NPA Clean-up Off to a Poor Start
Indian banks, particularly the public sector banks (PSBs) including SBI and its associates, have been victims of very high non-performing assets (NPAs) and other distressed assets camouflaged as restructured assets. The malaise has been compounded by the extremely slow legal process for recovery. PSBs’ gross NPAs and restructured assets stood at dangerous 18.5% of total loan outstanding as on 31 March 2017 (see graph on the next page). The asset quality is deteriorating rapidly, as is evident from worsening of  asset quality indicator (AQI) of the Reserve Bank of India (RBI), from 0.68 in March 2016 to 0.90 in March 2017. This calls for drastic measures to avert a banking crisis. Towards this end, the seven-point 
 
Indra-dhanush framework for revamping PSBs was announced in 2015. However, after adoption of the easier part, the framework has been forgotten and NPA resolution under the Indian Bankruptcy Code, 2016 (IBC) is being treated as a panacea. 
 
Robust Legislation
Under IBC, the process to fix financial distress has to be mandatorily completed in a maximum of 270 days after admission of an application by National Company Law Tribunal (NCLT) for insolvency resolution, failing which, the corporate debtor has to be necessarily liquidated. The creditors can practically decide to liquidate the company in less than two months of admission of the insolvency application. In other words, certainty and speed of resolution through restructuring or liquidation is the hallmark of IBC, unlike previous credit recovery legislations. 
 
 
While the financial creditors can file for insolvency resolution under Section 7 of the IBC, the operational creditors and the corporate borrowers can file under Section 9 and 10, respectively. Upon admission of the application, the borrowing company’s board of directors is suspended and the control passes on to the insolvency resolution professional who must execute the mandate in terms of IBC and under the guidance and supervision of the committee of creditors (COC). The resolution professional, initially, joins as interim resolution professional (IRP) for 30 days and, thereafter, may continue as regular resolution professional (RP) or be replaced by the COC. While the COC drives the decisions about the restructuring or liquidation, the adjudicator’s role is limited to compliances with the provisions of IBC and dealing with questions of law. 
 
Hence, this legislation will not degenerate like Sick Industrial Companies Act (SICA), The Recovery of Debts Due to Banks and Financial Institutions Act (RDDBFI) and The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI) each of which had created endless delays.
 
IBC: Restructuring / Liquidation
Under IBC, the IRP/RP in control of the company’s operations must protect and preserve the value of the property of the corporate debtor and manage its operations as a going concern while he presents two major deliverables for insolvency resolution. The first deliverable is the information memorandum (IM) under Section 29 of the IBC and Clause 36 of Corporate Insolvency Resolution Process (CIRP) regulations. The IM is expected to carry complete details of the financial position, operations, shareholding pattern, company’s guarantee obligations, litigations and other relevant information. 
 
The second deliverable is the resolution plan (RPlan), which the RP must catalyse through transparent bids for submission of RPlans under Section 30 of IBC by the resolution applicants (RAs). Efficient due diligence by RAs can be facilitated by comprehensive and credible IM which must go beyond the mandatory requirements in terms of IBC and CIRP, and make time and data available to the bidding RAs for efficient due diligence. If the RP does an efficient job, the process can lead to rigorous bidding and acquisition of the corporate entity by an RA, and maximised recovery for the lenders. In spite of catalysing significant interest of the RAs, if an acceptable RPlan does not emerge, COC can liquidate the assets, with RP acting as liquidator. Since the RP works under COC’s supervision, the liquidation process is also speedy. As IBC in India focuses on competitive bidding, Section 30 auctions can also catalyse acquisitions from operating buyers and financial investors. Since auctions of NPAs under 15:85 structures to asset reconstruction companies (ARCs) have tapered down, it is expected that, for survival and growth, ARCs would be in fray with competitive RPlans to take over the distressed assets. 
 
The major challenges in IBC process are: how the IRP/RP can ensure that the operating unit continues with normal operations, understand the business and catalyse an optimum RPlan. Acquisition entails rigorous due diligence and bottom-up analysis by the bidders. To make the auctions within statutorily limited period of 180-270 days under IBC successful, the RP must display the skill and speed comparable with that of an investment bank. The skill requirement increases exponentially with the size of the corporate creditor. Limitations of RP can result in adoption of the process for its sake and acceptance of sub-optimal RPlan. The process is likely to see significant change, based on experience.
 
Banks’ Response to IBC
As the IBC process is time-bound and under COC’s control, banks were expected to adopt IBC enthusiastically. However, the banks’ response to IBC has been muted. 
 
