How bankruptcy code will save lenders

A key design focus in the proposed code is speed of resolution. Delay is disincentivized at various stages 

Creditors to Kingfisher Airlines (KFA) suffered a setback when there were no bids above the reserve price they had set for the Kingfisher House auction. This only reflects the failures of the bankruptcy process and banking regulation in India, which yield low recoveries with huge delays. How will the proposed bankruptcy reforms in the Insolvency and Bankruptcy Code (IBC) help improve the situation?
Robust banking regulation and a sound bankruptcy process share a common goal: to recognize bad news and act quickly. This is not the driving principle in the current Indian bankruptcy regime. Take KFA as an example. In March 2009, it had a debt of Rs.5,600 crore along with a negative net worth. Even by 2013, lenders had taken no credible or coordinated action. Instead, the 2013 annual report records higher debt at more than Rs.10,000 crore, with banks having additional loans of Rs.2,000 crore.
The failure of the Kingfisher House auction is then perhaps about the angst of banks. The auction failed because the bid price set by the lenders was higher than the market price by at least three times. What might explain this? Perhaps the assets are being carried on the books of banks at inflated values, and banks are not keen on revealing the bad news and recognizing a large loss.
This is a failure of banking regulation, which needs reforms. The moment there are failures to repay, banking regulation must incentivize banks to rapidly recognize losses up front. This ensures that the valuation of banks, as seen in the public domain, is always conservative. Any recovery that takes place in the future is pure upside. Technically, robust regulation needs to be backed up by technically sound supervision, where the Reserve Bank of India inspects the books of banks, and block banks when they try to cover up.
A key design focus in the proposed IBC is speed of resolution. Delay is disincentivized at various stages in the process. Let us start at the first date of default. The Insolvency Resolution Process (IRP) can be triggered by any creditor— not just banks alone—on the date of the first default. This is unlike mechanisms in SARFAESI (the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest) Act, 2002, where banks can wait for 90 days before designating a default account as non-performing asset, and have to wait for 30 days before taking action. The IBC empowers even operational creditors including employees and trader creditors to trigger the process. The earliest publicly observed default by KFA was on employees’ salaries. Under IBC, default to employees can be used to trigger resolution. The possibility of this will help keep banks honest.
When IRP is triggered, the firm is protected as a going concern. No secured creditor can take away assets. However, at that point, the creditors’ committee and the resolution professional (RP) could choose to replace the management. This could perhaps have happened with Kingfisher Airlines in 2008 or 2009.
It is likely that at that time the airline had value as a going concern under a new management team. This would have dramatically reduced losses to the lenders. In the proposed IBC, while banks may favour wrong resolution owing to bad banking regulation and public sector ownership, three factors would push in favour of rationality: (a) the fees of the RP would be proportional to effective resolution, (b) the presence of non-bank lenders such as bond-holders in the committee, and (c) the transparency of the process.
Thus, if the creditors’ committee cannot agree on a plan to keep the company as a going concern, it would automatically go into liquidation. The RP would rarely make a mistake through which the auction fails, because his/her earnings are proportional to the value of recovery.
Lastly, suppose public sector banks have flawed incentives owing to weak regulation and political pressures. Suppose they dominate the creditors’ committee with over 75% of the debt, and decide to undertake an extend-and-pretend plan, under the proposed IBC, smaller creditors would get a seat on the table in the meeting of the creditors’ committee and get to protest vociferously. This would be recorded officially. Some of this would be visible in the press. If the firm is unviable, it is likely to default a few months later. In the next IRP, it would be harder for the public sector banks to operationalize another extend-and-pretend plan.
In summary, if we imagine how Kingfisher Airlines would have worked under the proposed IBC, it is likely that the outcomes would have been better, even if there is no progress on banking reform or public sector bank privatization. The bankruptcy reform, in and of itself, is beneficial. At the same time, it is a complex reform that will require a strong team to oversee the implementation, which includes perfecting the draft law, and setting up working groups or task forces to build the institutional infrastructure to enforce the law. Moreover, it is one of the critical pillars of a mature market economy.
The proposed IBC stands alongside other critical pillars, such as the Companies Act, contract law, contract enforcement through a well-functioning judiciary, macroeconomic stability and sound financial regulation through the Indian Financial Code. Each will strengthen the other to facilitate the development of the debt market that has been long sought in India.