Resolution of NPA and Insolvency and Bankruptcy Code, 2016

Introduction:

The financial services sector has been revolving under the pressure of mounting bad assets,
including failed restructuring attempts, and the situation seems far from over. The proposed
Bill on bankruptcy, consolidating the existing scattered laws relating to insolvency of
companies, is a noteworthy move by the government for accelerating the winding up
process for defaulting companies and providing a quicker exit route for lenders.

This bankruptcy code seems to have been inspired by the quick, equitable and efficient
approach of resolution processes established under chapter 7 and 11 of the US bankruptcy
code. Similar to chapter 11, the bankruptcy code provides for a resolution process where, in
essence, it allows companies to continue doing business while going through bankruptcy
proceedings. Nevertheless, the draft bankruptcy code differs also, with regard to some
aspects such as management control. While under chapter 11, proceedings remains with
the company, on the other hand under the bankruptcy code, the management control
passes over to ‘insolvency resolution professionals’.

The Code seems to be coming in at the right time with the banking regulator announcing a
March 2017 deadline for the banks to clean up their balance-sheets and take measures for
improving the quality of banks’ portfolios. According to the recent Financial Stability and
Development Council (FSDC) report, the Reserve Bank of India (RBI) has clearly indicated
that corporate sector vulnerabilities and the impact of their weak balance sheets on the
financial system need closer monitoring.

In the current regime, initiating recovery procedures was not only challenging but also time-
consuming for lenders/bankers. This led to a situation where, in some cases, non-
performing assets (NPAs) were not being accounted for in the books, and in some cases
companies were still provided additional ad hoc funding or extension of limits.

The Code will act as a catalyst in improving the NPA woes of banks. There are a number of
key areas where the impact can be felt.

(1) The fixation of the 180-day time limit (extension of further 90 days in exception
cases) for insolvency resolution shall help lenders take decisions about the viability
of the business. Else, the liquidation process would be initiated. It also provides for a
resolution process where, in essence, it allows companies to continue to do business
while going through bankruptcy proceedings. This would help banks in salvaging the
recovery value to a great extent.
(2) Decisions such as economic viability of the debtor company will be determined
through negotiations with the creditors. This exercise will be facilitated by
‘insolvency professionals’ and not courts, thereby adding more credibility to the
overall process.
 (3) Early identification of financial distress and voluntary initiation of the insolvency
process would further assist in easing out businesses that may have failed because of
genuine reasons and desire to refrain from further losses.

Currently, there are more than 40 Acts and circulars pertaining (indirectly and directly) to
insolvency and bankruptcy, and it is yet to been seen how all these are treated. Some laws
would be required to be repealed and subsumed in the final bankruptcy code and for some
respective amendments would be required.

Additionally, there are various routes that the parties to an insolvency transaction may take,
such as proceedings under:

(a) Debt recovery tribunal for recovery of debts;

(b) Winding-up petition in the High Court;
(c) Enforcement action under the Securitisation and Reconstruction of Financial Assets
and Enforcement of Security Interest Act, 2000 (SARFAESI);
(d) Corporate Debt Restructuring (CDR), Joint Lender Forum (JLF) or Strategic Debt
Restructuring (SDR) mechanism proposed by RBI.

However, the success of the Code would largely depend on how effectively it is
implemented, and if it is implemented in the exact shape and form it has been proposed—
especially the structure of DRAT, NCLAT and setting up of an ‘insolvency regulator’ with
requisite powers. In fact, according to RBI, “an early clearance of the Insolvency and
Bankruptcy Code will play an important role in the face of mounting potential losses.”

An important aspect to consider and assess is the intent of the promoter/borrower at the
time of initiating the insolvency process. While the time taken in the insolvency process
would considerably reduce, the real recovery value to be derived would depend on
existence and veracity of the underlying assets (whether stock, book debts, fixed assets or
assets in other forms).

It would be imperative for banks to undertake thorough due diligence of the defaulting
companies, including background checks of promoters, to gauge the genuineness of the
state of affairs and act accordingly, especially in case of wilful defaulters. With the existing
uncertainty in the environment and large corporate groups under the scanner for fraud or
diversion of funds, it would be worthwhile to include ‘forensic’ related skills for ‘insolvency
professionals’ to identify early warning signals.

