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The Viewpoint – Rethinking Insolvency In Times of Financial Crisis

The Viewpoint – Rethinking Insolvency In Times of Financial Crisis

Bar & Bench

Bar & Bench brings to you the second article on ‘The Viewpoint’ series with its knowledge Partner Luthra & Luthra. Partner Piyush Mishra and Associate Siddharth Srivastava discuss the need of an effective insolvency regime and the state of the current insolvency laws .

Need of an effective insolvency regime

As the experience in the current financial crisis demonstrates, corporate failures, irrespective of the level of maturity of corporate governance practices, are inevitable in a complex global economy. Today more than any other time in the past decade, it is essential that appropriate system of checks and balances are in place to detect and remedy failures at a sufficiently early stage and in case failures are inevitable to minimize their impact. The current financial crisis is but a result of regulatory and market lapses including corporate governance lapses.[i] Therefore, a mature legal system has to rely on both strong corporate governance as well as an efficient insolvency regime.

An effective insolvency and recovery framework serves twin objective:

  • it minimizes transaction and opportunity costs and helps maximize the value of distressed assets. Many companies in the US have used Chapter XI process to recast their operations and emerged out of it in a financially more viable position. In the Indian context, Essar debt restructuring is a good example of use of CDR mechanism; and
  • it inspires confidence in investors and stimulate the growth of secondary market in debt. The AMC market and trading in NPAs evolved in South East Asia post the East Asian crisis. KAMCO (Korea) and Taiwan embarked on a bulk sale of NPAs creating new market opportunities. In India, the AMC market is still at a nascent stage but it is poised for growth.[ii]

 Indian insolvency laws: where we stand

The East Asian crisis helped in evolving consensus for reforms in Indian insolvency laws. A number of committees[iii] established a strong case for insolvency reforms culminating in various reforms including Companies Second Amendment Act, 2002  and Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (the Securtisation Act or SARFAESI).

The current framework of insolvency/liquidation in India may be broadly categorized into the formal mechanism under the Companies Act, 1956 (court led reorganization, winding up etc.), Sick Industrial Companies Act, 1985 (SICA), Recoveries of Debts due to Banks and Financial Institutions Act, 1993 (DRT), the Securitisation Act, the State Financial Corporations Act, 1951 (and other sectoral laws and guidelines) and informal mechanism in the form of Corporate Debt Restructuring (CDR). The Companies Second Amendment Act, 2002  provided for establishment of National Companies Law Tribunal and consolidation of insolvency related laws into the Companies Act. Further, SICA was proposed to be repealed by Sick Industrial Companies (Special Provisions) Repeal Act, 2003. However, both the legislations are yet to be notified on account of litigation. The Union Cabinet has approved of the Companies Amendment Bill, 2011 and it has already been tabled in the parliament in the on going winter session though it appears unlikely that the same will be passed in the current state of log jam.

The efficiency of our insolvency regime on various efficiency indicators shows that the performance needs significant improvement. India ranks 128 out of 183 economies on ease of resolving insolvency. Resolving insolvency takes about 7 years on an average in India and costs 9% of the debtor’s estate while the average recovery is 20.1 cents/dollar. While the performance of India has improved over the years on that score (in 2004 the time was 10 years and recovery rate 12.1cents/dollar) but a comparison with the countries ranked in top ten on the index shows that we have a long way to go. The average time taken in these countries[iv] is typically less than one year. Further, it costs only about 1% of the estate in Singapore and Norway; each while it costs about 4% of the estate in six out of ten countries. The recovery is between 86.9 cents-92.7 cents/dollar.[v] Clearly in practice the various reforms have failed to deliver.

A Critique: The dichotomy between theory and practice

We have developed a good model of informal workout arrangement in the form of CDR mechanism based on the ‘London Approach’[vi] and BIFR was also entrusted with the task of restructuring of enterprises. Further, Securitisation Act has addressed the long felt need for non-judicial enforcement procedures. However, in practice the working of these mechanisms have given rise to a range of issues. But before we analyse these issues we need to understand our position with respect to non-performing assets (NPAs).

According to RBI, total NPAs of all scheduled commercial banks stood at Rs 89,017 crores in the year 2011. Though gross NPA (GNPA) to gross advance ratio was 2.25% in 2010-2011, it has been steadily rising from 1.81% in March, 2008 and there was an increase in the quantum in absolute terms. However, a concern remains that the restructured accounts can fall back in the NPA category in which case the figure could be as high as 5.01%. A look at performance of various modes of recovery might be helpful to put the issues in context.


