IBC: Should We Worry About Collusive Insolvencies?

In a recent order, the National Company Law Appellate Tribunal upheld an order of the NCLT dismissing an insolvency petition under the Insolvency and Bankruptcy Code on the ground of suspected collusion between the creditor and the debtor. This order presents a strange outcome. The tribunal, the creditor who filed the insolvency petition, and the debtor agree that the debtor defaulted to the petitioning financial creditor. The tribunal finds that there was no procedural defect with the petition as well. However, on a review of the debtor’s past financial net worth, the tribunal disbelieved the debtor that it was unable to repay its debt to the petitioning creditor. The order and the underlying reasoning are problematic. The order is inconsistent with the letter and spirit of the Code and opens the floodgates for subjective judicial discretion for admitting insolvency cases..Hytone-Satabadi Case: NCLAT Smells Collusion, Sets Aside Insolvency Application.To begin with, there is a widespread perception that strategically triggering bankruptcy can help debtors avoid paying their debt. The key intuition here is that once a bankruptcy is triggered, a statutory moratorium will save the debtor from honoring its obligations to its creditors, and compel the creditors to come to the negotiating table and restructure or write off their debt. Evidence, on the other hand, suggests that deliberately triggering bankruptcy may not necessarily help the debtor ‘game’ the system by using it as a creditor avoidance mechanism. Indeed, it may even lead to the debtor getting liquidated. This is because once a bankruptcy process begins, it is unpredictable and many things in the life-cycle of a bankruptcy case are not within the debtor’s control..Incentives In The Design Of The IBC.In the Indian context, a corporate debtor’s incentives to collude with a creditor to deliberately trigger a bankruptcy are very low. This is primarily because the Indian law does not provide for a debtor-in-possession model. Under the Insolvency and Bankruptcy Code, 2016, once a bankruptcy petition is admitted by the NCLT, the board of directors of the corporate debtor is suspended, and the affairs of the company are run by an insolvency professional appointed by the creditors. This feature of the law, by itself, will strongly disincentivise debtors from using bankruptcy as a route for creditor avoidance in India..Second, the IBC allows the debtor to trigger insolvency on its own motion. Given this entitlement, it is unclear why a debtor might feel the need to collude with a creditor to trigger the IBC..There are two other features in the design of the IBC that work to disincentivise ‘collusive’ bankruptcy filings. First, once the insolvency petition is admitted by the NCLT, the resolution process is a collective action process where all the financial creditors (not just the ‘colluding’ creditor) participate in the decision-making of the corporate debtor. Questions such as who the insolvency professional will be, whether the debtor should raise interim finance, the manner in which the corporate debtor must be put up for sale, whether the corporate debtor ought to be retained as a going concern or liquidated – all critical to value maximisation – are decided by a majority vote of the creditors..The second check is that the IBC allows the creditors to withdraw an insolvency petition, by a super-majority vote, if they do not find it in their interest to continue the corporate debtor in a resolution process. This implies that a collusive insolvency petition that does not work for all the creditors will likely be withdrawn..None of these features of the law have been designed to act as a check against collusive insolvencies. Nevertheless, they significantly lower the probability of a collusive bankruptcy meaningfully leading to creditor avoidance..One might argue that a bankruptcy may be collusively triggered by the debtor to avoid the claims of operational creditors who do not have a seat in the creditors’ committee. While this is theoretically true, it might not, in reality, suit financial creditors. This is because a large financial creditor, such as a bank, is required by law to downgrade the classification of a loan under insolvency, and provide for the debt in its books. This implies a hit on its profitability, which in turn, dilutes any motivation to collude with the debtor simply for avoiding the operational creditors’ claims. Given that contract enforcement in India can be particularly tardy and costly, the reality is that operational creditors would find it difficult to enforce their claims with or without the debtor firm being in bankruptcy..IBC's Aim Is Reorganisation, Not Recovery, Says Bankruptcy Regulator.Implications Of the NCLAT Order.The order of the NCLT and the NCLAT order upholding it, have widespread implications for the role of the judiciary in the resolution process..As has repeatedly been said of the IBC, a critical element is to minimise judicial intervention in resolving the financial distress of firms. For this reason, the IBC has carved out a specific and limited role for the judiciary, namely, that of oversight of due process in creditors’ committee meetings, acceptance and rejection of claims by the resolution professional, replacement of the resolution professional and the approval of resolution plans voted upon by the creditors’ committee. Toward this end, the Supreme Court, in one of the very first IBC cases before itself – Innoventive Industries Ltd. v. ICICI Bank – interpreted the provisions of the IBC strictly to exclude the possibility of any discretion in allowing insolvency petitions. To quote the court on this:.“The moment the adjudicating authority is satisfied that a default has occurred, the Application must be admitted unless it is incomplete, in which case it may give notice to the applicant to rectify the defect within 7 days of receipt of a notice from the adjudicating authority…”.In this case, the debtor contended that while it had indeed defaulted on its debt to the petitioning creditor, the debt had been waived by a state law. The Supreme Court held that the existence of debt and the fact of default were ascertained, and it was not open to the tribunal to reject the insolvency petition on the ground of the state law. A review of the debtor’s financial net worth, as is done by the NCLT in the instant case, seems even more far-fetched a ground for dismissing an insolvency petition..More importantly, if the NCLAT's order is used as a precedent, debtors will merely have to demonstrate previous good financial net worth, to deprive the creditors of their right to trigger the IBC on the basis of a debt default..This cannot be good for debtors either. While a debtor may possess good financial networth (assets minus liabilities), it may still not have adequate liquid cash flows to honour a debt repayment. For example, the value of my house contributes towards my net worth. However, a drop in my monthly salary may impact my ability to repay my EMI to the bank for that month. This is the difference between networth and cash flows. The noble aim of enabling creditors to identify and restructure financial distress in firms at an early stage, will be defeated if the NCLT were to judge firms’ eligibility for bankruptcy on the basis of their ‘good financial net worth’..This opens the floodgates for the exercise of discretion by the NCLT at the stage of admission of insolvency cases. Even worse, it implicitly obligates judges to review the debtor’s balance sheets, something that they are neither equipped nor trained to do. This cannot be a good thing..Bhargavi Zaveri is a researcher at xKDR Forum and an incoming doctoral candidate at NUS Law..The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team..The Surprising Exit Of Sintex BAPL From IBC

IBC: Should We Worry About Collusive Insolvencies?

A corporate debtor’s incentives to collude with a creditor to deliberately trigger bankruptcy are very low, writes Bhargavi Zaveri

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IBC: Should We Worry About Collusive Insolvencies?

A corporate debtor’s incentives to collude with a creditor to deliberately trigger bankruptcy are very low, writes Bhargavi Zaveri

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