INSOLVENCY AND BANKRUPTCY CODE, 2016:

The Insolvency and Bankruptcy Code, 2016 notified by the Government of India reflects a
clear intent to resolve and restructure bad debts in a time bound manner and plug
loopholes available to borrowers who have defaulted on their payments. The Code is being
understood as the new Bankruptcy Law of India which seeks to combine the existing
framework by creating a single law for insolvency and bankruptcy. Two separate tribunals
are recommended - the National Company Law Tribunal (NCLT) for Companies and Limited
Liability Partnership for firms, and the Debt Recovery Tribunal for individuals and
Partnership.

The Code intends to initiate an Insolvency Resolution Process (IRP) for a period of 180 days
when a default takes place. The Insolvency Resolution Process (IRP) is over seen by an
Insolvency Professional who has to ensure that no asset stripping has taken place from the
company by checking transactions for last two years. The law also enshrines a 'calm period'
where in the Creditors Committee is expected to analyse the records of the company, hear
rival proposals and make up its mind on the issue. A Revival Plan is binding on all creditors
and stake holders if 75% of Creditors Committee agrees to it. On the other hand, if 75% of
the Creditors Committee decide that the complexity of the case requires more time for
resolution, a onetime extension of 90 days is possible with the approval of the Adjudicating
Authority. Whereas, if in 180 days no Revival Plan achieves support of 75% of creditors, the
firm goes into liquidation.

These measures are expected to develop a robust secondary market for distressed debt in
India. Debt restructuring would lead to more productive allocation of capital and increase
the credit availability in the country. The World Bank Doing Business Report, 2017 states
that a higher time for resolution is associated with a lower recovery rate. As already
mentioned, the average time taken in India to resolve insolvency cases is 4.3 years and the
recovery rate is 26 cents to a dollar. Therefore, a lower rate for resolution inbuilt in the code
would minimize destruction in value of assets and result in a higher recovery rate leading to
greater availability of credit in the economy.

Initiatives to deal with Stressed Assets:

Indian Parliament has amended the Securitization and Reconstruction of Financial Assets
and Enforcement of Security Interests Act, 2002 (SARFAESI Act) and the Recovery of Debts
Due to Banks and Financial Institutions Act, 1993 (DRT Act) in 2016. These amendments aim
to create an enabling infrastructure to affectively deal with stressed assets. It also confers
more powers to the Reserve Bank of India (RBI) to regulate Asset Reconstruction Companies
(ARCs). It has given RBI powers to audit and inspect ARCs and freedom to remove the
chairman or any director and appoint central bank officials to the board. RBI will be
empowered to impose a penalty for non-compliance with its directives, besides regulating
the fees charged by these companies to banks at the time of acquiring such assets. RBI
regulates these entities but the Code widens the regulator's powers. It also increases the
penalty amount that can be levied by RBI to Rs.1 crore from Rs.5 lakh. The Code widens the
scope of the central registry that will house the central database of all loans against
properties given by all lenders. The aim is to create a database which will disclose all
encumbrances on property across all lenders.
The Code also pave the way for a sponsor of an ARC to hold up to a 100% stake in the ARC. It
will enable non-institutional investors to invest in security receipts issued by ARCs and lays
down a timeline for possession of secured assets. Secured creditors will be able to take over
a company and restore its business on acquisition of controlling interest in the borrower
company.

Almost 70,000 cases are pending in DRTs, as per data available with the government. The
Code proposes to speed up the process of recovery, besides moving towards online DRTs by
electronic filing of recovery applications, documents and written statements. DRTs will be
the core of the bankruptcy code and will deal with all insolvency proceedings involving
individuals. The debtor will have to deposit 50% of the amount of debt due before filing an
appeal in front of a DRT.

The public sector banks have a very important role to play in supporting a large number of
social programmes and extending the reach of banking and supporting infrastructure in the
country. Mission Indradhanush had allocated Rs. 70,000 crores for recapitalization of Public
Sector Banks in order to meet the global capital adequacy norms such as Basel III and to
ensure credit growth in 2015. For resolution of stressed assets, RBI has introduced a number
of tools such as Corporate Debt Restructuring (CDR), Strategic Debt Restructuring Scheme
(SDR) and Scheme for Sustainable Structuring of Stressed Assets (S4A).

