IBC’s Existential Problems

Move over Nirav Modi and Vijay Mallya, and Rishi Agarwal — a new poster boy is here to take the top honours for pulling a fast one on bankers. The Central Bureau of Investigation (CBI) in the last week of June booked Kapil Wadhawan and Dheeraj Wadhawan of DHFL for defrauding banks of ₹34,615 crore, making it the biggest fraud case probed by the central agency. Prior to the Wadhawans, Agarwal, the 56-year-old owner of Surat-based ABG Shipyard, was under the CBI lens for allegedly duping a 28-bank consortium of ₹22,842 crore by diverting funds to promoter-connected entities. Before Agarwal, diamond traders Nirav Modi and his uncle Mehul Choksi had topped the fraud league table with over ₹14,000 crore in dues, followed by Vijay Mallya at ₹9,900 crore.

What makes the ABG case stand out is that it is one of the dirty dozen bad loan accounts that were referred for resolution under the Indian Bankruptcy Code 2016, following the Reserve Bank of India’s (RBI) diktat in June 2017. Incidentally, since 2013, bankers have been struggling with the ABG account. After trying a loan recast under the Corporate Debt Restructuring mechanism in March 2014, it was declared NPA in 2016 and admitted under insolvency proceedings in August 2017. In April 2018, the NCLT (National Company Law Tribunal) passed a liquidation order and in the same month, Ernst & Young was appointed by the consortium for a forensic audit. After the liquidator failed to find buyers, the account was declared fraud in April 2019.

Of the 12, only eight cases have found resolution thus far. Two cases (Lanco Infratech and ABG) landed under liquidation and two (Jaypee Infratech and Era Infra Engineering) are currently undergoing insolvency. Against the cumulative claims of ₹2.26 lakh crore of the balance eight accounts, only ₹1.15 lakh crore was realised with just Essar Steel accounting for 83% of the ₹49,473-crore claim realisation, while Alok Industries fetched a dismal 17% against claims of ₹29,523 crore (See: Good but not good enough).

Lanco Infratech, which had five business verticals — EPC, power, natural resources, solar and infrastructure — when it went into insolvency in August 2017, is undergoing liquidation. In 2017, the company had an installed capacity of 3,475 megawatt (MW) and 4,536 MW under construction, while the EPC division was executing orders worth more than ₹15,680 crore.

Even as Lanco is being liquidated, its 10 subsidiaries, which either own a single or a clutch of assets, are facing corporate insolvency processes of their own. The holding company and special purpose vehicle (SPV) structure, as a result, is creating a challenge in assessing the right value of assets held. For instance, Lanco Thermal, the holding company of the group’s thermal power plants, has 15 SPVs. Further, subsidiaries holding the assets have different lenders through project finance. In the ensuing five years, the asset value would have seen a sharp erosion as well.

As for the other two cases, while Suraksha ARC’s offer for Jaypee is being contested in the court by ICICI Bank, Era Infra’s resolution plan is yet to be cleared by lenders over legality of bundling of the firm’s SPVs with the holding company. That speaks volumes about the IBC’s much-touted efficacy of paving the way for a faster resolution.

While 457 cases are under the corporate insolvency process as on December 2021, more than 3x the number are under liquidation. In terms of realisation as a percentage of their claims, financial creditors recovered just 34.8% through the insolvency process and a much lower figure of 6.8% through liquidation. A former IBC official, however, points out that the Code cannot be blamed for the losses.

“The problem is that when companies are being brought to the IBC, creditors may say we want ₹100 but the company has assets worth ₹20. Possibly, 10 or 20 years ago, when you gave money, the company may have had assets of ₹100. It’s akin to getting a patient at the terminal stage, where the hospital can’t do anything. If you have allowed the value of the asset to deteriorate from ₹100 to ₹20 or ₹5, you will only get as much. The market is very cruel and will not give value just like that.”

Incidentally, the Standing Committee on Finance had raised concerns over Liquidation Process Regulations 32 of the Code, which deal with the sale of a corporate debtor or its business as a going concern. But, the Supreme Court had held a view in the Arcelor Mittal India Vs. Satish Kumar Gupta & Ors case that “…If there is a resolution applicant who can continue to run the corporate debtor as a going concern, every effort must be made to try and see that this is made possible.”

“Unlike winding-up, where the aim is to dissolve the entity, the main objective of liquidation is to sell-off the asset at a maximum value for realisation and not necessarily kill the entity,” says Vinod Kothari, founder of financial consultancy firm, Vinod Kothari Consultants.

