India's reformed bankruptcy code
February 2018 | TALKINGPOINT | BANKRUPTCY & RESTRUCTURING
Financier Worldwide Magazine
February 2018 Issue
FW moderates a discussion on India's reformed bankruptcy code between Manish Aggarwal, Sai Venkateshwaran and Vivek Gupta at KPMG India.
FW: What challenges are currently facing companies operating in the Indian market? Are there any particular sectors showing signs of weakness or distress?
Aggarwal: There are some legacy challenges that have been faced by Indian companies. Policy paralysis of the past, high leverage by Indian companies that worked in an environment of huge economic growth, coupled with less restrictive financing, ultimately led to a situation of high non-performing assets (NPA). This also led to a sharp decline in credit growth due to banks’ reduced ability to lend further, and no new capacity expansion in the private sector as companies were too stretched to borrow. This led to the Reserve Bank of India (RBI) undertaking serious measures with the support of new government to clean up the huge NPA challenge. Energy and infrastructure, metals and mining, and engineering, procurement and construction (EPC) are some of the key sectors that showed signs of weakness and distress in particular. However, the government has separately been addressing some macro issues like the ease of doing business, the approval regime, the policy and regulatory environment and further liberalisation of the reform process, to make India more investment friendly.
FW: Could you outline the main features and provisions of India’s 2016 Insolvency and Bankruptcy Code? What led to the perceived need to update previous bankruptcy laws?
Venkateshwaran: The Insolvency and Bankruptcy Code, 2016 (IBC) overhauls the current highly-fragmented insolvency resolution regime and provides a unified framework. It is expected to help both corporates and lenders achieve speedy resolution to the mounting NPA problem plaguing the Indian economy. Several key features of the IBC are worth noting. First, it provides for a specialised forum to oversee such proceedings. Second, it empowers all classes of creditors to trigger the process in case of non-payment of a valid claim and enables a ‘stand still period’ which provides stakeholders – concerned creditors, promoters, and so on – time to facilitate discussions and reach a common resolution. Third, it requires the appointment of a ‘resolution professional’ who invites resolution plans on the basis of an information memorandum prepared by him. Finally, the resolution plan is required to be approved by a creditor committee with 75 percent majority, by value, and provides for compulsory liquidation if a resolution plan is not approved within 180 days extendable to 270 days. This law continues to evolve, with further changes being made to either address implementation issues or bring in certain anti-abuse provisions by specifying in what circumstances existing owners of the business may be ineligible to submit resolution plans.
FW: How effective is the new code in terms of dealing with corporate insolvencies and resolving India’s issues with non-performing loans and bad debt?
Gupta: We believe the new code has certainly provided a framework to deal with the NPA issue. We are seeing traction among lenders, government and corporates as they move toward work out solutions to address corporate insolvencies. There are of course some issues with the code that are being widely discussed and debated, to get the new framework tweaked to reflect some of the experiences to date. There are also certain critical changes required to many of the related laws and regulations impacting corporates, including tax law, competition law, capital market regulations, foreign exchange regulations and so on, to make IBC truly effective. The first of 12 IBC cases are underway, and some success stories from the current cases will surely provide investors with comfort around the effectiveness of the code and its implementation. We believe the code needs to be further strengthened around many issues that have emerged, but once it reflects these, and armed with a few success stories, it will provide momentum to many more resolutions.
FW: In your opinion, will reforms under the new code make the country an easier location in which to do business? How does this new insolvency regime compare to other jurisdictions?
Aggarwal: An insolvency and bankruptcy code has been a longstanding demand of investors to deal with the huge challenge of operating in India. This, therefore, is one of the biggest reforms that we have seen in recent years, and it has come on the back of several other corporate reporting and governance reforms that have been implemented over the past three years, with the aim of making India an easier location in which to do business. Multiple structural reforms have been undertaken by the Indian government over the last few years to achieve this objective, including GST, demonetisation, tax reforms, policy and sectoral reforms, the number of approvals required to start a business, introducing ‘plug and play’ models for investments in India, and many more. All that, when taken together with the IBC, has surely improved perceptions around the Indian investment story. The IBC is still in its nascent stages and will continue to evolve, based on local experience as well as lessons learned from other jurisdictions. For instance, the US has well-defined financial reporting and tax regulations that accompany its bankruptcy law, and there could be certain elements such as the concept of fresh start accounting which can be adopted into the Indian framework.
FW: To what extent does effective operation of the new bankruptcy code rely on a complementary ecosystem of quality insolvency professionals? Has this requirement caused any problems since implementation in May 2016?
Venkateshwaran: The IBC is still in an evolving phase. Lenders are recognising that one of the key ingredients for an effective resolution is quality insolvency professionals. So far, we have not experienced many challenges around this. However, given the increase in expected cases that may be referred to the IBC, and the increase in the number of individual insolvency professionals who lack the large backing of firms or the infrastructure to allow them to carry out their role effectively, this may become a cause of concern. That said, the government has been responsive and initiated discussions around this subject, as well ensuring the ecosystem of quality resolution professionals is not lacking while we move the insolvency process forward.