The economic boom & concurrent borrowings during 2003 to 2008 has left Indian banks
with huge amount of bad loans leading to depletion of profits, and lowering banking capital.
S4A is aimed to lessen the burden of stressed loans. RBI has laid down eligibility norms for
troubled companies with conditions that the project must be operating and generating cash;
total loans must be Rs. 500 crore or more and at least 50% of loans should be sustainable
(i.e. serviced by current cash flows) and an independent agency must be hired by banks to
evaluate sustainability of the debt. Unlike the Strategic Debt Restructuring, S4A allows
incumbent management to continue, if it is not a case of wilful default. Banks however are
urging RBI to soften qualifying norms for S4A Scheme. S4A Scheme insistence that at least
50% of the loan of a defaulter should be sustainable to qualify for restructuring has not
helped as many companies do not have sufficient cash flows to service half their loans.

RBI has allowed banks to take equity in debt laden firms permitting them to split total loans
of struggling companies into sustainable and unsustainable based on the cash flows of the
projects. Banks were allowed to continue loans that had current or future cash flows as
sustainable or Part A, while the remaining unsustainable debt could be converted into
equity or a convertible security.

Concerns regarding the Insolvency Bankruptcy Code

On 13th June 2017, the RBI directed banks to refer 12 troubled companies with a combined
debt of Rs 2.5 trillion to the NCLT. So far, the creditors have moved the Tribunal against Jyoti
Structures, Monet Ispat Ltd., Electrosteel Steels Ltd, Essar Steel ltd and Amtek Auto Ltd.
Essar Steels has challenged the RBI's alleged "arbitrariness" in selecting the 12 stressed
accounts for initiating insolvency proceedings under the new bankruptcy law citing that
other stressed borrowers were given 6 months to arrive at a resolution with their lenders &
that the cut-off date of March 31, 2016 was arbitrary, as it did not take into account
subsequent improvements in the companies' performance.

So far, there have been 67 cases filed since the IBC came into effect in December 2016. First
insolvency was filed by ICICI Bank against Innoventive Industries of Rs 100 crore on January
17, 2017.

On the up side, the Insolvency Bankruptcy Code has created a new institutional architecture
to deal with insolvency. It proposes the establishment of a new regulator, the creation of a
new profession of insolvency professionals and the establishment of institutions known as
information utilities that are designed to provide accurate information on defaults. It is
being seen as a step in the right direction for ease of doing business by providing a time
bound process for restructuring of stressed assets and easy exits of distressed debtors while
aiming to free capital and provide funds to creditors for further lending in the economy.

Code has differentiated liquidation and Insolvency process between Corporate Debtors
(which shall be dealt by the NCLT) and Individuals and firms liquidation process (which shall
be of the jurisdiction of DRT), the Corporate Debtors default should be at least INR 100,000
(USD 1495) (which limit may be increased up to INR 10,000,000 (USD 149,500) by the
Government).

(1) For the Corporate Debtors the Code proposes two independent stages:
(a) Insolvency Resolution Process: wherein the financial creditors assess the debtor’s
business and evaluate whether the business can be subjected to revival procedure
and evaluate options for its rescue and revival.
The Code does not elaborate on the types of revival plans that may be adopted,
which may include fresh finance, sale of assets, haircuts, change of management etc.
(b) Liquidation: if the insolvency resolution process fails or financial creditors decide to
wind down and distribute the assets of the debtor.
(2) Insolvency Resolution Process for Individuals/Unlimited Partnerships:
For individuals and unlimited partnerships, the Code applies in all cases where the
minimum default amount is INR 1000 (USD 15) and above (the Government may later
revise the minimum amount of default to a higher threshold). The Code envisages two
distinct processes in case of insolvencies: (i) automatic fresh start and (ii) insolvency
resolution.
Under the automatic fresh start process, eligible debtors (basis gross income) can apply
to the Debt Recovery Tribunal (DRT) for discharge from certain debts not exceeding a
specified threshold, allowing them to start afresh.
The insolvency resolution process consists of preparation of a repayment plan by the
debtor, for approval of creditors. If approved, the DRT passes an order binding the debtor
and creditors to the repayment plan. If the plan is rejected or fails, the debtor or creditors
may apply for a bankruptcy order.

SECURITIZATION AND RECONSTRUCTION OF FINANCIAL ASSETS AND ENFORCEMENT OF

SECURITY INTEREST ACT, 2002

SARFAESI Act: An act to regulate securitization and reconstruction of financial assets and
enforcement of security interest and to provide for a central database of security interests
created on property rights and for matters connected therewith or incidental thereto.