So far, seven benches of NCLTs have disposed of 22 applications (Section-7: 13, Section-9: 8 and Section-10: 1) for an amount of Rs14,423.60 crore, 97.5% of which is accounted for by two financial institutions which were not banks. RBI’s guidelines for 100% provisioning on IBC-driven accounts in two years causes disincentive for banks for the adoption of IBC for new NPAs. However, there is no such disincentive for NPAs that are two or more years old. Yet, banks do not seem to have adopted IBC enthusiastically due to low liquidation values expected under the IBC process and the resultant provisioning for the entire asset shortfall, aside from possible accountability issues. No wonder, an ordinance amending Banking Regulation Act, 1949 was passed in May 2017 authorising RBI to issue directions to banks for the speedy resolution of distressed assets or adoption of IBC. 
 
Simultaneously, RBI’s circular of 5 May  2017 laid strong emphasis on banks adopting restructuring under the existing RBI schemes within the prescribed timelines, or face penalty. 
 
IBC Restructuring: A Double-edged Sword?
Will such moves work? Resolution of distressed account entails trimming liabilities to a serviceable level so that operations remain financially viable. The critical parameter which separates restructuring from liquidation is the difference between the restructured loan amount over the estimated liquidation value of the assets, and the sacrifice that the lenders are willing to make. The extent of lenders’ acceptable sacrifice in restructuring has been left to the empowered group of banks for corporate debt restructuring (CDR) and corrective action plan (CAP) structures under joint lenders forum and other structures introduced by RBI periodically since 2002 when CDR was introduced.
 
But CDR/CAP have largely failed. This was due to the inability of promoters to meet restructuring parameters. The recent schemes, viz., strategic debt restructuring (SDR), introduced in June 2015, and scheme for sustainable structuring of stressed assets (S4A), introduced in June 2016, have also failed, since the distressed companies did not have sustainable debt of even 50% prescribed in the schemes. This establishes recoverability of less than 50% of the loan. IBC is free from such parameters and can even provide for waiver of past and future government dues in terms of clause 
 
37(1)(j) of CIRP regulations. This flexibility and accent on competitive RPlans has the potential to catalyse optimum price discovery and give to the lenders the maximum possible recovery, notwithstanding significant write-offs. The key, however, lies in transparent and competitive bidding by multiple RAs. Restricted and opaque bidding can induce the corporate borrower’s moral hazard and result in heightened losses to the lenders.  
 
Will the sale under IBC improve recoveries from NPA significantly beyond the current 10.3% (see graph)? It is a matter of months before the figure emerges with the resolution of 12 large accounts, with total debt of Rs2.50 lakh crore (25% of gross NPAs), put under IBC. If the solitary NCLT RPlan of Synergies Dooray Automotive Limited approved by NCLT in August 2017 is a precursor to NPA recovery levels from IBC process, it is worrisome for the banking sector. Let’s see the astounding features of Synergies RPLan.
 
Synergies Dooray made an application to NCLT Hyderabad under Section 10 of the IBC. RPlans under Sction 30 of IBC were submitted by the three RAs The COC composition as formed by the RP and accepted by NCLT was as follows:
 
 
The COC rejected the RPlans of the first two RAs and accepted that of SCL, a promoter group company. The RPlan involved payment of a small fraction of the debt outstanding.
 
In effect, the RPlan delivered to secured lenders just 4.8% of the debt outstanding. As a precedent, this is very damaging to banks. EARC contested the classification of MFL as a financial creditor and abstained from voting at the COC meeting which accepted the RPlan with 90.16% vote. EARC argued that the loans from five banks bought over by SCL were assigned to MFL through three assignment deeds. Since SCL was a related party, the debt assigned by it to MFL could not be treated as financial credit (this was not akin to assignment of receivables in normal course of business). Besides, even the assignment deeds were not executed as per the law, since the assignee (which had a paltry paid-up capital of Rs65.94 lakh as on 31 March 2016) had not paid consideration for the assignments. NCLT rejected EARC’s appeal on 2 August 2017. EARC has appealed. Interestingly, the RPlan allowed netting of MFL’s unpaid assignment value of Rs37.91 crore against interest-free instalments for three years after a one-year moratorium. Let’s look at what this means.
 
 
A buyer of non-performing loan expects a significant return from such risk-proven assets and would price them at the present value of anticipated cash flow discounted at the required rate of return. Assuming a modest required return of 20%pa, the present value (PV) of the above-mentioned cash flow to MFL works out to just Rs24.98 crore, only 66% of the assignment value of Rs37.91 crore. In other words, MFL accepted an RPlan with huge loss within months of executing assignment deeds. However, this loss is notional, since the receipts by MFL were to be fully netted with his payables in terms of the RPlan. So, the debt assignment to MFL reflected zero, or negative, consideration, having regard to the transaction costs.
 