FW: How would you describe the general reaction to the new bankruptcy code? Have any specific criticisms been made concerning its functions or roll-out, and, if so, how are these being addressed?
Gupta: Like any new framework, the reaction has been, overall, very positive, but at the same time there have been demands to plug certain loopholes and strengthen the framework in particular areas. The government has been very responsive to these demands, and recent laws reflect this response. Other issues are still under review. First, insolvency professional should be provided indemnity for all actions done in good faith, even after the successful completion of the resolution. Second, the Code does not distinguish between secured creditors, unsecured creditors and guarantors. All of them have the same voting rights vis-à-vis approval of key matters and the final resolution plan. Ideally, financial creditors with different security and rights need to have voting rights reflecting their actual position. Third, financial creditors are not following any defined or standard approach when preparing and finalising a resolution plan. Although, this will evolve over a period of time and best practices will emerge, in the interim there is an urgent need for guidance on approach and methodology. Further, given that most financial lenders are public sector banks, there is an urgent need for the top one or two banks to take the lead on behalf of all lenders for decision making, otherwise COCs will become like JLF or consortium meetings. Fourth, the incoming resolution applicant or white knight should not be allowed to sell, transfer or materially alter the corporate debtor until the resolution plan is successfully implemented or a scheme of modification is approved by the NCLT in the best interests of the corporate debtor. Fifth, an endeavour should be made through amendments to the IBC, to ensure pending commercial disputes and litigation, especially with the government or authorities, are resolved in a time-bound manner during the implementation period. IBC companies should be given priorities such as day-to-day hearings, time bound arbitration, mutual settlements, and so on, so that outstanding issues are resolved. Sixth, the government has also already set up a committee and invited suggestions around a comprehensive revisit of some of the clauses in the IBC, to make them more investor and resolution friendly. We are hopeful that incorporating the majority of these suggestions, once the committee issues its recommendations, will result in a more streamlined framework. Finally, another concern is around the entire micro, small and medium enterprises (MSME) sector. Recently, the finance minister stated that this segment of corporate borrowers requires a framework that is a little different, and the government is working toward this as well.
FW: What is your opinion on recent amendments which disallow existing sponsors to retain control of their companies as part of the resolution process?
Aggarwal: Disallowing sponsors to retain control of their companies is a major step toward creating a level playing field and providing comfort to new, incoming investors – particularly foreign players – that the resolution process is transparent. It also signals that the resolution process will ensure that existing sponsors who are directly or indirectly covered by the changes in the law cannot retain control of their companies at the cost of lenders by seeking huge haircuts and being back in business until they have cleared the overdue payments and become eligible to submit resolution plans. This also signals to the entire investor community that the Indian government is responding carefully to concerns that have been raised by participants in these processes or by prospective investors, which will go a long way to address the huge NPA situation in the Indian banking system. At the same time, concerns have been expressed in certain quarters that genuine promoters will also suffer, since in many cases an account may turn bad due to multiple other factors outside the control of promoters. Experts also believe that this will lead to subdued bidding for such assets, which ultimately will lead to lower value realisation for lenders. Our view is that this is a major step by the Indian government. It ensures that such promoters do not end up getting the business back after all the sacrifices have been made by the lenders. As the situation evolves, and experience manifests, these clauses can be further tweaked – however, there is a need to send a strong message during the first few large cases that the government means business. India’s banking system needs to make a transition from relationship or sponsor-driven financing to a more cash flow based, disciplined financing approach. Disruptions are likely during this transition.
FW: What provisions exist in the bankruptcy code to deal specifically with cross-border insolvencies? Do you believe the new framework will alleviate uncertainty among foreign investors and boost capital inflows?
Venkateshwaran: While the IBC regulations allow all classes of creditors, including foreign lenders, to seek relief under this new law, there may be some additional approvals and challenges that need to be dealt with by them. This stems from the fact that many of the other regulations, whether under the Foreign Exchange Management Act (FEMA) or other RBI regulations, have not been amended to be synchronised with IBC regulations. As a result, in the current scenario, a resolution plan may require various approvals based on the existing laws – for instance, approvals under FEMA regulations will be required in the case of a foreign acquirer, settlement of foreign creditors with capital assets, and so on. Further, in the case of a waiver or haircut of foreign loans or liabilities, approval of the RBI will be required, which will require additional time, effort and cost for the corporate debtor. Accordingly, certain relaxations, waivers or modifications in the approval process may need to be considered where such liabilities exist.
FW: Could you outline some of the issues that investors are grappling with, such as accounting, tax and structuring issues? What impact can these have on the bankruptcy process?
