On paper, India has a strong, coherent legal system, with a framework derived from the British. Every member of the Commonwealth, more or less, has a similar legal system. This gives overseas investors comfort when it comes to dipping their toes into the Indian economy.
But problems arise in practice when there is any contractual dispute or any attempt to enforce the code. That is because the justice system is very, very slow. Cases can be held up forever even when the creditor has a watertight case. This is one reason why bad debts have piled up.
India’s new Insolvency and Bankruptcy Code, which became law in 2016, plugs this gap by setting strict time limits for the resolution of debt defaults. Once a case is accepted by the National Company Law Tribunal under the new code, an Insolvency Resolution Professional is appointed and this liquidator puts together a plan for resolution within a maximum of 270 days for corporate defaults. The law gives banks the right to take over the ownership of a defaulting company and sell it to recover their dues.
This process gives Indian bankers a lever to coerce defaulters by offering them the choice between paying up, or suffering bankruptcy and the loss of the company. That is a normal situation under most global bankruptcy laws – it is part of the debt contract.
In India, an interesting factor is that operational creditors have started using the Insolvency and Bankruptcy Code. The firm in question owes these creditors some payment arising from a transaction related to the firm’s operations – for instance, the suppliers of goods or services. Reliance Communications is one company that has been targeted in this fashion. However, when suppliers start using a law intended to empower lenders, it could create problems for a profitable company that has a working capital issue. Such cases could also clog up the National Company Law Tribunal since suppliers not paid on time is a much more common problem.
One practical problem with the bankruptcy law is that a fair proportion of Indian non-performing assets are simply unrecoverable. The loans were made to infrastructure projects that did not become operational, or turned unviable for some reason. For example, the portfolio of non-performing assets of Indian banks contains half-built roads, and thermal power plants that have been mothballed because they run on expensive gas. There are no buyers for these assets and the companies in question have no revenues.
Even if operational assets are taken over and sold, a very large proportion of claimed debt may turn out to be unrecoverable. It is normal to see 40% to 50% discounts on claims. In at least one Insolvency and Bankruptcy Code case, the “haircut”, as these discounts are known, amounted to 94% of the claimed value of non-performing assets. What is more, the defaulting promoter bought back the assets. Given such deep discounts, the banks may prefer to attempt a private settlement. This is especially true when the loans are from a consortium of lenders, some of whom are unwilling to accept big haircuts.
A landmark law
Make no mistake, the Insolvency and Bankruptcy Code is a huge step forward. Given the mountain of non-performing assets in the Indian banking system, it is foundational. Impaired assets, which include non-performing assets as well as restructured loans, are now estimated to be at $207 billion and rising – that is close to 10% of India’s gross domestic product. No country can afford to have that much capital clogged up in roads to nowhere.
The Insolvency and Bankruptcy Code will enable the recovery of as much of the outstanding dues as is possible. About $31 billion worth of claimed defaults are up in front of the National Company Law Tribunal in 12 large bankruptcy claims. Even after the lion’s share of big non-performing assets are resolved, the banks will need huge amounts of money to recapitalise.
At least $180 billion of those impaired assets are held by public-sector banks. So far, the government has committed only to $32 billion worth of recapitalisation to these banks. That is about one-sixth of the impaired assets. The plan involves an extremely convoluted process and assumes at least Rs 58,000 crores (about $8.9 billion) will come in from the market. If there are massive haircuts, more capital will be required to maintain capital adequacy norms.
A recent amendment by an ordinance tweaks the law in a controversial fashion. It bars any promoter that has run up defaults for a year or longer from bidding to repurchase their own assets that are being auctioned. An earlier format of the amendment only proposed to debar wilful defaulters – that is, entities that had refused to service their debts despite possessing the ability to do so. This nuance allowed non-wilful defaulters off the hook and gave them a chance to raise funding and buy back their firms.
The new and harsher concept sounds good at first sight: punish anybody who has defaulted and thus send out a message that acts as a deterrent to prevent future defaults. Presumably this is the signal that the political establishment wants to send out to the voter.
However, life is rarely this simple. First, assume that a bankruptcy has occurred in a running, or at the least viable, business and there are productive assets to be sold off. The assets would be auctioned to the highest bidder. This would have to be a strategic sale. Only people knowledgeable about that specific sector and prepared to tackle the challenge of running a bankrupt firm will be interested.
There are very few entities capable of operating at large scales in any given sector. If we force the defaulting promoters out of the auction, the bids will be lower for sure. Then, the creditors take larger haircuts and in turn, the shareholders absorb larger losses. Recapitalisation then requires more funding and that is coming out of taxpayers’ pockets since the government is the majority shareholder in most of the affected banks.
There may have been other more reasonable ways to signal that the government was prepared to crack down on non-performing assets. Above all, no deterrent will work unless public sector banks are allowed to do due diligence and disburse loans on sound commercial lines.
This amendment would affect the 12 cases referred to above in terms of competitive bidding. Let us see how big the haircuts turn out to be. We also need to see if the deterrent actually works. That will only be perceptible in the future, when we can assess defaults on loans made after the ordinance.