ModeCases referredAmount* Recovery/



*Rs in crores.

N.B.: The data for DRT and SARFAESI pertains to financial year 2010- 2011 while in relation to CDRs it represents the status as on September 30, 2011.

Source: Report on Trend and Progress of Banking in India 2010-2011, RBI; Progress report (as on September 30, 2011), CDR Cell.

Though DRT and BIFR were in existence for quite sometime but the procedural delays led to an alarming position with respect to NPAs (the GNPAs at the end of March 1997 were 15.7%). The reasons for failure to arrest the growth of NPAs were multiple. Till 2002, BIFR had only been able to rehabilitate about 9% of the total cases registered by it.[vii] For quite sometime BIFR worked only at 50% of its strength of members.[viii] BIFR was increasingly viewed as a safe haven for defaulting promoters/managers since it allowed a stay on the proceeding and took a long time- typically 3 to 4 years to prepare and sanction a scheme.[ix] In the wake of the East Asian Crisis a need was felt to revamp the insolvency regime. The Securitisation Act, Companies Second Amendment Act, 2002 and the CDR mechanism were a product of this era. However, over a period of time the efficacy of these has been questioned.

A look at the FactSheet above brings out certain interesting facts. The DRT as well as SARFAESI mechanism have not been particularly efficient in terms of recovery (27.89% and 37.78% respectively; In the year 2009-2010 it was 32% and 30% respectively). Further, the average amount involved per proceeding is as low as Rs 25,79,525 for SARFAESI. On the other hand, CDR has been quite efficient mode of restructuring (around 75% of the debt has been restructured).

The CDR mechanism has been weakened by non- participation of various lenders. Many Indian (DCB, IFCI, Kotak Mahindra) and foreign lenders (e.g. Barclays, HSBC) have chosen not to participate in the scheme. In case of Vintners, even after approval of plan for more than 2 years, a little progress has been made in the revival of the company or recovery of dues by banks. Similarly, the case of Wockhardt and Vishal Retail shows the inherent tensions and limitations of CDR mechanism. Critiques argue that the CDR mechanism favours the secured lenders with majority participation to the detriment of secured lenders with small commitments and unsecured lenders. It is these lenders that take a disproportionate hit as opposed to the promoters. Further, quite a few restructuring exercises have been in the nature of cosmetic changes like debt rescheduling as opposed to any serious attempt at restructuring.[x] While cosmetic changes create a temporary feel good factor it will, in the long run only contribute to deferring and aggravating the problem. In certain cases write offs and liquidation may be a necessity.[xi]

Most foreign lenders and certain domestic lenders (such as SREI), in the absence of notification, do not have the benefit of the remedies under Securitisation Act and DRT Act. This has given rise to tricky inter-creditor issues in the domestic as well as cross border financing. Domestic notified lenders end up having better enforcement remedies over foreign lenders (even those having a superior charge). This gives rise to inequality of bargaining power during any restructuring process and has a fundamental impact of unsettling the agreed commercial position at the time of the original transaction.

The way forward

The performance of insolvency procedures has greatly improved over the past decade. There is much to be said in favour of these systems. The CDR system has by and large worked well. Though certain creditors (such as unsecured creditors) might not get the best deal but that really is a failure of the market forces to arrive at the optimal solution rather than a flaw of the system itself. Pre-packs (rapid sale before formal initiation of restructuring) have evolved in UK outside the legislative/regulatory procedure. Till such time as capacity deficiencies remain there will always be a dichotomy between law and its implementation yielding inequitable and sub-optimal results. There is an urgent need to engage in capacity building both at institutional and market level through involvement of professional insolvency practitioners, deploying sophisticated work out/rehabilitation remedies and providing more specialized/experienced personnel, regulators and judges.

Any legal system that seeks to effectively address the issues of NPAs needs to have a strong recovery, rehabilitation and liquidation procedure. Since liquidation obviates the need to take bold and sometimes unpopular decisions, typically liquidation procedures are more readily relied upon at the cost of the public money.[xii] Indian insolvency regime is no exception and is more titled towards liquidation/recovery rather than maximizing value through restructuring where possible. BIFR and CDR are the only rehabilitation mechanisms available and the former has clearly not been very successful. Insolvency procedures have to be viewed as part of an integral harmonious system tasked with the delicate exercise of balancing competing interests and making a rational timely choice between restructuring and liquidation. It follows as a logical corollary that the system has to permit conversion between remedies and exploit the inter-linkages between different procedures. The Indian insolvency framework is not flexible enough to accommodate such conversion of remedies or exploitation of interlinkages.