Following EARC’s objections, the RPlan has been reportedly modified and requires MFL to pay the debt assignment value first and recover later in terms of RPlan. In such a case, based on discount rate of 20%pa, the PV of receivables works out to around Rs29 crore reflecting a loss of Rs8.92 crore to MFL within months of the transaction. It is inconceivable that a finance company will settle for such losses without a murmur sans a sweetheart deal to compensate for such accommodation through a carefully structured invisible deal. 
 
IBC is of help to genuine as well as crooked corporate debtors. Where there is a likelihood of a significant asset shortfall, banks have no incentive to adopt IBC. In such cases, for a promoter whose account has turned non-performing due to factors beyond his control, IBC provides a vehicle for speedy discharge. IBC permits avoidance of undervalued or extortionate credit transactions up to two years preceding the insolvency commencement date. A crooked promoter, who has done such transactions earlier than two years, can adopt IBC for a speedy exit or continued control with substantial haircut by banks.
 
The role of RP is, therefore, crucial for maximising value for the banks from the distressed assets. The Synergies matter, as and when disposed of, would set a precedent for the transparency and quality of transactions, and conduct of intermediaries and COC, etc. A look at some of the advertisements inviting RPlans shows opacity in the process to thwart competition. This would mean banks living with the same promoters or their proxies with maximum haircut or head-cut! If that is the case, a robust legislation like IBC will be undermined.
 
 
India has the dubious distinction of being the slowest in credit recovery as is evident from World Bank study (See graph Average Recovery Time). This has resulted from extremely tardy process in SICA (Sick Industrial Companies Act) /BIFR (Board for Industrial and Financial Reconstruction) since repealed, and RDDBFI and SARFAESI Acts. With creditor-driven IBC, India is expected to substantially improve the recovery duration. While this will minimise asset impairment and enhance recovery, it cannot improve the inherent asset quality, since low NPA recovery of PSBs is primarily due to asset overstatement which has often come to light in the past. 
 
It is unlikely that the Synergies recovery figure would prove to be an outlier. My sense is that IBC will speed up and may improve the recovery significantly, it will not resolve the NPA problem which has resulted from PSBs’ management and organizational inadequacies Assuming an optimistic recovery of 22% (FY12-13) from NPAs and restructured assets of Rs11.50 lakh crore as on 31 March 2016, the government will have to recapitalise PSBs by Rs8.97 lakh crore in short to medium  term due to growing NPAs, notwithstanding provisionings. How will the epoch-making IBC reduce this? To save banks from the coming crisis, it is necessary for the government to go beyond IBC urgently, even as it tries to plug attempts to game it. To begin with, the government should immediately implement PJ Nayak committee’s recommendations by professionalising PSB top management and boards, apart from reducing the government stake below 50%, and removing compensation and operational constraints. Subsequently, PSBs must be privatised. Right now, the policy-makers and investors are complacent that the IBC will speedily shrink the mountain of NPAs and also prevent a growth of bad loans. This may be misplaced optimism with dangerous consequences.
 
Bankruptcy Resolution: Global Experience
In the paper, titled “Cashing Out: The Rise of M&A in Bankruptcy”, Stuart Gilson, Edith Hotchkiss, and Matthew Osborn studied a large sample of 350 filings for Chapter-11 bankruptcy protection in USA during 2002-2011, significant acquisitions under bankruptcy auctions (table-1).
 
Overall, 52.6% of the companies sold some or all the assets for cash, indicating significant role of mergers & acquisitions (M&A) in Chapter-11 process. The auctions  involved multiple biddings. The secured creditors catalysed the asset sale and use of M&A, particularly for the going concerns in many cases. Secured creditor recoveries often exceed 50% in USA.
 
Under the UK bankruptcy code, 50% of the distressed companies were sold as going concerns and over 40% liquidated piecemeal. The liquidation process gets concluded in about 1½ years and delivers, to the lenders, recovery of about 75%, with recovery cost of about 15%, of the asset value. Overall, 75% of the distressed assets undergo bankruptcy and the rest are restructured, reflecting the lenders’ preference for restructuring viable businesses. India’s situation was among the worst.

(Mr Gantra is a registered insolvency resolution professional, restructuring consultant and visiting faculty for MBA)

Comments
Sandeep Kotwal
4 years ago
There is hardly any attempt to understand the root cause and the process to eliminate it. It's only financial jugglery being put to use. There might be some process issues in the business operations flow, project management issues, people issues ....
Unless all these are factored appropriately, the problems might continue for ever....
Mukund Rajamannar
Replied to Sandeep Kotwal comment 4 years ago
Well said. For some reason, the law makers pretend to be completely oblivious of this fact.
Sridhar Rao
4 years ago
As always the smart borrower/defaulter will try to game the system and it is to be seen how the law holds up.
Rajendra Ganatra
4 years ago
Superb!
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