The IBC official quoted earlier explains that if a company with an asset of ₹20 fetches ₹37-38 under the IBC, then lenders are making 180% of the liquidation value. “So, the choice is to choose between a resolution or liquidation, that is, 180% vs ₹5. If you liquidate, you’re likely to get more or less the value, minus the cost of the transaction,” says the official.

In fact, according to the Insolvency and Bankruptcy Board of India, as of March 31, 2021, of the total 138 cases of liquidation, 128 (92.75%) were closed by dissolution, 6 (4.35%) by way of going concern sale and 4 (2.90%) through a compromise or arrangement. The six CDs — Emmanuel Engineering, K.T.C. Foods, Southern Online Bio Technologies, Smaat India, Winwind Power Energy and Topworth Pipes & Tubes — had claims amounting to ₹4,325.16 crore against the liquidation value of ₹290.03 crore. Thus, liquidators realised ₹336.76 crore and the companies were rescued. In essence, going-concern sales can be an important tool of value preservation.

Kothari believes resolution plans are more commercially attractive since the repayment schedule can be spread over multiple years, while in liquidation the entire amount is to be paid up-front.

Looking Beyond

Even as the debate around the effectiveness of the IBC continues, alternative mechanisms of fetching value have not fetched rich dividends either, expect for the one time when the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act yielded a higher recovery at 41% vs 21% for the IBC in FY21. But then the data is not conclusive enough to surmise that Sarfaesi is a better mechanism given that since FY20, the IBC has shown a higher recovery rate at 46.3% vs 17.4% (See: How they stack up).

But terming the IBC a failure would be premature. “In countries such as the U.S. where there is a strong bankruptcy law, statutes have developed over time,” says Pratik Datta, senior research fellow at Shardul Amarchand Mangaldas & Co. “In the U.S., their first statute was in 1898 before they got their modern statute right. So, the mechanism has developed over centuries resulting in a better understanding of skill sets, problems, and professional quality. But in comparison, the IBC is hardly six years old,” he adds. In fact, from its inception in 2016, to 2019, eight amendments were made to the Code.

Though banks have been resorting to sale of assets to asset reconstruction companies (ARCs) in recent years, the preference has shifted to alternative avenues. According to the RBI, this is partly owing to the worsening acquisition cost of ARCs as a proportion of book value of assets, reflecting in higher haircuts and lower realisable values in respect of the acquired assets (See: Feeling the pinch). Since 2018, the central bank has been disincentivising banks from holding security receipts in excess of 10% of the transaction value through increased provisions. As a result, the share of security receipts subscribed to by banks has been shrinking over the years.

Hence, bankers in question would be better off if they are proactive about credit risk assessment and manage to contain the stress before it becomes an NPA. In fact, in 2014, the RBI had paved the way for classification of special mention accounts (SMA) to help bankers identify accounts that have the potential to become an NPA or a stressed asset. While an NPA is one where the overdue period is over 90 days, the four types of SMAs (SMA-Non-financial, SMA 0, SMA1, and SMA 2) have overdue less than 90 days.

Though the bad bank or the National Asset Reconstruction Company (NARCL) is taking shape, the institution is unlikely to be a game changer. The NARCL, in the initial phase, will buy Rs 2 lakh crore worth of bad assets from banks and offer 15% upfront cash and 85% security receipts, which will be guaranteed by the Centre up to Rs 30,600 crore. But under this mechanism, the NPA in the system is merely being parked with a separate entity instead of banks’ books. The jury is still out on how effective the Indian Debt Resolution Company, the asset management company of the NARCL, will be in recovering value higher than the current resolution mechanism.

Against such a backdrop, the emergence of stressed asset funds could be an avenue for banks to avoid the pangs of steep haircuts under alternative resolution mechanisms. Unlike ARCs, stressed asset funds don’t engage in stripping down of asset values to the bone. Nikhil Shah, managing director, Alvarez & Marsal India, mentions that the entry of global capital in this space can strengthen the process based on best practices observed in more developed markets. More than $7 billion have been raised so far across seven major investment firms. However, these funds have still not deployed large amounts of capital in stressed assets due to information asymmetry, litigation delays and legal uncertainty surrounding the IBC, according to a report by Alvarez & Marsal. A delay in IBC cases beyond the stipulated time period has also left their capital blocked.

But there is hope for banks as the Securities and Exchange Board of India has paved the way for special situation funds under the alternative investment fund category, allowing funds to directly bid for stressed assets from banks or the bad bank. While the move might trigger competition in the bad loan market, the relevant question here is: Are bankers getting any better at credit appraisals?