Further, the current system still adopts a one size fits all approach. A mature system should differentiate not only between secured and unsecured lenders but also between the various class of defaulters depending on the size and nature of default. The world has already recognized the limitation of applying normal corporate insolvency procedures to systemically important financial institutions and in general to lenders itself.

The thresholds laid down for invocation of Securitisation Act (Rs. 1 lakh) and DRT Act (Rs. 10 lakhs or such lower amount as prescribed by the Central Government subject to a minimum of Rs. 1 lakh) may be reconsidered. In the context of NPAs of magnitude of Rs. 89,017 crores and taking into account the cost of proceedings this amount seems unreasonably low. The ready invocation of Securitsation Act (see FactSheet above) also gives rise to concerns about its misuse in the context of small enterprises and retail customers. Though RBI has come up with Fair Practices Code defining lenders’ liability to the borrowers in respect of loans and advances extended by them but the need of a strong lenders’ liability law is still felt. Similarly, the as yet un-notified Companies Second Amendment Act, 2002 (and now the Companies Amendment Bill (2011)) proposes to raise the threshold for a company being deemed unable to pay its debts to creditor for an amount in excess of Rs. 500 to Rs. 1 lakh. However, this threshold is still low and may not work in the changed economic reality.

Defaults of lesser amount should be subject to a separate mechanism where the rights of individual and small scale borrowers are balanced well against the rights of lenders. This distinction to a limited extent has been recognized in the CDR system. Such a change might help in reducing the pendency of cases and help in expeditious recovery of comparatively higher amounts within the existing framework.

Piyush Mishra (pictured left), is a Partner at Luthra & Luthra Law Offices and Siddharth Srivastava (pictured right) is an Associate at Luthra & Luthra Law Offices. The authors would like to acknowledge the research assistance provided by Anjaneya Das, Student, IV year, NALSAR, University of Law, Hyderabad and Azal Khan, Student, IV year, National Law University, Jodhpur.

[i] See for example, US Financial Crisis Inquiry Commission Report (2011) and FSA Report on RBS (December 12, 2011).

[ii] In India by end June 2011 the book value of assets acquired by Securitization Companies and Reconstruction Companies was Rs. 74,088 crores, the security receipts issued was Rs. 15,859 crores and SRs redeemed were Rs. 6,704 crores. RBI issued certificate of registration to fourteen Securitisation Companies and Reconstruction Companies as at end June 2011.

[iii] Justice Eradi Committee, Andyarujina Committee, Advisory Group in Bankruptcy Laws (Chairman: N.L. Mitra), JJ Irani Committee Report and Standing Committee on Finance 2009-2010.

[iv] Japan, Singapore, Canada, Norway, Finland, UK, Netherland, Belgium, Denmark and Ireland.

[v] Doing Business (2012), The World Bank and IFC; Doing Business (2012)- Economy profile: India, The World Bank and IFC.

[vi] The non-binding guidelines issued by the Bank of England in 1990 for interim financing of debtors in financial difficulty. Many work out arrangements in Asia (for example Jakarta initiative) are based on the London Approach. The US Chapter XI rules represent an alternate model and certain jurisdictions have followed it in Asia e.g. Brink 4 in Thailand.

[vii] Sumant Batra, Proposals for Reform the Indian Position, OECD Second Forum for Asian insolvency Reform (2002); Reference may also be made to Justice V. B. Eradi Committee Report (2001).

[viii] Developing the Asian Markets for Non-Performing Assets: Developments in India, Sumant Batra, OECD Third Forum for Asian insolvency Reform (2003).

[ix] Insolvency Laws in South Asia: Recent Trends and Development, Sumant Batra,  OECD Fifth Forum for Asian insolvency Reform (2006).

[x] NPAs Emerging Challenges , S. Khasnobis, Developing the Asian Markets for Non-Performing Assets, Ashwani Puri, OECD Third Forum for Asian Insolvency Reform (2003).

[xi] For example, write off of 10% of the previous years outstanding GNPAs as well as restructuring of advances pursuant to guidelines on restructuring of advances by banks issued by the RBI have helped in limiting the growth of gross non-performing loans. Similarly in Pakistan under 2002 directive large write offs were enabled, though the measure was criticized.

[xii] IMF, Orderly and Effective Insolvency Procedures- Key Issues, 1999.