the relevance of the CoC’s activities is crucial for safeguarding the interests of other stakeholders and the general public. Secondly, prevailing ethical standards are insufficient to serve as a guiding light for the CoC, and a standard guideline for ethics must be constructed for the CoC for reference while performing their duties. A three-pronged approach adopted by IL&FS that laid emphasis on resolution, restructuring, and recovery clearly justifies all that a CD undergoing CIRP could achieve. 

Third, the CIRP comes up with many riders and, knowing all the technicalities that go behind conducting CIRP, may not be feasible for early starters. The insolvency professional agencies governing the RPs are identical in nature, in terms of the eligibility criteria and ensuring code of conduct of the RPs. A distinctive self-regulatory body for RPs is needed to go beyond the existing legal framework to independently vouch for RP’s actions, foster competition, and create stricter norms for non-compliance.

Conclusion

The IBC came into being in the aftermath of the financial crisis of sick companies, but the abysmal huge haircuts have shown that the efficacy of the Code is failing. It is crystal clear that section 12A and the ‘infallible’ wisdom of CoC’s and the conduct of RPs have contributed to undermining the real intent behind the Code. The Sick Industrial Companies (Special Provisions) Act, 1985 did not live up to its mark because it could not resolve the sick companies with speedy recoveries. The IBC’s fate is also looming over along the same lines, unless several long-overdue steps are taken. A mechanism that can vouch for the actions of all the stakeholders to conduct the resolution process transparently and without any delays is the need of the hour. In a nutshell, it should be ensured firstly, that the resolution of a sick company has always been the paramount objective. Therefore, the CoC as well as all the other stakeholders should channel their individual goals towards the resolution of the company. Secondly, since time has always been the essence of the resolution process, “delayed revival is denied revival”.  

– Simran Lunagariya & Priyanshi Jain