India: Insolvency Ordinance | Moral Hazard Or Genuine Distress In M&A?

Background

The partly liberalized Indian economy has been aptly referred to in the Economic Survey of India 2015-16 as one that had transitioned from 'socialism with limited entry to "marketism" without exit.

Given the vexed 'twin balance sheet' problem chafing both banks and corporates in India, the Insolvency and Bankruptcy Code, 2016 (IBC/Code) was a critical structural reform. Many issues have surfaced since the Code was operationalised and the courts and the Central Government have stepped in to iron out such issues in the last one year.

The IBC Amendment (Ordinance), 2017 (Ordinance) promulgated yesterday addresses the long standing debate regarding the credentials of the resolution applicants to bid for assets in the corporate insolvency resolution process (CIRP) and liquidation.

Corporate Insolvency Resolution Process | Current Provisions

  • The provisions relating to CIRP were made effective from 1 December 2016 and so far, more than 300 insolvency petitions have already been admitted by various National Company Law Tribunals.
  • Prior to promulgation of the Ordinance, Section 2(25) of the Code permitted "any person" to submit a resolution plan to the resolution professional (RP) and participate in the CIRP process for acquiring the distressed assets.
  • Recent amendments to the CIRP regulations, (see our Ergo NewsFlash dated 10 November), prescribed that the resolution plan must set out (i) disclosures and details of resolution applicants and other 'connected persons' and (ii) diligence of fraudulent and extortionate transactions by RPs. The intent was to enable the Committee of Creditors (CoC) to assess the credibility of each resolution applicant (and other connected persons) and essentially filter out applicants with antecedent 'criminal / 'wilful default' backgrounds.

Moral Hazard or Genuine Distress?

  • Nevertheless, there has been a heated public debate in recent times on the ability of the existing promoters or management to bid for their own distressed assets.
  • One school of thought held that allowing promoters to submit the resolution plan on one hand and subjecting creditors to take severe hair-cuts on the other, would create a moral hazard problem. They argued that this provision would disincentivise creditors from taking recourse under the IBC in the future and fail to send a strong message to the erring borrowers/ promoters/ other resolution applicants.
  • Another school advocated that the Non-Performing Asset (NPA) problem in various sectors such as steel, commodities and infrastructure were caused by cyclical macroeconomic factors and other external business factors that were beyond control of the promoters. Accordingly, existing promoters should not be disallowed from participating in the insolvency process unless there is an evidence of 'bad behavior' on their part.

Credibility of the Resolution Process

  • To address the competing policy considerations, the definition of resolution applicant under Section 2(25) of the Code has been amended to permit only persons who submit a resolution plan pursuant to the invitation made by the RP under Section 25 (2) (h) of the Code. The latter replaces the otherwise public invitation process by a qualifying criterion laid down by the RP in consultation with the CoC. This decision would have to be made by them after considering the complexity and scale of operations of the business of the corporate debtor and other conditions as may be specified by the Insolvency and Bankruptcy Board of India. Accordingly, we expect corresponding amendments to the CIRP regulations setting out such conditions shortly.
  • Further, the CoC is now statutorily mandated to consider the feasibility and viability of the resolution plans while approving a resolution plan.

Disqualifications

A new Section 29A sets out the disqualification criteria for a resolution applicant. The section provides that if (i) a person; (ii) or any person who is acting jointly with such person; (iii) or a person who is a promoter or is in the management or control of such person; (iv) or a 'connected person' is:

  • An undischarged insolvent;
  • A wilful defaulter identified by any bank or financial institutions as per Reserve Bank of India (RBI) guidelines;
  • A person whose account is classified as an NPA for a period of over 1 (one) year and who has failed to make the payment of all NPA related overdue amounts and interest /charged before submission of a resolution plan;
  • A person convicted for any offence punishable with imprisonment for 2 (two) years or more,
  • A person disqualified from acting as a director under Companies Act, 2013;
  • A person prohibited from trading in or accessing the securities markets under any order or directions of the Securities and Exchange Board of India;
  • A person who has indulged in preferential, fraudulent or undervalued transactions with the corporate debtor in the preceding 2 (two) years;
  • A person who has executed an enforceable guarantee in favour of a creditor, in respect of a corporate debtor under CIRP or liquidation proceedings under the Code;
  • A person subject to any of the above disabilities under any law in a jurisdiction outside India;

they will not be eligible to submit a 'resolution plan'. Addressing the cases where CIRP is already ongoing, Section 30 (4) has been amended to, inter alia, provide that the CoC shall not accept the plans submitted prior to the Ordinance if the resolution applicant is ineligible and in the absence of other plans, the RP shall be required to invite fresh resolution plans.

For this section, a 'connected person' has been defined broadly to mean (a) person who is a promoter or in the management or control of the resolution applicant, (b) person who shall be promoter or in management or control of the business of the corporate debtor during the implementation of the resolution plan, or (c) holding company, subsidiary company, associate company and related party of such person.

Liquidation

The Ordinance prescribes that even in the liquidation process, the liquidator will not be permitted to sell any immovable or movable property or actionable claims of the corporate debtor to any of the above disqualified persons.

The amendments have set out comprehensive criteria to disqualify not just the willful defaulters or persons with criminal antecedents but also existing promoters/potential resolution applicants who may be in default led NPA situations.

Comment

While the Ordinance is intended to ensure that the CoC and the RP would invite applicants with strong financial backing and improve the prospects of a viable resolution, there is a risk of litigation initiated by potential applicants/existing promoters who are likely to be disqualified under the new regime. It also remains to be seen if this is value accretive for lenders whose interest should be central to the CIRP and its credibility.

While the changes with respect to the eligibility criteria seeks to address concerns regarding credibility of the process by putting the onus of diligence on RPs, to what extent will a RPs be able to confirm local and overseas compliances of the applicants? Will mere undertakings provided by each resolution applicant suffice for reliance? These are some of the issues which will require clarification in case of ongoing CIRPs and cases which will headed to insolvency in future. As the CIRP process matures, one may see the emergence of specialist distressed M&A investors and vulture funds with a keen eye for attractive assets at deep discounts.

The content of this document do not necessarily reflect the views/position of Khaitan & Co but remain solely those of the author(s). For any further queries or follow up please contact Khaitan & Co at legalalerts@khaitanco.com

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