Gupta: The bankruptcy legislation is new. Corporates, lenders and regulators are still learning. The core reason for the regulatory and tax problems around bankruptcy processes is the fact that these attendant laws are not bankruptcy specific; thus, the framework that is applicable in respect of a normal transaction is the one that applies even for bankruptcy cases. That said, the government has shown positive intent and announced one vital amendment relating to the taxability of a haircut that lenders take during a bankruptcy process. In the ordinary course, that haircut, by virtue of being recognised as a gain in the financial statements, would have triggered ‘minimum alternate tax’. Relief has been provided by suggesting that the law will be amended in the forthcoming Budget on 1 February 2018, to allow offset of all past losses against this gain. Issues, however, still remain. An important issue is the fact that a bargain purchase of the shares of a company during a bankruptcy process still triggers taxes in the hands of the buyer on the difference between a rule-based fair value and the actual transaction price. Likewise, no automatic carry forward of tax losses is available in the hands of the buyer in a merger scenario unless the company is what the tax law regards as an industrial company. For foreign buyers, Indian law provides pricing guidelines for the purchase of an Indian company. In many situations, particularly those involving listed companies, this pricing framework may itself artificially restrict the price at which a deal can take place for a foreign buyer. Given that this process is designed to discover true fair value, one would expect the government to recognise this and allow for such transactions to be consummated at the discovered price. Apart from accounting for haircuts as referred to earlier, other financial reporting issues need to be addressed. These include developing a set of fresh start accounting rules, challenges in applying certain fair value accounting requirements, and accounting for bargain purchases. Many of these need to be addressed for all stakeholders – the company itself, any potential buyer as well as the lenders involved in the process.
FW: What key piece of advice can you offer to both debtors and creditors in terms of utilising the new bankruptcy code?
Aggarwal: In our view, both sides should consider the IBC as a mechanic focused on ‘resolution’, so it does not become a ‘recovery’ mechanism for lenders. The recent legislation barring certain promoters from submitting resolution plans for corporate debtors will need to distinguish between malfeasance or intent versus genuine business failures. All endeavours should be made to provide a fresh start opportunity to genuine and competent promoters suffering from external factors beyond their control, as against instances of promoter-induced insolvency. It is important to once again revive the ‘spirit of entrepreneurship’ among existing and a new breed of promoters. On the other hand, lenders should be more realistic about the reasonable haircuts required to make these plans work. There is no denying the fact that in the majority of the cases, existing debts may not be sustainable and, therefore, there is a need to make these resolution plans, and the criterion process under which lenders evaluate these plans, more realistic. Another aspect that will be critical is aligning interest among all lenders to achieve the best course of action in the process.
FW: With the Indian government having opted to implement the bankruptcy code via a staged process, what are your predictions for its ongoing adoption and ultimate success across the country?
Venkateshwaran: We are very optimistic as well as cautious about the success of the entire IBC. We are optimistic since the government, as key stakeholder, introduced such a framework for the first time in India, has been working with the Reserve Bank of India (RBI), and lenders are supportive of efforts to clean up this huge issue facing the Indian banking system. This was the role that government had to play. It has also been responsive to market feedback and open to tweaking the code to reflect practical experiences. That said, we are also cautious since it is equally the job of other stakeholders to make the IBC initiative a success. Those stakeholders include lenders, corporate borrowers, ARCs and various investors keen to invest in this space. If every stakeholder is aligned to a larger objective – and treats this framework as facilitating ‘resolution’ rather than ‘recovery’ – then we have no doubt it will yield the desired results very soon.
Manish Aggarwal is a partner at KPMG, and heads the Energy & Infrastructure vertical in Corporate Finance. He also heads the Resolutions & Restructuring practice for KPMG in India. He has over 20 years of experience across the infrastructure space. Prior to joining KMPG, Mr Aggarwal was a director at CRISIL Risk and Infrastructure Solutions Limited (a Standard & Poor’s company), where he led the consulting and transactions verticals. He can be contacted on +91 (22) 3090 2625 or by email email@example.com.
Sai Venkateshwaran is a partner and head of Accounting Advisory Services for KPMG in India. He has over 21 years of experience in public accounting, providing assurance and advisory services to Indian and multinational companies across multiple sectors. Mr Venkateshwaran has been providing advisory services for over 10 years, with a specific focus on financial reporting matters, in particular in the context of transactions, including capital raising, acquisitions, divestitures, etc. He can be contacted on +91 22 3090 2020 or by email firstname.lastname@example.org.
Vivek Gupta is a partner and national head for KPMG India’s M&A/PE Tax practice. He has over 21 years of experience across corporate mergers and acquisitions, private equity and venture capital transactions as well as business reorganisations, domestic as well as multijurisdictional, having participated in a number of cross-border and domestic transactions, both on the regulatory as well as on the corporate finance side. He can be contacted on +91 (124) 307 4025 or by email email@example.com.
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