Businesses cheered moratorium on bankruptcy proceedings – but it may actually hurt them

As a part of its response to the economic turmoil caused by the Covid-19 pandemic, the government of India on June 5 promulgated an ordinance suspending the operative provisions of the Insolvency and Bankruptcy Code for a period of at least six months, from March 25. This move received widespread praise from businesses, which were already reeling under considerable economic stress.

While the Insolvency and Bankruptcy Code was envisioned as a mechanism to help restructure struggling businesses, in practice, it has proven to be a popular and powerful tool not just for restructuring, but also for recovering debt. With civil suits taking anywhere upto 10 years to conclude, suppliers and contractors have managed to use the threat of insolvency proceedings to recover their dues.

Reports suggest that nearly Rs 70,000 crore worth of debt was recovered in 2018-’19, up from about Rs 5,000 crore in 2017-’18. This number was expected to be around Rs 100,000 crore in 2019-’20.

If the Insolvency and Bankruptcy Code was allowed to continue even after the pandemic, banks and suppliers would have rushed to the National Company Law Tribunals seeking to recover their dues. This would only have worsened the financial pressure on businesses.

Overbroad amendment

However, the ordinance suspending the bankruptcy code may not be the panacea Indian business hopes it will be. Already, its constitutionality has been challenged before the Madras High Court. The Code was suspended by introducing Section 10A into it. But a close reading of the section shows that insolvency proceedings with respect to debts falling due for a period of six months after March 25 have been suspended for “ever”. This period of six months can be extended up to a year by the government.

In effect, this means that an invoice raised on January 26, 2020, with a credit period of 60 days, cannot be the basis of insolvency proceedings, even if the crisis is resolved and the business environment improves. The same is the case for a bank loan extended on August 31 , 2019, with its first installment payable after one year.

The government’s stated aim was to provide respite from “Covid-related” debts, and foster a climate where businesses need not worry about potential insolvency proceedings for debts they could not repay on account of the disruption caused by the lockdown. However, such benefits could have been easily achieved by a temporary suspension of Insolvency and Bankruptcy Code proceedings. In fact, countries such as Singapore have adopted such an approach.

In practice, the government has ended up providing a carte blanche to businesses to avoid paying their debts, so long as they incidentally fell due during the lockdown. It is difficult to see the rationale for this policy. Not every debt that falls due after March 25, 2020, resulted in a default because of the pandemic. It could well be that a business was already struggling to meet its obligations before the pandemic even began.

In any case, there is no reason why even a “Covid-related” debt should not be recovered after the economic situation has stabilised.

After-effects on struggling banks

The after-effects of the ordinance will be felt most keenly by India’s struggling banks. The India Ratings and Research agency estimates that non-performing assets that might be generated on account of the lockdown from the top 500 debt-heavy private sector companies to be as high as Rs 67,000 crore. This is a 6.63% addition to NPAs, taking the aggregate NPAs in India to a staggering 18%-20% of outstanding loans.

To make matters worse, the Indian economy is expected to shrink by as much as 5%, which may dent the appetite for fresh borrowing. All of this is bound to compound the strain on Indian banks. Further, none of the alternatives remedies available to a bank (such as approaching the Debt Recovery Tribunal or initiative proceedings under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act) can match the Insolvency and Bankruptcy Code in terms of efficacy. This is because no other remedy allows for a “resolution plan”, that is, the option to sell the business to prospective bidders as a going concern and repay the creditors.

Conventional remedies depend on attaching the assets and funds the business has available, over which multiple creditors will compete.

In the last three or four years, the Code has demonstrated that attempting to restructure or resell the business itself is more effective than attempting to realise value from individual assets. Even those who criticise the Code agree that it has vastly improved the recovery rates that conventional remedies offered, from about 25% to approximately 43%, in less than half the time, according to the Insolvency and Bankruptcy Board of India.

The comparable number for the Debt Recovery Tribunals was 3.5% and Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act proceedings 14.5%. It is difficult to justify an embargo on a bank using this regime, to restructure a business that cannot find its feet even after the economic situation has stabilised.

Suppliers could be hurt

Apart from banks, the move is also likely to hurt the very businesses it sought to protect: in the absence of the Code, suppliers will struggle to recover dues, and generate cash flow. They will now be forced to resort to more cumbersome and expensive alternate remedies available under the law, such as summary suits. A summary suit is usually decided only on the documents placed before the court and oral arguments. There is no oral evidence led and no cross-examination of witnesses.

However, in practice, summary suits are simply not as efficacious in terms of timelines and simplicity of proof. The threshold for a debtor to avoid a summary procedure is fairly low. She need only show that she has a probable defence or the prospect of success. If she does, the matter will then proceed to trial, which in India takes several years to complete. Moreover, if the creditor does not manage to secure the assets of the debtor at an interim stage, the business may even dispose of its assets.

The preference for the Insolvency and Bankruptcy Code among suppliers is borne out by the numbers as well. In the three years since its enactment, nearly 48% of the claims before the National Company Law Tribunal were brought by operational creditors.

In the long run, the ordinance suspending the Code may actually hurt suppliers and banks, creating a risk to the health of India’s economy. A constitutional challenge to it may actually carry some muster.

Dhruva Gandhi and Vinodini Srinivasan are advocates at the Bombay High Court. They are graduates of the National Law School of India University, Bangalore.