Under SARFAESI Act, secured creditors which include Banks and Financial institution can
refer the Non-Performing Asset (“NPA”) to any Asset Reconstruction Company, established
with the Reserve Bank of India under section 3 for the purposes of the Asset Reconstruction
or Securitization or both.

The provisions of this Act are applicable only for NPA loans with outstanding above Rs.
1,00,000/- (Rupees One Lakh). NPA loan accounts where the amount is less than 20% of the
principal and interest are not eligible to be dealt with under this Act.

NPA should be backed by Securities charged to the bank by way of hypothecation or charge
or assignment.

The SARFAESI Act provides for the manner for enforcement of security interests by a
secured creditor without the intervention of a court or tribunal. If any borrower fails to
discharge his liability in repayment of any secured debt within 60 days from the date of
notice by the secured creditor, the secured creditor is conferred with powers under the
SARFAESI Act to:

i) take possession of the secured assets of the borrower, including transfer by way of
lease, assignment or sale, for realizing the secured assets;
ii) takeover of the management of the business of the borrower including the right to
transfer by way of lease, assignment or sale for realizing the secured assets;
iii) appoint any person to manage the secured assets possession of which is taken by
the secured creditor, and
iv) require any person, who has acquired any of the secured assets from the borrower
and from whom money is due to the borrower, to pay the secured creditor so much
of the money as if sufficient to pay the secured debt.

The Central Government has prescribed Security Interest (Enforcement) Rules, 2002
pursuant to the powers conferred on it under the SARFAESI Act. The foregoing enforcement
measures must be exercised by a secured creditor in accordance with the Enforcement
Rules and are further subject to guidelines issued by the RBI.
The SARFAESI Act deals with Securitization, Asset reconstruction, Enforcement of security
without intervention of the court.

The Measures for Asset reconstruction have been amended and the same to that effect can
be found in Section 9 of the ACT.

The rules pertaining to Security Enforcement, Debt Recovery Tribunal (Procedure) Rules,
1993, The Debt Recovery Appellate Tribunal (Procedure) Rules, 1994 have been amended to
that effect To DRT (Procedure) Rules, 2016 and DRT Appellate Tribunal (Procedure) Rules,
2016, respectively.

CONCLUSION:

Banks which are considered as one of the creditors in both the cases can approach NCLT for
the Corporate Debtors or the DRT in case of Individuals/Firms opting for the Liquidation and
Bankruptcy wherein the Insolvency Professional shall be appointed to evaluate the financial
position and weigh the options available for if possible any recovery or rescue of the Debtor.

The Code pertains to a debt not satisfied, thus, in such cases an Insolvency Resolution
Process (IRP) can be initiated by any of the creditors to the company, not necessarily being a
Bank or Financial Institution. The Code thereby guarantees fair process wherein the options
pertaining to liquidation or otherwise, as in if the creditors’ committee cannot agree on a
plan to keep the company as a going concern, it would automatically go into liquidation. The
Resolution Professional (RP) would rarely make a mistake through which the auction fails,
because his/her earnings are proportional to the value of recovery.

Where as in the case of the SARFAESI Act, the liquidation and insolvency are not the prima
facie options rather a certain Asset reconstruction Firm would take up the financial assets
from the Bank or the financial institution and try to reconstruct that particular NPA to revive
and make it a performing Asset. The whole procedure is to be regulated by the RBI.

The SARFAESI Act allows secured creditors to take possession over collateral against which a
loan had been provided upon a default in repayment. This process is undertaken with
assistance of the District Magistrate, and does not require the intervention of courts or
tribunals and it is prescribed by bill that this process has to be completed in 30 days.

The Magistrate is empowered by the bill to assist the banks in taking over the management
of the company, in case the company is unable to repay the loans. This will be done in case
the banks convert their outstanding debt into equity shares and consequently hold a stake
of 5% of the company.

This Act helps the Banks and Financial Institutions who are the secured creditors to enforce
securities held as collaterals to loans disbursed by them, if such loans turn to be Non-
Performing Assets. The SARFAESI act as mentioned is applicable to the NPA which involves a
wilful defaulter. SARFAESI Amendment Act prescribes time limit for the proceedings.